ITEM 1. BUSINESS
Overview
We were organized as a Minnesota limited liability company on April 12, 2001 under the name “Generation II, LLC.” In June 2004, we changed our name to Heron Lake BioEnergy, LLC.
We operate a dry mill, coal fired ethanol plant in Heron Lake, Minnesota. Our subsidiary, Lakefield Farmers Elevator, LLC, has grain facilities at Lakefield and Wilder, Minnesota. At nameplate, our ethanol plant has the capacity to process approximately 18.0 million bushels of corn each year, producing approximately 50 million gallons per year of fuel-grade ethanol and approximately 160,000 tons of distillers’ grains with soluble (“DGS”).. On September 21, 2007, we began operations at ethanol plant. Fiscal year 2007 was the first fiscal year that includes any revenue generated from our operations. In our fiscal years 2010 and 2009 which ended October 31, 2010 and 2009, we sold approximately 53.4 and 46.5 million gallons of ethanol, respectively.
The following table sets forth a summary of significant milestones in our company’s history until we began operations at our plant.
Production
Since the beginning of operations at our ethanol plant, our primary business is the production and sale of ethanol and co-products, including dried distillers’ grains. We currently do not have or anticipate we will have any other lines of business or other significant sources of revenue other than the sale of ethanol and ethanol co-products.
Our Ethanol Plant
Our ethanol plant was designed and built by Fagen Inc. under a September 2005 design-build agreement who used certain proprietary property and information of ICM, Inc. in the design and construction of our ethanol plant.
Our ethanol plant uses a dry milling process to produce fuel-grade ethanol and distillers’ grains. The dry milling process involves grinding the entire corn kernel into flour and the starch is converted to ethanol through fermentation that also produces carbon dioxide and distillers’ grains.
The ethanol plant consists principally of a coal handling, storage and combustion area; storage and processing areas for corn; a fermentation area comprised mainly of fermentation tanks; a distillation finished product storage area; and a drying unit for processing the dried distillers’ grains. Additionally, the ethanol plant contains receiving facilities that have the ability to receive corn by rail and truck, store it for use in the plant and prepare the corn to be used in the plant. We have storage tanks on site to store the ethanol we produce. The plant also contains a storage building and silos to hold distillers’ grains until it is shipped to market.
The Union Pacific Railroad is the railroad adjacent to our ethanol plant. The ethanol plant has the facilities necessary to receive corn by truck and rail, coal by truck, and to load ethanol and distillers grains onto trucks and rail cars.
Our ethanol plant requires significant and uninterrupted amounts of electricity, coal and water. We have entered into agreements for our supply of electricity, coal and water.
Currently, fly-ash generated from the coal burned by our plant is hauled to a landfill. If it qualifies to predefined industry standards, fly-ash can be used as an admixture for cement mixes instead of being hauled to landfills. We are continuing to explore revenue-generating alternatives from fly-ash rather than incurring expense associated with shipping the fly-ash to landfills.
We are required to comply with various requirements of state and federal law regulating the operations at our plant, including regulations relating to air emissions. On July 2, 2010, we entered into a mutual release and settlement agreement with Fagen, Inc. and ICM, Inc. relating to the arbitration commenced by us in September 2009 in which we asserted claims against Fagen based on the design-build agreement for our ethanol plant and the plant’s air emissions. Please review the section entitled “Compliance with Environmental Laws and Other Regulatory Matters” for a description of how compliance with regulatory requirements, including requirements relating to air emissions, has impacted our business.
Our Principal Products
The principal products that we produce are fuel grade ethanol and distillers’ grains. Raw carbon dioxide is also a product of the ethanol production process, but we do not capture or market any carbon dioxide gas.
Ethanol
Ethanol is a type of alcohol produced in the U.S. principally from corn. Ethanol is primarily used in the U.S. gasoline fuel market as:
· an octane enhancer in fuels;
· an oxygenated fuel additive that can reduce ozone and carbon monoxide vehicle emissions;
· a gasoline substitute generally known as E85, a fuel blend composed of 85% ethanol; and
· as a renewable fuel to displace consumption of imported oil.
Ethanol used as an octane enhancer or fuel additive is blended with unleaded gasoline and other fuel products. The principal purchasers of ethanol are generally wholesale gasoline distributors or blenders.
Distillers’ Grains
The principal co-product of the ethanol production process is distillers’ grains, a high protein and high-energy animal feed ingredient.
Dry mill ethanol processing creates three primary forms of distillers’ grains: wet distillers’ grains, modified wet distillers’ grains, and dried distillers’ grains with solubles. Wet distillers’ grains are processed corn mash that contains a substantial amount of moisture. It has a shelf life of approximately three days and is primarily sold to feeders of beef animals within the immediate vicinity of the ethanol plant. Modified wet distillers’ grains are similar to wet distillers’ grains except that it has been partially dried and contains less moisture. Modified wet distillers’ grains has a shelf life of a maximum of fourteen days, contains less water to transport, is more easily adaptable to some feeding systems, and is sold to both local and regional markets, primarily for both beef and dairy animals. Dried distillers’ grains with solubles are corn mash that has been dried to approximately 10% moisture. It has an almost indefinite shelf life and may be sold and shipped to any market and to almost all types of livestock. Most of the distillers’ grains that we sell are in the form of dried distillers’ grains.
Procurement and Marketing Agreements
Corn Procurement
The primary raw material used in the production of ethanol at our plant is corn. We need to procure approximately 18 million bushels of corn per year for our dry mill ethanol process. We generally do not have long-term, fixed price contracts for the purchase of corn and our members are not obligated to deliver corn to us. Typically, we purchase our corn directly from grain elevators, farmers, and local dealers within approximately 80 miles of Heron Lake, Minnesota.
We generally purchase corn through cash fixed-price contracts and may utilize hedging positions in the corn futures market for a portion of our corn requirements to manage the risk of excessive corn price fluctuations. Our fixed-price forward contracts specify the amount of corn, the price and the time period over which the corn is to be delivered. These forward contracts are at fixed prices or prices based on the Chicago Board of Trade (CBOT) prices. Our corn requirements can be forward contracted on either a fixed-price basis or futures only contracts. The parameters of these contracts are based on the local supply and demand situation and the seasonality of the price. We also purchase a portion of our corn on a spot basis.
The price and availability of corn is subject to significant fluctuation depending upon a number of factors that affect commodity prices generally. These include, among others, crop conditions, crop production, weather, government programs, and export demands.
Coal Procurement
We have constructed a coal receiving, handling and storage facility next to the ethanol plant. Due to air permitting, a Wyoming/Montana-sourced coal must be used. As a result, in June 2007, we entered into a master coal supply agreement with Northern Coal Transportation Company (NCTC) to provide Powder River Basin (PRB) coal for the plant. The master coal supply agreement expires upon 60 days notice by either party. We are obligated to purchase coal and NCTC is obligated to sell coal identified in a confirmation that sets forth the quantity, price, term, mine and other relevant terms. Under a letter confirmation dated July 2007, we agreed to purchase a minimum number of tons in each contract year which runs from June 1 to May 31 through the five year period ending May 31, 2012. The letter confirmation also sets the price per ton for each contract year. Also, in June 2007, we entered into a coal transloading agreement with Southern Minnesota Beet Sugar Cooperative (SMBSC). SMBSC also uses coal of the same type as our ethanol plant to fuel its beet sugar plant. In order to achieve
transportation efficiencies, we and SMBSC entered into the coal transloading agreement so that both of our coal orders could be delivered to a single facility (the transloading facility) owned by SMBSC. The coal is transferred from the transloading facility to each of our respective plants and we pay SMBSC a per ton charge handling fee for the use of the transloading facility.
Ethanol Marketing
Effective September 30, 2009, we entered into an ethanol marketing agreement with C&N Ethanol Marketing Corporation (“C&N”). Under this agreement, C&N will purchase, market and re-sell all of the ethanol produced at our plant for the three year term of the agreement. Following the three year term, the agreement will automatically renew for subsequent year terms unless either party terminates the agreement 60 days before the end of the term. C&N will provide us with a remittance by Wednesday of each week for shipments of ethanol in the previous week and we will receive payment against that remittance on the following Wednesday. C&N will pay us the gross sales price to the customer less expenses and a 1% marketing fee after expenses. The agreement also contains provisions addressing other matters, including forecasting, the quality of product, transfer of title and auditing of records.
Effective September 30, 2009, we terminated the ethanol marketing agreement that was in effect during our fiscal years 2009, 2008 and 2007. That prior agreement was an Ethanol Fuel Marketing Agreement with RPMG, Inc. dated August 7, 2006. Under the ethanol marketing agreement with RPMG, Inc., our ethanol was pooled with the ethanol of other ethanol producers whose ethanol was marketed by RPMG. We paid RPMG a marketing fee and RPMG paid us a netback price per gallon that was based upon the difference between the pooled average delivered ethanol selling price and the pooled average distribution expense.
Distillers’ Grains Marketing
In addition to ethanol, our plant produces wet, modified wet and dried distillers’ grains.
In October 2005, we entered a marketing agreement with Commodity Specialists Corporation for the sale to Commodity Specialists Corporation of all distillers’ grains produced by our ethanol plant. The term of the agreement is for a one-year period from the date of start-up of our operations, and thereafter, the agreement will remain in effect unless terminated by either party upon 90 days’ written notice. Under the terms of the agreement, we receive a price equal to the selling price, less a charge of 2% or 4% of the price for distillers’ grains and a fee of $2.00 per ton of solubles, less the cost of delivering the product to the customer. In August 2007, as part of CHS Inc.’s acquisition of Commodity Specialist Corporation, our agreement with Commodity Specialist Corporation was assigned to CHS Inc. with our consent.
Pricing of Corn and Ethanol
The sale of ethanol represented approximately 82% of our revenue for the year ended October 31, 2010. The cost of corn represented approximately 68% of our cost of sales for the year ended October 31, 2010. We expect that ethanol sales will represent our primary revenue source and corn will represent our primary component of cost of goods sold. Therefore, changes in the price at which we can sell the ethanol we produce and the price at which we buy corn for our ethanol plant present significant operational risks inherent in our business.
Generally, the price at which ethanol can be sold does not track with the price at which corn can be bought. Historically, ethanol prices have tended to correlate with wholesale gasoline prices, with demand for and the price of ethanol increasing as supplies of petroleum decreased or appeared to be threatened, crude oil prices increased and wholesale gasoline prices increased. However, the prices of both ethanol and corn do not always follow historical trends. Trends in ethanol prices and corn prices are subject to a number of factors and are difficult to predict.
Demand for Ethanol
In recent years, the demand for ethanol has increased, particularly in the upper Midwest, in part because of two major programs established by the Clean Air Act Amendments of 1990: the Oxygenated Gasoline Program and the Reformulated Gasoline Program. Under these programs, an additive (oxygenate) is required to be blended with gasoline used in areas with excessive carbon monoxide or ozone pollution to help mitigate these conditions. According to the EPA, reformulated gasoline is currently used in 17 states and the District of Columbia pursuant to the requirements of federal law. Additionally, according to the EPA, there are fifteen states that have their own clean fuel program. Approximately 30% of the gasoline sold in the United States is reformulated. Because of the potential health and environmental issues associated with methyl tertiary butyl ether (MTBE) and the actions of the EPA, ethanol is now used as the primary oxygenate in those areas requiring an oxygenate additive.
In addition to demand for ethanol as an oxygenate, ethanol demand has increased because of the adoption of programs setting national renewable fuels standards (RFS). The first RFS program (RFS1) was introduced through the Energy Policy Act of 2005. RFS1 required 7.5 billion gallons of renewable fuel to be blended into gasoline by 2012. With the passage of the Energy Independence and Security Act of 2007, Congress made several important revisions to the RFS that required the EPA to promulgate new regulations to implement these changes. In February 2010, the EPA establish the revised annual renewable fuel standard (RFS2) and to make the necessary program modifications as set forth in the Energy Independence and Security Act of 2007. Further, for the first time, the EPA set volume standards for specific categories of renewable fuels including cellulosic, biomass-based diesel, and total advanced renewable fuels. In order to qualify for these new volume categories, fuels must demonstrate that they meet certain minimum greenhouse gas reduction standards, based on a lifecycle assessment, in comparison to the petroleum fuels they displace. Our ethanol does not qualify for the new volume categories of renewable fuels and therefore, the total renewable fuel requirement for each year will be most relevant to the demand for, and required use of, ethanol such as ours. Under RFS2, the total renewable fuel requirement will increase from 12.95 billion gallons in 2010 to 36 billion gallons by 2022. Of the 12.95 billion gallons of total renewable fuel required for 2010, 100 million gallons must be from cellulosic biofuels, 650 million gallons biomass-based diesel, and 950 million gallons must be from advanced biofuels, with the remaining 11.25 billion gallons consisting of other renewable fuels. Of the 36 billion gallons of total renewable fuel required for 2022, 16 billion gallons must be from cellulosic biofuels, the requirement for biomass-based diesel will be determined by the EPA but will not be less than 1.0 billion gallons, and 21 billion gallons must be from advanced biofuels, with the remaining gallons consisting of other renewable fuels. The RFS for 2011 is approximately 14 billion gallons, of which corn based ethanol can be used to satisfy approximately 12.6 billion gallons. Current ethanol production capacity exceeds the 2011 RFS requirement which can be satisfied by corn based ethanol. We believe the RFS program creates greater market for renewable fuels, such as ethanol, as a substitute for petroleum-based fuels.
In addition to the RFS program, one important incentive for the ethanol industry and its customers is the Volumetric Ethanol Excise Tax Credit, commonly referred to as the “blender’s credit.” The tax credit is provided to gasoline distributors as an incentive to blend their gasoline with ethanol. For each gallon of gasoline blended with ethanol, the distributors receive a tax credit. For 2008, the tax credit was 51¢ per gallon of pure ethanol or 5.1¢ per gallon of gasoline blended with 10% ethanol. The per gallon credit was reduced to 45¢ per gallon of pure ethanol in 2009. The tax credit is authorized through December 31, 2011 at 45¢ per gallon of pure ethanol.
Markets for Ethanol
There are local, regional, national and international markets for ethanol. Typically, a regional market is one that is outside of the local market, yet within the neighboring states. Some regional markets include large cities that are subject to anti-smog measures in either carbon monoxide or ozone non-attainment areas, or that have implemented oxygenated gasoline programs, such as Chicago, St. Louis, Denver and Minneapolis. We consider our primary regional market to be large cities within a 450-mile radius of our ethanol plant. In the national ethanol market, the highest demand by volume is primarily in the southern United States and the east and west coast regions.
The markets in which our ethanol is sold will depend primarily upon the efforts of C&N, which buys and markets our ethanol. However, we believe that local markets will be limited and must typically be evaluated on a case-by-case basis. Although local markets will be the easiest to service, they may be oversold because of the number of ethanol producers near our plant, which may depress the price of ethanol in those markets.
We transport our ethanol primarily by rail. In addition to rail, we service certain regional markets by truck from time to time. We believe that regional pricing tends to follow national pricing less the freight difference.
We believe that the E10 “blend wall” is one of the most critical governmental policies currently facing the ethanol industry. The “blend wall” issue arises because of several conflicting requirements. First, the renewable fuels standards dictate a continuing increase in the amount of ethanol blended into the national gasoline supply. Second, the EPA mandates a limit of 10% ethanol inclusion in non-flex fuel vehicles, and the E85 vehicle marketplace is struggling to grow due to lacking infrastructure. Total gasoline usage by the U.S. is expected to decrease over the next 5 years as fuel mileage standards are changed. RFS2 dictates an increasing amount of blending of total renewable fuels: 13.95 billion gallons in 2011, 15.2 billion gallons in 2012, and increasing to 36 billion gallons by 2022. To reach the standard as dictated by RFS2 in 2011, assuming 135 billion gallons of total gasoline usage nationally, each gallon of gasoline sold would have to be blended with greater than 10% ethanol. The EPA limit of 10% ethanol inclusion in non-flex fuel vehicles and the RFS increasing blend rate are at odds, which is sometimes referred to as the “blend wall.” While this issues has been considered by the EPA, there have been no regulatory changes that would reconcile the conflicting requirements. This issue is a major risk to the ethanol industry. Recently, the United States Environmental Protection Agency allowed the use of E15, gasoline which is blended at a rate of 15% ethanol and 85% gasoline, in vehicles manufactured in the model year 2007 and later. The EPA was expected to make a ruling on allowing E15 for use in vehicles produced in model year 2001 and later by the end of 2010, however, this decision has been delayed by the EPA. Management believes that many gasoline retailers will refuse to provide E15 due to the fact that not all standard vehicles will be allowed to use E15 and due to the labeling requirements the EPA may impose.
The EPA is considering instituting labeling requirements associated with E15 which may unfairly discourage consumers from purchasing E15. As a result, the approval of E15 may not significantly increase demand for ethanol.
Markets for Distillers’ Grains
We sell distillers’ grains as animal feed for beef and dairy cattle, poultry and hogs. However, the modified wet distillers’ grains typically have a shelf life of a maximum of fourteen days. This provides for a much smaller market and makes the timing of its sale critical. Further, because of its moisture content, the modified wet distillers’ grains are heavier and more difficult to handle. The customer must be close enough to justify the additional handling and shipping costs. As a result, modified wet distillers’ grains are principally sold only to local feedlots and livestock operations.
Various factors affect the price of distillers’ grain, including, among others, the price of corn, soybean meal and other alternative feed products, the performance or value of distillers’ grains in a particular feed market, and the supply and demand within the market. Like other commodities, the price of distillers’ grains can fluctuate significantly.
Competition
Producers of Ethanol
We sell our ethanol in a highly competitive market. We are in direct competition with numerous other ethanol producers, both regionally and nationally, many of which have more experience and greater resources than we have. Some of these producers are, among other things, capable of producing a significantly greater amount of ethanol or have multiple ethanol plants that may help them achieve certain benefits that we could not achieve with one ethanol plant. Further, new products or methods of ethanol production developed by larger and better-financed competitors could provide them competitive advantages over us and harm our business. A majority of the ethanol plants in the U.S. and the greatest number of gallons of ethanol production are located in the corn-producing states, such as Iowa, Nebraska, Illinois, Minnesota, South Dakota, Indiana, Ohio, Kansas, and Wisconsin.
According to the Renewable Fuels Association (RFA), as of January 2011, approximately 204 biorefineries have nameplate capacity of 13.8 million gallons of ethanol per years. Below is the U.S. ethanol production by state in millions of gallons for the ten states with the most total ethanol production as of January 2010:
Source: Renewable Fuels Association, January 2010
Because Minnesota is one of the top producers of ethanol in the U.S., we face increased competition because of the location of our ethanol plant in Minnesota. Additionally, according to the Minnesota Department of Agriculture, the capacity for ethanol production in Minnesota is 1,117 million gallons, while the projected ethanol consumption in Minnesota for 2010 is 239 million gallons. Therefore, we compete with other Minnesota ethanol producers both for markets in Minnesota and markets in other states.
Further, we believe that the competition in the ethanol market will increase in the near term as the ethanol plants recently sold through bankruptcy proceedings return to production. For example, in May 2009, Valero Energy Corporation and its subsidiaries purchased seven idle plants from VeraSun Energy Corporation as part of VeraSun’s reorganization. Several of our competitors including certain subsidiaries of Otter
Tail Ag Enterprises, Pacific Ethanol, Inc. and Aventine Renewable Energy Holdings, Inc. have filed to reorganize under federal bankruptcy laws as a result of margin pressure, inadequate liquidity and other considerations.
Despite the rapid increase in production, consumption of ethanol has been outpacing production for the past few years, which has led to increased imports in the United States, primarily from Brazil. According to the RFA, in 2009, the U.S. produced 10.6 billion gallons of fuel ethanol and imported an estimated 190 million gallons. In addition to intense competition with local, regional and national producers of ethanol, we expect increased competition from imported ethanol and foreign producers of ethanol. Currently, ethanol imported to the U.S. is subjected to a 2.5 percent ad valorem tax and an additional 54 cents a gallon surcharge, which will expire on December 31, 2011. If this tariff were not extended, we will face increased competition from imported ethanol and foreign producers of ethanol.
Producers of Other Fuel Additives and Alternative Fuels
In addition to competing with ethanol producers, we also compete with producers of other gasoline oxygenates. Many gasoline oxygenates are produced by other companies, including oil companies, that have far greater resources than we have. Historically, as a gasoline oxygenate, ethanol primarily competed with two gasoline oxygenates, both of which are ether-based: MTBE (methyl tertiary butyl ether) and ETBE (ethyl tertiary butyl ether). Many states have enacted legislation prohibiting the sale of gasoline containing certain levels of MTBE or are phasing out the use of MTBE because of health and environmental concerns. As a result, national use of MTBE has decreased significantly in recent years. Use of ethanol now exceeds that of MTBE and ETBE as a gasoline oxygenate.
While ethanol has displaced these two gasoline oxygenates, the development of ethers intended for use as oxygenates is continuing and we will compete with producers of any future ethers used as oxygenates.
A number of automotive, industrial and power generation manufacturers are developing alternative fuels and power systems, both for vehicles and other applications. Fuel cells have emerged as a potential alternative power system to certain existing power sources because of their higher efficiency, reduced noise and lower emissions. Fuel cell industry participants are currently targeting the transportation, stationary power and portable power markets in order to decrease fuel costs, lessen dependence on crude oil and reduce harmful emissions.
Additionally, there are more than a dozen alternative and advanced fuels currently in development, production or use, including the following alternative fuels that, like ethanol, have been or are currently commercially available for vehicles:
· biodiesel
· electricity
· hydrogen
· methanol
· natural gas
· propane
Several emerging fuels are currently under development. Many of these fuels are also considered alternative fuels and may have other benefits such as reduced emissions or decreasing dependence upon oil. Examples of emerging fuels include:
· Biobutanol: Like ethanol, biobutanol is an alcohol that can be produced through the processing of domestically grown crops, such as corn and sugar beets, and other biomass, such as fast-growing grasses and agricultural waste products.
· Biogas: Biogas is produced from the anaerobic digestion of organic matter such as animal manure, sewage, and municipal solid waste. After it is processed to required standards of purity, biogas becomes a renewable substitute for natural gas and can be used to fuel natural gas vehicles.
· Fischer-Tropsch Diesel: Diesel made by converting gaseous hydrocarbons, such as natural gas and gasified coal or biomass, into liquid fuel, including transportation fuel
· Hydrogenation-Derived Renewable Diesel (HDRD): The product of fats or vegetable oils-alone or blended with petroleum-that has been refined in an oil refinery
· P-Series: A blend of natural gas liquids (pentanes plus), ethanol, and the biomass-derived co-solvent methyltetrahydrofuran (MeTHF) formulated to be used in flexible fuel vehicles
· Ultra-Low Sulfur Diesel: This is diesel fuel with 15 parts per million or lower sulfur content. This ultra-low sulfur content enables the use of advanced emission control technologies on vehicles using ULSD fuels produced from non-petroleum and renewable sources that are considered alternative fuels.
Additionally, there are developed and developing technologies for converting natural gas, coal and biomass to liquid fuel, including transportation fuels such as gasoline, diesel, and methanol.
We expect that competition will increase between ethanol producers, such as HLBE, and producers of these or other newly developed alternative fuels or power systems, especially to the extent they are used in similar applications such as vehicles.
Producers of Distillers’ Grains
The amount of distillers’ grains produced annually in North America is expected to increase significantly as the number of ethanol plants increase. We compete with other producers of distillers’ grains products both locally and nationally, with more intense competition for sales of distillers’ grains among ethanol producers in close proximity to our ethanol plant. There are seven ethanol plants within an approximate 50 mile radius of our plant with a combined ethanol capacity of 436 million gallons that will produce approximately 1.4 million tons of distillers’ grains. These competitors may be more likely to sell to the same markets that we target for our distillers’ grains.
Additionally, distillers’ grains compete with other feed formulations, including corn gluten feed, dry brewers’ grain and mill feeds. The primary value of these products as animal feed is their protein content. Dry brewers’ grain and distillers’ grains have about the same protein content, and corn gluten feed and mill feeds have slightly lower protein contents. Distillers’ grains contain nutrients, fat content, and fiber that we believe will differentiate our distillers’ grains products from other feed formulations. However, producers of other forms of animal feed may also have greater experience and resources than we do and their products may have greater acceptance among producers of beef and dairy cattle, poultry and hogs.
Competition for Corn
We will compete with ethanol producers in close proximity for the supplies of corn we will require to operate our plant. Ethanol production consumes a significant portion of Minnesota’s corn crop, approximately 29% in 2009 and an expected 34% in 2010. The existence and development of other ethanol plants, particularly those in close proximity to our plant, will increase the demand for corn that may result in higher costs for supplies of corn. We estimate that the seven ethanol plants within an approximate 50 mile radius of our plant will use approximately 160 million bushels of corn and that we will compete with these other ethanol plants for corn for our ethanol plant.
We compete with other users of corn, including ethanol producers regionally and nationally, producers of food and food ingredients for human consumption (such as high fructose corn syrup, starches, and sweeteners), producers of animal feed and industrial users. According to estimates by the Minnesota Department of Agriculture for 2010, 34% of Minnesota corn production will be used in ethanol production, 40% will be exported, 17% will be used for feed, 7% will be put to a residual use, and 2% will be used in other processing.
Competition for Personnel
We will also compete with ethanol producers in close proximity for the personnel we will require to operate our plant. The existence and development of other ethanol plants will increase competition for qualified managers, engineers, operators and other personnel. We also compete for personnel with businesses other than ethanol producers and with businesses located outside the community of Heron Lake, Minnesota.
Hedging
We may hedge anticipated corn purchases and ethanol and distillers’ grain sales through a variety of mechanisms.
We procure corn through spot cash, fixed-price forward, basis only, futures only, and delayed pricing contracts. Additionally, we may use hedging positions in the corn futures and options market to manage the risk of excessive corn price fluctuations for a portion of our corn requirements.
For our spot purchases, we post daily corn bids so that corn producers can sell to us on a spot basis. Our fixed-price forward contracts specify the amount of corn, the price and the time period over which the corn is to be delivered. These forward contracts are at fixed prices indexed to Chicago Board of Trade, or CBOT, prices. Our corn requirements can be contracted in advance under fixed-price forward contracts or options. The parameters of these contracts are based on the local supply and demand situation and the seasonality of the price. For delayed pricing contracts, producers will deliver corn to our elevators, but the pricing for that corn and the related payment will occur at a later date.
To hedge a portion of our exposure to corn price risk, we may buy and sell futures and options positions on the CBOT. In addition, our facilities have significant corn storage capacity. We generally maintain inventories of corn at our ethanol plant, but can draw from our elevators at Lakefield and Wilder to protect against supply disruption. At the ethanol plant, we have the ability to store approximately 10 days of corn supply and our elevators have capacity for approximately an additional 50 days of supply.
We currently market all of our ethanol through C&N. Our marketers are obligated to use reasonable efforts to obtain the best price for our ethanol. To mitigate ethanol price risk and to obtain the best margins on ethanol that is marketed and sold by our marketer, we may utilize ethanol swaps, over-the-counter (“OTC”) ethanol swaps, or OTC ethanol options that are typically settled in cash, rather than gallons of the ethanol we produce.
Our marketing and risk management committee assists the board and our risk management personnel to, among other things, establish appropriate policies and strategies for hedging and enterprise risk.
Compliance with Environmental Laws and Other Regulatory Matters
Our business subjects us to various federal, state and local environmental laws and regulations, including those relating to discharges into the air, water and ground; the generation, storage, handling, use, transportation and disposal of hazardous materials; and the health and safety of our employees.
These laws and regulations require us to obtain and comply with numerous permits to construct and operate our ethanol plant, including water, air and other environmental permits. The costs associated with obtaining these permits and meeting the conditions of these permits have increased our costs of construction and production.
In particular, we have incurred additional costs relating to an air-emission permit from the Minnesota Pollution Control Agency (“MPCA”). We applied for a synthetic minor air-emissions source permit in July 2004 that was granted by the MPCA in May 2005. In June 2005, a coalition of two environmental groups and one energy group challenged the granting of this air emissions permit by an appeal to the Minnesota Court of Appeals. In July 2006, the Minnesota Court of Appeals affirmed the MPCA’s issuance of the permit. In conjunction with the permit and the permit dispute and to prevent further appeals by the coalition, we entered into a compliance agreement with the MPCA on January 23, 2007.
Under the compliance agreement, we agreed to submit an amendment to our air permit to qualify our facility as a “major emissions source.” The compliance agreement also allowed us to continue with the construction of our facility. Under the compliance agreement, we agreed to operate our facility such that each type of emission generated by our ethanol plant was within an established amount and we agreed to comply in all other respects with the air emissions permit previously issued by the MPCA. Accordingly, we submitted an amendment to our existing air-emissions permit in December 2008, and, following air pollution control device testing, we submitted a second amendment to our air permit in September 2009, seeking amendments to permit conditions and adjustments to other components of plant operations and production.
On December 16, 2010, the MPCA issued a permit to us that supersedes our previously issued air permit and the compliance agreement. The new permit establishes the applicable limits for each type of emission generated by our ethanol plant. The permit also requires us to take additional actions relating to our plant and our operations within certain time frames. For example, we are required to conduct a building capture efficiency study and submit it to the MPCA by June 30, 2011, fence our facility within one year and complete an engineering and mercury emissions remediation project.
We expect to incur additional costs to the additional actions required by our permit, as well as improvements to our plant to ensure compliance with our permit. Under our amended forbearance agreement with AgStar Financial Services, PCA, advances from our term revolving note may only be used for the engineering and mercury emissions remediation project and may not exceed $1.4 million.
We have also incurred additional expense to resolve a notice of violation issued by the MPCA in March 2008 that alleged violations certain rules, statutes, and permit conditions, including emission violations and reporting violations. On December 16, 2010, we entered into a stipulation agreement with the MPCA relating to this March 2008 notice of violation. Under the stipulation agreement, we agreed to pay a civil penalty of $66,000, of which $54,000 was paid within thirty days and up to $12,000 may be satisfied through our delivery of the building capture efficiency study referred to above.
We have incurred costs associated with obtaining the air permits and costs associated with the compliance agreement of approximately $208,000 in fiscal year 2008, $452,000 in fiscal year 2009, and $315,000 in fiscal year 2010.
Compliance with environmental laws and permit conditions in the future could require expensive pollution control equipment or operational changes to limit actual or potential impacts to the environment, as well as significant management time and expense. A violation of these laws, regulations or permit conditions can result in substantial fines, natural resource damage, criminal sanctions, permit revocations and/or plant shutdown, any of which could have a material adverse effect on our operations.
We have also experienced significant additional expense in fiscal year 2009 and part of fiscal year 2010 associated with equipment failures and/or warranty and other claims against Fagen, Inc. that were the subject of an arbitration action we brought against Fagen, Inc. relating to the design-build agreement and air emissions at our plant. While we settled this arbitration action against Fagen, Inc. on July 2, 2010, we incurred costs and expenses associated with our claims of approximately $743,000 in fiscal year 2010 and approximately $2,700,000 in fiscal year 2009.
Employees
As of October 31, 2010, we had 51 full-time employees, of which 40 were in operations and 11 were in executive, general management and administration. We also have two part-time employees in operations. Until December 1, 2010, we also engaged Brett L. Frevert of CFO Systems, LLC as our interim chief financial officer on a contract basis. We do not maintain an internal sales organization, but instead rely upon third-parties to market and sell the ethanol and distillers’ grains that we produce.
Corporate Information
Our principal executive offices are located at 91246 390th Avenue, Heron Lake, Minnesota 56137 and our telephone number is 507-793-0077. We maintain an Internet website at www.heronlakebioenergy.com. We make available free of charge on or through our Internet website, www.heronlakebioenergy.com, all of our reports and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (SEC). We will provide electronic or paper copies of these documents free of charge upon request.
Additionally, the SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.
ITEM 1A.
ITEM 1A. RISK FACTORS
If any of the following risks actually occur, our results of operations, cash flows and the value of our units could be negatively impacted.
Risks Related to Our Financial Condition
We need additional capital to continue and grow our business, which may not be available.
We need additional capital to continue our business. We are attempting to generate capital through increasing income and cash flow from our operations. Further, under the terms of the amended forbearance agreement with AgStar Financial Services, PCA (“AgStar”) relating to our master loan agreement with AgStar, we are required to obtain additional equity investments on terms and conditions acceptable to AgStar of an amount of not less than $4.5 million on or before March 1, 2011. Also on December 30, 2010, AgStar agreed to extend the
maturity of our line of credit to March 1, 2011. As of October 31, 2010, $3.5 million was outstanding on the line of credit. We intend to seek an extension of the maturity date of the line of credit beyond March 1, 2011, but such an extension cannot be assured and we may need capital to repay the line of credit on March 1, 2011. We may also be required to identify and secure capital to refinance our existing indebtedness or repay the full amount of our indebtedness to AgStar earlier, if required repayment of our debt is accelerated because of an event of default.
We are currently attempting to raise up to $6.8 million in additional capital from an offering of our units that we began in August 2010. No assurance can be given that additional capital will be obtained in an amount that is sufficient for our needs or in an amount that satisfies the requirements of the amended forbearance agreement. Further, no assurance can be given that we will be able to raise the required $4.5 million or an amount sufficient to repay our line of credit by March 1, 2011.
If we do not obtain sufficient proceeds from our current equity offering, we will likely seek additional capital by incurring additional indebtedness or from another offering of our equity securities or both. If we are able to obtain additional capital, the terms will be determined based upon negotiations between us and the lenders or investors. No assurance can be given that any capital we do receive will be in an amount that is sufficient for our needs, in a timely manner, or on terms and conditions acceptable to us or our members. The issuance of additional equity in a future offering will dilute and may dilute significantly the equity interests of our unit holders at the time of any such offering. If we incur any additional indebtedness, we will be further limited in distributions to our unit holders and our unit holders may receive no return on their investment in the event of our liquidation or dissolution.
Our financing needs are based upon management estimates as to future revenue and expense. Our business plan and financing needs are subject to change based upon, among other factors, market and industry conditions, our ability to increase cash flow from operations and our ability to control costs and expenses. If our estimates of our financing needs change, any capital that we do obtain may not be sufficient for our needs and we may need more capital in the future.
If we are unable to obtain sufficient capital, we may further curtail our capital expenditures, further reduce our expenses, or suspend or discontinue our operations or sell our assets. Our ability to comply with the amended forbearance agreement, the covenants of our master loan agreement or make required payments on our debt to AgStar will be impaired if we do not obtain sufficient additional capital, resulting in events of default, acceleration of our indebtedness, seizure by AgStar of assets that secure our indebtedness, loss of control of our business or bankruptcy.
Our efforts to raise additional capital through selling our equity or incurring additional indebtedness may be hampered by various factors, many of which are outside of our control.
Our efforts to raise additional funds from the sale of equity may be hampered by the significant volatility of ethanol businesses such as ours, depression of the ethanol industry, and bankruptcy or reorganization of other ethanol production companies. Our efforts to raise funds by incurring additional indebtedness may be hampered by the fact that we have significant outstanding indebtedness and the challenges we face in servicing our current indebtedness with cash flow from operations, as well as the fact that our assets are pledged to AgStar to secure existing debt. In addition, the covenants of our master loan agreement restrict our ability to make distributions, create liens, incur indebtedness, and sell our assets and properties.
The following factors may also affect our ability to obtain additional financing on favorable terms, or at all:
· our results of operations, financial condition and business prospects;
· conditions in the ethanol industry as well as other renewable energy industries; and
· general economic conditions, including the availability of credit and lending standards of banks and other financial institutions.
We anticipate that one or more of our covenants under the master loan agreement with AgStar will not be met after the forbearance period that ends March 1, 2011, without an amendment to the covenants, improved financial performance, or the addition of significant working capital.
As a result of our financial performance, we violated certain financial covenants under our master loan agreement with AgStar at the end of each quarter from January 31, 2009 to October 31, 2010, except the quarter ended July 31, 2010. At October 31, 2010, our total indebtedness to AgStar was approximately $53.6 million. All of our assets and real property are subject to security interests and mortgages in favor of AgStar as security for the obligations of the master loan agreement.
On December 30, 2010, we entered into an amended forbearance agreement with AgStar relating to our covenant violation at October 31, 2010. Under that amended forbearance agreement, AgStar agreed it will not declare a default under the loan documents or enforce any of
the remedies available to it for the period of December 30, 2010 to the earlier of an event of default (as defined under the amended forbearance agreement) or March 1, 2011. Without an amendment to the covenants, improved financial performance or the addition of significant working capital, we anticipate that we will again be in violation of one or more covenants of the master loan agreement at October 31, 2011. We are attempting to improve various aspects of our business and to raise significant additional capital in order to avoid any future covenant violations and events of default. There can be no assurance that our business and financial performance will improve, that any improvements will be sustained or that any improvements will result in our compliance with covenants. Further, there is no assurance that we will be able to obtain any additional working capital on terms favorable to us, if at all. Even if we obtain additional capital, the amounts we raise may not be sufficient to avoid future covenant violations and events of default.
Our failure to comply with covenants of the master loan agreement would result event of default under the master loan agreement, entitling AgStar to accelerate and declare due all amounts outstanding under the master loan agreement.
While we have relied upon on our master loan agreement to fund our past operations and past losses, we must generate a sufficient level of net income and obtain additional working capital to fund our ongoing operations.
We had net income of approximately $1.7 million for our fiscal year ended October 31, 2010, which included one-time settlement income of approximately $2.6 million. We experienced a net loss of approximately $11.3 million for the fiscal year ended October 31, 2009. Our income or loss has primarily been driven by our low or negative margins. For example, our cost of goods sold (including lower of cost or market adjustments) as a percentage of revenues was 93.9% and 102.9% for the fiscal years ended October 31, 2010 and October 31, 2009, respectively. Whether we achieve a sufficient level of net income to fund our operations will depend on a number of factors, including:
· our revenue in any given period, which depends both on the volume of our products produced and the price we receive for these products;
· our expense levels, particularly our operating expenses relating to corn; and
· the efficiency of our plant, particularly managing costs and expenses associated with repairs and air emissions compliance and remediation plans and avoiding plant shut downs and slow downs.
We have historically financed our operations primarily through borrowing under our master loan agreement with AgStar, and, to a lesser extent, cash from operating activities. As of October 31, 2010, we had cash and cash equivalents (other than restricted cash) of approximately $1.5 million. As of October 31, 2010, our indebtedness under the master loan agreement with AgStar was approximately $53.6 million.
Further, as of October 31, 2010, our availability under the master loan agreement with AgStar was limited and continues to be limited under the forbearance agreement we entered into on December 30, 2010. We have no available borrowing under the term note and advances from the term revolving note in the maximum principal amount of $5.0 million may only be used for an engineering and emissions remediation project and may not exceed $1.4 million. As of October 31, 2010, there was $3.25 million of available borrowing under our line of credit loan, subject to a defined borrowing base that may also significantly limit our borrowing. Additionally, if we are not in compliance with the covenants of our master loan agreement, we are not permitted to draw on the unused portion of our loans.
The amount currently available under our master loan agreement is insufficient to fund our ongoing operations. To fund our ongoing cash needs and to service our indebtedness, we must increase the income and cash generated from our operations and we must also obtain additional working capital. We cannot assure you that we will improve our liquidity to the extent required to enable us to service or reduce our indebtedness or to fund our other capital needs, if at all.
Certain provisions of our master loan agreement with AgStar present special risks to our business.
As of October 31, 2010, our debt with AgStar consists of approximately $38.3 million in fixed rate obligations and $13.0 million in variable rate obligations after giving effect to our election under our master loan agreement with AgStar to fix an interest rate of 6.58% on $45.0 million of our debt effective May 1, 2008 through April 30, 2011. The variable rate on a portion of our debt may make us vulnerable to increases in prevailing interest rates. If the interest rate on our variable rate debt were to increase, our aggregate annualized interest and principal payments would also increase and could increase significantly.
The principal and interest payments on our $49.0 million term loan are calculated using an amortization period of ten years even though the note will mature on October 1, 2012, five years from the date of its issuance. As a result, at maturity of the term loan, there would be approximately $38.7 million in principal remaining under the term loan, without any additional payments that may be required under the
master loan agreement. In order to finance this large payment of principal that would be due at maturity, we may attempt to extend the term of the loan under the master loan agreement, refinance the indebtedness under the master loan agreement, in full or in part, or obtain a new loan to repay the term loan. We cannot assure you that will be successful in obtaining an extension of or refinancing our indebtedness. We also cannot assure you that we will be able to obtain a new loan in an amount that is sufficient for our needs, in a timely manner or on terms and conditions acceptable to us or our members.
We also have a revolving term loan with AgStar that will mature on October 1, 2012. As of October 31, 2010, we have used approximately $1.1 million of AgStar’s commitment under this loan. We also have a revolving line of credit loan with AgStar that will mature at March 1, 2011. At October 31, 2010, $3.5 million was outstanding on this revolving line of credit loan. As with the term loan, at maturity we may attempt to extend, refinance, or obtain a new loan to repay any outstanding balance. We cannot assure you that any alternative will be sufficient for our needs, available in a timely manner or on terms and conditions acceptable to us or our members.
If we are unable to service our debt, AgStar may accelerate all of our indebtedness and may seize the assets that secure our indebtedness, causing us to lose control of our business. We may also be forced to sell our assets, restructure our indebtedness, submit to foreclosure proceedings, cease operations or seek bankruptcy or reorganization protection.
Risks Relating to Our Operations
Because we are primarily dependent upon one product, our business is not diversified, and we may not be able to adapt to changing market conditions or endure any decline in the ethanol industry.
Our success depends on our ability to efficiently produce and sell ethanol, and, to a lesser extent, distillers’ grains. We do not have any other lines of business or other significant sources of revenue to rely upon if we are unable to produce and sell ethanol and distillers’ grains, or if the market for those products decline. Our lack of diversification means that we may not be able to adapt to changing market conditions, changes in regulation, increased competition or any significant decline in the ethanol industry.
Our profitability depends upon purchasing corn at lower prices and selling ethanol at higher prices and because the difference between ethanol and corn prices can vary significantly, our financial results may also fluctuate significantly.
The substantial majority of our revenues are derived from the sale of ethanol. Our gross profit relating to the sale of ethanol is principally dependent on the difference between the price we receive for the ethanol we produce and the price we pay for the corn we used to produce our ethanol. Because we do have contracts establishing the price we receive for the ethanol we produce or for the corn we purchase, the price for both ethanol and corn will be determined in significant part by prevailing market conditions affecting these commodities.
The price we receive for our ethanol is dependent upon a number of factors. Increasing domestic ethanol capacity may boost demand for corn, resulting in increased corn prices and corresponding decrease in the selling price of ethanol as production increases. Further, the price of corn is influenced by weather conditions (including droughts or over abundant rainfall) and other factors affecting crop yields, farmers’ planting decisions and general economic, market and regulatory factors, including government policies and subsidies with respect to agriculture and international trade, and global and local supply and demand. Declines in the corn harvest, caused by farmers’ planting decisions or otherwise, could cause corn prices to increase and negatively impact our gross margins.
We have experienced low or negative margins in the past, reflecting a higher expenses for the corn we purchase and lower revenues from ethanol we produce. For example, our cost of goods sold (including lower of cost or market adjustments) as a percentage of revenues was 93.9% and 102.9% for the fiscal years ended October 31, 2010 and October 31, 2009, respectively. Reduction in ethanol prices without corresponding decreases in corn costs or increases in corn prices without corresponding increases in ethanol prices has adversely affected our financial performance in the past and may adversely affect our financial performance in the future.
If the supply of ethanol exceeds the demand for ethanol, the price we receive for our ethanol and distillers’ grains may decrease.
According to the RFA, domestic ethanol production capacity has increased steadily each year from 1999 to 2010 and is projected to further increase in 2011. However, demand for ethanol may not increase as quickly as expected or to a level that exceeds supply, or at all.
Excess ethanol production capacity may result from decreases in the demand for ethanol or increased domestic production or imported supply. There are many factors affecting demand for ethanol, including regulatory developments and reduced gasoline consumption as a result of increased prices for gasoline or crude oil. Higher gasoline prices could cause businesses and consumers to reduce driving or acquire vehicles
with more favorable gasoline mileage, or higher prices could spur technological advances, such as the commercialization of engines utilizing hydrogen fuel-cells, which could supplant gasoline-powered engines. There are a number of governmental initiatives designed to reduce gasoline consumption, including tax credits for hybrid vehicles and consumer education programs.
If ethanol prices decline for any reason, including excess production capacity in the ethanol industry or decreased demand for ethanol, our business, results of operations and financial condition may be materially and adversely affected.
In addition, because ethanol production produces distillers’ grains as a co-product, increased ethanol production will also lead to increased production of distillers’ grains. An increase in the supply of distillers’ grains, without corresponding increases in demand, could lead to lower prices or an inability to sell our distillers’ grains production. A decline in the price of distillers’ grains or the distillers’ grains market generally could have a material adverse effect on our business, results of operations and financial condition.
The price of distillers’ grains is affected by the price of other commodity products, such as soybeans, and decreases in the price of these commodities could decrease the price of distillers’ grains.
Distillers’ grains compete with other protein-based animal feed products. The price of distillers’ grains may decrease when the price of competing feed products decrease. The prices of competing animal feed products are based in part on the prices of the commodities from which they are derived. Downward pressure on commodity prices, such as soybeans, will generally cause the price of competing animal feed products to decline, resulting in downward pressure on the price of distillers’ grains. The price of distillers’ grains is not tied to production costs. However, decreases in the price of distillers’ grains would result in less revenue from the sale of distillers’ grains and could result in lower profit margins.
We face intense competition that may result in reductions in the price we receive for our ethanol, increases in the prices we pay for our corn, or lower gross profits.
Competition in the ethanol industry is intense. We face formidable competition in every aspect of our business from both larger and smaller producers of ethanol and distillers’ grains. Some larger producers of ethanol, such as Archer Daniels Midland Company, Cargill, Inc., Valero Energy Corporation, have substantially greater financial, operational, procurement, marketing, distribution and technical resources than we have. Additionally, smaller competitors, such as farmer-owned cooperatives and independent companies owned by farmers and investors, have business advantages, such as the ability to more favorably procure corn by operating smaller plants that may not affect the local price of corn as much as a larger-scale plant like ours or requiring their farmer-owners to sell them corn as a requirement of ownership.
Because Minnesota is one of the top producers of ethanol in the U.S., we face increased competition because of the location of our ethanol plant in Minnesota. For example, according to the Minnesota Department of Agriculture, for 2010, the capacity for ethanol production in Minnesota exceeds by approximately five times the projected ethanol consumption in Minnesota. Therefore, we compete with other Minnesota ethanol producers both for markets in Minnesota and markets in other states.
We also face increasing competition from international ethanol suppliers. Most international ethanol producers have cost structures that can be substantially lower than ours and therefore can sell their ethanol for substantially less than we can. While ethanol imported to the U.S. is subjected to an ad valorem tax and a per gallon surcharge that helps mitigate the effects of international competition for U.S. ethanol producers, the tax and per gallon surcharge are set to expire on December 31, 2011. If the tax and surcharge on imported ethanol is not extended beyond December 31, 2011, we will face increased competition from imported ethanol and foreign producers of ethanol. In addition, ethanol imports from certain countries are exempted from these tariffs under the Caribbean Basin Initiative to spur economic development in Central America and the Caribbean. Imports of ethanol from Central American and Caribbean countries represents a significant portion of the gallons imported into the U.S. each year and a source of intense competition for us due to the lower production costs these ethanol producers enjoy.
Competing ethanol producers may introduce competitive pricing pressures that may adversely affect our sales levels and margins or our ability to procure corn at favorable prices. As a result, we cannot assure you that we will be able to compete successfully with existing or new competitors.
We engage in hedging transactions which involve risks that can harm our business.
In an attempt to offset some of the effects of pricing and margin volatility, we may hedge anticipated corn purchases and ethanol and distillers’ grain sales through a variety of mechanisms. Because of our hedging strategies, we are exposed to a variety of market risks, including the effects of changes in commodities prices of ethanol and corn.
Hedging arrangements also expose us to the risk of financial loss in situations where the other party to the hedging contract defaults on its contract or, in the case of exchange-traded contracts, where there is a change in the expected differential between the underlying price in the hedging agreement and the actual prices paid or received by us. Hedging activities can themselves result in losses when a position is purchased in a declining market or a position is sold in a rising market. Our losses or gains from hedging activities may vary widely. For example, for the fiscal year ended October 31, 2010, we had losses of approximately $1.2 million on our corn and ethanol hedge contracts, but for the fiscal year ended October 31, 2009, we had gains of approximately $1.6 million on our corn and ethanol hedge contracts.
There can be no assurance that our hedging strategies will be effective and we may experience hedging losses in the future. We also vary the amount of hedging or other price mitigation strategies we undertake, and we may choose not to engage in hedging transactions at all. As a result, whether or not we engage in hedging transactions, our business, results of operations and financial condition may be materially adversely affected by increases in the price of corn or decreases in the price of ethanol.
Operational difficulties at our plant could negatively impact our sales volumes and could cause us to incur substantial losses.
We have experienced operational difficulties at our plant that have resulted in scheduled and unscheduled downtime or reductions in the number of gallons of ethanol we produce. Some of the difficulties we have experienced relate to production problems, repairs required to our plant equipment and equipment maintenance, the installation of new equipment and related testing, and our efforts to improve and test our air emissions. Our revenues are driven in large part by the number of gallons of ethanol we produce and the number of tons of distillers’ grains we produce. If our ethanol plant does not efficiently produce our products in high volumes, our business, results of operations, and financial condition may be materially adversely affected.
Our operations are also subject to operational hazards inherent in our industry and to manufacturing in general, such as equipment failures, fires, explosions, abnormal pressures, blowouts, pipeline ruptures, transportation accidents and natural disasters. Some of these operational hazards may cause personal injury or loss of life, severe damage to or destruction of property and equipment or environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. The occurrence of any of these operational hazards may materially adversely affect our business, results of operations and financial condition. Further, our insurance may not be adequate to fully cover the potential operational hazards described above or we may not be able to renew this insurance on commercially reasonable terms or at all.
Our operations and financial performance could be adversely affected by infrastructure disruptions and lack of adequate transportation and storage infrastructure in certain areas.
We ship our ethanol to our customers primarily by the railroad adjacent to our site. We also have the potential to receive inbound corn via the railroad, although we currently receive corn by truck from our facilities in Lakefield, Minnesota and Wilder, Minnesota, each of which is less than 15 miles away from our plant. Our customers require appropriate transportation and storage capacity to take delivery of the products we produce. Therefore, our business is dependent on the continuing availability of rail, highway and related infrastructure. Any disruptions in this infrastructure network, whether caused by labor difficulties, earthquakes, storms, other natural disasters, human error or malfeasance or other reasons, could have a material adverse effect on our business. We rely upon third-parties to maintain the rail lines from our plant to the national rail network, and any failure on their part to maintain the lines could impede our delivery of products, impose additional costs on us and could have a material adverse effect on our business, results of operations and financial condition.
In addition, lack of this infrastructure prevents the use of ethanol in certain areas where there might otherwise be demand and results in excess ethanol supply in areas with more established ethanol infrastructure, depressing ethanol prices in those areas. In order for the ethanol industry to grow and expand into additional markets and for our ethanol to be sold in these new markets, there must be substantial development of infrastructure including:
· additional rail capacity;
· additional storage facilities for ethanol;
· increases in truck fleets capable of transporting ethanol within localized markets;
· expansion of refining and blending facilities to handle ethanol; and
· growth in service stations equipped to handle ethanol fuels.
The substantial investments that will be required for these infrastructure changes and expansions may not be made on a timely basis, if at all, and decisions regarding these infrastructure improvements are outside of our control. Significant delay or failure to improve the infrastructure that facilitates the distribution could curtail more widespread ethanol demand or reduce prices for our products in certain areas, which would have a material adverse effect on our business, results of operations or financial condition.
Competition for qualified personnel in the ethanol industry is intense and we may not be able to hire and retain qualified personnel to operate our ethanol plant.
Our success depends in part on our ability to attract and retain competent personnel. For our ethanol plant, we must hire qualified managers, operations personnel, accounting staff and others, which can be challenging in a rural community. Competition for employees in the ethanol industry is intense, and we may not be able to attract and retain qualified personnel. If we are unable to hire productive and competent personnel and retain our existing personnel, our business may be adversely affected and we may not be able to efficiently operate our ethanol business and comply with our other obligations.
Technology in our industry evolves rapidly, potentially causing our plant to become obsolete, and we must continue to enhance the technology of our plant or our business may suffer.
We expect that technological advances in the processes and procedures for processing ethanol will continue to occur. It is possible that those advances could make the processes and procedures that we utilize at our ethanol plant less efficient or obsolete. These advances could also allow our competitors to produce ethanol at a lower cost than we are able. If we are unable to adopt or incorporate technological advances, our ethanol production methods and processes could be less efficient than those of our competitors, which could cause our ethanol plant to become uncompetitive.
Ethanol production methods are constantly advancing. The current trend in ethanol production research is to develop an efficient method of producing ethanol from cellulose-based biomass such as agricultural waste, forest residue and municipal solid waste. This trend is driven by the fact that cellulose-based biomass is generally cheaper than corn and producing ethanol from cellulose-based biomass would create opportunities to produce ethanol in areas that are unable to grow corn. Another trend in ethanol production research is to produce ethanol through a chemical or thermal process, rather than a fermentation process, thereby significantly increasing the ethanol yield per pound of feedstock. Although current technology does not allow these production methods to be financially competitive, new technologies may develop that would allow these methods to become viable means of ethanol production in the future. If we are unable to adopt or incorporate these advances into our operations, our cost of producing ethanol could be significantly higher than those of our competitors, which could make our ethanol plant obsolete. Modifying our plant to use the new inputs and technologies would likely require material investment.
If ethanol fails to compete successfully with other existing or newly-developed oxygenates or renewable fuels, our business will suffer.
Alternative fuels, additives and oxygenates are continually under development. Alternative fuels and fuel additives that can replace ethanol are currently under development, which may decrease the demand for ethanol. Technological advances in engine and exhaust system design and performance could reduce the use of oxygenates, which would lower the demand for ethanol, and our business, results of operations and financial condition may be materially adversely affected.
Our sales will decline, and our business will be materially harmed if our third party marketers do not effectively market or sell the ethanol and distillers grains we produce or if there is a significant reduction or delay in orders from our marketers.
We have entered into an agreement with a third party to market our supply of ethanol. We have also entered into an agreement with another third party to market our supply of distillers grains. Our marketers are independent businesses that we do not control. We cannot be certain that these marketers will market or sell our ethanol and distillers’ grains effectively. Our agreements with these marketers do not contain requirements that a certain percentage of such parties’ sales are of our products, nor do the agreements restrict their ability to choose alternative sources for ethanol or distillers grains.
Our success in achieving revenue from the sale of ethanol and distillers grains will depend upon the continued viability and financial stability of our marketers. These marketers may choose to devote their efforts to other ethanol producers or reduce or fail to devote the necessary resources to provide effective sales and marketing support of our products. We believe that our financial success will continue to depend in large part upon the success of our marketers in operating their businesses. If these marketers do not effectively market and sell our ethanol and distillers grains, our revenues may decrease and our business will be harmed.
Risks Related to Government Programs and Regulation
If the VEETC, or “blender’s credit,” is not extended beyond December 31, 2011 or is extended but is reduced, our business and the ethanol industry will be materially harmed.
Tax incentives have played a critical role in the development of the ethanol industry in the United States. The volumetric ethanol excise tax credit (VEETC) was established in 2004 in the American Jobs Creation Act as a $0.51 per gallon payment to gasoline refiners and marketers for blending ethanol into the gasoline supply. For this reason, it is sometimes referred to as the “blenders’ credit.” The 2008 Farm Bill reduced the credit to $0.45 per gallon, which is the current amount of the credit. A tariff is imposed on imported ethanol to offset the tax benefit of the VEETC. The VEETC was scheduled to expire on December 31, 2010, but the expiration date was recently extended to December 31, 2011. If the VEETC is eliminated, we also expect the import tariff would be eliminated.
The failure to extend the VEETC beyond December 31, 2011 will have a material adverse impact on our business and the ethanol industry. If the VEETC expires on December 31, 2011 and the import tariff is eliminated, refiners and marketers may replace domestic ethanol with cheaper imported ethanol in order to meet the requirements of the renewable fuels standard and other state and federal programs requiring or encouraging ethanol use. Refiners and marketers may also replace ethanol with another oxygenate without an economic incentive to purchase ethanol and a price differential between ethanol and other oxygenate alternatives. If the VEETC expires on December 31, 2011 and the import tariff is eliminated, we would expect that demand for U.S. produced ethanol and ethanol prices will decline. Reduction in domestic ethanol prices will deteriorate industry profitability and result in significantly reduced domestic ethanol production. The reduction in demand and in prices may be substantial and depending upon the severity in the reduction, may cause U.S. ethanol producers to reduce production or cease production entirely.
It is uncertain what action, if any, Congress may take with respect to the VEETC prior to its scheduled expiration or when such action may be effective. If Congress determines to extend the VEETC, there can be no assurance that Congress will maintain other features of the VEETC, including the amount of the credit at $0.45 per gallon. If the VEETC is reduced, the reduction may also lead to increased imports of ethanol, decreased prices to U.S. ethanol producers, and reduction in ethanol production as U.S. ethanol plants as plants curtail or cease production in response to demand and pricing pressures.
If the VEETC and the corresponding tariff are not extended beyond December 31, 2011 or if the VEETC provides a reduced tax credit, we may be unable to produce and sell ethanol profitably.
We have experienced significant costs in obtaining and complying with permits and environmental laws, particularly our air emissions permit, and may continue to experience significant costs in the future.
The costs associated with obtaining and complying with permits and complying with environmental laws have increased our costs of construction, production and continued operation. In particular, we have incurred significant expense relating to our air-emission permit in four categories: (1) obtaining our air emissions permit from the Minnesota Pollution Control Agency (“MPCA”); (2) compliance with our air emissions permit and the terms of our compliance agreement with the MPCA; (3) our dispute under the design-build agreement with Fagen, Inc. relating to equipment failures, warranty claims and other claims regarding air emissions at our plant that was the subject of an arbitration action that was settled on July 2, 2010; and (4) a March 2008 notice of violation from the MPCA that was resolved in December 2010 though a stipulation agreement.
While our air emissions permit issue was resolved with the December 16, 2010 issuance of a new air permit by the MPCA, our arbitration action against Fagen, Inc. has been settled, and we have addressed the notice of violation through a stipulation agreement, we anticipate future expense associated with compliance with our air permit and related environmental laws. The permit requires us to take additional actions relating to our plant and our operations within certain time frames. For example, we are required to conduct a building capture efficiency study and submit it to the MPCA by June 30, 2011, fence our facility within one year and complete an engineering and mercury emissions remediation project.
Continued compliance with our air emissions permit issue will involve management time and expense and may involve ongoing operational expense or further modifications to the design or equipment in our plant.
There can be no assurance that we will be able to comply with any of the conditions of any of our permits, or with environmental laws applicable to us. A violation of environmental laws, regulations or permit conditions can result in substantial fines, natural resource damage, criminal sanctions, permit revocations or plant shutdown, any of which could have a material adverse effect on our operations.
Our failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition and results of operations.
We are subject to various federal, state and local environmental laws and regulations, including those relating to the discharge of materials into the air, water and ground. Certain aspects of our operations require environmental permits and controls to prevent and reduce air and water pollution, and these permits are subject to modification, renewal and revocation by issuing authorities including the Minnesota Pollution Control Agency. We could incur substantial costs, including cleanup costs, fines and civil or criminal sanctions and third-party claims for property damage and personal injury as a result of violations of or liabilities under environmental laws or non-compliance with environmental permits. We could also incur substantial costs and experience increased operating expenses as a result of operational changes to comply with environmental laws, regulations and permits. As discussed above, we have incurred substantial costs relating to our air emissions permit and expect additional costs relating to this permit in the future.
Further, environmental laws and regulations are subject to substantial change. We cannot predict what material impact, if any, these changes in laws or regulations might have on our business. Future changes in regulations or enforcement policies could impose more stringent requirements on us, compliance with which could require additional capital expenditures, increase our operating costs or otherwise adversely affect our business. These changes may also relax requirements that could prove beneficial to our competitors and thus adversely affect our business. In addition, regulations of the Environmental Protection Agency and the Minnesota Pollution Control Agency depend heavily on administrative interpretations. We cannot assure you that future interpretations made by regulatory authorities, with possible retroactive effect, will not adversely affect our business, financial condition and results of operations.
Failure to comply with existing or future regulatory requirements could have a material adverse effect on our business, financial condition and results of operations.
Because federal and state regulation heavily influence the supply of and demand for ethanol, changes in government regulation that adversely affect demand or supply will have a material adverse effect on our business.
Various federal and state laws, regulations and programs impact the supply of and demand for ethanol. Some government regulation, for example those that provide economic incentives to ethanol producers, stimulate supply of ethanol by encouraging production and the increased capacity of ethanol plants. Others, such as a federal excise tax incentive program that provides gasoline distributors who blended ethanol with gasoline to receive a federal excise tax rate reduction for each blended gallon they sell, stimulate demand for ethanol by making it price competitive with other oxygenates. Further, tariffs generally apply to the import of ethanol from certain other countries, where the cost of production can be significantly less than in the U.S. These tariffs are designed to increase the cost of imported ethanol to a level more comparable to the cost of domestic ethanol by offsetting the benefit of the federal excise tax program. Tariffs have the effect of maintaining demand for domestic ethanol.
Additionally, the Environmental Protection Agency has established a revised annual renewable fuel standard (RFS2) that sets minimum national volume standards for use of renewable fuels. The RFS2 also sets volume standards for specific categories of renewable fuels: cellulosic, biomass-based diesel and total advanced renewable fuels. While our ethanol does not qualify one of the new volume categories of renewable fuels, we believe that the overall renewable fuels requirement of RFS2 creates an incentive for the use of ethanol. Other federal and state programs that require or provide incentives for the use of ethanol create demand for ethanol. Government regulation and government programs that create demand for ethanol may also indirectly create supply for ethanol as additional producers expand or new companies enter the ethanol industry to capitalize on demand. In the case of the RFS2, while it creates a demand for ethanol, the existence of specific categories of renewable fuels also creates a demand for these types of renewable fuels and will likely provide an incentive for companies to further develop these products to capitalize on that demand. In these circumstances, the RFS2 may also reduce demand for ethanol in favor of the renewable fuels for which specific categories exist.
Federal and state laws, regulations and programs are constantly changing. We cannot predict what material impact, if any, these changes might have on our business. Future changes in regulations and programs could impose more stringent operational requirements or could reduce or eliminate the benefits we receive, directly and indirectly, under current regulations and programs. Future changes in regulations and programs may increase or add benefits to ethanol producers other than us or eliminate or reduce tariffs or other barriers to entry into the U.S. ethanol market, any of which could prove beneficial to our competitors, both domestic and international. Future changes in regulation may also hurt our business by providing economic incentives to producers of other renewable fuels or oxygenates or encouraging use of fuels or oxygenates that compete with ethanol. In addition, both national and state regulation is influenced by public opinion and changes in public opinion. For example, certain states oppose the use of ethanol because, as net importers of ethanol from other states, the use of ethanol could increase gasoline prices in that state and because that state does not receive significant economic benefits from the ethanol industry, which are
primarily experienced by corn and ethanol producing states. Further, some argue that the use of ethanol will have a negative impact on gasoline prices to consumers, result in rising food prices, add to air pollution, harm car and truck engines, and actually use more fossil energy, such as oil and natural gas, than the amount of ethanol that is produced. We cannot predict the impact that opinions of consumers, legislators, industry participants, or competitors may have on the regulations and programs currently benefiting ethanol producers.
The EPA imposed E10 “blend wall” if not overcome will have an adverse effect on demand for ethanol.
We believe that the E10 “blend wall” is one of the most critical governmental policies currently facing the ethanol industry. The “blend wall” issue arises because of several conflicting requirements. First, the renewable fuels standards dictate a continuing increase in the amount of ethanol blended into the national gasoline supply. Second, the Environmental Protection Agency (EPA) mandates a limit of 10% ethanol inclusion in non-flex fuel vehicles, and the E85 vehicle marketplace is struggling to grow due to lacking infrastructure. Total gasoline usage by the U.S. is currently around 138 billion gallons, and is expected to decrease to less than 130 billion gallons over the next 5 years as fuel mileage standards are changed. The RFS2 dictates an increasing amount of ethanol blending, from 12.95 billion gallons in 2010 to 36 billion gallons by 2022. To reach the standard as dictated by the RFS2 in 2011, assuming 135 billion gallons of total gasoline usage nationally, each gallon of gasoline sold would have to be blended with greater than 10% ethanol. The EPA policy of 10% and the RFS increasing blend rate are at odds, which is sometimes referred to as the “blend wall.” While the issue is being considered by the EPA, there have been no regulatory changes that would reconcile the conflicting requirements. Recently, the United States Environmental Protection Agency allowed the use of E15, gasoline which is blended at a rate of 15% ethanol and 85% gasoline, in vehicles manufactured in the model year 2007 and later. The EPA was expected to make a ruling on allowing E15 for use in vehicles produced in model year 2001 and later by the end of 2010, however, this decision has been delayed by the EPA. Management believes that many gasoline retailers will refuse to provide E15 due to the fact that not all standard vehicles will be allowed to use E15 and due to the labeling requirements the EPA may impose. The EPA is considering instituting labeling requirements associated with E15 which may unfairly discourage consumers from purchasing E15. As a result, the approval of E15 may not significantly increase demand for ethanol.
Approval of a Low Carbon Fuel Standard (“LCFS”) by the California Air Resources Board (“CARB”) may have a negative impact on our ability to market our ethanol in California.
The CARB recently proposed rules to implement a LCFS, which would set standards for the carbon intensity of fuels used in the State of California starting in 2011. While the proposed rules are still subject to rulemaking process in California, certain provisions of the proposed LCFS rules have the potential to ban ethanol produced at our plant from being sold in California. While we believe there may be some negative impact to our sales from the approval of the LCFS in California, we believe we will still be able to market all the ethanol produced by our plant to markets outside of California. However, if additional states where our ethanol is marketed, or the federal government, adopt similar provisions it could have a severe negative impact on our ability to sell all of the ethanol produced at our plant.
Risks Related to the Units
Project Viking owns a large percentage of our units, which may allow it to control or heavily influence matters requiring member approval, and Project Viking has been granted additional board rights under our member control agreement.
As of October 31, 2010, Project Viking, L.L.C. beneficially owned 29.8% of our outstanding units. Project Viking is owned by Roland J. (Ron) Fagen and Diane Fagen, the principal shareholders of Fagen, Inc., the design-build firm for our ethanol plant. Project Viking, together with our executive officers and governors, together control approximately 33.5% of our outstanding units as of October 31, 2010. As a result, these unit holders, acting individually or together, could significantly influence our management and affairs and all matters requiring member approval, including the election of governors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing a change in control of our company and might affect the price of our units.
Additionally, our member control agreement gives members who hold significant amounts of equity in us the right to designate governors to serve on our board of governors. For every 9% of our units held, the member has the right to appoint one person to our board. Project Viking, L.L.C. has the right to appoint three persons to our board pursuant to this provision and has appointed two persons as of October 31, 2010. Although the designated governors do not represent a majority of our board, their presence on the board may allow Project Viking, L.L.C. to have greater influence over the decisions of our board and our business than other members.
Further, the interests of Project Viking, L.L.C. may not coincide with our interests or the interests of our other members. For example, Fagen, Inc. has invested and may continue to invest in a number of other ethanol producers, some of whom may compete with us. As a result of
these and other potential conflicting interests, these existing members may make decisions with respect to us with which we or our members may disagree.
There is no public market for our units and no public market is expected to develop.
There is no established public trading market for our units, and we do not expect one to develop in the foreseeable future. To maintain our partnership tax status, we do not intend to list the units on any stock exchange or automatic quotation system such as OTC Bulletin Board. As a result, units held by our members may not be easily resold and members may be required to hold their units indefinitely. Even if members are able to resell our units, the price may be less than the members’ investment in the units or may otherwise be unattractive to the member.
There are significant restrictions on the transfer of our units.
To protect our status as a partnership for tax purposes and to assure that no public trading market in our units develops, our units are subject to significant restrictions on transfer and transfers are subject to approval by our board of governors. All transfers of units must comply with the transfer provisions of our member control agreement and the unit transfer policy adopted by our board of governors. Our board of governors will not approve transfers which could cause us to lose our tax status or violate federal or state securities laws. On November 5, 2008, our board of governors adopted a revised unit transfer policy. While the revised policy permits transfers of our units under certain circumstances, including certain transfers of units for value, there continue to be significant restrictions on transfer of our units. Among other things, the revised unit transfer policy places limits on the number of units that may be transferred during any fiscal year and requires the transferor and transferee to complete a unit transfer agreement and application form and submit these to us along with the required documents and an application fee.
Effective July 2, 2010, the board of governors determined to suspend approvals of any transfers of units, provided that related-party transfers without consideration will still be considered. This suspension was approved by the board pursuant to its authority under our member control agreement. On July 9, 2010, we notified our members of the suspension of approvals by a letter. We also removed all postings on the unit bulletin board. The board will consider lifting the suspension on sales of units when it has determined a course of action on the strategies under consideration and information regarding the course of action has been communicated to members as required by law, and when otherwise reasonably believed to be in our best interests.
As a result of the provisions of our member control agreement, members may not be able to transfer their units and may be required to assume the risks of the investment for an indefinite period of time.
A transferee may be admitted as a member only upon approval by the board of governors and upon satisfaction of certain other requirements, including the transferee meeting the minimum unit ownership requirements to become a member (which for our present units requires holding a minimum of 2,500 units). Any transferee that is not admitted as a member will be deemed an unadmitted assignee. An unadmitted assignee will be a non-member unit holder and will have the same financial rights as other unit holders, such as the right to receive distributions that we declare or that are available upon our dissolution or liquidation. As a non-member unit holder, an unadmitted assignee will not have the voting or other governance rights of members and will not be entitled to any information or accountings regarding our business or to inspect our books and records.
There is no assurance that we will be able to make distributions to our unit holders, which means that holders could receive little or no return on their investment.
Distributions of our net cash flow may be made at the sole discretion of our board of governors, subject to the provisions of the Minnesota Limited Liability Company Act, our member control agreement and restrictions imposed by AgStar under our master loan agreement. Our master loan agreements with AgStar currently materially limit our ability to make distributions to our members and are likely to limit materially the future payment of distributions. If our financial performance and loan covenants permit, we expect to make future cash distributions at times and in amounts that will permit our members to make income tax payments. If our financial performance and loan covenants further permit, we intend to make distributions in excess of those amounts. However, our board may elect to retain cash for operating purposes, debt retirement, plant improvements or expansion. We may also never be in a position to pay distributions because of our financial performance or the terms of our master loan agreement. Consequently, members may receive little or no return on their investment in the units.
We may authorize and issue units of new classes which could be superior to or adversely affect holders of our outstanding units.
Our board of governors, upon the approval of a majority in interest of our members, has the power to authorize and issue units of classes which have voting powers, designations, preferences, limitations and special rights, including preferred distribution rights, conversion rights, redemption rights and liquidation rights, different from or superior to those of our present units. New units may be issued at a price and on terms determined by our board of governors. The terms of the units and the terms of issuance of the units could have an adverse impact on your voting rights and could dilute your financial interest in us.
Our use of a staggered board of governors and allocation of governor appointment rights may reduce the ability of members to affect the composition of the board.
We are managed by a board of governors, currently consisting of eight elected governors and two appointed governors. The seats on the board that are not subject to a right of appointment will be elected by the members without appointment rights. An appointed governor serves indefinitely at the pleasure of the member appointing him or her (so long as such member and its affiliates continue to hold a sufficient number of units to maintain the applicable appointment right) until a successor is appointed, or until the earlier death, resignation or removal of the appointed governor.
Under our member control agreement, non-appointed governors are divided into three classes, with the term of one class expiring each year. As the term of each class expires, the successors to the governors in that class will be elected for a term of three years. As a result, members elect only approximately one-third of the non-appointed governors each year.
The effect of these provisions may make it more difficult for a third party to acquire, or may discourage a third party from acquiring, control of us and may discourage attempts to change our management, even if an acquisition or these changes would be beneficial to our members.
Our units represent both financial and governance rights, and loss of status as a member would result in the loss of the holder’s voting and other rights and would allow us to redeem such holder’s units.
Holders of units are entitled to certain financial rights, such as the right to any distributions, and to governance rights, such as the right to vote as a member. If a unit holder does not continue to qualify as a member or such holder’s member status is terminated, the holder would lose certain rights, such as voting rights, and we could redeem such holder’s units. The minimum number of units presently required for membership is 2,500 units. In addition, holders of units may be terminated as a member if the holder dies or ceases to exist, violates our member control agreement or takes actions contrary to our interests, and for other reasons. Although our member control agreement does not define what actions might be contrary to our interests, and our board of governors has not adopted a policy on the subject, such actions might include providing confidential information about us to a competitor, taking a board or management position with a competitor or taking action which results in significant financial harm to us in the marketplace. If a holder of units is terminated as a member, our board of governors will have no obligation to redeem such holder’s units.
Voting rights of members are not necessarily equal and are subject to certain limitations.
Members of our company are holders of units who have been admitted as members upon their investment in our units and who are admitted as members by our board of governors. The minimum number of units required to retain membership is 2,500 units. Any holder of units who is not a member will not have voting rights. Transferees of units must be approved by our board of governors to become members. Members who are holders of our present units are entitled to one vote for each unit held. The provisions of our member control agreement relating to voting rights applicable to any class of units will apply equally to all units of that class.
However, our member control agreement gives members who hold significant amounts of equity in us the right to designate governors to serve on our board of governors. For every 9% of our units held, the member has the right to appoint one person to our board. Project Viking, L.L.C. has the right to appoint three persons to our board pursuant to this provision and has currently appointed two persons. If units of any other class are issued in the future, holders of units of that other class will have the voting rights that are established for that class by our board of governors with the approval of our members. Consequently, the voting rights of members may not be necessarily proportional to the number of units held.
Further, cumulative voting for governors is not allowed, which makes it substantially less likely that a minority of members could elect a member to the board of governors. Members do not have dissenter’s rights. This means that they will not have the right to dissent and seek payment for their units in the event we merge, consolidate, exchange or otherwise dispose of all or substantially all of our property. Holders of units who are not members have no voting rights. These provisions may limit the ability of members to change the governance and policies of our company.
All members will be bound by actions taken by members holding a majority of our units, and because of the restrictions on transfer and lack of dissenters’ rights, members could be forced to hold a substantially changed investment.
We cannot engage in certain transactions, such as a merger, consolidation, dissolution or sale of all or substantially all of our assets, without the approval of our members. However, if holders of a majority of our units approve a transaction, then all members will also be bound to that transaction regardless of whether that member agrees with or voted in favor of the transaction. Under our member control agreement, members will not have any dissenters’ rights to seek appraisal or payment of the fair value of their units. Consequently, because there is no public market for the units, members may be forced to hold a substantially changed investment.
Risks Related to Tax Issues in a Limited Liability Company
EACH UNIT HOLDER SHOULD CONSULT THE INVESTOR’S OWN TAX ADVISOR WITH RESPECT TO THE FEDERAL AND STATE TAX CONSEQUENCES OF AN INVESTMENT IN HERON LAKE BIOENERGY, LLC AND ITS IMPACT ON THE INVESTOR’S TAX REPORTING OBLIGATIONS AND LIABILITY.
If we are not taxed as a partnership, we will pay taxes on all of our net income and you will be taxed on any earnings we distribute, and this will reduce the amount of cash available for distributions to holders of our units.
We consider Heron Lake BioEnergy, LLC to be a partnership for federal income tax purposes. This means that we will not pay any federal income tax, and our members will pay tax on their share of our net income. If we are unable to maintain our partnership tax treatment or qualify for partnership taxation for whatever reason, then we may be taxed as a corporation. We cannot assure you that we will be able to maintain our partnership tax classification. For example, there might be changes in the law or our company that would cause us to be reclassified as a corporation. As a corporation, we would be taxed on our taxable income at rates of up to 35% for federal income tax purposes. Further, distributions would be treated as ordinary dividend income to our unit holders to the extent of our earnings and profits. These distributions would not be deductible by us, thus resulting in double taxation of our earnings and profits. This would also reduce the amount of cash we may have available for distributions.
Your tax liability from your allocated share of our taxable income may exceed any cash distributions you receive, which means that you may have to satisfy this tax liability with your personal funds.
As a partnership for federal income tax purposes, all of our profits and losses “pass-through” to our unit holders. You must pay tax on your allocated share of our taxable income every year. You may incur tax liabilities from allocations of taxable income for a particular year or in the aggregate that exceed any cash distributions you receive in that year or in the aggregate. This may occur because of various factors, including but not limited to, accounting methodology, the specific tax rates you face, and payment obligations and other debt covenants that restrict our ability to pay cash distributions. If this occurs, you may have to pay income tax on your allocated share of our taxable income with your own personal funds.
You may not be able to fully deduct your share of our losses or your interest expense.
It is likely that your interest in us will be treated as a “passive activity” for federal income tax purposes. In the case of unit holders who are individuals or personal services corporations, this means that a unit holder’s share of any loss incurred by us will be deductible only against the holder’s income or gains from other passive activities, e.g., S corporations and partnerships that conduct a business in which the holder is not a material participant. Some closely held C corporations have more favorable passive loss limitations. Passive activity losses that are disallowed in any taxable year are suspended and may be carried forward and used as an offset against passive activity income in future years. Upon disposition of a taxpayer’s entire interest in a passive activity to an unrelated person in a taxable transaction, suspended losses with respect to that activity may then be deducted.
Interest paid on any borrowings incurred to purchase units may not be deductible in whole or in part because the interest must be aggregated with other items of income and loss that the unit holder has independently experienced from passive activities and subjected to limitations on passive activity losses.
Deductibility of capital losses that we incur and pass through to you or that you incur upon disposition of units may be limited. Capital losses are deductible only to the extent of capital gains plus, in the case of noncorporate taxpayers, the excess may be used to offset up to $3,000 of ordinary income. If a noncorporate taxpayer cannot fully utilize a capital loss because of this limitation, the unused loss may be carried forward and used in future years subject to the same limitations in the future years.
You may be subject to federal alternative minimum tax
Individual taxpayers are subject to an “alternative minimum tax” if that tax exceeds the individual’s regular income tax. For alternative minimum tax purposes, an individual’s adjusted gross income is increased by items of tax preference. We may generate such preference items. Accordingly, preference items from our operations together with other preference items you may have may cause or increase an alternative minimum tax to a unit holder. You are encouraged and expected to consult with your individual tax advisor to analyze and determine the effect on your individual tax situation of the alternative minimum taxable income you may be allocated, particularly in the early years of our operations.
Preparation of your tax returns may be complicated and expensive.
The tax treatment of limited liability companies and the rules regarding partnership allocations are complex. We will file a partnership income tax return and will furnish each unit holder with a Schedule K-1 that sets forth our determination of that unit holder’s allocable share of income, gains, losses and deductions. In addition to United States federal income taxes, unit holders will likely be subject to other taxes, such as state and local taxes, that are imposed by various jurisdictions. It is the responsibility of each unit holder to file all applicable federal, state and local tax returns and pay all applicable taxes. You may wish to engage a tax professional to assist you in preparing your tax returns and this could be costly to you.
Any audit of our tax returns resulting in adjustments could result in additional tax liability to you.
The IRS may audit our tax returns and may disagree with the positions that we take on our returns or any Schedule K-1. If any of the information on our partnership tax return or a Schedule K-1 is successfully challenged by the IRS, the character and amount of items of income, gains, losses, deductions or credits in a manner allocable to some or all our unit holders may change in a manner that adversely affects those unit holders. This could result in adjustments on unit holders’ tax returns and in additional tax liabilities, penalties and interest to you. An audit of our tax returns could lead to separate audits of your personal tax returns, especially if adjustments are required.
The small ethanol producer credit is due to expire on December 31, 2011.
Since our production capacity is less than 60 million gallons per year, our unit holders are entitled to share in up to $1.5 million of small ethanol producer credits each year, subject to being limited by the passive loss and credit restrictions. This credit is due to expire at the end of 2011. While tax incentives such as this credit often have been routinely extended in the past, there is no assurance that the credit will be extended again, and at least one of the extension proposals would reduce the credit by 20%.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
We own approximately 216 acres of land located near Heron Lake, Minnesota on which we have constructed our ethanol plant, which also includes corn, coal, ethanol, and distillers’ grains storage and handling facilities. Located on these 216 acres is an approximately 7,320 square foot building that serves as our headquarters. Our address is 91246 390 th Avenue, Heron Lake, Minnesota 56137-3175.
We also own elevator and grain storage facilities in Lakefield, Minnesota and Wilder, Minnesota. The elevator and grain storage facilities at each location have grain handling equipment and both upright and flat storage capacity. The storage capacity of the Lakefield, Minnesota facility is approximately 1.9 million bushels and the storage capacity of the Wilder, Minnesota facility is approximately 900,000 bushels.
All of our real property is subject to mortgages in favor of AgStar as security for loan obligations.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4.
ITEM 4. [REMOVED AND RESERVED]
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
There is no established public trading market for the units and we do not expect one to develop in the foreseeable future. To maintain our partnership tax status, we do not intend to list the units on any stock exchange or over-the-counter securities market such as the OTC Bulletin Board.
Effective July 2, 2010, our board of governors determined to suspend approvals of any transfers of units, provided that related-party transfers without consideration will still be considered. This suspension was approved by the board pursuant to its authority under our member control agreement. On July 9, 2010, we notified our members of the suspension of approvals by a letter. We also removed all postings on the unit bulletin board. The board will consider lifting the suspension on sales of units when it has determined a course of action on the strategies under consideration and information regarding the course of action has been communicated to members as required by law, and when otherwise reasonably believed to be in our best interests.
Holders of Record
As of January 21, 2011, there were 30,208,074 Class A units outstanding and held of record by 1,147 persons. There are no other classes of units outstanding. As of October 31, 2010 and January 21, 2011, there were no outstanding options or warrants to purchase, or securities convertible into, our units.
Distributions
To date, we have only made tax distributions to our members. Our master loan agreement with AgStar Financial Services, PCA currently materially limits our ability to make distributions, other than tax distributions, to our members and is likely to limit materially the future payment of distributions. If our financial performance and loan covenants permit, we expect to make future cash distributions at times and in amounts that will permit our members to make income tax payments. If our financial performance and loan covenants further permit, we intend to make distributions in excess of those amounts. Cash distributions are not assured, however, and we may never be in a position to make distributions. Under Minnesota law, we cannot make a distribution to a member if, after the distribution, we would not be able to pay our debts as they become due or our liabilities, excluding liabilities to our members on account of their capital contributions, would exceed our assets.
For a further description of the limitations on our ability to make distributions to our members, please see “Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 9 of the notes to our audited consolidated financial statements.
Securities Authorized for Issuance under Equity Compensation Plans
There are no “compensation plans” (including individual compensation arrangements) under which any of our equity securities are authorized for issuance.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Selected Consolidated Financial Data
The following table presents selected consolidated financial and operating data as of the dates and for the periods indicated. The selected financial data for balance sheet as of October 31, 2010 and 2009 and the statement of operations for the years ended October 31, 2010, 2009 and 2008 have been derived from the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The Selected financial for the balance sheet as of October 31, 2008, 2007 and 2006 and the statement of operations for the years ended October 31, 2007 and 2006 were derived from audit financial statements filed previously.
This selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” within Item 7
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our financial statements and related notes contained elsewhere in this Annual Report on Form 10-K. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of selected factors, including those set forth under “Risk Factors” in Part I, Item 1A of this Form 10-K. All forward-looking statements included herein are based on information available to us as of the date hereof, and we undertake no obligation to update any such forward-looking statements.
We prepared the following discussion and analysis to help readers better understand our financial condition, changes in our financial condition, and results of operations for the fiscal year ended October 31, 2010.
Overview
Heron Lake BioEnergy, LLC is a Minnesota limited liability company that was owns and operates a dry mill corn-based, coal fired ethanol plant near Heron Lake, Minnesota. The plant has a stated capacity to produce 50 million gallons of denatured fuel grade ethanol and 160,000 tons of dried distillers’ grains (DDGS) per year. Production of ethanol and distillers’ grains at the plant began in September 2007. We began recording revenue from plant production in October 2007, the last month of our fiscal year. Our revenues are derived from the sale and distribution of our ethanol throughout the continental United States and in the sale and distribution of our distillers’ grains (DGS) locally, and throughout the continental United States. Our subsidiary, Lakefield Farmers Elevator, LLC, has grain facilities at Lakefield and Wilder, Minnesota.
Our operating results are largely driven by the prices at which we sell ethanol and distillers grains and the costs related to their production, particularly the cost of corn. Historically, the price of ethanol tended to fluctuate in the same direction as the price of unleaded gasoline and other petroleum products. However, during fiscal 2008 and continuing into fiscal 2010, it appears ethanol prices tended to move up and down proportionately, with changes in corn prices. The price of ethanol can also be influenced by factors such as general economic conditions, concerns over blending capacities, and government policies and programs. The price of distillers grains is generally influenced by supply and demand, the price of substitute livestock feed, such as corn and soybean meal, and other animal feed proteins. Our largest component of and cost of production is corn. The cost of corn is affected primarily by factors over which we lack any control such as crop production, carryout, exports, government policies and programs, and weather. The growth of the ethanol industry has increased the demand for corn. We believe that continuing increase in global demand will result in corn prices above historic averages. As an example of our potential sensitivity to price changes, if the price of ethanol rises or falls $.10 per gallon, our revenues may increase or decrease accordingly by approximately $5.0 million, assuming no other changes in our business. Additionally, if the price of corn rises or falls $0.25 per bushel, our cost of goods sold may increase or decrease by $5.0 million, again assuming no other changes in our business. During our fiscal 2010, the market price of ethanol and corn were extremely volatile. The price of corn hit a high of $5.86 per bushel in October 2010 and a low of $3.25 in June 2010, while the price of ethanol fluctuated from a high of $2.35 in October 2010 and a low of $1.47 in June 2010.
Trends and Uncertainties Impacting Our Operations
Our current and future results of operation are affected and will continue to be affected by factors such as (a) volatile and uncertain pricing of ethanol and corn; (b) availability of corn that is, in turn, affected by trends such as corn acreage, weather conditions, and yields on existing and new acreage diverted from other crops; and (c) the supply and demand for ethanol, which is affected by acceptance of ethanol as a substitute for fuel, public perception of the ethanol industry, government incentives and regulation, and competition from new and existing construction, among other things. Other factors that may affect our future results of operation include those factors discussed in “Item 1. Business” and “Item 1A. Risk Factors.”
Critical Accounting Estimates
We review long-lived assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Impairment testing for assets requires various estimates and assumptions, including an allocation of cash flows to those
assets and, if required, an estimate of the fair value of those assets. Our estimates are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. These valuations require the use of management’s assumptions, which do not reflect unanticipated events and circumstances that may occur. In our analysis, we consider future corn costs and ethanol prices, break-even points for our plant and our risk management strategies in place through our derivative instruments and forward contracts. Given the significant assumptions required and the possibility that actual conditions will differ, we consider the assessment of impairment of our long-lived assets to be a critical accounting estimate.
We reviewed our long-lived assets for impairment at October 31, 2010. As a result of this review and our related analysis, we believe our long-lived assets were not impaired as of October 31, 2010.
We enter forward contracts for corn purchases to supply the plant. These contracts represent firm purchase commitments which along with inventory on hand must be evaluated for potential market value losses. We have estimated a loss on these firm purchase commitments to corn contracts in place and for corn on hand at October 31, 2010 where the price of corn exceeds the market price and upon being used in the manufacturing process and eventual sale of products we anticipate losses. Our estimates include various assumptions including the future prices of ethanol, distillers grains and corn. For the years ended 2010, 2009 and 2008 we recognized a lower of cost or market loss of $97,000, $352,000 and $1,628,000.
Fiscal Year Ended October 31, 2010 Compared to Fiscal Year Ended October 31, 2009
The following table shows the results of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our statements of operations for the fiscal year ended October 31, 2010 and 2009:
Revenues
Ethanol revenues during the period ended October 31, 2010 were approximately $90.9 million, comprising 82% of our revenues compared to $70.4 million during the period ended October 31, 2009, representing 80% of our revenues.
For the year ended October 31, 2010, we sold approximately 53.4 million gallons of ethanol at an average price of $1.70 per gallon. For the year ended October 31, 2009, we sold approximately 46.4 million gallons of ethanol at an average price of $1.52 per gallon. We believe that the number of gallons of ethanol sold was affected by the plant’s productivity that was impacted by scheduled and unscheduled downtime during the fiscal year 2009, including testing and process changes relating to our air emissions. Further, the price of ethanol during our fiscal year was affected by the demand for ethanol as a motor fuel which is affected by, among other factors, regulatory developments, gasoline consumption, and the price of crude oil. The price was also affected by federal RFS blending mandates.
We may hedge anticipated ethanol sales through a variety of mechanisms. Our marketers, whether RPMG or C&N, are obligated to use reasonable efforts to obtain the best price for our ethanol. To mitigate ethanol price risk and to obtain the best margins on ethanol that is marketed and sold by a marketer, we may utilize ethanol swaps, over-the-counter (“OTC”) ethanol swaps, or OTC ethanol options that are typically settled in cash, rather than gallons of the ethanol we produce. Losses or gains on ethanol derivative instruments recorded in a particular period are reflected in revenue for that period. For the years ended October, 31, 2010 and 2009, we recorded a loss of $0.2 million and a gain $0.4 million, respectively, related to ethanol derivative instruments. There are timing differences in the recognition of losses or gains on derivatives as compared to the corresponding sale of ethanol. As such, the losses or gains recognized could be associated with related sales in fiscal years 2008, 2009 or 2010.
We expect to see fluctuations in ethanol prices over the next fiscal year. While the demand for ethanol is expected to continue since gasoline blenders will need increasing amounts of ethanol to meet the Renewable Fuels Standard’s blending requirements, the supply is also expected to increase as additional production facilities are completed or return to production. In addition, low prices for petroleum and gasoline will exert downward pressure on ethanol prices. If ethanol prices decline, our earnings will also decline, particularly if corn prices remain substantially higher than historic averages, as they were in our fiscal year 2010. Future prices for fuel ethanol will be affected by a variety of factors beyond our control including, the demand for ethanol as a motor fuel, federal incentives for ethanol production, the amount and timing of additional domestic ethanol production and ethanol imports and petroleum and gasoline prices.
Total sales of DGS during fiscal years 2010 and 2009 equaled approximately $13.0 million and $12.8 million, respectively, comprising 12% and 14% of our revenues for fiscal years 2010 and 2009, respectively. In fiscal years 2010 and 2009, we sold approximately 119,000 tons of dried distillers’ grain. The average price we received for distillers’ grain was approximately $99 per ton in fiscal year 2010 and approximately $107 per ton in fiscal year 2009.
Prices for distillers’ grains are affected by a number of factors beyond our control such as the supply of and demand for distillers’ grains as an animal feed and prices for competing feeds. We believe that current market prices for distillers’ grains are approaching levels that can be sustained long-term as long as the prices of competing animal feeds remain steady or increase, livestock feeders continue to create demand for alternative feed sources such as distillers’ grains and the supply of distillers’ grains remains relatively stable. On the other hand, if competing commodity price values retreat and distillers’ supplies increase due to growth in the ethanol industry, distillers’ grains prices may decline.
Cost of Goods Sold
Our costs of sales include, among other things, the cost of corn used in ethanol and DGS production (which is the largest component of costs of sales), coal, processing ingredients, electricity, and wages, salaries and benefits of production personnel. We use approximately 1.5 million bushels of corn per month at the plant. We contract with local farmers and elevators for our corn supply. We are able to store corn that we purchase in our elevators in Lakefield and Wilder, Minnesota, as well as in on-site storage at the plant.
Our costs of sales (including lower of cost or market adjustments) as a percentage of revenues were 93.9% and 102.9% for the twelve months ended October 31, 2010 and, 2009, respectively. The per bushel cost of corn purchased (net of losses realized in fiscal year 2009 for bushels delivered in fiscal 2010) decreased approximately 1% in the twelve months ended October 31, 2010 as compared to the twelve months ended October 31, 2009. Cost of goods sold includes lower of cost or market adjustments of $0.9 million for the fiscal year ended October 31, 2010, which related to forward purchase contracts and inventory where the fixed price was more than the estimated realizable value. The lower of cost or market adjustment for the twelve months ended October 31, 2009 was $5.4 million. We had a loss related to corn derivative instruments of approximately $1.0 million for the twelve months ended October 31, 2010, which increased cost of sales. We had a gain related to corn derivative instruments of approximately $1.2 million for the twelve months ended October 31, 2009 that reduced cost of sales. In summary, lower of cost or market adjustments decreased $4.5 million for the fiscal year ended October 31, 2010 as compared to the fiscal year ended October 31, 2009. During the same periods, gains on derivatives decreased $2.2 million. These decreased net costs combined with the 12% increase in the per gallon sales price of ethanol caused the decrease in the cost of goods sold as a percent of revenues for the twelve months ended October 31, 2010. Our gross margin (loss) for the twelve months ended October 31, 2010 increased to 6.1% from (2.9%) for the twelve months ended October 31, 2009. We had a positive gross margin in fiscal year 2010 as compared to negative gross margin in fiscal year 2009 due to the increase in ethanol prices; decreased costs of goods sold, relative to revenues; and due to a decrease in losses on forward contracts. In addition, higher production levels in fiscal year 2010 contributed to the positive gross margin experienced in fiscal year 2010.
The cost of corn fluctuates based on supply and demand, which, in turn, is affected by a number of factors that are beyond our control. We expect our gross margin to fluctuate in the future based on the relative prices of corn and fuel ethanol. We use futures and options contracts to minimize our exposure to movements in corn prices, but there is no assurance that these hedging strategies will be effective. Through October 31, 2010, none of our derivative contracts were designated as hedges and, as a result, changes to the market value of these contracts
were recognized as an increase or decrease to our costs of goods sold. As a result, gains or losses on derivative instruments do not necessarily coincide with the related corn purchases. This may cause fluctuations in cost of goods sold. While we do not use hedge accounting to match gains or losses on derivative instruments, we believe the derivative instruments provide an economic hedge.
Costs of sales also include expenses directly attributable to the repair and maintenance of the plant. Cost of sales as a percentage of revenue was higher in fiscal year 2009 as compared to fiscal year 2010 due to increased costs attributable to the repair and maintenance of the plant. During the third quarter of fiscal year 2009, we incurred costs of approximately $300,000 as part of a five day planned semi-annual shutdown and maintenance procedure. Upon shutdown, portions of the refractory section of the boiler collapsed. While there were no injuries sustained, significant additional costs were incurred to secure the refractory, ensure the safety of the workers completing repairs and to complete the repairs. This added eleven days to the shutdown for a total of sixteen days shutdown during May 2009.
Cost of sales for fiscal year 2010 also reflects the positive impact of an amended railcar leasing agreement we entered into in July 2009. The terms of the amendment reduce the rail cars under lease by 50 cars and increase the monthly rental amount per remaining rail car until July 1, 2014. This has resulted in a monthly cash savings of $425 per rail car or $21,250 per month.
We have forward contracts in place for corn purchases of approximately 700,000 bushels through March 2011 which represents approximately 4% of our anticipated purchases in fiscal 2011. During the fiscal year some forward contracts were above the current market price for corn which resulted in a loss. Accordingly, we recorded a loss on these purchase commitments of approximately $800,000 for the twelve months ended October 31, 2010. Of the amount recorded in costs of goods sold, we have realized all $800,000 upon delivery. The loss, along with a write down of inventory on hand of approximately $100,000, was recorded as a lower of cost or market adjustment on the statement of operations. The amount of the loss was determined by applying a methodology similar to that used in the lower of cost or market evaluation with respect to inventory. Given the uncertainty of future ethanol prices, this loss may or may not be recovered, and further losses on the outstanding purchase commitments could be recorded in future periods. In order to mitigate risk associated with price fluctuations of coal, the Company has entered into coal supply agreements with a minimum commitment of approximately $4,950,000 per year until May 2012, including transportation, with provisions for fuel surcharges and adjustments for inflation.
Operating Expense
Operating expenses include wages, salaries and benefits of administrative employees at the plant, insurance, professional fees and similar costs and generally do not vary with the level of production at the plant. These expenses were $3.9 million for the twelve months ended October 31, 2010 down 13.3% from $4.5 million for the twelve months ended October 31, 2009. These expenses generally do not vary with the level of production at the plant and were relatively constant from period to period other than costs of approximately $800,000 incurred for environmental emissions testing done and unusual boiler repairs during fiscal 2009. I ncreased revenue for the fiscal year ended October 31, 2010 positively affected operating expenses as a percentage of revenue as total revenues increased approximately 25%.
Settlement Income
From the settlement on July 2, 2010 of our arbitration proceeding involving Fagen, Inc., we recorded $2.6 million of settlement income from cash and noncash proceeds during the third quarter of fiscal year 2010. There was no settlement income in fiscal year 2009.
Operating Income
Our income from operations for fiscal year 2010 totaled $5.5 million compared to a loss from operations for fiscal year 2009 of approximately $7.1 million. We experienced operating income in fiscal year 2010 rather than an operating loss primarily due to positive gross margin in fiscal year 2010 of $6.7 million as compared to a negative gross margin of $2.5 million in fiscal year 2009 and the impact of $2.6 million in settlement income in fiscal year 2010.
Other Income and (Expense)
Other expense consisted primarily of interest expense. Interest expense consists primarily of interest payments on our credit facilities described below. Interest expense for fiscal year 2010, which was up slightly as compared to the twelve months ended October 31, 2009, is dependent on the balances outstanding, interest rate fluctuations and default interest accruals. As of October 31, 2010, debt balances were down 10% as compared to balances at October 31, 2009. The average 1 month LIBOR rate, applicable to our line of credit with AgStar, was 0.27% for the twelve months ended October 31, 2010 compared to 0.52% for the twelve months ended October 31, 2009. Balances on our line of credit decreased from $5,000,000 at October 31, 2009 to $3,500,000 outstanding at October 31, 2010. However, balances on our line of credit had a minimum interest rate of 6% during the twelve months ended October 31, 2010 and there was no minimum interest rate during the
twelve months ended October 31, 2009. Additionally, we accrued 2% in default interest on all of our indebtedness to AgStar beginning February 1, 2010 through July 2, 2010, which added additional expense for the twelve months ended October 31, 2010. We also accrued the same 2% default interest on all of our indebtedness to AgStar from May 1, 2009 through May 29, 2009. While interest expense remained rather flat from year to year, fiscal year 2009 included the write-off of loan costs of approximately $445,000 in other expense. Because we have not obtained a waiver from AgStar for actual or expected violations of our master loan agreement, our long-term debt with AgStar was classified as a current liability. As such, we wrote-off the remaining loan costs rather than amortizing them over the original contractual term of the loans.
Fiscal Year Ended October 31, 2009 Compared to Fiscal Year Ended October 31, 2008
The following table shows the results of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our statements of operations for the fiscal year ended October 31, 2009 and 2008:
Revenues
Ethanol revenues during the period ended October 31, 2009 were approximately $70.4 million, comprising 80% of our revenues as compared to $101.8 million for the year ended October 31, 2008 and 78% of our revenue. For the year ended October 31, 2009, we sold approximately 46.4 million gallons of ethanol at an average price of $1.52 per gallon. For the year ended October 31, 2008, we sold approximately 48.4 million gallons of ethanol at an average price of $2.10 per gallon. We believe that the number of gallons of ethanol sold was affected by the plant’s productivity that was impacted by scheduled and unscheduled downtime during the year, including as a result of testing and process changes relating to our air emissions. Further, the price of ethanol during our fiscal year was affected by the demand for ethanol as a motor fuel which is affected by, among other factors, regulatory developments, gasoline consumption, and the price of crude oil. Gasoline consumption was volatile during the fiscal year as the price for crude oil fluctuated radically. The price was also affected by federal RFS blending mandates.
We may hedge anticipated ethanol sales through a variety of mechanisms. Our marketers, whether RPMG or C&N, are obligated to use reasonable efforts to obtain the best price for our ethanol. To mitigate ethanol price risk and to obtain the best margins on ethanol that is marketed and sold by a marketer, we may utilize ethanol swaps, over-the-counter (“OTC”) ethanol swaps, or OTC ethanol options that are typically settled in cash, rather than gallons of the ethanol we produce. For the years ended October, 31, 2009 and 2008, we recorded gains of $0.4 million and $3.6 million respectively related to ethanol derivative instruments. There are timing differences in the recognition of gains on derivatives as compared to the corresponding sale of ethanol. As such, the gains recognized could be associated with related sales in fiscal years 2007, 2008 or 2009.
We expect to see fluctuations in ethanol prices over the next fiscal year. While the demand for ethanol is expected to continue since gasoline blenders will need increasing amounts of ethanol to meet the Renewable Fuels Standard’s blending requirements, the supply is also expected to increase as additional production facilities are completed or return to production. In addition, low prices for petroleum and gasoline will exert downward pressure on ethanol prices. If ethanol prices decline, our earnings will also decline, particularly if corn prices remain substantially higher than historic averages, as they were in our fiscal year 2009. Future prices for fuel ethanol will be affected by a variety of
factors beyond our control including, the demand for ethanol as a motor fuel, federal incentives for ethanol production, the amount and timing of additional domestic ethanol production and ethanol imports and petroleum and gasoline prices.
Total sales of DGS during fiscal years 2009 and 2008 equaled approximately $12.8 million and $18.2 million, respectively, comprising 14% of our revenues for each year. In fiscal year 2009 we sold approximately 119,000 tons of dried distillers’ grain compared to 113,000 tons sold in fiscal year 2008. The average price we received for distillers’ grain was approximately $107 per ton in fiscal year 2009 and approximately $147 per ton in fiscal year 2008.
The prices for DGS increased significantly during the first three quarters of fiscal 2008, due to the rising price of corn, soybean meal, and other animal feed proteins that are substitutes for DGS. These factors were not present in fiscal year 2009. However, during the last quarter of fiscal 2008, decreasing corn prices placed downward pressure on DGS prices which continued through fiscal 2009. In addition, the average price we received for our DGS in fiscal 2008 was limited by forward wet distillers grains contracts locking in a portion of our DGS prices.
Prices for distillers’ grains are affected by a number of factors beyond our control such as the supply of and demand for distillers’ grains as an animal feed and prices for competing feeds. We believe that current market prices for distillers’ grains are approaching levels that can be sustained long-term as long as the prices of competing animal feeds remain steady or increase, livestock feeders continue to create demand for alternative feed sources such as distillers’ grains and the supply of distillers’ grains remains relatively stable. On the other hand, if competing commodity price values retreat and distillers’ supplies increase due to growth in the ethanol industry, distillers’ grains prices may decline.
Cost of Goods Sold
Our costs of sales include, among other things, the cost of corn used in ethanol and DGS production (which is the largest component of costs of sales), coal, processing ingredients, electricity, and wages, salaries and benefits of production personnel. We use approximately 1.5 million bushels of corn per month at the plant. We contract with local farmers and elevators for our corn supply. We are able to store corn that we purchase in our elevators in Lakefield and Wilder, Minnesota, as well as in on-site storage at the plant.
Our costs of sales (including lower of cost or market adjustments) as a percentage of revenues were 102.9% and 87.3% for the twelve months ended October 31, 2009 and, 2008, respectively. The per bushel cost of corn purchased (net of losses realized in fiscal year 2008 for bushels delivered in fiscal 2009) decreased approximately 19% in the twelve months ended October 31, 2009 as compared to the twelve months ended October 31, 2008. Cost of goods sold includes lower of cost or market adjustments of $5.4 million for the fiscal year ended October 31, 2009, which related to forward purchase contracts and inventory where the fixed price was more than the estimated realizable value. The lower of cost or market adjustment for the twelve months ended October 31, 2008 was $8.7 million We had gains related to corn derivative instruments of approximately $1.2 million and $6.3 million for the twelve months ended October 31, 2009 and 2008, respectively, which reduced cost of sales. In summary, lower of cost or market adjustments decreased $3.3 million for the fiscal year ended October 31, 2009 as compared to the fiscal year ended October 31, 2008. During the same periods, gains on derivatives decreased $5.1 million. These increased net costs combine with the 28% decrease in the per gallon sales price of ethanol caused the increase in the cost of goods sold as a percent of revenues for the twelve months ended October 31, 2009. Our gross margin (loss) for the twelve months ended October 31, 2009 decreased to (2.9%) from 12.7% for the twelve months ended October 31, 2008. We had a negative gross margin in fiscal year 2009 as compared to positive gross margin in fiscal year 2008 due to the decline in ethanol prices; increased costs of goods sold, relative to revenues, due to losses on forward contracts; and decreased gains on derivative instruments. In addition, lower production levels and fixed costs contributed to the negative gross margin incurred.
The cost of corn fluctuates based on supply and demand, which, in turn, is affected by a number of factors that are beyond our control. We expect our gross margin to fluctuate in the future based on the relative prices of corn and fuel ethanol. We use futures and options contracts to minimize our exposure to movements in corn prices, but there is no assurance that these hedging strategies will be effective. Through October 31, 2009, none of our derivative contracts were designated as hedges and, as a result, changes to the market value of these contracts were recognized as an increase or decrease to our costs of goods sold. As a result, gains or losses on derivative instruments do not necessarily coincide with the related corn purchases. This may cause fluctuations in cost of goods sold. While we do not use hedge accounting to match gains or losses on derivative instruments, we believe the derivative instruments provide an economic hedge.
Costs of sales also include expenses directly attributable to the repair and maintenance of the plant. During the three months ended July 31, 2009, we incurred costs of approximately $300,000 as part of a five day planned annual shutdown and maintenance procedure. Upon shutdown, portions of the refractory section of the boiler collapsed. While there were no injuries sustained, significant additional costs were
incurred to secure the refractory, ensure the safety of the workers completing repairs and to complete the repairs. This added eleven days to the shutdown for a total of sixteen days shutdown during May.
During the three months ended July 31, 2009, we entered into an amendment to our agreement with a leasing company under which we lease certain rail cars. The terms of the amendment reduce the rail cars under lease by 50 cars and increase the monthly rental amount per remaining rail car until July 1, 2014. This will result in a monthly cash savings of $425 per rail car or $21,250.
At October 31, 2009 we had forward contracts in place for corn purchases of approximately 1.8 million bushel through May 2010 which represented approximately 9% of our anticipated purchases in fiscal 2010. These corn contract prices were above the current market price for corn at October 31, 2009. Upon taking delivery under these contracts, we incurred a loss. Accordingly, we recorded a loss on these purchase commitments of approximately $5.0 million for the twelve months ended October 31, 2009. Of the amount recorded in costs of goods sold at October 31, 2009, we had realized $3.8 million upon delivery realized the remaining $1.2 million in fiscal 2010. The loss, along with a write down of inventory on hand of $0.4 million, was recorded as a lower of cost or market adjustment on the statement of operations at October 31, 2009. The amount of the loss was determined by applying a methodology similar to that used in the lower of cost or market evaluation with respect to inventory. Given the uncertainty of future ethanol prices, this loss may or may not be recovered, and further losses on the outstanding purchase commitments could be recorded in future periods. At October 31, 2009, 1.2 million bushel subject to future contracted prices had contracted prices less than current market prices. Unrealized gains on these contracts have not been recorded. In order to mitigate risk associated with price fluctuations of coal, the Company has entered into coal supply agreements with a minimum commitment of approximately $4,950,000 per year until May 2012, including transportation, with provisions for fuel surcharges and adjustments for inflation.
Operating Expense
Operating expenses include wages, salaries and benefits of administrative employees at the plant, insurance, professional fees and similar costs and generally do not vary with the level of production at the plant. These expenses were $4.5 million for the twelve months ended October 31, 2009 up 34.7% from $3.3 million for the twelve months ended October 31, 2008. Upon a planned annual shutdown, portions of the refractory section of the boiler collapsed. While there were no injuries sustained, significant additional costs were incurred to secure the refractory, ensure the safety of the workers completing repairs and to complete the repairs. Costs associated with the unplanned repairs were approximately $700,000 and are included in operating expenses. Professional fees increased for the twelve months ended October 31, 2009 as compared to the prior year period because of additional legal, accounting and internal control consulting work in anticipation of required compliance with the Sarbanes-Oxley Act of 2002 and SEC reporting requirements, as well as the arbitration action we commenced against Fagen, Inc. Decreased revenue for the fiscal year ended October 31, 2009 negatively affected operating expenses as a percentage of revenue as total revenues declined approximately 33%.
Operating Income
Our loss from operations for fiscal year 2009 totaled $7.1 million compared to income from operations for fiscal year 2008 of approximately $13.3 million.
Other Income and (Expense)
Other expense consisted primarily of interest expense. Interest expense consists primarily of interest payments on our credit facilities described below. Interest expense for fiscal year 2009, which is down approximately 16.5% as compared to the twelve months ended October 31, 2008, is dependent on the balances outstanding and on interest rate fluctuations. As of October 31, 2009, debt balances were down slightly as compared to balances at October 31, 2008. The average 1 month LIBOR rate for the twelve months ended October 31, 2009 was 0.52% compared to 3.25% for the twelve months ended October 31, 2008. From May 1, 2009 through May 29, 2009, AgStar added an additional 2.0% in default interest to the interest rate on the outstanding amounts under the Company’s master loan agreement. Also included in other expense is the write-off of loan costs of approximately $445,000. Because we have not obtained a waiver from AgStar for actual or expected violations of our master loan agreement, our long-term debt with AgStar was classified as a current liability. As such, we wrote-off the remaining loan costs rather than amortizing them over the original contractual term of the loans.
Liquidity and Capital Resources
As of October 31, 2010, we had cash and cash equivalents (other than restricted cash) of approximately $1.5 million, current assets of approximately $18.3 million and total assets of approximately $109.5 million.
Our principal sources of liquidity consist of cash provided by operations, cash and cash equivalents on hand, and available borrowings under our master loan agreement with AgStar. Under the master loan agreement, we have three forms of debt: a term note, a revolving term note and a line of credit. The total indebtedness to AgStar at October 31, 2010 was $53.6 million, consisting of $49.0 million under the term note, $1.1 million under the revolving term note and $3.5 million under the line of credit. Among other provisions, our master loan agreement contains covenants requiring us to maintain various financial ratios and tangible net worth. It also limits our annual capital expenditures and membership distributions. All of our assets and real property are subject to security interests and mortgages in favor of AgStar as security for the obligations of the master loan agreement. Please see “Credit Arrangements - Credit Arrangement with AgStar” for a description of our indebtedness and agreements relating to our indebtedness with AgStar.
At October 31, 2010, we were in default of a covenant of our master loan agreement with AgStar requiring us to maintain a fixed charge ratio of 1.20 to 1.00 or greater. Additionally, we do not expect to be in compliance with one or more covenants of the master loan agreement during fiscal year 2011 without an amendment to the master loan agreement. Our failure to maintain the required fixed charge ratio constitutes an event of default under the master loan agreement, entitling AgStar to accelerate and declare due all amounts outstanding under the master loan agreement. Therefore, we have classified $44.5 million of the AgStar debt as a current liability that would otherwise be classified as long term. As a result, current liabilities as of October 31, 2010 totaled approximately $60.0 million, including $44.5 million of long-term debt reclassified as current liabilities. Our debt with AgStar remains classified as a current liability based on current and projected violations of debt covenants within the next year.
Under a forbearance agreement dated July 2, 2010 AgStar agreed it would not declare a default under the master loan agreement or enforce any of the remedies available to it for the period of July 2, 2010 to the earlier of an event of default (as defined under the forbearance agreement) or December 31, 2010. During this forbearance period, we failed to maintain the minimum fixed charge coverage ratio at October 31, 2010, which constituted an event of default under the July 2, 2010 forbearance agreement and entitled AgStar to accelerate payment of all of our indebtedness, among other remedies.
On December 30, 2010, we entered into an amended forbearance agreement under which AgStar agreed it will not declare a default under the loan documents or enforce any of the remedies available to it for the period of December 30, 2010 to the earlier of an event of default (as defined under the amended forbearance agreement) or March 1, 2011.
There is no assurance that we will be able to comply with the covenants and obligations of the master loan agreement or that any waiver or amendment to the master loan agreement or that any further forbearance will be provided by AgStar. We have violated certain financial covenants under our master loan agreement with AgStar at the end of each quarter from January 31, 2009 to October 31, 2010, except the quarter ended July 31, 2010.
Further, there can be no assurance that AgStar will not demand immediate repayment of all $53.6 million in indebtedness outstanding under the master loan agreement at October 31, 2010 or exercise any of its rights as a secured party with respect to the Company’s assets now or in the future should we fail to comply with any covenants in the future. We do not have adequate capital to repay all of the amounts that would become due if AgStar accelerates our obligations under the master loan agreement. Further, we do not have adequate cash to repay the $3.5 million outstanding on the line of credit at October 31, 2010 when due on March 1, 2011 and intend to request an additional extension of the maturity date of this line of credit beyond March 1, 2011. There can be no assurance that such an extension will be granted on terms advantageous to us, if at all. Further, while an event of default exists, the Company is not permitted to borrow additional funds under its line of credit or revolving term note unless AgStar consents to the advance. While AgStar has consented to make advances in the past, our potential inability to borrow additional funds under the master loan agreement may result in a working capital shortfall. Our plan to address our need for working capital is to generate capital through increased income and cash flow from our operations, conserve funds by utilizing and reducing corn inventory, reduce operating expenses through cost controls, and to raise additional working capital through obtaining equity investments or incurring additional indebtedness.
In addition, we are required by the December 30, 2010 amended forbearance agreement to obtain additional equity investments on terms and conditions acceptable to AgStar of an amount of not less than $4.5 million on or before March 1, 2011. The amounts from the additional equity investments must be held in escrow pending certain approvals from AgStar and thereafter, may be used for working capital purposes or, with AgStar’s consent, an engineering and emissions remediation project, not to exceed $1.4 million. We may also be required to identify and secure capital to refinance our existing indebtedness, repay amounts outstanding on the line of credit at maturity, or repay the full amount of our indebtedness to AgStar if accelerated because of an event of default.
We are currently attempting to raise up to $6.8 million in additional capital from an offering of our units that we began in August 2010. No assurance can be given that additional capital will be obtained in an amount that is sufficient for our needs or in an amount that
satisfies the requirements of the amended forbearance agreement. Further, no assurance can be given that we will be able to raise the required $4.5 million or an amount sufficient to repay our line of credit by March 1, 2011.
If we do not obtain sufficient proceeds from our current equity offering, we will likely seek additional capital by incurring additional indebtedness or from another offering of our equity securities or both. If we are able to obtain additional capital, the terms will be determined based upon negotiations between us and the lenders or investors. No assurance can be given that any capital we do receive will be in an amount that is sufficient for our needs, in a timely manner, or on terms and conditions acceptable to us or our members. The issuance of additional equity in a future offering will dilute and may dilute significantly the equity interests of our unit holders at the time of any such offering. If we incur any additional indebtedness, we will be further limited in distributions to our unit holders and our unit holders may receive no return on their investment in the event of our liquidation or dissolution.
Moreover, we are considering alternatives and improvements in our operations designed to increase our income and cash flow from operations. One of these alternatives involves converting our plant from the production of ethanol to the production of another biofuel. No assurance can be given that any alternative that may be available to us will be implemented or that even if implemented, will result in improved financial performance.
Our financing needs are based upon management estimates as to future revenue and expense. Our business plan and financing needs are subject to change based upon, among other factors, market and industry conditions, our ability to increase cash flow from operations and our ability to control costs and expenses. If our estimates of our financing needs change, any capital that we do obtain may not be sufficient for our needs and we may need more capital in the future.
If we are unable to obtain sufficient capital, we may further curtail our capital expenditures, further reduce our expenses, explore strategic alternatives or suspend or discontinue our operations or sell our assets. Our ability to comply with the amended forbearance agreement, the covenants of our master loan agreement or make required payments on our debt to AgStar will be impaired if we do not obtain sufficient additional capital, resulting in events of default, acceleration of our indebtedness, seizure by AgStar of assets that secure our indebtedness, loss of control of our business or bankruptcy.
Year Ended October 31, 2010 Compared to Year Ended October 31, 2009
Our principal uses of cash are to pay operating expenses of the plant and to make debt service payments. During the twelve months ended October 31, 2010, we used cash to make principal payments of approximately $5.1 million against the term note and to pay down $1.5 million on our line of credit.
The following table summarizes our sources and uses of cash and equivalents from our condensed consolidated statements of cash flows for the periods presented (in thousands):
During the twelve months ended October 31, 2010, we used $0.6 million in cash for operating activities. This use consists primarily of generating net income of $1.7 million plus non-cash expenses including depreciation and amortization of $5.6 million and cash used to purchase inventory of $6.0 million.
During the twelve months ended October 31, 2010, we used approximately $119,000 for investing activities to pay for capital expenditures and intangibles.
During the twelve months ended October 31, 2010, we used approximately $940,000 from financing activities consisting primarily of payments on our term note of approximately $5.1 million and $1.5 million on the line of credit. We also generated $4.5 million from member contributions.
Year Ended October 31, 2009 Compared to Year Ended October 31, 2008
During the twelve months ended October 31, 2009, we used $8.3 million in cash for operating activities. This use consists primarily of funding a net loss of $5.2 million exclusive of depreciation and amortization of $6.1 million, and payments for corn under deferred payment agreements and other payables of $3.2 million.
During the twelve months ended October 31, 2009, we used approximately $232,000 for investing activities to pay for capital expenditures and intangibles.
During the twelve months ended October 31, 2009, we generated $395,000 from financing activities consisting primarily of advances on the line of credit of $5.0 million, payments on long term debt of approximately $5.0 million and the release of restricted cash in the amount of $0.4 million.
Contractual Obligations
The following table provides information regarding the consolidated contractual obligations of the Company as of October 31, 2010:
(1) Long-term debt obligations include estimated interest and interest on unused debt.
(2) Purchase obligations primarily include forward contracts for corn and coal.
Off Balance-Sheet Arrangements
We have no off balance-sheet arrangements.
Credit Arrangements
Credit Arrangements with AgStar
We have entered into master loan agreement with AgStar Financial Services, PCA (“AgStar”) under which we have three forms of debt as of October 31, 2010: a term note dated October 1, 2007 in the original principal amount of $59.6 million , a revolving term note dated October 1, 2009 in the original principal amount of $5.0 million, and a line of credit that was renewed on July 2, 2010 for a maximum commitment of $6.75 million.
AgStar has been granted a security interest in substantially all of the assets of Heron Lake BioEnergy and its subsidiary, Lakefield Farmers Elevator, LLC. We also assigned to AgStar our interest in our agreements for the sale of ethanol and distillers grains, and for the purchases of coal, corn and electricity, as well as our design-build agreement with Fagen, Inc. AgStar also received a mortgage relating to our real property and that of Lakefield Farmers Elevator.
During the term of the loans, we are subject to certain financial loan covenants consisting of minimum working capital, minimum debt coverage, and minimum tangible net worth. We are only allowed to make annual capital expenditures up to $500,000 annually without prior approval. The loan agreements also impose restrictions on our ability to make cash distributions to our members.
Upon an occurrence of an event of default or an event that will lead to our default, AgStar may upon notice terminate its commitment to loan funds and declare the entire unpaid principal balance of the loans, plus accrued interest, immediately due and payable. An event of
default includes, but is not limited to, our failure to make payments when due, insolvency, any material adverse change in our financial condition or our breach of any of the covenants, representations or warranties we have given in connection with the transaction.
Please see the discussion above in “Liquidity and Capital Resources” regarding our failure to comply with covenants of the master loan agreement and the impact of these covenant violations on our liquidity and capital resources.
Term Note
The term note required interest only payments from November 2007 to April 2008 at the one-month LIBOR plus 3.25%. In May 2008, we locked in an interest rate of 6.58% on $45.0 million of the note for three years ending April 30, 2011. The remainder of the amounts outstanding on the term note is subject to a variable rate based on LIBOR plus 3.25%, which percentage is subject to reduction based upon the ratio of members’ equity to assets. We will make equal monthly payments of principal and interest of approximately $640,000 to amortize the note over a period not to exceed ten years, with a final balloon payment due in October 2012. In addition, we are required to make additional payments on the term note of excess cash flow, as defined in the master loan agreement, up to $2.0 million per year to AgStar until we reach a specified financial ratio.
Revolving Term Note
The amount available under the revolving term note is reduced each year by $500,000. As of October 31, 2010, the maximum amount of the revolving term note was $3,500,000. The applicable interest rate on the revolving note is 3.25% above the one month LIBOR rate. The revolving term note will mature on October 1, 2012. We pay a commitment fee of 0.35% per annum on the unused portion of the revolving term note.
Line of Credit
The revolving line of credit loan is for a maximum commitment of $6,750,000, subject to a defined borrowing base. By a series of amendments to the master loan agreement with AgStar, the maturity of the revolving line of credit was extended from its original maturity of November 1, 2009 to June 30, 2010. On July 2, 2010, the Company and AgStar agreed upon the terms of the renewal of the Company’s line of credit loan with a new maturity date of December 31, 2010 as part of a forbearance agreement also dated July 2, 2010. On December 30, 2010, AgStar also renewed this revolving line of credit loan commitment in an aggregate principal amount outstanding at any one time not to exceed $6,750,000 or 75% of certain accounts receivable and inventory amounts, with a maturity date of March 1, 2011.
Interest accrues on borrowings at the greater of 6.0% or the one month LIBOR plus 3.25%, which totaled 3.51%, 3.49% and 5.74% at October 31, 2010, 2009 and 2008, respectively. We must pay a 0.25% commitment fee on the average daily unused portion of the line of credit.
At October 31, 2010 and 2009, outstanding borrowings on the line of credit were $3.5 million and $5.0 million, respectively. Amounts available under the line of credit are reduced by outstanding standby letters of credit. We had no outstanding standby letters of credit at October 31, 2010 and 2009, respectively.
Other Credit Arrangements
In addition to our primary credit arrangement with AgStar, we have other material credit arrangements and debt obligations.
In October 2003, we entered into an industrial water supply development and distribution agreement with the City of Heron Lake, Jackson County, and Minnesota Soybean Processors. In consideration of this agreement, we and Minnesota Soybean Processors are allocated equally the debt service on $735,000 in water revenue bonds that were issued by the City to support this project that mature in February 2019. The parties have agreed that prior to the scheduled expiration of the agreement, they will negotiate in good faith to replace the agreement with a further agreement regarding the wells and related facilities. In May 2006, we entered into an industrial water supply treatment agreement with the City of Heron Lake and Jackson County. Under this agreement, we pay monthly installments over 24 months starting January 1, 2007 equal to one years’ debt service on approximately $3.6 million in water revenue bonds, which will be returned to us if any funds remain after final payment in full on the bonds and assuming we comply with all payment obligations under the agreement. As of October 31, 2010, there was a total of $3.1 million in outstanding water revenue bonds and we classify our obligations under these bonds as assessments payable. The interest rates on the bonds range from 0.50% to 8.73%.
In November 2007, we entered into a shared savings contract with Interstate Power and Light Company (“IPL”), our electrical service provider. Under the agreement, IPL is required to pay $1,850,000 to fund project costs for the purchase and installation of electrical equipment. In exchange, we are required to share a portion of the energy savings with IPL that may be derived from the decreased energy consumption from the new equipment. We are required to pay IPL approximately $30,000 for the first thirteen billing cycles, $140,000 at the end of the thirteenth billing cycle, and thereafter, approximately $30,000 for the remainder of the billing cycles. These amounts represent IPL’s portion of the shared savings. We also granted IPL a security interest in the electrical equipment to be installed on our site. The shared savings contract expires December 31, 2012.
In connection with the shared savings contract, IPL deposited $1,710,000 of the $1,850,000 in an escrow account on our behalf and we received the remaining $140,000 as cash proceeds. The escrow account expires at the same time as the shared savings contract or a termination by IPL of the escrow arrangement, at which time any remaining funds will be distributed to IPL. We earn interest at a rate of 4.2% on the funds escrowed and we pay a rate of interest of 1.5% on the funds deposited into escrow. Each month, a distribution from the escrow account is made to IPL to pay its portion of the shared savings under the shared savings contract.
To fund the purchase of the distribution system and substation for the plant, we entered into a loan agreement with Federated Rural Electric Association pursuant to which we borrowed $600,000 by a secured promissory note. Under the note we are required to make monthly payments to Federated Rural Electric Association of $6,250 consisting of principal and an annual fee of 1% beginning on October 10, 2009. In exchange for this loan, Federated Rural Electric Association was granted a security interest in the distribution system and substation for the plant. The balance of this loan at October 31, 2010 was $518,750.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to the impact of market fluctuations associated with interest rates and commodity prices as discussed below. We have no exposure to foreign currency risk as all of our business is conducted in U.S. Dollars. We use derivative financial instruments as part of an overall strategy to manage market risk. We use cash, futures and option contracts to hedge changes to the commodity prices of corn and ethanol. We do not enter into these derivative financial instruments for trading or speculative purposes, nor do we designate these contracts as hedges for accounting purposes pursuant to the requirements of FASB ASC 815, Derivatives and Hedging.
Interest Rate Risk
We may be exposed to market risk from changes in interest rates. Exposure to interest rate risk results primarily from holding variable term note, a revolving term note and a line of credit which bears a variable interest rate. At October 31, 2010, we had $3.5 million outstanding on our revolving line of credit, however, we may borrow on this line of credit at any time which would expose us to interest rate market risk. The specifics of this note are discussed in greater detail in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Commodity Price Risk
We seek to minimize the risks from fluctuations in the prices of raw material inputs, such as corn and finished products ethanol and distillers grains, through the use of hedging instruments. In practice, as markets move, we actively manage our risk and adjust hedging strategies as appropriate. Although we believe our hedge positions accomplish an economic hedge against our future purchases and sales, management has chosen not to use hedge accounting, which would match the gain or loss on our hedge positions to the specific commodity purchase being hedged. We are using fair value accounting for our hedge positions, which means as the current market price of our hedge positions changes, the realized or unrealized gains and losses are immediately recognized in our cost of goods sold or as an offset to revenues. The immediate recognition of hedging gains and losses under fair value accounting can cause net income to be volatile from quarter to quarter due to the timing of the change in value of the derivative instruments relative to the cost and use of the commodity being hedged.
As corn prices move in reaction to market trends and information, our income statement will be affected depending on the impact such market movements have on the value of our derivative instruments. Depending on market movements, crop prospects and weather, these price protection positions may cause immediate adverse effects, but are expected to produce long-term positive growth for us.
A sensitivity analysis has been prepared to estimate our exposure to ethanol and corn price risk. Market risk related to these factors is estimated as the potential change in income resulting from a hypothetical 10% adverse change in the fair value of our corn and average ethanol price as of October 31, 2010, net of the forward and future contracts used to hedge our market risk for corn usage requirements. The volumes are based on our expected use and sale of these commodities for a one year period from October 31, 2010. As of October 31, 2010,
approximately 3.61% of our estimated corn usage and none of our ethanol sales over the next 12 months were subject to fixed price or index contracts where a price has been established with an exchange. Other procurement and sales options including basis or index contracts without a price established on the exchange, for both corn and ethanol, are not included in this analysis. The results of this analysis, which may differ from actual results, are as follows:
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are included in this Annual Report on Form 10-K beginning at the “F” page noted:
Page Reference
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of October 31, 2010 and 2009
Consolidated Statements of Operations for the fiscal years ended October 31, 2010, 2009 and 2008
Consolidated Statements of Changes in Members’ Equity for the fiscal years ended October 31, 2010, 2009 and 2008
Consolidated Statements of Cash Flows for the fiscal years ended October 31, 2010, 2009 and 2008
Notes to Consolidated Financial Statements
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
We maintain a system of “disclosure controls and procedures,” as defined by Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended.
Our Chief Executive Officer, Robert J. Ferguson, and our Chief Financial Officer, Lucas G. Schneider, have evaluated our disclosure controls and procedures as of October 31, 2010. Based upon their review, they have concluded that these controls and procedures are effective.
(b) Management’s Report on Internal Control over Financial Reporting
The Board of Directors and Members of Heron Lake BioEnergy, LLC:
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a15-(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that:
(i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;
(ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
(iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision of our Chief Executive Officer and our Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
A material weakness (within the meaning of PCAOB Auditing Standard No. 5) is a control deficiency, or a combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
In conducting the aforementioned evaluation, management concluded that the Company’s internal control over financial reporting was effective as of October 31, 2010.
(c) Changes in Internal Controls Over Financial Reporting
As a small business, the Company does not have the resources to fund sufficient staff to ensure a complete segregation of responsibilities within the accounting function. However, Company management reviews financial statements and bank reconciliations on a monthly basis. These actions help minimize risk of a potential material misstatement occurring. Subsequent to October 31, 2010, the Interim Chief Financial Officer position was eliminated when the Company’s Senior Accountant was appointed to the position of Chief Financial Officer. While this change will eliminate the Senior Accountant position and one level of financial review, the Company will continue to utilize its current oversight processes and its remaining staff to provide reasonable assurances regarding the reliability of the Company’s financial statements.
There have been no changes in internal control over financial reporting that occurred during the fourth fiscal quarter ended October 31, 2010 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Our Board and Management
Under our member control agreement, our board of governors is to consist of not less than seven nor more than eleven governors, provided that the number of elected governors may not be less than the number of appointed governors. Currently, our board of governors consists of ten governors. Governors that are elected by members are divided into three classes, with the term of one class expiring each year and successors to the governors in that class elected for a three-year term.
Under our member control agreement, a member and its affiliates holding nine percent or more of the units outstanding are entitled to appoint one governor to the board for every 9% of our units held. Project Viking, L.L.C, which holds 29.8% of our outstanding units, has appointed two governors under this provision: David M. Reinhart and Mathew H. Sederstrom. An appointed governor serves indefinitely at the pleasure of the member appointing him or her (so long as such member and its affiliates continue to hold a sufficient number of units to maintain the applicable appointment right) until a successor is appointed, or until the earlier death, resignation or removal of the appointed governor. A member that is entitled to appoint one or more governors under the appointment right provided in the member control agreement and such member’s affiliates are not entitled to vote for the election of governors by the members.
Except for the appointment right described above, we know of no arrangements or understandings between a governor and any other person pursuant to which he has been selected as a governor. There is no family relationship between any of our governors or our executive officers.
Information Regarding Governors
Set forth below is biographical and other information with respect to our current governors. For governors other than those appointed by Project Viking, set forth below a discussion of the specific experience, qualifications, attributes and skills that led to the conclusion that the person should serve as a governor of Heron Lake BioEnergy at this time. Heron Lake BioEnergy does not evaluate or otherwise consider the experience, qualifications, attributes or skills of any governor appointed by Project Viking.
Name
Biography and Age
Robert J. Ferguson
Since 1972, Mr. Ferguson has farmed near Heron Lake, Minnesota. Mr. Ferguson was formerly a Jackson County Commissioner and served on the Jackson County Planning and Zoning board and the Prairieland Economic Development board. In addition, Mr. Ferguson is President of Heron Lake Development Corporation. He is a member of the Jackson County Corn and Soybean Associations, and the Heron Lake/ Okabena Community Club. Mr. Ferguson attended Worthington Community College to pursue his associate of arts degree in business administration but just after graduation was drafted by the U.S. Army to serve in the Vietnam War. Mr. Ferguson was an original member of our founding board of governors. Age 62.
Mr. Ferguson is qualified to serve on the HLBE Board because he brings to the Board a keen understanding of our products and industry. Additionally, Mr. Ferguson’s role as our Chief Executive Officer allows him to provide the Board with his unique perspective as a member of management.
David J. Woestehoff
Mr. Woestehoff operates grain farming operations in Belle Plaine, Minnesota and Arlington, South Dakota. Mr. Woestehoff is also the founder and 50% owner of Brewery Hill Grain Company, which operates independent grain elevators in Cleveland and Le Sueur, Minnesota. In 2009, Mr. Woestehoff became president and majority shareholder of Minnesota Valley Grain Company, LLC, which operates commercial grain elevators in LeCenter and Montgomery, Minnesota. Mr. Woestehoff also serves on various committees at First Lutheran Church in Le Sueur, Minnesota. Mr. Woestehoff graduated from the University of Wisconsin in 1990 with a B.S. degree in Agricultural Business and minors in Economics and Animal Science. Mr. Woestehoff was an original member of our founding board of governors. Age 41.
Mr. Woestehoff is qualified to serve on the HLBE Board because of his extensive experience farming and in grain management.
Timothy O. Helgemoe
Mr. Helgemoe is a fifth generation farmer who has been farming with his brother since 1993. In addition to raising corn, soybeans, and custom farming, Mr. Helgemoe has owned and operated Helgemoe Bros, Inc., a local trucking business, since October 1999. Mr. Helgemoe received his B.S. degree with an emphasis in dairy from the University of Minnesota. Mr. Helgemoe was an original member of our founding board of governors. Age 44.
Mr. Helgemoe’s background in farming and in business qualify him to serve on the Board of Heron Lake BioEnergy.
Name
Biography and Age
Doug Schmitz
Mr. Schmitz attended Willmar Community College in Willmar, Minnesota, and majored in Ag Business. Doug is a third generation farmer who has been farming with his brother since 1988. In addition to agriculture, Mr. Schmitz owns and operates Schmitz Grain, Inc., which was purchased from his father in 1991. Schmitz Grain has three locations in southwestern Minnesota and provides services to area farmers in grain merchandising, custom drying, feed sales, seed sales and fertilizer and chemical application. He also currently serves on the board of two privately-held companies: Agri-Tech Systems, Inc. located in Las Vegas, Nevada, and United Ag Resources of Slayton, Minnesota. Age 48.
Mr. Schmitz’ extensive experience in grain procurement, management, storage and risk management strategies qualify him for service on the Board.
Robert J. Wolf
Since 1994, Mr. Wolf has owned and operated County Seed, Inc. He is currently a director of the Nobles County Corn & Soybean Association, and is a member of the Minnesota Corn Growers Association and Minnesota Soybean Association. He is a Certified Crop Advisor and a member of Knights of Columbus. Mr. Wolf received an Associate of Arts Degree in Ag Business from Worthington Community College in Worthington, Minnesota. Age 58.
Mr. Wolf’s extensive background in farming and our industry qualify him to serve on our Board.
David J. Bach
Mr. Bach was raised on a family farm and has been farming full-time since 2001. From 1987 to 2001, Mr. Bach was employed at Pillsbury/Green Giant in Le Sueur, Minnesota. During his time at Pillsbury/Green Giant, Mr. Bach held primarily supervisory positions and was most recently the Ag Research Station Coordinator. He graduated from the University of Minnesota in St. Paul with a B.S. degree in Agronomy. Age 50.
Mr. Wolf is qualified to serve on our Board because of his farming and business experience.
Michael S. Kunerth
Mr. Kunerth has operated a corn and soybean farm in Brewster, Minnesota since 1990. Since 1992, Mr. Kunerth has also operated a retail seed service business. From 1994 to 2008, Mr. Kunerth also served as the Clerk of Graham Lakes Township. He holds a B.S. Degree in Business Management from St. John’s University, Collegeville, Minnesota. Mr. Kunerth was an original member of our founding board of governors. Age 43.
Mr. Kunerth’s experience in business and particularly his experience managing the financial aspects of business qualify him to serve on the Board of Heron Lake BioEnergy.
Milton J. McKeown
From 1991 to his retirement in October 2006, Mr. McKeown managed the Heron Lake Insurance Agency. While he is currently retired, Mr. McKeown is active in community affairs. Mr. McKeown graduated from Dakota State University with a B.S. degree in Industrial Arts. Mr. McKeown was an original member of our founding board of governors. Age 65.
With his background in insurance and understanding of business management, Mr. McKeown brings expertise to our board in both risk management and business operations.
Name
Biography and Age
David M. Reinhart
Appointed by Project Viking
Since 1975, Mr. Reinhart has operated family-owned supermarkets in Guthrie Center, Panora, and Stuart, Iowa. Mr. Reinhart serves as a board member of five privately-held ethanol production companies: CORN, LP in Goldfield, Iowa; Big River Resources, LLC in West Burlington, Iowa; Amaizing Energy in Denison, Iowa; and Platinum Ethanol, LLC in Arthur, Iowa. Mr. Reinhart graduated from Iowa Central Community College with an Associate’s Degree in Business and from the University of South Dakota with a Bachelor of Science degree in Education. Mr. Reinhart has served as a governor since 2007. Age 61.
Matthew H. Sederstrom
Appointed by Project Viking
Mr. Sederstrom joined Fagen, Inc. in 2001 as a project developer for fuel ethanol facilities. Mr. Sederstrom was appointed to our board by Project Viking, L.L.C. on February 15, 2010. Age 37.
The terms of Robert J. Ferguson, David J. Woestehoff and Timothy O. Helgemoe expire at the Annual Meeting of Members to be held in 2011. The terms of Doug Schmitz, Robert J. Wolf and David J. Bach expire at the Annual Meeting of Members to be held in 2012. The terms of Michael S. Kunerth and Milton J. McKeown expire at the Meeting to be held in 2013.
Information Regarding Officers
Set forth below is biographical and other information regarding Lucas G. Schneider, our Chief Financial Officer. Information about Mr. Robert J. Ferguson, our President and Chief Executive Officer and also a governor, may be found above under the heading “Information Regarding Governors.”
Mr. Schneider, age 29, served as the Senior Accountant of the Company since November 2008, during which time he was responsible for the Company’s corporate accounting and SEC reporting functions. From March 2008 to November 2008, Mr. Schneider served as a Staff Accountant with the Company. Prior to joining the Company, Mr. Schneider was a Staff Accountant at Gerber and Haugen, an accounting firm located in Slayton, Minnesota, from April 2007 to March 2008. From August 2004 to April 2007, Mr. Schneider was a Staff Accountant at M L Grams & Associates, an accounting firm located in Westbrook, Minnesota. Mr. Schneider holds a Bachelor of Science degree from Southwest Minnesota State University in Marshall, Minnesota.
Committees of the Board
We currently have four separate standing committees: the Audit Committee, the Compensation Committee, the Nomination and Governance Committee, and the Marketing and Risk Management Committee.
Our board of governors has adopted written charters for the Audit Committee, the Compensation Committee, and the Nomination and Governance Committee. Copies of the charter of each of these committees are available on our website at www.heronlakebioenergy.com by following the link to “Board of Governors.” The composition and function of the committees of the board are set forth below.
Compensation Committee. Currently, the Compensation Committee consists of three governors: David J. Bach (Chair), Michael S. Kunerth, and David M. Reinhart. The Compensation Committee oversees our compensation and employee benefit plans and practices, including any executive compensation plans, governor compensation plans and incentive compensation and equity-based plans.
Nomination and Governance Committee. Currently, the Nomination and Governance Committee consists of three governors: Robert J. Wolf (Chair), Milton J. McKeown and Doug Schmitz. The Nomination and Governance Committee’s responsibilities include (1) identifying and recommending to the board individuals qualified to serve as governors and on committees of the board, (2) advising the governors with respect to the board’s composition, procedures and committees, (3) developing and recommending to the board a set of corporate governance principles and (4) overseeing the evaluation of the board and the board committees.
Audit Committee. Currently, the Audit Committee consists of five governors: Michael S. Kunerth (Chair), David M. Reinhart, Robert J. Wolf, David J. Bach, and Milton J. McKeown. The Audit Committee assists the board in fulfilling its oversight responsibility for (1) the integrity of our financial statements and financial reporting process and our systems of internal accounting and financial controls, (2) the performance of our internal audit function, (3) the annual independent integrated audit of our consolidated financial statements and internal control over financial reporting and (4) our compliance with legal and regulatory requirements, including our disclosure controls and
procedures. The duties and responsibilities of the Audit Committee include the engagement of our independent registered public accounting firm and the evaluation of our accounting firm’s qualifications, independence and performance.
In January 2010, the board of governors reviewed the qualifications of each member of the Audit Committee for the purpose of determining whether any governor serving on the Audit Committee would qualify as an “audit committee financial expert” as that term is defined under the rules of the Securities and Exchange Commission. Based upon that review, the board of governors determined that no governor qualifies as an audit committee financial expert, but that the Audit Committee as a whole has sufficient experience and education to perform its duties.
Marketing and Risk Management Committee. Currently, the Marketing and Risk Management Committee consists of four governors: Doug Schmitz (Chair), David J. Woestehoff, Timothy O. Helgemoe, and Dave Reinhart. The Marketing and Risk Management committee assists the board and our management to, among other things, enhance our profitability and manage commodity price risk, by establishing appropriate policies and strategies for grain procurement, marketing of ethanol and distillers grains, and managing enterprise risk.
Board Nominations and Diversity Considerations
The Nomination and Governance Committee will consider candidates for board membership suggested by members of that committee, other governors, as well as management and members. The committee has not adopted minimum qualifications that nominees must meet in order for the committee to recommend them to the board of governors, as the committee believes that each nominee should be evaluated based on his or her merits as an individual, taking into account our needs and the needs of the board of governors. The Nomination and Governance Committee evaluates each prospective nominee against the standards and qualifications set out in our Governance Guidelines, including:
· Background, including demonstrated high personal and professional ethics and integrity, and the ability to exercise good business judgment and enhance the board’s ability to manage and direct our affairs and business;
· Commitment, including the willingness to devote adequate time to the work of the board and its committees, and the ability to represent the interests of all members and not a particular interest group;
· Board skills needs, in the context of the existing makeup of the board, and the candidate’s qualification as independent and qualification to serve on board committees;
· Diversity, in terms of knowledge, experience, skills, expertise, and other demographics which contribute to the board’s diversity; and
· Business experience, which should reflect a broad experience at the policy-making level in business, government and/or education.
The Nomination and Governance Committee also considers such other relevant factors, as it deems appropriate. The committee will consider persons recommended by the members in the same manner as other nominees.
While the Nomination and Governance Committee does not have a formal policy with respect to diversity, the Nomination and Governance Committee does consider how each director contributes to the diversity of the Board in terms of knowledge, experience, skills, expertise, and other demographics and the overall mix of the directors’ backgrounds.
The Nomination and Governance Committee will consider written proposals from members for nominees for governor. Any such nominations should be submitted to the Nomination and Governance Committee in care of the board secretary of Heron Lake BioEnergy and should include the following information: (a) all information relating to such nominee that is required to be disclosed pursuant to Regulation 14A under the Securities Exchange Act of 1934 (including such person’s written consent to being named in the proxy statement as a nominee and to serving as a governor if elected); (b) the name and record address of the member and of the beneficial owner, if any, on whose behalf the nomination will be made, and (c) the number of units owned by the member and beneficially owned by the beneficial owner, if any, on whose behalf the nomination will be made. As to each person the member proposes to nominate, the written notice must also state: (a) the name, age, business address and residence address of the person, (b) the principal occupation or employment of the person and (c) the number of units beneficially owned by the person. To be considered, the written proposals from members for nominees for governor must be received by us within the timeframes required by the proxy rules of the Securities and Exchange Commission.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act requires our governors, officers and persons who own more than 10% of our units to file reports of ownership and changes in ownership in our units with the Securities and Exchange Commission, and to furnish us with copies of the reports. Based on our review of such reports, we believe that our governors, officers and owners of 10% or more of our units timely filed all required Section 16(a) reports during our fiscal year ended October 31, 2010.
Code of Ethics
Our board has adopted a code of ethics that applies to our officers and governors, including our chief executive officer and chief financial officer, and a code of business conduct and ethics that applies to our officers, governors and employees. Copies of these codes of ethics are available to members without charge by writing to us at 91246 390th Avenue, Heron Lake, MN 56137.
We intend to satisfy the disclosure requirements of the Securities and Exchange Commission regarding certain amendments to, or waivers from, provisions of our code of ethics that apply to our principal executive officer, principal financial officer, principal accounting officer or controller by posting such information on our website at www.heronlakebioenergy.com.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Employment Arrangements with Named Executive Officers
Robert J. Ferguson has served as the President of our board since our inception and until September 1, 2007, Mr. Ferguson acted as our Chief Executive Officer through his position as board President. On September 1, 2007, we hired Robert J. Ferguson as an employee to serve as our Chief Executive Officer and entered into an employment agreement with him. Until September 1, 2008, he served under an employment agreement and currently serves at the pleasure of the board. Mr. Ferguson is currently paid an annual base salary of $124,800 on a bi-weekly basis and is eligible to participate in any bonus to employees at the discretion of the board of governors.
Effective November 25, 2008, we entered a letter agreement with CFO Systems, LLC and Brett L. Frevert. Under the letter agreement, CFO Systems provided financial and consulting services to us at a rate of $130 per hour. The consulting services included providing day-to-day leadership and oversight for our finance department; CFO-level expertise in areas such as the annual audit, SEC filings, reports to members, lender reporting and tax filings; and strategic planning, forecasting, and budgeting. In connection with the letter agreement, Mr. Frevert agreed to serve as our Interim Chief Financial Officer. Following fiscal year 2010, we terminated this letter agreement effective December 1, 2010 and Mr. Frevert’s service as our Interim Chief Financial Officer terminated concurrently with the termination of the letter agreement. Lucas G. Schneider was appointed as our Chief Financial Officer effective December 1, 2010 with an annual base salary of $72,500.
Our agreements with Messrs. Ferguson and Frevert do not provide for severance or any other compensation following termination of the employment or services.
Compensation Discussion and Analysis
The following discussion and analysis describes the Company’s compensation objectives and policies as applied to Robert J. Ferguson, our President and Chief Executive Officer.
Brett L. Frevert of CFO Systems served as our Interim Chief Financial Officer during fiscal year 2010. Because Mr. Frevert was hired on an interim basis through his firm, our Compensation Committee did not and did not attempt to apply overarching compensation objectives and policies to his compensation. The arrangement with Mr. Frevert and CFO Systems, which is described above, was negotiated separately with CFO Systems as the Company would negotiate any other arrangement with a specialty service provider or consultant. Accordingly, this Compensation Discussion and Analysis section does not discuss or analyze the compensation arrangements involving or the compensation paid to Mr. Frevert.
In determining compensation for the Chief Executive Officer, the Compensation Committee sometimes solicits input from our human resources personnel, primarily relating to benefit programs and local labor market conditions. The Chief Executive Officer is not present during deliberations or determination by the Compensation Committee or the Board of his compensation.
The Compensation Committee’s philosophy is to provide a competitive level of compensation that is consistent with the Company’s budget, financial performance, and local labor market conditions. Based upon this philosophy, the Compensation Committee has determined that the Chief Executive Officer’s compensation should consist of base salary and benefits to which our other employees are eligible. The Compensation Committee set Mr. Ferguson’s annual base salary at $124,800 per year for fiscal year 2010, which it believed was appropriate
based upon Mr. Ferguson’s responsibilities, the feedback from Mr. Ferguson’s review, and information provided by our human resources personnel. Mr. Ferguson is also eligible to participate in any cash bonus to which our other employees are eligible in the discretion of the Board. The Board did not award any discretionary bonus in fiscal year 2010 to Mr. Ferguson or other employees of HLBE. After weighing the complexities in designing and administering equity compensation programs and cash performance-based compensation programs and the limited benefits these other programs would offer as tools to compensate the Chief Executive Officer, the Compensation Committee determined not to use any equity or cash performance-based compensation for fiscal year 2010 compensation.
Report of the Compensation Committee
The following report of the Compensation Committee shall not be deemed to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933, as amended, or the 1934 Securities Exchange Act, as amended, except to the extent that the Company specifically incorporates it by reference in such filing.
The Compensation Committee has reviewed and discussed the section of this Annual Report on Form 10-K for the year ended October 31, 2010 entitled Compensation Discussion and Analysis (the “CD&A”) with management. In reliance on this review and discussion, the Compensation Committee recommended to the Board of Directors that the CD&A be included in this Annual Report on Form 10-K for the year ended October 31, 2010 for filing with the Securities and Exchange Commission.
By the Compensation Committee of the Board of Directors
David J. Bach (Chair), Michael S. Kunerth, and David M. Reinhart
Summary Compensation Table
The following table shows information concerning compensation earned for services in all capacities during fiscal years 2010 and 2009 for (i) Robert J. Ferguson, who was our Chief Executive Officer in fiscal years 2010 and 2009 and (ii) Brett L. Frevert, who served as our Interim Chief Financial Officer in fiscal year 2009 beginning on November 25, 2008 and for all of fiscal year 2010 (together referred to as our “named executive officers”). There were no other executive officers of our company in fiscal year 2010.
(1) Salary for Mr. Ferguson represents amounts other than board meeting fees and additional fees for service as the board President paid to Mr. Ferguson. For an explanation of compensation paid to Mr. Ferguson in fiscal year 2010 for his services as our governor and an officer of the board, please see below entitled “Governor Compensation.”
(2) Mr. Frevert began serving as our Interim Chief Financial Officer effective November 25, 2008 when we entered into a letter agreement with CFO Systems, LLC relating to his service. All other compensation for Mr. Frevert represent amounts paid to CFO Systems, LLC for Mr. Frevert’s services as our Interim Chief Financial Officer in the fiscal year. See “Employment Arrangements with Named Executive Officers” for a description of the arrangements with CFO Systems, LLC.
Governor Compensation
For fiscal year 2010 service, each governor received $1,500 per full quarter of board service, $250 for each board meeting attended (whether in person or telephonic), $250 for each committee meeting attended in person and $200 for each special meeting attended in person. Mr. Ferguson, the board president and our Chief Executive Officer, received the same retainer and per meeting fees as the other non-employee governors. Members of our board of governors are also reimbursed for reasonable expenses included in carrying out their duties as governors, including mileage reimbursement for travel to meetings.
Also for fiscal year 2010, governors received an additional quarterly retainer for holding board officer positions, as follows: board president, $2,500 per quarter; board vice president, $2,250 per quarter; board treasurer, $2,000 per quarter; board secretary, $1,750 per quarter. Each officer of the board receives an additional $250 for each meeting of the board attended either in person or telephonically. For fiscal year 2010, Robert J. Ferguson served as the president of the board; Doug Schmitz served as the vice president of the board; Michael S. Kunerth served as the treasurer of the board; and David J. Woestehoff served as secretary of the board.
The following table shows for fiscal year 2010 the total compensation paid by us to each of our governors:
(1) Represents cash retainers and meeting fees for fiscal year 2010 as described above and total compensation to each governor.
(2) Represents amounts paid by us to Fagen, Inc., an affiliate of Project Viking, L.L.C., in respect of the services of Matthew H. Sederstrom during fiscal year 2010 from his appointment by Project Viking on February 15, 2010 and in respect of the services of Chad A. Core during fiscal year 2010 from November 1, 2009 to his replacement on February 15, 2010. Each of Messrs. Sederstrom and Core was separately compensated by Fagen, Inc. for his service on our board.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth certain information as of January 21, 2011 with respect to our units beneficially owned by (i) each governor, (ii) each person known to us to beneficially own more than 5% percent of our units, (iii) each of the named executive officers, and (iv) all current executive officers and governors as a group. The beneficial ownership percentages are based on 30,208,074 units issued and outstanding as of January 21, 2011.
Unless otherwise indicated and subject to community property laws where applicable, each unit holder named in the table below has sole voting and investment power with respect to the units shown opposite such unit holder’s name. Each holder may be reached at our offices in Heron Lake, Minnesota.
* Indicates ownership of less than 1%.
(1)
Based on an Amendment No. 2 to Schedule 13D filed on December 3, 2010 by Project Viking, L.L.C., Roland J. (Ron) Fagen and Diane K. Fagen. Mr. Fagen and Mrs. Fagen each hold 50% of the voting membership interests of Project Viking, L.L.C.
(2)
Serves as a governor.
(3)
Named executive officer.
(4)
Includes 126,250 units owned jointly by Mr. Ferguson and his spouse and 21,000 units owned by son who resides with Mr. Ferguson.
(5)
Includes 25,000 units owned by Doug Schmitz, 10,500 units owned by Mr. Schmitz and his spouse, 25,000 units owned by Mr. Schmitz’s spouse, and 147,500 units owned by Schmitz Grain Inc., which is controlled by Doug Schmitz.
(6)
Includes 63,000 units owned by the Michael Kunerth Trust under agreement dated July 18, 2006, and 63,000 units owned by the Dawn Kunerth Trust under agreement dated July 18, 2006. Mr. Kunerth and his spouse are trustees of each of these trusts.
(7)
All units are owned jointly by Mr. Woestehoff and his spouse.
(8)
All units are owned jointly by Mr. Bach and his spouse.
(9)
Includes 15,000 units owned by Mr. Helgemoe’s spouse, 25,000 units owned jointly by Mr. Helgemoe and his spouse, and 21,500 units owned jointly by Mr. Helgemoe’s spouse and Mr. Helgemoe’s brother.
(10)
All units are owned jointly by Mr. McKeown and his spouse.
(11)
All units are owned jointly by Mr. Wolf and his spouse.
(12)
Appointed as a governor by Project Viking, L.L.C.
(13)
Mr. Frevert ceased serving as our Interim Financial Officer on November 24, 2010 when Lucas G. Schneider was appointed as our Chief Financial Officer.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
Transactions in Fiscal Year 2010
In fiscal year 2010 ending October 31, 2010, we have not entered into any transaction, in which we were or are to be a participant and the amount involved exceeds $120,000, and in which any related person had or will have a direct or indirect material interest, except as described below.
Corn Transactions. During fiscal year 2010, we bought grain from related persons on the same basis as we buy grain from un-related parties. During fiscal year 2010, we purchased approximately $0.4 million in grain from Robert J. Ferguson, and approximately $19.1 million in grain from Schmitz Grain, Inc. Robert J. Ferguson is our governor and our Chief Executive Officer. Schmitz Grain, Inc. is controlled by Doug Schmitz, our governor.
Resolution of Arbitration with Fagen. During fiscal year 2010, we resolved our dispute with Fagen relating to our design-build agreement. On July 2, 2010, HLBE, Fagen and ICM, Inc. (“ICM”) entered into a mutual release and settlement agreement relating to the arbitration we commenced in September 2009 in which we asserted claims against Fagen based on the design-build agreement for our ethanol plant. ICM joined in the arbitration action, but no claims against ICM, or answers, defenses, counterclaims or cross-claims by ICM, had been filed as of the date the settlement agreement was entered into. Under the terms of the settlement agreement, Fagen made a one-time cash payment to us, and released its claims to other amounts it claimed were owed by us under the design-build agreement. In the settlement agreement, each party provided the other with full releases of all claims in the arbitration, relating to our ethanol plant, or relating to the design-build agreement, except for certain claims arising under the ICM license agreement, which license agreement continues in full force and effect following the settlement agreement. The arbitration action, and the respective asserted and unasserted claims of HLBE, Fagen and ICM, were dismissed with prejudice.
In addition, one of the conditions to the effectiveness of the settlement agreement was the release of Roland J. Fagen by AgStar Financial Services, PCA from claims relating to and his obligations under his personal guaranty of $3.74 million of the our indebtedness to AgStar Financial Services, PCA under the our master loan agreement. The effective date of the settlement agreement was July 2, 2010.
Unit Purchase by Project Viking. On July 2, 2010, we entered into a subscription agreement with Project Viking, L.L.C. Under the subscription agreement, Project Viking purchased from us and we sold to Project Viking 3,103,449 of our units at a price per unit of $1.45 for total gross proceeds to us of $4,500,001.05. We agreed that $1.45 per unit will be the price per unit for any additional equity raised in any member offering commenced on or before December 31, 2010. The purchase price for the units was paid on July 2, 2010, and the units were issued to Project Viking effective July 2, 2010. All proceeds from the sale of the units to Project Viking were used to reduce the principal balance of our revolving line of credit note with AgStar Financial Services, PCA.
Process for Review, Approval or Ratification of Transactions with Related Persons
The charter of our Audit Committee provides that the Audit Committee is responsible for reviewing and approving the terms and conditions of all of transactions we enter into in which an officer, governor or any member holding greater than 5% or any affiliate of these persons has a direct or indirect material interest. Our Code of Business Conduct and Ethics, which is applicable to all of our employees and governors, also prohibits our employees, including our executive officers, and our governors from engaging in conflict of interest transactions. Requests for waivers by our executive officers and governors from the provisions of, or requests for consents by our executive officers and governors under, our Code of Business Conduct and Ethics must be made to the Audit Committee.
In addition, in December 2007, we adopted a formal related person transaction approval policy, which sets forth our policies and procedures for the review, approval or ratification of any transaction required to be reported in our filings with the Securities and Exchange Commission. Our policy applies to any financial transaction, arrangement or relationship or any series of similar transactions, arrangements or relationships in which our company is a participant and in which a related person has a direct or indirect interest. Through the policy, the Audit Committee has also identified and pre-approved certain transactions with related persons, including:
· employment and compensation of our executive officers or governor compensation, if required to be reported in under the disclosure requirements of the Securities and Exchange Commission;
· payment of ordinary expenses and business reimbursements;
· transactions with another company in which the related party’s only relationship is as a non-executive officer, employee, governor/director or beneficial owner of less than 10% of the other company’s voting equity and in which the dollar amount does not exceed the greater of $100,000 or 2% of the other company’s total revenues;
· any transaction with another company controlled by a related party or with a related party for the purchase by us of corn where (A) the amount of corn sold in the transaction does not exceed 200,000 bushels; (B) the contract for delivery of the corn specifies a delivery date of not more than sixty (60) days from the date of the contract; (C) the price per bushel is fixed at the time of the contract; and (D) where the amount paid per bushel or other material terms of the transaction are based on consideration or criteria generally applicable to other sellers of corn of a like quality and quantity, given the conditions of the grain markets at the time of sale;
· charitable contributions in which the dollar amount does not exceed $100,000 or 2% of the charitable organization’s receipts if the related party’s only relationship is as a non-executive officer, employee or a governor/director;
· payments made under our articles of organization, member control agreement, insurance policies or other agreements relating to indemnification;
· transactions in which our members receive proportional benefits; and
· transactions that involve competitive bid, banking transactions and transactions where the terms of which are regulated by law or governmental authority.
The Audit Committee must approve any related person transaction subject to this policy before commencement of the related party transaction. If pre-approval is not feasible, the Audit Committee may ratify, amend or terminate the related person transaction. The Audit Committee will analyze the following factors, in addition to any other factors the Committee deems appropriate, in determining whether to approve a related party transaction:
· whether the terms are fair to us;
· whether the terms of the related party transaction are no less favorable than terms generally available to an unaffiliated third-party under the same or similar circumstances;
· whether the related party transaction is material to us;
· the role the related party has played in arranging the transaction;
· the structure of the related party transaction;
· the interests of all related parties in the transaction;
· the extent of the related party’s interest in the transaction; and
· whether the transaction would require a waiver of our Code of Business Conduct and Ethics.
The Audit Committee may, in its sole discretion, approve or deny any related person transaction. Approval of a related person transaction may be conditioned upon our company and the related person taking such precautionary actions, as the Audit Committees deems appropriate.
Board and Committee Independence
The board of governors undertook a review of governor independence in January 2010 as to nine of the ten governors then serving. The board did not review the independence of Matthew H. Sederstrom due to lack of information. As part of that process, the board reviewed all transactions and relationships between the governor (or any member of his immediate family) and Heron Lake BioEnergy, its executive
officers and its auditors, and other matters bearing on the independence of governors. In particular, the board reviewed corn transactions by governors or their affiliates in relationship to the governor’s ability to exercise independent judgment.
Although our units are not listed on any stock exchange, the board of governors is required to select and apply the independence standards of a stock exchange. For the purposes of determining the independence of our governors and committee members, the board of governors selected the Nasdaq Listing Rules. This is also the definition used for “independence” for the purposes of determining eligibility of governors to serve on committees.
As a result of its review, the board of governors affirmatively determined that Michael S. Kunerth, David J. Bach, Timothy O. Helgemoe, Milton J. McKeown, and Robert J. Wolf are independent according to the “independence” definition of the Nasdaq Listing Rules. The board of governors did not make an independence determination with respect to Matthew H. Sederstrom.
Robert J. Ferguson is not “independent” under the Nasdaq Listing Rules because he served as our Chief Executive Officer in fiscal year 2010, and sold a significant amount of grain to us in our fiscal year 2010. Mr. Schmitz is also not independent because his affiliated company, Schmitz Grain, sold a significant amount of grain to us in fiscal year 2010. Mr. Reinhart is not independent because he is the brother of Diane Fagen, a principal shareholder in Fagen, Inc. We have significant transactions with Fagen, Inc. as described elsewhere in this Item 13. The charters of the Audit Committee, Compensation Committee, and Nomination and Governance Committee also established separate criteria for eligibility to serve as a member of those committees, which are discussed below.
The charter of the Audit Committee requires that the Audit Committee be comprised of three members, a majority of whom must be “independent” under the Nasdaq Listing Rules. A majority of the members must also be non-executive governors, free from any relationship that would interfere with the exercise of independent judgment and “independent” as defined by the applicable rules and regulations of the Securities and Exchange Commission. Moreover, all members of the committee must have a basic understanding of finance and accounting and be able to read and understand fundamental financial statements, and at least one member of the committee must have accounting or related financial management expertise. The board of governors determined that the membership of the Audit Committee meets the requirements of its charter.
The charter of the Compensation Committee requires that this committee consist of no fewer than two members. A majority of members of the Compensation Committee must satisfy the independence requirements of the Nasdaq Listing Rules, Section 16b-3 of the Exchange Act, and Section 162(m) of the Internal Revenue Code of 1986. A majority of the members of our Compensation Committee meet these requirements.
The charter of the Nomination and Governance Committee requires that this committee consist of at least two members, a majority of whom must satisfy the independence requirements of the Nasdaq Listing Rules. The membership of our Nomination and Governance Committee meets the requirements of its charter.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Accountant Fees and Services
Boulay, Heutmaker, Zibell & Co. P.L.L.P. (“BHZ”) served as our independent registered public accounting firm for the fiscal year ended October 31, 2010. The following is an explanation of the fees billed to us by BHZ for professional services rendered for the fiscal years ended October 31, 2010 and October 31, 2009, which totaled $173,870 and $183,289 respectively.
Audit Fees. The aggregate fees billed to us for professional services related to the audit of our annual financial statements, review of financial statements included in our reports with the Securities and Exchange Commission, or other services normally provided by BHZ in connection with statutory and regulatory filings or engagements for the fiscal years ended October 31, 2010 and October 31, 2009 totaled $149,300 and $169,758, respectively.
Audit-Related Fees. The aggregate fees billed to us for professional services for assurance and related services by Boulay, Heutmaker, Zibell & Co. P.L.L.P. that were reasonably related to the performance of the audit or review of our financial statements and were not reported above under “Audit Fees” for the fiscal year ended October 31, 2010 were $10,330 which includes fees related to equity transaction, contractor settlement, and internal control compliance. There were no audit-related fees not included with audit fees for the fiscal year ended October 31, 2009.
Tax Fees. The aggregate fees billed to us by BHZ for professional services related to tax compliance, tax advice, and tax planning for the fiscal year ended October 31, 2010 and October 31, 2009 totaled $14,240 and $13,531, respectively.
All Other Fees. For the fiscal year ended October 31, 2010 and October 31, 2009, there were no fees billed to us by BHZ for professional services or products not previously disclosed.
Audit Committee Pre-Approval Policies
We have adopted pre-approval policies and procedures for the Audit Committee that require the Audit Committee to pre-approve all audit and all permitted non-audit engagements and services (including the fees and terms thereof) by the independent auditors, except that the Audit Committee may delegate the authority to pre-approve any engagement or service less than $10,000 to one of its members, but requires that the member report such pre-approval at the next full Audit Committee meeting. The Audit Committee may not delegate its pre-approval authority for any services rendered by our independent auditors relating to internal controls. These pre-approval policies and procedures prohibit delegation of the Audit Committee’s responsibilities to our management. Under the policies and procedures, the Audit Committee may pre-approve specifically described categories of services which are expected to be conducted over the subsequent twelve months on its own volition, or upon application by management or the independent auditor.
All of the services described above for fiscal year 2010 were pre-approved by the Audit Committee or a member of the committee before Boulay, Heutmaker, Zibell & Co. P.L.L.P. was engaged to render the services.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENTS SCHEDULES
(a) Financial Statements
Page Reference
Audited Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of October 31, 2010 and 2009
Consolidated Statements of Operations for the fiscal years ended October 31, 2010, 2009 and 2008
Consolidated Statements of Changes in Members’ Equity for the fiscal years ended October 31, 2010, 2009 and 2008
Consolidated Statements of Cash Flows for the fiscal years ended October 31, 2010, 2009 and 2008
Notes to Consolidated Financial Statements
(b) Exhibits
See “Exhibit Index” on the page following the Signature Page.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Each person whose signature appears below hereby constitutes and appoints Robert J. Ferguson and Lucas G. Schneider, and each of them, as his true and lawful attorney-in-fact and agent, with full power of substitution, to sign on his behalf, individually and in each capacity stated below, all amendments to this Form 10-K and to file the same, with all exhibits thereto and any other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully and to all intents and purposes as each might or could do in person, hereby ratifying and confirming each act that said attorneys-in-fact and agents may lawfully do or cause to be done by virtue thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on behalf of the registrant by the following persons in the capacities indicated on January 21, 2011.
/s/ Robert J. Ferguson
Chief Executive Officer and President
Robert J. Ferguson
(principal executive officer), Governor
/s/ Lucas G. Schneider
Chief Financial Officer (principal
Lucas G. Schneider
financial and accounting officer)
/s/ Doug Schmitz
Governor
Doug Schmitz
/s/ Michael S. Kunerth
Governor
Michael S. Kunerth
/s/ David J. Woestehoff
Governor
David J. Woestehoff
/s/ David J. Bach
Governor
David J. Bach
/s/ Timothy O. Helgemoe
Governor
Timothy O. Helgemoe
/s/ Milton J. McKeown
Governor
Milton J. McKeown
/s/ David M. Reinhart
Governor
David M. Reinhart
/s/ Matthew H. Sederstrom
Governor
Matthew H. Sederstrom
/s/ Robert J. Wolf
Governor
Robert J. Wolf
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Governors
Heron Lake BioEnergy, LLC and Subsidiary
Heron Lake, Minnesota
We have audited the accompanying consolidated balance sheets of Heron Lake BioEnergy, LLC and Subsidiary as of October 31, 2010 and 2009, and the related consolidated statements of operations, changes in members’ equity, and cash flows for each of the fiscal years in the three-year period ended October 31, 2010. Heron Lake BioEnergy, LLC and Subsidiary’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heron Lake BioEnergy, LLC and Subsidiary as of October 31, 2010 and 2009, and the results of its operations and its cash flows for each of the fiscal years in the three-year period ended October 31, 2010 in conformity with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has incurred negative operating cash flows of approximately $0.6 million for the fiscal year ending October 31, 2010. The Company was also out of compliance of its master loan agreement and reclassified the long term debt related to this agreement to current liabilities. If the right to accelerate the maturity of the debt outstanding under the master loan agreement or the line of credit were to be exercised, the Company will not have adequate available cash to repay the amounts currently outstanding. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans regarding those matters also are described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Boulay, Heutmaker, Zibell & Co. P.L.L.P.
Certified Public Accountants
Minneapolis, Minnesota
January 21, 2011
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Consolidated Balance Sheets
Notes to Consolidated Financial Statements are an integral part of this Statement.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Consolidated Balance Sheets
Notes to Consolidated Financial Statements are an integral part of this Statement.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Consolidated Statements of Operations
Notes to Consolidated Financial Statements are an integral part of this Statement.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Consolidated Statements of Changes in Members’ Equity
Notes to Consolidated Financial Statements are an integral part of this Statement.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements are an integral part of this Statement.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements are an integral part of this Statement.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
The Company owns and operates a 50 million gallon ethanol plant near Heron Lake, Minnesota with ethanol distribution to upper Midwest states. In addition, the Company produces and sells distillers grains with solubles as co-products of ethanol production. The Company was formed on April 12, 2001 to have an indefinite life. The Company began its ethanol plant operations in September 2007.
Principles of Consolidation
The financial statements include the accounts of Heron Lake BioEnergy, LLC and its wholly owned subsidiary, Lakefield Farmers Elevator, LLC, collectively, the “Company.” All significant intercompany balances and transactions are eliminated in consolidation.
Fiscal Reporting Period
The Company’s fiscal year end for reporting financial operations is October 31.
Accounting Estimates
Management uses estimates and assumptions in preparing these financial statements in accordance with generally accepted accounting principles. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. The Company uses estimates and assumptions in accounting for significant matters including, among others, the carrying value and useful lives of property and equipment, analysis of impairment on long-lived assets, and valuation of forward purchase contract commitments and inventory. The Company periodically reviews estimates and assumptions, and the effects of revisions are reflected in the period in which the revision is made. Actual results could differ from those estimates.
Revenue Recognition
Revenue from sales is recorded when title transfers to the customer, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists, and the sales price is fixed and determinable. The title transfers when the product is loaded into the railcar or truck, the customer takes ownership and assumes risk of loss.
In accordance with the Company’s agreements for the marketing and sale of ethanol and related products, marketing fees and commissions due to the marketers are deducted from the gross sales price as earned. These fees and commissions are recorded net of revenues as they do not provide an identifiable benefit that is sufficiently separable from the sale of ethanol and related products. Shipping costs incurred by the Company in the sale of ethanol are not specifically identifiable and as a result, are recorded based on the net selling price reported to the Company from the marketer. Shipping costs incurred by the Company in the sale of ethanol related products are included in cost of goods sold.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
Cash and Equivalents
The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash and equivalents.
The Company maintains its accounts at five financial institutions. At times throughout the year, the Company’s cash balances may exceed amounts insured by the Federal Deposit Insurance Corporation and the Securities Investor Protection Corporation. The Company does not believe it is exposed to any significant credit risk on cash and equivalents.
Restricted Cash
The Company is periodically required to maintain cash balances at its broker related to derivative instrument positions. In addition, at October 31, 2010 the Company maintained restricted cash of approximately $346,000 related to a loan agreement as described in Note 10.
Accounts Receivable
Credit terms are extended to customers in the normal course of business. The Company performs ongoing credit evaluations of its customers’ financial condition and, generally, requires no collateral.
Accounts receivable are recorded at estimated net realizable value. Accounts are considered past due if payment is not made on a timely basis in accordance with the Company’s credit terms. Accounts considered uncollectible are written off. The Company’s estimate of the allowance for doubtful accounts is based on historical experience, its evaluation of the current status of receivables, and unusual circumstances, if any. At October 31, 2010 and 2009, the Company was of the belief that such accounts would be collectable and thus an allowance was not considered necessary.
Inventory
Inventory consists of raw materials, work in process, finished goods, supplies, and other grain inventory. Corn is the primary raw material and, along with other raw materials and supplies, is stated at the lower of cost or market on a first-in, first-out (FIFO) basis. Work in process and finished goods, which consists of ethanol and distillers grains produced, is stated at the lower of average cost or market. Other grain inventory, which consists of agricultural commodities, is valued at market value (net realizable value). Other grain inventory is readily convertible to cash because of its commodity characteristics, widely available markets and international pricing mechanisms. Other grain inventory is also freely traded, has quoted market prices, may be sold without significant further processing, and has predictable and insignificant disposal costs. Merchandise inventory is valued at lower of cost or market on a first-in, first-out (FIFO) basis.
Costs of sales also include expenses directly attributable to the repair and maintenance of the plant. During the fiscal year ended October 31, 2009, we incurred costs of approximately $300,000 as part of a five day planned annual shutdown and maintenance procedure. Costs associated with the unusual repairs were approximately $700,000 and are included in operating expenses for the fiscal year ended October 31, 2009.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
Derivative Instruments
From time to time, the Company enters into derivative transactions to protect gross margins from potentially adverse effects of market and price volatility in future periods. In order to reduce the risks caused by market fluctuations, the Company hedges a portion of its anticipated corn and natural gas purchases, and ethanol sales by entering into options and futures contracts. These contracts are used with the intention to fix the purchase price of anticipated requirements for corn and natural gas in the Company’s ethanol production activities and the related sales price of ethanol produced. The fair value of these contracts is based on quoted prices in active exchange-traded or over-the-counter market conditions.
The Company generally does not designate these derivative instruments as hedges for accounting purposes and derivative positions are recorded on the balance sheet at their fair market value, with changes in fair value caused from marking these instruments to market, recognized in current period earnings or losses on a monthly basis. While the Company does not designate the derivative instruments that it enters into as hedging instruments because of the administrative costs associated with the related accounting, the Company believes that the derivative instruments represent an economic hedge.
In order for a derivative to qualify as a hedge, specific criteria must be met and appropriate documentation maintained. If the derivative does qualify as a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will be either offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. Gains and losses from derivatives that do not qualify as hedges, or are undesignated, must be recognized immediately in earnings.
The Company evaluates its contracts to determine whether the contracts are derivatives. Certain contracts that literally meet the definition of a derivative may be exempted as “normal purchases or normal sales.” Normal purchases and normal sales are contracts that provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold over a reasonable period in the normal course of business. Certain corn, ethanol and distillers grains contracts that meet the requirement of normal purchases or sales are documented as normal and exempted from the accounting and reporting requirements, and therefore, are not marked to market in our financial statements.
Other Intangibles
Other intangibles are stated at cost and include road improvements located near the plant in which the Company has a beneficial interest in but does not own the road. The Company amortizes the assets over the economic useful life of 15 years.
Property and Equipment
Property and equipment are recorded at cost. Depreciation is provided over an estimated useful life by use of the straight-line deprecation method. Maintenance and repairs are expensed as incurred; major improvements and betterments are capitalized. Construction in progress is comprised of costs related to the construction of the ethanol plant facilities. Interest is capitalized during the construction period. Depreciable useful lives are as follows:
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
Long-Lived Assets
The Company reviews property and equipment and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Circumstances which could trigger a review include, but are not limited to: significant decreases in the market price of the asset; significant adverse changes in the business climate or legal factors; accumulation of costs significantly in excess of the amount originally expected for the acquisition of construction of the asset; current period cash flow or operating losses combined with a history of losses or a forecast of continuing losses associated with the use of the assets; and current expectation that the asset will more likely than not be sold or disposed significantly before the end of its estimated useful life. If circumstances require a long-lived asset be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by an asset to the carrying value of the asset. If the carrying value of the long-lived asset is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds its fair value. Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third-party independent appraisals, as considered necessary.
The Company’s ethanol production facilities, has an installed capacity of 50 million gallons per year. The carrying value of these facilities at October 31, 2010 was approximately $89.8 million. In accordance with the Company’s policy for evaluating impairment of long-lived assets described above, management has evaluated the recoverability of the facilities based on projected future cash flows from operations over the facilities’ estimated useful lives. Management has determined that the projected future undiscounted cash flows from operations of these facilities exceed their carrying value at October 31, 2010; therefore, no impairment loss was indicated or recognized. In determining the projected future undiscounted cash flows, the Company has made significant assumptions concerning the future viability of the ethanol industry, the future price of corn in relation to the future price of ethanol and the overall demand in relation to production and supply capacity. Given the uncertainties in the ethanol industry, should management be required to adjust the carrying value of the facilities at some future point in time, the adjustment could be significant and could significantly impact the Company’s financial position and results of operations. No adjustment has been made to these financial statements for this uncertainty.
Deferred Loan Costs
Costs associated with the issuance of the debt discussed in Note 9 and 10 are recorded as deferred loan costs, net of accumulated amortization. Loan costs are amortized to operations over the term of the related debt using the effective interest method. Prior to the commencement of operations in September 2007, the Company capitalized loan costs with interest costs during the construction of the plant. Once operations commenced, loan cost amortization was expensed. As explained in Note 10, the Company has reclassified the long term portion of certain debt to current. During fiscal 2009, the Company expensed the remaining unamortized loan costs totaling approximately $445,000 associated with this debt.
Fair Value of Financial Instruments
On November 1, 2008, the Company adopted guidance for accounting for fair value measurements of financial assets and financial liabilities and for fair value measurements of nonfinancial items that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis. On November 1, 2009, the Company adopted guidance for fair value measurement related to nonfinancial items that are recognized and disclosed at fair value in the financial statements on a nonrecurring basis. The guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to measurements involving significant unobservable inputs (Level 3 measurements).
The three levels of the fair value hierarchy are as follows:
· Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.
· Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
· Level 3 inputs are unobservable inputs for the asset or liability.
The level in the fair value hierarchy within which a fair measurement in its entirety falls is based on the lowest level input that is significant to the fair value measurement in its entirety.
Except for those assets and liabilities which are required by authoritative accounting guidance to be recorded at fair value in our balance sheets, the Company has elected not to record any other assets or liabilities at fair value. No events occurred during the years ended October 31, 2010 or 2009 that required adjustment to the recognized balances of assets or liabilities, which are recorded at fair value on a nonrecurring basis.
The carrying value of cash, short-term investments, restricted cash, accounts receivable, accounts payable and accrued liabilities approximates fair value due to the short maturity of these instruments. The fair value of long-term debt has been estimated using discounted cash flow analysis based upon the Company’s current incremental borrowing rates for similar types of financing arrangements. The fair value of outstanding debt will fluctuate with changes in applicable interest rates. Fair value will exceed carrying value when the current market interest rate is lower than the interest rate at which the debt was originally issued. The fair value of a company’s debt is a measure of its current value under present market conditions. It does not impact the financial statements under current accounting rules. The Company believes the carrying amount of the revolving term loan and line of credit approximates the fair value.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
The Company estimates the fair value of debt based on the difference between the market interest rate and the stated interest rate of the debt. The carrying amount and the fair value of long-term debt are as follows:
Income Taxes
The Company is treated as a partnership for federal and state income tax purposes and generally does not incur income taxes. Instead, its earnings and losses are included in the income tax returns of the members. Therefore, no provision or liability for federal or state income taxes has been included in these financial statements. Differences between financial statement basis of assets and tax basis of assets is related to capitalization and amortization of organization and start-up costs for tax purposes, whereas these costs are expensed for financial statement purposes. In addition, the Company uses the alternative depreciation system (ADS) for tax depreciation instead of the straight-line method that is used for book depreciation, which also causes temporary differences. The Company’s tax year end is December 31. Primarily due to the partnership tax status, the Company does not have any significant tax uncertainties that would require disclosure.
Net Income (Loss) per Unit
Basic net income (loss) per unit is computed by dividing net income (loss) by the weighted average number of members’ units outstanding during the period. Diluted net income or loss per unit is computed by dividing net income (loss) by the weighted average number of members’ units and members’ unit equivalents outstanding during the period. There were no member unit equivalents outstanding during the periods presented; accordingly, for all periods presented, the calculations of the Company’s basic and diluted net income (loss) per unit are the same.
Environmental Liabilities
The Company’s operations are subject to environmental laws and regulations adopted by various governmental entities in the jurisdiction in which it operates. These laws require the Company to investigate and remediate the effects of the release or disposal of materials at its location. Accordingly, the Company has adopted policies, practices, and procedures in the areas of pollution control, occupational health, and the production, handling, storage and use of hazardous materials to prevent material environmental or other damage, and to limit the financial liability, which could result from such events. Environmental liabilities are recorded when the liability is probable and the costs can be reasonably estimated.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
2. GOING CONCERN
The financial statements have been prepared on a going-concern basis, which contemplates the recoverability of assets and the satisfaction of liabilities in the normal course of business.
As a result of the Company’s financial performance, the Company violated certain financial covenants under its master loan agreement with AgStar Financial Services, PCA (“AgStar”) at the end of each quarter from January 31, 2009 to October 31, 2010, except the quarter ended July 31, 2010. At October 31, 2010, the Company was out of compliance with the minimum fixed charge ratio provisions of the master loan agreement. In addition, the Company anticipates that one or more of the covenants will not be met as of the end of fiscal year 2011 unless amended.
At January 31, 2009, the Company reclassified the long-term debt related to this agreement to current liabilities because the Company was not in compliance with the minimum working capital requirement. That reclassification remains as of October 31, 2010 because of the actual and anticipated covenant defaults stated above. As a result, the Company expensed the remaining unamortized loan costs totaling approximately $445,000 associated with this debt during the quarter ended January 31, 2009.
At October 31, 2010, the Company’s total indebtedness to AgStar was approximately $53.6 million. All of the Company’s assets and real property are subject to security interests and mortgages in favor of AgStar as security for the obligations of the master loan agreement.
On December 30, 2010, the Company entered into an amended forbearance agreement with AgStar relating to its covenant violation at October 31, 2010. Under that amended forbearance agreement, AgStar agreed it will not declare a default under the loan documents or enforce any of the remedies available to it for the period of December 30, 2010 to the earlier of an event of default (as defined under the amended forbearance agreement) or March 1, 2011. Without an amendment to the covenants, improved financial performance or the addition of significant working capital, the Company anticipates that it will again be in violation of one or more covenants of the master loan agreement at October 31, 2011. Further, the amended forbearance agreement requires the Company to raise at least $4.5 million in additional equity investments by March 1, 2011 and failure to comply with this obligation of the amended forbearance agreement would constitute an event of default. Also on December 30, 2010, AgStar agreed to extend the maturity of the Company’s line of credit to March 1, 2011. As of October 31, 2010, $3.5 million was outstanding on the line of credit. The Company intends to seek an extension of the maturity date of its line of credit beyond March 1, 2011, but such an extension cannot be assured.
The Company’s failure to comply with its obligations under the amended forbearance agreement, failure to comply with the covenants of the master loan agreement or its failure to repay the revolving line of credit loan when due would result event of default under the master loan agreement, entitling AgStar to accelerate and declare due all amounts outstanding under the master loan agreement.
If AgStar exercises its right to accelerate the maturity of the debt outstanding under the master loan agreement, the Company will not have adequate available cash to repay the amounts outstanding. Further, the Company will likely not have adequate cash to repay the amounts outstanding on its line of credit on March 1, 2011. While an event of default exists, the Company is not permitted to borrow additional funds under its line of credit or revolving term note without AgStar’s consent.
These factors raise substantial doubt about the Company’s ability to continue as a going concern.
The Company needs additional capital to continue its business. The Company’s plan to address its need for working capital is to generate capital through increased income and cash flow from our operations, conserve funds by utilizing and reducing corn inventory, reduce operating expenses through cost controls, and to raise additional working capital through obtaining equity investments or incurring additional indebtedness. As noted above, the Company is also required to obtain additional equity investments on terms and conditions acceptable to AgStar of an amount of not less than $4.5 million on or before March 1, 2011.
The Company is currently attempting to raise up to $6.8 million in additional capital from an offering of its units that it began in August 2010. No assurance can be given that additional capital will be obtained in an amount that is sufficient for the Company’s needs or in an amount that satisfies the requirements of the amended forbearance agreement. Further, no assurance can be given that the Company will be able to raise the required $4.5 million or an amount sufficient to repay the line of credit by March 1, 2011.
If the Company does not obtain sufficient proceeds from its current equity offering, the Company will likely seek additional capital by incurring additional indebtedness or from another offering of its equity securities or both. If the Company is able to obtain additional capital, the terms will be determined based upon negotiations between the Company and the lenders or investors. No assurance can be given that any capital the Company do receive will be in an amount that is sufficient for its needs, in a timely manner, or on terms and conditions acceptable to the Company or its members.
If the Company is unable to obtain sufficient capital, the Company may further curtail its capital expenditures, further reduce its expenses, or suspend or discontinue its operations or sell its assets. The Company’s ability to comply with the amended forbearance agreement, the covenants of the master loan agreement or make required payments on the Company’s debt to AgStar will be impaired if the Company does not obtain sufficient additional capital, resulting in events of default, acceleration of our indebtedness, seizure by AgStar of assets that secure its indebtedness, loss of control of the Company’s business or bankruptcy.
The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the Company be forced to take any such actions.
3. UNCERTAINTIES
The Company has certain risks and uncertainties that it experienced during volatile market conditions such as what the Company experienced during fiscal 2009 and 2008. These volatilities can have a severe impact on operations. The Company’s revenues are derived from the sale and distribution of ethanol and distillers grains to customers primarily located in the U.S. Corn for the production process is supplied to the plant primarily from local agricultural producers. Ethanol sales average 75% - 85% of total revenues and corn costs average 65% - 75% of cost of goods sold.
The Company’s operating and financial performance is largely driven by the prices at which it sells ethanol and the net expense of corn. The price of ethanol is influenced by factors such as supply and demand, the weather, government policies and programs, unleaded gasoline prices and the petroleum markets as a whole, although since 2005 the prices of ethanol and gasoline began a divergence with ethanol selling for less than gasoline at the wholesale level. Excess ethanol supply in the market, in particular, puts downward pressure on the price of ethanol. The largest cost of production is corn. The cost of corn is generally impacted by factors such as supply and demand, the weather, government policies and programs, and a risk management program used to protect against the price volatility of these commodities. Market fluctuations in the price of and demand for these products may have a significant adverse effect on the Company’s operations, profitability and the availability and adequacy of cash flow to meet the Company’s working capital requirements.
4. FAIR VALUE MEASUREMENTS
The following table provides information on those assets measured at fair value on a recurring basis.
The fair value of the derivative instruments is based on quoted market prices in an active market.
5. CONCENTRATIONS
The Company sells all of the ethanol and distiller grains produced to two customers under marketing agreements as described in Note 15. At October 31, 2010 and 2009, these two customers comprised 97% and 96% of accounts receivable, respectively.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
6. INVENTORY
Inventory consists of the following at October 31:
The Company recorded losses of approximately $97,000, $352,000 and $1,628,000 for the fiscal years ended October 31, 2010, 2009 and 2008 respectively, related to inventory, in addition to losses recorded on forward purchase contracts as noted in Note 15, where the market value was less than the cost basis, attributable primarily to decreases in market prices of corn and ethanol. The loss was recorded with the lower of cost or market adjustment in the statement of operations. In addition, the Company stored grain inventory for farmers. The value of these inventories owned by others is approximately $2,543,000 and $283,000 based on market prices at October 31, 2010 and 2009, respectively, and is not included in the amounts above.
7. DERIVATIVE INSTRUMENTS
As of October 31, 2010, the Company has corn derivative instruments, which are required to be recorded as either assets or liabilities at fair value in the Condensed Balance Sheet. Derivatives qualify for treatment as hedges when there is a high correlation between the change in fair value of the derivative instrument and the related change in value of the underlying hedged item and when the Company formally documents, designates, and assesses the effectiveness of transactions that receive hedge accounting initially and on an on-going basis. The Company must designate the hedging instruments based upon the exposure being hedged as a fair value hedge or a cash flow hedge. The Company does not enter into derivative transactions for trading purposes.
The Company enters into corn and ethanol derivatives in order to protect cash flows from fluctuations caused by volatility in commodity prices for periods up to 24 months. These derivatives are put in place to protect gross profit margins from potentially adverse effects of market and price volatility on ethanol sales and corn purchase commitments where the prices are set at a future date. Although these derivative instruments serve the Company’s purpose as an economic hedge, they are not designated as effective hedges for accounting purposes. For derivative instruments that are not accounted for as hedges, or for the ineffective portions of qualifying hedges, the change in fair value is recorded through earnings in the period of change. As of October 31, 2010, the notional amount of the Company’s outstanding derivative instruments was approximately 1,200,000 bushels that were entered into to hedge forecasted corn purchases through December 2010.
The following tables provide details regarding the Company’s fair value of the derivative instruments at October 31, 2010, none of which are designated as hedging instruments:
In addition, as of October 31, 2010 the Company had approximately $226,000 of restricted cash related to margin requirements for the Company’s derivative instrument positions.
The following tables provide details regarding the gains and (losses) from the Company’s derivative instruments in statements of operations, none of which are designated as hedging instruments:
8. QUARTERLY FINANCIAL DATA (UNAUDITED)
Summary quarterly results are as follows:
The above quarterly financial date is unaudited, but in the opinion of management, all adjustments necessary for a fair presentation of the selected data for these periods presented have been included.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
9. LINE OF CREDIT
Under the master loan agreement, the Company has a revolving line of credit loan with AgStar for a maximum commitment of $6,750,000, subject to a defined borrowing base. By a series of amendments to the master loan agreement with AgStar, the maturity of the revolving line of credit was extended from its original maturity of November 1, 2009 to June 30, 2010. On July 2, 2010, the Company and AgStar agreed upon the terms of the renewal of the Company’s line of credit loan with a new maturity date of December 31, 2010 as part of a forbearance agreement also dated July 2, 2010. On December 30, 2010, AgStar also renewed this revolving line of credit loan commitment in an aggregate principal amount outstanding at any one time not to exceed $6,750,000 or 75% of certain accounts receivable and inventory amounts, with a maturity date of March 1, 2011.
Interest accrues on borrowings at the greater of 6.0% or the one month LIBOR plus 3.25%, which totaled 3.51%, 3.49% and 5.74% at October 31, 2010, 2009 and 2008, respectively. The Company must pay a 0.25% commitment fee on the average daily unused portion of the line of credit.
At October 31, 2010 and 2009, outstanding borrowings on the line of credit were $3.5 million and $5.0 million, respectively. Amounts available under the line of credit are reduced by outstanding standby letters of credit. The Company had no outstanding standby letters of credit at October 31, 2010 and 2009, respectively.
As described in Note 2, the Company was not in compliance with the fixed charge ratio covenant of the master loan agreement at October 31, 2010. The Company accrued an additional 2.0% in default interest on all of its indebtedness to AgStar from February 1, 2010 through July 2, 2010 and from May 1, 2009 through May 29, 2009 because of covenant defaults.
10. LONG-TERM DEBT
Long-term debt consists of the following:
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
Term Note Payable
Under the master loan agreement with AgStar, the Company has a term note with outstanding indebtedness of $49.0 million and $53.4 million at October 31, 2010 and October 2009, respectively.
The term note required interest only payments from November 2007 to April 2008 at the one-month LIBOR plus 3.25%. In May 2008, the Company locked in an interest rate of 6.58% on $45.0 million of the note for three years ending April 30, 2011. The remainder of the amounts outstanding on the term note is subject to a variable rate based on LIBOR plus 3.25%, which percentage is subject to reduction based upon the ratio of members’ equity to assets. The Company will make equal monthly payments of principal and interest of approximately $640,000 to amortize the note over a period not to exceed ten years, with a final balloon payment due in October 2012. In addition, the Company is required to make additional payments on the term note of excess cash flow, as defined in the master loan agreement, up to $2.0 million per year to AgStar until the Company reaches a specified financial ratio.
As described in Note 2, the Company was not in compliance with the fixed charge ratio covenant of the master loan agreement at October 31, 2010. The Company accrued an additional 2.0% in default interest on all of its indebtedness to AgStar from February 1, 2010 through July 2, 2010 and from May 1, 2009 through May 29, 2009 because of covenant defaults.
Revolving Term Note
Under the master loan agreement with AgStar, the Company has a revolving term note for cash and inventory management purposes. The maximum amount available under the revolving term note is reduced each year by $500,000. As of October 31, 2010, the maximum amount of the revolving term note was $3,500,000. The applicable interest rate on the revolving note is 3.25% above the one month LIBOR rate. The Company accrued an additional 2.0% in default interest on all of its indebtedness to AgStar from February 1, 2010 through July 2, 2010 and from May 1, 2009 through May 29, 2009 because of covenant defaults. The revolving term note will mature on October 1, 2012. The Company pays a commitment fee of 0.35% per annum on the unused portion of the revolving term note. At October 31, 2010 and October 31, 2009, there was approximately $1.1 million outstanding on the revolving term note.
As described in Note 2, the Company was not in compliance with the fixed charge ratio covenant of the master loan agreement at October 31, 2010 and does not anticipate being in compliance as of and for the period ending October 31, 2011. As such, amounts due under the term note and revolving term note have been classified as current liabilities.
Estimated maturities of long-term debt at October 31, 2010 are as follows:
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
11. MEMBERS’ EQUITY
The Company is authorized to issue 50,000,000 capital units, of which 35,000,000 have been designated Class A units and 15,000,000 have been designated as Class B units. Members of the Company are holders of units who have been admitted as members and who hold at least 2,500 units. Any holder of units who is not a member will not have voting rights. Transferees of units must be approved by our board of governors to become members. Members are entitled to one vote for each unit held. Subject to the Member Control Agreement, all units share equally in the profits and losses and distributions of assets on a per unit basis.
In July 2010, the Company sold to Project Viking, L.L.C. (“Project Viking”), a related party, 3,103,449 of its Class A units at a price per unit of $1.45 for total gross proceeds to the Company of approximately $4.5 million as described in Note 14.
In August 2010, the Company approved an offering of up to 4,700,000 of its Class A units at a price of $1.45 per Unit to existing eligible unit holders and additional eligible accredited investors for a maximum offering of approximately $6.8 million. Existing eligible HLBE unit holders will have the first right to purchase Class A units before any new eligible investors may purchase Class A Units in the offering, subject to the terms and conditions of the offering and the subscription procedures established therefore. The offering will be limited to Minnesota residents only.
12. LEASES
The Company leases equipment, primarily rail cars, under operating leases through 2017. Equipment under operating lease primarily represents rail cars for which the rentals began in August 2007. Rent expense for fiscal 2010, 2009, and 2008 was approximately $1.9 million, $844,000, and $853,000, respectively.
At October 31, 2010, the Company had the following minimum future lease payments, which at inception had non-cancelable terms of more than one year:
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
13. INCOME TAXES
The differences between consolidated financial statement basis and tax basis of assets are as follows at October 31:
14. RELATED PARTY TRANSACTIONS
Effective July 2, 2010, the Company sold to Project Viking, L.L.C. (“Project Viking”) 3,103,449 of its units at a price per unit of $1.45 for total gross proceeds to the Company of approximately $4.5 million. All proceeds from the sale of the units to Project Viking were used to reduce the principal balance of the Company’s revolving line of credit note with AgStar Financial Services, PCA (“AgStar”). Following the purchase of units, Project Viking is a holder of 29.8% of the 30,208,074 units issued and outstanding at October 31, 2010.
The Company purchased approximately $43,233,000, $45,266,000 and $47,569,000 of corn from members in fiscal 2010, 2009 and 2008, respectively.
Please refer to the section titled “Legal Proceedings” in Note 15 for information on the settlement of the arbitration proceedings between the Company and Fagen, Inc., a related party. In addition, one of the conditions to the effectiveness of the Settlement Agreement described in Note 15 was the release of Roland J. Fagen by AgStar from his obligations under his personal guaranty of $3.74 million of the Company’s indebtedness to AgStar under the Company’s master loan agreement. The effective date of the release of Mr. Fagen’s personal guaranty was July 2, 2010.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
15. COMMITMENTS AND CONTINGENCIES
Water Agreements
In October 2003, the Company entered into an industrial water supply development and distribution agreement with the City of Heron Lake for 15 years. The Company has the exclusive rights to the first 600 gallons per minute of capacity that is available from the well, and provides for the Company, combined with Minnesota Soybean Processors (MnSP), to approve any other supply contracts that the City may enter into. In consideration, the Company will pay one half of the City’s water well bond payments of $735,000, plus a 5% administrative fee, totaling approximately $594,000, and operating costs, relative to the Company’s water usage, plus a 10% profit. These costs will be paid as water usage fees. The Company recorded an assessment of approximately $367,000 with long-term debt as described in Note 10. The Company pays operating and administrative expenses of approximately $12,000 per year.
In May 2006, the Company entered into a water treatment agreement with the City of Heron Lake and Jackson County for 30 years. The Company will pay for operating and maintenance costs of the plant in exchange for receiving treated water. In addition, the Company agreed to an assessment for a portion of the capital costs of the water treatment plant. The Company recorded assessments with long-term debt of $500,000 and $3,550,000 in fiscal 2007 and 2006, respectively, as described in Note 10. The Company paid operating and maintenance expenses of approximately $327,000 and $370,000 in fiscal 2010 and 2009, respectively.
Marketing Agreements
Effective September 30, 2009, the Company entered into an ethanol marketing agreement with an unrelated party under which the marketer will purchase, market and re-sell all of the ethanol produced at the Company’s plant for the three year term of the agreement. Following the three year term, the agreement will automatically renew for subsequent year terms unless either party terminates the agreement 60 days before the end of the term. The Company pays certain expenses and a 1% marketing fee after expenses. The Company assumed leases on 125 rail cars for approximately $980,000 per year until May 2014 as part of the termination of the prior marketing agreement.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
The Company has a distiller’s grain marketing agreement with an unrelated party to purchase all of the Company’s distiller’s grains. The agreement provides for predetermined formulas for the sale of distiller’s grains and solubles. The initial term was for one year after operations commenced and was automatically renewed on a monthly basis. The contract is terminable with 90 days written notice.
Legal Proceedings
Permit Matters
The costs associated with obtaining and complying with permits and complying with environmental laws have increased the Company’s costs of construction, production and continued operation. In particular, the Company has incurred significant expense relating to its air-emission permit in four categories: (1) obtaining the air emissions permit from the Minnesota Pollution Control Agency (“MPCA”); (2) compliance with the air emissions permit and the terms of the Company’s compliance agreement with the MPCA; (3) the Company’s dispute under the design-build agreement with Fagen, Inc. relating to equipment failures, warranty claims and other claims regarding air emissions at its plant that was the subject of an arbitration action that was settled on July 2, 2010 as described below; and (4) a March 2008 notice of violation from the MPCA that was resolved in December 2010 though a stipulation agreement.
On December 16, 2010, the MPCA issued a permit to the Company that supersedes its previously granted air permit and the compliance agreement. The permit establishes the applicable limits for each type of emission generated by the Company’s ethanol plant. The permit also requires the Company to take additional actions relating to its plant and its operations within certain time frames. The Company expects to incur additional costs to the additional actions required by its permit, as well as improvements to its plant to ensure compliance with its permit. Under the amended forbearance agreement with AgStar, advances from the Company’s term revolving note may only be used for an engineering and mercury emissions remediation project and may not exceed $1.4 million.
On December 16, 2010, the Company entered into a stipulation agreement with the MPCA relating to the March 2008 notice of violation. Under the stipulation agreement, the Company agreed to pay a civil penalty of $66,000, of which $54,000 was paid within thirty days and up to $12,000 may be satisfied through the Company’s delivery of a building capture efficiency study.
While the Company’s air emissions permit issue was resolved with the December 16, 2010 issuance of a new air permit by the MPCA, the Company’s arbitration action against Fagen, Inc. has been settled, and the Company has addressed the notice of violation through a stipulation agreement, the Company anticipates future expense associated with compliance with its air permit and environmental laws. A violation of environmental laws, regulations or permit conditions can result in substantial fines, natural resource damage, criminal sanctions, permit revocations and/or plant shutdown, any of which could have a material adverse effect on the Company’s operations.
Fagen Design-Build Dispute and Settlement
On September 28, 2005, the Company executed a Design-Build Agreement with Fagen, Inc. (“Fagen”) by which Fagen agreed to design and build a 50 million gallon per year coal-fired ethanol plant in Heron Lake, Minnesota, for a contract price of approximately $76,000,000. On September 18, 2009, the Company served and filed on Fagen a demand for arbitration and request for mediation relating to the Design-Build Agreement and the air emissions warranties under the Design-Build Agreement. In the demand for arbitration, the Company alleged various breaches of the Design-Build Agreement, negligence and negligent misrepresentation by Fagen. On January 4, 2010, Fagen requested to join ICM, Inc. (“ICM”) as a party to the arbitration action and on January 27, 2010, ICM, Inc. agreed to be joined.
On July 2, 2010, the Company, Fagen and ICM entered into a Mutual Release and Settlement Agreement (“Settlement Agreement”) relating to the arbitration commenced by the Company in September 2009. Although ICM joined in the arbitration action, no claims against ICM, or answers, defenses, counterclaims or cross-claims by ICM, had been filed as of the date the Settlement Agreement was entered into. Under the terms of the Settlement Agreement, Fagen made a one-time cash payment to the Company, and released its claims to other amounts it claimed were owed by the Company under the Design-Build Agreement. In the Settlement Agreement, each party provided the other with full releases of all claims in the arbitration, relating to the Company’s ethanol plant, or relating to the Design-Build Agreement, except for certain claims arising under the ICM license agreement, which license agreement continues in full force and effect following the Settlement Agreement. The effective date of the Settlement Agreement was July 2, 2010.
In furtherance of the Settlement Agreement, the Company, Fagen and ICM stipulated to the dismissal of the arbitration, along with their respective asserted and unasserted claims, with prejudice. The American Arbitration Association acknowledged the stipulation of dismissal with prejudice on July 27, 2010.
From the settlement, the Company recorded $2.6 million of settlement income from cash and noncash proceeds during the quarter ended July 31, 2010 representing reimbursement for incremental expenses incurred by the Company due to design issue of the plant. Also, the construction payable of approximately $3.8 million was extinguished during the quarter ended July 31, 2010, reducing current liabilities and fixed assets as this adjustment represented a price adjustment of the plant. In connection with the settlement and with the Company’s forbearance agreement with AgStar, the Company sold Class A units as described in Notes 11 and 14.
HERON LAKE BIOENERGY, LLC AND SUBSIDIARY
Notes to Consolidated Financial Statements
October 31, 2010 and 2009
Contractual Obligations
The Company has coal supply agreements with a minimum commitment of approximately $4,950,000 per year until May 2012, including transportation, with provisions for fuel surcharges and adjustments for inflation. The amounts related to these agreements are included with purchase obligations in the table above.
Forward Contracts
The Company has forward contracts in place for corn purchases of approximately $2.5 million through March 2011, which represents approximately 4% of the Company’s anticipated purchases in fiscal 2011.
The Company recorded a loss on purchase commitments of approximately $807,000, $5,056,000 and 7,123,000 for the twelve months ended October 31, 2010, 2009 and 2008 respectively. The loss was recorded as a lower of cost or market adjustment on the statement of operations. The amount of the loss was determined by applying a methodology similar to that used in the lower of cost or market evaluation with respect to inventory. Given the uncertainty of future ethanol prices, this loss may or may not be recovered, and further losses on the outstanding purchase commitments could be recorded in future periods.
16. SUBSEQUENT EVENTS
On December 30, 2010, the Company entered into an amended forbearance agreement with AgStar relating to its covenant violation at October 31, 2010. Under that amended forbearance agreement, AgStar agreed it will not declare a default under the loan documents or enforce any of the remedies available to it for the period of December 30, 2010 to the earlier of an event of default (as defined under the amended forbearance agreement) or March 1, 2011. Without an amendment to the covenants, improved financial performance or the addition of significant working capital, the Company anticipates that it will again be in violation of one or more covenants of the master loan agreement at October 31, 2011. Further, the amended forbearance agreement requires the Company to raise at least $4.5 million in additional equity investments by March 1, 2011 and failure to comply with this obligation of the amended forbearance agreement would constitute an event of default. Also on December 30, 2010, AgStar agreed to extend the maturity of the Company’s line of credit to March 1, 2011.
On December 16, 2010, the MPCA issued a permit to the Company that supersedes its previously granted air permit and the compliance agreement. The permit establishes the applicable limits for each type of emission generated by the Company’s ethanol plant. The permit also requires the Company to take additional actions relating to its plant and its operations within certain time frames. The Company expects to incur additional costs to the additional actions required by its permit, as well as improvements to its plant to ensure compliance with its permit. Under the amended forbearance agreement with AgStar, advances from the Company’s term revolving note may only be used for an engineering and mercury emissions remediation project and may not exceed $1.4 million.
On December 16, 2010, the Company entered into a stipulation agreement with the MPCA relating to the March 2008 notice of violation. Under the stipulation agreement, the Company agreed to pay a civil penalty of $66,000, of which $54,000 was paid within thirty days and up to $12,000 may be satisfied through the Company’s delivery of a building capture efficiency study.
HERON LAKE BIOENERGY, LLC
INDEX TO EXHIBITS TO FORM 10-K FOR FISCAL YEAR ENDED OCTOBER 31, 2008
Exhibit
Number
Exhibit Title
Incorporated by Reference To:
10.13
Distiller’s Grain Marketing Agreement dated October 5, 2005 by and between Heron Lake BioEnergy, LLC and Commodity Specialist Company as assigned to CHS Inc. as of August 17, 2007
Exhibit 10.13 of the Company’s 2008 Registration Statement.
10.14
Ethanol Fuel Marketing Agreement dated August 7, 2006 by and between RPGM, Inc. and Heron Lake BioEnergy, LLC
Exhibit 10.14 of the Company’s 2008 Registration Statement.
10.15
Letter Agreement re: Environmental Compliance Support dated March 12, 2007 by and between Fagen Engineering, LLC Heron Lake BioEnergy, LLC
Exhibit 10. 15 of the Company’s 2008 Registration Statement.
10.16
Coal Loading, Transport, and Delivery Agreement effective as of April 1, 2007 by and between Tersteeg Transport Inc. and Heron Lake BioEnergy, LLC
Exhibit 10.16 of the Company’s 2008 Registration Statement.
10.17
Coal Transloading Agreement dated June 1, 2007 by and between Southern Minnesota Beet Sugar Cooperative and Heron Lake BioEnergy, LLC
Exhibit 10.17 of the Company’s 2008 Registration Statement.
10.18
Master Coal Purchase and Sale Agreement dated June 1, 2007 by and between Northern Coal Transport Company and Heron Lake BioEnergy, LLC, including confirmation letter dated July 13, 2007
Exhibit 10.18 of the Company’s 2008 Registration Statement.
10.19
Loan Agreement dated December 28, 2007 by and between Federated Rural Electric Association and Heron Lake BioEnergy, LLC
Exhibit 10.19 of the Company’s 2008 Registration Statement.
10.20
Secured Promissory Note issued December 28, 2007 by Heron Lake BioEnergy, LLC as borrower to Federated Rural Electric Association as lender in principal amount of $600,000
Exhibit 10.20 of the Company’s 2008 Registration Statement.
10.21
Security Agreement dated December 28, 2007 by Heron Lake BioEnergy, LLC in favor of Federated Rural Electric Association
Exhibit 10.21 of the Company’s 2008 Registration Statement.
10.22
Electric Service Agreement dated October 17, 2007 by and between Interstate Power and Light Company and Heron Lake BioEnergy, LLC
Exhibit 10.22 of the Company’s 2008 Registration Statement.
10.23
Shared Savings Contract dated November 16, 2007 by and between Interstate Power and Light Company and Heron Lake BioEnergy, LLC
Exhibit 10.23 of the Company’s 2008 Registration Statement.
10.24
Escrow Agreement dated November 16, 2007 by and between Heron Lake BioEnergy, LLC , Farmers State Bank of Hartland for the benefit of Interstate Power and Light Company
Exhibit 10.24 of the Company’s 2008 Registration Statement.
10.25
Employment Agreement dated February 1, 2008 by and between Heron Lake BioEnergy, LLC and Robert J. Ferguson *
Exhibit 10.25 of the Company’s 2008 Registration Statement.
10.26
Compliance Agreement effective January 23, 2007 by and between Heron Lake BioEnergy, LLC and the Minnesota Pollution Control Agency
Exhibit 10.28 to Amendment No. 1 to the Company’s 2008 Registration Statement.
10.27
Letter Agreement dated November 25, 2008 by and between Heron Lake BioEnergy, LLC, CFO Systems, LLC and Brett L. Frevert relating to the services of Brett L. Frevert *
Exhibit 10.1 to Current Report on Form 8-K dated November 26, 2008.
10.28
Ethanol Purchase and Marketing Agreement dated September 2, 2009 by and between Heron Lake BioEnergy, LLC and C&N Ethanol Marketing Corporation
Exhibit 10.1 to Current Report on Form 8-K dated September 2, 2009.
10.29
Amendment No. 4 to Fifth Supplement dated December 8, 2009 by and between Heron Lake BioEnergy, LLC and AgStar Financial Services, PCA
Exhibit 10.32 to Annual Report on Form 10-K for the year ended October 31, 2009.
10.30
Amendment No. 5 to Fifth Supplement to the Master Loan Agreement dated March 25, 2010 by and between Heron Lake BioEnergy, LLC and AgStar Financial Services, PCA
Exhibit 10.1 to Current Report on Form 8-K dated March 25, 2010
Exhibit
Number
Exhibit Title
Incorporated by Reference To:
10.31
Amendment No. 6 to Fifth Supplement to the Master Loan Agreement dated May 27, 2010 by and between Heron Lake BioEnergy, LLC and AgStar Financial Services, PCA
Exhibit 10.2 to Current Report on Form 8-K dated March 25, 2010
10.32
Amended and Restated Fifth Supplement dated as of July 2, 2010 to the Master Loan Agreement by and between AgStar Financial Services, PCA and Heron Lake BioEnergy, LLC
Exhibit 10.1 to Current Report on Form 8-K dated July 2, 2010
10.33
Second Amended and Restated Revolving Line of Credit Note dated July 2, 2010 in the maximum principal amount of $6,750,000 by Heron Lake BioEnergy, LLC as borrower to AgStar Financial Services, PCA as lender
Exhibit 10.2 to Current Report on Form 8-K dated July 2, 2010
10.34
Forbearance Agreement dated July 2, 2010 by and between Heron Lake BioEnergy, LLC and AgStar Financial Services, PCA
Exhibit 10.3 to Current Report on Form 8-K dated July 2, 2010
10.35
Mutual Release and Settlement Agreement dated July 2, 2010 among Heron Lake BioEnergy, LLC, Fagen, Inc. and ICM, Inc. 
Exhibit 10.1 to Current Report on Form 8-K dated July 2, 2010
10.36
Subscription Agreement dated July 2, 2010 by Heron Lake BioEnergy, LLC and Project Viking, L.L.C.
Exhibit 10.1 to Current Report on Form 8-K dated July 2, 2010
10.37
First Amendment to Fifth Supplement to the Master Loan Agreement dated as of December 30, 2010 by and between AgStar Financial Services, PCA and Heron Lake BioEnergy, LLC
Exhibit 10.1 to Current Report on Form 8-K dated December 30, 2010
10.38
Third Amended and Restated Revolving Line of Credit Note dated December 30, 2010 in the maximum principal amount of $6,750,000 by Heron Lake BioEnergy, LLC as borrower to AgStar Financial Services, PCA as lender
Exhibit 10.2 to Current Report on Form 8-K dated December 30, 2010
10.39
First Amendment to Forbearance Agreement dated December 30, 2010 by and between Heron Lake BioEnergy, LLC and AgStar Financial Services, PCA
Exhibit 10.3 to Current Report on Form 8-K dated December 30, 2010
21.1
Subsidiaries of the Registrant
Exhibit 21.2 of the Company’s 2008 Registration Statement.
31.1
Certification of Chief Executive Officer (principal executive officer) pursuant to Rules 13a-14(a) and 15d-14(a) of the Exchange Act.
Attached hereto.
31.2
Certifications of Chief Financial Officer (principal financial officer) pursuant to Rules 13a-14(a) and 15d-14(a) of the Exchange Act.
Attached hereto.
Certification pursuant to 18 U.S.C. § 1350.
Attached hereto.
*
Indicates compensatory agreement.

Certain portions of this exhibit have been redacted and filed on a confidential basis with the Commission pursuant to a request for confidential treatment under Rule 24b-2 of under the Exchange Act. Spaces corresponding to the deleted portions are represented by brackets with asterisks [ * * * ].