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HIGHWATER ETHANOL LLC - Quarter Report: 2011 January (Form 10-Q)

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended January 31, 2011

 

o

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from                to                

 

Commission file number 000-53588

 

HIGHWATER ETHANOL, LLC

(Name of registrant as specified in its charter)

 

Minnesota

 

20-4798531

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

24500 US Highway 14, Lamberton, MN

 

56152

(Address of principal executive offices)

 

(Zip Code)

 

(507) 752-6160

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x Yes  o No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  o Yes  o No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer o
(Do not check if a smaller reporting company)

 

Smaller reporting company x

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:  As of March 1, 2011 there were 4,953 membership units outstanding.

 

 

 



Table of Contents

 

INDEX

 

 

 

Page

 

 

 

PART I - FINANCIAL INFORMATION

3

 

Item 1.  Financial Statements

3

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

15

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

28

 

Item 4.  Controls and Procedures

28

 

 

 

PART II — OTHER INFORMATION

28

 

Item 1.  Legal Proceedings

28

 

Item 1A.  Risk Factors

28

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

29

 

Item 3.  Defaults Upon Senior Securities

29

 

Item 4.  (Removed and Reserved)

29

 

Item 5.  Other Information

29

 

Item 6.  Exhibits

29

 

 

 

SIGNATURES

30

 

2



Table of Contents

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

HIGHWATER ETHANOL, LLC

 

Condensed Balance Sheets

 

 

 

January 31,

 

October 31,

 

 

 

2011

 

2010

 

 

 

(Unaudited)

 

 

 

ASSETS

 

 

 

 

 

Current Assets

 

 

 

 

 

Cash and equivalents

 

$

5,633,158

 

$

3,856,173

 

Restricted cash

 

185,460

 

67,857

 

Restricted marketable securities

 

79,405

 

109,555

 

Accounts receivable

 

5,549,942

 

4,764,588

 

Inventories

 

4,030,540

 

4,437,672

 

Prepaids and other

 

576,316

 

704,943

 

Total current assets

 

16,054,821

 

13,940,788

 

 

 

 

 

 

 

Property and Equipment

 

 

 

 

 

Land and land improvements

 

6,786,724

 

6,786,724

 

Buildings

 

37,965,861

 

37,965,861

 

Office equipment

 

343,133

 

343,133

 

Equipment

 

59,990,473

 

59,540,376

 

Vehicles

 

41,994

 

41,994

 

Construction in progress

 

14,644

 

355,968

 

 

 

105,142,829

 

105,034,056

 

Less accumulated depreciation

 

(9,029,279

)

(7,475,338

)

Net property and equipment

 

96,113,550

 

97,558,718

 

 

 

 

 

 

 

Other Assets

 

 

 

 

 

Restricted marketable securities

 

1,518,000

 

1,518,000

 

Debt issuance costs, net

 

1,361,680

 

1,433,751

 

Total other assets

 

2,879,680

 

2,951,751

 

 

 

 

 

 

 

Total Assets

 

$

115,048,051

 

$

114,451,257

 

 

 

 

January 31,

 

October 31,

 

 

 

2011

 

2010

 

 

 

(Unaudited)

 

 

 

LIABILITIES AND EQUITY 

 

 

 

 

 

Current Liabilities

 

 

 

 

 

Accounts payable

 

$

1,274,050

 

$

1,604,251

 

Construction payable - members

 

93,886

 

365,968

 

Accrued expenses

 

706,343

 

640,826

 

Derivative instruments

 

762,744

 

840,467

 

Line of credit

 

1,500,000

 

 

Current maturities of long-term debt

 

6,372,024

 

6,801,375

 

Total current liabilities

 

10,709,047

 

10,252,887

 

 

 

 

 

 

 

Long-Term Debt

 

55,970,003

 

56,439,317

 

 

 

 

 

 

 

Derivative Instrument

 

1,382,826

 

1,787,375

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Members’ Equity

 

 

 

 

 

Members’ equity, 4,953 units outstanding

 

46,986,175

 

45,971,678

 

Total members’ equity

 

46,986,175

 

45,971,678

 

 

 

 

 

 

 

Total Liabilities and Members’ Equity

 

$

115,048,051

 

$

114,451,257

 

 

Notes to Condensed Unaudited Financial Statements are an integral part of this Statement.

 

3



Table of Contents

 

HIGHWATER ETHANOL, LLC

 

Condensed Statements of Operations

 

 

 

Three Months Ended

 

Three Months Ended

 

 

 

January 31, 2011

 

January 31, 2010

 

 

 

(Unaudited)

 

(Unaudited)

 

 

 

 

 

 

 

Revenues

 

$

36,269,498

 

$

27,734,962

 

 

 

 

 

 

 

Cost of Goods Sold

 

34,185,426

 

23,507,912

 

 

 

 

 

 

 

Gross Profit

 

2,084,072

 

4,227,050

 

 

 

 

 

 

 

Operating Expenses

 

437,292

 

571,250

 

 

 

 

 

 

 

Operating Profit

 

1,646,780

 

3,655,800

 

 

 

 

 

 

 

Other Income (Expense)

 

 

 

 

 

Interest income

 

37,188

 

35,339

 

Other income

 

 

5,669

 

Interest expense

 

(1,165,081

)

(1,230,136

)

Gain on derivative instrument

 

525,760

 

17,317

 

Total other expense, net

 

(602,133

)

(1,171,811

)

 

 

 

 

 

 

Net Income

 

$

1,044,647

 

$

2,483,989

 

 

 

 

 

 

 

Weighted Average Units Outstanding

 

4,953

 

4,953

 

 

 

 

 

 

 

Net Income Per Unit

 

$

210.91

 

$

501.51

 

 

Notes to Condensed Unaudited Financial Statements are an integral part of this Statement.

 

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Table of Contents

 

HIGHWATER ETHANOL, LLC

 

Condensed Statements of Cash Flows

 

 

 

Three months ended

 

Three months ended

 

 

 

January 31, 2011

 

January 31, 2010

 

 

 

(Unaudited)

 

(Unaudited)

 

Cash Flows from Operating Activities

 

 

 

 

 

Net income

 

$

1,044,647

 

$

2,483,989

 

Adjustments to reconcile net income to net cash provided by operations

 

 

 

 

 

Depreciation and amortization

 

1,626,012

 

1,625,047

 

Interest payments made from restricted cash

 

11,220

 

 

Change in fair value of derivative instruments

 

(230,653

)

255,381

 

Increase in restricted cash from net interest earned

 

(33,638

)

(33,637

)

Change in assets and liabilities

 

 

 

 

 

Restricted cash

 

(95,185

)

 

Accounts receivable, including members

 

(785,354

)

1,454,531

 

Inventories

 

407,132

 

(1,652,575

)

Derivative instrument

 

(251,619

)

(272,698

)

Prepaids and other

 

128,627

 

(260,092

)

Accounts payable, including members

 

(330,201

)

111,663

 

Accrued expenses

 

65,517

 

139,383

 

Net cash provided by operating activities

 

1,556,505

 

3,850,992

 

 

 

 

 

 

 

Cash Flows from Investing Activities

 

 

 

 

 

Capital expenditures

 

(380,855

)

(596,483

)

Net cash used in investing activities

 

(380,855

)

(596,483

)

 

 

 

 

 

 

Cash Flows from Financing Activities

 

 

 

 

 

Proceeds from (payments on) line of credit

 

1,500,000

 

(1,000,000

)

Payments on long-term debt

 

(898,665

)

 

Net cash provided by (used in) financing activities

 

601,335

 

(1,000,000

)

 

 

 

 

 

 

Net Increase in Cash and equivalents

 

1,776,985

 

2,254,509

 

 

 

 

 

 

 

Cash and equivalents - Beginning of period

 

3,856,173

 

2,620,833

 

 

 

 

 

 

 

Cash and equivalents - End of period

 

$

5,633,158

 

$

4,875,342

 

 

 

 

 

 

 

Supplemental Cash Flow Information

 

 

 

 

 

Cash paid for interest

 

$

1,063,341

 

$

1,114,510

 

 

 

 

 

 

 

Supplemental Disclosure of Noncash Financing and Investing Activities

 

 

 

 

 

Unrealized gain (loss) on restricted marketable securities

 

$

(30,150

)

$

4,084

 

Capital expenditures included in accounts payable

 

$

93,886

 

$

1,815,536

 

 

Notes to Condensed Unaudited Financial Statements are an integral part of this Statement.

 

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Table of Contents

 

HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

The accompanying unaudited condensed interim financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission.  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted as permitted by such rules and regulations.  These financial statements and related notes should be read in conjunction with the financial statements and notes thereto included in the Company’s audited financial statements for the year ended October 31, 2010, contained in the Company’s Form 10-K.

 

In the opinion of management, the interim condensed financial statements reflect all adjustments, consisting of only normal recurring adjustments, considered necessary for fair presentation of the Company’s financial position as of January 31, 2011 and the results of operations and cash flows for all periods presented.

 

Nature of Business

 

Highwater Ethanol, LLC, (a Minnesota Limited Liability Company) operates a 50 million gallon per year ethanol plant in Lamberton, Minnesota.  The Company produces and sells fuel ethanol and distillers grains, a co-product of the fuel ethanol production process, in the continental United States, Mexico and Canada.

 

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, among others, the carrying value of property and equipment and related impairment testing, inventory valuation, and derivative instruments.  Actual results could differ from those estimates and such differences may be material to the financial statements. The Company periodically reviews estimates and assumptions and the effects of revisions are reflected in the period in which the revision is made.

 

Revenue Recognition

 

The Company generally sells ethanol and related products pursuant to marketing agreements. The Company’s products are shipped FOB shipping point. Revenues are recognized when the customer has taken title and has assumed the risks and rewards of ownership, prices are fixed or determinable and collectability is reasonably assured. For ethanol sales, title transfers when loaded into the rail car and for distiller’s grains when the loaded rail cars leave the plant facility.

 

In accordance with the Company’s agreements for the marketing and sale of ethanol and related products, marketing fees and freight due to the marketers are deducted from the gross sales price at the time incurred. Revenue is recorded net of these marketing fees and freight as they do not provide an identifiable benefit that is sufficiently separable from the sale of ethanol and related products.

 

Derivative Instruments

 

Derivatives are recognized in the balance sheet and the measurement of these instruments are at fair value. In order for a derivative to qualify as a hedge, specific criteria must be met and appropriate documentation maintained.  Gains and losses from derivatives that do not qualify as hedges, or are undesignated, must be recognized immediately in earnings.  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. Changes in the fair value of undesignated derivatives are recognized in earnings currently.

 

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Table of Contents

 

HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

Contracts are evaluated 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.  Contracts that meet the requirements of normal purchases or sales are documented as normal and exempted from accounting as derivatives, therefore, are not marked to market in our financial statements.

 

In order to reduce the risk caused by interest rate fluctuations, the Company entered into an interest rate swap agreement.  This contract is used with the intention to limit exposure to increased interest rates.  The fair value of this contract is based on widely accepted valuation techniques including discounted cash flow analysis which includes observable market-based inputs.  The fair value of the derivative is continually subject to change due to changing market conditions.  Although this serves as an economic hedge, the Company does not formally designate this instrument as a hedge and, therefore, records in earnings adjustments caused from marking the instrument to market on a monthly basis.

 

The Company entered into corn commodity-based derivatives in order to protect cash flows from fluctuations caused by volatility in commodity prices. These derivatives 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. Corn derivative changes in fair market value are included in costs of goods sold.

 

Fair Value of Financial Instruments

 

The carrying value of cash, accounts receivable, and accounts payable, and other working capital items approximate fair value at January 31, 2011 due to the short maturity nature of these instruments.

 

The carrying value of restricted marketable securities approximate their fair value based on quoted market prices at year end.  The Company believes the carrying value of the derivative instruments approximate fair value based on widely accepted valuation techniques including quotes obtained from an independent pricing service and discounted cash flow analysis which includes observable market-based inputs.

 

The Company believes the carrying amount of the long-term debt approximates the fair value because a significant portion of total indebtedness contains variable interest rates and this rate is a market interest rate for these borrowings as evidenced by recent debt negotiations.

 

Reclassifications

 

The Company made reclassifications to certain consulting and bank costs fees in the Condensed Statement of Operations for the three months ended January 31, 2010, to conform with classifications for the three months ended January 31, 2011.  These reclassifications had no effect on members’ equity, net income or cash flows as previously presented.

 

2.  UNCERTAINTIES

 

The Company derives substantially all of its revenues from the sale of ethanol and distillers grains.  These products are commodities and the market prices for these products display substantial volatility and are subject to a number of factors which are beyond the control of the Company.  The Company’s most significant manufacturing inputs are corn and natural gas.  The price of these commodities is also subject to substantial volatility and uncontrollable market factors.  In addition, these input costs do not necessarily fluctuate with the market prices for ethanol and distillers grains.  As a result, the Company is subject to significant risk that its operating margins can be reduced or eliminated due to the relative movements in the market prices of its products and major manufacturing inputs.  As a result, market fluctuations in the price of or demand for these commodities can have a significant adverse effect on

 

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Table of Contents

 

HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

the Company’s operations, profitability, and availability of cash flows to make loan payments and maintain compliance with the loan agreement.

 

3.  FAIR VALUE MEASUREMENTS

 

The following table provides information on those assets measured at fair value on a recurring basis.

 

 

 

Fair Value as of

 

Fair Value Measurement Using

 

 

 

January 31, 2011

 

Level 1

 

Level 2

 

Level 3

 

Restricted marketable securities - current

 

$

79,405

 

$

79,405

 

$

 

$

 

Restricted marketable securities — long-term

 

$

1,518,000

 

$

1,518,000

 

$

 

$

 

Derivative instruments — Interest rate swap

 

$

(2,102,082

)

$

 

$

(2,102,082

)

$

 

Derivative instruments — Corn contracts

 

$

(43,488

)

$

(43,488

)

$

 

$

 

 

The fair value of restricted marketable securities is based on quoted market prices in an active market. The Company determined the fair value of the interest rate swap by using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each instrument. The analysis reflects the contractual terms of the swap agreement, including the period to maturity and uses observable market-based inputs and uses the market standard methodology of netting the discounted future fixed cash receipts and the discounted expected variable cash payments. The Company determines the fair value of the commodity derivative instruments by obtaining fair value measurements from an independent pricing service.  The fair value measurements consider observable data that may include dealer quotes and live trading levels from the Chicago Board of Trade.

 

4.  RESTRICTED MARKETABLE SECURITIES

 

The cost and fair value of the Company’s restricted marketable securities consist of the following at January 31, 2011:

 

 

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Fair Value

 

 

 

 

 

 

 

 

 

Restricted marketable securities - Current Municipal obligations

 

$

79,405

 

$

 

$

79,405

 

 

 

 

 

 

 

 

 

Restricted marketable securities — Long-term Municipal obligations

 

1,429,712

 

88,288

 

1,518,000

 

 

 

 

 

 

 

 

 

Total restricted marketable securities

 

$

1,509,117

 

$

88,288

 

$

1,597,405

 

 

The long-term restricted marketable securities relate to the debt service reserve fund required by the capital lease agreement. The Company had gross unrealized gains of $88,288 and $118,438 included in accumulated other comprehensive income at January 31, 2011 and October 31, 2010, respectively.

 

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Table of Contents

 

HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

Shown below are the contractual maturities of marketable securities with fixed maturities at January 31, 2011.  Actual maturities may differ from contractual maturities because certain securities may contain early call or prepayment rights.

 

Due within 1 year

 

$

 

Due in 1 to 3 years

 

1,349,451

 

Due in 3 to 5 years

 

247,954

 

Total

 

$

1,597,405

 

 

5. INVENTORIES

 

Inventories consisted of the following at:

 

 

 

January 31, 2011

 

October 31, * 2010

 

 

 

 

 

 

 

Raw materials

 

$

1,616,176

 

$

1,972,604

 

Spare parts and supplies

 

194,410

 

190,386

 

Work in process

 

1,135,871

 

930,377

 

Finished goods

 

1,084,083

 

1,344,305

 

 

 

 

 

 

 

Total

 

$

4,030,540

 

$

4,437,672

 

 


*Derived from Audited financial statements

 

6. DERIVATIVE INSTRUMENTS

 

As of January 31, 2011, the Company had entered into corn derivative instruments and an interest rate swap agreement, which are required to be recorded as either assets or liabilities at fair value in the statement of financial position. 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. The Company must designate the hedging instruments based upon the exposure being hedged as a fair value hedge, a cash flow hedge or a hedge against foreign currency exposure.

 

Interest Rate Swap

 

At January 31, 2011, the Company had a notional amount of approximately $22,366,000 outstanding in the swap agreement that fixes the interest rate at 7.6% until June 2014. The interest rate swap is not designated as a hedge for accounting purposes.

 

Commodity Contracts

 

As of January 31, 2011, the Company has open positions for 80,000 bushels of corn on the Chicago Board of Trade. These derivatives have not been designated as a hedge for accounting purposes.  Management expects all open positions outstanding as of January 31, 2011 to be realized within the next fiscal year.

 

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Table of Contents

 

HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

The following tables provide details regarding the Company’s derivative instruments at January 31, 2011:

 

Instrument

 

Balance Sheet location

 

Assets

 

Liabilities

 

 

 

 

 

 

 

 

 

Interest rate swap

 

Derivative instruments

 

$

 

$

2,102,082

 

Corn contracts

 

Derivative instruments

 

 

43,488

 

 

The following tables provide details regarding the gains from the Company’s derivative instruments in statements of operations, none of which are designated as hedging instruments:

 

 

 

Statement of

 

Three Months Ended January 31,

 

 

 

Operations location

 

2011

 

2010

 

Interest rate swap

 

Gain on derivative instrument

 

$

525,760

 

$

17,317

 

 

 

 

 

 

 

 

 

 

 

Corn contracts

 

Cost of goods sold

 

56,456

 

 

 

7.  DEBT FINANCING

 

Long-term debt consists of the following at:

 

 

 

January 31,

 

October 31,*

 

 

 

2011

 

2010

 

 

 

 

 

 

Fixed rate note payable, see terms below

 

$

23,606,034

 

$

24,040,752

 

 

 

 

 

 

 

Variable rate note payable, see terms below

 

18,884,794

 

19,255,952

 

 

 

 

 

 

 

Long-term revolving note payable, see terms below

 

4,671,199

 

4,763,988

 

 

 

 

 

 

 

Capital lease

 

15,180,000

 

15,180,000

 

 

 

 

 

 

 

Total

 

62,342,027

 

63,240,692

 

 

 

 

 

 

 

Less amounts due within one year

 

6,372,024

 

6,801,375

 

 

 

 

 

 

 

Net long-term debt

 

$

55,970,003

 

$

56,439,317

 

 


*Derived from Audited financial statements

 

In January 2011, the Company entered into an amendment to the construction loan agreement with its primary lender (Lender).  Pursuant to the amended agreement, the Company is required to make an immediate $3,000,000 prepayment on the long-term revolving note payable, which was completed in February 2011. In exchange for the prepayment, the variable rate note payable will have interest only payments going forward with quarterly 50% excess cash flow payments which will be applied first to interest and then to principal on the variable rate note, with

 

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Table of Contents

 

HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

a minimum annual reduction of principal of $750,000. The Company is also required to make a $750,000 mandatory principal repayment on the long-term revolving note payable prior to February 2012 and reduce the outstanding principal balance to zero as of February 2013. The amendment also modifies the minimum working capital, minimum net worth, fixed charge coverage, and leverage ratios contained in the loan documents. The Company anticipates being in compliance with these revised covenant requirements through January 31, 2012.

 

The financial covenant conditions approved as part of the January 2011 amendment to the debt agreement are as follows:

 

Covenant Type

 

Compliance Dates

 

Covenant Requirements

 

Fixed charge coverage

 

Quarterly

 

No less than 1.10:1.00

 

Net worth

 

Annually

 

$

41,250,000

*

Working Capital

 

Quarterly

 

No less than $6,000,000

#

Maximum leverage

 

Annually

 

No greater than 1.65:1.00

 

 


* The Net Worth covenant requirement will be increased each fiscal year by an amount equal to the greater of $250,000 or the amount of undistributed earnings accumulated during the fiscal year just ended (less any allowable distributions attributable to the just ended fiscal year’s earnings).

 

# The minimum Working Capital covenant requirement of $6,000,000 will commence on May 1, 2011. Until that time, the minimum Working Capital covenant requirement is $4,500,000.

 

Bank Financing

 

On February 26, 2010 the construction loan was converted to three new promissory notes including a $25,200,000 Fixed Rate Note, a $20,200,000 Variable Rate Note, and a $5,000,000 Long-Term Revolving note, as described in the credit agreement and below. The credit agreement also provided a line of credit for $5,000,000 and supported the issuance of letters of credit up to $5,600,000, all of which are secured by substantially all assets.

 

Fixed Rate Note

 

The Fixed Rate Note was $25,200,000 at conversion with a variable interest rate that is fixed with an interest rate swap.  The Company makes monthly principal payments on the Fixed Rate Note initially for approximately $145,000 plus accrued interest which commenced in March 2010. Interest accrues on the Fixed Rate Note at the greater of the one-month LIBOR rate plus 300 basis points or 4%, which was 4% at January 31, 2011. A final balloon payment on the Fixed Rate Note of approximately $15,189,000 will be due February 26, 2015.

 

Variable Rate Note

 

The Variable Rate Note was $20,200,000 at conversion.  For the Variable Rate Note, the Company makes monthly payments initially for approximately $147,000 plus accrued interest which commenced in March 2010. Interest accrues on the Variable Rate Note at the greater of the one-month LIBOR rate plus 350 basis points or 4%. A final balloon payment of approximately $15,306,000 will be due February 26, 2015. Under the amendment entered into in January 2011, the minimum interest rate on the variable rate note increased to 5% and the principal balance increased by $336,000.

 

Long-term Revolving Note

 

The Long-Term Revolving Note was $5,000,000 at conversion.  The amount available on the Long-Term Revolving Note will decline annually by the greater of $125,000 or 50% of the excess cash flow, as defined by the agreement.  The Long-Term Revolving Note accrues interest monthly at the greater of the one-month LIBOR plus 350 basis points or 4% until maturity on February 26, 2015, which was 4% at January 31, 2011. Under the amendment entered

 

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HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

into in January 2011, there was a prepayment of $3,000,000 made on the long-term revolving note, the maximum availability was reduced to $4,500,000, and $336,000 of the remaining balance was allocated to the variable rate note. Additionally, the payment terms were adjusted as discussed above. The prepayment on the long-term revolving note was made in February 2011.

 

Line of Credit

 

The Company’s Line of Credit accrues interest at the greater of the 90-day LIBOR plus 450 basis points or 5.5%, which was 5.5% at January 31, 2011.  The line of credit requires monthly interest payments and was payable in full in February 2010.  In February 2010, the Company signed an amendment to extend the maturity date to February 26, 2011.  In February 2011, the Company signed an amendment to extend approximately $948,000 of the line of credit to June 30, 2011 and $4,052,000 to August 28, 2011.  On June 30, 2011, the maximum principal amount available under the line of credit will be reduced by approximately $948,000.  As of January 31, 2011, the Company had $1,500,000 outstanding on the line of credit.

 

As part of the amendment entered into in January 2011, the Company is required to make additional payments quarterly on debt for up to 50% of the excess cash flow, as defined by the agreement.  As part of the bank financing agreement, the premium above LIBOR on the loans may be reduced based on a financial ratio.  The loan agreements are secured by substantially all business assets and are subject to various financial and non-financial covenants that limit distributions and debt and require minimum debt service coverage, net worth, and working capital requirements.

 

As of January 31, 2011, the Company has letters of credit outstanding of $4,250,000. The Company pays interest at a rate of 1.75% on amounts outstanding and the letters of credit are valid until March 2011. One of the letters of credit will automatically renew for an additional one year period in the amount of $4,000,000.

 

Capital Lease

 

In April 2008, the Company entered into a lease agreement with the City of Lamberton, Minnesota, (the City) in order to finance equipment for the plant.  The lease has a term from April 1, 2008 through April 1, 2028 or until earlier terminated. The City financed the purchase of equipment through Solid Waste Facilities Revenue Bonds Series 2008A totaling $15,180,000.

 

Under the equipment lease agreement with the City, the Company started making interest payments on November 25, 2008 and monthly thereafter at an implicit interest rate of 8.5%. The monthly capital lease interest payments correspond to 1/6 the semi-annual interest payments due on the Bonds on the next interest payment date. Monthly capital lease payments for principal were originally scheduled to begin on November 25, 2009; however, the City amended the agreement in September 2008 which adjusted the start date for principal payments to begin on November 25, 2014.  These payments will equal 1/12 the annual principal payments scheduled to become due on the corresponding bonds on the next principal payment date.

 

The Company has guaranteed that if such assessed lease payments are not sufficient for the required bond payments, the Company will provide such funds as are needed to fund the shortfall. The lease agreement is secured by substantially all business assets and is subject to various financial and non-financial covenants that limit distributions and leverage and require minimum debt service coverage, net worth, and working capital requirements, and are secured by all business assets.

 

The capital lease includes an option to purchase the equipment at fair market value at the end of the lease term.  Under the capital lease agreement, the proceeds are for project costs and the establishment of a capitalized interest fund and a debt service reserve fund.  The Company received proceeds of approximately $14,876,000, after financing costs of approximately $304,000.

 

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HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

The estimated maturities of the long-term debt at January 31, 2011 are as follows:

 

2012

 

$

6,372,024

 

2013

 

3,516,491

 

2014

 

2,929,991

 

2015

 

4,081,386

 

2016 and thereafter

 

45,442,135

 

 

 

 

 

Long-term debt

 

$

62,342,027

 

 

8.  LEASES

 

In April 2009, the Company entered into a five-year operating lease agreement with an unrelated party for 50 covered hopper cars.  The Company pays approximately $425 per car per month.  In addition, a surcharge of $0.03 per mile will be assessed for each mile in excess of 30,000 miles per year a car travels.  Total lease expense for the three months ending January 31, 2011 was approximately $63,750.

 

Future minimum lease payments under the operating and capital leases are as follows at January 31, 2011:

 

 

 

Operating

 

Capital

 

2012

 

$

255,000

 

$

1,290,300

 

2013

 

255,000

 

1,290,300

 

2014

 

255,000

 

1,290,300

 

2015

 

106,250

 

1,523,633

 

2016

 

 

2,690,467

 

After 2016

 

 

18,396,600

 

Total

 

871,250

 

26,481,600

 

Less amount representing interest

 

 

11,301,600

 

Present value of minimum lease payments

 

871,250

 

15,180,000

 

Less current maturities

 

 

 

Long-term debt

 

$

871,250

 

$

15,180,000

 

 

9.  COMMITMENTS AND CONTINGENCIES

 

Marketing Agreements

 

The Company entered into a new ethanol marketing agreement with their current marketer that became effective February 1, 2011. Under the new marketing agreement, the marketer will continue to purchase, market, and distribute all the ethanol produced by the Company. The Company also entered into a member control agreement with the marketer whereby the Company will make a capital contribution and become a minority owner of the marketing company.  The member control agreement became effective on February 1, 2011 and provides the Company a membership interest with voting rights. The marketing agreement would terminate if the Company ceases to be a member.  The Company would assume certain of the member’s rail car leases if the agreement is terminated.

 

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HIGHWATER ETHANOL, LLC

 

Notes to Unaudited Condensed Financial Statements

 

January 31, 2011

 

Regulatory Agencies

 

The Company is subject to oversight from regulatory agencies regarding environmental concerns which arise in the ordinary course of its business. While the ultimate outcome of these matters is not presently determinable, it is in the opinion of management that the resolution of outstanding claims will not have a material adverse effect on the financial position or results of operations of the Company. Due to the uncertainties in the settlement process, it is at least reasonably possible that management’s view of outcomes will change in the near term.

 

Construction in Progress

 

The Company had construction in progress of approximately $14,600 at January 31, 2011 for enhancements to the gas monitoring system.  The addition is expected to amount to $36,500.

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Cautionary Statements Regarding Forward-Looking Statements

 

This report contains forward-looking statements that involve known and unknown risks and relate to future events, our future performance and our expected future operations and actions.  In some cases you can identify forward-looking statements by the use of words such as “will,” “may,” “should,” “anticipate,” “believe,” “expect,” “plan,” “future,” “intend,” “could,” “estimate,” “predict,” “hope,” “potential,” “continue,” or the negative of these terms or other similar expressions.  These forward-looking statements are only our predictions and involve numerous assumptions, risks and uncertainties.  Many factors could cause actual results to differ materially from those projected in forward-looking statements.  While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include, but are not limited to:

 

·                  Changes in our business strategy, capital improvements or development plans;

·                  Volatile commodity and financial markets;

·                  Limitations and restrictions contained in the instruments and agreements governing our indebtedness;

·                  Our ability to comply with the financial covenants contained in our credit agreements with our lender;

·                  Our ability to profitably operate the ethanol plant and maintain a positive spread between the selling price of our products and our raw materials costs;

·                  Our ability to generate free cash flow to invest in our business and service our debt;

·                  Changes in interest rates and lending conditions;

·                  The results of our hedging transactions and other risk management strategies;

·                  Changes in the environmental regulations or in our ability to comply with such regulations;

·                  Changes in general economic conditions or the occurrence of certain events causing an economic impact in the agriculture, oil or automobile industries;

·                  Changes in the availability of credit to support the level of liquidity necessary to implement our risk management activities;

·                  Changes in or elimination of federal and/or state laws or policies impacting the ethanol industry (including the elimination of any federal and/or state ethanol tax incentives);

·                  Ethanol and distillers grains supply exceeding demand and corresponding price reductions;

·                  Changes in plant production capacity or technical difficulties in operating the plant;

·                  Changes and advances in ethanol production technology;

·                  Our ability to retain key employees and maintain labor relations;

·                  Changes in our ability to secure credit or obtain additional debt or equity financing, if we so require;

·                  Lack of transportation, storage and blending infrastructure preventing our products from reaching high demand markets;

·                  Competition from alternative fuel additives; and

·                  Elimination of the United States tariff on imported ethanol.

 

The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf.  We are not under any duty to update the forward-looking statements contained in this report.  Furthermore, we cannot guarantee future results, levels of activity, performance or achievements.  We caution you not to put undue reliance on any forward-looking statements, which speak only as of the date of this report.  You should read this report and the documents that we reference in this report and have filed as exhibits completely and with the understanding that our actual future results may be materially different from what we currently expect.  We qualify all of our forward-looking statements by these cautionary statements.

 

Available Information

 

Our website address is www.highwaterethanol.com.  Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), are available, free of charge, on our website at www.highwaterethanol.com under the link “SEC Compliance,” as soon as reasonably practicable after we

 

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electronically file such materials with, or furnish such materials to, the Securities and Exchange Commission. The contents of our website are not incorporated by reference in this Quarterly Report on Form 10-Q.

 

Overview

 

Highwater Ethanol, LLC (“we,” “our,” “Highwater” or the “Company”) is a Minnesota limited liability company organized on May 2, 2006 for the purpose of developing, constructing, owning and operating a fuel-grade ethanol plant near Lamberton, Minnesota.  Since August 2009, we have been engaged in the production of ethanol and distillers grains at the ethanol plant.  Our plant has nameplate capacity of 50 million gallons of undenatured ethanol per year.  However, our environmental permits allow us to produce ethanol at a rate of 55 million gallons per year.  Management anticipates our plant will continue to produce approximately 54.9 million gallons per year.

 

Our operating results are largely driven by the prices at which we sell our ethanol and distillers grains as well as the other costs related to production.  We market our products through professional third party marketers.  Our ethanol is marketed by Renewable Products Marketing Group, LLC (RPMG).  Our distillers grains are marketed by CHS, Inc. (CHS).

 

The price of ethanol has historically fluctuated with the price of petroleum-based products such as unleaded gasoline, heating oil and crude oil.  The price of distillers grains has historically been influenced by the price of corn as a substitute livestock feed.  We expect these price relationships to continue for the foreseeable future, although recent volatility in the commodities markets makes historical pricing relationships less reliable.  Our largest costs of production are corn, natural gas, depreciation and manufacturing chemicals.  The cost of corn is largely impacted by geopolitical supply and demand factors and the outcome of our risk management strategies.  Prices for natural gas, manufacturing chemicals and denaturant are tied directly to the overall energy sector, crude oil and unleaded gasoline.

 

During 2010, the ethanol industry experienced a significant increase in distiller grains exports to China.  Animal feeding operations in China are growing which has prompted a significant increase in animal feed demand from China, including increased distillers grain demand.  However, China recently began investigating United States distillers grains exporters for dumping distillers grains in the Chinese market.  These dumping allegations may lead to China imposing high tariffs on distillers grains that are produced in the United States and transported to China.  While the United States distillers grains industry believes that China’s dumping claims are without merit and are retaliation by the Chinese government related to other trade disputes with the United States, these developments may negatively impact distillers grains exports to China.  If China were to impose a high tariff on distillers grains imports from the United States, it could negatively impact the market price of distillers grains which could negatively impact our financial performance.

 

Results of Operations for the Three Months Ended January 31, 2011 and 2010

 

The following table shows the results of our operations and the approximate percentage of revenues, costs of goods sold, operating expenses and other items to total revenues in our unaudited statements of operations for the three months ended January 31, 2011 and 2010:

 

 

 

Three Months
Ended January 31, 2011
(Unaudited)

 

Three Months
Ended January 31, 2010
(Unaudited)

 

Statement of Operations Data

 

Amount

 

Percent

 

Amount

 

Percent

 

Revenues

 

$

36,269,498

 

100.0

%

$

27,734,962

 

100.0

%

 

 

 

 

 

 

 

 

 

 

Cost of Goods Sold

 

34,185,426

 

94.25

%

23,507,912

 

84.76

%

 

 

 

 

 

 

 

 

 

 

Gross Profit

 

2,084,072

 

5.75

%

4,227,050

 

15.24

%

 

 

 

 

 

 

 

 

 

 

Operating Expenses

 

437,292

 

1.21

%

571,250

 

2.06

%

 

 

 

 

 

 

 

 

 

 

Operating Profit

 

1,646,780

 

4.54

%

3,655,800

 

13.18

%

 

 

 

 

 

 

 

 

 

 

Other Income (Expense), net

 

(602,133

)

(1.66

)%

(1,171,811

)

(4.23

)%

 

 

 

 

 

 

 

 

 

 

Net Income

 

$

1,044,647

 

2.88

%

$

2,483,989

 

8.96

%

 

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Revenues

 

Our revenues are derived from the sale of our ethanol and distillers grains.

 

The following table shows the sources of our revenue for the three months ended January 31, 2011.

 

 

 

Amount
(Unaudited)

 

Percentage of
Total Revenues
(Unaudited)

 

Revenue Sources

 

 

 

 

 

 

 

 

 

 

 

Ethanol Sales

 

$

30,969,714

 

85.39

%

Distillers Grains Sales

 

5,299,784

 

14.61

%

Total Revenues

 

$

36,269,498

 

100.00

%

 

The following table shows the sources of our revenue for the three months ended January 31, 2010.

 

 

 

Amount
(Unaudited)

 

Percentage of
Total Revenues
(Unaudited)

 

Revenue Sources

 

 

 

 

 

 

 

 

 

 

 

Ethanol Sales

 

$

24,012,930

 

86.58

%

Distillers Grains Sales

 

3,722,031

 

13.42

%

Total Revenues

 

$

27,734,962

 

100.00

%

 

The following table shows additional data regarding production and price levels for our primary inputs and products for the three months ended January 31, 2011 and 2010.

 

Additional Data

 

Three Months
Ended January 31, 2011
(Unaudited)

 

Three Months
Ended January 31, 2010
(Unaudited)

 

Ethanol sold (gallons)

 

14,578,000

 

13,315,000

 

Dried distillers grains sold (tons)

 

37,000

 

34,000

 

Modified distillers grains sold (tons)

 

2,000

 

2,500

 

Ethanol average price per gallon

 

$

2.15

 

$

1.85

 

Dried distillers grains average price per ton

 

$

151.44

 

$

110.42

 

Modified distillers grains average price per ton

 

$

53.88

 

$

38.12

 

Average corn costs per bushel

 

$

5.49

 

$

3.54

 

 

Revenues

 

Our total revenues were higher for our first quarter of 2011 compared to the same period in 2010, primarily due to increased sales and prices for ethanol and distillers grains.  For the three month period ended January 31, 2011, ethanol sales accounted for approximately 85.39% of our total revenue and distillers grains sales accounted for approximately 14.61% of our total revenue.  For the three month period ended January 31, 2010, ethanol sales accounted for approximately 86.58% of our total revenue and distillers grains sales accounted for approximately 13.42% of our total revenue.

 

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Management believes that distillers grains represent a larger portion of our revenues during the three months ended January 31, 2011 compared to the same period of 2010 as a result of the higher distillers grains prices we received.  Management believes these higher distillers grains prices are a result of the high price of other feed products available to livestock producers.

 

We experienced an increase in the gallons of ethanol sold in the three month period ended January 31, 2011 as compared to the three month period ended January 31, 2010.  We sold 14,578,000 gallons of ethanol during the three month period ended January 31, 2011 compared to 13,315,000 gallons for the three months ended January 31, 2010.  During the three months ended January 31, 2011, the Company had revenues from the sale of ethanol of approximately $30,970,000 compared to revenues of approximately $24,013,000 from the sale of ethanol for the three months ended January 31, 2010.  The average ethanol sales price we received for the three month period ended January 31, 2011 was approximately 16.21% higher than the average price we received for the same period of 2010.  For the three month period ended January 31, 2011, the Company received an average price of $2.15 per gallon of ethanol sold.  In comparison, the Company received an average price of $1.85 per gallon of ethanol sold for the three months ended January 31, 2010.  Management attributes this increase in the average price we received for our ethanol with higher corn and energy prices along with increased ethanol exports to Europe which positively impacted ethanol demand during the three month period ended January 31, 2011.  Recent geopolitical events in northern Africa and the Middle East have caused significant uncertainty about the global supply of crude oil and other petroleum based products.  Management anticipates that the price of ethanol will continue to be volatile during our 2011 fiscal year as a result of these factors.  Since the end of our fiscal quarter on January 31, 2011, ethanol prices have increased.

 

The Company received revenues from the sale of its dried distillers grains of approximately $5,300,000 (after freight and marketing fees) for the three months ended January 31, 2011, compared to revenues of approximately $3,722,000 for the three months ended January 31, 2010.  For the three months ended January 31, 2011, the Company received an average price of $151.44 (after freight but before marketing fees) per ton for the approximately 37,000 tons of dried distillers grains sold.  In comparison, the Company received an average price of $110.42 (after freight but before marketing fees) per ton for approximately 34,000 tons of dried distillers grains sold for the three months ended January 31, 2010.  Management attributes this increase in dried distillers grains prices during the three months ended January 31, 2011 with higher corn prices and increased export demand for dried distillers grains.  Generally, as corn prices increase, distillers grains prices also increase since distillers grains are typically used as a feed substitute for corn.  Management anticipates that distillers grains prices will continue to increase because of the recent increases in corn prices.  However, in the event China ceases importing distillers grains from the United States, we may experience excess supply of distillers grains in the market.  While we do not export a significant amount of distillers grains to China, management believes that changes in China’s imports of distillers grains may affect the market price of distillers grains in the United States.

 

Management also anticipates that our results of operations for our 2011 fiscal year may be affected by high corn prices, a surplus of ethanol, and volatility in the commodity markets. If plant operating margins remain low for an extended period of time, management anticipates that this could significantly impact our liquidity, especially if our raw material costs increase. Management believes the industry will need to continue to grow demand and further develop an ethanol distribution system to facilitate additional blending of ethanol and gasoline to offset the increased supply brought to the marketplace by additional production. Going forward, we are optimistic that ethanol demand will continue to grow and ethanol distribution will continue to expand as a result of the positive blend economics that currently exist once the Volumetric Ethanol Excise Tax Credit (“VEETC”) is accounted for by the gasoline refiners and blenders.  However, if VEETC is not renewed or if it is repealed, it likely would have a negative impact on the price of ethanol and demand for ethanol in the marketplace.

 

Cost of Goods Sold

 

Our costs of goods sold as a percentage of revenues were approximately 94.25% for the three months ended January 31, 2011 compared to 84.76% for the three months ended January 31, 2010.  Our two largest costs of production are corn (79.57% of cost of goods sold for the three months ended January 31, 2011) and natural gas (5.88% of cost of goods sold for the three months ended January 31, 2011).  Our cost of goods sold increased to approximately $34,185,000 for the three months ended January 31, 2011 from approximately $23,508,000 in the three months ended January 31, 2010.

 

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For the three months ended January 31, 2011, the Company paid an average price for corn of $5.49 per bushel, compared to an average price of $3.54 per bushel for the three months ended January 31, 2010.  Management anticipates that corn prices will remain high throughout much of our 2011 fiscal year until we are assured of a large 2011 corn crop which would increase corn carryover.  Should we experience an unfavorable growing season during 2011, we may continue to endure high corn prices through the rest of our 2011 fiscal year and beyond.

 

For the three month period ended January 31, 2011, we experienced a decrease in our overall natural gas costs compared to the same period of 2010.  We attribute this significant decrease in natural gas costs to improved efficiencies and lower natural gas prices.  Management anticipates that natural gas prices will be relatively stable in the next several months.

 

We occasionally engage in hedging activities with respect to corn.  We recognize the gains or losses that result from the changes in the value of our derivative instruments in cost of goods sold as the changes occur. As corn prices fluctuate, the value of its derivative instruments would be impacted, which effects would affect the Company’s financial performance. Any future use of hedging by the Company may result in the volatility in the Company’s cost of goods sold due to the timing of the changes in value of the derivative instruments relative to the cost and use of the commodity being hedged.

 

Operating Expense

 

Our operating expenses as a percentage of revenues were 1.21% for the three months ended January 31, 2011, compared to 2.06% for the three months ended January 31, 2010, as a result of the ethanol facility operating more efficiently.  Operating expenses include salaries and benefits of administrative employees, insurance, taxes, professional fees and other general administrative costs.  Management is pursuing strategies to optimize efficiencies and maximize production.  These efforts may result in a decrease in our operating expenses on a per gallon basis.  However, because these expenses do not vary with the level of production at the plant, we expect our operating expenses to remain steady with first quarter 2011 levels.

 

Operating Income

 

We had a profit from operations for the three months ended January 31, 2011, of approximately 4.54% of our revenues compared to 13.09% for the three months ended January 31, 2010.  For the three months ended January 31, 2011, we reported an operating profit of approximately $1,647,000, and for the three months ended January 31, 2010, we reported an operating profit of approximately $3,656,000.  This decrease in operating income is primarily due to escalating corn prices that outpaced the rising ethanol and distillers grains revenues.

 

Other Income (Expense)

 

We had total other expense (net) for the three months ended January 31, 2011, of approximately $602,000 compared to other expense (net) of approximately $1,172,000 for the three months ended January 31, 2010.  Our other expense for the three months ended January 31, 2011, consisted primarily of interest expense offset by derivative instrument gains.  The net decrease in other expense is due to the increase in the gain on derivative instrument for the three months ended January 31, 2011 compared to the same period of 2010 because of the underlying variable rate increasing from October 31, 2010.

 

Changes in Financial Condition for the Three Months Ended January 31, 2011

 

The following table highlights the changes in our financial condition for the three months ended January 31, 2011 from our previous fiscal year ended October 31, 2010:

 

 

 

January 31, 2011
(unaudited)

 

October 31, 2010*

 

Current Assets

 

$

16,054,821

 

$

13,940,788

 

Current Liabilities

 

10,709,047

 

10,252,887

 

Long-Term Debt

 

55,970,003

 

56,439,317

 

Members’ Equity

 

46,986,175

 

45,971,678

 

 


* Derived from audited financial statements

 

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Total and Current Assets.  Total assets were approximately $115,048,000 at January 31, 2011, compared to approximately $114,451,000 at October 31, 2010.  Current assets at January 31, 2011, increased from October 31, 2010 as a result of an increase in our cash on hand due to improved conditions in the ethanol market as well as the $1,500,000 drawn on our line of credit.  Also, we experienced an increase in our accounts receivables primarily because of the higher ethanol and distillers grains prices as of January 31, 2011.

 

Property and Equipment.  The net value of our property and equipment was lower at January 31, 2011 compared to October 31, 2010 as a result of depreciation taken on our operating assets during the period.

 

Current Liabilities.  Total current liabilities increased and totaled approximately $10,709,000 at January 31, 2011 and $10,253,000 at October 31, 2010.  As of January 31, 2011 we had drawn $1,500,000 on our line of credit.  Additionally, current maturities of long-term debt included $3,000,000 reclassified from long-term debt due to the prepayment on the Long-Term Revolving Note made in February 2011.

 

Long-term Liabilities.  Long-term debt decreased from approximately $56,439,000 at October 31, 2010, to approximately $55,970,000 at January 31, 2011, primarily because we continue to pay down our loans with FNBO and have reclassified $3,000,000 to current liabilities due to the prepayment on the Long-Term Revolving Note made in February 2011.

 

Liability and Capital Resources

 

Our primary sources of liquidity include: (1) cash, (2) Long-Term Revolving Note, and (3) line of credit.  On January 31, 2011 we amended our Construction Loan Agreement with First National Bank of Omaha of Omaha, Nebraska as administrative agent and collateral agent for the banks (collectively referred to as “FNBO”).  For a description of the modifications to our loan documents see below “Modifications to Loan Documents”.

 

Based on financial forecasts performed by our management, we anticipate that we will have sufficient cash from our current credit facilities and cash from our operations to continue to operate the ethanol plant at capacity for the next 12 months.   In addition, we have a revolving line of credit with maximum available funds up to $5,000,000.  We had $1,500,000 drawn on this credit facility as of January 31, 2011 and $3,500,000 available.

 

We do not currently anticipate seeking additional equity or debt financing in the near term.  However, should we experience unfavorable operating conditions in the future, we may have to secure additional debt or equity financing for working capital or other purposes.

 

We do not currently anticipate any significant purchases of property and equipment that would require us to secure additional capital resources in the next 12 months.  Management continues to evaluate conditions in the ethanol industry and explore opportunities to improve the efficiency and profitability of our operations, which may require more capital expenditures.

 

The following table shows cash flows for the three months ended January 31, 2011 and 2010:

 

 

 

Three Months Ended January

 

 

 

2011

 

2010

 

Net cash provided by operating activities

 

$

1,556,505

 

$

3,850,992

 

Net cash used in investing activities

 

(380,855

)

(596,483

)

Net cash provided by (used in) financing activities

 

601,335

 

(1,000,000

)

 

Cash Flow From Operations

 

We experienced a decrease of approximately $2,294,000 in our cash flows from operations for the three month period ended January 31, 2011, compared to the same period in 2010.  This decrease was due to decreased net income primarily driven by increased prices for corn during the 2011 period as well as a decrease in our working

 

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capital items.  During the three months ended January 31, 2011, our capital needs were being adequately met through cash from our operating activities and our credit facilities.

 

Cash Flow From Investing Activities

 

We used less cash for investing activities for the three month period ended January 31, 2011, as compared to 2010.  This decrease was primarily a result of the reduced capital expenditures.

 

Cash Flow From Financing Activities

 

We had net cash provided by financing activities during our three months ended January 31, 2011, as a result of the $1,500,000 draw on our line of credit offset by cash paid to decrease the principal balance on our loans with FNBO by approximately $899,000.

 

Short-Term and Long-Term Debt Sources

 

On April 24, 2008, we entered into a Construction Loan Agreement (the “Agreement”) with FNBO for the purpose of funding a portion of the cost of the ethanol plant.  Under the Agreement, FNBO agreed to loan us up to $61,000,000, consisting of a $50,400,000 Construction Loan, together with a $5,000,000 Revolving Loan, and $5,600,000 to support the issuance of letters of credit by FNBO.  As of January 31, 2011, the Company had issued $4,250,000 in letters of credit.

 

With construction complete and the ethanol plant commencing operations, the construction loan converted on February 26, 2010 to a $25,200,000 Fixed Rate Note, a $20,200,000 Variable Rate Note, a $5,000,000 Long-Term Revolving Note, and a $5,000,000 line of credit.

 

Modifications to Loan Documents

 

On January 31, 2011 we entered into a Third Amendment of Construction Loan Agreement with FNBO (“Third Amendment”).  The Long-term Revolving Note was initially $5,000,000.  Pursuant to the amended agreement, we paid $3,000,000 in February 2011 to FNBO as a principal prepayment of our Long-term Revolving Note.  In addition, we have agreed to make an additional mandatory principal prepayment of not less than $750,000 on the Long-term Revolving Note on or before February 1, 2012, as well as an additional mandatory principal payment on or before February 1, 2013, in an amount sufficient to reduce the outstanding principal balance of the Long-term Revolving Note to $0.  The maximum allowable principal balance outstanding on our Long-term Revolving Note has also been reduced to $4,500,000 and FNBO has no obligation to advance any additional funds on our Long-term Revolving Note and will only advance such funds as approved in its sole discretion. Furthermore, we have agreement to make no distributions without the prior consent of FNBO.  For a complete description of the modifications to the Long-term Revolving Note see below “Long-term Revolving Note”.  Our Variable Rate Note will now have a minimum interest rate floor of 5% and we will make monthly interest payments.  In addition, we will make quarterly fifty percent (50%) excess cash flow payments, with a maximum annual reduction of $750,000, which will be applied first to interest, then to principal on the Variable Rate Note and then, if there is still a balance, to the Long-term Revolving Note described below under “Variable Rate Note”.  The amendment also modifies the minimum working capital, minimum tangible net worth, fixed coverage charge and leverage ratios contained in the loan documents as described below under “Covenants and other Miscellaneous Financing Agreement Terms”.  Additionally, FNBO also granted a waiver regarding the violations of the fixed coverage ratio and the leverage ratio financial covenants when tested on July 31, 2010, as well as the minimum net worth financial covenant when tested on October 31, 2010.  We are currently in compliance with our financial loan covenants as modified.

 

Effective February 26, 2011 we entered into a Fourth Amendment of Construction Loan Agreement with FNBO (“Fourth Amendment”).  Pursuant to the Fourth Amendment, a portion of our line of credit will terminate on June 30, 2011 with the remainder terminating on August 28, 2011.  We have agreed to pay such amounts as are necessary to fully pay the outstanding principal balance and accrued and unpaid interest on the portion of the line of credit terminating on June 30, 2011.  Also, on June 30, 2011, the maximum principal amount of the line of credit will be reduced by approximately $948,000.

 

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Fixed Rate Note

 

The Fixed Rate Note was initially for $25,200,000 with a variable interest rate that is fixed with an interest rate swap.  We commenced making monthly principal payments on the Fixed Rate Note initially for approximately $145,000 plus accrued interest in March 2010.  Interest will accrue on the Fixed Rate Note at the greater of the one-month LIBOR Rate, in effect from time to time, plus 300 basis points or 4%.  The applicable interest rate was 4% at January 31, 2011.  However, the Company entered into an interest rate swap agreement with FNBO, which fixes the interest rate on the Fixed Rate Note at 7.6% until June 2014.  The Company entered into the fixed rate swap agreement to alter its exposure to the impact of changing interest rates on its results of operations and future cash outflows for interest.  A final balloon payment on the Fixed Rate Note of approximately $15,188,000 will be due February 26, 2015.

 

Variable Rate Note

 

The Variable Rate Note was initially for $20,200,000.  As part of our loan modifications with FNBO approximately $336,000 from the Long-term Revolving Note was added to the principal balance of the Variable Rate Note.  We commenced making monthly payments initially for approximately $147,000 plus accrued interest in March 2010.  As part of the Third Amendment, the Variable Rate Note was modified to monthly interest only payments and we will remit quarterly excess cash flow payments to FNBO which will be applied first to interest and then to principal on the Variable Rate Note with a minimum annual principal reduction of $750,000.

 

Interest will accrue on the Variable Rate Note at the greater of the one-month LIBOR rate plus 350 basis points or 5%.  The applicable interest rate at January 31, 2011, was 5%.  A final balloon payment of approximately $15,306,000 will be due February 26, 2015.

 

Long-term Revolving Note

 

The Long-term Revolving Note was initially for $5,000,000.  As part of the Third Amendment, in February 2011 we prepaid $3,000,000 on the Long-term Revolving Note.  On or before February 1, 2012, we will remit an additional mandatory principal prepayment on the Long-term Revolving Note in an amount not less than $750,000.  On or before February 1, 2013, we will make another additional mandatory principal prepayment on the Long-term Revolving Note in an amount sufficient to reduce the outstanding principal balance of the Long-term Revolving Note to $0.  In addition, the commitment on the Long-term Revolving Note was reduced from $5,000,000 to $4,500,000.  FNBO has no obligation to advance any additional funds and will only advance such sums as approved in its sole discretion.  Also, approximately $336,000 of the Long-term Revolving Note balance was transferred to the Variable Rate Note.

 

The Long-term Revolving Note will accrue interest monthly at the greater of the one-month LIBOR plus 350 basis points, or 4% until it is paid off on or before February 1, 2013. The applicable interest rate at October 31, 2010 was 4%.

 

Line of Credit

 

The Company has a line of credit available equal to the amount of the Company’s Borrowing Base, with a maximum limit of $5,000,000.  The Company’s Borrowing Base will vary and may at times be less than $5,000,000.  The Company has maximum availability of $3,500,000 under the line of credit at January 31, 2011.  The Company’s line of credit accrues interest at the greater of the 90-day LIBOR plus 450 basis points or 5.5%, which was 5.5% at January 31, 2011.  The line of credit requires monthly interest payments.

 

The Company signed an amendment to the Construction Loan Agreement to extend approximately $948,000 of the line of credit to June 30, 2011 and $4,052,000 to August 28, 2011.  We have agreed to pay such amounts as are necessary to fully pay the outstanding principal balance and accrued and unpaid interest on the portion of the line of credit terminating on June 30, 2011.  Also, on June 30, 2011, the maximum principal amount of the line of credit will be reduced by approximately $948,000.  As of January 31, 2011, there was $1,500,000 outstanding.

 

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Covenants and other Miscellaneous Financing Agreement Terms

 

The loan agreements are subject to various financial and non-financial covenants that limit distributions and debt and require minimum debt service coverage, net worth, and working capital requirements.  On January 31, 2011 we amended our Construction Loan Agreement with FNBO.  Pursuant to the amendment agreements we are required to maintain working capital of not less than $6,000,000 measured quarterly beginning in May 2011.  Additionally, the amount available on the Long-term Revolving Note will be included in the working capital covenant calculation.

 

Also, as part of the Third Amendment, the Company must maintain a fixed charge coverage ratio (earnings before interest, taxes, depreciation and amortization less taxes, less capital expenditures and less tax distributions and other permitted distributions plus the maximum availability on the Long-term Revolving Note compared to scheduled payments on the principal and interest of the construction loans, excluding any principal repaid on the  Revolving Loan and Long-Term Revolving Note and excluding the negative termination value of swap contracts) of no less than 1.10:1.0.  As part of the Third Amendment, the Company shall maintain a net worth (total assets less total liabilities and intangible assets) of not less than $41,250,000 measured annually which shall increase each fiscal year by an amount equal to the greater of $250,000 or the amount of undistributed earnings accumulated during the fiscal year just ended (less any allowable distributions attributable to the just ended fiscal year’s earnings).  The Company shall maintain a maximum leverage ratio (tangible book equity to total liabilities) of no greater than 1.65.

 

The financial covenant conditions approved as part of the Third Amendment are as follows:

 

Covenant Type

 

Compliance Dates

 

Covenant Requirements

 

Fixed Charge Coverage

 

Quarterly

 

No less than 1.10:1.00

 

Net Worth

 

Annually

 

$

41,250,000

*

Working Capital

 

Quarterly

 

No less than $6,000,000

#

Maximum Leverage

 

Quarterly

 

No greater than 1.65:1.00

 

 


*The Net Worth covenant requirement will be increased each fiscal year by an amount equal to the greater of $250,000 or the amount of undistributed earnings accumulated during the fiscal year just ended (less any allowable distributions attributable to the just ended fiscal year’s earnings.

#The minimum Working Capital covenant requirement of $6,000,000 will commence on May 1, 2011.  Until that time, the minimum Working Capital covenant requirement is $4,500,000.

 

Additionally, we are limited to annual capital expenditures of $1,000,000 without prior approval of FNBO.  We will also be prohibited from making distributions to our members without the prior approval of FNBO.

 

In connection with the bank financing agreement, we executed a mortgage in favor of FNBO creating a first lien on our real estate and plant and a security interest in all personal property located on the property.  In addition, we assigned in favor of FNBO, all rents and leases to our property, our marketing contracts, our risk management services contract, and our natural gas, electricity, water service and grain procurement agreements.

 

We will continue to work with our lenders to try to ensure that the terms of our loan agreements are met going forward.  However, we cannot provide any assurance that our actions will result in sustained profitable operations or that we will not be in violation of our loan covenants or in default on our principal payments in the future.  Presently, we are meeting our liquidity needs and complying with our financial covenants and the other terms of our loan agreements as modified. Should unfavorable market conditions result in our violation of the terms or covenants of our loan and we fail to obtain a waiver of any such term or covenant, our primary lender could deem us in default of our loans and require us to immediately repay a significant portion or possibly the entire outstanding balance of our loans.  In the event of a default, our lender could also elect to proceed with a foreclosure action on our plant.

 

Capital Lease

 

On April 24, 2008, we entered into certain financing and credit arrangements with U.S. Bank National Association, as trustee (the “Trustee”) and the City of Lamberton, Minnesota (the “City”) in order to secure the

 

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proceeds from the sale of the solid waste facilities revenue bonds, Series 2008A (the “Bonds”) issued by the City in the aggregate principal amount of $15,180,000 pursuant to a trust indenture between the City and the Trustee (“Trust Indenture”).  The City has undertaken the issuance of the Bonds to finance the acquisition and installation of certain solid waste facilities in connection with our ethanol plant to be located near Lamberton, Minnesota.  Highwater received proceeds of approximately $14,876,000, after financing costs of approximately $304,000.  The remaining proceeds were held as restricted cash or marketable securities based on anticipated use and are split between a project fund of approximately $11,527,000, a capitalized interest fund of approximately $1,831,000, and a debt service reserve fund of approximately $1,518,000.  The Bonds mature on December 1, 2022 and bear interest at a rate of 8.5%.

 

Under this equipment lease agreement with the City, we started making interest payments on November 25, 2008 and monthly thereafter at an implicit interest rate of 8.5%.  The monthly capital lease interest payments correspond to 1/6 the semi-annual interest payments due on the Bonds on the next interest payment date.  Monthly capital lease payments for principal were originally scheduled to begin on November 25, 2009; however, the City amended the agreement in September 2008 which adjusted the start date for principal payments to begin on November 25, 2014.  These payments will equal 1/12 the annual principal payments scheduled to become due on the corresponding bonds on the next principal payment date.

 

The Company has guaranteed that if such assessed lease payments are not sufficient for the required bond payments, the Company will provide such funds as are needed to fund the shortfall.  The lease agreement is secured by substantially all business assets of the Company and is also subject to various financial and non-financial covenants that limit distributions and leverage and require minimum debt service coverage, net worth, and working-capital requirements.

 

Compliance with Environmental Law

 

We are subject to extensive air, water and other environmental regulations and we were required to obtain a number of environmental permits to construct and operate the ethanol plant.  Although we have been successful in obtaining all of the permits currently required, any retroactive change in environmental regulations, either at the federal or state level, could require us to obtain additional or new permits or spend considerable resources in complying with such regulations.  Additionally, any changes that are made to the ethanol plant or its operations must be reviewed to determine if amended permits need to be obtained in order to implement these changes.

 

The National Pollutant Discharge Elimination System/State Disposal System (NPDES/SDS) permit, which regulates the water treatment, water disposal and stormwater systems at the facility, requires renewal every five years.  We will be required to submit a renewal application to the Minnesota Pollution Control Agency (“MPCA”) in 2012.  The Company has retained Mike Valentine & Associates and Barr Engineering to prepare the Company’s permits for renewal in May 2012.  The Company anticipates submitting the renewal requests in 2011.

 

On December 9, 2009, we received a Notice of Violation from the MPCA notifying us of alleged water treatment permit violations discovered by the MPCA staff during an inspection in September 2009.  On December 29, 2009, we received a Notice of Violation from the MPCA notifying us of alleged air emission permit violations discovered by the MPCA staff during an inspection in September 2009.  The Notices of Violation require us to take immediate corrective actions and provides us with an opportunity to respond to the alleged violations.  We have responded to the MPCA’s Notices of Violation and are in the process of rectifying the environmental and permitting concerns of MPCA.  We are currently negotiating with the MPCA regarding the Notices of Violation as management does not believe all of the alleged violations are warranted.  As a result of our negotiations with the MPCA, the Company has installed an equalization tank in order to provide a constant flow into the clarifier.  Management believes that the Company will have enough money from operations to pay for any additional equipment or monetary fines.

 

Trends and Uncertainties Impacting the Ethanol and Distillers Grains Industries and Our Future Revenues

 

Our revenues primarily consist of sales of the ethanol and distillers grains we produce. The ethanol industry needs to continue to expand the market for ethanol and distillers grains in order to maintain current price levels. According to the Renewable Fuels Association (“RFA”), as of March 3, 2011, there were 204 ethanol plants nationwide with the capacity to produce approximately 14.1 billion gallons of ethanol annually. The RFA estimates that plants with an

 

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annual production capacity of approximately 13.5 billion gallons are currently operating and that approximately 4.25% of the nameplate production capacity is not currently operational. Management believes the production capacity of the ethanol industry is greater than ethanol demand which may continue to depress ethanol prices.

 

The ethanol industry is dependent on several economic incentives to produce ethanol, including federal tax incentives and ethanol use mandates.  One significant federal ethanol support is the Renewable Fuels Standard (the “RFS”).  The RFS requires that in each year, a certain amount of renewable fuels be utilized in the United States.  The RFS requirement increases incrementally each year until the United States is required to use 36 billion gallons of renewable fuels by 2022.  The RFS for 2011 is approximately 14 billion gallons, of which corn based ethanol can be used to satisfy approximately 12.6 billion gallons.  Starting in 2009, the RFS required that a portion of the RFS must be met by certain “advanced” biofuels, which are alternative biofuels produced without using corn starch such as cellulosic ethanol and biomass-based biodiesel, with 21 billion gallons of the mandated 36 billion gallons of renewable fuel required to come from advanced biofuels by 2022.  This requirement essentially caps the corn based ethanol volume at 15 billion gallons.  Current ethanol production capacity exceeds the 2011 RFS requirement which can be satisfied by corn based ethanol.

 

In February 2010, the EPA issued new regulations governing the RFS.  These new regulations have been called RFS2.  RFS2 establishes a tiered approach, where regular renewable fuels are required to accomplish a 20% green house gas reduction compared to gasoline, advanced biofuels and biomass-based biodiesel must accomplish a 50% reduction in green house gases, and cellulosic biofuels must accomplish a 60% reduction in green house gases.  Any fuels that fail to meet this standard cannot be used by fuel blenders to satisfy their obligations under the RFS program.  RFS2 as adopted by the EPA provides that corn-based ethanol from modern ethanol production processes does meet the definition of renewable fuel under the RFS program.  Many in the ethanol industry are concerned that certain provisions of RFS2 as adopted may disproportionately benefit ethanol produced from sugarcane.  This could make sugarcane based ethanol, which is primarily produced in Brazil, more competitive in the United States ethanol market.  If this were to occur, it could reduce demand for the ethanol that we produce.

 

Many in the ethanol industry believe that it will be difficult to meet the RFS requirement in coming years without allowing higher percentage blends of ethanol to be used in conventional automobiles.  Currently, ethanol is blended with conventional gasoline for use in standard vehicles to create a blend which is 10% ethanol and 90% gasoline.  Estimates indicate that approximately 135 billion gallons of gasoline are sold in the United States each year.  Assuming that all gasoline in the United States is blended at a rate of 10% ethanol and 90% gasoline, the maximum demand for ethanol is 13.5 billion gallons per year.  This is commonly referred to as the “blending wall,” which represents a theoretical limit where more ethanol cannot be blended into the national gasoline pool.  Many in the ethanol industry believe that we will reach this blending wall in 2011, since the RFS requirement for 2011 is 14 billion gallons, much of which will come from ethanol.  The RFS mandate requires that 36 billion gallons of renewable fuels be used each year by 2022 which equates to approximately 27% renewable fuels used per gallon of gasoline sold.  In order to meet the RFS mandate and expand demand for ethanol, management believes higher percentage blends of ethanol must be utilized in conventional automobiles.

 

Such higher percentage blends of ethanol have continued to be a contentious issue.  Recently, the EPA 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 as well as for cars and light duty trucks manufactured in the model years between 2001 and 2006.  The EPA is considering instituting labeling requirements associated with E15 which may unfairly discourage consumers from purchasing E15.  Additionally, according to EPA estimates, flex-fuel vehicles make up only 7.3 million of the 240 million vehicles on the nation’s roads and there are only about 2,000 E85 pumps in the United States.  As a result, the approval of E15 may not significantly increase demand for ethanol.  Two lawsuits were filed on November 9, 2010, by representatives of the food industry and the petroleum industry challenging the EPA’s approval of E15 for use in vehicles 2007 and newer.  Representatives of the food industry and the petroleum industry filed lawsuits on March 11, 2011, challenging the EPA’s approval of E15 for use in vehicle models 2001 through 2006.  It is unclear what effect these lawsuits will have on the implementation of E15 in the United States retail gasoline market.  Additionally, members of both the United States House of Representatives and the United States Senate proposed legislation in February 2011 to prevent the EPA from implementing E15.  While the initial legislation proposed as amendments to the Full Year Continuing Appropriations Act 2011 did not survive, recently proposed legislation has been approved by the House Energy and Power Subcommittee.  It is unclear whether any legislation introduced will be enacted into law, however, if such legislation is enacted it likely would have a

 

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negative impact on the price of ethanol and demand for ethanol in the market.

 

In addition to the RFS, the ethanol industry depends on the Volumetric Ethanol Excise Tax Credit (“VEETC”).  VEETC provides a volumetric tax credit of 4.5 cents per gallon of gasoline that contains at least 10% ethanol.  VEETC was recently renewed until December 31, 2011.  However, in March 2011, a bill was introduced into the United States Senate that would repeal VEETC.  If this tax credit is repealed or if it is not renewed beyond December 31, 2011, it likely would have a negative impact on the price of ethanol and demand for ethanol in the market due to reduced discretionary blending of ethanol.  However, due to the RFS, we anticipate that demand for ethanol will continue to mirror the RFS requirement, even if the VEETC is repealed or if it is not renewed past 2011.  If the RFS is reduced or eliminated, the decrease in demand for ethanol related to the elimination of VEETC may be more substantial.

 

The USDA recently announced that it will provide financial assistance to help implement more “blender pumps” in the United States in order to increase demand for ethanol and to help offset the cost of introducing mid-level ethanol blends into the United States retail gasoline market.  Blender pumps typically can dispense E10, E20, E30, E40, E 50 and E85.  These blender pumps accomplish these different ethanol/gasoline blends by internally mixing ethanol and gasoline which are held in separate tanks at the retail gas stations.  Many in the ethanol industry believe that increased use of blender pumps will increase demand for ethanol by allowing gasoline retailers to provide various mid-level ethanol blends in a cost effective manner and allowing consumers with flex-fuel vehicles to purchase more ethanol through these mid-level blends.  However, blender pumps cost approximately $25,000 each, so it may take time before they become widely available in the retail gasoline market.

 

Effect of Governmental Regulation

 

The ethanol industry and our business depend upon the continuation of federal ethanol supports discussed above.  These incentives have supported a market for ethanol that might disappear without the incentives.  Alternatively, the incentives may be continued at lower levels.  The elimination or reduction of such federal ethanol supports would likely reduce our net income and negatively impact our future financial performance.

 

The government’s regulation of the environment changes constantly.  It is possible that more stringent federal or state environmental rules or regulations could be adopted, which could increase our operating costs and expenses.  It also is possible that federal or state environmental rules or regulations could be adopted that could have an adverse effect on the use of ethanol.  Furthermore, plant operations are governed by the Occupational Safety and Health Administration (“OSHA”).  OSHA regulations may change such that the costs of operating the plant may increase.  Any of these regulatory factors may result in higher costs or other adverse conditions effecting our operations, cash flows and financial performance.

 

In late 2009, California passed a Low Carbon Fuel Standard (“LCFS”).  The California LCFS requires that renewable fuels in California must accomplish certain reductions in green house gases, which is measured using a lifecycle analysis, similar to RFS2.  Management believes that this lifecycle analysis is based on unsound scientific principles that unfairly harms corn based ethanol.  Management believes that these new regulations will preclude corn based ethanol from being used in California.  California represents a significant ethanol demand market.  If we are unable to supply ethanol to California, it could significantly reduce demand for the ethanol we produce.  Currently, several lawsuits have been filed challenging the California LCFS.

 

United States ethanol production is currently benefited by a 54 cent per gallon tariff imposed on ethanol imported into the United States.  The 54 cent per gallon tariff was recently extended until December 31, 2011.  If this tariff is eliminated, it could lead to the importation of ethanol produced in other countries, especially in areas of the United States that are easily accessible by international shipping ports.  Ethanol imported from other countries may be a less expensive alternative to domestically produced ethanol and may affect our ability to sell our ethanol profitably.

 

Contracting Activity

 

We entered into a new member ethanol marketing agreement with RPMG in order to receive more favorable marketing fees offered by RPMG to its owners as well as to share in profits generated by RPMG.  This new

 

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agreement was effective as of February 1, 2011.

 

We also entered into a Contribution Agreement and a Member Control Agreement with RPMG whereby we made a capital contribution and became a minority owner of RPMG which became effective as of February 1, 2011.

 

Critical Accounting Estimates

 

Management uses various estimates and assumptions in preparing our financial statements in accordance with generally accepted accounting principles.  These estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Accounting estimates that are the most important to the presentation of our results of operations and financial condition, and which require the greatest use of judgment by management, are designated as our critical accounting estimates. We have the following critical accounting estimates:

 

Long-Lived Assets

 

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.  Given the significant assumptions required and the possibility that actual conditions will differ, we consider the assessment of carrying value of property and equipment to be a critical accounting estimate.

 

Inventory Valuation

 

We value our inventory at lower of cost or market.  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.  Given the significant assumptions required and the possibility that actual conditions will differ, we consider the valuation of the lower of cost or market on inventory to be a critical accounting estimate.

 

Derivatives

 

We are exposed to market risks from changes in interest rates, corn, natural gas, and ethanol prices. We may seek to minimize these commodity price fluctuation risks through the use of derivative instruments. In the event we utilize derivative instruments, we will attempt to link these instruments to financing plans, sales plans, market developments, and pricing activities, such instruments in and of themselves can result in additional costs due to unexpected directional price movements. Should we use derivative instruments in the future, we may incur such costs and they may be significant.

 

In April 2008, we entered into an interest fixed rate swap agreement, which is a derivative instrument, in order to manage our exposure to the impact of changing interest rates.  The initial notional amount of the swap was $23,305,000.  The interest rate swap fixes the interest rate on the notional amount at 7.6% until June 2014, even though variable interest rates may be less than this rate.  The changes in the fair value of the interest rate swap are recorded currently in operations.  As of January 31, 2011, we had a notional amount of approximately $22,366,000 outstanding in the swap agreement.

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet arrangements.

 

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Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

We are a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934 and are not required to provide information under this item.

 

Item 4.  Controls and Procedures.

 

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit pursuant to the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosures.

 

Our management, including our Chief Executive Officer (the principal executive officer), Brian Kletscher, along with our Chief Financial Officer (the principal financial officer), Mark Peterson, have reviewed and evaluated the effectiveness of our disclosure controls and procedures as of January 31, 2011. Based upon this review and evaluation, these officers have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the forms and rules of the Securities and Exchange Commission; and to ensure that the information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to our management including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

 

Changes in Internal Control over Financial Reporting

 

Our management, including our principal executive officer and principal financial officer, have reviewed and evaluated any changes in our internal control over financial reporting that occurred during the quarter ended January 31, 2011 and there has been no change that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.

 

PART II — OTHER INFORMATION

 

Item 1.  Legal Proceedings.

 

On December 9, 2009, we received a Notice of Violation from the MPCA notifying us of alleged water treatment permit violations discovered by the MPCA staff during an inspection in September 2009.  On December 29, 2009, we received a Notice of Violation from the MPCA notifying us of alleged air emission permit violations discovered by the MPCA staff during an inspection in September 2009.  The Notices of Violation require us to take immediate corrective actions and provides us with an opportunity to respond to the alleged violations.  We have responded to the MPCA’s Notices of Violation and are in the process of rectifying the environmental and permitting concerns of MPCA.

 

We are currently negotiating a stipulation agreement, including possible monetary sanctions with the MPCA regarding the Notices of Violation as management does not believe all of the alleged violations are warranted.

 

Item 1A.  Risk Factors.

 

The following risk factors are provided due to material changes from the risk factors previously disclosed in our annual report on Form 10-K. The risk factors set forth below should be read in conjunction with the risk factors section and the Management’s Discussion and Analysis section for the fiscal year ended October 31, 2010, included in our annual report on Form 10-K.

 

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If the Small Ethanol Producer Tax Credit (“SEPTC”) expires on December 31, 2011, it could negatively impact our profitability. The Small Ethanol Producer Tax Credit (“SEPTC”) is a tax incentive allowing small ethanol producers a 10 cent per gallon federal income tax credit on up to 15 million gallons of production. Our investor directly benefit from the SEPTC.  If the SEPTC is allowed to expire on December 31, 2011, along with the VEETC, it would negatively impact our investors.

 

Competition from the advancement of alternative fuels may lessen the demand for ethanol.  Alternative fuels, gasoline oxygenates and ethanol production methods are continually under development.  A number of automotive, industrial and power generation manufacturers are developing alternative clean power systems using fuel cells, plug-in hybrids, electric cars or clean burning gaseous fuels.  Like ethanol, these emerging technologies offer an option to address worldwide energy costs, the long-term availability of petroleum reserves and environmental concerns.  Fuel cells have emerged as a potential alternative 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.  If these alternative technologies continue to expand and gain broad acceptance and become readily available to consumers for motor vehicle use, we may not be able to compete effectively.  This additional competition could reduce the demand for ethanol, resulting in lower ethanol process that might adversely affect our results of operations and financial condition.

 

We may incur casualty losses that are not covered by our insurance which could negatively impact the value of our units.  We have purchased insurance which we believe adequately covers our losses from foreseeable risks.  However, there are risks that we may encounter for which there is no insurance or for which insurance is not available on terms that are acceptable to us.  If we experience a loss which materially impairs our ability to operate the ethanol plant which is not covered by insurance, the value of our units could be reduced or eliminated.

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

 

None.

 

Item 3.  Defaults Upon Senior Securities.

 

None.

 

Item 4.  (Removed and Reserved)

 

Item 5.  Other Information.

 

None.

 

Item 6.  Exhibits.  The following exhibits are included herein:

 

Exhibit No.

 

Description

3.2

 

Second Amended and Restated Member Control Agreement of the registrant.

*

 

 

 

 

10.1

 

Fourth Amendment of Construction Loan Agreement between First National Bank of Omaha and Highwater Ethanol, LLC dated February 26, 2011.

*

 

 

 

 

10.2

 

Third Amended and Restated Revolving Promissory Note with Deere Credit, Inc. dated February 26, 2011.

*

 

 

 

 

10.3

 

Third Amended and Restated Revolving Promissory Note with First National Bank of Omaha dated February 26, 2011.

*

 

 

 

 

10.4

 

Third Amended and Restated Revolving Promissory Note with First Bank & Trust dated February 26, 2011.

*

 

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31.1

 

Certificate Pursuant to 17 CFR 240.15d-14(a).

*

 

 

 

 

31.2

 

Certificate Pursuant to 17 CFR 240.15d-14(a).

*

 

 

 

 

32.1

 

Certificate Pursuant to 18 U.S.C. § 1350.

*

 

 

 

 

32.2

 

Certificate Pursuant to 18 U.S.C. § 1350.

*

 


(*)               Filed herewith

 

SIGNATURES

 

Pursuant to the requirements 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.

 

 

HIGHWATER ETHANOL, LLC

 

 

Date:

March 22, 2011

 

/s/ Brian Kletscher

 

Brian Kletscher

 

Chief Executive Officer

 

(Principal Executive Officer)

 

 

 

 

 Date:

March 22, 2011

 

/s/ Mark Peterson

 

Mark Peterson

 

Chief Financial Officer

 

(Principal Financial and Accounting Officer)

 

30