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

 

We prepared the following discussion and analysis to help readers better understand our financial condition, changes in our financial condition, and results of operations for the three and nine month periods ended July 31, 2014 , compared to the same periods of the prior fiscal year. This section should be read in conjunction with the condensed consolidated unaudited financial statements and related notes in Item 1 of this report and the Company’s Annual Report on Form 10-K for the fiscal year ended October 31, 2013 .

Disclosure Regarding Forward-Looking Statements

This report contains historical information, as well as forward-looking statements regarding our business, financial condition, results of operations, performance and prospects. All statements that are not historical or current facts are forward-looking statements. You can identify forward-looking statements by terms such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would,” and similar expressions intended to identify forward-looking statements. Forward-looking statements are subject to a number of known and unknown risks, uncertainties and other factors, many of which may be beyond our control, and may cause actual results, performance or achievements to differ materially from those projected in, expressed or implied by forward-looking statements. Certain of these risks and uncertainties are described in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended October 31, 2013 and in this Form 10-Q. We do not undertake any duty to update forward-looking statements after the date they are made or to conform forward-looking statements to actual results or to changes in circumstances or expectations. Furthermore, we cannot guarantee future results, events, 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.heronlakebioenergy.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, are available, free of charge, on our website under the link “SEC Filings,” as soon as reasonably practicable after we 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

 

Heron Lake BioEnergy, LLC is a Minnesota limited liability company that owns and operates a dry mill corn-based, natural gas fired ethanol plant near Heron Lake, Minnesota. References to "we," "us," "our", "Heron Lake BioEnergy", "HLBE", and the "Company" refer to Heron Lake BioEnergy, LLC.

Our ethanol plant has a nameplate capacity of 50 million gallons per year and a permitted capacity of approximately 59.2 million gallons per year. We are currently operating above our stated nameplate capacity and intend to continue to take advantage of the additional production allowed pursuant to our permit as long as we believe it is profitable to do so.

On July 1, 2014, the Company redeemed all of the outstanding 7.25% Subordinated Secured Notes due 2018 (the "Notes"), approximately $4,140,000 aggregate principal amount, by issuing 13,120,000 Class A units of the Company to the holders of approximately $3,936,000 principal amount of the Notes that elected conversion of the principal to units and paid cash to redeem the remaining $207,000 principal amount of the Notes. On the same day, the Company paid accrued and unpaid interest through July 1, 2014 to all note holders, including those electing conversion, per the terms of the Notes and the Indenture. The Company paid the cash redemption and accrued and unpaid interest from its cash on-hand. Details of redemption of the Notes is provided below in the section below entitled " PART I - Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations  - Liquidity and Capital Resources; Indebtedness ".

On July 29, 2014, the Company entered into an intercompany loan agreement and related loan documents (the “Loan Agreement”) with Agrinatural Gas, LLC (“Agrinatural”).  Agrinatural is a pipeline company formed to construct, own, and operate a natural gas pipeline that provides natural gas to the Company’s ethanol plant through a connection with the natural gas pipeline facilities of Northern Border Pipeline Company in Cottonwood County, Minnesota. The Company owns 73% of Agrinatural through the Company’s wholly-owned subsidiary HLBE Pipeline Company, LLC. The remaining

27% is owned by Rural Energy Solutions, LLC. Under the Loan Agreement, the Company agreed to make a five-year term loan in the principal amount of $3.05 million to Agrinatural (the "Agrinatural Loan") for use by Agrinatural to repay its outstanding debt and provide working capital to Agrinatural. Details of Loan Agreement with Agrinatural and the Agrinatural Loan are provided below in the section below entitled " PART I - Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations  - Liquidity and Capital Resources; Indebtedness ".

On July 29, 2014, the Company entered into a new master loan agreement and related loan documents (the "Credit Facility") the with AgStar Financial Services, FCLA ("AgStar").  The Credit Facility provides the Company with a new comprehensive revolving term loan commitment in the amount of $28 million (the "Term Revolving Loan"). Following the loan closing, we had approximately $7.5 million outstanding on the Term Revolving Loan under the Credit Facility which was primarily used to pay off our outstanding debt to AgStar under our prior master loan agreement and fund the Agrinatural Loan. The changes to our credit facilities and the loan to Agrinatural are described in more detail below in the section entitled " PART I - Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations  - Liquidity and Capital Resources; Indebtedness ".

In July 2013, Granite Falls Energy, LLC ("Granite Falls" or "GFE") acquired a controlling interest in the Company from Project Viking, L.L.C. ("Project Viking"). GFE, now a related party, owns an ethanol plant located in Granite Falls, Minnesota. As of September 15, 2014 , GFE owns approximately 50.6% of our outstanding membership units, a decrease from its prior ownership percentage of 60.8% due to our issuance of units as part of the redemption of the Notes. Notwithstanding this dilution, GFE retained its right to appoint five (5) of the nine (9) governors to our board of governors under our member control agreement as it continues to own a majority of the Company.    

In July 2013, the Company also entered into a Management Services Agreement with GFE.  Under the Management Services Agreement, GFE agreed to supply its own personnel to act as our Chief Executive Officer, Chief Financial Officer, and Commodity Risk Manager.  The initial term of the Management Services Agreement expires in July 2016, but automatically renews for successive one-year terms unless either party gives the other party written notice of termination prior to expiration of the then current term.

Our revenues are derived from the sale and distribution of our ethanol throughout the continental United States and in the sale and distribution of our distillers’ grains (DGS) locally, and throughout the continental United States. We have contracted with Eco-Energy, LLC to market all of our ethanol, Gavilon Ingredients, LLC to market our distillers grains and Renewable Products Marketing Group, LLC to market our corn oil.

The primary raw material used in the production of ethanol at our plant is corn.  We generally do not have long-term, fixed price contracts for the purchase of corn. Rather, we typically purchase our corn directly from grain elevators, farmers, and local dealers within approximately 80 miles of Heron Lake, Minnesota.

 

The primary source of energy in our manufacturing process is natural gas. We have a facilities agreement with Northern Border Pipeline Company which allows us access to an existing interstate natural gas pipeline located approximately 16 miles north from our plant. We have a transportation agreement with Agrinatural, a pipeline company formed to construct, own, and operate the natural gas pipeline that provides natural gas to our ethanol plant. Our wholly-owned subsidiary, HLBE Pipeline Company, LLC, owns 73% of Agrinatural Gas.

    

We expect to have sufficient cash generated by continuing operations and current lines of credit to fund our operations. However, should we experience unfavorable operating conditions in the ethanol industry that prevent us from profitably operating the ethanol plant, we may need to seek additional funding.

Trends and Uncertainties Impacting Our Operations

      

Our current results of operation are affected and will continue to be affected by factors such as (a) volatile and uncertain pricing of ethanol and corn; (b) availability of corn that is, in turn, affected by trends such as corn acreage, weather conditions, and yields on existing and new acreage diverted from other crops; and (c) the supply and demand for ethanol, which is affected by acceptance of ethanol as a substitute for fuel, public perception of the ethanol industry, government incentives and regulation, and competition from new and existing construction, among other things.

The demand for ethanol is affected by what is commonly referred to as the “blending wall” which is the threshold at which the Renewable Fuel Standard (RFS) volume requirement exceeds the demand for E10 (10% ethanol and 90%gasoline) gasoline. E10 is the most common ethanol blend sold and the only blend the EPA has approved for use in all American automobiles. There is growing availability of E85 (85% ethanol and 15% gasoline) for use in flexible fuel vehicles. In addition, the industry has been working to introduce E15 to the retail market since the EPA issued final approval in 2012 for the sale and use of E15 ethanol blends in light duty passenger vehicles model year 2001 and newer. Since that time, our application with the EPA to register ethanol for use in making E15 has also been approved, as well as 81 other fuel manufacturers according to EPA data. However, wide spread adoption of E15 is hampered by regulatory and infrastructure hurdles in many states, as well as consumer acceptance. To date only thirteen states have approved the commercial sale of E15. As such, we do not anticipate that E15 will impact ethanol demand or pricing in the near term. Rather, management believes consumer acceptance of E15 and flex fuel vehicles, along with continued growth of E85, is necessary before ethanol can achieve any market growth beyond the blend wall. As industry production capacity reaches the blend wall, the supply of ethanol in the market may surpass the demand which in turn may negatively impact prices.

The RFS requires a certain amount of renewable fuels be used each year in the United States, however, the EPA can adjust the renewable volume obligation (RVO) in certain circumstances through its rulemaking authority. In November 2013, the EPA issued a proposed rule that would reduce the 2014 RVO to 13.0 billion gallons of corn-based renewable fuel. As proposed, the 2014 RVO would be 1.4 billion gallon below the statutory RVO for 2014 and 800 million gallons less than the 2013 RVO, marking the first time the corn-based renewable fuel and total renewable fuel RVOs have been set below the legislated target. The proposal was subject to a 60-day comment period which ended in January 2014 during which the EPA received over 340,000 public comments and drew strong opposition from biofuels groups. On August 22, 2014, the final 2014 RVO rule was sent by the EPA to the Office of Management and Budget (OMB) for review. As of this filing, the proposed final rule is not publicly available, however, EPA administrator Gina McCarthy has previously stated that the final 2014 RVO would include changes from the November proposal but neither she nor the EPA has elaborated on the degree of changes. The final rule is expected to be released sometime this fall, however, OMB has up to 90 days, or more if an extension is granted, to complete its interagency review. Until the final rule is published, management expects continued uncertainty for ethanol demand for 2014. Moreover, further delay in the release of the final rule also creates uncertainty in ethanol demand in 2015 as the delay in the 2014 rule will likely cause delay in the final 2015 rule, which is due by November 30, 2014. If the final rule includes a significant decrease in the 2014 RVO similar to the EPA's November proposed rule, demand for ethanol in 2015 and beyond could be reduced due to blenders' carryover of renewable fuel credits in excess of the RVO into future years.

High demand on the rail industry due to high volumes of corn, oil and coal rail shipments and a harsh winter that saw record cold and snow has resulted in significant industry-wide delays and logistical problems. These delays have caused many ethanol plants to slow or suspend production due to inability to secure railcars to transport their ethanol to market. Our plant has not experienced any material delays from the rail congestion problems. Recently, rail congestion and delays have lessened, however, industry concerns remain that the existing backlog will be resolved before anticipated record corn and soybean harvest place additional stress on the rail transportation network. Management believes that slower rail shipping may continue through late spring 2015 and may continue to impact ethanol producers unless rail shipping capacity increases to meet the increased demand. If rail delays and congestion continue, we may begin to see material impacts to our plant if we run out of ethanol storage capacity and we are forced to reduce or cease production.

Other factors that may affect our future results of operation include those factors below in our Results of Operations of this Form 10-Q and those discussed in “Item 1. Business” and “Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended October 31, 2013, and in other filings we make with the Securities and Exchange Commission.

 

 

Revenues

 

Approximately 99% of our revenues from operations come from three sources: sales of fuel ethanol, sales of distillers grains and sales of corn oil. The remaining miscellaneous other revenues are made up of incidental sales of syrup, a by-product of the ethanol production process, and revenues from Agrinatural. Revenues decreased by 14.3% for the three months ended July 31, 2014 as compared to the three months ended July 31, 2013 due primarily to decreases in the average prices received for our ethanol and distillers grains.  Our results of operations will continue to be affected by volatility in the commodity markets. In the event that we experience a prolonged period of negative operating margins, our liquidity may be negatively impacted.

The following table shows the sources of our revenue for the three months ended July 31, 2014 :

The following table shows the sources of our revenue for the three months ended July 31, 2013 :

 

Ethanol

Net ethanol revenues were approximately $31.1 million  during the three months ended July 31, 2014 compared to approximately $36.4 million during the three months ended July 31, 2013 .  The average price we received for our ethanol decreased by approximately 14.4% for the quarter ended July 31, 2014 as compared to the quarter ended July 31, 2013 . However, the decrease in the price per gallon we received was slightly mitigated by an increase of approximately 0.3% more gallons of ethanol sold during the three months ended July 31, 2014 as compared to the three months ended July 31, 2013 .  There were no ethanol derivative gains or losses during the three months ended July 31, 2014 and 2013 .

Management attributes the drop in ethanol prices to continuing lower corn prices, which impacts the market price of ethanol. Management anticipates that ethanol prices will continue to change in relation to changes in corn and energy prices. However, ethanol prices have been somewhat buoyed by continuing rail delays and a stronger export market which has resulted in tighter ethanol inventories. Rail congestion and delays continue due to increased demand and rail infrastructure limitations. Management anticipates that current backlogs will continue through spring next year or longer if the rail system experiences further stress due to the anticipated record grain harvest this fall. Management anticipates that ethanol prices will continue to face downward pressures through the remainder of 2014 due to the anticipated record grain harvest and anticipated lower corn prices. Despite these downward pressures, ethanol margins have remained favorable as the decline in corn prices has outpaced the decline in ethanol prices. Management anticipates that the favorable price spread between ethanol and corn will continue until the supply and demand balance for ethanol returns to more traditional levels.

Distillers Grains

 

Total sales of distillers grains during the three months ended July 31, 2014 were approximately $6.9 million compared to sales of $7.8 million during the three months ended July 31, 2013 . The average distillers grains price decreased 27.4% for the quarter ended July 31, 2014 as compared to the quarter ended July 31, 2013 , which was partially mitigated by an increase of approximately 21.6% in distillers grains sold during the three months ended July 31, 2014 as compared to the three months ended July 31, 2013 .

 

Management believes these lower distillers grains prices are primarily a result of the decline in the price of corn, as market prices for distillers grains tend to move directionally with the prices of other livestock feed products. We anticipate that the market price of our dried distillers grains will continue to trend lower tracking changes in the price of corn. In addition, if plants that have suspended or reduced production due to rail shipping bottlenecks are able to resume or increase production, distillers grains prices may be negatively impacted.

Further recent changes in export demand for distillers grains by China have negatively impacted distillers grains prices. In June 2014, China stopped issuing permits for the import of distillers dried grains from the US due to the presence of a unapproved GMO corn trait in some distillers grains shipments. The GMO trait has been approved in the US and a number of other countries but not in China. At present, there is no reliable method to test for this trait in distillers grains and no mechanism in the US to meet other certification requirements imposed by China for imports of distillers grains that may contain the unapproved GMO trait. The ethanol industry and US government are examining China's actions to determine appropriate responses as many in the industry and trade community believe these actions are due more to protecting China's own farmers than concerns regarding this GMO trait. Management cannot estimate the effect China's actions will have on the overall distillers grains market long term. This could reduce distillers grains prices in the domestic market by decreasing worldwide demand for distillers grains.

Corn Oil

Corn oil sales for the three months ended July 31, 2014 were down approximately 16.9% compared to corn oil sales for the same period in 2013 . Management attributes this decline to decreased corn oil prices which is due primarily to lower corn prices and excess supplies of corn oil relative to demand. Management expects continued lower corn oil prices due to oversupply. Management believes the oversupply in the corn oil market stems, in part, from the diminished demand for corn oil from the biodiesel industry and the resumed production by ethanol plants that had suspended or reduced operations due to rail congestion. The biodiesel industry has been signficantly impacted by the expiration of the biodiesel blenders' tax credit and uncertainty regarding the biodiesel RVOs for 2014 under the RFS, which has resulting in declining demand for biodiesel. Corn oil prices could experience further decreases due to oversupply unless additional demand can be created.

Cost of Goods Sold

 

Our costs of sales include, among other things, the cost of corn and natural gas (which are the two largest components of costs of sales), as well as processing ingredients, electricity, and wages, salaries and benefits of production personnel. Our costs of sales as a percentage of revenues were 78.8% and 91.1% for the three months ended July 31, 2014 and the three months ended July 31, 2013 , respectively. Our gross margin for the three months ended July 31, 2014 increased to 21.2% from 8.9% for the three months ended July 31, 2013 .

    

Corn

The volume of corn we processed was up 6.0% for the three months ended July 31, 2014 as compared to the same period of fiscal year 2013 due to reduced production in 2013 when margins were poor. Although corn prices trended upwards during the three months ended July 31, 2014 , overall we experienced a decrease in corn prices of approximately 30.3% the same period of 2013 . This decrease in corn price is largely attributable to the record 2013 corn harvest and sufficient local supplies. Management expects that corn prices will stay lower through the remainder of our fiscal year due to 2014 corn crop projections and that there will be adequate local supply for our plant operations. The USDA's Crop Production report published on August 12, 2014 increased the USDA's prior projections for US corn production to 14.0 billion bushels for the 2014 growing season, with 1.3 billion bushels of corn production forecasted for Minnesota. If realized, this would be the highest corn production on record for the US. Management expects there to be an adequate corn supply available in our area to operate the ethanol plant and that prices during our 2014 fiscal year may be lower due to plentiful supply. However, corn prices may be volatile in the future depending on weather, world supply and demand, current and anticipated stocks, and other factors.

We had losses related to corn derivative instruments of $125,461 for the three months ended July 31, 2014 , which increased cost of sales, compared to no gains or losses related to corn derivative instruments for the same period of 2013 . We recognize the gains or losses that result from the changes in the value of our derivative instruments from corn in cost of goods sold as the changes occur.  As corn prices fluctuate, the value of our derivative instruments are impacted, which affects our financial performance. We anticipate continued volatility in our 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. 

Natural Gas

For the three months ended July 31, 2014 , we experienced an increase of approximately 23.3% in our overall natural gas costs compared to the same period of 2013 due to higher prices. Management anticipates that natural gas prices will continue to hold steady. However, if the natural gas industry experiences production problems, supply disruptions from hurricane activity, or if there are large increases in natural gas demand that limits the amount of gas that can be injected into storage ahead of winter demand, we may experience significant increases in natural gas prices.

Selling, General, and Administrative Expenses

 

Selling, general and administrative expenses include wages, salaries and benefits of administrative employees at the plant, insurance, professional fees and similar costs. Selling, general and administrative expenses for the three months ended July 31, 2014 increased 15.3% compared to the three months ended July 31, 2013 .  Despite the significant increase from period to period, as a percentage of total revenues selling, general and administrative expenses only increased slightly to 2.0% for the three months ended July 31, 2014 , as compared to 1.5% for three months ended July 31, 2013 .  Although we are focused on increasing operating efficiencies, these expenses generally do not vary with the level of production at the plant.

 

Operating Income (Loss)

Our income from operations for the three months ended July 31, 2014 was approximately $7.5 million compared to a income of $3.4 million for the same period 2013 . This increase resulted from increased production and the improvement of our net margin between the price we received for ethanol and the cost of corn and natural gas used in manufacturing.

Other Expense, Net

 

Other expense, net consists primarily of interest expense. Interest expense consists primarily of interest payments on our credit facilities described below. Interest expense, which was down 13.1% for the three months ended July 31, 2014 , as compared to the three months ended July 31, 2013 , is

dependent on the balances outstanding and on interest rates, including an additional 2% default interest rate we accrued on our AgStar loans during the three months ended July 31, 2013 . This default rate was not in effect during the three months ended July 31, 2014 . Interest expense for the three months ended July 31, 2014 , includes a write off of deferred financing costs of approximately $329,000 for the subordinated convertible debt and refinancing our senior debt facilities.

The following table shows the sources of our revenue for the  nine months ended July 31, 2013 :

Revenues decreased slightly, down by 4.8% for the nine months ended July 31, 2014 as compared to the nine months ended July 31, 2013 .  However, our gross margin improved dramatically comparing the nine months ended July 31, 2014 to the same period in 2013 due to increases in the volume of ethanol sold and significant decreases in the average price per bushel of corn processed.

 

Net ethanol revenues during the nine months ended July 31, 2014 were approximately 1.9% less than net ethanol revenues for the nine months ended July 31, 2013 . Additionally, the average price we received for our ethanol for nine months ended July 31, 2014 decreased by approximately 11.9% from the average price received for nine months ended July 31, 2013 and volume of ethanol sold increased by 11.3% from period to period.  There were no ethanol derivative gains or losses during the nine months ended July 31, 2014 and 2013 .

 

Total sales of distillers grains during the nine months ended July 31, 2014 were down approximately 15.2% from total distillers grains sales during the nine months ended July 31, 2013 . In addition, the average price for our distillers grains for the nine months ended July 31, 2014 decreased 25.2% compared to the same period of 2013 . The decrease in the average price was partially offset by an increase of 13.4% in the total volume of distillers grains sold during the nine months ended July 31, 2014 compared to the same period of 2013 .

Total sales of corn oil during the nine months ended July 31, 2014 were down approximately 14.2% from total corn oil sales during the nine months ended July 31, 2013 . This decrease was primarily due to a decrease in the average price for our corn oil for the nine months ended July 31, 2014 compared to the same period of 2013 .

Cost of Goods Sold

 

Our costs of sales include, among other things, the cost of corn used in ethanol and distillers grains production (which is the largest component of costs of sales); natural gas, processing ingredients and electricity. Over the last nine months, on average we have used approximately 1.8 million bushels of corn per month at the plant.

 

The per bushel cost of corn decreased approximately 30.5% in nine months ended July 31, 2014 as compared to the nine months ended July 31, 2013 .  We had a gain related to corn derivative instruments of $206,744 for the nine months ended July 31, 2014 . There were no corn derivative gains or losses during the nine months ended July 31, 2013 .

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expense for the nine months ended July 31, 2014 decreased approximately 3.0% compared to our selling, general and administrative expenses for the nine months ended July 31, 2013 due primarily to fees related to the planned plant asset sale, and the sale of the Lakefield Farmers Elevator.  These expenses represented 2.1% and 2.0% of total revenues for the nine months ended July 31, 2014 and 2013 , respectively.   

 

Other Expense, Net

 

Other expense, net consists primarily of interest expense. Interest expense consists primarily of interest payments on our credit facilities described below. Interest expense, which was down 35.4% for the nine months ended July 31, 2014 , as compared to the nine months ended July 31, 2013 , is dependent on the balances outstanding and on interest rates, including an additional 2% default interest rate we paid on our AgStar loans during the nine months ended July 31, 2013 . Interest expense for the nine months ended July 31, 2014 , includes a write off of deferred financing costs of approximately $329,000 for the subordinated convertible debt and refinancing our senior debt facilities.