NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, unless otherwise noted)

Note 1.  Accounting Policies and Basis of Presentation.

The Company. MGP Ingredients, Inc. ("Company") is a Kansas corporation headquartered in Atchison, Kansas.  It was incorporated in 2011 and is a holding company with no operations of its own.  Its principal directly-owned operating subsidiaries are MGPI Processing, Inc. ("Processing") and MGPI of Indiana, LLC ("MGPI-I").  Processing was incorporated in Kansas in 1957 and is the successor to a business founded in 1941 by Cloud L. Cray, Sr. On January 3, 2012 , MGP Ingredients, Inc. reorganized into a holding company structure (the "Reorganization") through a series of steps involving various legal entities. Prior to the Reorganization, Processing was named MGP Ingredients, Inc.

Basis of Presentation and Principles of Consolidation. The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. These unaudited condensed consolidated financial statements as of and for the quarter ended September 30, 2017 should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 filed with the Securities and Exchange Commission ("SEC").  The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of normal and recurring adjustments) necessary to fairly present the results for interim periods in accordance with U.S. generally accepted accounting principles (“GAAP”).  Pursuant to the rules and regulations of the SEC, certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted.

Use of Estimates.   The financial reporting policies of the Company conform to GAAP.  The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period.  The application of certain of these policies places significant demands on management’s judgment, with financial reporting results relying on estimation about the effects of matters that are inherently uncertain.  For all of these policies, management cautions that future events rarely develop as forecast, and estimates routinely require adjustment and may require material adjustment.

Inventory.   Inventory includes finished goods, raw materials in the form of agricultural commodities used in the production process and certain maintenance and repair items.  Bourbon and whiskeys are normally aged in barrels for several years, following industry practice; all barreled bourbon and whiskey is classified as a current asset. The Company includes warehousing, insurance, and other carrying charges applicable to barreled whiskey in inventory costs.

Inventories are stated at lower of cost or net realizable value on the first-in, first-out, or FIFO, method.  Inventory valuations are impacted by constantly changing prices paid for key materials, primarily corn. Inventory consists of the following:

Equity Method Investments.   The Company accounted for its investments in non-consolidated subsidiaries under the equity method of accounting when the Company had significant influence, but did not have more than 50 percent voting control, and was not considered the primary beneficiary.  Under the equity method of accounting, the Company reflected its investment in non-consolidated subsidiaries within the Company’s Condensed Consolidated Balance Sheets as Equity method investments; the Company’s share of the earnings or losses of the non-consolidated subsidiaries were reflected as Equity method investment earnings in the Condensed Consolidated Statements of Income.

The Company reviewed its investments in non-consolidated subsidiaries for impairment whenever events or changes in business circumstances indicated that the carrying amount of the investments may not be fully recoverable. Evidence of a loss in value that is other than temporary include, but are not limited to, the absence of an ability to recover the carrying amount of the investment, the inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment, or, where applicable, estimated sales proceeds which are insufficient to recover the carrying amount of the investment. If the fair value of the investment is determined to be less than the carrying value and the decline in value is considered to be other than temporary, an appropriate write-down is recorded based on the excess of the carrying value over the best estimate of fair value of the investment.

As of July 3, 2017, the Company has no equity method investments (see Note 2).

Revenue Recognition.   Except as discussed below, revenue from the sale of the Company’s products is recognized as products are delivered to customers according to shipping terms and when title and risk of loss have transferred.  Income from various government incentive grant programs is recognized as it is earned.

 

The Company’s Distillery segment routinely produces unaged distillate, and this product is frequently barreled and warehoused at a Company location for an extended period of time in accordance with directions received from the Company’s customers.  This product must meet customer acceptance specifications, the risks of ownership and title to the goods must be passed to the customer, and requirements for bill and hold revenue recognition must be met prior to the Company recognizing revenue from the sale of the product.  Separate warehousing agreements are maintained for customers who store their product with the Company and warehouse services revenues are recognized as the services are provided.

 

Sales include customer paid freight costs billed to customers for the quarters ended September 30, 2017 and 2016 of $3,858 and $3,599 , respectively and $10,936 and $10,272 for the year to date periods ended September 30, 2017 and 2016 , respectively.

Income Taxes. The Company accounts for income taxes using an asset and liability method which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis.

Evaluating the need for, and amount of a valuation allowance for deferred tax assets often requires significant judgment and extensive analysis of all available evidence on a jurisdiction-by-jurisdiction basis. Such judgments require the Company to interpret existing tax law and other published guidance as applied to the Company's circumstances. As part of this assessment, the Company considers both positive and negative evidence about its profitability and tax situation. A valuation allowance is recognized if it is more likely than not that at least some portion of the deferred tax asset will not be realized.

Accounting for uncertainty in income tax positions requires management judgment and the use of estimates in determining whether the impact of a tax position is "more likely than not" of being sustained. The Company considers many factors when evaluating and estimating its tax positions, which may require periodic adjustment and which may not accurately anticipate actual outcomes. It is possible that amounts reserved for potential exposure could change as a result of the conclusion of tax examinations and, accordingly, materially affect the Company’s reported net income after tax.

Earnings per Share.   Basic and diluted earnings per share are computed using the two-class method, which is an earnings allocation formula that determines net income per share for each class of Common Stock and participating security according to dividends declared and participation rights in undistributed earnings.  Per share amounts are computed by dividing net income attributable to common shareholders by the weighted average shares outstanding during the period.

Long-Lived Assets and Loss on Impairment of Assets.   Management reviews long-lived assets, mainly property and equipment assets, whenever events or circumstances indicate that usage may be limited and carrying values may not be fully recoverable.  Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are determined to be impaired, the impairment is measured by the amount by which the asset carrying value exceeds the estimated fair value of the assets.  Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.  Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third-party independent appraisals, as considered necessary.  No events or conditions occurred during the quarter ended September 30, 2017 that required the Company to test its long-lived assets for impairment.

Fair Value of Financial Instruments.   The Company determines the fair values of its financial instruments based on a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The hierarchy is broken down into three levels based upon the observability of inputs. Fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs include quoted prices for similar assets and liabilities in active markets and inputs other than quoted prices that are observable for the asset or liability. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value in its entirety requires judgment and considers factors specific to the asset or liability.

 

The Company’s short term financial instruments include cash and cash equivalents, accounts receivable and accounts payable.  The carrying value of the short term financial instruments approximates the fair value due to their short term nature. These financial instruments have no stated maturities or the financial instruments have short term maturities that approximate market.

 

The fair value of the Company’s debt is estimated based on current market interest rates for debt with similar maturities and credit quality. The fair value of the Company’s debt was $35,753 and $37,412 at September 30, 2017 and December 31, 2016 , respectively. The financial statement carrying value of total debt was $34,160 (including unamortized loan fees of $745 ) and $36,001 (including unamortized loan fees of $576 ) at September 30, 2017 and December 31, 2016 , respectively.  These fair values are considered Level 2 under the fair value hierarchy.

Recent Accounting Pronouncements.

In May 2017, the FASB issued Accounting Standards Update ("ASU") 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting, which clarifies what constitutes a modification of a share-based payment award. This ASU is effective for all entities for annual and interim periods in fiscal years beginning after December 15, 2017. Early adoption is permitted as of the beginning of an annual period for which financial statements (interim or annual) have not been issued or made available for issuance. The Company is evaluating the effect that ASU 2017-09 will have on its consolidated financial statements and related disclosures.

In March 2017, the FASB issued ASU 2017-07, Compensation-Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost , which requires companies to present the service cost component of net benefit cost in the same line items in which they report compensation cost. Companies will present all other components of net benefit cost outside operating income, if this subtotal is presented. This ASU is effective for public business entities for annual and interim periods in fiscal years beginning after December 15, 2017. Early adoption is permitted as of the beginning of an annual period for which financial statements (interim or annual) have not been issued or made available for issuance. The Company is evaluating the effect that ASU 2017-07 will have on its consolidated financial statements and related disclosures.

ASU Transition Updates.

In February 2016, the FASB issued ASU 2016-02, Leases , which aims to make leasing activities more transparent and comparable and requires substantially all leases be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability, including leases currently accounted for as operating leases. This ASU is effective for all interim and annual reporting periods beginning after December 15, 2018, with early adoption permitted. The Company is currently evaluating the impact that the adoption of ASU 2016-02 will have on its consolidated financial statements and related disclosures. At September 30, 2017 , the Company had various machinery and equipment operating leases, as well as operating leases for 208 rail cars and one office space.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606),  which will replace numerous requirements in GAAP, including industry specific requirements, and provide companies with a single revenue recognition model for recognizing revenue from contracts with customers. Since May 2014, the FASB has issued updates to ASU No. 2014-09. Update ASU No. 2015-14 was issued in August 2015, Revenue from Contracts with Customers (Topic 606) - Deferral of the Effective Date ; update ASU No. 2016-08, Revenue from Contracts with Customers - Principal versus Agent Considerations (Reporting Gross versus Net) was issued in March 2016; update ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606) - Identifying Performance Obligations and Licensing was issued in April 2016; update ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606) - Narrow-Scope Improvements and Practical Expedients was issued in May 2016; update ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers was issued in December 2016; and ASU No. 2017-13, Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842) - Amendments to SEC Paragraphs Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments was issued in September 2017. The core principle of the new standard, as well as the updates, is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. The two permitted transition methods under the new standard are the full retrospective method, in which case the standard would be applied to each prior reporting period presented and the cumulative effect of applying the standard would be recognized at the earliest period shown, or the modified retrospective method, in which case the cumulative effect of applying the standard would be recognized at the date of initial application. In July 2015, the FASB approved the deferral of the new standard's effective date by one year. The new standard is effective for annual reporting periods beginning after December 15, 2017. The FASB will permit companies to adopt the new standard early, but not before the original effective date of annual reporting periods beginning after December 15, 2016.

 

In 2016, the Company established an implementation team consisting of internal and external representatives. The implementation team is in the process of assessing the impact the new standard will have on the consolidated financial statements, as well as gathering data and information for the expanded revenue disclosure required under the new standard.   The scoping for the assessment is complete and the testing of individual contracts is also complete.  Assessment findings have been compiled and are in the review process. In addition, the implementation team is in the process of identifying, and will then implement, appropriate changes to business processes, systems and/or controls to support recognition and disclosure under the new standard. The implementation team will report findings and progress of the project to management and the Audit Committee on a frequent basis through the effective date. The Company will adopt the requirements of the new standard in the first quarter of 2018 and anticipates using the modified retrospective transition method. While we have not identified any material differences in the amount and timing of revenue recognition related to ASU 2014-09, our evaluation is not complete and, accordingly, we have not yet reached a conclusion on the overall impacts of adopting ASU 2014-09.

    

Note 2.  Equity Method Investments.

As of September 30, 2017 , the Company had no investments accounted for using the equity method of accounting. Until July 3, 2017, the Company had a 30 percent interest in Illinois Corn Processing ("ICP"), which manufactured alcohol for fuel, industrial and beverage applications.

On July 3, 2017 , the Company completed the sale of its 30 percent equity ownership interest in ICP to Pacific Ethanol Central, LLC ("Pacific Ethanol"), consistent with an Agreement and Plan of Merger ("Merger Agreement") entered into on June 26, 2017.

The Company received total cash proceeds of $9,000 (before transaction expenses and taxes), as well as a secured promissory note ("Note") with a principal amount of $14,008 . On September 15, 2017, the Note was paid off and the Company received a total of $14,263 , including principal, interest, and a final working capital adjustment. As a result of the ICP sale transaction, for the quarter and year to date period ended September 30, 2017 , the Company reported a gain on sale of equity method investment of $11,381 (before tax), on its Condensed Consolidated Statements of Income.

The Merger Agreement also contemplated a special distribution of all of ICP’s cash and cash equivalents to equity owners prior to the closing. On June 28, 2017, the Company received $6,600 representing its 30 percent share of a dividend in the amount of $22,000 approved on June 26, 2017. The Company also received a smaller distribution of $830 on June 30, 2017 representing its 30 percent share of an additional distribution in the amount of $2,765 .

Summary Financial Information (unaudited). Condensed financial information related to the Company’s non-consolidated equity method investment in ICP is shown below.

The Company’s equity method investment earnings (loss) and gain on sale of equity method investment, based on unaudited financial statements, was as follows:

The Company’s equity method investment was as follows:

		September 30, 2017				December 31, 2016
ICP (30% interest) (a)		$	—			$	18,934

^(a) The Company's equity method investment in ICP ended on July 3, 2017, when it completed the sale of its 30 percent equity ownership interest.

^(a) Interest rates are as of September 30, 2017 .

^(b) Loan fees are being amortized over the life of the Credit Agreements.

Credit Agreements. On August 23, 2017, the Company entered into a new credit agreement (the “Credit Agreement”) with Wells Fargo Bank, National Association. The new credit agreement replaces the Company’s existing Third Amended and Restated Credit Agreement, which included a revolver, a fixed asset sub-line term loan, and a term loan. The Credit Agreement provides for a $150,000 revolving credit facility. The Company may increase the facility from time to time by an aggregate principal amount of up to $25,000 provided certain conditions are satisfied and at the discretion of the lender. The Credit Agreement matures on August 23, 2022.

The Credit Agreement includes certain requirements and covenants, which the Company was in compliance with at September 30, 2017 . The Company incurred $183 of new loan fees related to the Credit Agreement during the quarter ended September 30, 2017 . The unamortized balance of total loan fees related to the Credit Agreement was $552 at September 30, 2017 and is included in the carrying value of total debt on the Condensed Consolidated Balance Sheets as described above in the Fair Value of Financial Instruments section. The loan fees are being amortized over the life of the Credit Agreement.

As of September 30, 2017 , the Company's total outstanding borrowings under the Credit Agreement were $12,848 leaving $137,152 available. The interest rate for the borrowings of the Credit Agreement at September 30, 2017 was 2.84 percent.

On August 23, 2017, the Company also entered into a Note Purchase and Private Shelf Agreement (the “Note Purchase Agreement”) with PGIM, Inc., an affiliate of Prudential Financial, Inc., and certain affiliates of PGIM, Inc. The Note Purchase Agreement provides for the issuance of up to $75,000 of Senior Secured Notes, and the Company issued $20,000 of Senior Secured Notes with a maturity date of August 23, 2027. The Senior Secured Notes bear interest at a rate of 3.53 percent per year. The Note Purchase Agreement includes certain requirements and covenants, which the Company was in compliance with at September 30, 2017 . The Company incurred $194 of new loan fees related to the Note Purchase Agreement during the quarter ended September 30, 2017 . The unamortized balance of total loan fees related to the Note Purchase Agreement was $192 at September 30, 2017 and is included in the carrying value of total debt on the Condensed Consolidated Balance Sheets as described above in the Fair Value of Financial Instruments section. The loan fees are being amortized over the life of the Note Purchase Agreement.

Note 4. Income Taxes.

Income tax expense for the quarter and year to date period ended  September 30, 2017  was  $7,491 and $13,292 , respectively, for an effective tax rate for the quarter of 34.6 percent and for the year to date period of 31.3 percent . The increase in tax expense compared to prior quarters in 2017, largely relates to the Company’s sale of its interest in ICP (see Note 2), and the corresponding tax gain being recognized in the annual effective tax rate calculation.

The effective tax rate differs from the 35 percent federal statutory rate on pretax income, primarily due to to state income taxes, the impact of income tax benefits related to share-based compensation as accounted for in ASU 2016-09, Compensation - Stock Compensation (Topic 718) Improvements to Employee Share-Based Payment Accounting, the domestic production activities deduction, and state tax planning, including state income tax credits in Indiana and Kansas, and changes to the Company's valuation allowance. The Company released its valuation allowance related to its capital loss carryforward deferred tax asset into the annual effective tax rate calculation in the quarter ended June 30, 2017. This release was based upon the anticipated capital gain related to the Company's sale of its 30 percent equity ownership interest in ICP (see Note 2). As of September 30, 2017 , the Company has a remaining valuation allowance of $106 related to state net operating loss carry forwards in states in which the Company no longer files tax returns.

Income tax expense for the quarter and year to date period ended September 30, 2016 , was $2,316 and $9,758 , respectively, for an effective tax rate of 19.5 percent for the quarter and 29.9 percent for the year to date period. The primary reasons for the increase in the effective tax rate from the prior year quarter and year to date period are a decrease in the amount of discrete excess tax benefits resulting from the implementation of ASU 2016-09, Compensation - Stock Compensation (Topic 718) Improvements to Employee Share-Based Payment Accounting , relative to a higher amount of pretax earnings, and the dilutive effect of the gain on sale of ICP sale (see Note 2) on certain tax attributes including the domestic production activities deduction.

The computations of basic and diluted earnings per share for the quarter and year to date periods ended September 30, 2017 and 2016 are as follows:

Note 6.  Commitments and Contingencies.

Commitments. Open purchase order commitments at September 30, 2017 related to raw materials and packaging used in the ordinary course of business were $51,539 extending out to December 2018 . Open purchase order commitments at September 30, 2017 related to the purchase of capital assets were $6,116 .

Certain commodities the Company uses in its production process are exposed to market price risk due to volatility in the prices for those commodities.  The Company's grain supply contract for its Lawrenceburg and Atchison facilities permits the Company to purchase grain for delivery up to 12 months into the future at negotiated prices.  The pricing for these contracts is based on a formula using several factors.  The Company has determined that the firm commitments to purchase grain under the terms of these contracts meet the normal purchases and sales exception as defined under ASC 815, Derivatives and Hedging , and has excluded the fair value of these commitments from recognition within its consolidated financial statements until the actual contracts are physically settled.

The Company’s production process also involves the use of wheat flour and natural gas. The contracts for wheat flour and natural gas range from monthly contracts to multi-year supply arrangements; however, because the quantities involved have always been for amounts to be consumed within the normal expected production process, the Company has determined that these contracts meet the criteria for the normal purchases and sales exception and have excluded the fair value of these commitments from recognition within its consolidated financial statements until the actual contracts are physically settled.

Contingencies. There are various legal and regulatory proceedings involving the Company and its subsidiaries.  The Company accrues estimated costs for a contingency when management believes that a loss is probable and can be reasonably estimated.