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Executives

Les Nelson - Director of IR

Ron Miller - President and CEO

Ajay Sabherwal - CFO

Analysts

Mansi Singhal - Barclays Capital

Ron Oster - Broadpoint.AmTech

Amit Sharma - BMO Capital Markets

Joe Gomes - Oppenheimer

Chris Shaw - UBS

Jeff Osborne - Thomas Weisel Partners

Gary Stromberg - Barclays Capital

JinMing Liu - Ardour Capital

David Woodburn - ThinkEquity Partners

Aventine Renewable Energy Holdings Inc (AVR) Q3 2008 Earnings Call October 31, 2008 9:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the third quarter Aventine Renewable Energy Holdings Incorporated Earnings Call. My name is Sandy and I will be your coordinator for today. (Operator Instructions)

I would now like to turn the presentation over to your host for today's conference, Mr. Les Nelson, Director of Investor Relations. Please proceed.

Les Nelson

Thank you, Sandy. Good morning. Thank you for joining us today. My name is Les Nelson, Director of External Reporting and Investor Relations. I would like to welcome you to Aventine's conference call discussing our results for the third quarter and nine months ended September 30, 2008.

With me today are Ron Miller, President and Chief Executive Officer and Ajay Sabherwal, our Chief Financial Officer.

Before we summarize and discuss the company's performance, I would like to remind you that much of what will be said today involves our use of forward-looking statements, which are estimates about where we are going including projected financial results, financial position and business development activities.

These forward-looking statements are subject to various risks and uncertainties, including market conditions, governmental mandates, demand for our products, technological advances and economic conditions, in general, that could cause actual results to differ materially from those stated or implied by such statements.

We refer you to our press release issued last night, which contains a more detailed description of our use of forward-looking statements, which applies to the discussion that follows. The financial details included in the press release and discussed on this call, including a reconciliation of net income to adjusted EBITDA, are available on our website at www.aventinerei.com in the Investor Relations section.

I would also like to mention that this conference call is being webcast and is open to analysts. We will start the call with some prepared remarks and then follow with a question-and-answer session for analysts. Please be mindful of others so that everyone may have an opportunity to ask a question.

Now, I'd like to turn the call over to Ron.

Ron Miller

Thank you, Les. Good morning and welcome to Aventine's conference call, discussing our third quarter and nine months results for the period ending September 30, 2008. We are pleased to have each of you with us today and wish to thank our shareholders and bondholders for their continued support.

Net income for the third quarter was $2.5 million, or $0.06 per fully diluted share. Adjusted EBITDA for the quarter, totaled $7.5 million. Cash generated from operations in the quarter, which excludes capital expenditures, totaled $14.3 million.

For the nine-month period, the net loss was $10.2 million and the fully diluted loss per share was $0.24. The nine-month results include a $31.6 million loss related to auction rate securities. Excluding this loss, net income for the first nine months would have been $21.4 million and fully diluted earnings per share would have been $0.51.

Cash flow from operations for the first nine months, excluding capital expenditures, totaled $56.6 million. Adjusted EBITDA for the nine-month period, totaled $46.1 million.

Declining ethanol prices and continued high corn costs resulted in lower commodity spreads. This combined with higher conversion costs reduced gross margins to breakeven levels.

Earnings for the third quarter were principally driven by gains on derivative positions and fee-based income from our marketing of third-party gallons.

Net gains from short corn and short gasoline positions in the third quarter more than offset the losses we incurred on hedge positions during the second quarter.

Increased demand for ethanol was the bright spot during the quarter. Ethanol demand continues to increase as lower pricing is the driving factor behind greater consumption.

Transportation and logistics facilities continue to grow to handle the new supplies that are coming into the marketplace.

In the third quarter, our realized average ethanol price declined slightly to $2.47 per gallon from the $2.50 average we received in the second quarter. However, the slight average decline in price masked the story of a steep decline in pricing at the end of the quarter that has continued so far into the fourth quarter. Ethanol pricing began falling quickly in late September, and spot gross margins are now at breakeven levels at best.

For the quarter, the commodity spread decreased to $0.98 per gallon, down from $1.29 per gallon in the second quarter of 2008. Co-product returns as a percentage of corn costs have fallen below 40%, as a result of lower co-product pricing.

Because we sold co-products in the spot market in a declining corn environment, but had fixed the price on about 50% of our corn in the third quarter, the lower price received on the co-product in the quarter translated into significantly lower co-product return percentage.

For the first nine months of 2008, our ethanol price averaged $2.40, versus $2.13 for the first nine months of 2007. However, the increase in the average price of corn for the first nine months of 2008 far exceeded the increase in ethanol price over the same period.

Adjusted EBITDA per produced gallon in the third quarter fell to $0.16 per gallon. Adjusted EBITDA for the quarter benefited principally from the gains on derivative positions and from fee-based income from our marketing and purchase resale business. For the nine-month period, adjusted EBITDA per produced gallon was $0.33.

Gallons sourced from marketing alliance partners increased approximately 8% in Q3 '08 versus Q2 of '08. Our marketing alliance annualized volume at the end of the quarter was 639 million gallons. With our own equity production, our marketing alliance partner volumes, and our purchase resale volumes, we distributed approximately 900 million gallons of ethanol on an annualized basis in the third quarter.

Our expectation for 2008 is that another 215 million gallons of annualized marketing alliance partner production will come online in the fourth quarter. Offsetting this increase in volumes in the fourth quarter will be disruptions in supply from marketing alliance partners as a result of poor industry margins.

We have in the fourth quarter already seen reductions in production levels and gallons available for distribution from marketing alliance partners, and may see additional supply disruptions in the future.

In addition to curtailments in supply as a result of lower production volumes caused by current industry margins, a few of our marketing alliance partners have indicated that they are exploring alternative marketing arrangements. To this end, we have received termination notices from some of our marketing partners for their services.

We announced during the quarter the extension of completion of our Aurora West expansion project. By extending the build schedule, we can lower the requirements for working capital that would have resulted from bringing the two plants online at the same time. We expect the new Mt. Vernon facility to begin producing in cash flow prior to the Aurora West facility beginning production, thereby reducing working capital requirements.

We recently completed the purchase of the minority interest in Nebraska Energy LLC from the Nebraska Energy Cooperative. We issued 1 million shares of Aventine common stock to acquire the remaining interest.

Now, Ajay will provide details on the numbers. And afterwards, I will make some additional remarks about our business and some comments on the ethanol marketplace and expectations for the remainder of 2008.

Ajay Sabherwal

Thank you, Ron, and thanks to everyone for participating in this conference call. I apologize in advance for my sore throat. Please bear with me. I will now take you through our income statement and balance sheet, highlighting the key trends and variances. After that, I will share with you some expectations for the remainder of '08.

Net sales, gallons sold in the third quarter reached another record at 226.6 million gallons versus the previous record of 220.3 million gallons sold in Q2.

Gross ethanol prices in the third quarter decreased to $2.47 per gallon, versus $2.50 per gallon in Q2. Revenue in Q3 was essentially flat, as higher volumes were offset by lower pricing.

Revenues in Q3 were $599.5 million, versus $601.6 million in Q2. Co-product revenue decreased 9% to $33.7 million. Co-product returns, defined as co-product revenue divided by gross corn cost, fell to 32.3%. Lower pricing was the primary reason for the revenue decline.

As a percentage of revenue, lower co-product pricing compared to partially fixed corn pricing, led to the percentage decrease.

Equity production in the third quarter totaled 47.4 million gallons. Gallons sourced from our marketing alliance totaled 133.3 million gallons, and purchases from other producers increased to 54.5 million gallons in the quarter. We also increased our ethanol inventory during the quarter by approximately 5.6 million gallons.

Equity production was breakeven during the quarter and was affected by increased costs, particularly higher corn, maintenance, and utility costs, along with a non-cash lower of cost or market valuation adjustment for ethanol and corn inventory.

Corn costs in the quarter increased by $0.40 a bushel to $5.78, versus $5.38 in Q2. However, our average corn cost in Q3 continued to be below the average CBOT corn price of $5.82 per bushel for the quarter.

The decrease in commodity spread expressed per gallon of ethanol can be broken down as follows. Average ethanol prices decreased by $0.03, co-product revenue decreased $0.10 and corn prices increased by $0.18.

Conversion costs increased in the third quarter by $0.04 per gallon, primarily from higher maintenance and utility costs. Conversion costs in Q3 increased to $0.77 per gallon, from $0.73 per gallon in Q2.

Our freight and distribution costs fell slightly to $0.19 per gallon, versus $0.20 in Q2. Freight logistics costs per gallon as discussed here are calculated by taking freight logistics expenses incurred, those include cost to ship co-products, and dividing by the total ethanol gallons sold.

Although fuel surcharges have begun to ease, freight costs continue to be affected by such surcharges and from general freight increases associated by moving product along longer supply lines to emerging new markets in the Southeast.

The average inventory cost of $2.08 per gallon at the end of Q3, which includes the effect of lower of cost or market inventory adjustment, versus $2.28 at the end of Q2, using our weighted average FIFO approach, reflects the effects of declining ethanol prices during the quarter.

The economic impact of selling gallons held in inventory at the end of Q2, with a $2.28 per gallon value during Q3 in which prices were declining, was a negative impact to cost of goods sold of approximately $7.3 million. This amount includes a non-cash lower of cost or market inventory adjustment of $4.7 million.

SG&A expense decreased $1.3 million, or approximately 12.9%, to $8.8 million in Q3, from $10.1 million in Q2. The lower expense in Q3 primarily relates to reductions in stock-based compensation expense, as a result of changes in forfeiture estimates, and the number of performing shares expected to vest, totaling 1.2 million. In addition, lower legal and other outside service fees decreased $600,000.

Adjusted EBITDA decreased $8 million from Q2 to Q3. Adjusted EBITDA in Q3 was $7.5 million, versus $15.5 million in Q2. Adjusted EBITDA benefited in Q3 from significant gains in derivative transactions, principally gains on short corn positions. Adjusted EBITDA in both periods have been adjusted by non-cash items, such as stock compensation expense and losses related to auction rate securities.

Moving down the income statement, interest expense for the third quarter was $200,000. Interest expense includes $7.5 million in interest on $300 million aggregate principal amount of our 10% notes, $0.2 million of amortization of deferred financing fees, reduced by interest capitalized during the quarter of $7.5 million.

Other non-operating income reflects the net gains incurred in third quarter of '08 on derivative positions, totaling $18.4 million. This compares to a net loss on derivative positions of $14.1 million in Q2.

Derivative gains and losses for Q3 are composed of net realized gains on CBOT corn positions of $300,000, net realized losses on short gasoline future positions of $4.8 million, net unrealized gains on CBOT corn positions of $12.3 million, and net unrealized gains on short gasoline positions of $10.6 million.

All of our derivative positions require cash settlement on a daily basis. Offsetting our short gasoline positions are forward ethanol sales contracts that are indexed to gasoline. Such contracts are not mark-to-market. Also not mark-to-market are forward contracts to purchase corn that are either standalone or are taken against short futures positions.

Our effective income tax rate was approximately 42% in Q3. For the year, the company does not expect to receive an income tax benefit related to auction rate securities, as we do not expect to have sufficient capital gains to offset the $31.6 million capital loss. As such, we have recorded an allowance against the income tax benefit for the loss related to auction rate securities.

Now a look at the balance sheet, cash and cash equivalents at quarter-end were $36.3 million. Cash generated by operations during this third quarter of 2008, which excludes CapEx, was $14.3 million, and for the nine months it was $56.6 million. We did not make an interest payment on our senior security secured bonds during the third quarter, as no payment was due until October 1st.

Non-expansion capital spending in Q3 totaled $3.3 million. For the first nine months of '08, we spent $9 million on non-expansion capital projects.

Capital spending on expansion projects, totaled $81.4 million in Q3, excluding capitalized interest of $7.5 million. For the year, we have spent $193.3 million on capital expansion projects, excluding capitalized interest of $19.5 million.

We expect to spend approximately $109.9 million on our capital expansion projects, excluding capitalized interest, through the second quarter of '09. The company did not repurchase any stock during Q3.

As of September, the company has available under its existing secured revolving credit facility approximately $132.9 million in borrowing capacity, which is net of $22.2 million in outstanding letters of credit. This amount includes $50 million we previously indicated that we do not expect to be able to access. No amount was drawn on this facility at September 30.

In early October, we drew down $60 million on our secured revolving credit facility. We have invested these funds in cash equivalents until they are needed.

Pro forma cash on hand at September 30th, including the $60 million borrowing, would have been $96.3 million. In addition to extending the construction period and pushing out the start-up date of our ethanol facility expansion in Aurora, Nebraska, as previously announced, we continue to evaluate a number of other actions designed to increase the amount of liquidity available to us, including, reducing inventory levels, seeking additional debt and equity financing, of course potentially delaying construction or start-up of our Mt. Vernon, Indiana, expansion, and other strategic initiatives. We cannot assure you that any of these initiatives will generate additional liquidity for us on acceptable terms, or at all.

Let me share with you some expectations for the remainder of '08. As of September 30, we had contracts for delivery of ethanol, totaling 143.1 million gallons through September of '09. These contracts are shared for the benefit of the marketing alliance pool as a whole, of which Aventine is a part, and are not solely applicable to Aventine.

As at September 30th, we had no meaningful contracts for sale of ethanol past year end '08. For delivery in the fourth quarter of '08, we had contracts for delivery of ethanol, totaling 137.9 million gallons.

These commitments were for 14.9 million gallons at an average fixed price of $2.26 a gallon; 13.6 million gallons at an average spread to wholesale gasoline of negative $0.39, based on NYMEX, Chicago, and New York Harbor indices; and 109.4 million gallons of spot prices, using various Platt, OPIS and AXXIS indices. Clearly we remain heavily weighted toward the spot ethanol market for the remainder of '08.

At September 30th, we had fixed the price of 9.3 million bushels of corn through December '08 at an average of 5.25 per bushel, which represents approximately 49% of our average remaining corn requirements for '08. We also have the following derivative positions, which are also detailed in our press release.

Fixed forward physical delivery purchase contracts outstanding cover 14.7 million bushels through December '09 at an average price of $5.82 per bushel. 5.4 million bushels of these positions are for periods beyond '08. None of these forward physical purchase contracts have been mark-to-market.

These forward physical purchases have been partially offset by sale of CBOT futures positions, covering 5.9 million bushels of corn, with an average price of $5.88 per bushel. We sometimes do this to lock in the basis differential against forward purchase contracts, while letting the purchase price fluctuate. These short positions are mark-to-market each period, with corresponding gains and losses recorded in other non-operating income at the end of each period.

Finally, to partially hedge ourselves against further price increases in corn, we have also purchased long CBOT futures positions, totaling 100,000 bushels of corn at an average price of $4.97. These long positions extend through December and are mark-to-market each period.

We also had outstanding at the end of the quarter short gasoline positions, covering 3.9 million gallons of gasoline for delivery through December at an average price of $2.06 per gallon. We did this to protect some of our gas-related sales contracts from potentially falling gasoline prices. These short positions are mark-to-market each period, with corresponding gains and losses recorded in other non-operating income.

Our remaining CapEx spending expectations for Phase I of our expansion projects is estimated to be $109.9 million, excluding capitalized interest. We continue to expect our ongoing SG&A annualized run rate for '08 to be between $35 million and $40 million. This amount includes certain SG&A costs that are recoverable from our marketing alliance partners and also includes non-cash stock compensation expense.

Now, I would like to turn the call back to Mr. Miller.

Ron Miller

Thank you, Ajay. Looking into our crystal ball for the near-term, ethanol production margins will most likely be as difficult in the fourth quarter as they have been all year. At today's spot corn and ethanol pricing, gross margins are breakeven at best.

We continue to believe that this environment while difficult is helping to cement ethanol into the transportation fuel supply in the gasoline component, and that this bodes well for ethanol on a long-term basis.

With increasing mandates as a floor to absorb the increasing supply, we should see industry fundamentals rebound as the supply/demand balance becomes more known and certain.

Given the tougher operating environment we foresee, we may see some market participants cease production and companies restructuring or going out of business altogether. Such a scenario should help ease corn prices further and increase ethanol prices as supply tightens.

We believe that we are well positioned to take advantage of these potential disruptions in the marketplace. We also continue to focus on our own liquidity situation and need as we move forward towards completing our expansion plans. We are looking at all options to stretch or increase liquidity in today's credit markets.

While our focus is on the long-term marketplace, we are cognizant of the need to have sufficient liquidity to get to the long-term. We will take whatever actions we believe will help us achieve this goal. We remain positive about the growth and economics of ethanol and view the current negative sentiment towards the industry as excessive and temporary.

Now, Ajay and I would be happy to answer any questions that you may have. Operator, please open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Mansi Singhal of Barclays Capital. Please proceed.

Mansi Singhal - Barclays Capital

Hi, good morning.

Ron Miller

Good morning, Mansi.

Mansi Singhal - Barclays Capital

Could you help explain your conversion costs in the quarter a little bit? If I look back on my notes from the second quarter, you had said the spike was due to higher natural gas prices and lower production, and both those things kind of reversed in the third quarter, and your costs didn't come down. Can you just kind of break down some of the variances there?

Ron Miller

Well, I can let Ajay talk more about the numbers, but we had a maintenance outage at our Pekin facility that stretched out. And this often times happens. It stretched out longer than we had originally planned. We took the opportunity to take an early outage at our Pekin II facility that was originally scheduled for later in the year.

So the combined effect resulted in lower production. We have also continued to experience higher natural gas price during the quarter.

Mansi Singhal - Barclays Capital

Going forward, what kind of a number is your kind of a normal base number without maintenance that we should be modeling in?

Ajay Sabherwal

Mansi, firstly congratulations on your new position.

Mansi Singhal - Barclays Capital

Thank you.

Ajay Sabherwal

We hope to see the numbers come down, obviously. Now in the near-term, we have some natural gas contracts that are higher. Now natural gas is 40% of our energy source. Remember, we use a coal-fired boiler in Pekin, so that helps. And natural gas prices for the amounts that may not have purchased have come down quite a bit.

So we do expect to see decreases. I can't give you an exact sense of when we would get closer to the $0.60 that we feel is more normal for us, given our more complex wet mill with the higher co-product returns. But I would hope by first, second quarter, we should see that sort of a number.

Mansi Singhal - Barclays Capital

Okay. Could you talk a little bit about the utilization rate? I guess it's been in early 90s over the last four to five quarters. Do you see it kind of rising going forward? Because I mean some of the other companies have been operating at more than 100%, do you see kind of your plants reaching that level?

Ajay Sabherwal

Mansi, part of it is the denaturing mix. See, we are not blending at the 4.705% denaturant that the nameplate capacity is based upon. So that causes a natural sort of 3% decline. Again, our mills have been running for quite a while, have a different operating history. Some of these other mills, they are more newer so they are able to present a higher capacity number.

Now, we are building two brand new mills as well. So I think our utilization is based more on our historic experience. I'll leave it at that.

Mansi Singhal - Barclays Capital

Okay. And Ron, if I could just kind of sneak in one final question on industry. RFA right now is talking about 10.9 billion gallons of capacity, and as you mentioned a lot of users are shutting down because the margins don't exist anymore. Do you run any internal estimates on how much production may be right now, compared to that capacity number?

And just on the demand side now, with that now trading at a premium to gasoline, have you seen any slowdown in ethanol blending? Are you seeing people not blend 10% anymore? Or people who were blending 10% are continuing to do so in spite of the premium?

Ron Miller

Well, keep in mind, the premium to gasoline, there is also a $0.51 tax credit that goes to the blender. So to be at a premium to gasoline, you need to be higher than gasoline plus the $0.51. So there is still a margin in there for the blenders.

With this steep drop in gasoline price, and ethanol is trading more with corn, we are seeing the margin enhancement that was there three months ago, while there is some margin enhancement, it is considerably less. The whole gasoline market is sort of in a period of doldrums, which usually happens in the third quarter. I think it's probably more exacerbated right now with the summer of high gasoline prices.

So gasoline demand is down. I think what we are seeing is we are holding our own in markets that we're in; but the rate of growth is probably slowing down. But that's probably a temporary situation. The mandate goes up 1.5 billion gallons next year to 10.5 for corn. And we are probably right now at this point about 15% oversupplied.

So the new mandate will take up most of the current supply, but then we will have more plants coming on next year. So we are probably still looking in the neighborhood of 10% to 15% that we are going to need for discretionary blending above the mandate next year.

Mansi Singhal - Barclays Capital

Have you seen any kind of infrastructure projects being canceled because of what has happened in the market or kind of in the Southeast especially?

Ron Miller

Infrastructure markets, I don't think we've seen anything canceled yet. The pace is probably slowing down a little bit, but I haven't seen anything canceled.

Mansi Singhal - Barclays Capital

Okay, thank you.

Operator

Your next question comes from the line of Ron Oster of Broadpoint.AmTech. Please proceed.

Ron Oster - Broadpoint.AmTech

Good morning. I just wanted to drill down a little bit on your potential options for improving liquidity. Notably, you mentioned reducing inventory. If I look at your balance sheet, you have about $120 million of inventory. I'm just wondering what's the minimum level you could go there? And what percentage of that or how much of that is really an option to improve your liquidity?

Ron Miller

Well, I don't have specifics, but about half of that inventory is in transit, and there are ways of selling that inventory on an FOB basis versus a delivered basis. Whether you can get it all sold is maybe a question, but the in-transit volumes there are opportunities to reduce some of that inventory as well.

Obviously, we've got a great relationship with Kiewit. They are a wonderful company to work with. We have worked with them on extending the Aurora West project. We are continuing to look at the business. This is all predicated on what the margins are going to be over the next six months. Right now, they are near zero. Are they sustainable near zero?

Quite frankly, the marketplace is relatively in balance. The physical market is in balance. And if plants shut down, I could see some stress on supply in the market, which should result in some price enhancement. The thing I think that is keeping price down is the knowledge that we have capacity, idle capacity, either coming online in. So it acts as if we are oversupplied, but the physical market is not oversupplied.

So the real question for us is, when do those margins turn? I think we have a very strong belief they are going to turn. But will they turn in two weeks, two months, four months, that's the question. So as we go on, we continue to evaluate well ahead of time to make sure that we have enough liquidity. We can stretch out projects further. There are several things like selling inventory. And so we are continuing to evaluate each one of these as we are watching the market on a daily basis.

Ron Oster - Broadpoint.AmTech

Okay. And you mentioned back to the inventory, half of it is in-transit. What is the other half of that 120 million?

Ron Miller

Well, it would be at terminals and we have some bottoms in terminals. We have stock available for sale. We can sell some of that down as well.

Ron Oster - Broadpoint.AmTech

Okay. And then also on your marketing alliance partners, you mentioned you saw some voluntary shut-in production. Can you quantify or give a percentage of your partners that you've seen do this thus far?

Ron Miller

I really can't at this. All we can say is we have seen some that have curtailed some production. There have been some published reports out there of some plants in South Dakota not having corn available right now. That is the other side of the coin.

We have a robust corn harvest, but it's coming in later this year than normal, and so we've had some spot outages in areas like South Dakota that have been documented. So some have curtailed just because they can't get the corn. Others are cutting back production just because of liquidity issues and thin margins. But it really wouldn't be appropriate for us to identify those or give volumes at this stage.

Ron Oster - Broadpoint.AmTech

Okay. And then, following up on an earlier question about the conversion costs in the mid-$0.70 range here now the last two quarters, what should we be expecting going forward? Is it still the mid-$0.60 range per gallon or is this probably a better run rate at these levels?

Ajay Sabherwal

I think we phased down to that $0.60 level over a quarter or so. We should see that come down.

Ron Miller

I think the impact we've seen of high gas prices, we will have some of that in the fourth quarter, but the production rates again should improve. We were hit, I think, especially hard in September, because the scheduled outage we had at our wet mill at Pekin, once we got in there we took a few extra days, which we hadn't planned on the extra days.

And because of that, it made a lot of sense for us to go ahead and take down our dry mill for scheduled maintenance, which was originally planned to happen in the fourth quarter. So now we don't have to do that in the fourth quarter, that should help us.

Ajay Sabherwal

Plus there is an element of denaturant in this. Denaturant prices have come down with gasoline prices. Natural gas, to the extent not fixed, has come down. So as the petroleum complex comes down, all the energy inputs come down, so we should see the improvement. I would like to say Q1 to see us back to those levels.

Ron Oster - Broadpoint.AmTech

Okay. And then last one for me. With regards to the margin outlook, you mention breakeven, maybe best case breakeven. Is it an option, or how long would it take for you guys? Are you considering potentially voluntarily shutting in some of your production capacity, given that you might be losing money on each gallon of output?

Ron Miller

Well, we are still operating well above variable cost. So I think you would get down to the point where you are below variable cost before you would shut in production. We are looking at all the plants constantly on that.

Obviously, the wet mill we do a little bit better because we have got co-product returns. We have got a highly efficient dry mill there at Pekin. But even thought we are at breakeven margins on a variable cost basis, we are still positive because we have to carry on those fixed costs if we shut down.

Ajay Sabherwal

But there is no question across the industry, the difference between not shutting and shutting at this point is someone made the wrong hedging decision. So across the industry, there is massive economic disruption, and hundreds of millions of gallons are being shut in. And we will assess our options very, very carefully at all times. We are not in the business of running unprofitably.

Ron Miller

That's right.

Ron Oster - Broadpoint.AmTech

Okay, thank you.

Operator

Your next question comes from the line of Ken Zaslow of BMO Capital Markets. Please proceed.

Amit Sharma - BMO Capital Markets

Hi, this is Amit Sharma. Ron, given your breakeven gross margins, and if we look at future corner curve as well, do you think Aventine will be profitable in '09 on an EPS basis?

Ron Miller

Well, again, it depends upon the margins that will occur in '09, so primarily driven by ethanol price. There is every reason to expect improvement in ethanol pricing during '09, because of the fact that we do have an increase in mandated demand in '09 by 1.5 billion gallons. We are seeing some slowdown in the supply estimates as plants get deferred or stretched out on construction, as players have difficulty there.

And so one does expect to see the margins turns around that would result in a positive EPS. But I continue to call the market choppy, because we do have the plants, we do have some idle capacity and we could go for a period of time near breakeven. Sometime this is going to turn. And long-term, we are headed to 36 billion gallons of ethanol use in this country, so margins will turn.

I would hope that by '09 we are going to see, particularly the last half of '09, we would see a much smoother environment. But obviously, I think we will have to see how long these choppy waters last.

Amit Sharma - BMO Capital Markets

Right. In terms of we've seen pending bankruptcies, we are seeing delaying construction, how does this impact demand/supply dynamics over the longer-term? Not in the next three months, six months, but over the longer-term. Do you think these bankruptcies will favor ethanol producers like you who will still be in business? And also, if you take this a step further, how does this impact gasoline ethanol spread, do we expect to go back to '06 levels, any thoughts on that?

Ron Miller

Well, I don't see it going back to '06 levels on a gasoline ethanol spread. That was an extraordinary period where the oil industry virtually overnight elected to shift from MTBE to ethanol and it put a strain on the ethanol supplies, and therefore we saw very high margins.

If you look over a long history and sort of the last year and a half excluded, we've seen ethanol pricing related to gasoline at somewhere at a slight discount to the ethanol credit. So if it's gas plus $0.51, maybe average in gas plus $0.45, something like that. As we move into '09, that tax credit actually drops to $0.45.

But the new phenomenon that is developing as customers shift to E-10 blends is the fact that they are shifting to sub-octane gasoline. We call it CBOB. It's the same thing they do in the reformulated gasoline markets where they make an 84 octane for ethanol blending. And that adds octane value to the use of ethanol.

So we could reasonably go over gas plus $0.45 and still be an economic blending component for refiners, because they're saving probably $0.03 a gallon making the 84 octane at the refinery. So the marketplace, as long as it's balanced, bodes well for us to continue to have a premium to gasoline. So the real question is, when does the market get in balance?

With respect to the question about the bankruptcies, I think this industry is going through a period, which is maybe not unusual to a lot of industries, where you have had rapid growth, you have a highly fragmented industry. I think that's one of the reasons why the markets are what they are.

We have a very fragmented group of players out there. And I think that will ultimately result in some consolidation. You see this in industry after industry. We saw it in the oil industry, which one would have thought was highly concentrated and became more concentrated probably 10 years ago, for a very good reason, given the dynamics of the global markets.

So I think we will see a similar thing, whether companies have to go through bankruptcy to get restructured, that is an open question. I actually see this period, while it is very difficult, being very healthy for the industry for the long-term.

Amit Sharma - BMO Capital Markets

And briefly, how long can you delay the Mt. Vernon project without incurring any construction-related delay penalties?

Ron Miller

I really don't have an answer to that. Again, we've had a great relationship with Kiewit. They are a very great partner to work with. I think if we have to do that, we can figure out the right solution that is manageable. I'm not too worried about the cost of penalties or anything like that.

Amit Sharma - BMO Capital Markets

Okay. And then just finally, co-product return came down substantially. Going forward, what should we model that? Should it be closer to 40, or should be mid-30s?

Ron Miller

Well, we have historically run in that 40 range. We were low a little higher earlier in the year, a little bit below that. Now that's with a mix of about 50% wet mill, 50% dry mill. So, on a normalized market, where you don't have a lot of volatility in corn, which I think affected us really in the third quarter, you should see probably in that neighborhood of 40, give or take a little bit.

Now, as time moves on and we start adding the capacity of dry mill, and it will eventually be roughly three-fourths dry mill, one-fourth wet mill and the normal returns on a wet, on a dry mill are around 30%. So we will probably push down toward that 30% level. But we will still be a little above it because of the wet mill contribution..

Amit Sharma - BMO Capital Markets

Great. Thank you very much.

Operator

Your next question comes from the line of Joe Gomes of Oppenheimer. Please proceed.

Joe Gomes - Oppenheimer

Good morning.

Ron Miller

Good morning, Joe.

Joe Gomes - Oppenheimer

Ron, just real quick, I mean I am talking about some of the industry rationalization and consolidation, some guys going possibly into bankruptcy. But do you really see any capacity coming out if people go into bankruptcy? Just given as you were saying some of the positive longer-term trends, I just wonder if you might be able to comment on that.

Ron Miller

It's hard to say. Excuse me just a second. Ajay has got a cold, and I think he gave it to the rest of us. You'd have to look, I guess, at the individual case, case-by-case basis. You can see maybe an individual player that goes bankrupt; maybe there is not sufficient way to get that plant up and starting. If you got a major player that goes bankrupt, there may be a way of restructuring those plants to get them back in operation.

Question could be how long does that take during that process? Are they down for a few months, a couple of days, do they not go down at all? So it's a difficult question to answer. But we are seeing again with these economics, in particular with people that have sort of got on the wrong side of a hedging decision, we are seeing some production coming offline.

I think no matter what happens, we will see some capacity coming offline; but it may not be for very long. And that's one of the reasons I think the marketplace is going to continue to be choppy. Because with thin margins people could come offline, and so if they come off, the markets tight, we should see a corresponding increase in price, brings margins back.

And the question is, how fast do they come back on? Do they have the cash to do it quickly, or is it going to take longer? And that is sort of an unknown. And that is why I think we will see some choppiness where margins may arrive for a while and then disappear again and come back and disappear.

Joe Gomes - Oppenheimer

Okay.

Ajay Sabherwal

The plant takes $0.10 to $0.15 of working capital. If you are not making $0.10 to $0.15 and you are facing bankruptcy, you might shut it down. Then when it comes back again, you're not going to turn it up again the day it goes above $0.15. You need some sustainable margin before that happens. So it is quite conceivable you see a massive disruption in supply.

Joe Gomes - Oppenheimer

Okay. Ajay, I was wondering if you might be able to talk a little bit more about freight costs, seeing as what is going on here so far in this quarter. If you might be able to talk a little bit, if you are still seeing them come off.

Ajay Sabherwal

I didn't catch that.

Ron Miller

What the freight cost is, are we seeing freight cost come off for the fourth quarter? I think the fuel surcharges are coming down.

Ajay Sabherwal

And we are going to tighten in terms of inventory and supply lines and whatnot, but I don't want to give a prediction just yet.

Ron Miller

Yes. There are several factors when it comes to freight. The vast majority of the freight is variable, so that is the freight itself. Freight surcharge is sort of related to the oil prices. Those are coming off. But really the largest piece of it is the footprint. How many tank cars are we shipping to the East Coast or the Gulf Coast, versus how much we are selling in the Midwest? If we do sell more FOB, that might affect the freight, so there are many factors.

Ajay Sabherwal

Plus the volume. If there are more substantial supply disruptions in the ethanol space, then you have fixed overhead against lower volume. So we have got to assess all of that.

Joe Gomes - Oppenheimer

Okay. And given the fact that gasoline is now less than ethanol, you guys increase the amount of denaturant you are using?

Ron Miller

That would be the economic decision, yes.

Ajay Sabherwal

Though as yet, we have not done so. Again, we watch that carefully.

Joe Gomes - Oppenheimer

Okay, thanks.

Operator

Your next question comes from the line of Chris Shaw of UBS. Please proceed.

Chris Shaw - UBS

Hi. Good morning, guys. How are you doing?

Ron Miller

Hi, Chris, how are you doing?

Chris Shaw - UBS

Good. There have been some references to other producers, and hedging, and the possibility of more messing up their hedging and taking capacity offline. But what kind of confidence can you give us that you might not be one of those victims of bad hedging and have to do the same?

Ron Miller

Well, I think, if you look at the press release, we very much spell out our positions that we have to-date. So I would think that would give some comfort that we haven't made a huge bet the wrong way. I mean, I would just go through the positions that we have.

Ajay Sabherwal

We want to say, we've had our share of challenges, as you well know. So what we have tried to do is derivative positions, you have to mark-to-market with cash every day. So in a tight liquidity situation, you want to avoid derivative positions just for that reason alone. And this is what we are doing. We aren't entering into virtually any new ones for that reason.

Then there is a secondary aspect of whether you called it, your view is incorrect. We have tried that. We have some ethanol sold forward at fixed prices. We have some co-product sold forward at fixed prices as well. So there is an offset to the corn that is purchased at fixed prices. There is a mismatch at the moment. There is a little bit more corn purchased than there is ethanol and co-product sold.

But that was a significant gain through the first six, eight months, and a little bit on the opposite side for the next three months. But derivative positions are what cause the major cash outflows and we are avoiding them completely.

Ron Miller

Also, Chris, one, as you look at the markets this year, and if you track spot ethanol and spot corn, you will see the correlation is much stronger this year than we've had in past years. It's probably the function of the supply/demand and the supply coming out. So we are trading more on corn price than we are on fuel price, on gasoline price.

As you know, we've indicated we are heavily skewed on our contracts toward the spot market on the ethanol side. So that would tell someone that if your ethanol is following corn that you are probably better off staying in the spot markets, because they are more correlated at this point in time and probably for the near-term, given the continuation of the supply/demand dynamics.

Chris Shaw - UBS

Yes, I understand that. So that actually brings up the question then, it looks like if so much of your ethanol in the future will be spot based, and you've got a lot of forward corn contracts , if I do the calculation correctly, it was only maybe like 40% of it was, you had a derivative contract against a short or something.

So I mean you have already locked in some of that, maybe 60%, well, for 60% of the corn you have locked in is fixed it seems like. So if ethanol moves against you, isn't that an issue, or am I reading that wrong?

Ajay Sabherwal

No, that is an issue. We use about 18 million to 19 million bushels at the moment a quarter. And we have about 8 million to 9 million bushels where we don't have short futures against it. Most of it is in Q4 and there is another million odd bushels in Q1. It is all laid out in the press release in that table.

So yes, on those bushels which we have purchased at about where current markets are, that is an issue. That helped us over the course of the first six to eight months; hurts us in the next three, four months. Now, the rationale was corn and ethanol were decoupled for most of the history. And we took a view on corn which benefited us quite a bit for a period of time.

For this next few months, it doesn't. Going forward, as Ron explained, the two are relatively linked, so we don't see a reason to take one view one way or the other.

Chris Shaw - UBS

So some of sort of hedged corn going into the fourth quarter was done before the correlation sort of developed?

Ajay Sabherwal

Correct.

Chris Shaw - UBS

Okay.

Ajay Sabherwal

That's early in the year.

Chris Shaw - UBS

That makes some sense. All right. And then curiously, as of the end of the second quarter, I thought your marketing volumes would have been higher this quarter. Was that because people took time off? Because at the end of the second quarter, I think you said your run rate would have suggested you would have done about 135 million gallons, but it came in a little less than that.

Ajay Sabherwal

We had the beginnings of shut-in, yes.

Chris Shaw - UBS

Okay. So that it did impact. And then did the new capacity from your marketing alliance start up later in the quarter? Is that what also affected it?

Ron Miller

(inaudible).

Ajay Sabherwal

All of the above.

Ron Miller

Yes.

Chris Shaw - UBS

Okay. Just on the tax rate, is 42%, there is something unusual there? Or would you expect it to come back down when you are more profitable?

Ajay Sabherwal

No, I don't think, it's in the vicinity of what we should see in the high 30s, low 40s.

Chris Shaw - UBS

Okay, great. Thanks guys.

Operator

Your next question comes from the line of Jeff Osborne of Thomas Weisel Partners. Please proceed.

Jeff Osborne - Thomas Weisel Partners

Great, guys. Most of my questions have been answered at this time. But, is there any sense on what kind of minimum cash level you view that you need to have on hand, Ajay, to run the business? How should we think about that, especially as it relates to that $0.10 to $0.15 working capital needs that you talked about?

Ajay Sabherwal

Jeff, in our case now what it hinges upon is the new construction, what the base of such new construction and what the payments related to that new construction are going to be. It hinges on that equation for us right now predominantly versus the run rate on the business, because that is where the cash is going. And we are working every option in that regards.

So, if you put that aside, though, you certainly should have your working capital and more. So that would be the correct way to do it. In that case, we have a credit revolver. You don't really necessarily have to have the cash on the balance sheet. You have a credit revolver for that purpose. The reason we funded our credit revolver is there was nervousness about the banking sector, so.

Jeff Osborne - Thomas Weisel Partners

Makes sense. I mean I may have missed it, but could you just run through again. I thought you said you had 49% corn locked up through December. But then I thought the release said 39% at $5.25. Can you just run through those stats again?

Ajay Sabherwal

Yes. Instead of doing the percentage, what I would request you do is if you take the table at the end of the press release; it takes you through, the 49 may relate to another percentage. The table at the end is the correct way, where you take the physicals and the short, subtract the physicals from the short, or subtract the short from the physical, take that number divide by about 18.5 or 19 million bushels, that is the percentage.

Jeff Osborne - Thomas Weisel Partners

Okay, thanks much.

Operator

Your next question comes from the line of Gary Stromberg of Barclays. Please proceed.

Gary Stromberg - Barclays Capital

Hi, good morning.

Ron Miller

Good morning, Gary.

Gary Stromberg - Barclays Capital

I just wanted to drill down a little bit on liquidity. What is the borrowing base or the size of the credit facility today? And do you anticipate that will change as pricing comes in and inventory comes down?

Ajay Sabherwal

We talk to it at the end of the quarter. We don't have auditor certified numbers on a daily basis, so it's better to talk at the end of the quarter. At the end of the quarter, we lay out, it's a $200 million credit facility subject to a borrowing base made up of some funding, some PP&E in percentage of inventory and receivables, subject to a number of reserves, and LCs.

The last $50 million you can draw only if you are above a certain FCC ratio. Today, we are above that FCC ratio. But if we continue to spend in the manner that we are planning to spend, plus margins remain weak, then that FCC ratio we expect to be below it. Therefore at some future date, we have said we don't expect to be able to draw the last $50 million. So that is the notional.

Of course, as prices come down for ethanol and corn, the value of inventory and receivables come down, which then reduces the amount that you can borrow, offsetting that, of course, is that your working capital requirements come down, in our case substantially so, because not only do we have a production business, but a marketing business. So there are a number of pieces in this equation that you put together to get to an answer.

Gary Stromberg - Barclays Capital

Okay. So the $132.9 million, that includes the $50 million that you don't expect to use?

Ajay Sabherwal

Yes, put it this way. Clearly, we could have drawn the $132 million at the end of the quarter because our FCC ratio is north of the 1.1 times on a trailing 12-month basis. It is as we continue to build the plants and a certain amount of CapEx related to the plants, the last $75 million gets counted towards or against the FCC ratio. We then don't expect to be able to meet this ratio. Also, the margins affect it as well. But as of the end of the quarter, we were not in violation of the ratio and could have drawn that money.

Gary Stromberg - Barclays Capital

Okay. Then just on with the build-out of the facilities. Is there any ability to delay further into 2009 the spend rates? And then number two is, can you break out approximately over the next three quarters, what that capital expenditure looks like? I know you gave a total number, can you give us percentages?

Ajay Sabherwal

What we have done is we have given our current position, our current estimations, and we have clearly said we are working on all the options. It would be premature to say something before you worked up the options.

Gary Stromberg - Barclays Capital

Okay. So the $110 million that is remaining to be spent, can you give us some sense of how that breaks out over the next three quarters?

Ajay Sabherwal

It would be a little bit more in Q4 and Q1 and a little bit less in Q2, if we were to complete at the current schedule.

Gary Stromberg - Barclays Capital

I see. Okay, thank you.

Operator

Your next question comes from the line of JinMing Liu of Ardour Capital. Please proceed.

JinMing Liu - Ardour Capital

Good morning.

Ron Miller

Good morning.

JinMing Liu - Ardour Capital

I have a question regarding your marketing alliance. Can you give us some idea what is an annualized capacity of your marketing alliance right now, and what will be the expected volume for next year?

Ajay Sabherwal

I think we laid that out, didn't we? We said 600 million gallons annualized at the moment.

Ron Miller

Right.

Ajay Sabherwal

And there's a couple of hundred million gallons more coming on. What we cannot accurately project is how many people shut in and what economics affect them. And we have clearly said that that is occurring in this industry, and our marketing alliance is no exception.

JinMing Liu - Ardour Capital

I see. Actually I've just got one more question left here. What is the interest rate on your newly borrowed $60 million?

Ajay Sabherwal

It is LIBOR plus 1.75.

JinMing Liu - Ardour Capital

Okay, thanks.

Operator

Your next question comes from the line of David Woodburn of ThinkEquity. Please proceed.

David Woodburn - ThinkEquity Partners

Thanks for taking the question. I guess let me be the first to congratulate you guys on having a working hedging strategy, at least so far. Ron, you have been making ethanol for a couple decades now. So can you give us some examples of some of the worst times that Aventine has been through before? And how bad did it get? Did you guys shut down for how long? And do some of those examples still potentially apply today? Or is the market so much bigger and more competitive now that really history plays no example?

Ron Miller

I think history probably does play some example. I would have said there is probably a couple times we should have died as an industry. I think back to 1986 when Sheikh Yamani drove the price of crude down about $9.50 a barrel and I think gasoline was selling for $0.29 and trying to sell ethanol in that kind of environment was pretty interesting.

We actually never did shut down in that environment, although we were at that time owned by Texaco and Corn Products. We never had to borrow any money from them, but we were able to suspend the dividends to them and basically get through.

The next crisis, if you will, sort of occurred about 10 years later when corn shot up to $5 a bushel, because back in those days the government controlled the price of corn by limiting production, by shutting in land on a periodic basis. They shut down about 25% of the land, and then there was a drought. So we had a corn problem. And that was the only time we actually ever did take an extended outage. We were down about six weeks at our Pekin facility.

It had more to do with not being able to get corn than anything else. But we were able to keep our markets supplied during that period of time. We lost a little bit of discretionary demand as an industry about that time. About 30% of the demand dropped, but it was all discretionary blending.

Then sort of post that event, we saw $10 oil again in the late '90s, with the Asian meltdown, and so those two periods of time were very difficult. And other than the one six-week outage we took at Pekin, we never really did a shutdown operation. Today, you know, quite frankly, the fundamentals aren't all that bad. The price of oil is much higher. The price of corn, although we saw some high prices this summer, I think fundamentally is cheaper than oil.

I think the thing that has changed my mind in the last 20 years is that the fundamental cost of carbohydrate energy is going down versus the cost of fossil fuel energy is going up. I think it's for a very good reason. You look at genetics in corn today, we are producing much more corn per acre than we ever have before. We are a going to have a second probably record crop, second-highest level crop ever this year. And we had some really lousy growing conditions early in the year, but the crop has been very robust.

You talk to Monsanto and others, and they are going to see a doubling of yields in the next 20 years. And so what it essentially means is that my finding cost, if you use that petroleum term, is going down because I'm getting more output per unit of land, whereas in the case of oil, most of the cheap oil has been found, and so new oil offshore, tar sands, and things like that.

So fundamentally when I look at this period of time versus over the last 20 years, I don't think we are in nearly as bad a shape fundamentally as we were. Now, in terms of the pain the industry is experiencing right now, it is probably more intense, which I think mostly has to do with the industry itself. We had a lot of people that jumped into this business in 2006 when margins were good. I think a lot of people thought they would make a quick dollar and sort of spend the business out. That is not happening.

I think there will be a lot of pain in this industry. But quite frankly, at the end of the day, I think it will be a healthy period because we will be able to structure the industry probably a little more competitively, and I do see some consolidation happening. I think the fundamental benefit is that we will have the infrastructure in place, steel in the ground and operating to really trans this to more ethanol blends.

So I think while the near-term looks kind of ugly, the future looks very bright. And I would say look at history, but also understand that today, and the lessons that we learned as a company through our history I think are helping us today. You know watching our cash, we have always tried to maintain a little stronger balance sheet than some of our competitors. Obviously liquidity is still an issue. But compared to others, we are sitting in pretty good shape. But that is the experience of the last 20 years of going through some of those down cycles.

David Woodburn - ThinkEquity Partners

And then you mention consolidation. I mean compared to a lot of other industries, for instance, pharmaceutical industry where I used to spend a lot of time, here I don't see big cost synergies, big cost savings. So it seems like the big driver is just access to capital, access to cash for those that are cash challenged.

Ron Miller

Yes, I would agree with you. I think in terms of the plants themselves, they are somewhat autonomous. The scale that you perhaps see in other industries in the manufacturing side, I don't see as prevalent here. Now, in some cases, if you look at an ADM plant, they have very large-scale facilities. Essentially our organic growth plan is sort of modeled very similar where eventually we will have 250 million gallon plus facilities, which require you to create a corn flow into that facility, instead of sitting in the middle of a cornfield somewhere.

So, you can get some synergies. But just consolidating I don't think gives you much in the way of synergies in terms of the plants themselves. You do get very significant synergies in SG&A cost and in logistics and distribution costs, you can. By putting volumes together, you do save. You can use the gallons where they are most effective given the location. It also reduces fragmentation in the industry, which I think is very important, because we are selling into what we would perceive as a highly concentrated industry.

Now I'm sure if you are in the oil industry and you look at all the national oil companies around the world, it's very fragmented. And I can understand of course their perspective. But in the US gasoline market, there are probably eight or 10 very large players; and we have 100 or so ethanol players. A lot of us trading companies out there and stuff like that. And so that fragmentation, I think, will hurt the ability to get more capital into the business. So the consolidation will reduce the fragmentation, which I think will be positive for the industry.

David Woodburn - ThinkEquity Partners

All right. Thanks a lot, Ron.

Ron Miller

You bet.

Operator

Ladies and gentlemen, this concludes the question-and-answer session. I would now like to turn the call back over to Les Nelson for closing remarks.

Les Nelson

Thank you, Sandy. This concludes our conference call for today. If you have any other questions, feel free to give me a call. We would like to thank you again for your participation. Have a great day.

Operator

Thank you for your participation in today's conference. This concludes the presentation. And have a great day.

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Source: Aventine Renewable Energy Holdings Inc Q3 2008 Earnings Call Transcript
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