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Company (NASDAQ:MGPI)

MGP Ingredients Q1 2008 Earnings Call

May 8, 2008 10:00 a.m.

Executives

Steve Pickman – Vice President Corporate Relations

Tim Newkirk – President and CEO

Brian Cahill – Executive Vice President

Analysts

Steve Denault – Northland Securities

Jonathan Lechter – Sidoti

Tyson Bower – Wealth Monitors, Inc.

Operator

Good morning, my name is Shay and I will be your conference operator today. At this time, I would like to welcome everyone to MGP Ingredients fiscal 2008 third quarter earnings conference call. (Operator instructions) It is now my pleasure to turn the floor over to your host, Steve Pickman. Sir, you may begin your conference.

Steve Pickman

Good morning. I am Steve Pickman, Vice President of Corporate Relations at MGP Ingredient. It is my pleasure this morning to welcome you to our third quarter conference call. In just a few moments, Tim Newkirk, our President and CEO will present highlights and results of activities pertinent to our quarter and year to date performance. Also joining us this morning are Robert Zonneveld, Vice President of Finance and CFO and Brian Cahill, Executive Vice President of our distillery business segment.

Before Tim begins and prior to taking questions this morning, I need to note that any forward-looking statements we might make today are qualified in the following respect, the right number of factors in addition to those already mentioned in our earnings release that could cause our actual results in any guidance to vary materially from expectations.

Additional information about these factors may be found in report that we filed with the Security and Exchange Commission, including our annual report and annual form 10-K and quarterly report and 10-Q. I would also like to mention that this conference call is being webcast and is open to analysts.

Now I would like to turn the call over to Tim.

Tim Newkirk

Thanks Steve. Good morning everyone and thank you for joining us. As you can see there were a number of items that impacted our reported earnings for the third quarter in first nine months. We will be glad to answer your questions on any of these matters following our prepared remarks.

Before I provide a high level review of our results, I want to offer you my perspective on things. MGPI is becoming a more nibble competitor. By that I mean we are putting a greater emphasis on a smaller number of large scale opportunities. As part of this exercise we are also strengthening our financial planning and reporting systems.

We know that the actions we have taken related to the impairment of assets and the write downs of inventories have had a negative impact on our reported earnings over the short term. However, we feel that these steps create a better framework for creating and measuring economic value over the long term as we execute our strategy.

With that in mind, I would like to talk about our results. We achieved record sales of 106.7 million, a gain of 14% over one year ago. Our ingredient solution segment produced most of the gains with increases in both unit volumes and pricing.

For the quarter, we reported a net loss of $6.6 million or a loss of $0.39 in diluted earnings per share. This compares with net income a year ago of $2.1 million or $0.13 in diluted earnings per share. The loss we reported in this quarter included a one time impairment charge of $4.9 million net of income tax, which equated to $0.29 per share.

As I noted in our news release we are continuing to transform MGPI into a company increasingly focused on the innovation and commercialization of our unique product technologies. This requires a considerable amount of evaluation of our business fundamentals, opportunities, and objections.

In the process of reviewing our pet business, we took the opportunity to further rationalize our manufacturing footprint. This involved the write down of plant and equipment associated with the manufacturing of pet related products and certain of our wheat textured wheat proteins that in the future we intend to produce through third parties. Our distillery operations are running near planned combined capacity and are therefore positioned to benefit from improved pricing in both the food grade and fuel grade alcohol areas.

As you know, we have been working to achieve the ideal configuration between our intellectual capital and our fixed assets. To this end we determined that we could further reduce our total manufacturing base and at the same time bring greater alignment with our business strategies.

Excluding the impairment charge however, we still reported a net after tax loss from operations of $1.7 million due to losses in both our ingredient solutions and other segments. Higher wheat costs contributed substantially to the $4.6 million pre-tax loss in ingredient solutions, this was despite a 49% increase in segment sales resulting from volume growth and strengthen pricing.

Specialty ingredients were up near 25%. We also benefitted from higher sales of vita-wheat gluten and pricing compared with a year ago. But this was not enough to offset wheat costs, which increased more than 86% over the prior year. This is just one more reason we are driving our ingredients product mix to higher value applications that will have the benefit of reducing the impact of grain prices on our cost of goods sold.

Let me say a few words about the results in our segment. Biopolymer resin sales are small but growing. Even at these levels we are generating a positive gross margin. But it is still too early to determine our next course of action. In pet products we face a continuing uphill battle. Demand for premium pet treats has declined as the economy has weakened.

Under these conditions we do not see the prospect for producing our protein-based resin volumes to levels required to reach profitability. With most of the operating loss in the other segment this quarter stemming from pet products; we are reviewing strategic alternatives for this business.

You can understand the sensitive nature of these discussions so I am therefore unable to offer you more details. Suffice it to say we are determined to reverse the drag on MGPI's total operating profit.

Moving on to distillery operations, third quarter sales improved by 6% compared to the same period a year ago. The higher volume in pricing in food grade alcohol were offset by the lower volumes in fuel alcohol which I would like to remind everyone accounts for only one-third of our overall corporate revenue.

Our earnings in this segment have continued to be impacted by higher corn costs. The per bushel cost of corn averaged nearly 22% more than the prior years third quarter. Pre tax income in the distillery product segment declined to $3.4 million compared with $4.2 million in last years third quarter.

This is a good time to talk about the non-cash gains we reported in the quarter from the mark to market valuation of our commodity positions. Please refer to the press release in 10-Q for more details regarding our derivative transactions. Given the commodity price volatility and the associated complexity in cost, we have decided to discontinue hedge accounting in favor of marking to market derivative instruments with the adjusting amounts recorded in current earnings.

You will note from the news release that if these derivatives had been designated for hedge accounting the company would have recognized an additional loss of $1.5 million net of taxes or $0.09 less than diluted earnings per share for the third quarter. With higher prices for both raw materials and finished goods, mark to market adjustments also added $9 million to the total increase in our inventories.

Staying with the income statement, our increases in SG&A for the quarter and nine months versus a year ago are in line with a previously communicated expectations. These increases reflect a number of items including higher legal and accounting fees; higher depreciation expense related to our new technical innovation center and corporate offices and increased salaries in most departments due to additional staffing.

The recent personnel hires in internal promotions reflect our intensified focus in a number of areas to support our long term growth objectives. These include innovation in commercialization as demonstrated by the nearly 25% year over year third quarter sales increase in specialty ingredients, financial management, and continuous improvement methodologies such preparations for our ISO 14001 and OHSAS 18001 certifications.

For the year to date cash flow from operations amounted to $2.9 million. Our inventories at quarters end were significantly higher due mainly to higher commodity prices and mark to market adjustments. Capital expenditures for the nine months were $4.3 million compared with $16.8 million last year.

For the current fiscal year we are still projecting capital expenditures in the range of $9 to $10 million or about one-half the amount we spent in recent years. This is more typical of sustaining capex spending until such time as the board approves a new capital project.

As also announced today, on May 5, 2008, the company entered a new borrowing base secured credit agreement. This credit agreement replaces the company's former $30 million line of credit agreement and subject to borrowing base limits provides for a $40 million three year revolving credit facility and a 425 million five year term loan facility.

The credit agreement contains accordion features which permit the lenders and their sole discretion to agree to a one time increase in the revolving credit commitment of up to $20 million and a one time term loan increase of up to $10 million.

Now before we open up the call for your questions I want to reiterate that we have two basic leverage to drive our future growth: Specialty ingredient solutions and food grade alcohol. Our fuel grade alcohol is expected to provide long term cash flows as ethanol and corn pricing becomes more favorable. However, it will be the other two areas I mentioned where MGPI is making a concerted effort to find new revenues and capture them profitably.

This concludes our prepared remarks. Operator we are now ready to open the call for questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question is coming from Steve Denault from Northland Securities.

Steve Denault - Northland Securities

Walk me through; I am assuming from an ethanol standpoint you are going to remain totally on contract or mostly on contract in moving forward.

Brian Cahill

I think going forward right now when we look at the food grade area of our ethanol business we continue to work with long term customers in that area, some of that being longer term contract and some of that just being month to month regular business we do with them.

In the fuel ethanol business the trend has been in the last six to twelve months to go less long term business and more spot business. And that is kind of where our position is right now although as opportunities present themselves long term what we can lock in margins we will do that.

Steve Denault - Northland Securities

And I know you guys entered the March quarter I think maybe from a wheat perspective maybe 25% hedged. Where do you stand now as you look out over June and September quarters?

Brian Cahill

As we are finishing up our fiscal year we basically have our wheat position for the rest of the year through the end of June. As we get into the new crop we have some position going into first quarter and second quarter next year and kind of looking where the market is now versus where it was on our last call it appears wheat is becoming more favorable.

And also being more of a world crop. A lot of other areas in the world are seeing some favorable conditions along with the high prices will generate a lot of plannings in world wide.

Steve Denault - Northland Securities

Does that mean you locked in your needs at higher than the 750 level that you were hedged at in the December quarter?

Brian Cahill

The new crop did not see the levels at the old crop. We don't give specific dollar amounts but I guess where we are at now is below current market.

Steve Denault - Northland Securities

Okay, for both March and June quarter. Or for June and September quarter I should say

Brian Cahill

More for going forward in the next fiscal year. The current quarter we are in we are living with high prices most of this quarter.

Steve Denault - Northland Securities

But you put on these hedges for fiscal '09.

Brian Cahill

Yes, that is correct.

Steve Denault - Northland Securities

Where do you stand on corn?

Brian Cahill

Well similar for the rest of the fiscal year corn we have got positions on there. As we get into the next fiscal year first quarter we have some position there. And as time goes further out just in our hedging program the way it works you have less and less. As you go forward in the fiscal year next year.

Steve Denault - Northland Securities

So I know I think I remember you saying for the March quarter you had 75% of your needs locked in at the 375 level. What do you have locked in for June?

Brian Cahill

Well we have locked in above levels for June basically we have locked in pretty close to where we were at the third quarter I think. Probably slightly higher than that. I do not have an exact number but June quarter is definitely going to be higher than March quarter just because the market has been moving up during the year.

Steve Denault - Northland Securities

Okay. The vital wheat gluten how did that do in the quarter

Tim Newkirk

Volumes remain pretty consistent with where we have run for the first six months of this fiscal year. Obviously there has been with Europe having a terrible wheat crop last year and Australia having two failed crops in a row there has been some upward pressure on the U.S. market because supply has fallen back over where we might have seen imported gluten in our FYO6 and FYO7 areas. So the gluten market on a demand basis is pretty strong.

Most of the contracts were done before we took off and went to the levels it went to but there will be an opportunity for us to do some repricing for July forward and then of course the majority of our product will be repricing later this fall. But the demand, which is the important thing, is staying pretty strong.

Steve Denault - Northland Securities

Okay. With the impairment of your pet food related assets in the March quarter, how does that change the profitability of your ingredient division on a go forward basis, if at all?

Tim Newkirk

Remember that is in the other category, that is not in the ingredient segment. Second of all practically what is saved in the short run is depreciation. What you need to understand though is that is really the first step that we are taking in really getting our asset base aligned with where we want to go strategically. So as we indicated in the remarks and the release we are looking at all of our strategic options for that business. And that really is about all I can say, at least in the short run.

Steve Denault - Northland Securities

Okay what was the depreciation associated with that write down.

Brian Cahill

The depreciation associated with that was probably $700,000 or $800,000.

Steve Denault - Northland Securities

Okay perfect. Thanks guys.

Operator

Thank you. Our next question is coming from Jonathan Lechter [ph] from Sidoti.

Jonathan Lechter - Sidoti

You said in the release should wheat prices decline to the second quarter levels you would expect better ingredient results. What kind of prices do you have in the second quarter?

Tim Newkirk

Wheat prices in the second quarter would have been, you have to kind of rewind the clock, would have been somewhere probably in that $8 to $9 range. High 8's somewhere around there. If you kind of go back and remember when those bushels would have been bought.

Brian Cahill

That is a good number in the $8 to $9 range. Again you have two factors in wheat. It is the futures price and the protein premium you pay based on the level of protein we are trying to extract for our operations.

Tim Newkirk

And Jonathan I can't overstate the importance of realizing those two components to get to the final wheat price because at the end of day that is what is drove the Minneapolis market to $25 on a synthetic trade and in the $20 in the real trade.

What really has been adding a tremendous amount of volatility outside of just the futures was the protein of the wheat. So we had had some 12 and 13 protein wheat premiums in the multiple dollars a bushel range on top of the futures price.

So that is why you can't just take a number if we say $8 to $9 and look at a futures price and say okay that is what it is. And we won't know. That is always the other big trick in this business. We won't know until we get to new crop and what the new crop protein is before we really know what those premiums are. But just in general if you think about what it is delivered the mill somewhere in that $9 range.

Jonathan Lechter - Sidoti

So we just can't look at the current prices which look like they are a little over $8 and say you will be profitable going forward?

Tim Newkirk

Well you are looking at a futures. It is reasonable to assume, obviously that is a much better level than what we just went through. But again until we really know where new crop protein levels are going to be and what the associated premiums. There is trade out there. There is liquidity out there. You can see it.

And I would say those numbers for some protein premiums are what we would have seen historically so there is no big surprise out there from that perspective. So if you were looking at example an $8.00 market on the futures basis you are probably going to be looking at $0.60 to $0.70 for a protein premium to get 13 protein and so that kind of gives you some feel maybe. Does that help?

Jonathan Lechter - Sidoti

A little bit.

Tim Newkirk

I don't know how to explain it much clearer. It is a combination of all those things and so you know the wheat just came through in Q3 obviously was going to be dramatically higher than that and Q2 levels like I said delivered our mill where somewhere in the $8 to $9 range.

Jonathan Lechter - Sidoti

Moving on to the pet area. How much of the other loss was in this quarter related to the pet initiative?

Tim Newkirk

In the remarks we talked about the majority of the loss in the other segment came out of the continuing operations of the pet business.

Jonathan Lechter - Sidoti

Was it three quarters of it?

Tim Newkirk

I would say probably at least three quarters of it.

Brian Cahill

And one thing to remember with the impairment of the assets it is really something we look at on a quarterly basis but these assets are part of a Kansas City sale so the impairment is for our Kansas City overall facility not just related to our pet business.

Jonathan Lechter - Sidoti

Okay. So I guess potentially could you sell these assets. Is that a possibility?

Tim Newkirk

We are revealing all of our strategic alternatives at this point in time.

Jonathan Lechter - Sidoti

I mean potentially you could decide to keep them as well, is that a possibility as well?

Tim Newkirk

Yes, we could. We could decide to sell, we could decide to keep them. That is correct. And that is part of, we are not trying to be coy, but that is part of where we are with this in reviewing all of our strategic alternatives. And that means literally all of them.

Jonathan Lechter - Sidoti

Thank you.

Operator

(Operator instructions). Our next question comes from Tyson Bower from Wealth Monitors Inc.

Tyson Bower – Wealth Monitors, Inc.

Thank you. Going forward gentleman it looks like with S&L increasing hopefully corn will come down once the planting season gets done. We could have better days ahead which is what we are all hoping for. Can you provide an inventory breakdown in regards to raw materials and products?

Brian Cahill

Inventory breakdown for raw materials, finished goods is about $32 million. Raw materials is about $15 million. So total finished good is $47 million. We have about another $11 million in ingredients maintenance materials and those kind of things and there is a $9 million U.S. GAAP hedge accounting with a total of 67.

Tyson Bower – Wealth Monitors, Inc.

Do you provide a further breakdown of the finished products?

Brian Cahill

No we don't.

Tyson Bower – Wealth Monitors, Inc.

Okay. On the pet division with the 8.1 million write down I guess is how it is referred or impairment change, is there any remaining value left on the balance sheet?

Brian Cahill

Yes there is. I mean again just to clarify a little bit. It is a Kansas City facility which is also used for food ingredients and also used for pet. It is actually half and half. There is a wall running right now the middle of it.

So there is still, because there are some value left for that equipment et cetera. And there is value for the building et cetera. So we wrote it down from basically on accounting side from what future cash flows were looking like but yes there is value left.

Tyson Bower – Wealth Monitors, Inc.

Do you have that number and what the remaining value on the balance sheet is?

Brian Cahill

No we are not going to be able to disclose that.

Tyson Bower – Wealth Monitors, Inc.

Okay. On the distillery of revenues you mentioned that you brought some products out of inventory. Of that revenue that was reported how much of that was just out of your normal operations during the quarter as opposed to taking volumes out of your inventories.

Tim Newkirk

Just so we are pretty clear the sales rate, and the reason we said that was so that everybody kind of had an idea. The sales rate is within about 98% of what our maximum name plate capacity is on the sales side. So I would say there was maybe 5 or so percent of that volume that we sold came out of inventory versus what we actually produced within the quarter.

Tyson Bower – Wealth Monitors, Inc.

It also appears you have made greater strides in being able to produce more food grade alcohol and having that converge in possibilities with the fuel grade. Where do you stand on that endeavor and do you hope to make further strides in being able to have the ability to switch production from one to the other.

Brian Cahill

Yes I think we have stated strategically our long term goal is to increase our high quality alcohol sales and so we are continuing to build our sales in that area and continue to expand production in that area and also look at areas we can even increase our capacity further. So that is a big focus on us going forward is to get higher revenues and higher production rates into high quality alcohol.

Tyson Bower – Wealth Monitors, Inc.

In your press release verbiage it mentions on the food grade you are looking at other markets or being able to increase or going and seeking end markets for providing that product too. Are there areas you are not in currently that you can get in to or what is the intent of that statement?

Brian Cahill

Just to get into additional areas both working to increase business with our existing customers and looking at certain areas we have just not focused on. As we get more capacity we will be able to focus in those areas.

Tyson Bower – Wealth Monitors, Inc.

I am guessing by that response you are not going to detail what those are. Just a last item, there has been a lot of increased political rhetoric of possible rollbacks of alternative fuel mandates at least in the short term. What just is your opinion in regards to that kind of commentary of what impact that may have? Whether it is positive or may be adverse.

Tim Newkirk

Let me start specific to MGP and then we can kind of talk about the bigger macro or global issues there. Again, as we noted in our comments remember that fuel grade ethanol revenues are only about a third of our corporate overall revenues.

And that is an important point we want to get out. It is an important piece of our business but as I also indicated at the end of the prepared remarks it is not one of our what I would call strategic levers as we go forward. You are correct we have continued to focus on the food grade alcohol side and continuing to try and grow our presence there.

And in doing that it is literally is a zero sum gain for MGPI we will be reducing our participation in the fuel ethanol market. So that has been our strategy. That was our strategy when three years ago when there was extraordinary profit in fuel ethanol because we anticipated this.

And again this is not MGPI's first run through this cycle that the U.S. fuel ethanol business has seen over the last 30 years. We have been in the business that long and obviously we have seen this before and we anticipated it.

So we are prepared and we continue to execute our strategic plan. When we think about this on a macro level there is going to be a lot of pressure but at the end of the day math tells us that gasoline is less expensive at the pump because of ethanol being blended.

And we don't believe that fuel ethanol from corn or from grain is the answer but it is certainly a part of the overall answer toward reducing our dependency on foreign oil and keeping prices as reasonably as I can.

I mean you look at spot ethanol futures today and look at RBOB today and ethanol is trading $0.50 plus below gasoline. I mean so it is certainly making gasoline cheaper at a retail level. But there is a lot of political pressure.

Fuel ethanol has been political from day one so that is again why MGPI has strategically tried to focus on things in which we have more control which is the food grade alcohol side. Brian if you have any comments.

Brian Cahill

No that really. Really when you look and it is an economic question right now but definitely at current price levels fuel ethanol is keeping gasoline prices lower than if fuel ethanol was not out there. And even if you get into the food area and that could be a big debate but just generally a lot of the food price increases are related to energy not just commodities. So that really where I think we are at on that position.

Tyson Bower – Wealth Monitors, Inc.

Last summer we have the same situation where we had ethanol well below the rob level and then it gradually tried to converge and got much closer and then all of sudden now here recently gasoline has jumped well ahead or increased at an accelerated rate as compared to ethanol. Would you anticipate a conversation again or getting closer to historical trading of balances between the two?

Tim Newkirk

I think if you look back at any point in time there seems to be beginning to be a convergence and then a divergence and I think a lot of those sign waves going together and getting apart have to do with some of these big junks of capacity that are coming that we are already in various stages of completion.

You have also got to remember on blending side of the business we had to have the terminals come on and where those timings match we get convergence and where you get new supply ahead of new markets you begin to get a little bit of divergence but I think the overall trend and I would interested to hear Brian's thoughts too but I think the overall trend is probably going to be more convergence than divergence.

Brian Cahill

I think that is right. It is strictly become if you look historically at a supply and demand issue and when supply becomes more than demand you will see that discount widen and then as it gets more imbalanced you will see ethanol trade closer to gasoline. Even if you back historically two or three years ago typically it had a $0.30 to $0.40 premium to gasoline. So I think as things in balance you will see ethanol will get closer to gasoline prices.

Tyson Bower – Wealth Monitors, Inc.

Very well, thanks a lot gentleman.

Brian Cahill

Thank you.

Operator

Thank you we appear to have no further questions. I would like turn the floor back over to the speakers for any further comments.

Tim Newkirk

Okay well in closing we want to thank you again for joining us this morning. We look forward to talking to you later when we report our first quarter earnings. Until then, thank you and this concludes our call.

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