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MGP Ingredients, Inc. (NASDAQ:MGPI)

F4Q08 Earnings Call

August 26, 2008 11:00 am ET

Executives

Steven J. Pickman - Vice President - Corporate Relations and Marketing Services

Timothy W. Newkirk - Chief Executive Officer

Robert J. Zonneveld - Vice President - Finance and Administration, Chief Financial Officer

Brian T. Cahill - Executive Vice President - Distillery Products Segment

Don Coffey - Executive Vice President - Ingredient Solutions

Analysts

Steve Denault - Northland Securities

Jonathan Lichter - Sidoti & Company

Tyson Bower - Wealth Monitors

Tom Driscoll - Seacrest Investment

Operator

Welcome to the MGP Ingredients fourth quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to Steve Pickman, Vice President of Corporate Relations.

Stephen J. Pickman

It’s my pleasure this morning to welcome you to today’s conference call. Very shortly Tim Newkirk, President and CEO, will present highlights, results and activities pertinent to our fiscal 2008 fourth quarter and year-end performance. Also joining us this morning are Robert Zonneveld, Vice President of Finance and CFO, Brian Cahill, Executive Vice President of Distillery business segment, and Don Coffey, Executive Vice President of our Ingredient Solutions business segment.

Before Tim begins and prior to taking questions this morning, we need to note the following. Any forward-looking statements we might make today are qualified in the following respect: There are a number of factors in addition to those already mentioned that could cause our actual results and any guidance to vary materially from expectations. Additional information about these factors may be found in reports that we filed with the Securities and Exchange Commission including our annual report on Form 10K and quarterly reports on 10Q.

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.

Timothy W. Newkirk

I have a few opening remarks and then I will turn the call over to Robert for the financial discussion. We will then open up the call for your questions.

We started out the fourth quarter with high hopes that our rising input prices particularly wheat and corn would start to reverse direction. In fact, just the opposite occurred with July corn futures reaching all-time highs of over $7.50 per bushel in late June and May wheat futures reaching nearly $9.00 per bushel. This ended up impacting our fourth quarter numbers even to a greater extent than we witnessed in the third quarter. For the entire year the increased prices for corn and wheat as well as the price hike in natural gas had a significant impact on our annual operating costs. As we stated in our news release, corn prices in the fourth quarter of fiscal 2008 averaged over 44% higher, wheat prices more than 90% higher and natural gas prices nearly 3% higher than levels experienced in the prior year’s fourth quarter.

As explained in our news release based on United States Department of Agriculture data domestic corn production from this year’s upcoming harvest is forecasted at about 12.3 billion bushels. This figure is down 6% from last year’s harvest but up 17% above the 2006 harvest. Global wheat production is projected at nearly 671 million tons, an increase of over 60 million tons over the previous year. The anticipated increase in global wheat production and the forecasted size of the 2008 US corn crop has led grain analysts to expect some downward pressure on wheat and corn prices later this fall.

Since you have our earnings release, I am not going to spend time reciting all the quarterly numbers. We reported a net loss of approximately $10 million in the fourth quarter equating to a loss of $0.60 per diluted share. This was on a sales increase of about 3% over the year ago period. We have provided a table on page 2 of the earnings release that gives you the details behind the results. However I think it is worth repeating some of the highlights in this call.

Total ingredient solutions sales in the fourth quarter of fiscal 2008 increased by approximately $6.5 million or 31% compared to the prior year’s fourth quarter. Combined sales especially proteins and starches increased by $3.2 million or 25% during the quarter compared to the same quarter in fiscal 2007. These increases were due to both higher unit sales and improved pricing.

Total sales of distillery products in the fourth quarter of fiscal 2008 declined by approximately $4.2 million compared to the same quarter of fiscal 2007. However sales of food grade alcohol improved by $6.4 million or 26% over the prior year again due to improved volumes and pricing and reflecting gains in both beverage and industrial applications. Sales of fuel grade alcohol declined by 29% compared with a year ago primarily on reduced volumes. Sales of distillers feed the principal co-products of the alcohol production process increased by approximately $3.8 million or 49% over last year’s fourth quarter due mainly to improved pricing.

For all of fiscal 2008 sales in our ingredient solutions segment were up an impressive 49% over fiscal 2007 as the result of increased unit sales combined with strength in pricing. Higher unit sales and pricing drove record yearly revenues in the food grade alcohol area where our volume increased by 8% and average pricing by 6%.

I would like to say a few words here about how the actions we are taking built on our strategic initiatives are driving growth of our specialty ingredients and why we are excited about our prospects going forward. In the last year sales of our unique fiber-enhancing resistant starches were up 30% in volume and 40% in revenue. Our sales of specialty proteins were up 14% in volume and 36% in revenue, and our sales of textured proteins were up 15% in volume and 19% in revenue.

In addition to this progress we have started more than 300 new ingredient evaluations with our customers around the world. Consistent with our strategy 88% of these new evaluations are with our specialty ingredients, those with much better and sustainable margins than our heritage product. This is an example of our ingredient solutions growth strategy in action and how we are creating our future of serving our customers needs in the space where we can provide the greatest expertise and be the most effective.

Our financial results for the fourth quarter and fiscal year need to be reviewed in the appropriate context. Make no mistake, we are not offering excuses for reporting a negative earnings performance. But we want our stockholders to understand the industry dynamics that came into play, some of which are still in force. This will also help to explain our sense of urgency in taking the necessary midcourse corrections with our long-term strategy that are geared to increase revenues and cash flows while reducing risk and volatility.

As you know MGPI is the largest US producer of wheat proteins and wheat starches; we are among the leading US producers of natural food grade industrial alcohol; we are one of the three largest US producers of grain neutral spirits for beverage applications; and we are among the oldest producers of fuel grade alcohol. Given this strong business foundation we decided that we could create and sustain more stockholder value by putting our resources behind a smaller number of very large opportunities. We are already seeing the benefit of this approach in our ingredient solutions segment where we have narrowed the portfolio of products and where value, price and cost are producing a winning combination.

MGPI is the true wheat expert. There is no other competitor that can match our full capabilities for creating wheat-based ingredient solutions for the food industry. For example, our specialty cook-up starches can meet a variety of today’s formulation and processing challenges faced by food manufacturers. Our job begins when a customer faces a challenge or seeks opportunities to create new and/or enhanced products. For example, they need crisper coatings on fried foods, icing on bakery goods to stay moist but keep from melting, or cereal to stay crisp longer in a bowl of milk.

Demand for healthy foods drives our long-term opportunities. Our two key enablers are proteins and fiber with special attention on our unique line of Arise wheat protein isolants, wheat textured wheat proteins, and Fibersym and FiberRite resistant wheat starches. Companies are working at breakneck speed to develop new and differentiated products. On the other hand, the food industry is extremely competitive and as a result our customers are very cost conscious. That means they are tough on their ingredient suppliers. That’s why we have to fortify our efforts to be able to plan, budget and execute at a high level every time. The creation of product technology platforms was a major step in aligning our resources around the customer. We want MGPI to be the first call they make when they need a solution.

Let’s move on to distillery products. This is a business of scale economy. MGPI has an estimated annual capacity of approximately 130 million gallons of alcohol. For every bushel of corn we process we are able to produce 2.7 gallons of pure alcohol. Every $0.10 per gallon change in the selling price of alcohol can impact our pre-tax profits by approximately $13 million. On the cost side however every $0.10 per bushel change in corn impacts our pre-tax profit by approximately $5 million.

Our results over the 2008 fiscal year illustrate the impact of price movement in both selling prices and cost. We had record food grade alcohol sales in production. We did experience production shortfalls in our Pekin facility, which have since been corrected.

On the fuel grade side our results reflected lower units of pricing combined with record corn prices. Gross margins in this business declined by more than $32 million from the prior year with similar aggregate sales pricing. While the near-term outlook for ethanol is cautious at best, we see this important alternative fuel source contributing no more than roughly 30% of our total corporate revenues going forward. We recognize that our long-term opportunity for earnings growth from fuel grade alcohol will largely depend on commodity pricing and our efforts in hedging in price contracting.

As we have indicated on past occasions, our growth strategy in our distillery products segment is focused on the food grade alcohol area. As we continue to grow this part of our business along with initiatives and action plans to steadily grow our ingredient solutions segment, our percent of sales represented by fuel grade alcohol should gradually diminish. In the meantime having our fuel alcohol capabilities in place enables us to maximize our total alcohol production capacity when conditions warrant. This in turn provides us with the ability to optimize our ingredient manufacturing capabilities through our fully integrated processes. As we pursue new growth opportunities in food grade alcohol, our basic competitive strategy on the distillery side is cost leadership while supplying the highest quality alcohol in the world.

For all of fiscal 2008 energy costs accounted for nearly 18% of our cost of sales. As you know we are in the process of pursuing plans for the construction of a pull boiler cogeneration facility at our Pekin, Illinois plant. We currently are seeking a third party energy provider to fund, own and operate the facility. Based on the current price of natural gas, this project has potential to general significant annual energy savings if everything goes according to plan.

With that I want to turn the call over to Robert for more details on our financials.

Robert J. Zonneveld

I will focus my discussion on the key financial highlights since you already have the earnings release. The loss of $10 million reported in this quarter includes the one-time asset write-off of $1 million net of income tax. As you know this year we’ve reviewed and aligned our asset base to better reflect our business strategy. These write-offs have included both inventory and fixed assets. We believe at this point we have completed our asset review and do not expect to make additional write-offs. But we will continue to review our asset base to ensure that it’s appropriate to our strategy.

As we announced our fourth quarter results led to a breach of several financial covenants under the company’s credit facility. We have discussed our default with our banks. Though they could have terminated our ability to borrow or accelerated our debt, they have elected not to do so at this time and have continued to honor our draws under the credit facility. We’re discussing a definitive agreement with them and expect to enter one in the next few days. Under the contemplated agreement they have told us they will be increasing our revolving line of credit from $40 million to $55 million and we would be restricted from paying dividends and there will be a 60-day standstill period. During the standstill period they could review our commodity positions and hedging strategy and measure our performance under our new forbearance financial covenants that would set minimum adjusted EBITDA and tangible net worth requirements. After the standstill period the bank can decide whether and how they want to proceed.

For fiscal 2008 the company reported a net loss of $11.7 million or $0.70 in diluted earnings per share on sales of $393 million. This compares to net income of $17.6 million or $1.04 for diluted earnings per share on sales of $368 million for fiscal 2007.

The key drivers for defining the decline in profitability were a decrease in gross margin of $9 million in ingredient solutions, $32 million for distillery products, and $1 million for the other segment. This decrease was principally attributed to higher wheat prices of 38%, higher corn prices of 63% for the year, while natural gas averaged 14% higher than the previous year and overall ethanol pricing compared to the previous year.

This concludes my remarks.

Steven J. Pickman

We’re now ready to open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Steve Denault - Northland Securities.

Steve Denault - Northland Securities

What percent of your corn input needs in that June quarter had you hedged?

Brian T. Cahill

We roughly hedged about 50% of our corn needs in the quarter.

Steve Denault - Northland Securities

At what levels were they hedged at?

Brian T. Cahill

They’re done at different levels. They were hedged below the period of what the average price was. I believe the average price for the quarter at the Chicago Board of Trade was about $6.30 and they were hedged at below those numbers.

Steve Denault - Northland Securities

You make references to percentage increase year-over-year, what was the average corn cost in the quarter for you guys?

Brian T. Cahill

We don’t give the numbers of the costs. The increase from third quarter to fourth quarter in corn costs was about 28%.

Steve Denault - Northland Securities

So what do things look like in terms of hedging in the September quarter?

Brian T. Cahill

If you’ve been following the corn market, obviously the end of June we hit record highs approaching $8.00 on new crop corn, have since seen those approach $5.00, and have since in the last couple weeks gone back to $6.00. We have got positions on that are below the current market right now for the September quarter.

Steve Denault - Northland Securities

Below the current $6.00 level?

Brian T. Cahill

Yes.

Steve Denault - Northland Securities

Is that on another 50% of your needs?

Brian T. Cahill

We would be approximately over the next quarter about 50%, maybe a little stronger than that.

Steve Denault - Northland Securities

If I could ask the same question for your wheat, how much was hedged in the June quarter, kind of at what levels, and what do you have hedged in the September quarter at what levels?

Brian T. Cahill

We look at more purchase plan of wheat because we’re trying to get protein in that area rather than doing strictly derivatives but we probably in our weak period have about 60% to 65% of our wheat bought for the first quarter.

Steve Denault - Northland Securities

At what levels?

Brian T. Cahill

Well, the wheat market has not been near as volatile. We would be below current market right now though on a daily basis that’s pretty touch to see with some of the ups and downs in the market, but we would I would say slightly below market right now on our wheat purchases.

Steve Denault - Northland Securities

Is it safe to assume that wheat really hurt you guys in the quarter? It’s probably safe to assume the same thing’s going to occur here in the September quarter? You can’t get the price increases through fast enough I would imagine.

Timothy W. Newkirk

Really there were a couple of things that happened to us on the wheat side. It wasn’t just the raw Kansas City Board of Trade price. You also have to look at what was going on in the protein premium at that time. And because we buy wheat for the protein, we had to actually pay up quite a bit or the other option was to buy lower protein and buy more bushels. So you have kind of a combination of both of those things on the cost side for wheat. So you’re right. Wheat had a pretty big impact. Just in kind of rough numbers the wheat costs between Q3 and Q4 was more than $5 million higher and again that’s a combination of the per bushel price for the commodity itself plus the protein premium or our election to run lower protein and run more bushels through to get the same output. That was one factor.

The other factor as we’ve talked about before in the ingredients world, even in the specialty ingredients world, while we have significantly more pricing power as we noted than we do in the heritage products, those contracts still are a little bit more over longer-run timeframes. And some of them aren’t even contracts but the pricing ability to change relative to the rate that corn and wheat in this case were changing over the last four or five months, we cannot get those in sync. It’s going to take a little bit longer.

Now the flip side is also true. Those tend to typically hang on a little bit longer on the downward run. So hopefully you’re making up equal to or greater than on the downside than you do on the upside. But there is a significant lag when we have this kind of volatility. And I would just add, this is really unprecedented levels of volatility that we’ve seen in the corn and wheat markets. As Brian said, when you look at the run-up in corn, the rapid fall and the rapid run again, wheat hasn’t had that absolute magnitude of volatility but it’s still been very volatile. And relative to corn wheat’s still trading above its long-run historical spread what to corn. So we’ve had to deal with that issue too.

The good news on wheat going forward Steve is that this crop year looks like it’s going to be very good on a protein basis and we hopefully won’t see the extreme protein premiums that we had and that we suffered through in Q3 and Q4 and this last year’s wheat crop where we had lower protein and then basically the US almost ran out of good protein wheat. Hopefully things are looking pretty good from that perspective on a go-forward basis.

Steve Denault - Northland Securities

And the highest level of protein wheat is which variety of wheat?

Timothy W. Newkirk

Last year it was kind of unique. Usually you can get the highest protein in the spring. We don’t know what that crop’s going to be yet for sure. We just finished up the hard red winter. I would say hard red winter’s going to average 12.5% to 13%, maybe 13.1%, as an average and we still don’t know because we’re still in the finalization of the growing season for the spring wheat. But typically it would be a little bit higher.

Steve Denault - Northland Securities

If I remember correctly in the June quarter, on the ethanol output side I don’t remember you entering it too much in the way of long-term contracts. Is most of it still going to be sold at spot market pricing?

Brian T. Cahill

Yes, that’s correct. We have a very minor amount contracted out. Almost everything is in the spot market.

Timothy W. Newkirk

To add on to that, with the margins from an industry perspective as razor thin as they are, and again there’s tremendous volatility in that if you follow the Chicago Board of Trade ethanol future and you use that as your benchmark, there’s quite a bit of volatility there too, but overall I think it’s safe to say margins are pretty thin. There’s no reason for us to get really long and do any contracting at this time. I think you’ll see us on a go-forward basis stay in fairly short.

Steve Denault - Northland Securities

What do you think the likely outcome is with your lenders then? Is it higher interest rates?

Robert J. Zonneveld

I think there will be an upcharge in interest rates. I mean, there’s a forbearance period but in principal we’re talking about decreasing that three year facility to a one-year facility that would end on August 31. We’re already looking at amendment documents, so the process is moving along pretty well.

Steve Denault - Northland Securities

Do you still feel like the distillery and ingredients are so integrated that the two need to belong together I should say under the same umbrella?

Timothy W. Newkirk

To optimize our overall cost structure, they need to be. If we don’t have the distillery, then we’re paying waste treatment costs on all of the effluent and we’re wasting carbohydrates and this is not a world today where you want to be wasting carbohydrates. Some of the B starches, some of the soluble proteins are actually beneficial in the alcohol process relative to running them into a waste water treatment facility where then you have to deal with the waste. So we can actually create value out of those by running them integrated. That said, Steve remember we have this swing capacity and the ability to run not just fuel grade ethanol. And I think that’s one of the advantages that we try to talk about in the opening remarks, and you’ll see it’s focused more and more on that. We can’t swing 100% of our 130 million gallons into high quality but we can swing enough so that margins get thin enough in fuel ethanol we don’t have to produce fuel ethanol to run our ingredients business at the rates that we want to run it.

Steve Denault - Northland Securities

How much better are the food grade alcohol margins today versus fuel grade?

Robert J. Zonneveld

As I think we’ve talked the high quality food grade alcohol is certainly a long-term strategic focus for us. The pricing on that moves quite a bit slower and we will see much improvement here as we do contracts going forward. But in the period of our fourth quarter, the prices there were pretty stable from third quarter to fourth quarter. As we move into our new fiscal year we’ll see improvement there. But to answer your question, over a long-term period the margins are much better and more stable in the food grade alcohol business.

Operator

Our next question comes from Jonathan Lichter - Sidoti & Company.

Jonathan Lichter - Sidoti & Company

Can you talk a little bit about the hedging beyond the September quarter into anything in the December quarter or beyond?

Brian T. Cahill

We do have some positions into the second quarter in our corn area. We have longer-term positions in our natural gas area going forward throughout the rest of this fiscal year. Right now in the corn area again as we follow that we look to lock in margins basically trying to protect our high-quality alcohol margins and as Tim had indicated, margin’s very thin. In the fuel ethanol area we’re continually looking if there are locks there. But without long-term contracts at higher values our hedging position on corn is just going to more or less follow our high-quality food alcohol sales.

Jonathan Lichter - Sidoti & Company

So would it be fair to say that you’ve hedged about 50% in Q2 as well?

Brian T. Cahill

We are probably a third to 40% in Q2 and then past the rest of the year not really nothing after that period.

Jonathan Lichter - Sidoti & Company

Would that go for wheat as well?

Brian T. Cahill

Wheat is a little bit more as we’re in the harvest period for wheat right now. We’re looking to buy more cash in the protein levels in that area. So really we have some positions in the second quarter but not very much and nothing past that.

Jonathan Lichter - Sidoti & Company

You mentioned there were some production problems at I think it was Pekin. Have those been resolved or when will they be?

Timothy W. Newkirk

Yes. I did mention that. Those were really affecting us in the third quarter. A little bit in the fourth quarter some of the shortfall you see was a planned reduction in output due to poor margins in June that carried over a little bit into July. We took our annual maintenance outage and some of those kinds of things, but basically if you go back and look at when corn was spiking and ethanol was trading at $1.00 below our bob, it just didn’t make a lot of sense. So we took some planned downtime there for both of those reasons.

Jonathan Lichter - Sidoti & Company

Will it be run just based on the economics there?

Timothy W. Newkirk

We will run Pekin nominally at let’s call it 50% rate because that’s what we need to do to fully run the food business up there, which is where we can have some swing capacity in the fuel ethanol side. And then we’re going to be looking at fuel ethanol economics as everybody in the industry is almost on a day-to-day week-to-week basis and making decisions about run rates based on where things are.

Robert J. Zonneveld

The good news with that is that’s not the only business we’re in. We’re in the food grade alcohol and ingredients business. So if you look at other ethanol companies, if they shut down, they shut down and they’re not working.

Jonathan Lichter - Sidoti & Company

In terms of the pet area, I saw it’s still reported in there. Will that continue or when will it be a discontinued operation or how will you treat that?

Timothy W. Newkirk

I’ll let Robert address the accounting side of that Jonathan but essentially right now we’re in active discussions regarding our strategic options. We said at the last earnings call that we would be exploring those. We are doing what we said we would do. Nobody really knows and I’m not in a position to predict when those might end or not end. But we are proceeding on the path that we outlined in our third quarter call.

Jonathan Lichter - Sidoti & Company

Also in the release I think it mentions that food companies are introducing products pretty quickly. A couple or several other companies have mentioned that given the economy that they’ve actually seen some slowdown. Have you seen any of that at all?

Timothy W. Newkirk

I’ll let Don Coffey respond to that one Jonathan.

Don Coffey

That’s true that the trends in the industry are still favorable for large numbers of new product development activities at the branded food companies and we have noticed that there is a bit of a slowdown or a pullback in some developmental efforts, in general it has not been that significant. So on a case-by-case basis we might see some customers that are kind of delaying introductions because new product introductions are very expensive, but in general new product development efforts continue because consumers are fickle and they demand new products from the branded companies.

Jonathan Lichter - Sidoti & Company

So nothing too significant there?

Don Coffey

No. Nothing significant.

Timothy W. Newkirk

I think to build on what Don said Jonathan, remember too as we noted in the opening remarks a large part of our focus is on those health and wellness type products, and we have not seen any slowdown in those areas. So products that would use our fiber or our specialty proteins, those really have not slowed down. I’m sure maybe some new product introductions for the sake of new product introductions maybe, but that’s the idea and the exciting part about our focus on those ingredients and not some of the others is we’re not seeing any real slowdown in our pipeline there.

Jonathan Lichter - Sidoti & Company

Where does debt stand today?

Robert J. Zonneveld

Our credit line was at $37 million last week as kind of the high point and like on Monday morning we were at $31 million. I think today right around $35 million. So it bounces around a little bit but we’re staying within our credit limits at this particular point.

Jonathan Lichter - Sidoti & Company

You mentioned in the release also that you would get back to where you were before the run up in costs. Which quarter would you plan to as kind of an example of that?

Timothy W. Newkirk

We’re going to be running through still some of the residual higher priced inputs that we encounter in the fourth quarter in the early part of this first quarter. I hesitate to make too many predictions just simply because there’s so much volatility out there, but if things were as they are today more or less we’ll see some improvement by the time we hit second quarter. But again that volatility out there notwithstanding, I’d say somewhere in that second quarter.

Jonathan Lichter - Sidoti & Company

Lastly, you mentioned it sounds like more of a focus on the food grade side. Do you have any concerns that that could hurt industry pricing at all?

Timothy W. Newkirk

On the food grade alcohol side?

Jonathan Lichter - Sidoti & Company

Yes.

Timothy W. Newkirk

It’s an increased focus but there’s always new demand coming on line; there are all sorts of opportunities that come along every single year. That’s not a high growth area; we talked about that; it’s probably growing with population 1% or 2%. It’s not like there’s a huge unfilled void out there but there is always new developmental work going on in the industrial area, not so much on the food grade alcohol side or the beverage alcohol side I guess, certainly in the food grade market place as a whole. Pricing there though tends to be pretty stable and have some relationship, certainly not one to one but some relationship, with the directional movement in corn as it has for more than 60 or 70 years. When we talked about focus in that area, it’s really because it gives us a few more levers to pull if you will when it comes to managing margin. And you don’t have any right now on the fuel ethanol side. There’s a complete disconnect. The delta to our bob continues to grow. That’s just an area where if that’s your business model and your only business model, there’s not a lot you can do to effect real change. We do have some of that ability in the high quality area though. And if you go back and look, we have continued to report increases on a regular basis quarter-over-quarter and year-over-year in that food grade alcohol area because that has been a concerted effort for the last several years.

Robert J. Zonneveld

In volume and pricing.

Timothy W. Newkirk

Yes, in volume and pricing, which has followed corn. So we’re not talking about unleashing an avalanche of new capacity because we just don’t have it.

Operator

Our next question comes from Tyson Bower - Wealth Monitors.

Tyson Bower - Wealth Monitors

A couple of quick questions just to follow up on the last question that you were talking about. The 16% increase in volume with the distillery segment, I’m guessing that’s either for food grade or has the capability of being swing capacity between food grade and fuel grade?

Robert J. Zonneveld

Yes. That would be in our food grade area is where that increase in capacity is during the period.

Tyson Bower - Wealth Monitors

Do you differentiate what you would consider functional capacity that is dedicated to the food grade with a swing capacity that you could do one or the other? And if so, how would that look?

Robert J. Zonneveld

Well Tyson I think we’ve stated that about 50% of our corporate capacity is available in the high quality food grade alcohol area. We’re continuing to work to improve that percentage to a higher rate through debottled necking or small incremental capital improvements. So that’s our goal to continually get that number above the 50%. And then there are different types of industrial alcohol that can be sold in the market place from different customers’ specifications. There are some tweaks in that area too. But our goal is to continue to get that number above the 50%.

Tyson Bower - Wealth Monitors

So we can reasonably look at this and say non-fuel grade is 50%; that’s what you’re producing. If you could produce more, you would.

Robert J. Zonneveld

Yes. And we’re working continually to do that both form the market side and the production side.

Tyson Bower - Wealth Monitors

What kind of timetables or do you have any particular timetables that are more significant than others regarding re-pricing contracts both on the ingredients side and also on the food grade alcohol side?

Robert J. Zonneveld

Let me talk about this food grade alcohol side and there are really two areas there: Beverage and industrial markets. It varies. A lot of customers are in quarter-to-quarter pricing. We do also have some annual contracts in the industrial area. In the industrial area there are some annual prices that are done in the January to December calendar year period.

Timothy W. Newkirk

On the ingredients side Tyson we have things staggered all over. On more of the heritage type products, kind of our base loading products, those are typically annual contracts that will be renegotiated here in the fall for usually a January to December end. On some of the specialties, those range all over because those are going to all sorts of different types of customers. We had some re-price here effective July 1; there’s be a small chunk here in October; and a fairly significant chunk in January. I would say on a volume basis looking across all of the ingredients units, which is kind of a dangerous thing to do because in some respects it’s an apple to an orange, but the bulk of the pounds of the units there in the ingredients side will re-price in January. And again that’s because that’s most of that heritage and these specialties haven’t hit and are growing rapidly as we talked about but they’re coming from a smaller base.

Tyson Bower - Wealth Monitors

And that leads me into my next question. Can you give the growth in those three specific areas that look impressive, but overall percentage of volume what would you consider is that high value added specialty product compared to more of your commodity starches or vital wheat gluten?

Timothy W. Newkirk

I would say somewhere between a quarter and a third on a volume basis. And again if we rewind a couple years ago when we really started developing our new strategy and our focus, they were quite a bit less than that. So I would say on a volume basis about a quarter to a third.

Tyson Bower - Wealth Monitors

Do you do currently any modified starches or plan on doing that?

Timothy W. Newkirk

When we talk about specialty starch, those would be either chemically or physically modified.

Tyson Bower - Wealth Monitors

And that’s the area that you hope to grow significantly?

Timothy W. Newkirk

Right. For example, the Fibersym product is a modified starch, FiberRite’s a modified starch, the Arise proteins we talked about are modified wheat proteins. So that’s that group of some kind of value-added operation done on it Tyson that gives a value-added result. A value-added functionality for our customer would be somewhere in that 25% to 30% on a volume basis.

Tyson Bower - Wealth Monitors

In regards to profitability being your number one focus, it sounds as if the first true quarter of hopefully targeting that doesn’t come until the second half of fiscal 09 or calendar 09 for you. Obviously nobody knows for sure, but will it be a big enough hole in the first two quarters that’s going to be difficult to get out of in the second half or we just don’t know at this point?

Robert J. Zonneveld

Quarter one’s obviously going to be a tough quarter and quarter two a little bit less tough. But yes, we do kind of see by the end of the year we’ll fill the hole.

Timothy W. Newkirk

I think Tyson to be fair, as Brian indicated earlier on the call, some of the risk management decisions we’ve made were trying to help bridge that gap between now and the second half of the year. So we’re trying to not allow the hole to get too deep based on whether the natural gas side it was a surprise hurricane in the Gulf or normal volatility that we’ve seen the last several months in corn. So we’re trying to mitigate some of that risk here in the first half of the year and then we can get to the second half and see what happens.

Tyson Bower - Wealth Monitors

And the last question for me is, can you provide us an update on the progress with your European JV plant?

Timothy W. Newkirk

We ran a small run of production in July; the third party toll manufacturer made some additional modifications so we could produce a couple of additional SKUs. We will come back up again here the first couple of weeks in September and run another run. So that is progressing right according to plan.

Tyson Bower - Wealth Monitors

I’m guessing still a drag until you get up to full speed. What kind of drag would you anticipate here in this first quarter?

Timothy W. Newkirk

I would say we’re going to be fairly consistent. It’s not going to be any greater than what we’ve seen drag-wise specific from our internal Wheatex manufacturing operations anyway. It shouldn’t be any worse. In fact, wheat costs are down so wheat gluten is the raw material input to that process so on the cost side we’ll have a little bit of help but the real improvement comes when that takes off. So I don’t think it’ll be any worse. Like you said, there just won’t be a huge benefit probably till we get into the second quarter where we’re running real consistent.

Operator

Our next question comes from Tom Driscoll - Seacrest Investment.

Tom Driscoll - Seacrest Investment

Very sympathetic to the conditions that you’re dealing with and I’m sure you’re doing everything possible to strengthen the company so that you benefit in the case of a turnaround. One statement and then just two questions. An examination of the industry broadly over the last two, three, four years in terms of capacity expansions, green field construction and so forth suggests that the company currently is trading at a value in the market below what might be considered its replacement cost and by implication there’s little or no value as a growing concern, which as a shareholder is disconcerting. I presume that the Board and senior management recognize that. That’s the first question. And the second question is, has the Board communicated to management a time limit within which their expectations to meet certain operational and financial goals and at that point are there alternatives that have been examined that might be available to realize shareholder value?

Timothy W. Newkirk

I’ll address that as best I can. I guess, yes management and the Board are aware. I don’t know again if replacement cost is a real accurate measure. I don’t know because I don’t know that you’d want to think about replacement costs in an industry that’s operating with the kind of economics this one is. So I don’t know what replacement cost means on a relative basis and if that’s really a good measure.

But that said, we were pretty consistent several years ago actually, as early as 2005 and for sure in 2006, before this construction boom began, we were one of the few companies t hat continued to say “Hey, this is irrational. There’s irrational exuberance,” I think is the term I happened to use on a Mad Money call-in that I did. So we recognized this a couple of years ago and have been working on getting MGP reconfigured for this very event.

I would remind you if you go back and look on the ingredients side of the business at some of the performance back in 2005 and 2006 and then look at where wheat was there versus where wheat is here.

We are effecting change inside this company. Is it fast enough to counter all-time record highs in a 90-day period and corn, wheat and natural gas getting back to where it was post-Katrina? No. But it’s a company that’s been around for 65 years; we’re making steady improvement; we’ll continue to make steady improvement; and when we get a little bit of relief on the volatility side I think you’ll be able to see it.

It is extremely frustrating for senior management on the inside to be making the magnitude of changes we are but have the overall magnitude of the commodity input volatility overshadow everything we’re doing so it doesn’t show itself in the P&L at the end of the day. And that is extremely frustrating for us but we will persevere and we will continue on.

We’ve been around for more than 65 years and we intend to be around longer than that with a much healthier company than what we’ve historically had because of our focus on value-added ingredients, whether it’s the food grade alcohol or whether it’s the specialty proteins and starches that we’ve been developing throughout the last five or six years but have no recently given it much more focus on the sales side. If you look at the capital structure and the balance sheet, we’re a very, very strong company. So we will be one of the survivors.

While the Board is obviously talking to us on a regular basis about the sense of urgency, I assure you we don’t need the Board to remind us of the sense of urgency. We live in these communities where we do business and we feel the sense of urgency ourselves.

Tom Driscoll - Seacrest Investment

Just one last comment if I might. With respect to the fuel alcohol business, a lot of money as you’re well aware and you alluded to was raised to produce a lot of capacity in that area. With that said, some folks were left with excess idle capacity and are singly focused. But there were pools of money that were collected for the purpose of going forward with incremental construction and capacity that were not spent. Has the company spoken to or taken a look at the possibility of some sort of a JV that takes advantage of those assets that are waiting to commit to the industry and at the same time unleashes some value from that capacity that you have that may not be immediately realized in the spot market?

Timothy W. Newkirk

We’re always looking and actively involved in what’s going on in that industry and always looking for opportunities that we might be able to create value either with our assets, through arbitrage, of our sales area or sales geography relative to others. We’re always looking at opportunities. That said, the fuel ethanol business is an important piece and has been an important profit driver over the last several years but as we’ve said that’s not the strategic focus of the company. Continuing to leverage our 65 years plus in the food grade alcohol is and we are certainly much more focused on opportunities in those areas than we are in the fuel ethanol market. But that said, because we’re one of the oldest fuel ethanol companies we are always looking for opportunities because we have those assets and would leverage them when and where it makes sense.

Tom Driscoll - Seacrest Investment

In addition to leverage then you might consider in some manner, shape or form selling them or selling an interest in them.

Operator

Our next question comes from Steve Denault - Northland Securities.

Steve Denault - Northland Securities

I’m just following up. On your alcohol capacity in the September quarter to date, what percent of capacity are you running that at?

Brian T. Cahill

As Tim mentioned earlier, when the corn pricing and margins got tough in the first part of July, we did some shutdown work and maintenance work and did some work in that area. We’re always running our plants at 100% capacity on the food grade high quality alcohol. I would say for the quarter we’re going to be in the area on the other side of the business of 70% to 80% I would think is what the quarter will be.

Steve Denault - Northland Securities

In total?

Brian T. Cahill

Of the fuel grade, yes.

Steve Denault - Northland Securities

So you’ll be at 100% of food grade and 70% or 80% of fuel grade?

Brian T. Cahill

I would think that would be a fair number right now Steve, yes.

Operator

There are no further questions.

Timothy W. Newkirk

I see the coming year unfolding in stages where we gradually progress both in our performance and the execution of our operating plan and strategies. The first stage will come from better input costs and higher distillery production. The next stage is really more about realizing our longer-term opportunities. These will be driven by the progress we make on growing the top line specifically through higher sales of specialty ingredients and food grade alcohol as we’ve been discussing this morning. We thank you for joining us and we look forward to talking with you again when we report our fiscal 2009 first quarter earnings. This concludes our call.

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Source: MGP Ingredients, Inc. F4Q08 (Qtr End 06/30/08) Earnings Call Transcript
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