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MGPI > SEC Filings for MGPI > Form 10-K on 12-Mar-2013All Recent SEC Filings

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Form 10-K for MGP INGREDIENTS INC


12-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS (Dollars in thousands except per-share amounts)

GENERAL

We produce certain distillery products and ingredients and as of December 31, 2012, we had three reportable segments: a distillery products segment, an ingredient solutions segment, and an other segment. As previously discussed, substantially all assets used in the other segment were sold effective February 8, 2013. Substantially all of our sales are made directly or through distributors to manufacturers and processors of finished goods. Sales to our customers purchasing food grade alcohol are made primarily on a spot, monthly or quarterly basis, with some annual contracts, depending on the customer's needs and market conditions. Customers who purchase whiskey or bourbon may also enter into separate warehouse service agreements with us, allowing the product to age. As part of our acquisition of LDI's Distillery Business, we assumed certain multi-year contracts to supply distilled products as well as certain contracts to provide barreling warehousing services, which typically are multi-year contracts. Sales of fuel grade alcohol are made on the spot market. Contracts with distributors may be for multi-year terms with periodic review of pricing. Contracts with ingredients customers are generally price and term agreements which are fixed for three or six month periods, with very few agreements of twelve months duration or more.

Since fiscal 2009, when we incurred significant impairment and restructuring costs, our business focus has been on the production of value-added ingredients and distillery products. As a part of our strategy, given the available capacity at our Indiana Distillery, we produce certain volumes of bourbon and whiskey that is in addition to current customer demand. This product is barreled and included in our inventory. Our goal is to maintain inventory levels for whiskey and bourbon sufficient to satisfy anticipated future purchase orders in the wholesale market. Production schedules are adjusted from time to time to bring inventories into balance with established future demand. The majority of our former Pekin plant's capacity for several years had been dedicated to the production of fuel grade alcohol, of which the market economics has been volatile in recent years. The Pekin plant is now owned and operated by a joint venture, ICP, which produces food grade alcohol, which we have historically purchased, and fuel grade alcohol, which SEACOR Energy Inc. purchases. We retain some exposure to the volatility to fuel grade alcohol through our remaining interest in ICP as well as from the fuel that we make as a co-product at our Atchison facility. Through our investment in ICP, we have an opportunity to participate when the economics of that market are good, and we believe that the extent of our exposure to bad markets is significantly less than when we operated Pekin ourselves. Further, we have the ability, through the termination provisions in the ICP Limited Liability Company Agreement, to limit our operating losses by causing ICP to shut down the plant if losses reach specified amounts. ICP's revolving credit facility has expired and has not been renewed. If ICP should be unable to secure financing from its lender or another source, this creates a risk to ICP's future working capital needs.


Our principal raw materials are corn and flour. Corn is processed into alcohol and animal feed and flour is processed into all of our products, except whiskey and bourbon. The cost of raw materials is subject to substantial fluctuations depending upon a number of factors which affect commodity prices in general, including crop conditions, weather, disease, plantings, government programs and policies, competition for acquisition of inputs such as agricultural commodities, purchases by foreign governments and changes in demand resulting from population growth and customer preferences. While corn prices have fluctuated significantly over the past several years and the overall trend in recent prices has been up, there has been a lot of variability in corn pricing during this period. We expect corn pricing to remain volatile in the near term due to a number of factors impacting global demand and supply of this commodity. These fluctuating prices create challenges since our customers are interested in stable prices for the distillery products they purchase from us.

We have a supply agreement with ConAgra Mills, who supplies wheat flour for use in the production of protein and starch ingredients. The price we pay ConAgra for flour is a function of the per-bushel cost of wheat and, accordingly, wheat prices continue to directly impact the cost of raw materials. We believe our focus on value-added products can reduce our risk to such price variations as larger profit margins related to such products can absorb higher levels of raw material volatility and as we may more readily seek adjustable price terms in contracts for such products. However, we will continue to be affected by commodity price fluctuations to some degree, which may be significant at times, and may not be able to recoup cost increases in our selling prices, particularly when price fluctuations are volatile.

Historically, we have engaged in the forward purchase of grain and in the purchase of commodity futures and options to hedge economic risks associated with fluctuating grain and grain products prices. These contracts help fix corn prices over short periods of time, generally three to six months, which is consistent with most of the sales orders we typically enter into with our distillery customers. During fiscal 2011, we changed our risk management program related to the volatility of raw material costs, and began purchasing a larger amount of contracts for future delivery, which we typically held until maturity, in order to protect margins on contracted, and a portion of spot market, alcohol sales and expected ingredients sales. During the six month transition period ended December 31, 2011, we began to buy and sell derivative instruments to manage market risk associated with alcohol purchases, including ethanol futures and options contracts, in order to mitigate risks associated with our investment in ICP. During the quarter ended March 31, 2012, we entered into a grain supply contract for our Indiana Distillery that permits us to purchase corn for delivery up to 12 months in the future, at negotiated prices. During the quarter ended June 30, 2012, we extended this grain supply agreement used for its Indiana Distillery to its Atchison facility. The pricing is based on a formula with several factors. We now order corn anywhere from a month to 12 months in the future. As we are now able to purchase corn for delivery up to 12 months in the future under these grain supply agreements, we have reduced the volume of our corn futures and options contracts.

From April 1, 2008 until June 30, 2011, we did not use hedge accounting for our open commodity derivative positions. This was primarily due to the increased record keeping and documentation requirements needed to meet these accounting standards. This accounting policy led to significant volatility in earnings as a result of unrealized losses (or gains) on our open contracts. Effective July 1, 2011 we elected to restart the use of hedge accounting for qualifying derivative contracts entered into on and after July 1, 2011and we continued to use hedge accounting until February 29, 2012. During this period of hedge accounting, we typically entered into cash flow hedges to cover between 70 and 80 percent of our monthly anticipated grind. To the extent we did not enter such cash flow hedges and were unable to timely adjust the prices we charged under sales contracts, we could be adversely impacted by market fluctuations in the cost of grain and natural gas. During the quarter ended September 30, 2011, we began to buy and sell derivative instruments to manage market risks associated with ethanol purchases, including ethanol futures and options contracts. These contracts were entered into to mitigate risks associated with our investment in ICP. On February 29, 2012, we de-designated our cash flow hedges. See Note 14. Derivative Instruments and Fair Value Measurements and "Critical Accounting Policies and Estimates".

Energy represents a major cost of operations, and seasonal increases in natural gas and other utility costs can affect our profitability. Energy costs have typically increased year to year. We sometimes try to protect ourselves from increased energy costs by entering into natural gas contracts for future delivery.


Historically, we recorded the collection of excise taxes on distilled products sold to customers as accrued expenses and no revenue or expense was recognized in the Consolidated Statements of Operations. With the Company's acquisition of the distillery operations of LDI on December 27, 2011, the Company is now subject to more excise taxes. In the quarter ended March 31, 2012, because excise taxes exceeded 1 percent of net sales, the Company began to present excise taxes as a caption on the Consolidated Statements of Operations, which is a reduction to gross sales. The prior years and quarters within those years have been conformed to the current presentation. This reclassification had no impact on net loss or reported loss per share.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

In preparing consolidated financial statements, management must make estimates and judgments that affect the carrying values of our assets and liabilities as well as recognition of revenue and expenses. Management's estimates and judgments are based on our historical experience and management's knowledge and understanding of current facts and circumstances. The policies discussed below are considered by management to be critical to an understanding of our consolidated financial statements. The application of certain of these policies places significant demands on management's judgment, with financial reporting results relying on estimations about the effects of matters that are inherently uncertain. For all of these policies, management cautions that future events rarely develop as forecast, and estimates routinely require adjustment and may require material adjustment.

Derivative and Hedging Activities. From April 1, 2008 until June 30, 2011 and from February 29, 2012 to December 31, 2012, we did not use hedge accounting for our open commodity derivative positions. Accordingly, during these periods changes in the value of derivatives have been recorded in cost of sales in our Consolidated Statements of Operations. Additionally, derivative instruments entered into during these periods have not been designated as hedges. Derivative instruments related to our hedging program have been recorded as either assets or liabilities and measured at fair value. The change in the fair value of these instruments has been recorded in cost of sales in our Consolidated Statements of Operations.

From July 1, 2011, until February 28, 2012, we used hedge accounting for qualifying derivative contracts entered into on or after July 1, 2011. On February 29, 2012, we discontinued hedge accounting and de-designated our cash flow hedges, which resulted in a reclassification of a $27 loss from accumulated other comprehensive income ("AOCI") into current period earnings. The application of hedge accounting requires significant resources, record-keeping and analytical systems. Under hedge accounting, the changes in fair value of such contracts historically were highly effective at offsetting changes in price movements of the hedged items. Consistent with application of hedge accounting under Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 815, Derivatives and Hedging, gains and losses arising from open and closed hedging transactions were recorded as part of other comprehensive income (loss) and are recognized in costs of sales as part of product costs when the related products are sold. Any ineffective portion of a hedged transaction was immediately recognized in current earnings.

We may discontinue cash-flow hedge accounting for a particular derivative instrument prospectively when we (i) determine that the derivative is no longer considered to be highly effective in offsetting changes in the expected cash flows of the hedged item; (ii) the derivative is sold, terminated or exercised;
(iii) we de-designate the derivative as a hedging instrument because it is unlikely that a forecasted transaction will occur; or (iv) it determines that designation of the derivative as a hedging instrument is no longer appropriate. When cash flow hedge accounting is discontinued, we continue to carry the derivative on the Consolidated Balance Sheet at its fair value, and gains and losses that were included in AOCI are deferred until the original hedged item affects earnings. However, if the original hedged transaction is no longer probable of occurring, the related gains and losses incurred as of discontinuation are recognized in current period earnings.

Regardless of accounting treatment, we believe all of our commodity hedges are economic hedges.

Business Combination. We account for acquired businesses using the acquisition method of accounting, which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. The difference between the total cost of the acquisition and the sum of the fair values of the acquired tangible and identifiable intangible assets less liabilities is recorded as either goodwill or bargain purchase gain, depending on whether total cost exceeds, or is less than, such net fair values. A bargain purchase gain must be recognized in earnings as of the acquisition date. Any adjustments to the fair values assigned to the assets acquired and the liabilities assumed during the measurement period, which may be up to one year from the acquisition date, has a corresponding increase or decrease to bargain purchase gain or goodwill. Transaction costs are expensed as incurred.


We completed a significant business acquisition during the six month transition period ended December 31, 2011 with our acquisition of LDI's Distillery Business. In connection with this acquisition, we recognized a bargain purchase gain of $13,048 (net of taxes of $8,336) based on the difference between the purchase price ($11,041) and fair values of the assets acquired. We acquired these assets from a distressed seller.

Some of the more significant estimates and assumptions used by management in valuing our acquisition of LDI's Distillery Business and allocating purchase price include: (a) the business enterprise value, which is based on estimated future cash flows (including timing) which are estimated using the income approach and discount rates reflecting the risk inherent in the future cash flows, and (b) the values of land, buildings and equipment, which are estimated using the cost and market approaches. The determination of fair value is based on internal assumptions as well as assistance from third party valuation specialists. The estimated fair values recorded were based on unobservable inputs, which are material and represent Level 3 measures in the fair value hierarchy discussed in Note 14. Derivative Instruments and Fair Value Measurements. There are also judgments made to determine the expected useful life assigned to each class of assets acquired and the duration of liabilities assumed. The judgments made in this determination of the estimated fair value assigned to the assets acquired and liabilities assumed, as well as the estimated useful life of each asset and the duration of each liability, can materially impact the financial statements in periods after acquisition, such as through depreciation and amortization expense.

We believe the resulting bargain purchase gain of $13,048 (net of taxes of $8,336) is reasonable based on the following circumstances: (a) the seller was financially distressed, (b) LDI's Distillery Business was not widely marketed for sales - an investment bank was hired, however efforts were initially unsuccessful, (c) the machinery and equipment are highly specialized for the industry, resulting in limited alternative uses for the property, and (d) independent property appraisals and business valuations indicated that its fair value was in excess of the purchase price. See Note 18. Business Combination.

Impairment of Assets.

Impairment of Investments

We review our investments in non-consolidated subsidiaries for impairment whenever events or changes in business circumstances indicate that the carrying amount of the investments may not be fully recoverable. Evidence of a loss in value that is other than temporary include, but are not limited to, the absence of an ability to recover the carrying amount of the investment, the inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment, or, where applicable, estimated sales proceeds which are insufficient to recover the carrying amount of the investment. If the fair value of the investment is determined to be less than the carrying value and the decline in value is considered to be other than temporary, an appropriate write-down is recorded based on the excess of the carrying value over the best estimate of fair value of the investment. Considerable judgment is used in these measurements, and a change in the assumptions could result in a different determination of impairment loss and/or the amount of any impairment.

The Company's evaluation of ICP includes a specific assessment of the fair value of ICP's net assets, after considering ICP capitalization, sales proceeds of other similar plants and expected net sales proceeds that management would expect to be realized if ICP were sold to a third party. Given this specific situation, the Company's management has concluded the fair value of the Company's 30% interest in ICP is greater than the $6,898 carrying value of the ICP investment at December 31, 2012.

No events or conditions occurred during the year ended December 31, 2012, during the six month transition period ended December 31, 2011 or the year ended June 30, 2011 that required us to record an impairment. Given significant contingencies related to ICP (see Note 3. Equity Method Investments), we anticipate that impairment testing will be required at each quarterly reporting period for the foreseeable future given the volatility of the business in which ICP operates and the since fair values can change over time. If there was an other than temporary decline in the fair value of the ICP investment below ICP's carrying value management would record an impairment charge to write down the invested value at that time.


Impairment of Long-Lived Assets

We review long-lived assets, mainly buildings and equipment assets, for impairment when events or circumstances indicate that usage may be limited and carrying values may not be fully recoverable.

In making such assessments, management must make estimates and judgments relating to anticipated revenues and expenses and values of our assets and liabilities. Management's estimates and judgments are based on our historical experience and management's knowledge and understanding of current facts and circumstances. Management derives data for its estimates from both outside appraisals and internal sources, and considers such matters as product mix, unit sales, unit prices, input costs, expected target volume levels in supply contracts and expectations about new customers as well as overall market trends. Should events indicate the assets cannot be used as planned, the realization from alternative uses or disposal is compared to the carrying value. Considerable judgment is used in these measurements, and a change in the assumptions could result in a different determination of impairment loss and/or the amount of any impairment.

No events or conditions occurred during the year ended December 31, 2012 or the year ended June 30, 2011 that required us to record an impairment.

We recognized non-cash impairment losses of $706 and $595 during the six month transition period ended December 31, 2011. In measuring the $706 impairment loss, management estimated the undiscounted future cash flows generated by the equipment that manufacture Wheatex® and determined that the estimated cash flows were less than their carrying values. Given the short duration of future cash flow stream, the undiscounted future cash flows were determined to be fair value. In conjunction with the impairment described above, management performed an impairment review of certain other equipment used to produce Wheatex®. In this review, management reviewed the timing of the anticipated business development and recent decisions to not renew leases where Wheatex® is currently produced. The carrying values of the equipment were reduced to fair value, which resulted in a charge of $595. Because of the uncertainty in estimated cash flow estimates, management estimated fair value using a third party appraisal. During the year ended December 31, 2012, we were able to identify a buyer for certain equipment previously used to produce Wheatex® that we had previously impaired. We sold this equipment, resulting in a gain on sale of $889 during the year ended December 31, 2012.

Defined Benefit Retirement Plans. We sponsor two funded, noncontributory qualified Defined Benefit Retirement Plans that cover substantially all our union employees at Atchison and former union employees at Pekin, who did not begin work at ICP, and thus remain our obligation. The benefits under these plans are based upon years of qualified credited service. However, benefit accruals under both plans were frozen in the second quarter of 2010. Our funding policy is to contribute annually not less than the regulatory minimum and not more than the regulatory maximum amount deductible for income tax purposes. Historically, the measurement and valuation date of the plans was June 30 of each year; however in conjunction with our change in fiscal year end, the measurement date was changed to December 31, beginning December 31, 2011. We make various assumptions in valuing the liabilities and benefits under the plan each year. We consider the rates of return on long-term, high-quality fixed income investments using the Citigroup Pension Liability Index as of December 31, 2012. Assumptions regarding employee and retiree life expectancy are based upon the RP 2000 Combined Mortality Table.

Other Post-Retirement Benefits. We also provide certain other post retirement health care and life insurance benefits to certain retired employees. Currently, the plan covers 277 participants, both active and retired. The number of participants was reduced during fiscal 2010, in part due to the transfer of employees to our joint venture, ICP, as described elsewhere. These actions caused a partial settlement and curtailment of our obligation for accrued retirement benefits. The number of participants was further reduced during the year ended December 31, 2012, when we made a change to the plan to terminate health care and life insurance benefits at retirement age for non-union employees who were not at least 60 years old on September 1, 2012, which was treated as a negative plan amendment and a curtailment.


We fund the post retirement benefit plans on a pay-as-you-go basis, and there are no assets that have been segregated and restricted to provide for post retirement benefits. We pay claims as they are submitted for the medical plan. We provide varied levels of benefits to participants depending upon the date of retirement and the location in which the employee worked. The retiree medical and life plans are available to union employees who have attained the age of 62 and rendered the required five years of service. All health benefit plans provide company-paid continuation of the active medical plan until the retiree reaches age 65. At age 65, we pay a lump sum advance premium on behalf of the retiree to the MediGap carrier of the retiree's choice. The employee retirement date determines which level of benefits is provided.

Consistent with the discussion above, our plan measurement date is now December
31. We make various assumptions in valuing the liabilities and benefits under the plan each year. We consider the rates of return on currently available, high-quality fixed income investments, using the Citigroup Pension Liability Index as of December 31 (long term rates of return are not considered because the plan has no assets). For the year ended December 31, 2012, the accumulated post retirement benefit obligation ("APBO") decreased to $5,700 from $6,309 at December 31, 2011. A portion of the other post-retirement benefits obligation reduction was due to the previously mentioned negative plan amendment and curtailment during the year ended December 31, 2012. The effect of this plan change was a negative plan amendment of $1,165 and a $79 curtailment. The negative plan amendment includes $1,021 for health care benefits and $144 for life insurance benefits. These amounts will be recognized into income over the average remaining years of service to retirement and the average expected lifetime remaining for health care benefits and life insurance benefits, respectively. The accounting impact for the curtailment resulted in immediate recognition of a benefit related to unamortized prior service cost of $79. Assumptions regarding employee and retiree life expectancy are based upon the RP 2000 Combined Mortality Table. We also consider the effects of expected long term trends in health care costs, which are based upon actual claims experience and other environmental and market factors impacting the cost of health care in the short and long-term.

Income Taxes. We account for deferred income tax assets and liabilities resulting from the effects of transactions reported in different periods for financial reporting and income tax under the liability method of accounting for income taxes. This method gives consideration to the future tax consequences of the deferred income tax items and immediately recognizes changes in income tax laws upon enactment as well as applied income tax rates when facts and circumstances warrant such changes. We establish a valuation allowance to reduce deferred tax assets when it is more likely than not that a deferred tax asset may not be realized. Additionally, we follow the provisions of FASB ASC 740, Income Taxes, related to the accounting for uncertainty in income tax positions, which requires management judgment and use of estimates in determining whether the impact of a tax position is "more likely than not" of being sustained on audit by the relevant taxing authority. We consider many factors when evaluating and estimating our tax positions, which may require periodic adjustment and which may not accurately anticipate actual outcomes.

2012 AND RECENT INITIATIVES

Acquisition of the Indiana Distillery

On December 27, 2011, we acquired substantially all the assets used by LDI in its beverage alcohol business, and we now produce premium bourbon, corn and rye whiskeys, gin, grain neutral spirits and distillers feed at our Indiana Distillery. The purchase price of the acquisition was equal to the current assets minus current liabilities as of December 27, 2011, which was estimated at closing to be $11,041. During April 2012, management and the seller completed working capital true-ups. The result of the true-ups was not material to our financial position or operating results.

During the quarter ended March 31, 2012, MGPI-I and the union that covers certain employees at the Indiana Distillery ratified a new multi-year collective bargaining unit agreement that terminates December 31, 2017.

In conjunction with the acquisition of the distillery operations of LDI, we acquired a grain elevator that was not expected to be used, which was reported as Assets held for sale at December 31, 2011. On March 21, 2012, we sold this . . .

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