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** **

 

** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**x**      **Quarterly report under Section 13 or 15(d) of the SecuritiesExchange Act of 1934.**

 

**For thefiscal quarter ended April 30, 2010**

 

**OR**

 

**o**         **Transition report under Section 13 or15(d) of the Exchange Act.**

 

**For thetransition periodfrom                    to                  .**

 

**COMMISSIONFILE NUMBER 000-51825**

 

**HERONLAKE BIOENERGY, LLC**

(Exact name of Registrantas specified in its charter)

 

| **Minnesota**                                  | ** ** | **41-2002393**                        |
|------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of organization) |       | (I.R.S. Employer  Identification No.) |

 

**91246390****th**** Avenue,Heron Lake, MN 56137-1375**

(Address of principalexecutive offices)

 

**(507)793-0077**

(Issuer’s telephonenumber)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has been subjectto such filing requirements for the past 90 days.   x Yes  o No

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T during the preceding 12 months (or for such shorter periodthat the registrant was required to submit and post such files).   o** **Yes**  **o No

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See the definitions of “large accelerated filer,” “acceleratedfiler,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

| Large accelerated  filer o                                              |   | Accelerated filer o          |
|------------------------------------------------------------------------------|--------|-----------------------------------|
|                                                                         |   |                              |
| Non-accelerated  filer x  (Do not check if a smaller reporting company) |   | Smaller reporting  company o |

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).   o Yes  x No

 

As of June 14, 2010, there were 27,104,625 Class Aunits outstanding.

 

 

 

 

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**INDEX**

 
| ** **                                                                                               | **Page No.** |
|----------------------------------------------------------------------------------------------------------|-------------------|
| PART I. FINANCIAL INFORMATION                                                                       |              |
| Item 1.  Financial Statements                                                                       | 1                 |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 16                |
| Item 4T. Controls and Procedures                                                                    | 22                |
| PART II.  OTHER INFORMATION                                                                         |              |
| Item  1. Legal Proceedings                                                                               |              |
| Item  1A. Risk Factors                                                                                   | 23                |
| Item 3. Defaults Upon Senior Securities                                                             | 23                |
| Item  4. [Removed and Reserved]                                                                          | 23                |
| Item  5. Other Information                                                                               | 23                |
| Item 6.  Exhibits                                                                                   | 23                |
| SIGNATURES                                                                                               | 24                |

 

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**PART I.  FINANCIALINFORMATION**

 

**Item 1.  FinancialStatements**

 

**HERON LAKEBIOENERGY, LLC AND SUBSIDIARY**

 

Condensed ConsolidatedBalance Sheets

 
| ** **                       | ** ** | **April 30,** | ** **  | **October 31,** | ** ** |
|----------------------------------|------------|--------------------|-------------|----------------------|------------|
| ** **                       | ** ** | **2010**           | ** **  | **2009***            | ** ** |
| ** **                       | ** ** | **(Unaudited)**    | ** **  | ** **           | ** ** |
| **ASSETS**                       |       |               |        |                 |       |
| **Current  Assets**              |       |               |        |                 |       |
| Cash and equivalents             |       | $                  | 1,908,945   |                 | $          | 3,184,074 |   |
| Restricted cash                  |       | 361,027            |        | 340,644              |       |
| Accounts receivable              |       | 4,796,739          |        | 4,439,701            |       |
| Inventory                        |       | 7,262,491          |        | 4,752,117            |       |
| Prepaid expenses                 |       | 325,350            |        | 210,136              |       |
| Total current assets             |       | 14,654,552         |        | 12,926,672           |       |
|                             |       |                    |        |                 |       |
| Property and equipment           |       |               |        |                 |       |
| Land and improvements            |       | 12,574,760         |        | 12,574,760           |       |
| Plant buildings and  equipment   |       | 97,351,576         |        | 97,332,591           |       |
| Vehicles and other  equipment    |       | 620,788            |        | 604,783              |       |
| Office buildings and  equipment  |       | 618,968            |        | 618,437              |       |
|                             |       | 111,166,092        |        | 111,130,571          |       |
| Less accumulated depreciation    |       | (15,362,413        | )           | (12,569,966          | )          |
|                             |       | 95,803,679         |        | 98,560,605           |       |
|                             |       |               |        |                 |       |
| **Other  Assets**                |       |               |        |                 |       |
| Restricted cash                  |       | 558,907            |        | 718,790              |       |
| Other intangibles                |       | 469,826            |        | 488,010              |       |
| Debt service deposits  and other |       | 523,430            |        | 395,200              |       |
| Total other assets               |       | 1,552,163          |        | 1,602,000            |       |
|                             |       |                    |        |                 |       |
| **Total  Assets**                |       | $                  | 112,010,394 |                 | $          | 113,089,277 |   |

 

See Notes to Condensed Consolidated FinancialStatements

 

----

* Derived from audited financial statements

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Condensed ConsolidatedBalance Sheets

 
| ** **                                                                      | ** ** | **April 30,** | ** **  | **October 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------|-------------|----------------------|------------|
| ** **                                                                      | ** ** | **2010**           | ** **  | **2009***            | ** ** |
| ** **                                                                      | ** ** | **(Unaudited)**    | ** **  | ** **           | ** ** |
| **LIABILITIES AND MEMBERS’ EQUITY**                         |       |               |        |                 |       |
| **Current  Liabilities**                                                        |       |               |        |                 |       |
| Line of credit                                                                  |       | $                  | 6,750,000   |                 | $          | 5,000,000 |   |
| Current maturities of  long-term debt                                           |       | 53,071,401         |        | 55,224,183           |       |
| Accounts payable:                                                               |       |               |        |                 |       |
| Trade accounts payable                                                          |       | 1,694,247          |        | 2,466,040            |       |
| Trade accounts payable  — related party                                    |       | 584,128            |        | 714,115              |       |
| Construction payable —  related party                                      |       | 3,839,413          |        | 3,839,413            |       |
| Accrued expenses                                                                |       | 1,028,736          |        | 566,481              |       |
| Accrued losses on  forward contracts                                            |       | 121,197            |        | 1,249,495            |       |
| Derivative instruments                                                          |       | 1,335              |        | —               |       |
| Total current liabilities                                                       |       | 67,090,457         |        | 69,059,727           |       |
|                                                                            |       |                    |        |                 |       |
| **Long-Term  Debt,** net of  current maturities                                 |       | 4,540,642          |        | 4,775,804            |       |
|                                                                            |       |                    |        |                 |       |
| **Commitments  and Contingencies**                                              |       |               |        |                 |       |
|                                                                            |       |                    |        |                 |       |
| **Members’  Equity, 27,104,625 Class A units issued and outstanding** |       | 40,379,295         |        | 39,253,746           |       |
|                                                                            |       |                    |        |                 |       |
| **Total  Liabilities and Members’ Equity**                                 |       | $                  | 112,010,394 |                 | $          | 113,089,277 |   |

 

See Notes to Condensed Consolidated FinancialStatements

 

----

*                               Derived from audited financial statements

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Condensed ConsolidatedStatements of Operations

 
| ** **                                                  | ** ** | **Three Months  Ended April 30,** | ** ** | **Three Months  Ended April 30,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                  | ** ** | **2010**                                         | ** ** | **2009**                                         | ** ** |
| ** **                                                  | ** ** | **(Unaudited)**                                  | ** ** | **(Unaudited)**                                  | ** ** |
|                                                        |       |                                             |       |                                             |       |
| **Revenues**                                                |       | $                                                | 25,501,136 |                                             | $          | 21,493,104 |   |
|                                                        |       |                                                  |       |                                             |       |
| **Cost  of Goods Sold**                                     |       |                                             |       |                                             |       |
| Cost of goods sold                                          |       | 24,842,423                                       |       | 21,241,824                                       |       |
| Lower of cost or market  adjustment`                        |       | 156,300                                          |       | 1,448,381                                        |       |
| **Total  Cost of Goods Sold**                               |       | 24,998,723                                       |       | 22,690,205                                       |       |
|                                                        |       |                                                  |       |                                             |       |
| **Gross  Margin (Loss)**                                    |       | 502,413                                          |       | (1,197,101                                       | )          |
|                                                        |       |                                                  |       |                                             |       |
| **Selling,  General, and Administrative Expenses**          |       | 1,042,113                                        |       | 705,677                                          |       |
|                                                        |       |                                                  |       |                                             |       |
| **Operating  Loss**                                         |       | (539,700                                         | )          | (1,902,778                                       | )          |
|                                                        |       |                                                  |       |                                             |       |
| **Other  Income (Expense)**                                 |       |                                             |       |                                             |       |
| Interest income                                             |       | 10,042                                           |       | 13,991                                           |       |
| Interest expense                                            |       | (1,165,426                                       | )          | (905,485                                         | )          |
| Other income, net                                           |       | 202,471                                          |       | 16,339                                           |       |
| Total other expense,  net                                   |       | (952,913                                         | )          | (875,155                                         | )          |
|                                                        |       |                                                  |       |                                             |       |
| **Net  Loss**                                               |       | $                                                | (1,492,613 | )                                                | $          | (2,777,933 | ) |
|                                                        |       |                                                  |       |                                             |       |
| **Net Loss  Per Unit - Basic and Diluted**                  |       | $                                                | (0.06      | )                                                | $          | (0.10 | ) |
|                                                        |       |                                                  |       |                                             |       |
| **Weighted  Average Units Outstanding - Basic and Diluted** |       | 27,104,625                                       |       | 27,104,625                                       |       |

 

See Notes to Condensed Consolidated FinancialStatements

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Condensed ConsolidatedStatements of Operations

 
| ** **                                                  | ** ** | **Six Months  Ended April 30,** | ** ** | **Six Months  Ended April 30,** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                  | ** ** | **2010**                                       | ** ** | **2009**                                       | ** ** |
| ** **                                                  | ** ** | **(Unaudited)**                                | ** ** | **(Unaudited)**                                | ** ** |
|                                                        |       |                                           |       |                                           |       |
| **Revenues**                                                |       | $                                              | 55,188,351 |                                           | $          | 39,588,470 |   |
|                                                        |       |                                                |       |                                           |       |
| **Cost  of Goods Sold**                                     |       |                                           |       |                                           |       |
| Cost of goods sold                                          |       | 49,345,327                                     |       | 41,119,676                                     |       |
| Lower of cost or market  adjustment                         |       | 789,199                                        |       | 3,458,230                                      |       |
| **Total  Cost of Goods Sold**                               |       | 50,134,526                                     |       | 44,577,906                                     |       |
|                                                        |       |                                                |       |                                           |       |
| **Gross  Margin (Loss)**                                    |       | 5,053,825                                      |       | (4,989,436                                     | )          |
|                                                        |       |                                                |       |                                           |       |
| **Selling,  General, and Administrative Expenses**          |       | 2,053,687                                      |       | 1,736,337                                      |       |
|                                                        |       |                                                |       |                                           |       |
| **Operating  Income (Loss)**                                |       | 3,000,138                                      |       | (6,725,773                                     | )          |
|                                                        |       |                                                |       |                                           |       |
| **Other  Income (Expense)**                                 |       |                                           |       |                                           |       |
| Interest income                                             |       | 24,296                                         |       | 51,872                                         |       |
| Interest expense                                            |       | (2,106,766                                     | )          | (1,923,529                                     | )          |
| Write off of loan costs                                     |       | —                                         |       | (444,985                                       | )          |
| Other income, net                                           |       | 207,881                                        |       | 17,677                                         |       |
| Total other expense,  net                                   |       | (1,874,589                                     | )          | (2,298,965                                     | )          |
|                                                        |       |                                                |       |                                           |       |
| **Net  Income (Loss)**                                      |       | $                                              | 1,125,549  |                                           | $          | (9,024,738 | ) |
|                                                        |       |                                                |       |                                           |       |
| **Net Income  (Loss) Per Unit - Basic and Diluted**         |       | $                                              | 0.04       |                                           | $          | (0.33 | ) |
|                                                        |       |                                                |       |                                           |       |
| **Weighted  Average Units Outstanding - Basic and Diluted** |       | 27,104,625                                     |       | 27,104,625                                     |       |

 

See Notes to Condensed Consolidated FinancialStatements

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Condensed ConsolidatedStatements of Cash Flows

 
| ** **                                                                         | ** ** | **Six Months  Ended April 30,** | ** ** | **Six Months  Ended April 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2010**                                       | ** ** | **2009**                                       | ** ** |
| ** **                                                                         | ** ** | **(Unaudited)**                                | ** ** | **(Unaudited)**                                | ** ** |
| **Operating  Activities**                                                          |       |                                           |       |                                           |       |
| Net income (loss)                                                                  |       | $                                              | 1,125,549  |                                           | $          | (9,024,738 | ) |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                           |       |                                           |       |
| Depreciation and  amortization                                                     |       | 2,810,631                                      |       | 2,796,132                                      |       |
| Amortization of loan  costs included with interest expense                         |       | —                                         |       | 22,143                                         |       |
| Write-off of loan costs                                                            |       | —                                         |       | 444,985                                        |       |
| Lower of cost or market  adjustments                                               |       | 789,199                                        |       | 3,458,230                                      |       |
| Change in fair value of  derivative instruments                                    |       | (23,737                                        | )          | (93,873                                        | )          |
| Change in operating  assets and liabilities:                                       |       |                                           |       |                                           |       |
| Restricted cash                                                                    |       | (20,383                                        | )          | 770,726                                        |       |
| Accounts receivable                                                                |       | (357,038                                       | )          | 766,817                                        |       |
| Inventory                                                                          |       | (2,577,561                                     | )          | 2,011,004                                      |       |
| Derivative instruments                                                             |       | 25,072                                         |       | 738,720                                        |       |
| Prepaid expenses and  other                                                        |       | (243,444                                       | )          | (531,098                                       | )          |
| Accounts payable                                                                   |       | (901,781                                       | )          | (4,074,250                                     | )          |
| Accrued expenses                                                                   |       | 462,256                                        |       | 137,137                                        |       |
| Accrued loss on forward  contracts                                                 |       | (1,850,310                                     | )          | (7,299,691                                     | )          |
| Net cash used in  operating activities                                             |       | (761,547                                       | )          | (9,877,756                                     | )          |
|                                                                               |       |                                                |       |                                           |       |
| **Investing  Activities**                                                          |       |                                           |       |                                           |       |
| Payments for  intangibles                                                          |       | —                                         |       | (59,835                                        | )          |
| Capital expenditures                                                               |       | (35,521                                        | )          | (258,901                                       | )          |
| Net cash used in  investing activities                                             |       | (35,521                                        | )          | (318,736                                       | )          |
|                                                                               |       |                                                |       |                                           |       |
| **Financing  Activities**                                                          |       |                                           |       |                                           |       |
| Proceeds from line of  credit, net                                                 |       | 1,750,000                                      |       | 2,000,000                                      |       |
| Payments of long-term  debt                                                        |       | (2,387,944                                     | )          | (2,232,505                                     | )          |
| Proceeds from issuance  of long-term debt                                          |       | —                                         |       | 1,011,486                                      |       |
| Debt service deposits  included with other assets                                  |       | —                                         |       | (30,350                                        | )          |
| Release of restricted  cash                                                        |       | 159,883                                        |       | 228,344                                        |       |
| Net cash provided by  (used in) financing activities                               |       | (478,061                                       | )          | 976,975                                        |       |
|                                                                               |       |                                                |       |                                           |       |
| **Net  decrease in cash and equivalents**                                          |       | (1,275,129                                     | )          | (9,219,517                                     | )          |
|                                                                               |       |                                                |       |                                           |       |
| **Cash  and Equivalents********— Beginning of Period**                        |       | 3,184,074                                      |       | 11,355,075                                     |       |
|                                                                               |       |                                                |       |                                           |       |
| **Cash  and Equivalents — End of Period**                                     |       | $                                              | 1,908,945  |                                           | $          | 2,135,558 |   |
| ** **                                                                         |       |                                           |       |                                           |       |
| **Supplemental  Cash Flow Information**                                            |       |                                           |       |                                           |       |
| Total interest paid                                                                |       | $                                              | 1,743,454  |                                           | $          | 1,849,256 |   |

 

Notes to Condensed Consolidated Financial Statementsare an integral part of these Statements.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

**1.**             **SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

The accompanying unaudited condensed consolidatedinterim financial statements have been prepared pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information anddisclosures normally included in annual financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted as permitted by such rules andregulations. These financial statements and related notes should be read inconjunction with the financial statements and notes thereto included in theCompany’s audited financial statements for the year ended October 31, 2009,contained in the Company’s annual report on Form 10-K.

 

In the opinion of management, the condensedconsolidated interim financial statements reflect all adjustments (consistingof normal recurring accruals, with the exception of the adjustments to write-offdeferred loan costs, reduce inventory and forward contacts to net realizablevalue and to reclassify certain debt as current) that we consider necessary topresent fairly the Company’s results of operations, financial position and cashflows. The results reported in these condensed consolidated interim financialstatements should not be regarded as necessarily indicative of results that maybe expected for any other quarter or for the fiscal year.

 

*Nature of Business*

 

The Company owns and operates a 50 million gallonethanol plant near Heron Lake, Minnesota. In addition, the Company produces and sells distillers grains withsolubles as co-products of ethanol production.

 

*Principles of Consolidation*

 

The financial statements include the accounts of HeronLake BioEnergy, LLC and its wholly owned subsidiary, Lakefield FarmersElevator, LLC, collectively, the “Company.”  All significant intercompanybalances and transactions are eliminated in consolidation.

 

*Accounting Estimates*

 

Management uses estimates and assumptions in preparingthese financial statements in accordance with generally accepted accountingprinciples. Those estimates and assumptions affect the reported amounts ofassets and liabilities, the disclosure of contingent assets and liabilities,and the reported revenues and expenses.  The Company uses estimates andassumptions in accounting for significant matters including, among others, theanalysis of impairment of long-lived assets, and valuation of forward purchasecontract commitments and inventory.  The Company periodically reviewsestimates and assumptions, and the effects of revisions are reflected in theperiod in which the revision is made. Actual results could differ from thoseestimates.

 

*Long-Lived Assets*

 

The Company reviews property and equipment and otherlong-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying amount may not be recoverable.  Circumstanceswhich could trigger a review include, but are not limited to: significant decreasesin the market price of the asset; significant adverse changes in the businessclimate or legal factors; accumulation of costs significantly in excess of theamount originally expected for the acquisition or construction of the asset;current period cash flow or operating losses combined with a history of lossesor a forecast of continuing losses associated with the use of the assets; andcurrent expectation that the asset will more likely than not be sold ordisposed significantly before the end of its estimated useful life.  Ifcircumstances require a long-lived asset be tested for possible impairment, theCompany first compares undiscounted cash flows expected to be generated by anasset to the carrying value of the asset. If the carrying value of thelong-lived asset is not recoverable on an undiscounted cash flow basis, animpairment is recognized to the extent that the carrying value exceeds its fairvalue. Fair value is determined through various valuation techniques includingdiscounted cash flow models, quoted market values and third-party independentappraisals, as considered necessary.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

The Company’s ethanol production plant has a statedcapacity of 50 million gallons per year.  The carrying value of theCompany’s facilities at April 30, 2010 and October 31, 2009 wasapproximately $95.8 million and $98.5 million, respectively. In accordancewith the Company’s policy for evaluating impairment of long-lived assetsdescribed above, management has evaluated the recoverability of the facilitiesbased on projected future cash flows from operations over the facilities’estimated useful lives. Management has determined that the projected futureundiscounted cash flows from operations of these facilities exceed theircarrying value at April 30, 2010 and October 31, 2009; therefore, noimpairment loss was indicated or recognized. In determining the projectedfuture undiscounted cash flows, the Company has made significant assumptionsconcerning the future viability of the ethanol industry, the future price ofcorn in relation to the future price of ethanol and the overall demand inrelation to production and supply capacity.  Given the uncertainties inthe ethanol industry, should management be required to adjust the carryingvalue of the facilities at some future point in time, the adjustment could besignificant and could significantly impact the Company’s financial position andresults of operations.  No adjustment has been made to these financialstatements for this uncertainty.

 

*Financial Instruments*

 

The Company believes the carrying value of cash andequivalents and restricted cash approximate fair value.

 

The Company believes the carrying amount of derivativeinstruments approximates fair value based on quoted prices in activeexchange-traded or over-the-counter markets.

 

The Company believes the carrying amount of the lineof credit and the variable rate portion of the note payable approximates thefair value.

 

The Company estimates the fair value of debt based onthe difference between the market interest rate and the stated interest rate ofthe debt.  The carrying amount and the fair value of long-term debtare as follows:

 
| ** **                               | ** ** | **Carrying Amount** | ** ** | **Fair Value** | ** ** |
|------------------------------------------|------------|--------------------------|------------|---------------------|------------|
|                                     |       |                     |       |                |       |
| Long-term debt at  April 30, 2010   |       | $                        | 57,612,043 |                | $          | 55,562,862 |   |
| Long-term debt at  October 31, 2009 |       | $                        | 59,999,987 |                | $          | 60,228,760 |   |

 

*Environmental Liabilities*

 

The Company’s operations are subject to environmentallaws and regulations adopted by various governmental entities in thejurisdiction in which it operates.  These laws require the Company toinvestigate and remediate the effects of the release or disposal of materialsat its location.  Accordingly, the Company has adopted policies,practices, and procedures in the areas of pollution control, occupationalhealth, and the production, handling, storage and use of hazardous materials toprevent material environmental or other damage, and to limit the financialliability that could result from such events.  Environmental liabilitiesare recorded when the liability is probable and the costs can be reasonablyestimated.

 

**2.**           **GOING CONCERN**

 

The financial statements have been prepared on agoing-concern basis, which contemplates the recoverability of assets and thesatisfaction of liabilities in the normal course of business. Significantvolatility in the commodity markets caused margins in the ethanol industry tobe negative during portions of fiscal year 2009 and 2010. The Company incurreda loss of approximately $1.5 million and generated cash of approximately$700,000 from operating activities during the three months ended April 30,2010.  For the six months ended April 30, 2010, the Company had netincome of approximately $1.1 million and used cash of approximately $762,000for operating activities.  At April 30, 2010, as at January 31,2010 and October 31, 2009, the Company was out of compliance withcovenants of its master loan agreement with AgStar Financial Services,PCA (“AgStar”). In addition, the Company anticipates that one or more ofthe covenants will not be met as of October 31, 2010 and April 30,2011 unless amended.  The Companypreviously reclassified the long-term debt related to this agreement to currentliabilities because the Company was not in compliance with the minimum workingcapital requirement. That reclassification remains as of

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

April 30, 2010 because of the actual andanticipated covenant defaults stated above.  If AgStar exercises its rightto accelerate the maturity of the debt outstanding under the master loanagreement or the line of credit, the Company will not have adequate availablecash to repay the amounts currently outstanding at April 30, 2010. Further, while an event of default exists, the Company is not permittedto borrow additional funds under its line of credit or revolving term notewithout AgStar’s consent. These factors raise substantial doubt about theCompany’s ability to continue as a going concern.

 

During fiscal year 2009, AgStar waived the Company’sdefault of the working capital covenant of the master loan agreement for theperiods ending January 31, 2009, April 30, 2009 and July 31,2009.  However, AgStar has not waived the covenant defaults for theperiods ending October 31, 2009 relating to minimum working capital,tangible net worth and the fixed charge ratio.  AgStar has also not waivedthe default of the minimum working capital covenant for the periods ending January 31,2010 and April 30, 2010.  The Company is actively negotiating thesewaivers with AgStar.

 

Effective March 25, 2010, the Company and AgStaramended the master loan agreement as previously amended and supplemented, whichresulted in an extension of the maturity date of the revolving line of creditto April 30, 2010.  The Company did not repay the $6.75 millionoutstanding on the revolving line of credit on the April 30, 2010 maturitydate because of ongoing negotiations with AgStar regarding the renewal of theline of credit, which on May 27, 2010 resulted in a renewal of the line ofcredit as described below.  AgStar began accruing default interest ata 2.00% default rate effective February 1, 2010 on all of the Company’sloans with AgStar.

 

On May 27, 2010, the Company and AgStar agreedupon the terms of the renewal of the Company’s line of credit.  Therefore,effective May 27, 2010, the Company entered into an Amendment No. 6to the Fifth Supplement to its master loan agreement, as previously amended andsupplemented, with AgStar.  Among other things, the effect of thisamendment was to renew the Company’s revolving line of credit loan with amaturity date of June 30, 2010.

 

The Company believes it has sufficient capitalresources through April 30, 2011 based upon its current cash reserves,inventory sales, projected commodity markets and the available borrowing underthe master loan agreement, as well as the effect of expense reduction measures,provided that AgStar extends the maturity date of the revolving line of credit,does not exercise its right to accelerate the maturity of the long term debt,and the Company is not otherwise required to repay its indebtedness to AgStarunder the master loan agreement on an accelerated basis. The Company’s expensereduction measures and cash conservation measures include utilizing andreducing corn inventory as well as reducing operating expenses through cost controls. If the Company is not able to maintain sufficient funding in the short-term,the Company may be forced to raise additional capital through incurringsubordinated debt or selling additional equity (although no assurance can begiven that the Company will be able to raise capital on favorable terms, if atall), restructure or significantly curtail its operations, file for bankruptcyor cease operations.  The financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or amounts and classification of liabilities that might be necessaryshould the Company be forced to take any such actions*.*

 

**3.**             **UNCERTAINTIES**

 

The Company has certain risks and uncertainties thatit experienced during volatile market conditions such as what the Companyexperienced during fiscal 2009. These volatilities can have a severe impact onoperations. The Company’s revenues are derived from the sale and distributionof ethanol and distillers grains to customers primarily located in the U.S.Corn for the production process is supplied to the plant primarily from localagricultural producers.  Ethanol sales average 75% - 85% of total revenuesand corn costs average 65% - 75% of cost of goods sold.

 

The Company’s operating and financial performance islargely driven by the prices at which it sells ethanol and the net expense ofcorn. The price of ethanol is influenced by factors such as supply and demand,the weather, government policies and programs, unleaded gasoline prices and thepetroleum markets as a whole. Excess ethanol supply in the market, inparticular, puts downward pressure on the price of ethanol. The largest cost ofproduction is corn. The cost of corn is generally impacted by factors such as supplyand demand, the weather, government policies and programs, and a riskmanagement program used to protect against the price volatility of thesecommodities. Market fluctuations in the price of and demand for these productsmay have a significant adverse effect on the Company’s operations,profitability and the availability and adequacy of cash flow to meet theCompany’s working capital requirements.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

**4.**             **FAIR VALUE MEASUREMENTS**

 

The Company measures certain financial instruments atfair value in its balance sheets.  The fair value of these instruments isbased on valuations that include inputs that can be classified within one ofthe three levels of a hierarchy.  Level 1 inputs include quoted marketprices in an active market for identical assets or liabilities.  Level 2inputs are market data, other than Level 1, that are observable either directlyor indirectly.  Level 2 inputs include quoted market prices for similarassets or liabilities, quoted market prices in an inactive market, and otherobservable information that can be corroborated by market data.  Level 3inputs are unobservable and corroborated by little or no marketdata.   The fair value of certain long-lived assets is based onrecoverability through utilization in operations.  Except for those assetsand liabilities which are required by authoritative accounting guidance to berecorded at fair value in the balance sheets, the Company has elected not torecord any other assets or liabilities at fair value.

 

The following table provides information on thoseassets measured at fair value on a recurring basis.

 
| ** **                        | ** ** | **Fair Value as of** | ** ** | **Fair Value Measurement Using** | ** ** |
|-----------------------------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|
| ** **                        | ** ** | **April 30, 2010**        | ** ** | **Level 1**                                | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Restricted cash –  current   |       | $                                   | 361,027    |                                            | $          | 361,027 |   | $ | — |   | $ | — |   |
|                              |       |                                |       |                                            |       |   |   |   |   |
| Restricted cash –  long-term |       | $                                   | 558,907    |                                            | $          | 558,907 |   | $ | — |   | $ | — |   |
|                              |       |                                |       |                                            |       |   |   |   |   |
| Commodity derivative  instruments |       | $                                   | (1,335     | )                                               | $          | (1,335 | ) | $ | — |   | $ | — |   |

 

The fair value of the money market funds included inrestricted cash and derivative instruments are based on quoted market prices inactive markets.

 

**5.**             **INVENTORY**

 

Inventory consisted ofthe following at April 30, 2010 and October 31, 2009:

 
| ** **      | ** ** | **April 30,** | ** ** | **October 31,** | ** ** |
|-----------------|------------|--------------------|------------|----------------------|------------|
| ** **      | ** ** | **2010**           | ** ** | **2009 ***      | ** ** |
| Raw materials   |       | $                  | 3,892,852  |                 | $          | 1,551,255 |   |
| Work in process |       | 710,130            |       | 776,801              |       |
| Finished goods  |       | 1,415,605          |       | 800,915              |       |
| Supplies        |       | 868,185            |       | 847,289              |       |
| Other grains    |       | 375,719            |       | 775,857              |       |
| Total           |       | $                  | 7,262,491  |                 | $          | 4,752,117 |   |

 

----

*    Derived from audited financialstatements

 

The Company recorded losses of approximately $9,000and $67,000 for the three and six months ended April 30, 2010,respectively, related to inventory, in addition to losses recorded on forwardpurchase contracts as noted in Note 10, where the market value was less thanthe cost basis, attributable primarily to decreases in market prices of cornand ethanol. The loss was recorded with the lower of cost or market adjustmentin the statement of operations. In addition, the Company stored grain inventoryfor farmers.  The value of these inventories owned by others is approximately$396,000 and $283,000 based on market prices at April 30, 2010 and October 31,2009, respectively, and is not included in the amounts above.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

**6.**             **DERIVATIVE INSTRUMENTS**

 

As of April 30, 2010, the Company has ethanolderivative instruments, which are required to be recorded as either assets orliabilities at fair value in the Condensed Balance Sheet. Derivatives qualifyfor treatment as hedges when there is a high correlation between the change infair value of the derivative instrument and the related change in value of theunderlying hedged item and when the Company formally documents, designates, andassesses the effectiveness of transactions that receive hedge accountinginitially and on an on-going basis. The Company must designate the hedginginstruments based upon the exposure being hedged as a fair value hedge or acash flow hedge. The Company does not enter into derivative transactions fortrading purposes.

 

The Company enters into corn and ethanol derivativesin order to protect cash flows from fluctuations caused by volatility incommodity prices for periods up to 24 months. These derivatives are put inplace to protect gross profit margins from potentially adverse effects ofmarket and price volatility on ethanol sales and corn purchase commitmentswhere the prices are set at a future date. Although these derivativeinstruments serve the Company’s purpose as an economic hedge, they are notdesignated as effective hedges for accounting purposes. For derivative instrumentsthat are not accounted for as hedges, or for the ineffective portions ofqualifying hedges, the change in fair value is recorded through earnings in theperiod of change. As of April 30, 2010, the notional amount of the Company’soutstanding derivative instruments was approximately 870,000 gallons that wereentered into to hedge forecasted ethanol sales through May 2010.

 

The following tables provide details regarding theCompany’s fair value of the derivative instruments at April 30, 2010, noneof which are designated as hedging instruments:

 
| ** **        | ** ** | **Balance  Sheet location** | ** ** | **Assets** | ** ** | **Liabilities** | ** ** |
|-------------------|------------|-----------------------------|------------|------------|------------|-----------------|------------|
| Ethanol contracts |       | Derivative instruments      |       | $          | —     |            | $          | 1,335 |   |
|                   |            |                             |            |            |            |                 |            |  |  |

 

In addition, as of April 30, 2010 the Company hadapproximately $18,000 of restricted cash related to margin requirements for theCompany’s derivative instrument positions.

 

The following tables provide details regarding thegains and (losses) from the Company’s derivative instruments included inthe consolidated statements of operations, none of which are designated ashedging instruments:

 
| ** **        | ** ** | **Statement  of**        | ** ** | **Three-Months  Ended April 30,** | ** ** |
|-------------------|------------|--------------------------|------------|----------------------------------------|------------|
| ** **        | ** ** | **Operations  location** | ** ** | **2010**                               | ** ** | **2009** | ** ** |
| Corn contracts    |       | Cost of goods sold       |       | $                                      | 9,000      |   | $ | 647,000 |   |
|              |       |                     |       |                                   |       |   |   |
| Ethanol contracts |       | Revenues                 |       | (138,000                               | )          | — |   |
| Totals            |       |                     |       | $                                      | (129,000   | ) | $ | 647,000 |   |

 
| ** **        | ** ** | **Statement  of**        | ** ** | **Six-Months  Ended April 30,** | ** ** |
|-------------------|------------|--------------------------|------------|--------------------------------------|------------|
| ** **        | ** ** | **Operations  location** | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| Corn contracts    |       | Cost of goods sold       |       | $                                    | 9,000      |   | $ | 1,134,000 |   |
|              |       |                          |       |                                 |       |   |   |
| Ethanol contracts |       | Revenues                 |       | (138,000                             | )          | 373,000 |   |
| Totals            |       |                     |       | $                                    | (129,000   | ) | $ | 1,507,000 |   |

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

**7.**             **LINE OF CREDIT**

 

The Company has a line of credit with AgStar subjectto certain borrowing base requirements.  The Company’s revolving line ofcredit loan is for a maximum commitment of $6,750,000 and had a maturity dateof November 1, 2009.  Effective December 8, 2009, the Companyand AgStar agreed upon an amendment that further extended the maturity date ofthe revolving line of credit to February 1, 2010.  Effective March 25, 2010, the Companyand AgStar agreed upon an amendment that further extended the maturity date ofthe revolving line of credit to April 30, 2010.  As of the dateof this filing, the Company has not repaid the revolving line of credit due on April30, 2010.  On May 27, 2010, the Company and AgStar agreed upon theterms of the renewal of the Company’s line of credit.  Therefore,effective May 27, 2010, the Company entered into an Amendment No. 6to the Fifth Supplement to its master loan agreement, as previously amended andsupplemented, with AgStar.  The effect of this amendment was to renew theCompany’s revolving line of credit loan with a maturity date of June 30,2010.  As of April 30, 2010 and January 31,2010, the Company was not in compliance with the minimum working capitalrequirement of the master loan agreement.  As of October 31, 2009,the Company was not in compliance with the minimum working capital, minimumtangible net worth and minimum fixed charge ratio provisions of the master loanagreement.  The Company is actively negotiating waivers of theunwaived covenant defaults at October, 31, 2009, January 31, 2010, and April 30,2010.  Interest accrues on borrowings atthe greater of 6.0% or the one-month LIBOR plus 3.25%, which totaled 3.50% at April 30,2010 and 3.49% at October 31, 2009.  AgStar began accruing defaultinterest at a 2.00% default rate effective February 1, 2010 on all ofthe Company’s loans with AgStar.  The Company has a 0.25% commitment feeon the unused portion of the line of credit.   As of April 30, 2010and October 31, 2009, the Company had drawn $6,750,000 and $5,000,000 on theline of credit respectively.

 

If AgStar exercises its right to accelerate thematurity of the debt outstanding under the master loan agreement or the line ofcredit, the Company will not have adequate available cash to repay the amountscurrently outstanding at April 30, 2010.  Further, while an event ofdefault exists, the Company is not permitted to borrow additional fundsunder its line of credit or revolving term note without AgStar’s consent.

 

**8.**             **DEBT FINANCING**

 

Debt financing consists of the following:

 
| ** **                                                   | ** ** | **April 30,** | ** ** | **October 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **2010**           | ** ** | **2009***            | ** ** |
| Term note payable to  lending institution, see terms below   |       | $                  | 51,224,524 |                 | $          | 53,381,697 |   |
|                                                         |       |                    |       |                 |       |
| Revolving term note to  lending institution, see terms below |       | 1,155,872          |       | 1,155,872            |       |
|                                                         |       |                    |       |                 |       |
| Assessments payable                                          |       | 3,665,849          |       | 3,677,128            |       |
|                                                         |       |               |       |                 |       |
| Notes payable to  electrical company                         |       | 1,512,589          |       | 1,719,773            |       |
|                                                         |       |                    |       |                 |       |
| Equipment note                                               |       | 53,209             |       | 65,517               |       |
|                                                         |       |                    |       |                 |       |
| Total                                                        |       | 57,612,043         |       | 59,999,987           |       |
|                                                         |       |                    |       |                 |       |
| Less amounts due on  demand or within one year               |       | 53,071,401         |       | 55,224,183           |       |
|                                                         |       |                    |       |                 |       |
| Net long term debt                                           |       | $                  | 4,540,642  |                 | $          | 4,775,804 |   |

 

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*    Derivedfrom audited financial statements

 

As described in Note 2, the Company is currently notin compliance with certain covenants of the master loan agreement with AgStarand has reclassified the long-term portion of the debt with them to current.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

*Term Note*

 

The term note requires monthly payments ofapproximately $652,000 of principal and interest. Interest accrues at theone-month LIBOR plus 3.25%, which totaled 3.50% and 3.49% at April 30,2010 and October 31, 2009, respectively. In May 2008, the Companylocked in an interest rate of 6.58% on $45,000,000 of the note for three yearsending April 30, 2011. As described in Notes 2 and 7, as of April 30,2010 and October 31, 2009, the Company was not in compliance with certaincovenants of the master loan agreement and the Company does not expect tobe in compliance with one or more covenants of the master loan agreement as of October 31,2010 and April 30, 2011.  Therefore, the term note and the revolvingterm note described below remain classified as current liabilities. The termnote originally had a ten year amortization, with a final balloon payment duein October 2012. In addition, the Company is required to make additionalpayments on the term note of excess cash flow, as defined in the agreement, upto $2,000,000 per year to AgStar until the Company meets a specified financialratio. As part of the debt financing, the premium above LIBOR may be reducedbased on the ratio of members’ equity to assets. The owner of the general contractor,who is a member, has personally guaranteed up to $3,740,000 of the Company’sobligations under the master loan agreement.  If AgStar exercises itsright to accelerate the maturity of the debt outstanding under the master loanagreement or the line of credit, the Company will not have adequate availablecash to repay the amounts currently outstanding at April 30, 2010. Further, while an event of default exists, the Company is not permittedto borrow additional funds under its line of credit or revolving term notewithout AgStar’s consent.  AgStar beganaccruing default interest at a 2.00% default rate effective February 1,2010 on all of the Company’s loans with AgStar.

 

*Revolving Term Note*

 

The Company has a revolving term note with AgStar forup to $4,000,000 for cash and inventory management purposes. The maximum amountavailable under the revolving term note decreases $500,000 each year.  TheCompany pays interest on principal advances monthly at the one-month LIBOR rateplus 3.25%, which totaled 3.50% and 3.49% at April 30, 2010 and October 31,2009, respectively. The Company pays a commitment fee of 0.35% per annum on theunused portion of the revolving term note. As described above and in Notes 2and 7, as of and for the period ending April 30, 2010, the Company was outof compliance with the working capital covenant of the master loan agreementand does not anticipate being in compliance as of and for the periods ending October 31,2010 and April 30, 2011.  As such, amounts due under the revolvingterm note have been classified as current liabilities and while an event ofdefault exists, the Company is not permitted to borrow additional fundsunder the revolving term note without AgStar’s consent.  AgStar began accruing default interest ata 2.00% default rate effective February 1, 2010 on all of the Company’sloans with AgStar.

 

Estimated maturities of long-term debt afterreclassification to current at April 30, 2010 are as follows:

 
| 2010                 |   | $         | 53,071,401 |   |
|----------------------|--------|-----------|------------|--------|
| 2011                 |   | 711,554   |       |
| 2012                 |   | 615,238   |       |
| 2013                 |   | 366,229   |       |
| 2014                 |   | 383,050   |       |
| After 2014           |   | 2,464,571 |       |
|                 |   |           |       |
| Total long-term debt |   | $         | 57,612,043 |   |

 

**9.**             **MEMBERS’ EQUITY**

 

The Company is authorized to issue 50,000,000 capitalunits, of which 35,000,000 have been designated Class A units and15,000,000 have been designated as Class B units.  As of April 30,2010 and October 31, 2009, the Company had outstanding 27,104,625 Class Aand no Class B units.  Members ofthe Company are holders of units who have been admitted as members and whohold at least 2,500 units.  Any holder of units who is not a member willnot have voting rights.  Transferees of units must be approved by ourboard of governors to become members.  Members are entitled to one votefor each unit held. Subject to the Member Control Agreement, all units shareequally in the profits and losses and distributions of assets on a per unitbasis.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

**10.            LEASES**

 

The Company leases equipment, primarily rail cars,under operating leases through 2017.   Rent expense for the sixmonths ended April 30, 2010 and 2009 was approximately $895,000 and $484,000,respectively.

 

At April 30, 2010 the Company had the followingminimum future lease payments, which at inception had non-cancelable terms ofmore than one year:

 
| 2011                    |   | $         | 1,681,960 |   |
|-------------------------|--------|-----------|-----------|--------|
| 2012                    |   | 1,662,810 |      |
| 2013                    |   | 1,590,475 |      |
| 2014                    |   | 1,556,100 |      |
| 2015                    |   | 849,475   |      |
| Thereafter              |   | 1,940,400 |      |
|                    |   |           |      |
| Total lease commitments |   | $         | 9,281,220 |   |

 

**11.**             **COMMITMENTS AND CONTINGENCIES**

 

*Legal Proceedings*

 

Permit Matters

 

The Company’s business subjects it to various federal,state and local environmental laws and regulations, including those relating todischarges into the air, water and ground; the generation, storage, handling,use, transportation and disposal of hazardous materials; and the health andsafety of its employees.

 

The costs associated with obtaining required permitsand meeting the demands of regulators reflected in the permits have increasedthe costs of construction and production. In particular, the Company hasincurred additional costs relating to an air-emission permit from the MinnesotaPollution Control Agency (“MPCA”). The Company applied for a synthetic minorair-emissions source permit in July 2004 that was granted by the MPCA in May 2005.In June 2005, a coalition of two environmental groups and one energy groupchallenged the grant of this air emissions permit by an appeal to the MinnesotaCourt of Appeals. In July 2006, the Minnesota Court of Appeals affirmedthe MPCA’s issuance of the permit. In conjunction with the permit and thepermit dispute and to prevent further appeals by the coalition, the Companyentered into a compliance agreement with the MPCA on January 23, 2007 thatcurrently governs the air emissions from the plant. Under the complianceagreement, the Company agreed to submit an amendment to its air permit toqualify its facility as a “major emissions source”. The compliance agreementalso allowed the Company to continue the construction of the facility. Underthe compliance agreement, the Company agreed to operate its facility in amanner such that the emissions of each of the criteria pollutants generated bythe ethanol plant, as determined on a 12 month rolling sum, do not exceed 95tons per year and agreed to comply in all other respects with the air emissionspermit previously issued by the MPCA. Accordingly, the Company submitted amajor amendment to its existing air-emissions permit in December 2008,and, following air pollution control device testing, the Company submitted asecond major amendment in September 2009, both seeking amendments to theair permit, including amendments to permit conditions and adjustments to othercomponents of plant operations and production.   However, the Companyis continuing discussions with the MPCA regarding the necessity for qualifyingthe facility as a major emissions source, particularly in light of changes infederal law that increased the limit of certain emissions allowed as asynthetic minor source. On March 13, 2008, MPCA issued a notice ofviolation to the Company for violations of certain rules, statutes, and permitconditions (as modified by the compliance agreement), including emissionviolations and reporting violations.  As part of the Company’s continuingdiscussions with MPCA, it is seeking to resolve these violations by agreementwith MPCA.  A violation of environmental laws, regulations or permitconditions can result in substantial civil fines or criminal sanctions, orpermit revocations or plant shutdown.  Pending the resolution of this airpermit issue, the Company continues to operate subject to the complianceagreement.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

Fagen Design-Build Dispute

 

On September 28, 2005, the Company executed aDesign-Build Agreement with Fagen, Inc. by which Fagen, Inc. agreedto design and build a 50 million gallon per year coal-fired ethanol plant inHeron Lake, Minnesota, for a contract price of approximately $76,000,000. The agreement contained numerous warranty and guarantee provisions as well as aliquidated damages provision.  Construction began in late 2005, and afterseveral delays the first corn grind took place on September 21,2007.  The plant, however, has not been able to meet the air emissionswarranties or operate as a “synthetic minor source” as warranted and intendedunder the design-build agreement.

 

By the terms of the Design-Build Agreement, claims orcontroversies between the Company and Fagen, Inc. arising out of orrelating to the Design-Build Agreement, or the breach thereof, are ultimatelyto be decided by Arbitration in accordance with the Construction IndustryArbitration Rules of the American Arbitration Association.  On September 18,2009 the Company served and filed its Demand for Arbitration and Request forMediation.  A Revised Demand for Arbitration was served and filed on December 23,2009 following an unsuccessful attempt to mediate the dispute.  In theseDemands for Arbitration, the Company alleges that Fagen, Inc. breached theterms and conditions of the Design-Build Agreement including its warranties andguarantees, was negligent in its efforts to correct various performance andemissions problems, had not completed the plant on a timely basis in accordancewith the Design-Build Agreement, and prior to the execution of the Agreementhad made certain negligent misrepresentations with respect to coal-firedethanol plants.  In the Demand for Arbitration, the Company seeks damagesfor breach of contract and breach of the warranties and guarantees, damagesresulting from the negligent efforts to correct the problems, damages for thenegligent misrepresentations, as well as liquidated damages for delays in theplant construction.  The Company seeks damages in the amount of$22,800,000.

 

Fagen, Inc. responded to the Demand forArbitration by denying liability and asserting various affirmativedefenses.  In addition, Fagen, Inc. brought a Counterclaim alleging thatit is entitled to payment of a retainage held by the Company in the amount ofapproximately $3.8 million.  In addition, Fagen, Inc. alleges that itperformed additional work and provided additional labor and materials to theplant in the amount of approximately $2.2 million; it alleges that this did notconstitute warranty or guarantee work and therefore it claims it is entitled topayment of this additional amount.   The Company responded to theCounterclaim by denying the allegations and asserting various affirmativedefenses. On January 4, 2010, Fagen, Inc. requested to join ICM, Inc.as a party to the arbitration action, claiming that joinder was necessary forproper resolution of the claims and defenses in the arbitration action. On January 27, 2010, ICM, Inc. responded to the request, agreeing to bejoined provided certain procedures are established.  In its response, ICMalso indicated that it intends to assert claims against the Company under thelicense agreement the Company entered into with ICM as part of the design buildagreement with Fagen.  An estimate of the amount of any such claims, ifasserted, cannot be made. On January 27, 2010, the Company filed itsresponse and objections to Fagen’s request to join ICM as a party, andrequested that a special arbitrator be appointed to resolve the joinderissues.  The Company intends to defend against the Fagen counterclaims andany claims brought by ICM, Inc. and assert its defenses vigorously.

 

The arbitration proceeding is in its early phase, andarbitrators have not yet been selected.

 

*Contractual Obligations*

 

The following table provides information regarding theconsolidated contractual obligations of the Company as of April 30, 2010:

 
| ** **                      | ** ** | **Total**  | ** ** | **Less than  One Year** | ** ** | **One to Three  Years** | ** ** | **Three to  Five Years** | ** ** | **Greater  Than Five  Years** | ** ** |
|---------------------------------|------------|------------|------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| Long-term debt  obligations (1) |       | $          | 66,575,619 |                              | $          | 56,900,876                        |       | $                                  | 5,561,387  |                               | $          | 1,065,318 |   | $ | 3,048,038 |   |
| Operating lease  obligations    |       | 9,281,220  |       | 1,681,960                         |       | 3,253,285                         |       | 2,405,575                          |       | 1,940,400                          |       |
| Purchase obligations  (2)       |       | 14,702,115 |       | 8,989,859                         |       | 5,712,256                         |       | —                             |       | —                             |       |
| Total contractual  obligations  |       | $          | 90,558,954 |                              | $          | 67,572,695                        |       | $                                  | 14,526,928 |                               | $          | 3,470,893 |   | $ | 4,988,438 |   |

 

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(1)                                 Long-term debt obligations includeestimated interest and interest on unused debt.

(2)                                 Purchase obligations primarily includeforward contracts for corn and coal.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

April 30, 2010(Unaudited)

 

*Forward Contracts*

 

The Company has forward contracts in place for cornpurchases of approximately $3.7 million through October 2010, whichrepresents approximately 11% of the Company’s anticipated corn purchases forthe remainder of fiscal 2010.

 

Currently, some of these corn contract prices areabove market prices for corn. Given the recent changing price of corn upontaking delivery under these contracts, the Company would incur a loss.Accordingly, the Company recorded a loss on purchase commitments ofapproximately $147,000 and $722,000 for the three and six months ended April 30,2010, respectively.  The loss was recorded as a lower of cost or marketadjustment on the statement of operations. The amount of the loss wasdetermined by applying a methodology similar to that used in the lower of costor market evaluation with respect to inventory. Given the uncertainty of futureethanol prices, this loss may or may not be recovered, and further losses onthe outstanding purchase commitments could be recorded in future periods.

 

**12.**          **RELATED PARTY TRANSACTIONS**

 

During the three months ending April 30, 2010 andApril 30, 2009, the Company purchased corn from members for approximately$9.2 million and $10.6 million, respectively.  The Company purchased cornfrom members of approximately $21.0 million and $24.8 million during the sixmonths ended April 30, 2010 and April 30, 2009, respectively.

 

Please refer to the section titled “Legal Proceedings”in Note 10 for information on arbitration proceedings between the Company andFagen, Inc., a related party.

 

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**Item 2. Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

*This Management’s Discussion andAnalysis of Financial Condition and Results of Operations, contains, inaddition to historical information, forward-looking statements that are basedon our expectations, beliefs, intentions or future strategies. These statementsare subject to risks and uncertainties that could cause actual results to**differmaterially from the statements because of certain factors, including those setforth under Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-Kfor the year ended October 31, 2009, as well as in other filings we makewith the Securities and Exchange Commission. All forward-looking statementsincluded herein are based on information available to us as of the date hereof,and we undertake no obligation to update any such forward-looking statements.*

 

The following is a discussion and analysis of HeronLake BioEnergy’s financial condition and results of operations as of and forthe three month and six month periods ended April 30, 2010 and 2009. Thissection should be read in conjunction with the condensed consolidated financialstatements and related notes in Item 1 of this report and the Company’s AnnualReport on Form 10-K for the year ended October 31, 2009.

 

We prepared the following discussion and analysis tohelp readers better understand our financial condition, changes in ourfinancial condition, and results of operations for the six months ended April 30,2010.

 

**Overview**

 

Heron Lake BioEnergy, LLC is a Minnesota limitedliability company that was formed for the purpose of constructing and operatinga dry mill corn-based ethanol plant near Heron Lake, Minnesota. The plant has astated capacity to produce 50 million gallons of denatured fuel gradeethanol and 160,000 tons of dried distillers’ grains per year. Production ofethanol and distillers’ grains at the plant began in September 2007. Webegan recording revenue from plant production in October 2007, the lastmonth of our fiscal year. Our revenues are derived from the sale anddistribution of our ethanol and in the sale and distribution of our distillers’grains.

 

Our operating results are largely driven by the pricesat which we sell ethanol and distillers grains and the costs related to theirproduction, particularly the cost of corn. Historically, the price of ethanoltended to fluctuate in the same direction as the price of unleaded gasoline andother petroleum products. However, during fiscal 2009 and continuing intofiscal 2010, ethanol prices tended to move up and down proportionately withchanges in corn prices. The price of ethanol can also be influenced by factorssuch as general economic conditions, concerns over blending capacities, andgovernment policies and programs. The price of distillers grains is generallyinfluenced by supply and demand, the price of substitute livestock feed, suchas corn and soybean meal, and other animal feed proteins. Our largest componentof and cost of production is corn. The cost of corn is affected primarily byfactors over which we lack any control such as crop production, carryout, exports,government policies and programs, and weather. The growth of the ethanolindustry has increased the demand for corn. We believe that continuing increasein global demand will result in corn prices above historicaverages.   During the second quarter of fiscal year 2010 ended April 30,2010, the price of ethanol on the Chicago Board of Trade fluctuated from $1.51to $1.82 per gallon; our average sales price was $1.52 per gallon, withbasis.  During the same period, the price of corn on the Chicago Board ofTrade fluctuated from a low of $3.44 to a high of $3.91 per bushel; our averagepurchase price was $3.43 per bushel, with basis.

 

**Trends and Uncertainties ImpactingOur Operations**

 

Our current and future results of operation areaffected and will continue to be affected by factors such as (a) volatileand uncertain pricing of ethanol and corn; (b) availability of corn thatis, in turn, affected by trends such as corn acreage, weather conditions, andyields on existing and new acreage diverted from other crops; and (c) thesupply and demand for ethanol, which is affected by acceptance of ethanol as asubstitute for fuel, public perception of the ethanol industry, governmentincentives and regulation, and competition from new and existing construction, amongother things. Other factors that may affect our future results of operationinclude those factors discussed in “Item 1. Business” and “Item 1A. RiskFactors” of our Annual Report on Form 10-K for the year ended October 31,2009.

 

**Critical Accounting Estimates**

 

A description of our critical accounting estimates wasprovided in the *Management’s Discussion andAnalysis of Financial Condition and Results of Operations* section ofour Annual Report on Form 10-K for the year ended October 31, 2009.At April 30, 2010, our critical accounting estimates continue to includethose described in our Annual Report on Form 10-K. In addition, ouranalysis of future projections, resolution of debt terms and other assumptionsin consideration of continuing as a going concern include critical accountingestimates.

 

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**Results of Operations for the ThreeMonths Ended April 30, 2010 and 2009**

 

The following table shows summary information from ourStatement of Operations for the three months ended April 30, 2010 and April 30,2009.

 
| ** **                          | ** ** | **Three  Months Ended********April 30, 2010** | ** ** | **Three  Months Ended********April 30, 2009** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| **Income Statement Data** | ** ** | **Amount**                                         | ** ** | **%**                                              | ** ** | **Amount** | ** ** | **%** | ** ** |
| Revenues                            |       | $                                                  | 25,501,136 |                                               | 100.0      |   | $ | 21,493,104 |   | 100.0 |   |
|                                |       |                                                    |       |                                               |       |   |   |   |   |
| Cost of Goods Sold                  |       |                                               |       |                                               |       |   |   |   |   |
| Cost of goods sold                  |       | 24,842,423                                         |       | 97.4                                               |       | 21,241,824 |   | 99.6 |   |
| Lower of cost or market  adjustment |       | 156,300                                            |       | 0.6                                                |       | 1,448,381 |   | 6.0 |   |
| Total Cost of Goods  Sold           |       | 24,998,723                                         |       | 98.0                                               |       | 22,690,205 |   | 105.6 |   |
|                                |       |                                                    |       |                                               |       |   |   |   |   |
| Gross Profit (Loss)                 |       | 502,413                                            |       | 2.0                                                |       | (1,197,101 | ) | (5.6 | ) |
|                                |       |                                                    |       |                                               |       |   |   |   |   |
| Operating Expenses                  |       | 1,042,113                                          |       | 4.1                                                |       | 705,677 |   | 3.3 |   |
|                                |       |                                                    |       |                                               |       |   |   |   |   |
| Operating Income (Loss)             |       | (539,700                                           | )          | (2.1                                               | )          | (1,902,778 | ) | (8.9 | ) |
|                                |       |                                                    |       |                                               |       |   |   |   |   |
| Other Expense, net                  |       | (952,913                                           | )          | (3.8                                               | )          | (875,155 | ) | (4.0 | ) |
|                                |       |                                                    |       |                                               |       |   |   |   |   |
| Net Income (Loss)                   |       | $                                                  | (1,492,613 | )                                                  | (5.9       | ) | $ | (2,777,933 | ) | (12.9 | ) |

 

*Revenues*

 

Revenues, derived from the sale of fuel ethanol anddistillers’ grains with solubles (“DGS”) produced at the plant, increased 19%for the quarter ended April 30, 2010 as compared to the quarter ended April 30,2009. Net ethanol revenues during the quarter ended April 30, 2010, wereapproximately $21.1 million, representing 83% of our sales, compared toapproximately $16.7 million during the quarter ended April 30, 2009,representing 78% of our sales. The increase in ethanol revenue was a result ofan 8% increase in the average price per gallon of ethanol quarter to quarter,in conjunction with a 17% increase in the gallons of ethanol sold. The maincontributing factor to the increase in gallons of ethanol sold is thecorrection of production difficulties experienced during the second quarter offiscal 2009.  We had losses ofapproximately $138,000 related to ethanol derivatives for the quarter ended April 30,2010. There were no ethanol derivative gains or losses during the quarter endedApril 30, 2009.

 

Total sales of DGS during the quarter ended April 30,2010 were approximately $3.4 million comprising 13% of our sales. DGSsales during the quarter ended April 30, 2009 were $3.8 million or 18% ofsales. The average DGS price decreased 22% for the quarter ended April 30,2010 as compared to the quarter ended April 30, 2009. DGS tonnage salesincreased by 44% for the quarter ended April 30, 2010 as compared to thequarter ended April 30, 2009 due to an increase in modified DGS produced.

 

*Cost of Goods Sold*

 

Our costs of sales include, among other things, thecost of corn used in ethanol and DGS production (which is the largest componentof costs of sales); coal, processing ingredients, electricity, and wages,salaries and benefits of production personnel. We use approximately 1.5 millionbushels of corn per month at the plant. We contract with local farmers andelevators for our corn supply.

 

Our cost of goods sold (including lower of cost ormarket adjustments) as a percentage of revenues were 98.0% and 105.6% for thethree months ended April 30, 2010 and April 30, 2009, respectively.The per bushel cost of corn, including lower of cost or market adjustments, decreasedapproximately 7% in the quarter ended April 30, 2010 as compared to thequarter ended April 30, 2009. This decrease combined with the 8% increasein the per gallon sales price of ethanol caused the decrease in the cost ofgoods sold as a percent of revenues. Cost of goods sold also includes lower ofcost or market adjustments of approximately $156,000 and $1,448,000 for thethree months ended April 30, 2010 and 2009, respectively, which related toforward purchase contracts and inventory where the fixed price was more thanthe estimated realizable value.  We had gains related to corn derivativeinstruments of approximately $9,000 and $647,000 for the quarters ended April 30,2010, and 2009, which reduced cost of sales. Our gross profit margin for thethree months ended April 30, 2010 increased to 2.0% from a loss of 5.6%for the three months ended April 30, 2009. We had a positive gross marginin the second quarter of fiscal 2010 as compared to a negative gross margin inthe second quarter of fiscal 2009 due to the 8% increase in ethanol priceswhile the cost of corn, including lower of cost or market adjustments, decreased7%.  For the same period, production increased 19% due to productionproblems in second quarter of fiscal 2009.

 

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The cost of corn fluctuates based on supply anddemand, which, in turn, is affected by a number of factors which are beyond ourcontrol. We expect our gross margin to fluctuate in the future based on therelative prices of corn and fuel ethanol. We use futures and option contractsto minimize our exposure to movements in corn prices, but there is no assurancethat these hedging strategies will be effective. At April 30, 2010, noneof our contracts were designated as hedges and, as a result, changes to themarket value of these contracts were recognized as a gain or loss. As a result,gains or losses on derivative instruments do not necessarily coincide with therelated corn purchases. This may cause fluctuations in our statement ofoperations. While we do not use hedge accounting to match gains or losses onderivative instruments, we believe the derivative instruments provide aneconomic hedge.

 

*Operating Expenses*

 

Operating expenses include wages, salaries andbenefits of administrative employees at the plant, insurance, professional feesand similar costs. These expenses represented 4.1% of total revenues for thethree months ended April 30, 2010 and 3.3% of total revenues for the threemonths ended April 30, 2009.   These expenses generally do not varywith the level of production at the plant and were relatively constant fromperiod to period other than costs incurred for environmental emissions testingdone during the three months ended April 30, 2010.

 

*Other Expense, Net*

 

Other expenses consisted primarily of interestexpense. Interest expense consists primarily of interest payments on our creditfacilities described below. Interest expense, which was up for the three monthsended April 30, 2010 approximately 29% as compared to the three months endedApril 30, 2009, is dependent on the balances outstanding and on interestrate fluctuations. For the three months ended April 30, 2010, debtbalances were down approximately 2%. However, balances on our line of credit increased from $2,000,000 at April 30,2009 to $6,750,000 at April 30, 2010 with interest rates of 3.81% and6.0%, respectively.  Balances on our lineof credit have a minimum interest rate of 6% at April 30, 2010.  Additionally, we accrued a 2% defaultinterest on all AgStar debt beginning February 1, 2010 which addedadditional expense for the three months ended April 30, 2010 that was notincurred for the three months ended April 30, 2009.

 

**Results of Operations for the SixMonths Ended April 30, 2010 and 2009**

 

The following table shows summary information from ourStatement of Operations for the six months ended April 30, 2010 and April 30,2009.

 
| ** **                          | ** ** | **Six Months Ended********April 30, 2010** | ** ** | **Six Months Ended********April 30, 2009** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| **Income Statement Data** | ** ** | **Amount**                                                     | ** ** | **%**                                                          | ** ** | **Amount** | ** ** | **%** | ** ** |
| Revenues                            |       | $                                                              | 55,188,351 |                                                           | 100.0      |   | $ | 39,588,470 |   | 100.0 |   |
|                                |       |                                                                |       |                                                           |       |   |   |   |   |
| Cost of Goods Sold                  |       |                                                           |       |                                                           |       |   |   |   |   |
| Cost of goods sold                  |       | 49,345,327                                                     |       | 89.4                                                           |       | 41,119,676 |   | 104.3 |   |
| Lower of cost or market  adjustment |       | 789,199                                                        |       | 1.4                                                            |       | 3,458,230 |   | 8.3 |   |
| Total Cost of Goods  Sold           |       | 50,134,526                                                     |       | 90.8                                                           |       | 44,577,906 |   | 112.6 |   |
|                                |       |                                                                |       |                                                           |       |   |   |   |   |
| Gross Profit (Loss)                 |       | 5,053,825                                                      |       | 9.2                                                            |       | (4,989,436 | ) | (12.6 | ) |
|                                |       |                                                                |       |                                                           |       |   |   |   |   |
| Operating Expenses                  |       | 2,053,687                                                      |       | 3.7                                                            |       | 1,736,337 |   | 4.3 |   |
|                                |       |                                                                |       |                                                           |       |   |   |   |   |
| Operating Income (Loss)             |       | 3,000,138                                                      |       | 5.5                                                            |       | (6,725,773 | ) | (16.9 | ) |
|                                |       |                                                                |       |                                                           |       |   |   |   |   |
| Other Expense, net                  |       | (1,874,589                                                     | )          | (3.4                                                           | )          | (2,298,965 | ) | (5.9 | ) |
|                                |       |                                                                |       |                                                           |       |   |   |   |   |
| Net Income (Loss)                   |       | $                                                              | 1,125,549  |                                                           | 2.1        |   | $ | (9,024,738 | ) | (22.8 | ) |

 

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*Revenues*

 

Revenues are derived from the sale of fuel ethanol anddistillers’ grains with solubles (“DGS”) produced at the plant and increased39% for the six months ended April 30, 2010 as compared to the six monthsended April 30, 2009. Net ethanol revenues during the six months ended April 30,2010, were approximately $45.1 million, representing 82% of our sales,compared to approximately $30.4 million during the six months ended April 30,2009, representing 77% of our sales. The increase in ethanol revenue was aresult of a 15% increase in the average price per gallon of ethanol period toperiod, in conjunction with a 27% increase in the gallons of ethanol sold. Themain contributing factor to the increase in gallons of ethanol sold is thecorrection of production difficulties experienced during the first six monthsof fiscal 2009.  We had losses ofapproximately $138,000 and a gain of $373,000 related to ethanol derivativesfor the six months ended April 30, 2010 and 2009, respectively.

 

Total sales of DGS during the six months ended April 30,2010 were approximately $6.2 million comprising 11% of our sales.  DGS sales during the six months ended April 30,2009 were $6.4 million or 16% of sales. The average DGS price decreased 21% forthe six months ended April 30, 2010 as compared to the six months ended April 30,2009. DGS tonnage sales increased by 52% for the six months ended April 30,2010 as compared to the six months ended April 30, 2009 due to an increasein modified DGS produced.

 

*Cost of Goods Sold*

 

Our costs of goods sold includes, among other things,the cost of corn used in ethanol and DGS production (which is the largestcomponent of costs of sales); coal, processing ingredients, electricity, andwages, salaries and benefits of production personnel. We use approximately1.5 million bushels of corn per month at the plant. We contract with localfarmers and elevators for our corn supply.

 

Our cost of goods sold (including lower of cost ormarket adjustments) as a percentage of revenues were 90.8% and 112.6% for thesix months ended April 30, 2010 and April 30, 2009, respectively. Theper bushel cost of corn, including lower of cost or market adjustments, decreasedapproximately 15% in the six months ended April 30, 2010 as compared tothe six months ended April 30, 2009. This decrease combined with the 15%increase in the per gallon sales price of ethanol caused the decrease in thecost of goods sold as a percent of revenues. Cost of goods sold also includeslower of cost or market adjustments of approximately $789,000 and $3,458,000for the six months ended April 30, 2010 and 2009, respectively, whichrelated to forward purchase contracts and inventory where the fixed price wasmore than the estimated realizable value.  We had gains related to cornderivative instruments of approximately $9,000 and $1,134,000 for the six monthsended April 30, 2010, and 2009, which reduced cost of goods sold. Ourgross profit margin for the six months ended April 30, 2010 increased to9.2% from a loss of 12.6% for the six months ended April 30, 2009. We hada positive gross margin in the first two quarters of fiscal 2010 as compared toa negative gross margin in the first two quarters of fiscal 2009 due to the 15%increase in ethanol prices while the cost of corn, including lower of cost ormarket adjustments decreased 15%.  For the same period, productionincreased 29% due to fewer plant shutdowns related to production problems.

 

The cost of corn fluctuates based on supply anddemand, which, in turn, is affected by a number of factors which are beyond ourcontrol. We expect our gross margin to fluctuate in the future based on therelative prices of corn and fuel ethanol. We use futures and option contractsto minimize our exposure to movements in corn and ethanol prices, but there isno assurance that these hedging strategies will be effective. At April 30,2010, none of our contracts were designated as hedges and, as a result, changesto the market value of these contracts were recognized as an increase ordecrease to our revenue and costs of goods sold. As a result, gains or losseson derivative instruments do not necessarily coincide with the related cornpurchases. This may cause fluctuations in our statement of operations. While wedo not use hedge accounting to match gains or losses on derivative instruments,we believe the derivative instruments provide an economic hedge.

 

*Operating Expenses*

 

Operating expenses include wages, salaries andbenefits of administrative employees at the plant, insurance, professional feesand similar costs. These expenses represented 3.7% of total revenues for thesix months ended April 30, 2010 and 4.3% of total revenues for the sixmonths ended April 30, 2009.   These expenses generally do not varywith the level of production at the plant and were relatively constant fromperiod to period other than costs incurred for environmental emissions testingdone during the six months ended April 30, 2010.

 

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*Other Expense, Net*

 

Other expenses consisted primarily of interestexpense. Interest expense consists primarily of interest payments on our creditfacilities described below. Interest expense, which was up for the six monthsended April 30, 2010 approximately 10% as compared to the six months endedApril 30, 2009, is dependent on the balances outstanding and on interestrate fluctuations. For the six months ended April 30, 2010, debt balanceswere down approximately 4%.  However,balances on our line of credit increased from $2,000,000 at April 30, 2009to $6,750,000 at April 30, 2010 with interest rates of 3.81% and 6.0%,respectively.  Balances on our line ofcredit have a minimum interest rate of 6% at April 30, 2010.  Additionally, we accrued a 2% defaultinterest on all AgStar debt beginning February 1, 2010 which addedadditional expense for the three months ended April 30, 2010 that was notincurred for the three months ended April 30, 2009.

 

**Liquidity and Capital Resources**

 

As of April 30, 2010, we had cash and cash equivalents(other than restricted cash) of approximately $1.9 million, current assets ofapproximately $14.7 million and total assets of approximately$112.0 million.

 

Our principal sources of liquidity consist of cashprovided by operations, cash and cash equivalents on hand and historically wehave also obtained liquidity through borrowing from AgStar Financials Services,PCA under a master loan agreement.  Underthe master loan agreement with AgStar, we have three forms of debt: a termnote, a revolving term note and a line of credit.  The total indebtednessto AgStar at April 30, 2010 consists of $51.2 million under the term note,$1.1 million under the revolving term note and $6.8 million under the line ofcredit.  Among other provisions, our master loan agreement containscovenants requiring us to maintain various financial ratios and tangible networth. It also limits our annual capital expenditures and member distributions.All of our assets and real property are subject to security interests andmortgages in favor of AgStar as security for the obligations of the master loanagreement.  As of April 30, 2010, as at January 31, 2010, wewere in default of covenants of our master loan agreement with AgStar requiringus to maintain at least $5.0 million minimum working capital.  As of October 31,2009, we were in default of covenants of our master loan agreement with AgStarrequiring us to maintain at least $5.0 million minimum working capital; atleast $39.5 million of tangible net worth; and a fixed charge ratio of 1.20 to1.00 or greater.

 

As of the date of this filing, AgStar has not waivedthe April 30, 2010, January 31, 2010 or October 31, 2009covenant violations. Our failure to maintain the required amount of workingcapital constitutes an event of default under the master loan agreement,entitling the lender to accelerate and declare due all amounts outstandingunder the master loan agreement. Therefore, we have classified $47.0 million ofthe AgStar debt as a current liability that would otherwise be classified aslong term. As a result, current liabilities as of April 30, 2010 totaledapproximately $67.1 million, including $47.0 million of long-term debtreclassified as current liabilities. We are currently negotiating with AgStarto forbear from exercising its rights as a secured lender relating to thecurrent and future covenant violations through October 31, 2010.

 

In May 2008, we locked in an interest rate of3.58% plus 3.00%, which totals 6.58%, on $45.0 million of the term note, forthree years ending April 30, 2011. The remainder of the amountsoutstanding on the term note is subject to the variable rate based on theone-month LIBOR plus 3.25%.  We are required to make equal monthlypayments of principal and interest of approximately $652,000 to amortize thenote over a period not to exceed ten years, with a final balloon payment due inOctober 2012. In addition, we are required to make additional payments onthe term note of excess cash flow, as defined in the agreement, up to $2.0million per year to the lending institution until we meet certain minimumtangible owner’s equity, as defined in the agreement. As part of the debtfinancing, the premium above LIBOR may be reduced based on the ratio of members’equity to assets.

 

Our principal uses of cash are to pay operatingexpenses of the plant and to make debt service payments on our long-term debt.During the six months ended April 30, 2010 the Company drew $1.75 millionon the line of credit described below.

 

The following table summarizes our sources and uses ofcash and equivalents from our condensed consolidated statements of cash flowsfor the periods presented (in thousands):

 
| ** **                             | ** ** | **Six  Months Ended  April 30** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|
| ** **                             | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| Net cash used in  operating activities |       | $                                    | (761,547   | ) | $ | (9,877,756 | ) |
| Net cash used in  investing activities |       | (35,521                              | )          | (318,736 | ) |
| Net cash used in  financing activities |       | (478,061                             | )          | 976,975 |   |
| Net decrease in cash  and equivalents  |       | $                                    | (1,275,129 | ) | $ | (9,219,517 | ) |

 

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During the six months ended April 30, 2010, weused $762,000 in cash for operating activities. This use consists primarily ofgenerating net income of $1.1 million plus non-cash expenses includingdepreciation and amortization of $2.8 million and lower of cost or marketadjustments of $0.8 million offset by increasing inventory on hand by $2.6million and decreasing accrued loss on forward contracts by $1.8 million.

 

During the six months ended April 30, 2009, weused $9.9 million in cash for operating activities. This use consists primarilyof a net loss of $9.0 million, payments for corn in accounts payable andpayments under forward purchase contracts, which had losses that were accruedon October 31, 2008.

 

During the six months ended April 30, 2010, weused approximately $36,000 for investing activities to pay for capitalexpenditures. During the six months ended April 30, 2010, we used $0.5million for financing activities consisting primarily of payments on long-termdebt of $2.4 million and advances on the line of credit of $1.7 million.

 

During the six months ended April 30, 2009, weused $0.3 million for investing activities to pay for capital expenditures andintangibles. During the six months ended April 30, 2009, we had $1.0million provided by financing activities consisting primarily of payment onlong term debt of $1.1 million net of release of restricted cash, a draw on theline of credit of $2.0 million and issuance of long-term debt of $1.0 million.

 

Our line of credit under the master loan agreementwith AgStar was renewed in May 2009 at a maximum commitment of $6,750,000and a maturity date of November 1, 2009.  Effective December 8,2009, the maturity date of the revolving line of credit was further extended toFebruary 1, 2010.  Effective March 25, 2010, the maturity dateof the revolving line of credit was further extended to April 30,2010.   As of April 30, 2010, we haddrawn $6.75 million on the line of credit. We did not repay the revolving lineof credit on April 30, 2010 pending further negotiations with AgStar foran extension of the maturity date.  On May 27, 2010, AgStar renewedour revolving line of credit loan effective May 27, 2010 with a maturitydate of June 30, 2010.  AgStar beganaccruing default interest at a 2.00% default rate effective February 1,2010 on all of the Company’s loans with AgStar, which was $59.1 million at April 30,2010.

 

We are not currently in compliance with certaincovenants of the master loan agreement and there is no assurance that we willbe able to comply in the future with all covenants and obligations of themaster loan agreement or that any waiver or amendment to the master loanagreement will be provided by AgStar.  Further, there can be no assurancethat AgStar will not demand immediate repayment of all $59.1 million inindebtedness outstanding under the master loan agreement at April 30, 2010or exercise any of its rights as a secured party with respect to the Company’sassets now or in the future should we fail to comply with any covenants in thefuture. We do not have adequate capital to repay all of the amounts that wouldbecome due if AgStar accelerates our obligations under the master loanagreement.  Further, we may not have adequate cash to repay the $6.75million outstanding on the line of credit at June 30, 2010.  There can be no assurance that such anextension will be granted on terms advantageous to us, if at all. Further, while an event of default exists, the Company is not permitted toborrow additional funds under its line of credit or revolving term note unlessAgStar consents to the advance. While AgStar has consented to make advances inthe past, our potential inability to borrow additional funds under the masterloan agreement may result in a working capital shortfall.

 

The Company’s plan to address the expected shortfallof working capital is to conserve funds by utilizing and reducing corninventory as well as reducing operating expenses through cost controls. TheCompany believes it has sufficient funding for its business in the short-termif it is not required to repay the outstanding indebtedness to AgStar or theoutstanding indebtedness on the line of credit on an accelerated basis, basedon converting and selling inventory, and reducing expenses. If the currentindustry conditions continue and the Company is not able to maintain sufficientfunding in the short-term, the Company may be forced to raise additionalcapital through incurring subordinated debt or selling additional equity(although no assurance can be given that the Company will be able to raisecapital on favorable terms, if at all), restructure or significantly curtailits operations, file for bankruptcy or cease operations. The financial statementsdo not include any adjustments relating to the recoverability andclassification of recorded asset amounts or amounts and classification ofliabilities that might be necessary should the Company be forced to take anysuch actions.  We may require additional capital in the future, which maynot be available to us on satisfactory terms, if at all.

 

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**Outlook**

 

We anticipate that ethanol prices will recoversomewhat during the remainder of fiscal year 2010 from the lower pricesreceived during the six months ended April 30, 2010, based on recentprices quoted for ethanol futures on the Chicago Board of Trade, and as energyprices historically increase during the summer driving season. Nevertheless, weexpect to see continuing volatility in ethanol prices.  Future prices forfuel ethanol will be affected by a variety of factors beyond our controlincluding the amount and timing of additional domestic ethanol production andethanol imports; petroleum and gasoline prices; and the development of otheralternative fuels.

 

Prices for DGS are also affected by a number offactors beyond our control such as the supply of and demand for DGS as ananimal feed, prices of competing feeds, and perceptions of nutritional value ofDGS as compared to those of competing feeds. We believe that current marketprices for DGS can be sustained long-term as long as the prices of competinganimal feeds remain steady or increase, livestock feeders continue to createdemand for alternative feed sources such as distillers’ grains and the supplyof distillers’ grains remains relatively stable. On the other hand, ifcompeting commodity price values retreat and DGS supplies increase due togrowth in the ethanol industry, DGS prices may decline.

 

Corn prices have been volatile for the pastyear due in part to higher demand from the renewable fuels industry. Theexpansion of ethanol productive capacity has brought about a substantialincrease in demand for corn and thus in corn prices.  However this has been mitigated by a largeincrease in crop size.  We expect theprice of corn to remain at current price levels well into 2010.   Due toincreased exposure of ethanol, corn is now being viewed as an “energy commodity”as opposed to strictly a “grain commodity”, contributing to the upward pressureon corn prices.  The USDA’s May 13, 2010 Feed Outlook Report,projects U.S. corn prices for the season average to be at $3.20 to $3.80 perbushel.

 

**Off-Balance Sheet Arrangements**

 

We do not have any off-balance sheet arrangements.

 

**Item 3. Quantitative and QualitativeDisclosures about Market Risk**

 

We are subject to market risks concerning ourlong-term debt, future prices of corn, coal, ethanol and distillersgrains.  We consider market risk to be the impact of adverse changes inmarket prices on our results of operations.  In general, ethanol pricesare affected by the supply and demand for ethanol, the cost of ethanolproduction, the availability of other fuel oxygenates, the regulatory climateand the cost of alternative fuels such as gasoline. The price of corn isaffected by weather conditions and other factors affecting crop yields, farmerplanting decisions and general economic, market and regulatoryfactors.   From time to time, we may purchase corn futures andoptions to hedge a portion of the corn we anticipate we will need. In addition,we have contracted for future physical delivery of corn. We are exposed to thefull impact of market fluctuations associated with interest rates and commodityprices.

 

We are also subject to market risk on the sellingprices of our distiller grains. These prices fluctuate seasonally when theprice of corn or other cattle feed alternatives fluctuate in price.

 

As an example of our potential sensitivity to pricechanges, if the price of ethanol rises or falls $0.10 per gallon, our annualrevenues may increase or decrease accordingly by approximately$5.0 million, assuming no other changes in our business. Additionally, ifthe price of corn rises or falls $0.25 per bushel, our annual cost of goodssold may increase or decrease by $5.0 million, again assuming no otherchanges in our business.  During the second quarter of fiscal year 2010ended April 30, 2010, the price of ethanol on the Chicago Board of Tradefluctuated from $1.51 to $1.82 per gallon; our average sales price was $1.52per gallon, with basis.  During the same period, the price of corn on theChicago Board of Trade fluctuated from a low of $3.44 to a high of $3.91 perbushel; our average purchase price was $3.43 per bushel, with basis.  Our future earnings may be affected bychanges in interest rates due to the impact those changes have on our interestexpense on borrowings under our credit facilities. As of April 30, 2010,we had $20.0 million of outstanding borrowings with variable interest rates.With each 1% change in interest rates our annual interest expense would changeby $200,000.

 

**Item 4T. Controls and Procedures**

 

**Effectiveness of Disclosure Controlsand Procedures**

 

Our management, with theparticipation of our Chief Executive Officer and Interim Chief FinancialOfficer, has evaluated the effectiveness of our “disclosure controls andprocedures” (as defined in Rules 13a-15(e) under the Exchange Act) asof the end of the period covered by this report. Based on that evaluation, ourChief Executive Officer and Interim Chief Financial Officer have concludedthat, as of the end of such period, our disclosure controls and procedures wereeffective.

 

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**Changes in Internal Control overFinancial Reporting**

 

There has been no change in our internal control overfinancial reporting (as defined in Rule 13a-15(f) under the ExchangeAct) that occurred in the fiscal quarter ended April 30, 2010 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**PART II.OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

Discussionsof legal matters are incorporated by reference from Part I, Item 1, Note10, “Commitments and Contingencies”, of this document, and should be consideredan integral part of Part II, Item 1, “Legal Proceedings”.

 

**Item 1A. Risk Factors**

 

The most significant risk factors applicable to theCompany are described in Part I, Item 1A “Risk Factors” of our AnnualReport on Form 10-K for the year ended October 31, 2009. There havebeen no material changes from the risk factors previously disclosed in ourAnnual Report on Form 10-K.

 

**Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds**

 

None.

 

**Item 3. Defaults upon SeniorSecurities**

 

None.

 

**Item 4. [Removed and Reserved]**

 

**Item 5.  Other Information**

 

None.

 

**Item 6. Exhibits**

 

The following exhibits are included in this report:

 
| **Exhibit  No.** | ** ** | **Exhibit**                                                                                                       |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                              |
| 31.1             |       | Certification of Chief Executive Officer Pursuant to  Section 13a-14 and 15d-14 of the Exchange Act.         |
|             |       |                                                                                                              |
| 31.2             |       | Certification of Interim Chief Financial Officer  Pursuant to Section 13a-14 and 15d-14 of the Exchange Act. |
|             |       |                                                                                                              |
| 32               |       | Certification pursuant to 18 U.S.C. § 1350.                                                                  |

 

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**SIGNATURES**

 

In accordance with the requirements of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                     | HERON LAKE BIOENERGY, LLC                                                     |
|--------------------------|-------------------------------------------------------------------------------|
|                     |                                                                          |
| Date: June 14, 2010 | /s/  Robert J. Ferguson                                                  |
|                     | Robert J Ferguson                                                             |
|                     | President and Chief Executive Officer

(Principal Executive Officer)          |
|                     |                                                                          |
|                     |                                                                          |
| Date: June 14, 2010 | /s/  Brett L. Frevert                                                    |
|                     | Brett L. Frevert                                                              |
|                     | Interim Chief Financial Officer

(Principal Accounting and Financial Officer) |

 

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