Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

x     **Quarterly report under Section 13 or 15(d) ofthe Securities Exchange Act of 1934.**

 

**For thefiscal quarter ended January 31, 2010**

 

**OR**

 

**o****     Transitionreport under Section 13 or 15(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 beensubject to 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). Yes o     No o

 

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                        |   | Smaller reporting  company  o |
| (Do not check if a  smaller reporting company) |   |                               |

 

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 March 17, 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 | 13                |
| Item 3. Quantitative and Qualitative Disclosures  About Market Risk                                 | 17                |
| Item 4T. Controls and Procedures                                                                    | 18                |
| PART II.  OTHER INFORMATION                                                                         |              |
| Item  1. Legal Proceedings                                                                               | 19                |
| Item  1A. Risk Factors                                                                                   | 19                |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                     | 19                |
| Item 3. Defaults Upon Senior Securities                                                                  | 19                |
| Item 4. Submission of Matters to a Vote of Security  Holders                                             | 19                |
| Item  5. Other Information                                                                               | 19                |
| Item 6.  Exhibits                                                                                   | 19                |
| SIGNATURES                                                                                               | 20                |

 

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Table of Contents

 

**PART I.  FINANCIALINFORMATION**

 

**Item 1.  FinancialStatements**

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Condensed ConsolidatedBalance Sheets

 
| ** **                       | ** ** | **January 31,** | ** **  | **October 31,** | ** ** |
|----------------------------------|------------|----------------------|-------------|----------------------|------------|
| ** **                       | ** ** | **2010**             | ** **  | **2009***            | ** ** |
| ** **                       | ** ** | **(Unaudited)**      | ** **  | ** **           | ** ** |
| **ASSETS**                       |       |                 |        |                 |       |
| **Current  Assets**              |       |                 |        |                 |       |
| Cash and equivalents             |       | $                    | 718,086     |                 | $          | 3,184,074 |   |
| Restricted cash                  |       | 341,923              |        | 340,644              |       |
| Accounts receivable              |       | 4,263,311            |        | 4,439,701            |       |
| Inventory                        |       | 8,904,764            |        | 4,752,117            |       |
| Prepaid expenses                 |       | 487,466              |        | 210,136              |       |
| Total current assets             |       | 14,715,550           |        | 12,926,672           |       |
|                             |       |                 |        |                 |       |
| Property and Equipment           |       |                 |        |                 |       |
| Land and improvements            |       | 12,574,760           |        | 12,574,760           |       |
| Plant buildings and  equipment   |       | 97,342,928           |        | 97,332,591           |       |
| Vehicles and other  equipment    |       | 620,788              |        | 604,783              |       |
| Office buildings and  equipment  |       | 618,968              |        | 618,437              |       |
|                             |       | 111,157,444          |        | 111,130,571          |       |
| Less accumulated  depreciation   |       | (13,972,403          | )           | (12,569,966          | )          |
|                             |       | 97,185,041           |        | 98,560,605           |       |
|                             |       |                 |        |                 |       |
| **Other  Assets**                |       |                 |        |                 |       |
| Restricted cash                  |       | 639,425              |        | 718,790              |       |
| Other intangibles                |       | 478,918              |        | 488,010              |       |
| Debt service deposits  and other |       | 395,200              |        | 395,200              |       |
| Total other assets               |       | 1,513,543            |        | 1,602,000            |       |
|                             |       |                 |        |                 |       |
| **Total  Assets**                |       | $                    | 113,414,134 |                 | $          | 113,089,277 |   |

 

See Notes to Condensed Consolidated FinancialStatements.

 

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*                 Derived from audited financial statements

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Condensed ConsolidatedBalance Sheets

 
| ** **                                                           | ** ** | **January 31,** | ** **  | **October 31,** | ** ** |
|----------------------------------------------------------------------|------------|----------------------|-------------|----------------------|------------|
| ** **                                                           | ** ** | **2010**             | ** **  | **2009***            | ** ** |
| ** **                                                           | ** ** | **(Unaudited)**      | ** **  | ** **           | ** ** |
| **LIABILITIES AND MEMBERS’ EQUITY**              |       |                 |        |                 |       |
| **Current  Liabilities**                                             |       |                 |        |                 |       |
| Line of credit                                                       |       | $                    | 5,000,000   |                 | $          | 5,000,000 |   |
| Current maturities of  long-term debt                                |       | 54,159,968           |        | 55,224,183           |       |
| Accounts payable:                                                    |       |                 |        |                 |       |
| Trade accounts payable                                               |       | 2,493,963            |        | 2,466,040            |       |
| Trade accounts payable  — related party                         |       | 296,091              |        | 714,115              |       |
| Construction payable —  related party                           |       | 3,839,413            |        | 3,839,413            |       |
| Accrued expenses                                                     |       | 519,515              |        | 566,481              |       |
| Accrued losses on  forward contracts                                 |       | 574,773              |        | 1,249,495            |       |
| Total current  liabilities                                           |       | 66,883,723           |        | 69,059,727           |       |
|                                                                 |       |                 |        |                 |       |
| **Long-Term  Debt,** net of  current maturities                      |       | 4,658,503            |        | 4,775,804            |       |
|                                                                 |       |                 |        |                 |       |
| **Commitments  and Contingencies**                                   |       |                 |        |                 |       |
|                                                                 |       |                 |        |                 |       |
| **Members’  Equity, 27,104,625 Class A units outstanding** |       | 41,871,908           |        | 39,253,746           |       |
|                                                                 |       |                 |        |                 |       |
| **Total  Liabilities and Members’ Equity**                      |       | $                    | 113,414,134 |                 | $          | 113,089,277 |   |

 

See Notes to Condensed Consolidated FinancialStatements.

 

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*      Derived from audited financial statements

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Condensed ConsolidatedStatements of Operations

 
| ** **                                                  | ** ** | **Three Months  Ended January 31,** | ** ** | **Three Months  Ended January 31,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                  | ** ** | **2010**                                           | ** ** | **2009**                                           | ** ** |
| ** **                                                  | ** ** | **(Unaudited)**                                    | ** ** | **(Unaudited)**                                    | ** ** |
|                                                        |       |                                               |       |                                               |       |
| **Revenues**                                                |       | $                                                  | 29,413,131 |                                               | $          | 18,095,366 |   |
|                                                        |       |                                               |       |                                               |       |
| **Cost  of Goods Sold**                                     |       |                                               |       |                                               |       |
| Cost of goods sold                                          |       | 24,228,820                                         |       | 19,877,852                                         |       |
| Lower of cost or market  adjustment                         |       | 632,899                                            |       | 2,009,849                                          |       |
| **Total  Cost of Goods Sold**                               |       | 24,719,719                                         |       | 21,887,701                                         |       |
|                                                        |       |                                               |       |                                               |       |
| **Gross  Margin**                                           |       | 4,551,412                                          |       | (3,792,335                                         | )          |
|                                                        |       |                                               |       |                                               |       |
| **Selling,  General, and Administrative Expenses**          |       | 1,011,574                                          |       | 1,008,518                                          |       |
|                                                        |       |                                               |       |                                               |       |
| **Operating  Income (Loss)**                                |       | 3,539,838                                          |       | (4,800,853                                         | )          |
|                                                        |       |                                               |       |                                               |       |
| **Other  Income (Expense)**                                 |       |                                               |       |                                               |       |
| Interest income                                             |       | 14,254                                             |       | 37,880                                             |       |
| Interest expense                                            |       | (941,340                                           | )          | (1,040,186                                         | )          |
| Write-off of loan costs                                     |       | —                                             |       | (444,985                                           | )          |
| Other income, net                                           |       | 5,410                                              |       | 1,338                                              |       |
| Total other expense,  net                                   |       | (921,676                                           | )          | (1,445,953                                         | )          |
|                                                        |       |                                               |       |                                               |       |
| **Net  Income (Loss)**                                      |       | $                                                  | 2,618,162  |                                               | $          | (6,246,806 | ) |
|                                                        |       |                                               |       |                                               |       |
| **Net  Income (Loss) Per Unit - Basic and Diluted**         |       | $                                                  | 0.10       |                                               | $          | (0.23 | ) |
|                                                        |       |                                               |       |                                               |       |
| **Distributions  Per Unit — Basic and Diluted**        |       | $                                                  | —     |                                               | $          | — |   |
|                                                        |       |                                               |       |                                               |       |
| **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

 
| ** **                                                                         | ** ** | **Three Months  Ended January 31,** | ** ** | **Three Months  Ended January 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2010**                                           | ** ** | **2009**                                           | ** ** |
| ** **                                                                         | ** ** | **(Unaudited)**                                    | ** ** | **(Unaudited)**                                    | ** ** |
| **Operating  Activities**                                                          |       |                                               |       |                                               |       |
| Net income (loss)                                                                  |       | $                                                  | 2,618,162  |                                               | $          | (6,246,806 | ) |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                               |       |                                               |       |
| Depreciation and  amortization                                                     |       | 1,411,529                                          |       | 1,409,261                                          |       |
| Amortization of loan  costs included with interest expense                         |       | —                                             |       | 22,143                                             |       |
| Write-off of loan costs                                                            |       | —                                             |       | 444,985                                            |       |
| Lower of cost or market  adjustments                                               |       | 632,899                                            |       | 2,009,849                                          |       |
| Change in fair value of  derivative instruments                                    |       | —                                             |       | (68,002                                            | )          |
| Change in operating  assets and liabilities:                                       |       |                                               |       |                                               |       |
| Restricted cash                                                                    |       | (1,279                                             | )          | 593,923                                            |       |
| Accounts receivable                                                                |       | 176,390                                            |       | 1,000,711                                          |       |
| Inventory                                                                          |       | (4,210,983                                         | )          | (2,659,700                                         | )          |
| Derivative instruments                                                             |       | —                                             |       | 164,872                                            |       |
| Prepaid expenses                                                                   |       | (277,330                                           | )          | (276,981                                           | )          |
| Accounts payable                                                                   |       | (390,101                                           | )          | (3,409,595                                         | )          |
| Accrued expenses                                                                   |       | (46,966                                            | )          | 51,262                                             |       |
| Accrued loss on forward  contracts                                                 |       | (1,249,285                                         | )          | (3,709,389                                         | )          |
| Net cash used in  operating activities                                             |       | (1,336,964                                         | )          | (10,673,467                                        | )          |
|                                                                               |       |                                               |       |                                               |       |
| **Investing  Activities**                                                          |       |                                               |       |                                               |       |
| Payments for  intangibles                                                          |       | —                                             |       | (59,835                                            | )          |
| Capital expenditures                                                               |       | (26,873                                            | )          | (162,921                                           | )          |
| Net cash used in  investing activities                                             |       | (26,873                                            | )          | (222,756                                           | )          |
|                                                                               |       |                                                    |       |                                               |       |
| **Financing  Activities**                                                          |       |                                               |       |                                               |       |
| Proceeds from line of  credit, net                                                 |       | —                                             |       | 1,000,000                                          |       |
| Payments of long-term  debt                                                        |       | (1,181,516                                         | )          | (1,212,808                                         | )          |
| Debt service deposits  included with other assets                                  |       | —                                             |       | (30,350                                            | )          |
| Release of restricted  cash                                                        |       | 79,365                                             |       | 212,651                                            |       |
| Net cash used in  financing activities                                             |       | (1,102,151                                         | )          | (30,507                                            | )          |
|                                                                               |       |                                                    |       |                                               |       |
| **Net  decrease in cash and equivalents**                                          |       | (2,465,988                                         | )          | (10,926,730                                        | )          |
|                                                                               |       |                                                    |       |                                               |       |
| **Cash  and Equivalents****— Beginning of Period**                            |       | 3,184,074                                          |       | 11,355,075                                         |       |
|                                                                               |       |                                                    |       |                                               |       |
| **Cash  and Equivalents — End of Period**                                     |       | $                                                  | 718,086    |                                               | $          | 428,345 |   |
|                                                                               |       |                                                    |       |                                               |       |
| **Supplemental  Cash Flow Information**                                            |       |                                               |       |                                               |       |
| Interest paid                                                                      |       | $                                                  | 894,574    |                                               | $          | 977,123 |   |

 

See Notes to Condensed Consolidated FinancialStatements.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to CondensedConsolidated Financial Statements

 

January 31, 2010(Unaudited)

 

**1.             SUMMARYOF 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 condensed consolidatedinterim financial statements reflect all adjustments (consisting of normalrecurring accruals, with the exception of the adjustments to write-off deferredloan costs and to reclassify certain debt as current) that we considernecessary to present fairly the Company’s results of operations, financialposition and cash flows. The results reported in these condensed consolidatedinterim financial statements should not be regarded as necessarily indicativeof results that may be expected for the entire year.

 

*Nature of Business*

 

The Company owns and operates a 50 million gallonethanol plant near Heron Lake, Minnesota.  In addition, the Companyproduces and sells distillers grains with solubles as co-products of ethanolproduction.

 

*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 amountsof assets and liabilities, the disclosure of contingent assets and liabilities,and the reported revenues and expenses.   The Company uses estimatesand assumptions in accounting for significant matters including, among others,the carrying value and useful lives of property and equipment, analysis ofimpairment of long-lived assets, and valuation of forward purchase contractcommitments and inventory.  The Company periodically reviews estimates andassumptions, and the effects of revisions are reflected in the period in whichthe revision is made. Actual results could differ from those estimates.

 

*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: significantdecreases in the market price of the asset; significant adverse changes in thebusiness climate or legal factors; accumulation of costs significantly inexcess of the amount originally expected for the acquisition or construction ofthe asset; current period cash flow or operating losses combined with a historyof losses or a forecast of continuing losses associated with the use of the assets;and current 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.

 

The Company’s ethanol production facilities, has astated capacity of 50 million gallons per year.  The carrying valueof these facilities at January 31, 2010 and October 31, 2009 wasapproximately $97.2 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 

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

January31, 2010 (Unaudited)

 

projected future cash flows from operations over thefacilities’ estimated useful lives. Management has determined that theprojected future undiscounted cash flows from operations of these facilitiesexceed their carrying value at January 31, 2010 and October 31, 2009;therefore, no impairment loss was indicated or recognized. In determining theprojected future undiscounted cash flows, the Company has made significantassumptions concerning the future viability of the ethanol industry, the futureprice of corn in relation to the future price of ethanol and the overall demandin relation 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 andthe fair value of long-term debt are as follows:

 
| ** **                               | ** ** | **Carrying Amount** | ** ** | **Fair Value** | ** ** |
|------------------------------------------|------------|--------------------------|------------|---------------------|------------|
|                                     |       |                     |       |                |       |
| Long-term debt at  January 31, 2010 |       | $                        | 58,818,471 |                | $          | 55,808,633 |   |
| 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, which 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. The Company had net income ofapproximately $2.6 million in the quarter ended January 31, 2010 and usedcash of approximately $1.3 million for operating activities. The Companyincurred a loss of approximately $11.3 million and used cash of approximately$8.3 million for operating activities during the twelve months ended October 31,2009.  At January 31, 2010 and October 31, 2009, the Company wasout of compliance with covenants of its master loan agreement with AgStarFinancial Services, PCA (“AgStar”). In addition, the Company anticipatesthat one or more of the covenants will not be met as of October 31, 2010and January 31, 2011 unless amended. At January 31, 2009, the Companyreclassified the long-term debt related to this agreement to current liabilitiesbecause the Company was not in compliance with the minimum working capitalrequirement. That reclassification remains as of January 31, 2010 becauseof the actual and anticipated covenant defaults stated above.  If AgStarexercises its right to accelerate the maturity of the debt outstanding underthe master loan agreement or the line of credit, the Company will not haveadequate available cash to repay the amounts currently outstanding at January 31,2010.  Further, while an event of default exists, the Company is notpermitted to borrow additional funds under its line of credit or revolvingterm note without AgStar’s consent. These factors raise substantial doubt aboutthe Company’s ability to continue as a going concern.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

January31, 2010 (Unaudited)

 

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 thecovenant defaults for the periods ending October 31, 2009 relating tominimum working capital, tangible net worth and the fixed charge ratio.  AgStar has also not waived the default of theminimum working capital covenant for the period ending January 31,2010.  The Company is activelynegotiating these waivers with AgStar.

 

Effective December 8, 2009, the Company andAgStar amended the master loan agreement as previously amended andsupplemented, which resulted in an extension of the maturity date of therevolving line of credit to February 1, 2010.  The Company did notrepay the $5.0 million outstanding on the revolving line of credit on the February 1,2010 maturity date or as of the date of this filing.   The Company is actively negotiating theextension of the maturity date with AgStar. As of February 1, 2010, AgStar added a 2.0% surcharge to theinterest rate on the outstanding amount on this line of credit due tonon-payment at maturity.

 

The Company believes it has sufficient capitalresources through January 31, 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 costcontrols.  If the Company is not able to maintain sufficient funding inthe short-term, the Company may be forced to raise additional capital throughsubordinated debt, if available, sell additional equity, restructure orsignificantly curtail its operations, file for bankruptcy or ceaseoperations.  The financial statements do not include any adjustmentsrelating to the recoverability and classification of recorded asset amounts oramounts and classification of liabilities that might be necessary should theCompany be forced to take any such actions*.*

 

**3.****                                     ****UNCERTAINTIES**

 

The Company has certain risks and uncertainties that itexperienced during volatile market conditions such as what the Companyexperienced during fiscal 2009.  These volatilities can have a severeimpact on operations. The Company’s revenues are derived from the sale anddistribution of ethanol and distillers grains to customers primarily located inthe U.S. Corn for the production process is supplied to the plant primarilyfrom local agricultural producers.  Ethanol sales average 75% - 85% oftotal revenues and corn costs average 65% - 70% 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.  Excessethanol supply in the market, in particular, puts downward pressure on theprice of ethanol. The largest cost of production is corn. The cost of corn isgenerally impacted by factors such as supply and demand, the weather,government policies and programs, and a risk management program used to protectagainst the price volatility of these commodities. Market fluctuations in theprice of and demand for these products may have a significant adverse effect onthe Company’s operations, profitability and the availability and adequacy ofcash flow to meet the Company’s working capital requirements.

 

**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.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

January31, 2010 (Unaudited)

 
| ** **                        | ** ** | **Fair  Value as of**      | ** ** | **Fair  Value Measurement Using** | ** ** |
|-----------------------------------|------------|----------------------------|------------|-----------------------------------|------------|
| ** **                        | ** ** | **January 31,  2010** | ** ** | **Level 1**                       | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Restricted cash —  current   |       | $                          | 341,923    |                              | $          | 341,923 |   | — |   | — |   |
|                              |       |                       |       |                              |       |   |   |   |   |
| Restricted cash —  long-term |       | $                          | 639,425    |                              | $          | 639,425 |   | — |   | — |   |

 

The fair value of the money market funds included inrestricted cash is based on quoted market prices in an active market.

 

**5.**             **INVENTORY**

 

Inventory consisted of the following at January 31,2010 and October 31, 2009:

 
| ** **      | ** ** | **January 31,** | ** ** | **October 31,** | ** ** |
|-----------------|------------|----------------------|------------|----------------------|------------|
| ** **      | ** ** | **2010**             | ** ** | **2009 ***      | ** ** |
| Raw materials   |       | $                    | 4,592,283  |                 | $          | 1,551,255 |   |
| Work in process |       | 1,020,724            |       | 776,801              |       |
| Finished goods  |       | 1,749,086            |       | 800,915              |       |
| Supplies        |       | 865,563              |       | 847,289              |       |
| Other grains    |       | 677,108              |       | 775,857              |       |
| Total           |       | $                    | 8,904,764  |                 | $          | 4,752,117 |   |

 

----

*      Derived from audited financial statements

 

The Company recorded losses of approximately $58,000and $195,000 for the three months ended January 31, 2010 and 2009,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 isapproximately $996,000 and $283,000 based on market prices at January 31,2010 and October 31, 2009, respectively, and is not included in theamounts above.

 

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

 

As of January 31, 2010 and October 31, 2009,the Company held no derivative instrument positions.

 

The following tables provide details regarding thegains and (losses) from the Company’s derivative instruments in statementsof operations, none of which are designated as hedging instruments:

 
| ** **        | ** ** | **Statement  of**        | ** ** | **Three-Months  Ended January 31,** | ** ** |
|-------------------|------------|--------------------------|------------|------------------------------------------|------------|
| ** **        | ** ** | **Operations  location** | ** ** | **2010**                                 | ** ** | **2009** | ** ** |
| Grain contracts   |       | Cost of goods sold       |       | $                                        | —     |   | $ | 450,000 |   |
|              |       |                     |       |                                     |       |   |   |
| Ethanol contracts |       | Revenues                 |       |                                     |       | 373,000 |   |
| Totals            |       |                     |       | $                                        | —     |   | $ | 823,000 |   |

 

**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, theCompany 

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

January31, 2010 (Unaudited)

 

and AgStar agreed upon an amendment that furtherextended the maturity date of the revolving line of credit to February 1,2010.  As of the date of this filing, the Company has not repaid therevolving line of credit due on February 1, 2010.  As of January 31, 2010, the Company wasnot in compliance with the minimum working capital requirement of the masterloan agreement.  As of October 31,2009, the Company was not in compliance with the minimum working capital,minimum tangible net worth and minimum fixed charge ratio provisions of themaster loan agreement.  The Company is actively negotiating theextension of the maturity date of the revolving line of credit with AgStar, aswell as additional waivers of the unwaived covenant defaults at January 31,2010 and October 31, 2009. Interest accrues on borrowings at the greaterof 6.0% or the one-month LIBOR plus 3.25%, which totaled 3.48% at January 31,2010 and 3.49% at October 31, 2009. As of February 1, 2010, AgStar added a 2.0% surcharge to theinterest rate on the outstanding amount on this line of credit due tonon-payment at maturity.    TheCompany has a 0.25% commitment fee on the unused portion of the line of credit.  As of January 31, 2010 and October 31, 2009, the Company haddrawn $5,000,000 on the line of credit.

 

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 January 31, 2010.  Further, while an eventof default 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:

 
| ** **                                                   | ** ** | **January 31,** | ** ** | **October 31,** | ** ** |
|--------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **2010**             | ** ** | **2009***            | ** ** |
| Term note payable to  lending institution, see terms below   |       | $                    | 52,315,297 |                 | $          | 53,381,697 |   |
|                                                         |       |                 |       |                 |       |
| Revolving term note to  lending institution, see terms below |       | 1,155,872            |       | 1,155,872            |       |
|                                                         |       |                 |       |                 |       |
| Assessments payable                                          |       | 3,671,550            |       | 3,677,128            |       |
|                                                         |       |                 |       |                 |       |
| Notes payable to  electrical company                         |       | 1,616,340            |       | 1,719,773            |       |
|                                                         |       |                 |       |                 |       |
| Equipment note                                               |       | 59,412               |       | 65,517               |       |
|                                                         |       |                 |       |                 |       |
| Total                                                        |       | 58,818,471           |       | 59,999,987           |       |
|                                                         |       |                 |       |                 |       |
| Less amounts due on  demand or within one year               |       | 54,159,968           |       | 55,224,183           |       |
|                                                         |       |                 |       |                 |       |
| Net long term debt                                           |       | $                    | 4,658,503  |                 | $          | 4,775,804 |   |

 

----

*      Derived from 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.

 

*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 3.48% and 3.49% at January 31,2010 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 January 31,2010 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 January 31, 2011unless the covenants are amended or additionalequity is raised.  Therefore, the term note and the revolving term notedescribed below remain classified as current liabilities. The term note originallyhad a ten year amortization, with a final balloon payment due in October 2012.In addition, the Company is required to make additional payments on the termnote of excess cash flow, as defined in the agreement, up to $2,000,000 peryear 

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

January31, 2010 (Unaudited)

 

to AgStar until the Company meets a specifiedfinancial ratio. As part of the debt financing, the premium above LIBOR may bereduced based on the ratio of members’ equity to assets. The owner of thegeneral contractor, who is a member, has personally guaranteed up to $3,740,000of the Company’s obligations under the master loan agreement.  If AgStarexercises its right to accelerate the maturity of the debt outstanding underthe master loan agreement or the line of credit, the Company will not have adequateavailable cash to repay the amounts currently outstanding at January 31,2010.  Further, while an event of default exists, the Company is notpermitted to borrow additional funds under its line of credit or revolvingterm note without AgStar’s consent.

 

*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 3.48% and 3.49% at January 31, 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 January 31, 2010, the Company wasout of compliance with the working capital covenant of the master loanagreement and does not anticipate being in compliance as of and for the periodsending October 31, 2010 and January 31, 2011.  As such, amountsdue under the revolving term note have been classified as current liabilitiesand while an event of default exists, the Company is not permittedto borrow additional funds under the revolving term note without AgStar’sconsent.

 

Estimated maturities of long-term debt afterreclassification to current at January 31, 2010 are as follows:

 
| 2010                 |   | $         | 54,159,968 |   |
|----------------------|--------|-----------|------------|--------|
| 2011                 |   | 709,364   |       |
| 2012                 |   | 709,139   |       |
| 2013                 |   | 365,557   |       |
| 2014                 |   | 382,316   |       |
| After 2014           |   | 2,492,127 |       |
|                 |   |      |       |
| Total long-term debt |   | $         | 58,818,471 |   |

 

**9.             LEASES**

 

The Company leases equipment, primarily rail cars,under operating leases through 2017.   Rent expense for the threemonths ended January 31, 2010 and 2009 was approximately $436,000 and$258,000, respectively.

 

At January 31, 2010 the Company had the followingminimum future lease payments, which at inception had non-cancelable terms ofmore than one year:

 
| 2011                    |   | $         | 1,700,560 |   |
|-------------------------|--------|-----------|-----------|--------|
| 2012                    |   | 1,660,560 |      |
| 2013                    |   | 1,616,590 |      |
| 2014                    |   | 1,556,100 |      |
| 2015                    |   | 1,030,600 |      |
| Thereafter              |   | 2,148,300 |      |
|                    |   |      |      |
| Total lease commitments |   | $         | 9,712,710 |   |

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

January31, 2010 (Unaudited)

 

**10.**          **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.

 

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 emissions warranties oroperate as a “synthetic minor source” as warranted and intended under thedesign-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 allegingthat it is entitled to payment of a retainage held by the Company in the amountof approximately $3.8 million.  In addition, Fagen, Inc. alleges thatit performed 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 affirmative 

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notesto Condensed Consolidated Financial Statements

 

January31, 2010 (Unaudited)

 

defenses. On January 4, 2010, Fagen, Inc.requested to join ICM, Inc. as a party to the arbitration action, claimingthat joinder was necessary for proper resolution of the claims and defenses inthe arbitration action.  On January 27, 2010, ICM, Inc.responded to the request, agreeing to be joined provided certain procedures areestablished.  In its response, ICM also indicated that it intends toassert claims against the Company under the license agreement the Companyentered into with ICM as part of the design build agreement with Fagen.  **An estimate of the amountof any such claims, if asserted, cannot be made.**On January 27,2010, the Company filed its response and objections to Fagen’s request to joinICM as a party, and requested that a special arbitrator be appointed to resolvethe joinder issues.  The Company intends to defend against the Fagencounterclaims and any claims brought by ICM, Inc. and assert its defensesvigorously.

 

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 January 31,2010:

 
| ** **                      | ** ** | **Total**  | ** **  | **Less than  One Year** | ** ** | **One to Three  Years** | ** ** | **Three to  Five Years** | ** ** | **Greater  Than Five  Years** | ** ** |
|---------------------------------|------------|------------|-------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| Long-term debt  obligations (1) |       | $          | 73,013,238  |                              | $          | 62,381,777                        |       | $                                  | 6,383,461  |                               | $          | 1,146,112 |   | $ | 3,101,888 |   |
| Operating lease  obligations    |       | 9,712,710  |        | 1,700,560                         |       | 3,277,150                         |       | 2,586,700                          |       | 2,148,300                          |       |
| Purchase obligations (2)        |       | 21,782,274 |        | 14,771,018                        |       | 7,011,256                         |       | —                             |       | —                             |       |
| Total contractual  obligations  |       | $          | 104,508,222 |                              | $          | 78,853,355                        |       | $                                  | 16,671,867 |                               | $          | 3,732,812 |   | $ | 5,250,188 |   |

 

----

(1)           Long-term debtobligations include estimated interest and interest on unused debt.

(2)           Purchase obligationsprimarily include forward contracts for corn and coal.

 

*Forward Contracts*

 

The Company has forward contracts in place for cornpurchases of approximately $9.5 million through October 2010, whichrepresents approximately 19% of the Company’s anticipated corn purchases infiscal 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 of approximately $575,000and $1,815,000 for the three months ended January 31, 2010 and 2009,respectively.  The loss was recorded as alower of cost or market adjustment on the statement of operations. The amountof the loss was determined by applying a methodology similar to that used inthe lower of cost or market evaluation with respect to inventory. Given theuncertainty of future ethanol prices, this loss may or may not be recovered,and further losses on the outstanding purchase commitments could be recorded infuture periods.

 

**11**.          **RELATED PARTY TRANSACTIONS**

 

The Company purchased approximately $11,756,000 and$19,232,000 of corn from members in the three months ended January 31,2010 and 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 periods ended January 31, 2010 and 2009. This sectionshould 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 our financialcondition, and results of operations for the three months ended January 31,2010.

 

**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 theethanol industry has increased the demand for corn. We believe that continuingincrease in global demand will result in corn prices above historicaverages.   During the first quarter of fiscal year 2010 ended January 31,2010, the price of ethanol on the Chicago Board of Trade fluctuated from $1.76to $2.17 per gallon; our average sales price was $1.84 per gallon.  During the same period, the price of corn onthe Chicago Board of Trade fluctuated from a low of $3.55 to a high of $4.26 perbushel; our average purchase price was $3.57 per bushel.

 

**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,among other 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 January 31, 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**

 

The following table shows summary information from ourStatement of Operations for the three months ended January 31, 2010 and January 31,2009.

 
| ** **                          | ** ** | **January  31, 2010** | ** ** | **January  31, 2009** | ** ** |
|-------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| **Income Statement Data** | ** ** | **Amount**            | ** ** | **%**                 | ** ** | **Amount** | ** ** | **%** | ** ** |
| Revenues                            |       | $                     | 29,413,131 |                  | 100.0      |   | $ | 18,095,366 |   | 100.0 |   |
|                                |       |                  |       |                  |       |   |   |   |   |
| Cost of Goods Sold                  |       |                  |       |                  |       |   |   |   |   |
| Cost of goods sold                  |       | 24,228,820            |       | 82.3                  |       | 19,877,852 |   | 109.8 |   |
| Lower of cost or market  adjustment |       | 632,899               |       | 2.2                   |       | 2,009,849 |   | 11.1 |   |
| Total Cost of Goods  Sold           |       | 24,861,719            |       | 84.5                  |       | 21,887,701 |   | 120.9 |   |
|                                |       |                  |       |                  |       |   |   |   |   |
| Gross Profit (Loss)                 |       | 4,551,412             |       | 15.5                  |       | (3,792,335 | ) | (20.9 | ) |
|                                |       |                  |       |                  |       |   |   |   |   |
| Operating Expenses                  |       | 1,011,574             |       | 3.5                   |       | 1,008,518 |   | 5.6 |   |
|                                |       |                  |       |                  |       |   |   |   |   |
| Operating Income (Loss)             |       | 3,539,838             |       | 12.0                  |       | (4,800,853 | ) | (26.5 | ) |
|                                |       |                  |       |                  |       |   |   |   |   |
| Other Expense, net                  |       | (921,676              | )          | (3.1                  | )          | (1,445,953 | ) | (8.0 | ) |
|                                |       |                  |       |                  |       |   |   |   |   |
| Net Income (Loss)                   |       | $                     | 2,618,162  |                  | 8.9        |   | $ | (6,246,806 | ) | (34.5 | ) |

 

*Revenues*

 

Revenues are derived from the sale of fuel ethanol anddistillers’ grains with solubles (“DGS”) produced at the Plant and increased63% for the quarter ended January 31, 2010 as compared to the quarterended January 31, 2009. Net ethanol revenues during the quarter ended January 31,2010, were approximately $23.7 million, representing 80.6% of our sales,compared to approximately $13.8 million during the quarter ended January 31,2009, representing 76.2% of our sales. The increase in ethanol revenue was aresult of a 24% increase in the average price per gallon of ethanol quarter toquarter, in conjunction with a 39% 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 quarter offiscal 2009 related to coal handling equipment. We had gains of approximately$373,000 related to ethanol derivatives for the quarter ended January 31,2009. There were no ethanol derivative gains during the quarter ended January 31,2010.

 

Total sales of DGS during the quarter ended January 31,2010 were approximately $2.5 million comprising 8.5% of oursales. DGS sales during the quarter ended January 31, 2009 were $2.6million or 14.4% of sales. The average DGS price decreased 2% for the quarterended January 31, 2010 as compared to the quarter ended January 31,2009. DGS tonnage sales increased by 25% for the quarter ended January 31,2010 as compared to the prior year quarter as the production difficultiesexperienced during the quarter ended January 31, 2009 were corrected.

 

*Cost of Sales*

 

Our costs of sales includes, 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 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 84.5% and 120.9% for thethree months ended January 31, 2010 and January 31, 2009,respectively. The per bushel cost of corn purchased decreased approximately 18%in the quarter ended January 31, 2010 as compared to the quarter ended January 31,2009. This decrease combined with the 24% increase in the per gallon salesprice of ethanol caused the decrease in the cost of goods sold as a percent ofrevenues. Cost of goods sold also includes lower of cost or market adjustmentsof approximately $633,000 and $2,010,000 for the three months ended January 31,2010 and 2009, respectively, which related to forward purchase contracts andinventory where the fixed price was more than the estimated realizablevalue.  We had no gains or losses relatedto corn derivative instruments for the three months ended January 31,2010.  We had gains related to cornderivative instruments of approximately $450,000 for the quarter ended January 31,2009, which reduced cost of sales. Our gross profit margin for the three monthsended January 31, 2010 increased to 15.5% from a loss of 20.9% for thethree months ended January 31, 2009. We had a positive gross margin in thefirst quarter of fiscal 2010 as compared to a negative gross margin in thefirst quarter of fiscal 2009 due to the 24% increase in ethanol prices whilecorn prices decreased 18%.  For the sameperiod, production increased 39%.

 

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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 January 31, 2010, noneof our contracts were designated as hedges and, as a result, changes to themarket value of these contracts were recognized as an increase or decrease toour costs of goods sold. As a result, gains or losses on derivative instrumentsdo not necessarily coincide with the related corn purchases. This may causefluctuations in cost of goods sold. While we do not use hedge accounting tomatch gains or losses on derivative instruments, we believe the derivativeinstruments 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 3.5% of total revenues for thequarter ended January 31, 2010 and 5.6% of total revenues for the quarterended January 31, 2009.  Theseexpenses generally do not vary with the level of production at the plant andwere relatively constant from period to period.

 

*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 down for the threemonths ended January 31, 2010 approximately 10% as compared to the threemonths ended January 31, 2009, is dependent on the balances outstandingand on interest rate fluctuations. For the three months ended January 31,2010, debt balances were down approximately 2% and interest rates decreased aswell over the period. Because we did not obtain a waiver from AgStar FinancialServices, PCA (“AgStar”) for actual or expected violations of our master loanagreement, our long-term debt with AgStar was classified as current during thequarter ended January 31, 2009. As such, we wrote-off the remaining loancosts rather than amortizing them over the original contractual term of theloans.  As a result, other expenses forthe three months ended January 31, 2009 include this charge ofapproximately $445,000.

 

**Liquidity and Capital Resources**

 

As of January 31, 2010, we had cash and cashequivalents (other than restricted cash) of approximately $718,000, currentassets of approximately $14.7 million and total assets of approximately$113.4 million.

 

Our principal sources of liquidity consist of cashprovided by operations, cash and cash equivalents on hand. Under the masterloan agreement, we have three forms of debt: a term note, a revolving term noteand a line of credit.  The total indebtedness to AgStar at January 31,2010 consists of $52.3 million under the term note, $1.1 million under therevolving term note and $5.0 million under the line of credit.  Amongother provisions, our master loan agreement contains covenants requiring us tomaintain various financial ratios and tangible net worth. It also limits ourannual capital expenditures and membership distributions. All of our assets andreal property are subject to security interests and mortgages in favor ofAgStar as security for the obligations of the master loan agreement.  Asof January 31, 2010, we were in default of covenants of our master loanagreement with AgStar requiring us to maintain at least $5.0 million minimumworking 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 January 31, 2010 or October 31, 2009 covenant violations. We arecurrently negotiating with AgStar to forbear from exercising its rights as asecured lender relating to the current and future covenant violations through October 31,2010. We are also negotiating with AgStar to extend the maturity of the revolvingline of credit beyond the February 1, 2010 maturity.  Pending those negotiations, we did not repaythe outstanding amounts on the revolving line of credit on February 1,2010 or as of the date of this filing. As of February 1, 2010, AgStar added a 2.0% surcharge to theinterest rate on the outstanding amount on this line of credit due tonon-payment at maturity.

 

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 three months ended January 31, 2010 the Company did not drawany additional funds on the line of credit described below.

 

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

 
| ** **                             | ** ** | **Three  Months Ended  January 31** | ** ** |
|----------------------------------------|------------|------------------------------------------|------------|
| ** **                             | ** ** | **2010**                                 | ** ** | **2009** | ** ** |
| Net cash used in  operating activities |       | $                                        | (1,336,964 | ) | $ | (10,673,467 | ) |
| Net cash used in  investing activities |       | (26,873                                  | )          | (222,756 | ) |
| Net cash used in  financing activities |       | (1,102,151                               | )          | (30,507 | ) |
| Net decrease in cash  and equivalents  |       | $                                        | (2,465,988 | ) | $ | (10,926,730 | ) |

 

*Three Months Ended January 31,2010 Compared to Three Months Ended January 31, 2009*

 

During the three months ended January 31, 2010,we used $1.3 million in cash for operating activities. This use consistsprimarily of generating net income of $4.7 million exclusive of non cashexpenses including depreciation and amortization of $1.4 million and lower ofcost or market adjustments of $0.6 million offset by increasing inventory onhand by $4.2 million.

 

During the quarter ended January 31, 2009, weused $10.7 million in cash for operating activities. This use consistsprimarily of a net loss of $6.2 million, payments for corn under deferredpayment agreements and payments under forward purchase contracts the losses onwhich had been accrued on October 31, 2008.

 

During the three months ended January 31, 2010,we used approximately $27,000 for investing activities to pay for capitalexpenditures. During the three months ended January 31, 2010, we used $1.1million for financing activities consisting primarily of payments on long termdebt.

 

During the three months ended January 31, 2009,we used $0.2 million for investing activities to pay for capital expendituresand intangibles. During the quarter ended January 31, 2009, we used$31,000 for financing activities consisting primarily of payment on long termdebt of $1.0 million net of release of restricted cash and a draw on the lineof credit of $1.0 million.

 

At January 31, 2010, we were in default ofcovenants of our master loan agreement with AgStar requiring us to maintain atleast $5.0 million minimum working capital. At October 31, 2009, we were in default of covenants of our masterloan agreement with AgStar requiring us to maintain at least $5.0 millionminimum working capital; at least $39.5 million of tangible net worth; and afixed charge ratio of 1.20 to 1.00 or greater. Additionally, we do not expectto be in compliance with one or more covenants of the master loan agreement asof fiscal year end 2010 and the three months end January 31, 2011 unlessamendments are issued. Our failure to maintain the required amount of workingcapital constitutes an event of default under the master loan agreement, entitlingthe lender to accelerate and declare due all amounts outstanding under themaster loan agreement. Therefore, we have classified $48.1 million of theAgStar debt as a current liability that would otherwise be classified as longterm. As a result, current liabilities as of January 31, 2010 totaledapproximately $66.9 million, including $48.1 million of long-term debtreclassified as current liabilities.

 

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.  As of January 31, 2010, we had drawn $5.0million on the line of credit. We did not repay the revolving line of credit onFebruary 1, 2010 pending further negotiations with AgStar for an extensionof the maturity date.  As of February 1,2010, AgStar added a 2.0% surcharge to the interest rate on the outstandingamount on this line of credit due to non-payment at maturity.

 

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 the masterloan agreement or that any waiver or amendment to the master loan agreementwill be provided by AgStar.  Further, there can be no assurance thatAgStar will not demand immediate repayment of all $58.5 million in indebtednessoutstanding under the master loan agreement at January 31, 2010 orexercise 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 do not have adequate cash to repay the $5.0million outstanding on the line of credit at January 31, 2010 if we wererequired to and we did not pay the outstanding amount when due on February 1,2010.  We have requested an additionalextension of the maturity date of this line of credit beyond February 1,2010.  There can be no assurance that such an extension will be granted onterms advantageous to us, if at all.  Further, while an event of defaultexists, the Company is not permitted to borrow additional funds under its lineof credit or revolving term note 

 

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unless AgStar consents to the advance. While AgStarhas consented to make advances in the past, our potential inability to borrowadditional funds under the master loan agreement may result in a workingcapital 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 subordinateddebt, if available, raise additional equity, restructure or significantly curtailits operations, file for bankruptcy or cease operations. The financialstatements do 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.  However, there can be no assurance, that we will notrequire additional financing in the future or that any additional financingwill be available to us on satisfactory terms, if at all.

 

**Outlook**

 

Currently, ethanol prices are favorable. Nevertheless,we expect to see continuing volatility in ethanol prices.  Future pricesfor fuel 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 an animalfeed, prices of competing feeds, and perceptions of nutritional value of DGS ascompared to those competing feeds. We believe that current market prices forDGS can be sustained long-term as long as the prices of competing animal feedsremain steady or increase, livestock feeders continue to create demand foralternative feed sources such as distillers’ grains and the supply ofdistillers’ grains remains relatively stable. On the other hand, if competingcommodity price values retreat and DGS supplies increase due to growth in theethanol 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 beenmitigated by a large increase in crop size. We expect the price of corn to remain at current price levels well into2010.   Due to increased exposure of ethanol, corn is now being viewed asan “energy commodity” as opposed to strictly a “grain commodity,” contributingto the upward pressure on corn prices.  The USDA’s February 9, 2010Feed Outlook Report, projects U.S. corn prices for the season average to be at$3.45 to $3.95 per bushel.

 

**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 bethe impact of adverse changes in market prices on our results ofoperations.  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 regulatory factors.   From time to time, we may purchase cornfutures and options to hedge a portion of the corn we anticipate we will need.In addition, we have contracted for future physical delivery of corn. We areexposed to the full impact of market fluctuations associated with interestrates and commodity prices.

 

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 thefirst quarter of fiscal year 2010 ended January 31, 2010, the price ofethanol on the Chicago Board of Trade fluctuated from $1.76 to $2.17 pergallon; our average sales price was $1.84 per gallon.  During the same period, the price of corn onthe Chicago Board of Trade fluctuated from a low of $3.55 to a high of $4.26per bushel; our average purchase price was $3.57 per bushel.

 

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Our future earnings may be affected by changes ininterest rates due to the impact those changes have on our interest expense onborrowings under our credit facilities. As of January 31, 2010, we had$18.6 million of outstanding borrowings with variable interest rates. With each1% change in interest rates our annual interest expense would change by$186,000.

 

**Item 4T. Controls and Procedures**

 

**Effectivenessof Disclosure Controls and Procedures**

 

Our management, with the participation of our ChiefExecutive Officer and Interim Chief Financial Officer, has evaluated theeffectiveness of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) underthe Exchange Act) as of the end of the period covered by this report. Based onthat evaluation, our Chief Executive Officer and Interim Chief FinancialOfficer have concluded that, as of the end of such period, our disclosurecontrols and procedures were effective.

 

**Changesin Internal Control Over Financial 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 January 31, 2010 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**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. Submission of Matters to aVote of Security Holders**

 

None.

 

**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: March 17, 2010 | /s/  Robert J. Ferguson                 |
|                      | Robert J Ferguson                            |
|                      | President and Chief Executive Officer        |
|                      | (Principal Executive Officer)                |
|                      |                                         |
|                      |                                         |
| Date: March 17, 2010 | /s/  Brett L. Frevert                   |
|                      | Brett L Frevert                              |
|                      | Interim Chief Financial Officer              |
|                      | (Principal Accounting and Financial Officer) |

 

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