MGP Ingredients (MGPI)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March  31, 2008.

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                                    to                                 

Commission File Number:  0-17196

(Exact name of registrant as specified in its charter)

(913) 367-1480

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x  Yes  o  No

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common stock, no par value

16,559,253 shares outstanding

as of March 31, 2008

INDEX

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Report of Independent Registered Public Accounting Firm

Audit Committee, Board of Directors and Stockholders

MGP Ingredients, Inc.

Atchison, Kansas

We have reviewed the accompanying condensed consolidated balance sheets of MGP Ingredients, Inc. as of March 31, 2008 and April 1, 2007, and the related condensed consolidated statements of income for the three-month and nine-month periods ended March 31, 2008 and April 1, 2007, and cash flows for the nine-month periods ended March 31, 2008 and April 1, 2007.  These interim financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of July 1, 2007 and the related consolidated statements of income, stockholders’ equity and cash flows for the year then ended (not presented herein); and in our report dated August 31, 2007, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of July 1, 2007 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

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MGP INGREDIENTS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME(LOSS)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements

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MGP INGREDIENTS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

See Notes to Condensed Consolidated Financial Statements

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MGP INGREDIENTS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Year-to-Date Ended

(Unaudited)

See Notes to Condensed Consolidated Financial Statements

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MGP INGREDIENTS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The accompanying unaudited condensed consolidated balance sheets of MGP Ingredients, Inc. as of March 31, 2008 and April 1, 2007, condensed consolidated statements of income for the quarter and year-to-date periods ended March 31, 2008 and April 1, 2007 and the condensed consolidated statements of cash flow for the year-to-date periods ended March 28, 2008 and April 1, 2007 reflect all adjustments that are, in the opinion of the Company’s management, necessary to fairly present the financial position, results of operations and cash flows of the Company.  Except for the $8.1 million impairment loss further discussed in Note 11 and the $2.0 million accounting error correction discussed in Note 12, those adjustments consist only of normal recurring adjustments.  The condensed consolidated balance sheet as of July 1, 2007 has been derived from the audited consolidated balance sheet of the Company as of that date.  Certain information and note disclosures normally included in the Company’s annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted.  These condensed consolidated financial statements as of and for the period ended March 31, 2008 should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Form 10-K Annual Report for the fiscal year ended July 1, 2007 filed with the Securities and Exchange Commission.  The condensed consolidated balance sheet as of April 1, 2007 should be read in conjunction with the consolidated financial statements and notes thereto in the Company’s Form 10-K Annual Report for the fiscal year ended June 30, 2006 filed with the Securities and Exchange Commission.  The results of operations for the period ended March 31, 2008 are not necessarily indicative of the results to be expected for the full year.  Certain prior year amounts have been reclassified to conform to current year presentation.

For the quarter and year-to-date periods ended March 31, 2008 and April 1, 2007, the Company has reclassified other operating income into cost of sales.  Following a review of the transactions reported within other operating income, management concluded that it would be more appropriate to reclassify them within cost of sales because they  relate to amounts received from transactions involving the sale of by-products or the use of operating assets by third parties which reduce the cost of sales. As a result, for the quarter ended April 1, 2007, cost of sales and gross profit previously reported of $85,517,000 and $8,290,000 respectively (adjusted for restatement), are now reported as $85,720,000 and $8,087,000 respectively.  For the year-to-date period ended April 1, 2007, cost of sales and gross profit previously reported of $227,000,000 and $39,447,000 respectively (adjusted for restatement), are now reported as $226,279,000 and $40,168,000 respectively.

The Company’s most recently completed fiscal year ended on July 1, 2007.  On March 6, 2008 the Board of Directors amended the Company’s bylaws to effect a change in the fiscal year.  The change will affect the current fiscal year, which was to have expired on June 29, 2008.  As a result of the change, the current quarter and fiscal year will end on March 31 and June 30 respectively, and will contain one additional day.

Basic earnings per share data is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period.  Potentially dilutive instruments are stock options and unvested restricted stock awards.

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The following is a reconciliation from the weighted average shares used for the basic earnings per share computation to the shares used for the diluted earnings per share computation for the quarters and year-to-date periods ended March 31, 2008 and April 1, 2007, respectively.

In the quarter ended September 30, 2007, the Company expanded the number of operating segments from two to three.  Following a review of the Company’s business, management concluded that it would be more appropriate and would provide the Company’s shareholders with better information if the Company were to include its pet treat resins and plant-based biopolymers in a separate segment.  These are now being reported within the other segment (“other”).  The ingredients segment has been re-titled ingredient solutions, to better reflect the Company’s integrated approach to providing comprehensive solutions to its ingredient solutions customers.  The ingredient solutions segment continues to report vital wheat gluten, commodity starch, specialty proteins and starches as well as mill products, currently consisting of wheat flour and mill feeds sold primarily for agricultural purposes.  The distillery products segment continues to report food grade alcohol (consisting of beverage and industrial alcohol), fuel grade alcohol and distillery by-products, currently consisting of distillers grain.

In the quarter ended December 30, 2007, the Company further refined the methodology for assessing identifiable assets and earnings (loss) before income taxes for all segments, resulting in greater allocation to operating segments of identifiable assets and earnings (loss) before income taxes versus non-allocated corporate.  Amounts previously disclosed as identifiable assets as of July 1, 2007 and earnings (loss) before income taxes for the quarter and year-to-date periods ended April 1, 2007 reflect this revision.

In connection with the purchase of raw materials, principally corn and wheat, for anticipated operating requirements, the Company enters into readily marketable exchange-traded commodity futures and option contracts to reduce the risk of future grain price increases.  Changes in the market value of the Company’s futures and option contracts have historically been, and are expected to continue to be, highly effective at offsetting changes in the price of the hedged items. Derivative instruments related to the Company’s hedging program are recorded as either assets or liabilities and are measured at fair market value.  Consistent with application of hedge accounting under Statement of Financial Accounting Standards No. 133 as amended (“SFAS 133”), prior to April 1, 2008 changes in the fair market value of the derivative instruments designated as cash flow hedges were recorded either in current earnings or in other comprehensive income, depending on the nature of the hedged transaction.  Gains or losses recorded in other comprehensive

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income were reclassified into current earnings in the periods in which the hedged items were consumed.  Any ineffective portion of a hedged transaction was immediately recognized in current earnings.

Application of hedge accounting under SFAS 133 requires significant resources, recordkeeping and analytical systems.  As a result of the rising compliance costs and the complexity related to the application of hedge accounting under SFAS 133, the Company’s management has elected to discontinue the use of hedge accounting for all commodity derivative positions effective April 1, 2008.  Accordingly, changes in the value of derivatives subsequent to March 31, 2008 will be recorded in cost of sales in the Company’s Consolidated Statements of Income.  Additionally, certain derivative instruments entered into during the third quarter were not designated as hedges. The change in the market value of these  instruments has been recorded in cost of sales in the Company’s Consolidated Statements of Income.  These instruments were adjusted to market value at March 31, 2008.  If these derivatives had been designated for hedge accounting, the Company would have recognized lower net income of $1.5 million (net of tax of $0.8 million), or $0.09 less in earnings per share, as a result of deferred gains and ineffectiveness recognized in the third quarter. As of March 31, 2008, the mark-to-market adjustment included in accumulated other comprehensive income will remain in equity until the forecasted transactions to which the specific hedged positions relate occur. At that time, the accumulated comprehensive income will be reclassified to earnings.  Regardless of accounting treatment, the Company’s management believes all commodity hedges are economic hedges of the Company’s risk exposures.

The Company is a party to various legal proceedings, all of which are of an ordinary, routine nature and incidental to its operations. Management considers that the aggregate liabilities, if any, arising from such actions would not have a material adverse effect on the consolidated financial position or operations of the Company.

Note 6.  Operating Segments.

The Company is a fully integrated producer of ingredient solutions, distillery and other products.  Products included within the ingredient solutions segment consist of vital wheat gluten, commodity wheat starch, specialty wheat starches and proteins and mill feeds.  Distillery products consist of food grade alcohol (consisting of beverage and industrial alcohol), fuel grade alcohol, commonly known as ethanol, and distillers grain and carbon dioxide, which are by-products of the Company’s distillery operations.  Other products include pet treat resins and plant-based biopolymers as well as other products.  For the quarter and year-to-date periods ended March 31, 2008, revenues from products in the other segment represent less than 2.0 percent of the Company’s consolidated revenues.

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The operating profit for each segment is based on net sales less identifiable operating expenses.  Interest expense, investment income and other general miscellaneous expenses have been excluded from segment operations and classified as Corporate.  Receivables, inventories and equipment have been identified with the segments to which they relate.  All other assets are considered as Corporate.

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Note 7.  Pension and Post Retirement Benefit Obligations.

Pension Benefits.  The Company and its subsidiaries provide defined retirement benefits to certain employees covered under collective bargaining agreements.  Under the collective bargaining agreements, the Company’s pension funding contributions are a function of the wages paid and are determined as a percentage of wages paid.  The funding is divided between the defined benefit plan and a 401(k) plan.  It has been management’s policy to fund the defined benefit plan first in order to render it adequately funded.  Any remaining amounts have been used to fund the 401(k) plan.  The collective bargaining agreements allow the pension benefits defined under the agreements to be reduced if the funding as described herein is insufficient to provide for such defined benefits. The Company uses a June 30 measurement date for the plan.

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The components of the Net Periodic Benefit Cost for the quarter and year-to-date periods ended March 31, 2008 and April 1, 2007, respectively, are as follows:

The Company made employer contributions of $665,000 for the year-to-date period ended March 31, 2008, all of which were paid in the first quarter of fiscal 2008.

Post Retirement Benefits.  The Company and its subsidiaries provide certain post-retirement health care and life benefits to all employees.  The liability for such benefits is unfunded.  The Company uses a May 31 measurement date for the plan.

The components of the Net Periodic Benefit Cost for the quarter and year-to-date periods ended March 31, 2008 and April 1, 2007, respectively, are as follows:

The Company previously disclosed in its financial statements for the year ended July 1, 2007, amounts expected to be paid to plan participants.  There have been no revisions to these estimates and there have been no changes in the estimate of total employer contributions expected to be made for the fiscal year ended June 30, 2008.

Total employer contributions for the quarter and year-to-date periods ended March 31, 2008 were $49,970 and $195,719 respectively.

The Medicare Prescription Drug Improvement Modernization Act of 2003 (the Act) provides certain drug benefits under Medicare Part D, as well as a federal subsidy to sponsors of retiree health care benefit plans that provide benefits at least actuarially equivalent to Medicare Part D.  The Company has been unable to conclude whether the benefits provided under the plan are actuarially equivalent to Medicare Part D.  Accordingly, the net periodic post-retirement benefit costs above do not reflect any amount associated with the subsidy.

Note 8.  Newly Implemented Management Incentive Programs.

Annual Cash Incentive Plan.  Beginning in the 2008 fiscal year, the Company has implemented a new annual cash incentive plan based upon modified economic profit (“MEP”).  MEP equals income from operations, net of taxes, less the product of total capital employed in the business multiplied by the estimated cost of capital, which for purposes of the new program is 11 percent.  Total capital represents current assets (excluding cash) less current liabilities plus the book value of property, plant and equipment, plus goodwill and other long-term assets.  The Board of Directors approved a five year annual cash incentive plan whereby annual awards are based on improvements in MEP.  The Board has established a targeted annual growth rate for MEP (“Target”) of $3.15 million.   Additionally, there is a starting hypothetical bonus pool amount (“available pool amount”) of $10.5 million, which will amortize in equal increments over five years.  Although it is anticipated that the annual growth rate will be the same for each year of the program, the Company’s compensation committee may change the targeted growth rate from year-to-year.  The compensation committee may also determine whether any non-recurring or extraordinary items will be included in income from operations.

In a year in which the change in MEP from the prior year is positive yet less than the Target amount, participants will receive an incentive payment equal to the change in MEP plus 1/3 of the available pool amount, less the amortized amount.  In a year in which the change in MEP from the prior year is positive and also greater than the Target, the amount of MEP in excess of the Target amount will be added to the available pool amount and the incentive payment will equal the Target amount plus 1/3 of the available pool amount, less the amortized amount.  In a year in which the change in MEP from the prior year is negative, the available pool amount will be reduced by the amount of the negative change in MEP, not to exceed the Target amount, and the incentive payment, if any, will equal 1/3 of the remaining available pool amount, less the amortized amount.  The compensation committee must approve and may adjust any award prior to payment.

Restricted Stock Program.  The Company has also implemented a new restricted stock program which will be administered under the Company’s 2004 Stock Incentive Plan and under which amounts awarded will be based in part on improvements to MEP. Under the program, subject to the availability of shares under the 2004 Stock Incentive Plan, restricted stock awards will be made each year and generally will be based on a percentage (approximately 85.7 percent) of the increase in MEP over the prior year. However, the maximum grant date market value of the awards made for any year to all participants will be $4.5 million and the minimum grant date market value made in any year to all participants, including years in

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which the change in MEP is negative,  will be $1.5 million. The actual number of shares issued to all participants will be determined on the date the Committee certifies the increase in MEP for fiscal 2008.  Shares awarded will vest in 5 years and will pay dividends during the vesting period. Provisions for forfeiture and accelerated and pro rata vesting generally are similar to those under the guidelines for the Company’s outstanding performance accelerated restricted stock awards.

On December 27, 2007, the Company settled its two year patent infringement and contract litigation.  Under the terms of the settlement, the Company agreed to dismiss its lawsuit with prejudice and was paid $8 million, which was received on December 28, 2007.  In connection with the settlement, the Company also granted the other parties in the lawsuit a non-exclusive license under its U.S. Patent No. 5,665,152.  For the first and second quarters of Fiscal 2008, the Company incurred professional fees of $568,000 and $386,000 respectively, related to this litigation.  These amounts have been netted against the gross proceeds for a net amount of $7,046,000.  The Company has recorded the settlement as a separate line item below income from operations.  The Company used the proceeds from the settlement to reduce the amount outstanding under its line of credit.

FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”), clarifies the accounting for uncertainty in income taxes by defining criteria that a tax position on an individual matter must meet before that position is recognized in the financial statements.  Additionally, FIN 48 provides guidance on measurement, derecognition, balance sheet classification, interest and penalties, interim period accounting, disclosures and transition.

The Company adopted the provisions of FIN 48 on July 2, 2007.  In accordance with the recognition standards established by FIN 48, the Company performed a comprehensive review of potential uncertain tax positions in each jurisdiction in which the Company operates. As a result of the Company’s review, the Company adjusted the carrying amount of the liability for unrecognized tax benefits, resulting in a net increase to retained earnings of $59,000.  The Company’s gross liability for unrecognized tax provision is $1.49 million as of July 2, 2007.  The Company has recorded deferred tax assets of $711,000 related to the recording of the liability for unrecognized tax benefits.

In accordance with FIN 48, the Company has elected to treat interest and penalties related to tax liabilities as a component of income tax expense.  As of the date of adoption, the Company had $199,000 accrued for the payment of interest, and $11,000 accrued for the payment of penalties, which was included in the $1.49 million unrecognized tax benefit liability discussed above.

The amount of the Company’s liability for uncertain tax benefits at July 2, 2007 that would impact the effective tax rate, if recognized, was $783,000.

During the first quarter of fiscal 2008, the Company settled an IRS exam related to its June 30, 2005 and June 30, 2006 tax years.  An assessment of $85,000 was paid as a result of this exam.  The tax and interest assessed was previously recorded as part of the adoption of FIN 48.  In addition, in the third quarter of fiscal 2008, the statute of limitations on the Company’s 2003 tax returns lapsed.  As a result, the FIN 48 liability, excluding the impact of accrued interest and penalties, decreased by approximately $71,000.  The benefit was recorded as a component of income taxes for the quarter.

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The statute of limitations for the Company’s federal income tax returns is open for fiscal years ending on or after the June 30, 2005.  The Company files in the states of Kansas, Illinois and Pennsylvania.  The statute of limitations on these state tax returns is open for fiscal years ending on or after June 30, 2005.

In connection with the preparation of financial statements for the quarter ended March 31, 2008, the Company undertook a review of its long-lived assets contained within its other segment  and its ingredient solutions segment in accordance with Statement of Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”).  The review took into account the impact of the rising trend of commodity prices on existing contracts and consumer preferences, anticipated sales to existing customers, the failure of anticipated business to develop, recent decisions to cease R&D activities on pet products and reduce staffing in the pet product area and plans to shift production of certain texturized wheat proteins to third parties.  Based upon this review, management estimates that the carrying value of the assets comprising its Kansas City manufacturing facility (“KCIT facility”) exceeds the estimated realizable fair value of these assets.  In accordance with SFAS No. 144, the Company  has recorded a non-cash pre-tax charge of $8.1 million for the quarter ended March 31, 2008 related to the impairment of these assets.  Of this amount, $4.7 million relates to assets allocated to the Company’s other segment and $3.4 million relates to assets allocated to the Company’s ingredient solutions segment. The Company is evaluating the strategic alternatives for the plant and equipment at its KCIT facility, which may include their sale.

Note 12.  Correction of Accounting Error.

The Condensed Consolidated Statements of Income for the quarter and year-to-date periods ended April 1, 2007, Condensed Consolidated Balance Sheets as of April 1, 2007 and July 1, 2007 and the Condensed Consolidated Statement of Cash Flow for the year-to-date period ended April 1, 2007, presented herein have been restated to correct the following error,  in accordance with Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”).  Since fiscal 2001, the Company over recognized deferred income from funds that it received over the course of fiscal years 2001 to 2003 under a Commodity Credit Corporation program implemented by Congress following termination of import quotas on gluten.  The Company  received a total of $26 million under the program, of which approximately $17.5 million was used for capital expenditures.   Recognition of the amount used for these capital items was deferred and is being recognized over the life of the assets.  The amount recognized each year was to have approximated the amount of depreciation on the assets that the Company acquired under the program. The Company has determined that, through errors made at the offset and throughout execution of the program that were undetected until recently, certain assets were placed on, or omitted from, the depreciation schedule for commodity credit corporation funded assets. As a result of the error, the asset pool whose depreciation determined the amount of deferred credit that was  amortized each year and recognized as  income had  assets whose original cost was $21 million instead of $17.5 million, and as a result, the company  recognized excess deferred income in each of fiscal years 2001 through the second quarter of the current fiscal year.  The amount of revenue involved ranged annually from a high of $397,000 in 2002 to $175,000 in the current year, resulting in annual overstatements of net income after taxes ranging from a low of 1% to a high of 4.4% through fiscal 2007.  The cumulative effect of the error on retained earnings as of March 31, 2008 was $1.2 million on a pre-tax adjustment of $2.0 million.

The Company has conducted a materiality analysis under SAB 108 and determined that the impact on prior years was not material.  However, it is required to report the error as an adjustment to its prior period financial statements.  The condensed consolidated statements of income  for the quarter and year-to-date periods ended April 1, 2007, the balance sheets as of April 1, 2007 and July 1, 2007 and the

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condensed consolidated statement of cash flows for the nine months ended April 1, 2007 included in this report have been adjusted to reflect a correction of the period-specific effects of the error and the effect of the correction on each financial statement line item and per share amounts is shown below.  The cumulative effect of the error on retained earnings as of the beginning of the year-to-date period ended April 1, 2007 was $1.0 million  and the effect on net income for the fiscal year immediately prior thereto (FY 2006) was  $124,000.

An analysis of the adjustment to the Condensed Consolidated Statement of Income for the Quarter ended April 1, 2007 is as follows: (In thousands)

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An analysis of the adjustment to the Condensed Consolidated Statement of Income for the Year-to-Date ended April 1, 2007 is as follows: (In thousands)