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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x                Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended April 30, 2010

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 000-53588

HIGHWATER ETHANOL, LLC

(Name of registrant as specified in its charter)

(507) 752-6160

(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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  o  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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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:  As of June 11, 2010 there were 4,953 membership units outstanding.

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INDEX

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

HIGHWATER ETHANOL, LLC

Condensed Balance Sheets

Notes to Condensed Unaudited Financial Statements are an integral part of this Statement.

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HIGHWATER ETHANOL, LLC

 Condensed Statements of Operations

Notes to Condensed Unaudited Financial Statements are an integral part of this Statement.

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HIGHWATER ETHANOL, LLC

Condensed Statements of Operations

Notes to Condensed Unaudited Financial Statements are an integral part of this Statement.

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HIGHWATER ETHANOL, LLC

Condensed Statements of Cash Flows

Notes to Condensed Unaudited Financial Statements are an integral part of this Statement.

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HIGHWATER ETHANOL, LLC

Notes to Unaudited Condensed Financial Statements

April 30, 2010

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited condensed interim financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission.  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted as permitted by such rules and regulations.  These financial statements and related notes should be read in conjunction with the financial statements and footnotes thereto included in the Company’s audited financial statements for the year ended October 31, 2009, contained in the Company’s Form 10-K.

In the opinion of management, the interim condensed financial statements reflect all adjustments, consisting of only normal recurring adjustments, considered necessary for fair presentation of the Company’s financial position as of April 30, 2010 and the results of operations and cash flows for all periods presented.

Nature of Business

Highwater Ethanol, LLC, (a Minnesota Limited Liability Company) operates a 50 million gallon per year ethanol plant in Lamberton, Minnesota.  The Company produces and sells fuel ethanol and distillers grains, a co-product of the fuel ethanol production process, in the continental United States, Mexico and Canada.

Accounting Estimates

Management uses estimates and assumptions in preparing these financial statements in accordance with generally accepted accounting principles.  Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses.  The Company uses estimates and assumptions in accounting for significant matters, among others, the carrying value of property and equipment and related impairment testing, inventory valuation, and derivatives.  Actual results could differ from those estimates and such differences may be material to the financial statements. The Company periodically reviews estimates and assumptions and the effects of revisions are reflected in the period in which the revision is made.

Restricted Cash

The Company maintains restricted cash balances as part of the capital lease financing agreement.  The restricted cash balances include money market accounts and similar financial instruments which currently exceed amounts insured by the Federal Deposit Insurance Corporation and the Securities Investor Protection Corporation.  The Company does not believe it is exposed to any significant credit risk on these balances.

In February 2010, the Company made their final withdrawal on the construction loan of approximately $524,000.  These funds were placed into a restricted account for the payment of open construction invoices.

Revenue Recognition

The Company generally sells ethanol and related products pursuant to marketing agreements. The Company’s products are shipped FOB shipping point. Revenues are recognized when the customer has taken title and has assumed the risks and rewards of ownership, prices are fixed or determinable and collectability is reasonably assured. For ethanol sales, title transfers when loaded into the rail car and for distiller’s grains when the loaded rail cars leave the plant facility.

In accordance with the Company’s agreements for the marketing and sale of ethanol and related products, marketing fees and freight due to the marketers are deducted from the gross sales price at the time incurred. Revenue is recorded net of these marketing fees and freight as they do not provide an identifiable benefit that is sufficiently separable from the sale of ethanol and related products.

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HIGHWATER ETHANOL, LLC

Notes to Unaudited Condensed Financial Statements

April 30, 2010

Carrying Value of Long-Lived Assets

Long-lived assets, such as property and equipment, and other long-lived assets subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.  If circumstances require a long-lived asset be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by an asset to the carrying value of the asset.  If the carrying value of the long-lived asset is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying value exceeds its fair value.  Fair value is determined through various valuation techniques including discounted cash flow models, quoted market values and third-party independent appraisals, as considered necessary.

In August 2009, the Company completed construction of its ethanol production facilities with installed capacity of 50 million gallons per year.  The carrying value of these facilities at April 30, 2010 was approximately $104.7 million.  In accordance with the Company’s policy for evaluating impairment of long-lived assets described above, management evaluates the recoverability of the facilities based on projected future cash flows from operations over the facilities’ estimated useful lives.  In determining the projected future undiscounted cash flows, the Company makes significant assumptions concerning the future viability of the ethanol industry, the future price of corn in relation to the future price of ethanol and the overall demand in relation to production and supply capacity. The Company has determined that there is no impairment at April 30, 2010.

Fair Value of Financial Instruments

The carrying value of cash, restricted cash, and restricted marketable securities approximate their fair value based on quoted market prices at year end.  The Company believes the carrying value of the derivative instrument approximates fair value based on widely accepted valuation techniques including discounted cash flow analysis which includes observable market-based inputs.

The Company believes the carrying amount of the long-term debt approximates fair value due to a significant portion of total indebtedness contains variable interest rates and this rate is a market interest rate for these borrowings.

The carrying value of cash, accounts receivable, and accounts payable, and other working capital items approximate fair value at April 30, 2010 due to the short maturity nature of these instruments.

2.  UNCERTAINTIES

The Company derives substantially all of its revenues from the sale of ethanol and distillers grains.  These products are commodities and the market prices for these products display substantial volatility and are subject to a number of factors which are beyond the control of the Company.  The Company’s most significant manufacturing inputs are corn and natural gas.  The price of these commodities is also subject to substantial volatility and uncontrollable market factors.  In addition, these input costs do not necessarily fluctuate with the market prices for ethanol and distillers grains.  As a result, the Company is subject to significant risk that its operating margins can be reduced or eliminated due to the relative movements in the market prices of its products and major manufacturing inputs.  As a result, market fluctuations in the price of or demand for these commodities can have a significant adverse effect on the Company’s operations, profitability, and availability of cash flows to make loan payments and maintain compliance with the loan agreement.

3.  FAIR VALUE MEASUREMENTS

Various inputs are considered when determining the value of financial instruments. The inputs or methodologies used for valuing securities are not necessarily an indication of the risk associated with investing in these securities. These inputs are summarized in the three broad levels listed below:

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HIGHWATER ETHANOL, LLC

Notes to Unaudited Condensed Financial Statements

April 30, 2010

·                  Level 1 inputs are quoted prices in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

·                  Level 2 inputs include the following:

·                  Quoted prices in active markets for similar assets or liabilities.

·                  Quoted prices in markets that are not active for identical or similar assets or liabilities.

·                  Inputs other than quoted prices that are observable for the asset or liability.

·                  Inputs that are derived primarily from or corroborated by observable market data by correlation or other means.

·                  Level 3 inputs are unobservable inputs for the asset or liability.

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

The fair value of restricted cash, which includes money market funds, and restricted marketable securities are based on quoted market prices in an active market. The Company determined the fair value of the interest rate swap by using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each instrument. The analysis reflects the contractual terms of the swap agreement, including the period to maturity and uses observable market-based inputs and uses the market standard methodology of netting the discounted future fixed cash receipts and the discounted expected variable cash payments.

4.  RESTRICTED MARKETABLE SECURITIES

The cost and fair value of the Company’s restricted marketable securities consist of the following at April 30, 2010:

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HIGHWATER ETHANOL, LLC

Notes to Unaudited Condensed Financial Statements

April 30, 2010

The long-term restricted marketable securities relate to the debt service reserve fund required by the capital lease agreement. The Company had gross unrealized gains of $96,671 and $92,334 included in accumulated other comprehensive income at April 30, 2009 and October 31, 2009, respectively.

Shown below are the contractual maturities of marketable securities with fixed maturities at April 30, 2010.  Actual maturities may differ from contractual maturities because certain securities may contain early call or prepayment rights.

5. INVENTORIES

Inventories consisted of the following at:

*Derived from Audited financial statements

6. DERIVATIVE INSTRUMENTS

The Company does not enter into derivative transactions for trading purposes.  As of April 30, 2010, the Company has an interest rate swap agreement.

Interest Rate Swap

At April 30, 2010, the Company had a notional amount of approximately $23,751,000 outstanding in the swap agreement that fixes the interest rate at 7.6% until June 2014. The interest rate swap is not designated as an effective hedge for accounting purposes.

The following tables provide details regarding the Company’s derivative instruments at April 30, 2010:

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HIGHWATER ETHANOL, LLC

Notes to Unaudited Condensed Financial Statements

April 30, 2010

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

7.  DEBT FINANCING

Long-term debt consists of the following at:

*Derived from Audited financial statements

Bank Financing

On February 26, 2010 the construction loan was converted to three new promissory notes including a $25,200,000 Fixed Rate Note, a $20,200,000 Variable Rate Note, and a $5,000,000 Long-Term Revolving Note, as described in the credit agreement and below. The credit agreement also provided a line of credit for $5,000,000 and supported the issuance of letters of credit up to $5,600,000, all of which are secured by substantially all assets.

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HIGHWATER ETHANOL, LLC

Notes to Unaudited Condensed Financial Statements

April 30, 2010

Fixed Rate Note

The Fixed Rate Note was $25,200,000 at conversion with a variable interest rate that is fixed with an interest rate swap.  The Company makes monthly principal payments on the Fixed Rate Note initially for approximately $145,000 plus accrued interest which commenced in March 2010. Interest accrues on the Fixed Rate Note at the greater of the one-month LIBOR rate plus 300 basis points or 4%, which was 4% at April 30, 2010. A final balloon payment on the Fixed Rate Note of approximately $15,184,000 will be due February 26, 2015.  The Company entered into an interest rate swap which fixes the interest rate on the Fixed Rate Note at 7.6% for five years which began in June 2009.

Variable Rate Note

The Variable Rate Note was $20,200,000 at conversion.  For the Variable Rate Note, the Company makes monthly payments initially for approximately $147,000 plus accrued interest which commenced in March 2010. Interest accrues on the Variable Rate Note at the greater of the one-month LIBOR rate plus 350 basis points or 4%, which was 4% at April 30, 2010. A final balloon payment of approximately $14,807,000 will be due February 26, 2015.

Long-term Revolving Note

The Long-Term Revolving Note was $5,000,000 at conversion.  The amount available on the Long-Term Revolving Note will decline annually by the greater of $125,000 or 50% of the excess cash flow, as defined by the agreement.  The Long-Term Revolving Note accrues interest monthly at the greater of the one-month LIBOR plus 350 basis points or 4% until maturity on February 26, 2015, which was 4% at April 30, 2010.

Line of Credit

The Company’s Line of Credit accrues interest at the greater of the 90-day LIBOR plus 450 basis points or 5.5%, which was 5.5% at April 30, 2010.  The Line of Credit requires monthly interest payments and was payable in full in February 2010.  In February 2010, the Company signed an amendment to extend the maturity date to February 26, 2011.  As of April 30, 2010, there are no borrowings outstanding and the maximum availability was $2,875,000.

The Company is required to make additional payments annually on debt for up to 50% of the excess cash flow, as defined by the agreement.  As part of the bank financing agreement, the premium above LIBOR on the loans may be reduced based on a financial ratio.  The loan agreements are secured by substantially all business assets and are subject to various financial and non-financial covenants that limit distributions and debt and require minimum debt service coverage, net worth, and working capital requirements.

The Company was in compliance with the covenants applicable at April 30, 2010; however, due to the nature of the business, there is a risk that the Company may be out of compliance with certain covenants when they are measured in subsequent periods. Specifically, management is currently working with its lender to redefine the calculation of the net worth covenant.

As of April 30, 2010, the Company has letters of credit outstanding of $4,950,000 as mentioned previously. The Company pays interest at a rate of 1.75% on amounts outstanding and the letters of credit are valid until July 2010.  One of the letters of credit will automatically renew for an additional one year period in the amount of $4,000,000.  The outstanding balances under the line of credit agreement were $0 and $1,000,000 at April 30, 2010 and October 31, 2009, respectively.

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HIGHWATER ETHANOL, LLC

Notes to Unaudited Condensed Financial Statements

April 30, 2010

The estimated maturities of the long-term debt at April 30, 2010 are as follows:

8.  LEASES

In April 2009, the Company entered into a five-year operating lease agreement with an unrelated party for 50 covered hopper cars.  The Company pays approximately $425 per car per month.  In addition, a surcharge of $0.03 per mile will be assessed for each mile in excess of 30,000 miles per year a car travels.  Total lease expense for the three and six months ending April 30, 2010 was approximately $62,800 and $133,000, respectively.

The Company has also entered into a capital lease agreement.

Future minimum lease payments under the capital lease are as follows at April 30, 2010:

9.  COMMITMENTS AND CONTINGENCIES

Regulatory Agencies

The Company is subject to discussions with regulatory agencies regarding environmental concerns which arise in the ordinary course of its business. While the ultimate outcome of these matters is not presently determinable, management believes that the resolution of outstanding claims will not have a material adverse effect on the financial position or results of operations of the Company. Due to the uncertainties in the settlement process, it is at least reasonably possible that management’s view of outcomes will change in the near term.

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

Cautionary Statements Regarding Forward-Looking Statements

This report contains forward-looking statements that involve known and unknown risks and relate to future events, our future performance and our expected future operations and actions.  In some cases you can identify forward-looking statements by the use of words such as “will,” “may,” “should,” “anticipate,” “believe,” “expect,” “plan,” “future,” “intend,” “could,” “estimate,” “predict,” “hope,” “potential,” “continue,” or the negative of these terms or other similar expressions.  These forward-looking statements are only our predictions and involve numerous assumptions, risks and uncertainties.  Many factors could cause actual results to differ materially from those projected in forward-looking statements.  While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include, but are not limited to:

·                  Changes in our business strategy, capital improvements or development plans;

·                  Volatile commodity and financial markets;

·                  Limitations and restrictions contained in the instruments and agreements governing our indebtedness;

·                  Our ability to comply with the financial covenants contained in our credit agreements with our lender;

·                  Our ability to profitably operate the ethanol plant and maintain a positive spread between the selling price of our products and our raw materials costs;

·                  Our ability to generate free cash flow to invest in our business and service our debt;

·                  Changes in interest rates and lending conditions;

·                  The results of our hedging transactions and other risk management strategies;

·                  Changes in the environmental regulations or in our ability to comply with such regulations;

·                  Changes in general economic conditions or the occurrence of certain events causing an economic impact in the agriculture, oil or automobile industries;

·                  Changes in the availability of credit to support the level of liquidity necessary to implement our risk management activities;

·                  Changes in or elimination of federal and/or state laws or policies impacting the ethanol industry (including the elimination of any federal and/or state ethanol tax incentives);

·                  Ethanol and distillers grains supply exceeding demand and corresponding price reductions;

·                  Changes in plant production capacity or technical difficulties in operating the plant;

·                  Changes and advances in ethanol production technology;

·                  Our ability to retain key employees and maintain labor relations;

·                  Changes in our ability to obtain additional debt financing, if we so require;

·                  Lack of transportation, storage and blending infrastructure preventing our products from reaching high demand markets; and

·                  Competition from alternative fuel additives.

The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf.  We are not under any duty to update the forward-looking statements contained in this report.  Furthermore, we cannot guarantee future results, levels of activity, performance or achievements.  We caution you not to put undue reliance on any forward-looking statements, which speak only as of the date of this report.  You should read this report and the documents that we reference in this report and have filed as exhibits completely and with the understanding that our actual future results may be materially different from what we currently expect.  We qualify all of our forward-looking statements by these cautionary statements.

Available Information

Our website address is www.highwaterethanol.com.  Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), are available, free of charge, on our website at www.highwaterethanol.com under the link “SEC Compliance,” as soon as reasonably practicable after we electronically file such materials with, or furnish such materials to, the Securities and Exchange Commission. The contents of our website are not incorporated by reference in this Quarterly Report on Form 10-Q.

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Overview

Highwater Ethanol, LLC (“we,” “our,” “Highwater” or the “Company”) is a Minnesota limited liability company organized on May 2, 2006 for the purpose of developing, constructing, owning and operating a fuel-grade ethanol plant near Lamberton, Minnesota.  Since August 2009, we have been engaged in the production of ethanol and distillers grains at the ethanol plant.  Our plant has an approximate annual capacity of 50 million gallons of undenatured ethanol.

Our operating results are largely driven by the prices at which we sell our ethanol and distillers grains as well as the other costs related to production.  We market our products through professional third party marketers.  Our ethanol is marketed by Renewable Products Marketing Group, LLC (RPMG).  Our distillers grains are marketed by CHS, Inc. (CHS).

The price of ethanol has historically fluctuated with the price of petroleum-based products such as unleaded gasoline, heating oil and crude oil.  The price of distillers grains has historically been influenced by the price of corn as a substitute livestock feed.  We expect these price relationships to continue for the foreseeable future, although recent volatility in the commodities markets makes historical pricing relationships less reliable.  Our largest costs of production are corn, natural gas, depreciation and manufacturing chemicals.  The cost of corn is largely impacted by geopolitical supply and demand factors and the outcome of our risk management strategies.  Prices for natural gas, manufacturing chemicals and denaturant are tied directly to the overall energy sector, crude oil and unleaded gasoline.

As of the date of this report, we have 40 employees.  Approximately, ten of these employees are involved primarily in management and administration.  The remaining employees are involved primarily in plant operations.  We do not currently anticipate any significant change in the number of employees at our plant.

Results of Operations for the Three Months Ended April 30, 2010

Our plant did not become operational until August 2009.  Accordingly, we do not yet have comparable income, production and sales data for the three months ended April 30, 2010, from the three months ended April 30, 2009, because we were not generating revenue for the three months ended April 30, 2009.  Consequently we do not provide a comparison of our financial results between reporting periods in this report.  If you undertake your own comparison of our results for the three months ended April 30, 2010, and the three months ended April 30, 2009, it is important that you keep this in mind.

The following table shows the result of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our statement of operations for the three months ended April 30, 2010.

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The following table shows the sources of our revenue for the three months ended April 30, 2010.

The following table shows additional data regarding production and price levels for our primary inputs and products for the three months ended April 30, 2010:

Revenues

Our revenues are derived from the sale of our ethanol and distillers grains.  The Company had total revenues of approximately $23,221,000 for the three months ended April 30, 2010, compared to total revenues of approximately $27,735,000 for the three months ended January 31, 2010.  For the three months ended April 30, 2010, ethanol sales comprised approximately 84.7% of our revenues and distillers grains sales comprised approximately 15.3% percent of our revenues.

During the current fiscal year, ethanol prices were the highest in November 2009 and have been decreasing since that time.  Management attributes this decreasing trend in ethanol prices to increased production of ethanol and steady demand.  The Company received an average price of $1.85 (before marketing fees) per gallon of ethanol sold during the three months ended January 31, 2010, compared to an average price of $1.46 (before marketing fees) per gallon of ethanol sold during the three months ended April 30, 2010.  Increased ethanol prices during the last calendar quarter of 2009 allowed the ethanol industry to realize more favorable margins, resulting in many plants in the industry reporting a profit during that time period.  Management believes the increased margins led some idled ethanol plants to again commence production, which resulted in an increased supply of ethanol thereby decreasing the price of ethanol.  During the three months ended April 30, 2010, the Company had revenues from the sale of ethanol of approximately $19,671,000 compared to revenues of approximately $24,013,000 from the sale of ethanol for the three months ended January 31, 2010.

Management anticipates that the price of ethanol may remain relatively stable during the remainder of our 2010 fiscal year with typical price and demand increases during the summer driving season.  However, management believes that if the EPA approves an increase in the ethanol blend rate for standard (non-flex fuel) vehicles, it could positively impact ethanol demand and ethanol prices during our 2010 fiscal year.  Conversely, ethanol prices could decrease if additional ethanol supply capacity enters the market without corresponding increases in ethanol demand.  This could result if the EPA does not implement an increase in the ethanol blend rate and the ethanol industry reaches the blending wall of approximately 13.5 billion gallons of ethanol during our 2010 fiscal year.

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Management also anticipates that our results of operations for our 2010 fiscal year may be affected by high corn prices, a surplus of ethanol, and volatility in the commodity markets. If plant operating margins remain low for an extended period of time, management anticipates that this could significantly impact our liquidity, especially if our raw material costs increase. Management believes the industry will need to continue to grow demand and further develop an ethanol distribution system to facilitate additional blending of ethanol and gasoline to offset the increased supply brought to the marketplace by additional production. Going forward, we are optimistic that ethanol demand will continue to grow and ethanol distribution will continue to expand as a result of the positive blend economics that currently exist once the Volumetric Ethanol Excise Tax Credit (VEETC) is accounted for by the gasoline refiners and blenders.  VEETC provides a volumetric ethanol excise tax of 4.5 cents per gallon of ethanol blended with gasoline at a rate of ten percent (10%).  VEETC is scheduled to expire on December 31, 2010.  If this tax credit is not renewed, it likely would have a negative impact on the price of ethanol and demand for ethanol in the marketplace.

The Company received revenues from the sale of its dried distillers grains of approximately $3,457,000 for the three months ended April 30, 2010, compared to revenues of approximately $3,253,000 for the three months ended January 31, 2010.  For the three months ended April 30, 2010, the Company received an average price of $95.12 (after freight but before marketing fees) per ton for the approximately 37,000 tons of dried distillers grains sold resulting in revenues of approximately $3,532,000 (before deducting marketing fees).  In comparison, the Company received an average price of $98.88 (after freight but before marketing fees) per ton for approximately 34,000 tons of dried distillers grains sold resulting in revenues of approximately $3,332,000 (before deducting marketing fees) for the three months ended January 31, 2010.  However, as barge traffic on the Mississippi River opened up, the dry distillers grain bid increased from March 2010 lows of approximately $77 per ton to over $100 per ton in April 2010.  Management anticipates that distillers grains prices will follow their usual annual trend of increasing into the end of June and early July and then falling into the end of summer and early fall.  However, management believes that distillers grains prices will largely depend on corn and soybean prices.  If we experience significant decreases in corn and soybean prices, management anticipates that distillers grains prices will similarly decrease.

Cost of Goods Sold

Our costs of goods sold as a percentage of revenues were approximately 101.2% for the three months ended April 30, 2010 compared to 83.44% for the three months ended January 31, 2010.  Our two largest costs of production are corn (69.7% of cost of goods sold for the three months ended April 30, 2010) and natural gas (9.1% of cost of goods sold for the three months ended April 30, 2010).

For the three months ended April 30, 2010, the Company paid an average price for corn of $3.39 per bushel,  compared to an average price of $3.59 per bushel for the three months ended January 31, 2010.  Management anticipates that corn prices will remain steady for the next several months similar to corn prices experienced over the past few months.  The preliminary estimates by the USDA April 12, 2010 Crop Production report indicate that there is an additional 2.3 million acres of corn planted this year.  However, corn prices could increase during our 2010 fiscal year should we experience unfavorable weather conditions which affect expected corn yields for the fall of 2010.  In addition, if demand for corn increases significantly, such as from improved global economic conditions or from increased ethanol production in the United States due to the implementation of a 15% ethanol blend, we could experience increased corn prices.  Management does not anticipate having difficulty securing all the corn that it requires to operate the ethanol plant at capacity in the next 12 months.

Management anticipates that natural gas prices will be relatively stable in the next several months.  However, should we experience a more robust economic recovery, it could increase demand for energy which could lead to increases in natural gas prices.  Further, should we experience any natural gas supply disruptions, including disruptions from hurricane activity, this could result in significant increases in natural gas prices.

Operating Expense

Our operating expenses as a percentage of revenues were 2.0% for the three months ended April 30, 2010, compared to 3.46% for the three months ended January 31, 2010, as a result of the ethanol facility operating more efficiently.  Operating expenses include salaries and benefits of administrative employees, insurance, taxes,

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professional fees and other general administrative costs.  Management is pursuing strategies to optimize efficiencies and maximize production.  These efforts may result in a decrease in our operating expenses on a per gallon basis.  However, because these expenses do not vary with the level of production at the plant, we expect our operating expenses to remain steady.

Operating Loss

Our loss from operations for the three months ended April 30, 2010, was approximately 3.2% of our revenues.  For the three months ended April 30, 2010, we reported an operating loss of approximately $728,000 and for the three months ended January 31, 2010, we reported an operating profit of approximately $3,631,000.  Our operating loss for the three months ended April 30, 2010, was the net result of our costs of goods sold and our operating expenses exceeding our revenues, as a result of a decline in revenues as the result of a reduction in the average price per gallon of ethanol as well as a reduction in the average price per ton for dried distillers grains received by the Company.

Other Income (Expense)

We had total other expense (net) for the three months ended April 30, 2010, of approximately $1,183,000 compared to other expense (net) of approximately $1,147,000 for the three months ended January 31, 2010.  Our other expense for the three months ended April 30, 2010, consisted primarily of interest expense.  During the three months ending April 30, 2010, the interest rate swap liability incurred a market interest rate increase.  The increase in interest rates resulted in gains of approximately $32,600.

Results of Operations for the Six Months Ended April 30, 2010

Our plant did not become operational until August 2009.  Accordingly, we do not yet have comparable income, production and sales data for the six months ended April 30, 2010, from the six months ended April 30, 2009, because we were not generating revenue for the six months ended April 30, 2009.  Consequently we do not provide a comparison of our financial results between reporting periods in this report.  If you undertake your own comparison of our results for the six months ended April 30, 2010, and the six months ended April 30, 2009, it is important that you keep this in mind.

The following table shows the result of our operations and the percentage of revenues, cost of goods sold, operating expenses and other items to total revenues in our statement of operations for the six months ended April 30, 2010.

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Revenues

Our revenues are derived from the sale of our ethanol and distillers grains.  For the six months ended April 30, 2010, ethanol sales comprised approximately 86.3 percent of our revenues and distillers grains sales comprised approximately 13.7 percent of our revenues.

Cost of Goods Sold

Our costs of goods sold as a percentage of revenues were approximately 91.5% for the six months ended April 30, 2010.  Our two largest costs of production are corn (73.2% of cost of goods sold for the six months ended April 30, 2010) and natural gas (9.7% of cost of goods sold for the six months ended April 30, 2010).

Operating Expense

Our operating expenses as a percentage of revenues were 2.8% for the six months ended April 30, 2010.  We experienced a significant increase in our operating expenses for the six months ended April 30, 2010, compared to the same period of 2009 primarily due to an increase in the number of employees employed as a result of our plant becoming fully operational.  Operating expenses include salaries and benefits of administrative employees, insurance, taxes, professional fees and other general administrative costs.  Management is pursuing strategies to optimize efficiencies and maximize production.  These efforts may result in a decrease in our operating expenses on a per gallon basis.  However, because these expenses do not vary with the level of production at the plant, we expect our operating expenses to remain steady.

Operating Income

Our income from operations for the six months ended April 30, 2010, was approximately 5.7% of our revenues compared to a loss for the same period of 2009.  Our operating profit for the six months ended April 30, 2010, was the net result of our revenues exceeding our costs of goods sold and our operating expenses.

Other Income (Expense)

We had total other expense (net) for the six months ended April 30, 2010 of approximately $2,330,000 compared to other expense (net) of approximately $1,552,000 for the same period of 2009.  Our other expense for the six months ended April 30, 2010, consisted primarily of interest expense.  For the six months ended April 30, 2009, interest expense was capitalized during the time we were constructing the plant and therefore, it consisted primarily of loss on derivative instrument.  During the second quarter of 2010, the interest rate swap liability incurred a market interest rate increase.  The increase in interest rates resulted in gains of approximately $49,900 due to the fair value of the derivative liability decreasing.

Changes in Financial Condition for the Six Months Ended April 30, 2010

The following table highlights the changes in our financial condition for the six months ended April 30, 2010 from our previous fiscal year ended October 31, 2009:

Current Assets.  Total assets were approximately $114,697,000 at April 30, 2010, compared to approximately $115,288,000 at October 31, 2009.  Current assets at April 30, 2010, increased from October 31, 2009 as a result of an increase in our cash on hand due to improved conditions in the ethanol market, profitable operations year to date, and a

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reduction in working capital.  We experienced a significant decrease in our accounts receivable at April 30, 2010, as a result of a drop in ethanol prices and volume as the ethanol plant was shut down for scheduled maintenance for a week in mid April 2010.  Additionally, our ethanol marketer advanced us payments on our sales that were closer to what the actual ethanol was sold as compared to October 31, 2009.

Current Liabilities.  Our total current liabilities were higher at April 30, 2010, compared to October 31, 2009, primarily as a result of the fact that more of our long-term debt has become current now that our loans have converted from the construction loan to term loans with scheduled payments.

Long-term Liabilities.  Long-term debt decreased slightly from approximately $62,712,000 at October 31, 2009, to approximately $61,415,000 at April 30, 2010, due to more of our debt becoming current and principal payments made.

Liability and Capital Resources

Our primary source of liquidity include: (1) cash, (2) Long-Term Revolving Note, and (3) line of credit, which are discussed in greater detail below.  Based on financial forecasts performed by our management, we anticipate that we will have sufficient cash from our current credit facilities and cash from our operations to continue to operate the ethanol plant at capacity for the next 12 months.  We did not have any amount outstanding on our line of credit as of April 30, 2010, and we had more than $4,992,000 in cash and cash equivalents as of April 30, 2010.

We do not currently anticipate seeking additional equity or debt financing in the near term.  However, should we experience unfavorable operating conditions in the future, we may have to secure additional debt or equity financing for working capital or other purposes.

We do not currently anticipate any significant purchases of property and equipment that would require us to secure additional capital resources in the next 12 months.  However, management is currently exploring potential opportunities to enhance the Company’s water treatment center with the potential addition of a 110,000 gallon holding tank.  Management continues to evaluate conditions in the ethanol industry and explore opportunities to improve the efficiency and profitability of our operations which may require more capital expenditures.

The following table shows cash flows for the six months ended April 30, 2010 and 2009:

Cash Flow From Operations

We experienced a significant change in our cash flows from operations for the six month period ended April 30, 2010, compared to the same period in 2009.  This change is related to our commencement of operations at our ethanol facility in August 2009, which provided for net income of approximately $573,000, non-cash depreciation and amortization expenses of approximately $3,269,000, and cash generated from lower working capital amounts.  During the six months ended April 30, 2010, our capital needs were being adequately met through cash from our operating activities and our credit facilities.

Cash Flow From Investing Activities

We used significantly less cash for investing activities during our fiscal quarter ended April 30, 2010, as compared to 2009.  This decrease was primarily a result of the construction and completion of our ethanol plant during our 2009 fiscal year.  During the six months ended April 30, 2010, we paid approximately $858,000 to pay down our construction payables that were outstanding at October 31, 2009.

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Cash Flow From Financing Activities

We used cash in our financing activities in our six months ended April 30, 2010, to pay down the line of credit and long-term debt as compared to the same period in 2009 when we were receiving proceeds from long-term debt for the construction of our ethanol plant.

Short-Term and Long-Term Debt Sources

On April 24, 2008, we entered into a Construction Loan Agreement (the “Agreement”) with First National Bank of Omaha of Omaha, Nebraska (“FNBO”) for the purpose of funding a portion of the cost of the ethanol plant.  Under the Agreement, FNBO agreed to loan us up to $61,000,000, consisting of a $50,400,000 Construction Loan, together with a $5,000,000 Revolving Loan, and $5,600,000 to support the issuance of letters of credit by FNBO.  As of April 30, 2010, the Company had issued $4,950,000 in letters of credit.

With construction complete and the ethanol plant commencing operations, the construction loan converted on February 26, 2010 to a $25,200,000 Fixed Rate Note, a $20,200,000 Variable Rate Note, a $5,000,000 Long-Term Revolving Note, and a $5,000,000 line of credit.

Fixed Rate Note

The Fixed Rate Note was initially for $25,200,000 with a variable interest rate that is fixed with an interest rate swap.  We commenced making monthly principal payments on the Fixed Rate Note initially for approximately $145,000 plus accrued interest in March 2010.  Interest will accrue on the Fixed Rate Note at the greater of the one-month LIBOR Rate, in effect from time to time, plus 300 basis points or 4%, which was 4% at April 30, 2010.  However, the Company entered into an interest rate swap agreement which fixes the interest rate on the Fixed Rate Note at 7.6% until June 2014.  The Company entered into the fixed rate swap agreement to alter its exposure to the impact of changing interest rates on its results of operations and future cash outflows for interest.  A final balloon payment on the Fixed Rate Note of approximately $15,184,000 will be due February 26, 2015.

Variable Rate Note

The Variable Rate Note was initially for $20,200,000.  We commenced making monthly payments initially for approximately $147,000 plus accrued interest in March 2010.  Interest will accrue on the Variable Rate Note at the greater of the one-month LIBOR rate plus 350 basis points or 4%, which was 4% at April 30, 2010.  A final balloon payment of approximately $14,807,000 will be due February 26, 2015.

Long-term Revolving Note

The Long-term Revolving Note was initially for $5,000,000 and was fully drawn at April 30, 2010.  The amount available on the Long-term Revolving Note will decline annually by the greater of $125,000 or 50% of the excess cash flow, as defined by the agreement.  The Long-term Revolving Note will accrue interest monthly at the greater of the one-month LIBOR plus 350 basis points, or 4% until maturity on February 26, 2015, which was 4% at April 30, 2010.

Line of Credit

The Company has a line of credit available equal to the amount of the Company’s Borrowing Base, with a maximum limit of $5,000,000.  The Company’s Borrowing Base will vary and may at times be less than $5,000,000.  The Company has maximum availability of $2,875,000 under the line of credit at April 30, 2010.  The Company’s line of credit accrues interest at the greater of the 90-day LIBOR plus 450 basis points or 5.5%, which was 5.5% at April 30, 2010.  The line of credit requires monthly interest payments and was payable in full in February 2010.  In February 2010, Highwater signed an amendment to the Construction Loan Agreement to extend the maturity date to February 26, 2011.  As of April 30, 2010, there are no borrowings outstanding.

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Covenants and other Miscellaneous Financing Agreement Terms

The Company is required to make additional payments on debt for up to 50% of the excess cash flow, as defined by the bank financing agreement which is measured annually.  As part of the bank financing agreement, the premium above LIBOR on the loans may be reduced based on a financial ratio.  The loan agreements are subject to various financial and non-financial covenants that limit distributions and debt and require minimum debt service coverage, net worth, and working capital requirements.

Until June 2010, the Company is required to maintain at all times working capital of not less than $1,000,000.  Subsequent to June the Company is required to maintain at all times working capital of not less than $3,000,000.  Additionally, we are limited to annual capital expenditures of $1,000,000 without prior approval of FNBO.  We will also be prohibited from making distributions to our members of greater than 45% of our net income during any fiscal year if our interest coverage ratio (combined total liabilities to net worth) is greater than or equal to 1.1:1.0.

As of April 30, 2010, we were in compliance with all applicable covenants.  However, due to the nature of the industry, there is a risk that we may be out of compliance with certain covenants when they are measured in subsequent periods.  Management is currently working with FNBO to redefine the calculation of net worth.  Our failure to comply with the protective loan covenants or maintain the required financial ratios may cause acceleration of the outstanding principal balances on the term notes and revolving note and/or the imposition of fees, charges or penalties and or FNBO could call the loan immediately due.  Any acceleration of the debt financing or imposition of the significant fees, charges or penalties may restrict or limit our access to the capital resources necessary to continue plant operations.

In connection with the bank financing agreement, we executed a mortgage in favor of FNBO creating a first lien on our real estate and plant and a security interest in all personal property located on the property.  In addition, we assigned in favor of FNBO, all rents and leases to our property, our marketing contracts, our risk management services contract, and our natural gas, electricity, water service and grain procurement agreements.

Capital Lease

On April 24, 2008, we entered into certain financing and credit arrangements with U.S. Bank National Association, as trustee (the “Trustee”) and the City of Lamberton, Minnesota (the “City”) in order to secure the proceeds from the sale of the solid waste facilities revenue bonds, Series 2008A (the “Bonds”) issued by the City in the aggregate principal amount of $15,180,000 pursuant to a trust indenture between the City and the Trustee (“Trust Indenture”).  The City has undertaken the issuance of the Bonds to finance the acquisition and installation of certain solid waste facilities in connection with our ethanol plant to be located near Lamberton, Minnesota.  Highwater received proceeds of approximately $14,876,000, after financing costs of approximately $304,000.  The remaining proceeds were held as restricted cash or marketable securities based on anticipated use and are split between a project fund of approximately $11,527,000, a capitalized interest fund of approximately $1,831,000, and a debt service reserve fund of approximately $1,518,000.  The Bonds mature on December 1, 2022 and bear interest at a rate of 8.5%.

Under this equipment lease agreement with the City, we started making interest payments on November 25, 2008 and monthly thereafter at an implicit interest rate of 8.5%.  The monthly capital lease interest payments correspond to 1/6 the semi-annual interest payments due on the Bonds on the next interest payment date.  Monthly capital lease payments for principal were originally scheduled to begin on November 25, 2009; however, the City amended the agreement in September 2008 which adjusted the start date for principal payments to begin on November 25, 2014.  These payments will equal 1/12 the annual principal payments scheduled to become due on the corresponding bonds on the next principal payment date.

The Company has guaranteed that if such assessed lease payments are not sufficient for the required bond payments, the Company will provide such funds as are needed to fund the shortfall.  The lease agreement is secured by substantially all business assets of the Company and is also subject to various financial and non-financial covenants that limit distributions and leverage and require minimum debt service coverage, net worth, and working-capital requirements.

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Plant Operations

Our ethanol plant has nameplate capacity of 50 million gallons per year.  However, our environmental permits allow us to produce ethanol at a rate of 55 million gallons per year.  Management anticipates our plant will continue to produce approximately 54.9 million gallons per year.  We expect to have sufficient cash generated by continuing operations, current lines of credit and cash reserves to cover our usual operating costs, which consist primarily of our corn supply, our natural gas supply, staffing expense, office expense, audit and legal compliance, working capital and debt service obligations.

Trends and Uncertainties Impacting the Ethanol Industry and Our Company

According to the Renewable Fuels Association, as of April 27, 2010, there were 201 ethanol plants in operation nationwide with the nameplate capacity to produce approximately 13.5 billion gallons of ethanol annually.  The RFA estimates that plants with annual production capacity of approximately 12.8 billion gallons are currently operating and that approximately 8.7% of nameplate production capacity is not currently operational.  Accordingly, management anticipates that the production capacity of the ethanol industry is greater than ethanol demand which may continue to depress ethanol prices.  This overcapacity issue may be exacerbated by increased production from plants that had previously slowed their rate of production or idled altogether due to poor operating margins.

Currently, ethanol is blended with conventional gasoline for use in standard (non-flex fuel) vehicles to create a blend which is 10% ethanol and 90% conventional gasoline.  Estimates indicate that approximately 135 billion gallons of gasoline are sold in the United States each year.  However, gasoline demand may be shrinking in the United States as a result of the global economic slowdown.  Assuming that all gasoline in the United States is blended at a rate of 10% ethanol and 90% gasoline, the maximum demand for ethanol is 13.5 billion gallons.  This is commonly referred to as the “blending wall”, which represents a limit where more ethanol cannot be blended into the national gasoline pool.  This is a theoretical limit since it is believed it would not be possible to blend ethanol into every gallon of gasoline that is used in the United States and it discounts higher percentage blends of ethanol such as E85 use in flex fuel vehicles.  Many in the ethanol industry believed that the ethanol industry reached this blending wall in 2009.  In addition, the RFS requires that 36 billion gallons of renewable fuels being used each year by 2022.  The Energy Independence and Security Act of 2007 also requires the increased use of “advanced” biofuels, which are alternative biofuels produced without using corn starch such as cellulosic ethanol and biomass-based diesel, with 21 billion gallons of the mandated 36 billion gallons of renewable fuel required to come from advanced biofuels by 2022.

The ethanol industry benefits from the Renewable Fuels Standard (RFS) which requires that a certain amount of renewable fuels must be used in the United States each year.  In February 2010, the EPA issued new regulations governing the RFS.  These new regulations have been called RFS2.  The most controversial part of RFS2 involves what is commonly referred to as the lifecycle analysis of green house gas emissions.  Specifically, the EPA adopted rules to determine which renewable fuels provided sufficient reductions in green house gases, compared to conventional gasoline, to qualify under the RFS program.  RFS2 establishes a tiered approach, where regular renewable fuels are required to accomplish a 20% green house gas reduction compared to gasoline, advanced biofuels and biomass-based biodiesel must accomplish a 50% reduction in green house gases, and cellulosic biofuels must accomplish a 60% reduction in green house gases.  Any fuels that fail to meet this standard cannot be used by fuel blenders to satisfy their obligations under the RFS program.  The scientific method of calculating these green house gas reductions has been a contentious issue.  Many in the ethanol industry were concerned that corn based ethanol would not meet the 20% green house gas reduction requirement based on certain parts of the environmental impact model that many in the ethanol industry believed was scientifically suspect.  However, RFS2 as adopted by the EPA provides that corn-based ethanol from modern ethanol production processes does meet the definition of a renewable fuel under the RFS program.  Many in the ethanol industry are concerned that certain provisions of RFS2 as adopted may disproportionately benefit ethanol produced from sugarcane.  This could make sugarcane based ethanol, which is primarily produced in Brazil, more competitive in the United States ethanol market.  If this were to occur, it could reduce demand for the ethanol that we produce.

In addition to RFS2 which included greenhouse gas reduction requirements, in 2009, California passed a Low Carbon Fuels Standard (LCFS).  The California LCFS requires that renewable fuels used in California must accomplish certain reductions in greenhouse gases which is measure using a lifecycle analysis, similar to RFS2. 

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Management believes that this lifecycle analysis is based on unsound scientific principles that unfairly harms corn based ethanol.  Management believes that these new regulations may preclude corn based ethanol form being used in California.  California represents a significant ethanol demand market.  If we are unable to supply ethanol to California, it could significantly reduce demand for the ethanol we produce.  Several lawsuits have been filed challenging the California LCFS.

Ethanol production in the United States benefits from various tax incentives.  The most significant of these tax incentives is the federal VEETC which provides a volumetric ethanol excise tax credit of 4.5 cents per gallon of ethanol blended with gasoline at a rate of 10%.  VEETC is scheduled to expire on December 31, 2010.  If this tax credit is not renewed, it likely would have a negative impact on the price of ethanol and demand for ethanol in the marketplace.  On December 31, 2009, the portion of VEETC that benefits the biodiesel industry was allowed to expire.  However, in March 2010, the United States Senate voted to pass the American Workers, State and Business Relief Act including H.R. 4213, the Extenders Package which contains a retroactive extension of the $1/gallon biodiesel tax credit.  The bill extends the tax credit through December 31, 2010.  With the passage of H.R. 4213, the United States House of Representatives and the United States Senate must reconcile the differences between the two versions of the bill.  Timing for presidential signature and tax credit reinstatement is uncertain.  While many believe that this tax credit will be reinstated, the VEETC for ethanol may similarly be allowed to expire which could negatively impact the ethanol industry.

Under current law, small ethanol producers are allowed a 10 cents per gallon, production income tax credit on up to 15 million gallons of production, annually. The credit, which is capped at $1.5 million per year per producer, is only available to small scale ethanol producers with an annual production capacity of no more than 60 million gallons per year. The credit can be claimed against the producer’s income tax liability.  The Small Ethanol Producer Tax Credit (“SEPTC”) is set to expire on December 31, 2010.  Legislation has been introduced in both the House of Representatives and the Senate which would extend the small ethanol producers and VEETC for five years, through the end of 2015.

Trends and Uncertainties Impacting the Corn and Natural Gas Markets and Our Future Cost of Goods Sold

Our cost of goods sold consists primarily of costs relating to the corn and natural gas supplies necessary to produce ethanol and distillers grains for sale.  Corn prices could increase during our 2010 fiscal year should we experience unfavorable weather conditions which affect expected corn yields for the fall of 2010.  In addition, if demand for corn increases significantly, such as from improved global economic conditions or from increased ethanol production in the United States due to the implementation of a 15% ethanol blend, we could experience increased corn prices.

Natural gas is also an important input commodity to our manufacturing process.  We use natural gas to dry our distillers grain products to a moisture content at which they can be stored for long periods of time, and can be transported greater distances. Any sustained increase in the price level of natural gas will increase our cost of production and will negatively impact our future profit margins.  Management will attempt to work to find ways to limit our natural gas price risk through efficient usage practices, research of new technologies and pricing strategies.

Compliance with Environmental Law

We are subject to extensive air, water and other environmental regulations and we have been required to obtain a number of environmental permits to construct and operate the ethanol facility.  As such, any changes that are made to the ethanol facility or its operations must be reviewed to determine if amended permits need to be obtained in order to implement these changes.