ALTO

Business Context and Reporting Period

Company: Pacific Ethanol, Inc. (Note: Metadata listed "Alto Ingredients, Inc." but the filing text identifies the registrant as Pacific Ethanol, Inc.)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2006
Business Overview: The Company is engaged in the marketing and production of ethanol and its co-products in the Western United States. As of the reporting date, the Company had completed construction of a 35 million gallon facility in Madera County, California, and was constructing a similar facility in Boardman, Oregon. The Company also acquired a 42% interest in Front Range Energy, LLC, which operates a facility in Windsor, Colorado.

Key Financial Metrics

Note: The significant loss available to common stockholders for the nine-month period is primarily due to a non-cash "deemed dividend" of $84,000,000 recorded on Series A Preferred Stock.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 131% for the quarter and 183% for the nine-month period compared to the prior year. This was driven by a 43% increase in sales volume (to 23.1 million gallons for the quarter) and a 49% increase in average sales price (to $2.45/gallon).
• Profitability: The Company reported a net income of $3.8 million for the quarter, compared to a net loss of $0.9 million in the same period in 2005. Gross profit margins improved to 12.2% from 6.2% due to favorable hedging and market conditions.
• Liquidity: Cash and cash equivalents surged from $4.5 million at year-end 2005 to $100.7 million at September 30, 2006. This increase was funded by the sale of Series A Preferred Stock ($84 million gross proceeds) and common stock ($145 million gross proceeds).
• Capital Structure: The Company issued 5,250,000 shares of Series A Preferred Stock. A $84 million deemed dividend was recorded, significantly impacting earnings available to common shareholders for the nine-month period.
• Assets: Property and equipment increased by $57.5 million, primarily due to construction of the Madera County ethanol plant. Restricted funds for plant construction totaled $60.7 million.

Guidance, Outlook, Risks, and Unusual Items

Management Commentary and Outlook

Management expects to complete the Boardman, Oregon facility by the second quarter of 2007. The Company anticipates that current capital resources, including restricted funds and cash on hand, will be adequate to meet working capital and capital expenditure requirements for the next twelve months. Future profitability is expected to depend on the commencement of production at owned facilities and the ability to manage commodity price volatility.

Unusual Items

• Deemed Dividend: A non-cash charge of $84,000,000 was recorded for the nine months ended September 30, 2006, related to the beneficial conversion feature of the Series A Preferred Stock. This item reduced income available to common stockholders but did not impact cash flow.
• Stock-Based Compensation: The Company adopted SFAS No. 123(R) in 2006, resulting in increased non-cash compensation expenses.

Risks and Contingencies

• Material Weakness in Internal Controls: The Company's independent auditors identified a material weakness in disclosure controls and procedures due to a lack of appropriate resources and technical skills in the accounting department. Management is hiring additional staff to remediate this issue.
• Commodity Price Volatility: The Company is exposed to fluctuations in ethanol, corn, and natural gas prices. While hedging strategies are employed, ineffectiveness in hedges can impact earnings.
• Litigation: The Company is involved in the "Spiegel Action" (seeking $22 million in damages) and the "Mercator Action" (seeking over $100 million). Management believes these matters will not materially affect financial position at this time.
• Customer Concentration: Sales to the four largest customers represented approximately 55% of total sales for the quarter.

Investor Verification Checklist

• Internal Control Remediation: Verify the timeline and success of hiring the new Controller, Director of Accounting, and Internal Auditor to address the material weakness in financial reporting.
• Construction Progress: Confirm the status and budget adherence of the Madera and Boardman ethanol production facilities, as well as the integration of the Front Range Energy acquisition.
• Deemed Dividend Impact: Understand the long-term impact of the $84 million non-cash deemed dividend on future earnings per share calculations and common shareholder equity.
• Litigation Exposure: Monitor the status of the Spiegel and Mercator lawsuits for potential future liabilities or settlements.
• Commodity Hedging: Review the effectiveness of hedging strategies in future quarters to ensure gross margins remain stable against volatile corn and ethanol prices.