UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-K

 

 

Commission File Number 0-11488

Penford Corporation

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (303) 649-1900

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 at least the past 90 days.  Yes þ     No o

 

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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 definition of “accelerated filer” and “large 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).  Yes o     No þ

 

The aggregate market value of the Registrant’s Common Stock held by non-affiliates of the Registrant as of February 27, 2009, the last business day of the Registrant’s second quarter of fiscal 2009, was approximately $52.9 million based upon the last sale price reported for such date on The NASDAQ Global Market. For purposes of making this calculation, Registrant has assumed that all the outstanding shares were held by non-affiliates, except for shares held by Registrant’s directors and officers and by each person who owns 10% or more of the outstanding Common Stock. However, this does not necessarily mean that there are not other persons who may be deemed to be affiliates of the Registrant.

 

The number of shares of the Registrant’s Common Stock (the Registrant’s only outstanding class of stock) outstanding as of November 3, 2009 was 11,363,553.

 

Documents Incorporated by Reference

 

Portions of the Registrant’s definitive Proxy Statement relating to the 2010 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.

 

 

PENFORD CORPORATION

 

FISCAL YEAR 2009 FORM 10-K ANNUAL REPORT

 

TABLE OF CONTENTS

 

 

Forward-looking Statements

 

This Annual Report on Form 10-K (“Annual Report”), including, but not limited, to statements found in the Notes to Consolidated Financial Statements and in Item 1 — Business and Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains statements that are forward-looking statements within the meaning of the federal securities laws. In particular, statements pertaining to anticipated operations and business strategies contain forward-looking statements. Likewise, statements regarding anticipated changes in the Company’s business and anticipated market conditions are forward-looking statements. Forward-looking statements involve numerous risks and uncertainties and should not be relied upon as predictions of future events. Forward-looking statements depend on assumptions, dates or methods that may be incorrect or imprecise, and the Company may not be able to realize them. Forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” or “anticipates,” or the negative use of these words and phrases or similar words or phrases. Forward-looking statements can be identified by discussions of strategy, plans or intentions. The following factors, among others, could cause actual results and future events to differ materially from those set forth or contemplated in the forward-looking statements:

 

 

 

Description of Business

 

Penford Corporation (which, together with its subsidiary companies, is referred to herein as “Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for industrial and food ingredient applications, including fuel grade ethanol. The Company’s strategically-located manufacturing facilities in the United States provide it with broad geographic coverage of its target markets. Penford is a

Washington corporation originally incorporated in September 1983. The Company commenced operations as a publicly-traded company on March 1, 1984.

 

Penford operates in two business segments, each utilizing its carbohydrate chemistry expertise to develop starch-based ingredients for value-added applications that improve the quality and performance of customers’ products. The Industrial Ingredients — North America and Food Ingredients — North America segments are broad categories of end-market users. Financial information about Penford’s segments and geographic areas is included in Note 18 to the Consolidated Financial Statements.

 

The Company has significant research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and in developing applications to address customer needs.

 

Penford’s two business segments are:

 

 

In May 2008, the Company’s Industrial Ingredients — North America segment began commercial production and sales of ethanol from its facility in Cedar Rapids, Iowa. This ethanol plant gave the Company the ability to select an additional output choice to capitalize on changing industry conditions and selling opportunities. Sales of ethanol in fiscal years 2009 and 2008 were 29% and 3%, respectively, of this segment’s reported revenue.

 

In June 2008, the Company’s Cedar Rapids, Iowa plant, operated by the Industrial Ingredients — North America business, was temporarily shut down due to record flooding of the Cedar River and government-ordered mandatory evacuation of the plant and surrounding areas. See Note 3 to the Consolidated Financial Statements.

 

 

Discontinued Operations

 

On August 27, 2009, the Company’s Board of Directors made a determination that the Company would exit from the business conducted by the Company’s Australia/New Zealand Operations. This determination was the completion of a process, announced on February 27, 2009, involving an examination of a range of strategic and operating choices for the Company’s Australia/New Zealand Operations as part of a continuing program to maximize the Company’s asset values and returns. On September 2, 2009, the Company completed the sale of

Penford New Zealand Limited. On November 11, 2009, the Company’s Australian operating subsidiary, Penford Australia Limited, executed two asset sale agreements with unrelated parties to sell substantially all of its operating assets. The completion and timing of these transactions remain subject to risks and uncertainties.

 

The Australia/New Zealand Operations developed, manufactured and marketed ingredient systems, including specialty starches and sweeteners for food and industrial applications. Until September 2, 2009, the Company operated a corn wet milling facility in Auckland, New Zealand. The Company continues to operate a corn wet milling facility in Lane Cove, Australia and a wheat starch manufacturing facility in Tamworth, Australia. These facilities are covered by the asset sale agreements noted above.

 

The financial data for the Australia/New Zealand Operations have been presented as discontinued operations. The financial statements have been prepared in compliance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). Accordingly, for all periods presented herein, the Consolidated Balance Sheets, Statements of Operations and Statements of Cash Flows have been conformed to this presentation. The Australia/New Zealand Operations was previously reported as the Company’s third operating segment. See Note 2 to the Consolidated Financial Statements for further details.

 

Unless otherwise noted, all amounts, analyses and discussions are based on continuing operations.

 

Raw Materials

 

Corn:  Penford’s North American corn wet milling plant is located in Cedar Rapids, Iowa, the middle of the U.S. corn belt. Accordingly, the plant has truck-delivered corn available throughout the year from a number of suppliers at prices consistent with those available in the major U.S. grain markets.

 

Potato Starch:  The Company’s facilities in Idaho Falls, Idaho; Richland, Washington; and Plover, Wisconsin use starch recovered as by-products from potato processors as the primary raw material to manufacture modified potato starches. The Company enters into contracts typically having durations of one to three years with potato processors in the United States and Canada to acquire potato-based raw materials.

 

Chemicals:  The primary chemicals used in the manufacturing processes are readily available commodity chemicals. The prices for these chemicals are subject to price fluctuations due to market conditions.

 

Natural Gas:  The primary energy source for most of Penford’s plants is natural gas. Penford contracts its natural gas supply with regional suppliers, generally under short-term supply agreements, and regularly uses futures contracts to hedge the price of natural gas.

 

Corn, potato starch, chemicals and natural gas are not currently subject to availability constraints; however, demand for these items can significantly affect the prices. Penford’s current potato starch requirements constitute a material portion of the available North American supply. Penford estimates that it purchases approximately 50-55% of the recovered potato starch in North America. It is possible that, in the long term, continued growth in demand for potato starch-based ingredients and new product development could result in capacity constraints.

 

Over half of the Company’s manufacturing costs consist of the costs of corn, potato starch, chemicals and natural gas. The remaining portion consists of the costs of labor, distribution, depreciation and maintenance of manufacturing plant and equipment, and other utilities. The prices of raw materials may fluctuate, and increases in prices may affect Penford’s business adversely. To mitigate this risk, Penford hedges a portion of corn and gas purchases with futures and options contracts in the U.S. and enters into short-term supply agreements for other production requirements.

 

Research and Development

 

Penford’s research and development efforts cover a range of projects including technical service work focused on specific customer support projects which require coordination with customers’ research efforts to develop innovative solutions to specific customer requirements. These projects are supplemented with longer-term, new product development and commercialization initiatives. Research and development expenses were $4.3 million, $5.7 million and $5.1 million for fiscal years ended August 31, 2009, 2008 and 2007, respectively.

At the end of fiscal 2009, Penford had 29 scientists, including five with a Ph.D. degree with expert knowledge of carbohydrate characteristics and chemistry.

 

Patents, Trademarks and Tradenames

 

Penford owns a number of patents, trademarks and trade names.

 

Penford has approximately 60 current patents and pending patent applications, most of which are related to technologies in french fry coatings, coatings for the paper industry, and animal and human nutrition. Penford’s issued patents expire at various times between 2012 and 2025. The annual cost to maintain all of the Company’s patents is not significant. However, most of Penford’s products are currently made with technology that is broadly available to companies that have the same level of scientific expertise and production capabilities as Penford.

 

Specialty starch ingredient brand names for industrial applications include, among others, Penford^® gums, Pensize^® binders, Penflex^® sizing agent, Topcat^® cationic additive and the Apollo^® starch series. Product brand names for food ingredient applications include PenBind^®, PenCling^® and PenPlus^®.

 

Quarterly Fluctuations

 

Penford’s revenues and operating results vary from quarter to quarter. Sales volumes of the Food Ingredients — North America products used in french fry coatings are generally lower during Penford’s second fiscal quarter due to decreased consumption of french fries during the post-holiday season. The cost of natural gas in North America is generally higher in the winter months than the summer months.

 

Working Capital

 

The Company’s growth is funded through a combination of cash flows from operations and short- and long-term borrowings. For more information, see the “Liquidity and Capital Resources” section under “Management’s Discussion and Analysis of Financial Condition and the Results of Operations” in Item 7 and the audited consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K.

 

Penford generally carries a one- to 45-day supply of materials required for production, depending on the lead time for specific items. Penford manufactures finished goods to customer orders or anticipated demand. The Company is therefore able to carry less than a 30-day supply of most products. Terms for trade receivables and trade payables are standard for the industry and region and generally do not exceed 30-day terms except for trade receivables for export sales.

 

Environmental Matters

 

Penford’s operations are governed by various federal, state, local and foreign environmental laws and regulations. In the United States, these laws and regulations include the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the EPA Oil Pollution Control Act, the Occupational Safety and Health Administration’s hazardous materials regulations, the Toxic Substances Control Act, the Comprehensive Environmental Response Compensation and Liability Act, and the Superfund Amendments and Reauthorization Act.

 

Permits are required by the various environmental agencies that regulate the Company’s operations. Penford believes that it has obtained all necessary material environmental permits required for its operations. Penford believes that its operations are in compliance with applicable environmental laws and regulations in all material aspects of its business. Penford estimates that annual compliance costs, excluding operational costs for emission control devices, wastewater treatment or disposal fees, are approximately $1.4 million.

 

Penford has adopted and implemented a comprehensive corporate-wide environmental management program. The program is managed by the Corporate Director of Environmental, Health and Safety and is designed to structure the conduct of Penford’s business in a safe and fiscally responsible manner that protects and preserves the health and safety of employees, the communities surrounding the Company’s plants, and the environment. The Company continuously monitors environmental legislation and regulations that may affect Penford’s operations.

During fiscal 2009, compliance with environmental regulations did not have any material effects on the Company’s operations. No unusual expenditures for environmental facilities and programs are anticipated in fiscal 2010.

 

Principal Customers

 

Penford sells to a variety of customers and has several relatively large customers in each business segment. The Company’s sales of ethanol to its sole ethanol customer, Eco-Energy, Inc., represented approximately 21% of the Company’s net sales for fiscal year 2009. Eco-Energy, Inc. is a marketer and distributor of bio-fuels in the United States and Canada. The Company’s second largest customer, Domtar, Inc., represented approximately 11%, 15% and 17% of the Company’s net sales for fiscal years 2009, 2008 and 2007, respectively. Domtar, Inc. and Eco-Energy are customers of the Company’s Industrial Ingredients — North America business.

 

Competition

 

In its primary markets, Penford competes directly with approximately five other companies that manufacture specialty starches for the papermaking industry, approximately six other companies that manufacture specialty food ingredients, and numerous producers of fuel ethanol. Penford competes indirectly with a larger number of companies that provide synthetic and natural-based ingredients to industrial and food customers. Some of these competitors are larger companies, and have greater financial and technical resources than Penford. Application expertise, quality and service are the major competitive advantages for Penford.

 

Employees

 

At August 31, 2009, Penford had 320 employees in North America, of which approximately 42% were members of a trade union. The collective bargaining agreement covering the Cedar Rapids-based manufacturing workforce expires in August 2012.

 

Sales and Distribution

 

Sales are generated using a combination of direct sales and distributor agreements. In many cases, Penford supports its sales efforts with technical and advisory assistance to customers. Penford generally ships its products upon receipt of purchase orders from its customers and, consequently, backlog is not significant.

 

Since Penford’s customers are generally other manufacturers and processors, most of the Company’s products are distributed via rail or truck to customer facilities in bulk.

 

Export Sales

 

Export sales from Penford’s businesses in the U.S. accounted for approximately 8%, 11% and 12% of total sales in fiscal 2009, 2008 and 2007, respectively. See Note 18 to the Consolidated Financial Statements in Item 8 for sales, depreciation and amortization, income and loss from operations, net capital expenditures and total assets by geographic segment, which information is incorporated by reference.

 

Available Information

 

Penford’s Internet address is www.penx.com. The Company makes available, free of charge, through its Internet site, the Company’s annual reports on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8-K; Directors and Officers Forms 3, 4 and 5; and amendments to those reports, as soon as reasonably practicable after electronically filing such materials with, or furnishing them to, the Securities and Exchange Commission (“SEC”). The information found on Penford’s web site will not be considered to be part of this or any other report or other filing filed with or furnished to the SEC. The SEC also maintains an Internet site which contains reports, proxy and information statements, and other information regarding issuers that file information electronically with the SEC. The SEC’s Internet address is www.sec.gov.

In addition, the Company makes available, through the Investor Relations section of its Internet site, the Company’s Code of Business Conduct and Ethics and the written charters of the Audit, Governance and Executive Compensation and Development Committees.

 

Executive Officers of the Registrant

 

 

Mr. Malkoski joined Penford Corporation as Chief Executive Officer and was appointed to the Board of Directors in January 2002. He was named President of Penford Corporation in January 2003. From 1997 to 2001, he served as President and Chief Executive Officer of Griffith Laboratories, North America, a formulator, manufacturer and marketer of ingredient systems to the food industry. Previously, he served in various senior management positions, including as Vice President/Managing Director of the Asia Pacific and South Pacific regions for Chiquita Brands International, an international marketer and distributor of bananas and other fresh produce. Mr. Malkoski began his career at the Procter and Gamble Company, a marketer of consumer brands, progressing through major product category management responsibilities. Mr. Malkoski holds a Masters of Business Administration degree from the University of Michigan.

 

Mr. Cordier is Penford’s Senior Vice President, Chief Financial Officer and Assistant Secretary. He joined Penford in July 2002 as Vice President and Chief Financial Officer, and was promoted to Senior Vice President in November 2004. From September 2005 to April 2006, Mr. Cordier served as the interim Managing Director of Penford’s Australian and New Zealand operations. He came to Penford from Sensient Technologies Corporation, a manufacturer of specialty products for the food, beverage, pharmaceutical and technology industries, where he held a variety of senior financial management positions.

 

Mr. Dratt joined Penford in June 2008 as Vice President, Corporate Development. From October 2007 to June 2008, Mr. Dratt was the Director — Product Development for Sensient Flavors and Fragrances, a division of Sensient Technologies Corporation, a manufacturer of specialty chemicals and food products. From October 2006 to October 2007, Mr. Dratt was the Director — Global Marketing for Sensient Flavors and Fragrances. Mr. Dratt served as the Director — Beverage & Culinary Business Units from 2005 to October 2006 and the Director — Marketing and Business Development from May 2002 to 2005 for FONA International, a developer and manufacturer of flavors for the food and beverage industries.

 

Mr. Kortemeyer has served as Vice President of Penford Corporation since October 2005 and President, Industrial Ingredients since June 2006. He served as General Manager of Penford Products from August 2005 to June 2006. Mr. Kortemeyer joined Penford in 1999 and served as a Team Leader in the manufacturing operations of Penford Products until 2001. From 2001 until 2003, he was an Operations Manager and Quality Assurance Manager. From July 2003 to November 2004, Mr. Kortemeyer served as the business unit manager of the Company’s co-products business, and from November 2004 until August 2005, as the director of the Company’s specialty starches product lines, responsible for sales, marketing and business development.

 

Dr. Kunerth has served as Penford’s Vice President and Chief Science Officer since 2000. From 1997 to 2000, he served in food applications research management positions in the Consumer and Nutrition Sector at Monsanto Company, a provider of hydrocolloids, high intensity sweeteners, agricultural products and integrated solutions for industrial, food and agricultural customers. Before Monsanto, he was the Vice President of Technology at Penford’s food ingredients business from 1993 to 1997.

Mr. Lawlor joined Penford in April 2005 as Vice President-Human Resources, General Counsel and Secretary. From 2002 to April 2005, Mr. Lawlor served as Vice President-Human Resources for Sensient Technologies Corporation, a manufacturer of specialty chemicals and food products. From 2000 to 2002, he was Assistant General Counsel for Sensient. Mr. Lawlor was Vice President-Administration, General Counsel and Secretary for Kelley Company, Inc., a manufacturer of material handling and safety equipment from 1997 to 2000. Prior to joining Kelley Company, Mr. Lawlor was employed as an attorney at a manufacturer of paper and packaging products and in private practice with two national law firms.

 

Mr. Randall is Vice President of Penford Corporation and President, Food Ingredients. He joined Penford in February 2003 as Vice President and General Manager of Penford Food Ingredients and was promoted to President of the Food Ingredients division in June 2006. Prior to joining Penford, Mr. Randall was Vice President, Research & Development/Quality Assurance of Griffith Laboratories, USA, a specialty foods ingredients business, from 1998 to 2003. From 1993 to 1998, Mr. Randall served in various research and development positions with KFC Corporation, a quick-service restaurant business, most recently as Vice President, New Product Development. Prior to 1993, Mr. Randall served in research and development leadership positions at Romanoff International, Inc., a manufacturer and marketer of gourmet specialty food products, and at Kraft/General Foods.

 

 

Risks Related to Penford’s Business

 

The availability and cost of agricultural products Penford purchases are vulnerable to weather and other factors beyond its control. The Company’s ability to pass through cost increases for these products is limited by worldwide competition and other factors.

 

In fiscal 2009, approximately 38% of Penford’s manufacturing costs were the costs of corn, potato starch and other agricultural raw materials. Weather conditions, plantings, government programs and policies, and energy costs and global supply, among other things, have historically caused volatility in the supply and prices of these agricultural products. Due to local and/or international competition, the Company may not be able to pass through the increases in the cost of agricultural raw materials to its customers. To manage price volatility in the commodity markets, the Company may purchase inventory in advance or enter into exchange traded futures or options contracts. Despite these hedging activities, the Company may not be successful in limiting its exposure to market fluctuations in the cost of agricultural raw materials. Increases in the cost of corn, potato starch and other agricultural raw materials due to weather conditions or other factors beyond Penford’s control and that cannot be passed through to customers will reduce Penford’s future profitability.

 

Increases in energy and chemical costs may reduce Penford’s profitability.

 

Energy and chemicals comprised approximately 14% and 12%, respectively, of the cost of manufacturing the Company’s products in fiscal 2009. Penford uses natural gas extensively in its Industrial Ingredients business to dry starch products, and, to a lesser extent, in the Food Ingredients business. The Company uses chemicals in all of the businesses to modify starch for specific product applications and customer requirements. The prices of these inputs to the manufacturing process fluctuate based on anticipated changes in supply and demand, weather and the prices of alternative fuels, including petroleum. The Company may use short-term purchase contracts or exchange traded futures or option contracts to reduce the price volatility of natural gas; however, these strategies are not available for the chemicals the Company purchases. If the Company is unable to pass on increases in energy and chemical costs to its customers, margins and profitability would be adversely affected.

 

The loss of a major customer could have an adverse effect on Penford’s results of operations.

 

The Company’s sales of ethanol to its sole ethanol customer, Eco-Energy, Inc., represented approximately 21% of the Company’s net sales for fiscal year 2009. Eco-Energy, Inc. is a marketer and distributor of bio-fuels in the United States and Canada. The Company’s second largest customer, Domtar, Inc., represented approximately 11%, 15% and 17% of the Company’s net sales for fiscal years 2009, 2008 and 2007, respectively. Sales to the top ten customers represented 69% and 62% of net sales for fiscal years 2009 and 2008, respectively. Generally, the Company does not have multi-year sales agreements with its customers. Many customers place orders on an

as-needed basis and generally can change their suppliers without penalty. If Penford lost one or more major customers, or if one or more major customers significantly reduced its orders, sales and results of operations would be adversely affected.

 

The Company is substantially dependent on its manufacturing facilities; any operational disruption could result in a reduction of the Company’s sales volumes and could cause it to incur substantial losses.

 

Penford’s revenues are, and will continue to be, derived from the sale of starch-based ingredients and ethanol that the Company manufactures at its facilities. The Company’s operations may be subject to significant interruption if any of its facilities experiences a major accident or is damaged by severe weather or other natural disasters, as occurred as a result of the flood of the Cedar River at the Company’s Cedar Rapids, Iowa facility in fiscal 2008. In addition, the Company’s operations may be subject to labor disruptions and unscheduled downtime, or other operational hazards inherent in the industry, such as equipment failures, fires, explosions, abnormal pressures, blowouts, pipeline ruptures, transportation accidents and natural disasters. Some of these operational hazards may cause personal injury or loss of life, severe damage to or destruction of property and equipment or environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. The Company’s insurance may not be adequate to fully cover the potential operational hazards described above or that it will be able to renew this insurance on commercially reasonable terms or at all.

 

The agreements governing the Company’s debt contain various covenants that limit its ability to take certain actions and also require the Company to meet financial maintenance tests, and Penford’s failure to comply with any of the debt covenants could have a material adverse effect on the Company’s business, financial condition and results of operations.

 

The agreements governing Penford’s outstanding debt contain a number of significant covenants that, among other things, limit its ability to:

 

 

In addition, the Company’s revolving credit facility requires it to comply with specific financial ratios and tests, under which it is required to achieve specific financial and operating results. Events beyond the Company’s control may affect its ability to comply with these provisions. A breach of any of these covenants would result in a default under the Company’s revolving credit facility. In the event of any default that is not cured or waived, the Company’s lenders could elect to declare all amounts borrowed under the revolving credit facility, together with accrued interest thereon, due and payable, which could permit acceleration of other debt. If any of the Company’s debt is accelerated, there is no assurance that the Company would have sufficient assets to repay that debt or that it would be able to refinance that debt on commercially reasonable terms or at all.

 

Changes in interest rates may affect Penford’s profitability.

 

Although the Company has fixed the interest rates on a significant portion of its outstanding debt through interest rate swaps as of August 31, 2009, approximately $62.4 million of its outstanding debt was subject to variable interest rates which move in direct relation to the United States or Australian London InterBank Offered Rate (“LIBOR”), or the prime rate in the United States, depending on the selection of borrowing options. Any significant changes in these interest rates would materially affect the Company’s profitability by increasing or decreasing its borrowing costs.

Unanticipated changes in tax rates or exposure to additional income tax liabilities could affect Penford’s profitability.

 

The Company is subject to income taxes in the United States and, until the operations are divested, the Company is also subject to income taxes in Australia and New Zealand. The Company’s effective tax rates could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities or changes in tax laws. The carrying value of deferred tax assets, which are predominantly in the United States, is dependent on the Company’s ability to generate future taxable income in the United States. The amount of income taxes paid is subject to interpretation of applicable tax laws in the jurisdictions in which the Company operates. Although the Company believes it has complied with all applicable income tax laws, there is no assurance that a tax authority will not have a different interpretation of the law or that any additional taxes imposed as a result of tax audits will not have an adverse effect on the Company’s results of operations.

 

Fluctuations in the relative value of the U.S. dollar and foreign currencies may negatively affect Penford’s revenues and profitability.

 

In the ordinary course of business, the Company is subject to risks associated with changing foreign exchange rates. The value of the U.S. dollar against foreign currencies has been generally in decline in recent years. The Company’s revenues and profitability may be adversely affected by fluctuations in exchange rates between the U.S. dollar and other currencies.

 

Pension expense and the funding of pension obligations are affected by factors outside the Company’s control, including the performance of plan assets, interest rates, actuarial data and experience, and changes in laws and regulations.

 

The future funding obligations for the Company’s two U.S. defined benefit pension plans qualified with the Internal Revenue Service depend upon the level of benefits provided for by the plans, the future performance of assets set aside in trusts for these plans, the level of interest rates used to determine funding levels, actuarial data and experience and any changes in government laws and regulations. The pension plans hold a significant amount of equity and fixed income securities. When the values of these securities decline, pension expense can increase and materially affect the Company’s results. Decreases in interest rates that are not offset by contributions and asset returns could also increase the Company’s obligations under such plans. The Company is legally required to make contributions to the pension plans in the future, and those contributions could be material. The Company expects to contribute $1.8 million to its pension plans during fiscal 2010.

 

Penford’s results of operations could be adversely affected by litigation and other contingencies.

 

The Company faces risks arising from litigation matters in which various factors or developments can lead to changes in current estimates of liabilities, such as final adverse judgments, significant settlements or changes in applicable law. A future adverse outcome, ruling or unfavorable development could result in future charges that could have a material effect on the Company’s results of operations.

 

The current capital and credit market conditions may adversely affect the Company’s access to capital, cost of capital and business operations.

 

The general economic and capital market conditions in the United States and other parts of the world have deteriorated significantly and have adversely affected access to capital and increased the cost of capital. If these conditions continue or become worse, the Company’s future cost of debt and equity capital and its access to capital markets could be adversely affected. Any inability to obtain adequate financing from debt and equity sources could force the Company to self-fund strategic initiatives or even forgo some opportunities, potentially harming its financial position, results of operations and liquidity.

Economic conditions may impair the businesses of the Company’s customers and end user markets, which could adversely affect the Company’s business operations.

 

As a result of the current economic downturn and macro-economic challenges currently affecting the economy of the United States and other parts of the world, the businesses of some of the Company’s customers may not be successful in generating sufficient revenues. Customers may choose to delay or postpone purchases from the Company until the economy and their businesses strengthen. In this connection, the Company’s Industrial Ingredients business is dependent upon end markets for paper and ethanol in North America. Paper markets have been under competitive pressure from imports and over-capacity and may be further stressed by an economic downturn. Ethanol markets have been under pressure from declining oil prices and increasing ethanol production capacity in the United States. Decisions by current or future customers to forego or defer purchases and/or customers’ inability to pay the Company for its products may adversely affect the Company’s earnings and cash flow.

 

Penford depends on its senior management team; the loss of any member could adversely affect its operations.

 

Penford’s success depends on the management and leadership skills of its senior management team. The loss of any of these individuals, particularly Thomas D. Malkoski, the Company’s President and Chief Executive Officer, or Steven O. Cordier, the Company’s Chief Financial Officer, or the Company’s inability to attract, retain and maintain additional personnel, could prevent it from fully implementing its business strategy. There is no assurance that it will be able to retain its existing senior management personnel or to attract additional qualified personnel when needed.

 

Penford is subject to stringent environmental and health and safety laws, which may require it to incur substantial compliance and remediation costs, thereby reducing profits.

 

Penford is subject to many federal, state and local environmental and health and safety laws and regulations, particularly with respect to the use, handling, treatment, storage, discharge and disposal of substances and hazardous wastes used or generated in its manufacturing processes. Compliance with these laws and regulations is a significant factor in the Company’s business. Penford has incurred and expects to continue to incur significant expenditures to comply with applicable environmental laws and regulations. The Company’s failure to comply with applicable environmental laws and regulations and permit requirements could result in civil or criminal fines or penalties or enforcement actions, including regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, installation of pollution control equipment or remedial actions.

 

The Company may be required to incur costs relating to the investigation or remediation of property, including property where it has disposed of its waste, and for addressing environmental conditions. Some environmental laws and regulations impose liability and responsibility on present and former owners, operators or users of facilities and sites for contamination at such facilities and sites without regard to causation or knowledge of contamination. Consequently, there is no assurance that existing or future circumstances, the development of new facts or the failure of third parties to address contamination at current or former facilities or properties will not require significant expenditures by the Company.

 

The Company expects to continue to be subject to increasingly stringent environmental and health and safety laws and regulations. It is difficult to predict the future interpretation and development of environmental and health and safety laws and regulations or their impact on the Company’s future earnings and operations. The Company anticipates that compliance will continue to require increased capital expenditures and operating costs. Any increase in these costs, or unanticipated liabilities arising, for example, out of discovery of previously unknown conditions or more aggressive enforcement actions, could adversely affect the Company’s results of operations, and there is no assurance that they will not have a material adverse effect on its business, financial condition and results of operations.

Penford’s unionized workforce could cause interruptions in the Company’s provision of services.

 

As of August 31, 2009, approximately 42% of the Company’s 320 North American employees were members of trade unions. Although the Company’s relations with unions are stable and the Company’s labor contract does not expire until August 2012, there is no assurance that the Company will not experience work disruptions or stoppages in the future, which could have a material adverse effect on its business and results of operations and adversely affect its relationships with its customers.

 

The Company may be unable to execute its plan to completely exit from its Australia/New Zealand Operations.

 

In August 2009, the Company made a determination to exit from its Australia/New Zealand Operations. While the Company has completed the sale of its New Zealand subsidiary, it still must complete the disposal of its remaining operations in Australia. On November 11, 2009, the Company’s Australian operating subsidiary, Penford Australia Limited, entered into two asset sale agreements with unrelated parties to sell substantially all of its operating assets. The completion and timing of these transactions remain subject to risks and uncertainties.

 

Risk Factors Relating to Penford’s Common Stock

 

Penford’s stock price has fluctuated significantly; the trading price of its common stock may fluctuate significantly in the future.

 

The trading price of the Company’s common stock has fluctuated significantly. In fiscal 2009, the stock price ranged from a low of $2.07 on March 6, 2009 to a high of $19.79 on September 19, 2008. The trading price of Penford’s common stock may fluctuate significantly in the future as a result of a number of factors, including:

 

 

The stock markets in general have experienced broad fluctuations that have often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of the Company’s common stock. Accordingly, Penford’s common stock may trade at prices significantly below an investor’s cost and investors could lose all or part of their investment in the event that they choose to sell their shares.

 

Provisions of Washington law could discourage or prevent a potential takeover.

 

Washington law imposes restrictions on certain transactions between a corporation and certain significant shareholders. The Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with an “acquiring person,” which is defined as a person or group of persons that beneficially owns 10% or more of the voting securities of the target corporation, for a period of five years after such acquisition, unless the transaction or acquisition of shares is approved by a majority of the members

of the target corporation’s board of directors prior to the time of the acquisition. Such prohibited transactions include, among other things, (1) a merger or consolidation with, disposition of assets to, or issuance or redemption of stock to or from, the acquiring person; (2) a termination of 5% or more of the employees of the target corporation as a result of the acquiring person’s acquisition of 10% or more of the shares; and (3) allowing the acquiring person to receive any disproportionate benefit as a shareholder. After the five year period, a “significant business transaction” may occur if it complies with “fair price” provisions specified in the statute. A corporation may not “opt out” of this statute.

 

 

Not applicable.

 

 

Penford’s facilities as of August 31, 2009 are as follows:

 

 

 

 

Penford’s production facilities are strategically located near sources of raw materials. The Company believes that its facilities are maintained in good condition and that the capacities of its plants are sufficient to meet current production requirements. The Company invests in expansion, improvement and maintenance of property, plant and equipment as required.

 

Penford’s owned and leased property related to the discontinued operations in Lane Cove and Tamworth, Australia, and Auckland, New Zealand, are not included in this Item 2.

 

 

On January 23, 2009, the Company filed suit in the U.S. District Court for the Northern District of Iowa, Cedar Rapids Division, against two insurance companies, National Union Fire Insurance Company of Pittsburgh, Pennsylvania and ACE American Insurance Company, related to insurance coverage arising out of the flood that struck the Company’s Cedar Rapids, Iowa plant in June 2008. The Company seeks additional payments from the insurers of more than $30 million for property damage, time element and various other exposures due to costs and losses incurred as a result of the flood. The Company cannot at this time determine the likelihood of any outcome or estimate any damages that might be awarded.

The Company is involved from time to time in various other claims and litigation arising in the normal course of business. In the judgment of management, which relies in part on information from the Company’s outside legal counsel, the ultimate resolution of these matters will not materially affect the consolidated financial position, results of operations or liquidity of the Company.

 

 

No matter was submitted to a vote of shareholders during the fourth quarter of fiscal 2009.

 

 

Market Information and Holders of Common Stock

 

Penford’s common stock, $1.00 par value, trades on The NASDAQ Global Market under the symbol “PENX.” On November 3, 2009, there were 458 shareholders of record. The high and low closing prices of Penford’s common stock during the last two fiscal years are set forth below.

 

 

Dividends

 

During each quarter of the first half of fiscal year 2009 and each quarter of fiscal year 2008, the Board of Directors declared a $0.06 per share cash dividend.

 

In April 2009, the Board of Directors suspended payment of dividends. Pursuant to an amendment to the Company’s bank credit agreement effective July 9, 2009, the Company may not declare or pay dividends on, or make any other distributions in respect of, its common stock. During fiscal years 2009 and 2008, the Company declared dividends on its common stock of $1.4 million and $2.6 million, respectively.

 

Issuer Purchases of Equity Securities

 

None

 

Performance Graph

 

The following graph compares the Company’s cumulative total shareholder return on its common stock for a five-year period (September 1, 2004 to August 31, 2009) with the cumulative total return of the Nasdaq Market Index and all companies traded on the Nasdaq Stock Market (“Nasdaq”) with a market capitalization of $100 - $200 million, excluding financial institutions. The graph assumes that $100 was invested on September 1, 2004 in the Company’s common stock and in the stated indices. The comparison assumes that all dividends are reinvested. The Company’s performance as reflected in the graph is not indicative of the Company’s future performance.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Penford Corp., The NASDAQ Composite Index
And A Peer Group

 

 

 

 

ASSUMES $100 INVESTED ON SEPTEMBER 1, 2004
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING AUGUST 31, 2009

 

 

Management does not believe there is either a published index or a group of companies whose overall business is sufficiently similar to the business of Penford to allow a meaningful benchmark against which the Company can be compared. The Company sells products based on specialty carbohydrate chemistry to several distinct markets, making overall comparisons to one of these markets misleading with respect to the Company as a whole. For these reasons, the Company has elected to use non-financial companies traded on Nasdaq with a similar market capitalization as a peer group.

 

The following table sets forth certain selected financial information for the five fiscal years as of and for the period ended August 31, 2009. The amounts have been restated to reflect the reclassification of discontinued operations and should be read in conjunction with the consolidated financial statements and the notes to these statements included in Item 8.

 

 

 

 

 

Overview

 

Penford generates revenues, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for industrial and food applications and ethanol. The Company develops and manufactures ingredients with starch as a base, providing value-added applications to its customers. Penford’s starch products are manufactured primarily from corn and potatoes and are used principally as binders and coatings in paper and food production.

 

In May 2008, the Company’s Industrial Ingredients — North America segment began commercial production and sales of ethanol from its facility in Cedar Rapids, Iowa. This ethanol plant gives the Company the ability to select from multiple output choices to capitalize on changing industry conditions and selling opportunities. This increased flexibility allows the Company to direct production towards the most attractive mix of strategic and financial opportunities.

 

In analyzing business trends, management considers a variety of performance and financial measures, including sales revenue growth, sales volume growth, and gross margins and operating income of the Company’s business segments. Penford manages its business in two segments. Industrial Ingredients — North America and Food Ingredients — North America, are broad categories of end-market users, served by operations in the United States. See Item 1 and Note 18 to the Consolidated Financial Statements for additional information regarding the Company’s business segment operations.

 

On August 27, 2009, the Company’s Board of Directors made a determination that the Company would exit from the business conducted by the Company’s Australia/New Zealand Operations. This determination was the completion of a process, announced on February 27, 2009, involving the examination of a range of strategic and operating choices for the Company’s Australia/New Zealand Operations as part of a continuing program to maximize the Company’s asset values and returns. On September 2, 2009, the Company completed the sale of Penford New Zealand Limited. On November 11, 2009, the Company’s Australian operating subsidiary, Penford Australia Limited, executed two asset sale agreements with unrelated parties to sell substantially all of its operating assets. The timing and completion of these transactions remain subject to significant risks and uncertainties.

 

The financial data for the Australia/New Zealand Operations have been presented as discontinued operations. The financial statements have been prepared in compliance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). Accordingly, for all periods presented herein, the Consolidated Balance Sheets, Statements of Operations and Statements of Cash Flows have been conformed to this presentation. The Australia/New Zealand Operations was previously reported as the Company’s third operating segment. See Note 2 to the Consolidated Financial Statements for further details.

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes. The notes to the Consolidated Financial Statements referred to in this MD&A are included in Part II Item 8, “Financial Statements and Supplementary Data.” Unless otherwise noted, all amounts and analyses are based on continuing operations.

Impact of Cedar River Flooding

 

On June 12, 2008, the Company’s Industrial Ingredients — North America plant in Cedar Rapids, Iowa was temporarily shut down due to record flooding of the Cedar River and government-ordered mandatory evacuation of the plant and surrounding areas. The Company sustained substantial damage to this facility and the plant was shut down from mid-June 2008 until the end of August 2008. By the end of August 2008, the Company had begun manufacturing industrial starch in Cedar Rapids. In late September 2008, the Company resumed the commercial production and sale of ethanol.

 

During the fourth quarter of fiscal 2008, the Company recorded costs of flood remediation and restoration of $27.6 million, net of insurance recoveries of $10.5 million. In fiscal 2009, the Company recorded flood-related costs of $7.6 million and insurance recoveries of $16.7 million. See Note 3 to the Consolidated Financial Statements for details of the flood restoration costs.

 

The Company maintains property damage and business interruption insurance coverage applicable to the Cedar Rapids plant. The Company is seeking additional payments from its insurers for damages arising from the flooding in June 2008 and has filed a lawsuit against the insurers. See Note 20 to the Consolidated Financial Statements for additional information regarding this lawsuit. The Company does not provide assurance as to any amount or timing of the ultimate recoveries under its insurance policies.

 

Consolidated Results of Operations

 

Consolidated fiscal 2009 sales increased 6.7% to $255.6 million from $239.6 million in fiscal 2008 on volume growth arising from the recovery by the Industrial Ingredients — North America business from the severe flooding in Cedar Rapids in fiscal 2008, and on pricing and product mix improvements in the Food Ingredients — North America segment. During fiscal 2009, the Company’s paper industry customers were negatively impacted by the global recession, resulting in weak demand for printing and writing paper products. As the paper demand contracted, paper mills closed, inventory levels declined and production schedules were cut back. As a result, demand declined for the Company’s industrial starch products. In response to this decline, the Company shifted more of its industrial starch manufacturing capacity to the production of ethanol, which accounted for $54.8 million, or 21% of consolidated sales. Food Ingredients — North America sales for fiscal 2009 rose on a 13% improvement in average unit pricing.

 

Fiscal 2009 consolidated gross margin decreased to $12.3 million, or 4.8% of sales, from $44.6 million, or 18.6% of sales, in fiscal 2008. Consolidated gross margin declined primarily due to the increase in ethanol production with a lower unit price than industrial starch, and falling ethanol and industrial starch prices during fiscal 2009.

 

Consolidated operating loss was $6.4 million in fiscal 2009 compared to an operating loss of $15.8 million in fiscal 2008. The decline in size of the loss relative to fiscal 2008 is primarily due to $9.1 million of net insurance recoveries recorded in fiscal 2009, as well as a $2.2 million reduction in operating expenses. In fiscal 2008, the operating loss included $27.6 million of net flood-related costs and $1.4 million of litigation settlement costs.

 

Interest expense in fiscal 2009 was $5.6 million compared with $3.1 million in fiscal 2008. Interest expense increased in fiscal 2009 due to a $1.1 million decrease in capitalized interest costs, an increase in average debt balances, and an increase in the applicable margin over LIBOR beginning in July 2009. Interest costs of $1.1 million related to the construction of the ethanol facility in Cedar Rapids, Iowa were capitalized in fiscal 2008.

 

The effective tax rate for fiscal 2009 was 34%. In fiscal 2009, the effective tax rate was lower than the U.S. federal statutory rate of 35% primarily due to adjustments to the unrecognized tax benefits and adjustments resulting from filing current and amended tax returns, offset by state income taxes. See Note 16 to the Consolidated Financial Statements.

 

Accounting Changes

 

Effective September 1, 2008, the Company adopted Financial Accounting Standards Board (“FASB”) Statement No. 157, “Fair Value Measurements” (“SFAS 157”), for financial assets and liabilities carried at fair

value that are recognized or disclosed at fair value in the financial statements on a recurring basis. SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. The adoption did not have a material impact on the company’s financial statements. See Note 14 to the Consolidated Financial Statements. Due to the issuance of FASB Staff Position No. 157-2 (“FSP 157-2”), the effective date of SFAS 157 has been deferred to fiscal years beginning after November 15, 2008 (fiscal 2010 for the Company) for non-recurring, nonfinancial assets and liabilities that are recognized or disclosed at fair value. The Company is continuing to evaluate the impact of adopting these provisions in fiscal 2010. In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”). FSP 157-3 clarifies the application of SFAS 157 and addresses how the fair value of a financial asset is determined when the market for that financial asset is inactive. FSP 157-3 was effective upon issuance. The implementation of this standard did not have an impact on the Company’s consolidated financial statements.

 

In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB No. 115” (“SFAS 159”) which allows companies the option to measure certain financial assets and financial liabilities at fair value at specified election dates. Effective September 1, 2008, the Company adopted SFAS 159 and elected not to measure any additional financial instruments and other items at fair value.

 

In March 2008, the FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB No. 133” (“SFAS 161”). SFAS 161 requires additional disclosures about the objectives for using derivative instruments and hedging activities, the method of accounting for such instruments under SFAS 133 and its related interpretations, the effect of derivative instruments and related hedged items on financial position, results of operations, and cash flows, and a tabular disclosure of the fair values of derivative instruments and their gains and losses. Effective December 1, 2008, the Company adopted SFAS 161. See Note 14 to the Consolidated Financial Statements.

 

Results of Operations

 

Fiscal 2009 Compared to Fiscal 2008

 

Industrial Ingredients — North America

 

 

Industrial Ingredients fiscal 2009 sales of $186.5 million increased $13.2 million, or 7.6%, from fiscal 2008. Annual sales volume of industrial starches declined 22.8%. The business suffered severe flood damage to its Cedar Rapids, Iowa manufacturing facility in June 2008 which shut down production for most of the fourth quarter of fiscal 2008. Limited production of starch products resumed in August 2008 and customer shipments were phased in during the first quarter of fiscal 2009 as the business restarted manufacturing processes. During the remainder of fiscal 2009, the Industrial Ingredients starch business was significantly impacted by weak demand for printing and writing paper products. Paper industry customers reacted to the demand decline by implementing extended downtime, closing mills and reducing inventory levels.

 

As starch demand decreased, the Industrial Ingredients business shifted more of its manufacturing mix to the production of ethanol. In May 2008, the Company began commercial production of ethanol, which was also suspended in June 2008 due to the impact of the Cedar Rapids flood. Ethanol production was restarted on a limited basis in late September 2008. Sales of ethanol in fiscal 2009 were $54.8 million compared to $6.0 million in fiscal 2008.

Gross margin declined from $26.2 million in fiscal 2008 to a loss of $9.3 million in fiscal 2009, a reduction of $35.6 million. Gross margin decreased primarily due to the shift in the manufacturing mix to ethanol production and a fall in ethanol selling prices. Ethanol has a lower unit selling price than industrial starch. The effect of lower industrial starch pricing of $5.1 million, higher depreciation on the ethanol facility of $2.2 million, higher distribution costs of $2.4 million, and $3.3 million of lower yields on corn and corn by-products also contributed to the margin decline.

 

Loss from operations for fiscal 2009 included $9.1 million of net insurance recoveries related to the Cedar Rapids flooding in fiscal 2008. See Note 3 to the Consolidated Financial Statements for details of the costs and recoveries. Operating expenses decreased to $8.3 million in fiscal 2009 from $11.6 million in fiscal 2008 on lower employee costs. Fiscal 2008 operating expenses included $1.4 million related to the settlement of a lawsuit. Research and development expenses decreased $1.0 million primarily due to lower employee costs.

 

Food Ingredients — North America

 

 

Sales at the Food Ingredients — North America business of $69.0 million rose $2.8 million, or 4.2%, over fiscal 2008, driven by improvements in average unit selling prices. The annual volume declined 7% from 2008, approximately half of which was due to the sale of the dextrose business in the second quarter of fiscal 2009. Sales of non-coating applications, excluding dextrose applications, grew 3.5% and sales of coating applications rose 11%.

 

Income from operations grew 32.8% from $10.2 million in fiscal 2008 to $13.5 million in fiscal 2009 on an increase in gross margin. Improvements in average unit pricing and product mix more than offset raw material increases of $2.4 million and the effect of volume declines of $1.4 million.

 

Corporate Operating Expenses

 

Corporate operating expenses decreased to $9.3 million in fiscal 2009 from $10.0 million in fiscal 2008, primarily due to a decrease in employee incentive costs and an increase in the cash value of the Company-owned life insurance policies.

 

Fiscal 2008 Compared to Fiscal 2007

 

Industrial Ingredients — North America

 

 

Industrial Ingredients’ fiscal 2008 sales of $173.3 million decreased $21.6 million, or 11%, from fiscal 2007. Annual sales volume declined 18%, caused by the severe flooding in Cedar Rapids, Iowa, which shut down production for most of the fourth quarter. Limited production of specialty starch products continued after the flooding on June 12, 2008. Sales for the fourth quarter were $14.2 million. Annual sales decreased by $34.4 million due to reduced volumes, partially offset by $12.8 million in improvements in average unit selling prices and product mix.

Gross margin declined $8.9 million, or 25%, from fiscal 2007 to $26.2 million, and, as a percentage of sales, decreased to 15.1% in fiscal 2008 compared to 18.0% in fiscal 2007. The impact of improved unit pricing and product mix of $8.1 million was more than offset by higher chemical and corn procurement costs of $3.7 million and the effect of lower volumes due to the flooding of $9.5 million. Also reducing gross margin were higher repair and maintenance expenses, lower utility yields and production inefficiencies caused by severe weather in the Midwest in the first half of the fiscal year and the flooding in the fourth quarter, and the start-up costs of ethanol production totaling $3.8 million.

 

Loss from operations for fiscal 2008 included $27.6 million of flood remediation costs incurred in the fourth quarter, net of $10.5 million of insurance recoveries, as discussed above. See Note 3 to the Consolidated Financial Statements for a discussion of the costs recorded in fiscal 2008. Included in operating results for fiscal years 2008 and 2007 are expenses of $1.4 million and $2.4 million related to the settlement of a lawsuit. See Note 20 to the Consolidated Financial Statements. Operating expenses and research and development expenses increased $0.4 million in fiscal 2008.

 

Food Ingredients — North America

 

 

Sales at the Food Ingredients — North America business of $66.3 million rose $3.2 million, or 5.2%, over fiscal 2007, driven by an 8.6% increase in average unit sales prices. Annual volumes declined 3% from 2007. Sales of non-coating applications grew 10% and pricing for these products expanded 11%, with sales to the bakery, dairy/cheese, sauces and gravies, and pet chew end markets experiencing double-digit growth in fiscal 2008.

 

Income from operations declined from $10.7 million in fiscal 2007 to $10.2 million in fiscal 2008. Gross margin decreased by $0.6 million from fiscal 2007 to $18.3 million. Improvements in pricing and product mix were more than offset by higher raw material costs and a decline in volumes. Operating expenses declined by $0.1 million due to a reduction in employee costs.

 

Corporate Operating Expenses

 

Corporate operating expenses increased to $10.0 million in fiscal 2008 from $9.6 million in fiscal 2007, primarily due to increases in employee costs and the costs of benefits and insurance.

 

Non-Operating Income (Expense)

 

Other non-operating income (expense) consists of the following:

 

 

In the second quarter of fiscal 2009, the Company’s Food Ingredients — North America business segment sold assets related to its dextrose product line to a third-party purchaser for $2.9 million, net of transaction costs. The Company recorded a $1.6 million gain on the sale.

The Company recognized a gain (loss) on foreign currency transactions on Australian dollar denominated assets and liabilities as disclosed in the table above.

 

As discussed in Note 3 to the Consolidated Financial Statements, in June 2008, the flooding of the Cedar Rapids manufacturing facility shut down production for most of the fourth quarter of fiscal 2008. The Company had derivative instruments designated as cash flow hedges to reduce the price volatility of corn and natural gas used in the production of starch. Due to the June 12, 2008 flood event, derivative positions held as of that date that were forecasted to hedge exposures during the period the Cedar Rapids plant was shut down were no longer deemed to be effective cash flow hedges. The $2.9 million gain, representing ineffectiveness on these instruments, was reclassified from other comprehensive income and recognized as a component of non-operating income.

 

Interest expense

 

Interest expense was $5.6 million, $3.1 million and $3.7 million in fiscal years 2009, 2008 and 2007, respectively. Interest expense for fiscal 2009 increased $2.5 million over the prior year’s expense due to a $1.1 million decrease in capitalized interest costs, an increase in average debt balances, and an increase in the applicable margin over LIBOR beginning July 2009. In connection with the amendment to the Company’s credit facility in July 2009, the Company paid additional arrangement and commitment fees to its lenders of $1.0 million. The amortization of these and existing deferred loan fees over the shortened maturity of the debt will increase annual interest expense by an estimated $1.1 million. This amendment also increased the maximum commitment fee for undrawn balances and the maximum LIBOR margin payable on outstanding debt. The incremental annual interest expense from these pricing changes and the revised amortization schedule is estimated at $1.2 million. See “Liquidity and Capital Resources” in the MD&A for a discussion of the Company’s financing.

 

Interest expense for fiscal 2008 declined $0.6 million from fiscal 2007 due to a decline in U.S. interest rates from the previous year and lower average debt balances, excluding interest costs which were capitalized on debt related to the construction of the ethanol facility. Interest costs related to construction of the ethanol manufacturing plant were capitalized until May 2008, when the facility began commercial production. No interest costs were capitalized in fiscal 2009. Interest costs of $1.1 million and $0.4 million were capitalized in fiscal years 2008 and 2007, respectively, related to construction of the ethanol facility.

 

As of August 31, 2009, all of the Company’s outstanding debt was subject to variable interest rates. As of August 31, 2009, under interest rate swap agreements with several banks, the Company had fixed its interest rates on U.S. dollar denominated term debt of $23.2 million at 4.18% and $5.8 million at 5.08%, plus the applicable margin under the Company’s credit facility.

 

Income taxes

 

The effective tax rates for fiscal years 2009, 2008 and 2007 were 34%, 33% and 31%, respectively. In fiscal 2009 and 2008, the effective tax rate is lower than the U.S. federal statutory rate of 35% primarily due to adjustments to the unrecognized tax benefits and adjustments resulting from filing current and amended tax returns, offset by state income taxes. See Note 16 to the Consolidated Financial Statements.

 

The effective tax rate for fiscal 2007 varied from the U.S. federal statutory rate of 35% primarily due to U.S. tax incentives related to research and development, the favorable tax effect of domestic (U.S.) production activities, and the effect of a tax settlement. In May 2007, the Company settled Internal Revenue Service (“IRS”) audits of the Company’s U.S. federal income tax returns for the fiscal years ended August 31, 2001 and 2002. In connection with the settlement of these audits, the Company reversed a current tax liability in the amount of $0.7 million, which represented its estimate of the probable loss on certain tax positions being examined.

Results of Discontinued Operations

 

 

Overview

 

On August 27, 2009, the Company’s Board of Directors made a determination that the Company would exit from the business conducted by the Company’s Australia/New Zealand Operations. This determination was the completion of a process, announced on February 27, 2009, involving the examination of a range of strategic and operating choices for the Company’s Australia/New Zealand Operations as part of a continuing program to maximize the Company’s asset values and returns. On September 2, 2009, the Company completed the sale of Penford New Zealand Limited. On November 11, 2009, the Company’s Australian operating subsidiary, Penford Australia Limited, executed two asset sale agreements with unrelated parties to sell substantially all of its operating assets. The timing and completion of these transactions remain subject to significant risks and uncertainties. The Australia/New Zealand Operations was previously reported in the consolidated financial statements as an operating segment.

 

Fiscal 2009 Compared to Fiscal 2008

 

The Australian business reported a $29.5 million decrease in sales in fiscal 2009 over fiscal 2008 on a $19.5 million decline in foreign currency exchange rates compared to the U.S. dollar, and a sales volume decrease of 11%, partially offset by $1.8 million of improvements in pricing and product mix. Sales in local currency declined 10% and average unit pricing increased 1.2% in local currency.

 

Fiscal 2009 gross margin declined $9.1 million from last year, from positive margin of $5.0 million to a loss of $4.1 million as raw material grain costs rose $6.4 million and unit manufacturing costs rose $5.3 million. Favorable average unit pricing partially offset the increased input and production costs. Operating and research and development expenses for fiscal 2009 decreased by $2.0 million over the same period a year ago due to the decrease in average foreign currency exchange rates.

 

In the second quarter of fiscal 2009, the Company performed an interim impairment evaluation of its goodwill. As a result of this interim assessment, the Company recorded a non-cash goodwill impairment charge of $13.8 million representing all of the goodwill allocated to the Australia/New Zealand reporting unit.

 

The financial statements have been prepared in compliance with the provisions of SFAS 144. Accordingly, as of August 31, 2009, the Company stated the long-lived assets of the Australia/New Zealand Operations at the lower

of their carrying values or fair value less costs to sell. The Company estimated fair value of the long-lived assets based on executed sales agreements for substantially all of its Australian operating assets and the completed sale price of Penford New Zealand. The Company recorded a non-cash asset impairment charge of $33.0 million in the fourth quarter of fiscal 2009 to reduce the carrying value of the long-lived assets of the Australia/New Zealand Operations to estimated fair value less costs to sell. The estimates used in determining the impairment charge, including, but not limited to, the sales proceeds and costs to sell, are subject to significant risks and uncertainties. The actual asset impairment may be materially more or less than the charge recorded at August 31, 2009. Estimates of fair value will be evaluated each quarter and revisions to the estimates will be recorded as adjustments to the carrying values of the long-lived assets.

 

The Company’s Australian operations reported a tax loss for fiscal years 2009 and 2008. Australian tax law provides for an unlimited carryforward period for net operating losses but does not allow losses to be carried back to previous tax years. Due to classification of the Australia operations as discontinued and the uncertainty related to generating sufficient future taxable income in Australia, the Company currently believes that it is more likely than not that the net deferred tax benefit will not be realized. At August 31, 2009, the Company has recorded a valuation allowance against the entire Australian net deferred tax asset.

 

Fiscal 2008 Compared to Fiscal 2007

 

The Australian business reported a 2.2% increase in sales in fiscal 2008 over fiscal 2007. Volumes declined 21% from fiscal 2007 levels, reflecting a planned shift to product offerings with higher long-term return opportunities. Improvements in average unit selling prices of 29% contributed $12.7 million to revenue gains and stronger average foreign currency exchange rates increased revenues by $11.5 million. Sales in local currencies declined 10%.

 

Gross margin declined to 4.7% of sales in fiscal 2008 from 9.6% in fiscal 2007 on lower volumes and higher manufacturing costs. Manufacturing costs increased due to higher procurement and processing charges on grain that was imported to supplement local grain supplies. Increased raw material grain and chemical costs were offset by higher selling prices.

 

Operating expenses increased $0.8 million in fiscal 2008 compared to fiscal 2007 primarily due to the strengthening of the Australian and New Zealand dollar exchange rates which added $0.7 million to expenses. The remainder of the increase was due to higher employee costs. Similarly, research and development expenses increased $0.6 million, of which half was due to foreign currency exchange rates and the remainder due to increased headcount, patent and consultant costs.

 

The segment’s operating loss for fiscal 2008 included $1.4 million of employee severance costs and related benefits that were paid in connection with workforce reductions implemented during the reconfiguring of the Australian and New Zealand businesses.

 

Liquidity and Capital Resources

 

The Company’s primary sources of short- and long-term liquidity are cash flow from operations and its revolving line of credit, which expires in 2011. The Company expects to generate sufficient cash flow from operations and to have sufficient borrowing capacity and ability to fund its cash requirements during fiscal 2010.

 

Operating Activities

 

At August 31, 2009, Penford had working capital from continuing operations of $23.4 million, and $91.4 million outstanding under its credit facility. Cash flow from continuing operations was $(11.2) million, $(1.4) million and $19.2 million in fiscal years 2009, 2008 and 2007, respectively. The change in cash flow in fiscal 2009 was primarily due to an increase in trade receivables of $20.1 million as sales of the Industrial Ingredients business grew after the Cedar Rapids flooding in fiscal 2008 and reduction in payables of $16.0 million. The decline in cash flow in fiscal 2008 compared to fiscal 2007 is primarily related to the fourth quarter operating loss due to the temporary shut down of the Company’s Cedar Rapids, Iowa plant, operated by the Industrial Ingredients — North America business, due to record flooding of the Cedar River and government-ordered mandatory evacuation of the

plant and surrounding areas. In addition, the fluctuations in working capital balances in fiscal 2008 compared to fiscal 2007 are primarily related to the interruption in operations due to the flooding and additional payables at year end related to the flood discussed above.

 

Investing Activities

 

Capital expenditures were $5.4 million, $38.5 million and $32.8 million in fiscal years 2009, 2008 and 2007, respectively. Capital expenditures in fiscal years 2008 and 2007 include $26.9 million and $19.3 million, respectively, for construction of the ethanol production facility in Cedar Rapids, Iowa. Penford expects capital expenditures to be approximately $6.5 million in fiscal 2010. In fiscal 2009, the Company’s Food Ingredients — North America business segment sold assets related to its dextrose product line to a third-party purchaser for $2.9 million, net of transaction costs.

 

Financing Activities

 

On October 5, 2006, Penford entered into a $145 million Second Amended and Restated Credit Agreement (the “2007 Agreement”) among the Company; Harris N.A.; LaSalle Bank National Association (now Bank of America); Cooperative Centrale Raiffeisen-Boorleenbank B.A., “Rabobank Nederland” (New York Branch); U.S. Bank National Association; and the Australia and New Zealand Banking Group Limited.

 

On February 26, 2009, the Company entered into a second amendment to the 2007 Agreement (the “Second Amendment”). The Second Amendment adjusted certain covenants and other provisions in the 2007 Agreement to provide additional relief from the financial impact of the flood at the Company’s Cedar Rapids, Iowa facility. Pursuant to the Second Amendment, Bank of Montreal became the Administrative agent under the 2007 Agreement, replacing Harris N.A.

 

On July 9, 2009, the Company and its lenders under the 2007 Agreement executed a third amendment to the 2007 Agreement (the “Third Amendment”). The Third Amendment, among other things, amended financial covenants effective as of May 31, 2009, reduced the amounts that the Company may borrow under the various facilities available under the 2007 Agreement, shortened the maturity dates on borrowed funds, increased applicable interest rates, eliminated the Company’s ability to declare dividends on its stock, and adjusted the amortization schedule and provisions regulating mandatory prepayments, additional indebtedness, subsidiary company support, and reporting requirements.

 

The Third Amendment adjusted the final maturity date of the term loan available under the 2007 Agreement to December 15, 2009, and the maturity date of the revolver and the capital expansion loans to November 30, 2010. Beginning on September 30, 2009, the Company was required to repay the capital expansion loans in quarterly installments of $1.0 million through December 31, 2009, and $2.0 million thereafter. In addition to the quarterly installments on the capital expansion loan, a one-time payment of $9.625 million is due on December 15, 2009. Any remaining amount due on the capital expansion loans and revolver is due at final maturity.

 

The Third Amendment adjusted the financial covenants in the 2007 Agreement, as amended, effective May 31, 2009. The Company must maintain a minimum EBITDA (as defined in the Third Amendment), tangible net worth and fixed charge coverage ratio each fiscal quarter in accordance with the revisions contained in the Third Amendment. The Third Amendment also provides that the Company may not declare or pay dividends on, or make any other distributions in respect of, its common stock. Annual capital expenditures are limited to $8 million. The availability on the $60 million revolver facility is limited to $52.5 million unless the Company obtains the approval of the lenders holding more than 50% of the U.S. Dollar equivalent of the sum of the total borrowing and unused commitments under the 2007 Agreement.

 

In connection with the Third Amendment, the Company paid additional arrangement and commitment fees to its lenders of $1.0 million. The amortization of these and existing deferred loan fees over the shortened maturity of the Company’s debt will increase annual interest expense by an estimated $1.1 million. The Third Amendment increased the maximum commitment fee for undrawn balances by 25 basis points and the maximum London Interbank Offering Rates (“LIBOR”) margin payable on outstanding debt by 150 basis points to 5.00%. The incremental annual interest expense from these pricing changes and the revised amortization schedule is estimated

at $1.2 million. Interest rates under the 2007 Agreement are based on either the LIBOR in Australia or the United States, or the prime rate, depending on the selection of available borrowing options under the 2007 Agreement.

 

At August 31, 2009, the Company had $45.6 million and $5.4 million outstanding, respectively, under the revolving credit and term loan portions of its credit facility. In addition, the Company had $40.4 million outstanding under its capital expansion credit facility on August 31, 2009. The Company’s ability to borrow under its revolving credit facility is subject to the Company’s compliance with, and is limited by, the covenants in the 2007 Agreement, as amended. The Company was in compliance with the covenants in the 2007 Agreement, as amended, as of August 31, 2009.

 

As of August 31, 2009, all of the Company’s outstanding debt was subject to variable interest rates. Under interest rate swap agreements with several banks, the Company has fixed its interest rates on U.S. dollar denominated term debt of $23.2 million at 4.18% and $5.8 million at 5.08%, plus the applicable margin under the 2007 Agreement.

 

In December 2007, the Company completed a public offering of common stock resulting in the issuance of 2,000,000 additional common shares at a price to the public of $25.00 per share. The Company received approximately $47.2 million of net proceeds (net of $2.8 million of expenses related to the offering) from the sale of 2,000,000 shares and these proceeds were used to reduce the Company’s outstanding debt.

 

Dividends

 

During each quarter of the first half of fiscal year 2009 and each quarter of fiscal year 2008, the Board of Directors declared a $0.06 per share cash dividend.

 

In April 2009, the Company’s Board of Directors suspended payment of dividends. Pursuant to the Third Amendment, the Company may not declare or pay dividends on, or make any other distributions in respect of, its common stock. During fiscal years 2009 and 2008, the Company declared dividends on its common stock of $1.4 million and $2.6 million, respectively.

 

Critical Accounting Estimates

 

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The process of preparing financial statements requires management to make estimates, judgments and assumptions that affect the Company’s financial position and results of operations. These estimates, judgments and assumptions are based on the Company’s historical experience and management’s knowledge and understanding of the current facts and circumstances. Management believes that its estimates, judgments and assumptions are reasonable based upon information available at the time this report was prepared. To the extent there are material differences between estimates, judgments and assumptions and the actual results, the financial statements will be affected.

 

Management has reviewed the accounting estimates and related disclosures with the Audit Committee of the Board of Directors. The estimates that management believes are the most important to the financial statements and that require the most difficult, subjective and complex judgments include the following:

 

 

 

A description of each of these follows:

 

Evaluation of the Allowance for Doubtful Accounts Receivable

 

Management makes judgments about the Company’s ability to collect outstanding receivables and provides allowances for the portion of receivables that the Company may not be able to collect. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. If the estimates do not reflect the Company’s future ability to collect outstanding invoices, Penford may experience losses in excess of the reserves established. At August 31, 2009, the allowance for doubtful accounts receivable was $0.6 million.

 

Hedging Activities

 

Penford uses derivative instruments, primarily exchange traded futures contracts, to reduce exposure to price fluctuations of commodities used in the manufacturing processes in the United States. The Company relies upon exchange settlement to address the default risk exposure. Penford has elected to designate these activities as hedges. This election allows the Company to defer gains and losses on those derivative instruments until the underlying commodity is used in the production process. To reduce exposure to variable short-term interest rates, Penford uses interest rate swap agreements. Penford uses over-the-counter interest rate swap agreements with large commercial banks as counterparties. The Company is unaware of any events or circumstances that would prevent these banks from fulfilling their obligations.

 

The requirements for the designation of hedges are very complex, and require judgments and analyses to qualify as hedges as defined by Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS No. 133”). These judgments and analyses include an assessment that the derivative instruments used are effective hedges of the underlying risks. If the Company were to fail to meet the requirements of SFAS No. 133, or if these derivative instruments are not designated as hedges, the Company would be required to mark these contracts to market at each reporting date. See Note 14 to the Consolidated Financial Statements.

 

Benefit Plans

 

Penford has defined benefit plans for its U.S. employees providing retirement benefits and coverage for retiree health care. Qualified third-party actuaries assist management in determining the expense and funded status of these employee benefit plans. Management makes several estimates and assumptions in order to measure the expense and funded status, including interest rates used to discount certain liabilities, rates of return on plan assets, rates of compensation increases, employee turnover rates, anticipated mortality rates, and increases in the cost of medical care. The Company makes judgments about these assumptions based on historical investment results and experience as well as available historical market data and trends. However, if these assumptions are wrong, it could materially affect the amounts reported in the Company’s future results of operations. Disclosure about these estimates and assumptions are included in Note 12 to the Consolidated Financial Statements. See “Defined Benefit Pension and Postretirement Benefit Plans” below.

 

Valuation of Goodwill

 

Penford is required to assess, on an annual basis, whether the value of goodwill reported on the balance sheet has been impaired, or more often if conditions exist that indicate that there might be impairment. These assessments require extensive and subjective judgments to assess the fair value of goodwill. While the Company engages qualified valuation experts to assist in this process, their work is based on the Company’s estimates of future operating results and allocation of goodwill to the business units. If future operating results differ materially from the estimates, the value of goodwill could be adversely impacted. In the second quarter of fiscal 2009, the Company

performed an interim impairment evaluation of its goodwill. As a result of this interim assessment, the Company recorded a non-cash goodwill impairment charge of $13.8 million representing all of the goodwill allocated to the Australia/New Zealand reporting unit. The impairment charge is included in the results of operations for discontinued operations.

 

Self-Insurance Program

 

The Company maintains a self-insurance program covering portions of workers’ compensation and group health liability costs. The amounts in excess of the self-insured levels are fully insured by third-party insurers. Liabilities associated with these risks are estimated in part by considering historical claims experience, severity factors and other actuarial assumptions. Projections of future losses are inherently uncertain because of the random nature of insurance claims occurrences and changes that could occur in actuarial assumptions. The financial results of the Company could be significantly affected if future claims and assumptions differ from those used in determining these liabilities.

 

Income Taxes

 

The determination of the Company’s provision for income taxes requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. The Company’s provision for income taxes reflects a combination of income earned and taxed in the various U.S. federal and state taxing jurisdictions. Jurisdictional tax law changes, increases or decreases in permanent differences between book and tax items, accruals or adjustments of accruals for tax contingencies or valuation allowances, and the Company’s change in the mix of earnings from these taxing jurisdictions all affect the overall effective tax rate.

 

Prior to fiscal 2008, in evaluating the exposures connected with the various tax filing positions, the Company established an accrual, when, despite management’s belief that the Company’s tax return positions were supportable, management believed that certain positions may be successfully challenged and a loss was probable. When facts and circumstances changed, these accruals were adjusted. Beginning in fiscal 2008, the Company adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN 48”), which changed the accounting for uncertain tax positions. FIN 48 provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination based on the technical merits of the position. The amount recognized is measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon settlement. See Note 16 to the Consolidated Financial Statements.

 

The liability for unrecognized tax benefits contains uncertainties because the Company is required to make assumptions and to apply judgment to estimate the exposures associated with the various tax filing positions. Management believes that the judgments and estimates it uses in evaluating its tax filing positions are reasonable; however, actual results could differ, and the Company may be exposed to significant gains and losses and the Company’s effective tax rate in a given financial statement period could be materially affected.

 

Stock-Based Compensation

 

The Company recognizes stock-based compensation in accordance with SFAS No. 123R. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period of the award. Determining the appropriate fair value model and calculating the fair value of the share-based awards at the date of grant requires judgment, including estimating stock price volatility, forfeiture rates, the risk-free interest rate, dividends and expected option life. See Note 11 to the Consolidated Financial Statements.

 

If circumstances change, and the Company uses different assumptions for volatility, interest, dividends and option life in estimating the fair value of stock-based awards granted in future periods, stock-based compensation expense may differ significantly from the expense recorded in the current period. SFAS No. 123R requires forfeitures to be estimated at the date of grant and revised in subsequent periods if actual forfeitures differ from those estimated. Therefore, if actual forfeiture rates differ significantly from those estimated, the Company’s results of operations could be materially impacted.

Discontinued Operations

 

In connection with classifying its Australia/New Zealand Operations as “held for sale,” the Company stated the long-lived assets of the Australia/New Zealand Operations at the lower of their carrying values or fair value less costs to sell. The Company estimated fair value of the long-lived assets based on executed sales agreements for substantially all of its Australian operating assets and the completed sale price of Penford New Zealand. The Company recorded a non-cash asset impairment charge of $33.0 million in the fourth quarter of fiscal 2009 to reduce the carrying value of the long-lived assets of the Australia/New Zealand Operations to estimated fair value less costs to sell. The estimates used in determining the impairment charge, including, but not limited to, the sales proceeds and costs to sell, are subject to significant risks and uncertainties. The actual asset impairment may be materially more or less than the charge recorded at August 31, 2009.

 

Contractual Obligations

 

As more fully described in Notes 7 and 10 to the Consolidated Financial Statements, the Company is a party to various debt and lease agreements at August 31, 2009 that contractually commit the Company to pay certain amounts in the future. The purchase obligations at August 31, 2009 represent an estimate of all open purchase orders and contractual obligations through the Company’s normal course of business for commitments to purchase goods and services for production and inventory needs, such as raw materials, supplies, manufacturing arrangements, capital expenditures and maintenance. The majority of terms allow the Company or suppliers the option to cancel or adjust the requirements based on business needs.

 

The following table summarizes such contractual commitments at August 31, 2009 (in thousands):

 

 

 

 

Off-Balance Sheet Arrangements

 

The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on the Company’s financial condition, changes in financial conditions, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

 

Defined Benefit Pension and Postretirement Benefit Plans

 

Penford maintains defined benefit pension plans and defined benefit postretirement health care plans in the United States.

 

The most significant assumptions used to determine benefit expense and benefit obligations are the discount rate and the expected return on assets assumption. See Note 12 to the Consolidated Financial Statements for the assumptions used by Penford.

 

The discount rate used by the Company in determining benefit expense and benefit obligations reflects the yield of high quality (AA or better rating by a recognized rating agency) corporate bonds whose cash flows are

expected to match the timing and amounts of projected future benefit payments. Benefit obligations and expense increase as the discount rate is reduced. The discount rates to determine net periodic expense used in 2007 (6.15%), 2008 (6.51%) and 2009 (6.92%) reflect the changes in bond yields over the past several years. Lowering the discount rate by 25 basis points would increase pension expense by approximately $0.2 million and other postretirement benefit expense by $0.01 million. During fiscal 2009, bond yields declined and Penford has lowered the discount rate for calculating its benefit obligations at August 31, 2009, as well as net periodic expense for fiscal 2010, to 5.98%.

 

The expected long-term return on assets assumption for the pension plans represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. Pension expense increases as the expected return on plan assets decreases. In developing the expected rate of return, the Company considers long-term historical market rates of return as well as actual returns on the Company’s plan assets, and adjusts this information to reflect expected capital market trends. Penford also considers forward looking return expectations by asset class, the contribution of active management and management fees paid by the plans. The plan assets are held in qualified trusts and anticipated rates of return are not reduced for income taxes. The expected long-term return on assets assumption used to calculate net periodic pension expense was 8.0% for fiscal 2009. A 50 basis point decrease (increase) in the expected return on assets assumptions would increase (decrease) pension expense by approximately $0.1 million based on plan assets at August 31, 2009. The expected return on plan assets used in calculating fiscal 2010 pension expense is 8.0%.

 

Unrecognized net loss amounts reflect the difference between expected and actual returns on pension plan assets as well as the effects of changes in actuarial assumptions. Unrecognized net losses in excess of certain thresholds are amortized into net periodic pension and postretirement benefit expense over the average remaining service life of active employees. As of August 31, 2009, unrecognized losses from all sources are $15.6 million for the pension plans and unrecognized losses of $4.2 million for the postretirement health care plan. Amortization of unrecognized net loss amounts is expected to increase net pension expense by approximately $1.2 million in fiscal 2010. Amortization of unrecognized net losses is expected to increase net postretirement health care expense by approximately $0.3 million in fiscal 2010.

 

Penford recognized pension expense of $2.0 million, $1.6 million and $1.7 million in fiscal years 2009, 2008 and 2007, respectively. Penford expects pension expense to be approximately $3.6 million in fiscal 2010. The Company contributed $1.1 million, $1.5 million and $1.0 million to the pension plans in fiscal years 2009, 2008 and 2007, respectively. Penford estimates that it will be required to make minimum contributions to the pension plans of $1.8 million during fiscal 2010. Because of the decline in general economic and capital market conditions, the Company expects that pension plan funding contributions will increase over the medium and long term.

 

The Company recognized benefit expense for its postretirement health care plan of $1.0 million in each fiscal years 2009, 2008 and 2007. Penford expects to recognize approximately $1.6 million in postretirement health care benefit expense in fiscal 2010. The Company contributed $0.5 million, $0.5 million, and $0.6 million in fiscal years 2009, 2008 and 2007 to the postretirement health care plans and estimates that it will contribute $0.7 million in fiscal 2010.

 

Future changes in plan asset returns, assumed discount rates and various assumptions related to the participants in the defined benefit plans will affect future benefit expense and liabilities. The Company cannot predict what these changes will be.

 

Recent Accounting Pronouncements

 

In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162 (“SFAS 168”). SFAS 168 establishes the FASB Accounting Standards Codification as the source of authoritative U.S. generally accepted accounting principles recognized by the FASB to be applied by nongovernmental entities. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. In the first quarter of fiscal 2010, all references made to U.S. generally accepted accounting principles will use the new Codification numbering system prescribed by the FASB. As the Codification is not intended to change or alter U.S. generally

accepted accounting principles, the Company does not believe that the adoption of SFAS 168 will have any impact on its consolidated financial statements.

 

In April 2009, the FASB issued FSP SFAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP SFAS 107-1 and APB 28-1”). This FSP requires additional disclosures regarding financial instruments for interim reporting periods of publicly traded companies. This FSP requires that disclosures provide quantitative and qualitative information on fair value estimates for all financial instruments not measured on the balance sheet at fair value, when practicable, with the exception of certain financial instruments listed in SFAS 107. This FSP is effective prospectively for interim reporting periods ending after June 15, 2009. The Company will adopt FSP in the first quarter of fiscal 2010. The Company is currently evaluating the disclosure requirements of this standard.

 

In December 2008, the FASB issued Staff Position No. 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets” (“FSP 132(R)-1”). FSP 132(R)-1 requires additional disclosures on a prospective basis about assets held in an employer’s defined benefit pension or other postretirement plan. FSP 132(R)-1 is effective for fiscal years beginning after December 15, 2008 (fiscal 2010 for the Company). The Company is currently evaluating the disclosure requirements of this standard.

 

In June 2008, the FASB issued Staff Position FSP Emerging Issues Task Force (“EITF”) 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (“FSP EITF 03-6-1”). FSP EITF 03-6-1 addresses whether unvested share-based payment awards that contain rights to nonforfeitable dividends are participating securities prior to vesting and, therefore, included in the computation of earnings per share. FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008 (fiscal 2010 for the Company). The Company is currently evaluating the impact of adopting FSP EITF 03-6-1 on the Company’s consolidated financial statements.

 

In February 2008, the FASB issued FASB Staff Position No. 157-2, “Effective Date of SFAS No. 157” (“FSP 157-2”), which delays the effective date of SFAS 157, “Fair Value Measurements,” for non-recurring, nonfinancial assets and liabilities that are recognized or disclosed at fair value to fiscal years beginning after November 15, 2008 (fiscal 2010 for the Company). The Company is continuing to evaluate the impact of adopting these provisions in fiscal 2010.

 

 

Market Risk Sensitive Instruments and Positions

 

Penford is exposed to market risks that are inherent in the financial instruments that are used in the normal course of business. Penford may use various hedge instruments to manage or reduce market risk, but the Company does not use derivative financial instrument transactions for speculative purposes. The primary market risks are discussed below.

 

Interest Rate Risk

 

The Company’s exposure to market risk for changes in interest rates relates to its variable-rate borrowings. As of August 31, 2009, all of the Company’s outstanding debt is subject to variable interest rates, which are generally set for one or three months. Under interest rate swap agreements with several banks, the Company has fixed its interest rates on U.S. dollar denominated term debt of $23.2 million at 4.18% and $5.8 million at 5.08%, plus the applicable margin under the Company’s credit facility. The market risk associated with a 100 basis point adverse change in interest rates at August 31, 2009 is approximately $0.7 million.

 

Foreign Currency Exchange Rates

 

The Company has U.S.-Australian dollar currency exchange rate risks due to debt borrowings denominated in Australian dollars. At August 31, 2009, the Company had $10.1 million of Australian dollar-denominated debt outstanding. The Company does not maintain any derivative instruments to mitigate the U.S.-Australian dollar currency exchange translation exposure. This position is reviewed periodically, and based on the Company’s review, may result in the incorporation of derivative instruments in the Company’s hedging strategy. At August 31, 2009, a

10% change in the Australian dollar foreign currency exchange rates compared with the U.S. dollar would increase or decrease reported debt balances by $1.0 million.

 

From time to time, Penford enters into foreign exchange forward contracts to manage exposure to payables denominated in currencies different from the U.S. dollar. At August 31, 2009 and 2008, Penford had no foreign exchange forward contracts outstanding.

 

Commodities

 

The availability and price of corn, Penford’s most significant raw material, is subject to fluctuations due to unpredictable factors such as weather, plantings, domestic and foreign governmental farm programs and policies, changes in global demand and the worldwide production of corn. To reduce the price risk caused by market fluctuations, Penford generally follows a policy of using exchange-traded futures and options contracts to hedge exposure to corn price fluctuations in North America. These futures and options contracts are designated as hedges. The changes in market value of these contracts have historically been, and are expected to continue to be, highly effective in offsetting the price changes in corn. A majority of the Company’s sales contracts for corn-based industrial starch ingredients contain a pricing methodology which allows the Company to pass-through the majority of the changes in the commodity price of net corn.

 

Penford’s net corn position in the U.S. consists primarily of inventories, purchase contracts and exchange-traded futures and options contracts that hedge Penford’s exposure to commodity price fluctuations. The fair value of the position is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2009 and 2008, the fair value of the Company’s net corn position was approximately $(1.5) million and $1.8 million, respectively. The market risk associated with a 10% adverse change in corn prices at August 31, 2009 and 2008 is approximately $149,000 and $180,000, respectively.

 

Prices for natural gas fluctuate due to anticipated changes in supply and demand and movement of prices of related or alternative fuels. To reduce the price risk caused by sudden market fluctuations, Penford generally enters into short-term purchase contracts or uses exchange-traded futures and options contracts to hedge exposure to natural gas price fluctuations. These futures and options contracts are designated as hedges. The changes in market value of these contracts have historically been, and are expected to continue to be, closely correlated with the price changes in natural gas.

 

Penford’s exchange traded futures and options contracts hedge production requirements. The fair value of these contracts is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2009 and 2008, the fair value of the natural gas exchange-traded futures and options contracts was a loss of approximately $1.3 million and a loss of approximately $1.2 million, respectively. The market risk associated with a 10% adverse change in natural gas prices at August 31, 2009 and 2008 is estimated at $130,000 and $123,000, respectively.

 

TABLE OF CONTENTS

 

 

 

The accompanying notes are an integral part of these statements.

 

 

The accompanying notes are an integral part of these statements.

 

 

The accompanying notes are an integral part of these statements.

 

 

The accompanying notes are an integral part of these statements.

 

 

The accompanying notes are an integral part of these statements.

 

 

Business

 

Penford Corporation (“Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for industrial and food ingredient applications and ethanol. Penford’s products provide convenient and cost-effective solutions derived from renewable sources. Sales of the Company’s products are generated using a combination of direct sales and distributor agreements.

 

The Company has extensive research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and in developing applications to address customer needs. In addition, the Company has specialty processing capabilities for a variety of modified starches.

 

Penford manages its business in two segments. The Industrial Ingredients and Food Ingredients segments, located in the U.S., are broad categories of end-market users. The Industrial Ingredients segment is a supplier of chemically modified specialty starches to the paper and packaging industries and a producer of ethanol. The Food Ingredients segment is a developer and manufacturer of specialty starches and dextrins to the food manufacturing and food service industries. See Note 18 for financial information regarding the Company’s business segments.

 

Basis of Presentation

 

The accompanying consolidated financial statements include the accounts of Penford and its wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated. Certain reclassifications have been made to prior years’ financial statements primarily related to discontinued operations in order to conform to the current year presentation.

 

Discontinued Operations

 

In August 2009, the Company committed to a plan to exit from the business conducted by the Company’s Australia/New Zealand Operations. On August 13, 2009, the Company announced that it had entered into a contract to sell Penford New Zealand Limited and on September 2, 2009, the Company completed that sale. The financial results of the Australia/New Zealand Operations have been classified as discontinued operations in the consolidated statement of operations for all periods presented. The assets and liabilities of this business are reflected as assets and liabilities of discontinued operations in the consolidated balance sheets for all periods presented. See Note 2 for additional information regarding discontinued operations. Unless otherwise indicated, amounts and discussions in these notes pertain to the Company’s continuing operations.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates are used in accounting for, among other things, the allowance for doubtful accounts, accruals, the determination of assumptions for pension and postretirement employee benefit costs, and the useful lives of property and equipment. Actual results may differ from previously estimated amounts.

 

Cash and Cash Equivalents

 

Cash and cash equivalents consist of cash and temporary investments with maturities of less than three months when purchased. Amounts are reported in the balance sheets at cost, which approximates fair value.

 

Allowance for Doubtful Accounts and Concentration of Credit Risk

 

The allowance for doubtful accounts reflects the Company’s best estimate of probable losses in the accounts receivable balances. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. Activity in the allowance for doubtful accounts for fiscal 2009, 2008 and 2007 is as follows (dollars in thousands):

 

 

In fiscal 2007, approximately $0.5 million was written off from the allowance for doubtful accounts related to an uncollectible receivable of bankrupt customer in the industrial ingredients segment.

 

Approximately 52%, 70% and 76% of the Company’s sales in fiscal 2009, 2008 and 2007, respectively, were made to customers who operate in the North American paper industry. This industry has suffered an economic downturn, which has resulted in the closure of a number of smaller mills.

 

Financial Instruments

 

The carrying value of financial instruments including cash and cash equivalents, receivables, payables and accrued liabilities approximates fair value because of their short maturities. The Company’s bank debt re-prices with changes in market interest rates and, accordingly, the carrying amount of such debt approximates fair value.

 

Inventories

 

Inventory is stated at the lower of cost or market. Inventory is valued using the first-in, first-out (“FIFO”) method, which approximates actual cost. Capitalized costs include materials, labor and manufacturing overhead related to the purchase and production of inventories.

 

Goodwill and Other Intangible Assets

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized, but instead is tested for impairment at least annually or more frequently if there is an indication of impairment.

 

Patents are amortized using the straight-line method over their estimated period of benefit. At August 31, 2009, the weighted average remaining amortization period for patents is seven years. Penford has no intangible assets with indefinite lives.

 

Property, Plant and Equipment