UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED May 31, 2011

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

Commission File No. 0-11488

PENFORD CORPORATION

(Exact name of registrant as specified in its charter)

Washington		91-1221360
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

7094 South Revere Parkway,
Centennial, Colorado		80112-3932
(Address of Principal Executive Offices)		(Zip Code)

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

Indicate by a check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer o		Accelerated Filer þ		Non-Accelerated Filer o		Smaller Reporting Company o
				(Do not check if a smaller reporting company)

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 net number of shares of the Registrant’s common stock outstanding as of July 5, 2011 was 11,346,601.

 

 

PENFORD CORPORATION AND SUBSIDIARIES

INDEX

		Page
PART I—FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets — May 31, 2011 and August 31, 2010			3
Condensed Consolidated Statements of Operations — Three and Nine Months ended May 31, 2011 and 2010			4
Condensed Consolidated Statements of Cash Flows — Nine Months ended May 31, 2011 and 2010			5
Notes to Condensed Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			20
Item 3. Quantitative and Qualitative Disclosures About Market Risk			25
Item 4. Controls and Procedures			25
PART II—OTHER INFORMATION
Item 1. Legal Proceedings			26
Item 1A. Risk Factors			26
Item 6. Exhibits			26
Signatures			27

PART I — FINANCIAL INFORMATION

Item 1:		Financial Statements

PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)		May 31, 2011				August 31, 2010
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	227			$	315
Trade accounts receivable, net			31,446				26,749
Inventories			27,026				19,849
Prepaid expenses			6,496				5,237
Income tax receivable			262				3,678
Other			7,044				5,287
Total current assets			72,501				61,115
Property, plant and equipment, net			107,841				111,930
Restricted cash value of life insurance			7,996				7,951
Deferred tax assets			15,222				16,493
Other assets			2,596				3,022
Goodwill, net			7,897				7,897
Total assets		$	214,053			$	208,408
Liabilities and Shareholders’ Equity
Current liabilities:
Cash overdraft, net		$	6,453			$	4,385
Current portion of long-term debt and capital lease obligations			429				429
Accounts payable			14,081				14,650
Accrued liabilities			8,274				6,536
Total current liabilities			29,237				26,000
Long-term debt and capital lease obligations			24,713				21,038
Redeemable preferred stock, Series A			37,725				34,104
Other postretirement benefits			17,373				16,891
Pension benefit liability			16,537				20,597
Other liabilities			6,782				6,206
Total liabilities			132,367				124,836
Shareholders’ equity:
Common stock, par value $1.00 per share, authorized 29,000 shares, issued 13,328 and 13,354 shares, respectively, including treasury shares			13,243				13,190
Preferred stock, Series B			100				100
Additional paid-in capital			102,815				102,303
Retained earnings			12,537				14,586
Treasury stock, at cost, 1,981 shares			(32,757	)			(32,757	)
Accumulated other comprehensive loss			(14,252	)			(13,850	)
Total shareholders’ equity			81,686				83,572
Total liabilities and shareholders’ equity		$	214,053			$	208,408

The accompanying notes are an integral part of these statements.

PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

		Three months ended								Nine months ended
		May 31,								May 31,
(In thousands, except per share data)		2011				2010				2011				2010
Sales		$	85,233			$	61,909			$	231,802			$	191,272
Cost of sales			74,815				58,644				205,285				171,317
Gross margin			10,418				3,265				26,517				19,955
Operating expenses			6,664				6,312				17,093				18,854
Research and development expenses			1,248				1,044				3,462				3,165
Income (loss) from operations			2,506				(4,091	)			5,962				(2,064	)
Interest expense			(2,380	)			(1,904	)			(6,953	)			(5,324	)
Other non-operating income (expense), net			(12	)			(2,606	)			77				(1,997	)
Income (loss) from continuing operations before income taxes			114				(8,601	)			(914	)			(9,385	)
Income tax expense (benefit)			823				(2,843	)			1,034				(2,882	)
Loss from continuing operations			(709	)			(5,758	)			(1,948	)			(6,503	)
Income (loss) from discontinued operations, net of tax			—				(218	)			—				16,312
Net income (loss)		$	(709	)		$	(5,976	)		$	(1,948	)		$	9,809
Weighted average common shares and equivalents outstanding, basic and diluted:			12,262				11,796				12,247				11,396
Earnings (loss) per common share, basic and diluted:
Loss per share from continuing operations		$	(0.06	)		$	(0.49	)		$	(0.16	)		$	(0.58	)
Earnings (loss) per share from discontinued operations		$	—			$	(0.02	)		$	—			$	1.43
Earnings (loss) per share		$	(0.06	)		$	(0.51	)		$	(0.16	)		$	0.85

The accompanying notes are an integral part of these statements.

PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

		Nine Months Ended
		May 31
(In thousands)		2011				2010
Cash flows from operating activities:
Net income (loss)		$	(1,948	)		$	9,809
Less: Income from discontinued operations			—				16,312
Net loss from continuing operations			(1,948	)			(6,503	)
Adjustments to reconcile net income (loss) from continuing operations to net cash provided by (used in) operations:
Depreciation and amortization			10,859				11,149
Non-cash interest on Series A Preferred Stock			2,861				900
Stock-based compensation			858				1,200
Deferred income tax expense (benefit)			929				(2,548	)
Non-cash gains on hedging transactions			(485	)			(659	)
Foreign currency transaction gain			—				(417	)
Loss on early extinguishment of debt			—				1,049
Other			—				(3	)
Changes in assets and liabilities:
Trade receivable			(4,734	)			4,170
Prepaid expenses			(1,259	)			(1,271	)
Inventories			(6,692	)			909
Decrease in margin accounts			(1,113	)			(474	)
Accounts payable and accrued liabilities			1,190				33
Income tax receivable			3,361				(372	)
Other			(4,046	)			2,397
Net cash flow provided by (used in) operating activities — continuing operations			(219	)			9,560
Cash flows from investing activities:
Acquisition of property, plant and equipment, net			(5,595	)			(4,342	)
Net proceeds received from sale of discontinued operations and other			(45	)			20,779
Net cash provided by (used in) investing activities — continuing operations			(5,640	)			16,437
Cash flows from financing activities:
Proceeds from revolving line of credit			31,000				23,200
Payments on revolving line of credit			(27,000	)			(51,833	)
Proceeds from issuance of long-term debt			—				2,000
Payments of long-term debt			(150	)			(45,942	)
Proceeds from issuance of preferred stock			—				40,000
Issuance costs of preferred stock			—				(1,995	)
Payments under capital lease obligation			(185	)			(182	)
Payment of loan fees			—				(1,227	)
Increase in cash overdraft			2,068				4,442
Other			38				—
Net cash provided by (used in) financing activities — continuing operations			5,771				(31,537	)
Cash flows from discontinued operations:
Net cash provided by operating activities			—				6,330
Net cash used in investing activities			—				(2,848	)
Net cash used in financing activities			—				(3,399	)
Effect of exchange rate changes on cash and cash equivalents			—				(353	)

		Nine Months Ended
		May 31
(In thousands)		2011				2010
Net cash used in discontinued operations			—				(270	)
Decrease in cash and cash equivalents			(88	)			(5,810	)
Cash and cash equivalents of continuing operations, beginning of period			315				5,540
Cash balance of discontinued operations, beginning of period			—				634
Cash and cash equivalents, end of period			227				364
Less: cash balance of discontinued operations, end of period			—				—
Cash and cash equivalents of continuing operations, end of period		$	227			$	364

The accompanying notes are an integral part of these statements.

PENFORD CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

     1—BUSINESS

     Penford Corporation (“Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for food and industrial applications, including fuel grade 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 significant research and development capabilities, which are used in applying 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: Industrial Ingredients and Food Ingredients. These segments are based on 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 fuel grade ethanol. The Food Ingredients segment is a developer and manufacturer of specialty starches and dextrin for the food manufacturing and food service industries. See Note 14 for financial information regarding the Company’s business segments.

Discontinued Operations

     In fiscal 2010, the Company sold the operating assets of its Australia/New Zealand Operations, which were previously reported in the consolidated financial statements as an operating segment.

     The financial results of the Australia/New Zealand Operations for the three- and nine-month periods of fiscal 2010 have been classified as discontinued operations in the condensed consolidated statements of operations. Australian administrative expenses for the three- and nine-month periods ended May 31, 2011 of $30,000 and $115,000, respectively, were included in income from continuing operations. The net assets of the Australia/New Zealand Operations as of May 31, 2011 and August 31, 2010 have been reported as assets and liabilities of the continuing operations in the condensed consolidated balance sheets. At May 31, 2011, the remaining net assets of the Australia/New Zealand Operations consist of $0.2 million of cash and $0.8 million of other net assets, primarily a receivable from the purchaser of one of the Company’s Australian manufacturing facilities. See Note 9 for additional information regarding discontinued operations. Unless otherwise indicated, amounts and discussions in these notes pertain to the Company’s continuing operations.

     2—BASIS OF PRESENTATION

     Consolidation

     The accompanying condensed consolidated financial statements include the accounts of Penford and its wholly owned subsidiaries. Intercompany accounts and transactions are eliminated in consolidation. The condensed consolidated balance sheet at May 31, 2011 and the condensed consolidated statements of operations and cash flows for the interim periods ended May 31, 2011 and May 31, 2010 have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly the financial information, have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles, have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The results of operations for interim periods are not necessarily indicative of the operating results of a full year or of future operations. Certain prior period amounts have been reclassified to conform to the current period presentation. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended August 31, 2010.

     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, stock-based compensation, the determination of assumptions for pension and postretirement employee benefit costs, the determination of assumptions for asset impairment assessments, useful lives of property and equipment and the valuation allowance for deferred tax assets. Actual results may differ from previously estimated amounts.

     3—INVENTORIES

     The components of inventory are as follows:

		May 31,				August 31,
		2011				2010
		(In thousands)
Raw materials		$	12,750			$	8,708
Work in progress			6,910				1,299
Finished goods			7,366				9,842
Total inventories		$	27,026			$	19,849

     4—PROPERTY, PLANT AND EQUIPMENT

     The components of property, plant and equipment are as follows:

		May 31,				August 31,
		2011				2010
		(In thousands)
Land		$	10,435			$	10,307
Plant and equipment			328,902				324,904
Construction in progress			5,304				4,272
			344,641				339,483
Accumulated depreciation			(236,800	)			(227,553	)
Net property, plant and equipment		$	107,841			$	111,930

     5—PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION

     On April 7, 2010, the Company issued $40 million of Series A 15% cumulative non-voting, non-convertible preferred stock (“Series A Preferred Stock”) and 100,000 shares of Series B voting convertible preferred stock (“Series B Preferred Stock”) in a private placement to Zell Credit Opportunities Master Fund, L.P., an investment fund managed by Equity Group Investments, a private investment firm (the “Investor”). The Company has 1,000,000 shares of authorized preferred stock, $1.00 par value, of which 200,000 shares are issued and outstanding at May 31, 2011 in two series as shown below.

		Shares Issued and
		Outstanding
Series A 15% Cumulative Non-Voting Non-Convertible Preferred Stock, redeemable			100,000
Series B Voting Convertible Preferred Stock			100,000

     The Company recorded the Series A Preferred Stock and the Series B Preferred Stock at their relative fair values at the time of issuance. The Series A Preferred Stock of $32.3 million was recorded as a long-term liability due to its mandatory redemption feature and the Series B Preferred Stock of $7.7 million was recorded as equity. The discount on

the Series A Preferred Stock is being amortized into income using the effective interest method over the contractual life of seven years. At May 31, 2011, the carrying value of the Series A Preferred Stock liability of $37.7 million includes $4.3 million of accrued dividends, and $1.2 million of discount accretion for the period from the date of issuance. The accrued dividends represent the 9% dividends that may be paid currently or accrued at the option of the Company. Dividends on the Series A Preferred Stock and the discount accretion are recorded as interest expense in the Condensed Consolidated Statements of Operations. During the nine-month period ended May 31, 2011, non-cash dividends of $2.9 million were recorded as interest expense.

     The holders of the Series A Preferred Stock are entitled to cash dividends of 6% on the sum of the outstanding Series A Preferred Stock plus accrued and unpaid dividends. In addition, dividends equal to 9% of the outstanding Series A Preferred Stock may accrue or be paid currently at the discretion of the Company. Dividends are payable quarterly.

     The Series A Preferred Stock is mandatorily redeemable on April 7, 2017 at a per share redemption price equal to the original issue price of $400 per share plus any accrued and unpaid dividends. At any time on or after April 7, 2012, the Company may redeem, in whole or in part, the shares of the Series A Preferred Stock at a per share redemption price of the original issue price plus any accrued and unpaid dividends.

     The Company may not declare or pay any dividends on its common stock or incur new indebtedness that exceeds a specified ratio without first obtaining approval from the holders of a majority of the Series A Preferred Stock.

     6—DEBT

     On April 7, 2010, the Company entered into a $60 million Third Amended and Restated Credit Agreement (the “2010 Agreement”) among the Company; Penford Products Co., a wholly-owned subsidiary of the Company; Bank of Montreal; Bank of America National Association; and Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A., “Rabobank Nederland” New York Branch.

     Under the 2010 Agreement, the Company may borrow $60 million under a revolving line of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. On May 31, 2011, the Company had $22.9 million outstanding under the 2010 Agreement, which is subject to variable interest rates. Under the 2010 Agreement, there are no scheduled principal payments prior to maturity on April 7, 2015. The Company’s obligations under the 2010 Agreement are secured by substantially all of the Company’s assets. Pursuant to the 2010 Agreement, the Company may not declare or pay dividends on, or make any other distributions in respect of, its common stock. The Company was in compliance with the covenants in the 2010 Agreement as of May 31, 2011.

     Interest rates under the 2010 Agreement are based on either the London Interbank Offered Rate (“LIBOR”) or the prime rate, depending on the selection of available borrowing options under the 2010 Agreement. The Company may choose a borrowing rate of 1-month, 3-month or 6-month LIBOR. Pursuant to the 2010 Agreement, the interest rate margin over LIBOR ranges between 3% and 4%, depending upon the Total Funded Debt Ratio (as defined). At May 31, 2011, the Company’s borrowing rate was 3.9%.

     During the first quarter of fiscal 2010, the Iowa Department of Economic Development (“IDED”) awarded financial assistance to the Company as a result of the temporary shutdown of the Cedar Rapids, Iowa plant in the fourth quarter of fiscal 2008 due to record flooding of the Cedar River. The IDED provided two five-year non interest bearing loans as follows: (1) a $1.0 million loan to be repaid in 60 equal monthly payments of $16,667 beginning December 1, 2009, and (2) a $1.0 million loan which is forgivable if the Company maintains certain levels of employment at the Cedar Rapids plant. At May 31, 2011, the Company had $1.7 million outstanding related to the IDED loans.

     7—INCOME TAXES

     For interim periods in fiscal 2010, the Company estimated the effective income tax rate expected to be applicable for the full fiscal year ended August 31, 2010 and used that rate to calculate income tax expense or benefit on year-to-date income or loss. In fiscal 2011, the amounts of expected permanent differences between book and taxable income resulted in significant variations in the customary relationship between pretax book income and income tax expense (benefit) in interim periods. A small change in the Company’s expected annual pretax income could result in a significant change in the annual expected effective tax rate. For the three- and nine-month periods ended May 31, 2011,

the Company used the year-to-date effective income tax rate. This rate is used to calculate income tax expense or benefit on current year-to-date pre-tax income or loss.

     In reviewing its effective tax rate, the Company uses estimates of the amounts of permanent differences between book and tax accounting. Adjustments to the Company’s estimated tax expense related to the prior fiscal year, amounts recorded to increase or decrease unrecognized tax benefits, changes in tax rates, and the effect of a change in the beginning-of-the-year valuation allowance are generally treated as discrete items and are recorded in the period in which they arise.

     Tax expense for the three-month period ended May 31, 2011 was $0.8 million on pre-tax income of $0.1 million. The difference between the recorded tax expense and the expected tax expense at the U.S. federal statutory rate was primarily due to federal and state income taxes on $1.9 million of non-deductible dividends and discount accretion on the Company’s Series A Preferred Stock.

     Tax expense for the nine-month period ended May 31, 2011 was $1.0 million on a pre-tax loss of $0.9 million. The difference between the recorded tax expense and the expected tax benefit at the U.S. federal statutory rate was due to federal and state income taxes on $5.7 million of non-deductible dividends and discount accretion on the Company’s Series A Preferred Stock, offset by a $0.9 million tax benefit associated with the tax credit for small ethanol producers and a $0.2 million tax credit related to research and development activities.

     The Company’s effective tax rates for the three- and nine-month periods ended May 31, 2010 were 33.1% and 30.7%, respectively. The difference between the effective tax rate and the U.S. federal statutory rate was primarily due to state income taxes offset by dividends and discount accretion on the preferred stock which are recorded as interest expense for financial reporting purposes but are not deductible in the computation of taxable income.

     At May 31, 2011, the Company had $16.9 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of May 31, 2011. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter. The Company believes that it is more likely than not that future operations and the reversal of existing taxable temporary differences will generate sufficient taxable income to realize its deferred tax assets. In addition, dividends on the Series A Preferred Stock, as well as accretion of the related discount, which are included in interest expense in the Condensed Consolidated Statements of Operations, are not deductible for U.S. federal income tax purposes. There can be no assurance that management’s current plans will be achieved or that a valuation allowance will not be required in the future.

     The Internal Revenue Code and applicable regulations contain provisions which may limit the net operating loss carryforwards available to be used in any given year upon the occurrence of certain events, including changes with respect to the Company’s capital stock that result in a cumulative ownership change of more than 50 percentage points by 5-percent stockholders over a three-year period. If changes to the Company’s ownership occur in the future, annual limitations may apply with respect to the Company’s ability to utilize its net operating loss carryforwards and certain current deductions against taxable income in future periods.

     In the nine months ended May 31, 2011, the amount of unrecognized tax benefits increased by less than $0.1 million. The total amount of unrecognized tax benefits at May 31, 2011 was $1.2 million, all of which, if recognized, would favorably impact the effective tax rate. At May 31, 2011, the Company had $0.2 million of accrued interest and penalties included in the long-term tax liability. The Company does not believe that the total amount of unrecognized tax benefits at May 31, 2011 will change materially in the next 12 months.

     In January 2011, the U.S. Internal Revenue Service (“IRS”) notified the Company that its tax refund of $3.5 million resulting from a carryback of tax losses from fiscal year 2009 to fiscal years 2006 and 2007 is being evaluated to determine whether the refund will be examined or accepted without examination.

     8—OTHER COMPREHENSIVE INCOME (LOSS) (“OCI”)

     The components of total comprehensive income (loss) are as follows:

		Three months ended								Nine months ended
		May 31,								May 31,
		2011				2010				2011				2010
						(In thousands)
Net income (loss)		$	(709	)		$	(5,976	)		$	(1,948	)		$	9,809
Foreign currency translation adjustments			—				—				—				930
Gain from foreign currency translation reclassified into earnings			—				—				—				(13,420	)
Net unrealized gain (loss) on derivative instruments that qualify as cash flow hedges, net of tax			2,378				318				(402	)			1,509
Total comprehensive income (loss)		$	1,669			$	(5,658	)		$	(2,350	)		$	(1,172	)

     The liquidation of the remaining net assets of Penford Australia was substantially completed in the second quarter of fiscal 2010 and, as a result, currency translation adjustments were reclassified from accumulated other comprehensive income into second quarter fiscal 2010 earnings. The accumulated derivative instrument losses, net of tax, included in OCI at August 31, 2010 and 2009 were $0.6 million and $2.3 million, respectively. The accumulated derivative instrument losses, net of tax, included in OCI at May 31, 2011 and 2010 were $1.0 million and $0.7 million, respectively.

     9 — DISCONTINUED OPERATIONS

     In the first quarter of fiscal 2010, the Company sold the assets of its Australia/New Zealand Operations, which were previously reported in the consolidated financial statements as an operating segment. Penford Australia completed the sale of the shares of its wholly-owned subsidiary, Penford New Zealand, on September 2, 2009. Proceeds from the sale, net of transaction costs, were $4.8 million. On November 27, 2009, Penford Australia completed the sale of substantially all of its operating assets, including property, plant and equipment, intellectual property, and inventories in two transactions to unrelated parties. Proceeds from the sales, net of estimated transaction costs, were $15.3 million.

     Proceeds from the Penford Australia asset sales included $2.0 million placed in escrow to be released in four equal installments. Two installments totaling $1.0 million were received as of May 31, 2011. The remaining two installments of $0.5 million each, which are subject to the buyer’s right to make warranty claims under the sale contract, are due in July 2011 and May 2012. While no assurances can be given that the buyer will not develop and submit valid warranty claims, Penford Australia currently expects that it will receive the proceeds from the escrow account as scheduled.

     10—STOCK-BASED COMPENSATION

     Stock Compensation Plans

     Penford maintains the 2006 Long-Term Incentive Plan (the “2006 Incentive Plan”) pursuant to which various stock-based awards may be granted to employees, directors and consultants. As of May 31, 2011, the aggregate number of shares of the Company’s common stock that were available to be issued as awards under the 2006 Incentive Plan was 21,767. In addition, any shares previously granted under the 1994 Stock Option Plan which are subsequently forfeited or not exercised will be available for future grants under the 2006 Incentive Plan. Non-qualified stock options granted under the 2006 Incentive Plan generally vest ratably for periods from one to four years and expire seven years from the date of grant.

     General Option Information

     A summary of the stock option activity for the nine months ended May 31, 2011, is as follows:

										Weighted
						Weighted				Average
		Number of				Average				Remaining				Aggregate
		Shares				Exercise Price				Term (in years)				Intrinsic Value
Outstanding Balance, August 31, 2010			1,264,564			$	15.07
Granted			98,000				6.59
Exercised			—				—
Cancelled			(17,551	)			13.02
Outstanding Balance, May 31, 2011			1,345,013				14.48				2.94			$	12,200
Options Exercisable at May 31, 2011			1,081,013			$	14.78				2.43			$	—

     Under the 2006 Incentive Plan, the Company granted 98,000 stock options during the first nine months of fiscal 2011, (i) 80,000 stock options which vest one year from the date of grant, and (ii) 18,000 stock options which vest ratably over four years. The Company estimated the fair value of stock options granted during the first nine months of fiscal 2011 using the following weighted-average assumptions and resulting in the following weighted-average grant date fair value:

Expected volatility			71	%
Expected life (years)			4.3
Interest rate			1.1-2.8	%
Weighted-average fair value		$	3.62

     The aggregate intrinsic value disclosed in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $5.82 as of May 31, 2011 that would have been received by the option holders had all option holders exercised on that date. No stock options were exercised during the nine months ended May 31, 2011.

     As of May 31, 2011, the Company had $0.4 million of unrecognized compensation cost related to non-vested stock option awards that is expected to be recognized over a weighted average period of 1.2 years.

     Restricted Stock Awards

     The grant date fair value of each share of the Company’s restricted stock awards is equal to the fair value of Penford’s common stock at the grant date. The following table summarizes the restricted stock award activity for the nine months ended May 31, 2011 as follows:

						Weighted
						Average
						Grant Date
		Number of Shares				Fair Value
Nonvested at August 31, 2010			154,707			$	15.67
Granted			—				—
Vested			(70,475	)			16.87
Cancelled			—				—
Nonvested at May 31, 2011			84,232			$	14.67

     As of May 31, 2011, the Company had $0.2 million of unrecognized compensation cost related to non-vested restricted stock awards that is expected to be recognized over a weighted average period of 1.1 years.

     Compensation Expense

     The Company recognizes stock-based compensation expense utilizing the accelerated multiple option approach over the requisite service period, which equals the vesting period. The following table summarizes the total stock-based compensation cost for the three and nine months ended May 31, 2011 and 2010 and the effect on the Company’s Condensed Consolidated Statements of Operations (in thousands):

		Three Months Ended								Nine Months Ended
		May 31,								May 31,
		2011				2010				2011				2010
Cost of sales		$	30			$	39			$	92			$	125
Operating expenses			204				374				739				1,053
Research and development expenses			8				7				27				22
Income (loss) from discontinued operations			—				—				—				(25	)
Total stock-based compensation expense		$	242			$	420			$	858			$	1,175
Income tax benefit			92				160				326				447
Total stock-based compensation expense, net of tax		$	150			$	260			$	532			$	728

     11—NON-OPERATING INCOME (LOSS), NET

     Non-operating income (loss), net consists of the following:

		Three months ended								Nine months ended
		May 31,								May 31,
		2011				2010				2011				2010
						(In thousands)
Loss on extinguishment of debt		$	—			$	(1,049	)		$	—			$	(1,049	)
Loss on interest rate swap termination							(1,562	)							(1,562	)
Gain on foreign currency transactions			—				—				—				417
Other			(12	)			5				77				197
Total		$	(12	)		$	(2,606	)		$	77			$	(1,997	)

     In the third quarter of fiscal 2010, the Company refinanced its bank debt. See Note 6. In connection with the refinancing, the Company recorded a pre-tax non-cash charge to earnings of approximately $1.0 million in the third quarter of fiscal 2010 related to unamortized transaction fees associated with the prior credit facility. In addition, the Company terminated its interest rate swap agreements with several banks and recorded a loss of approximately $1.6 million.

     During the nine months ended May 31, 2010, the Company recognized a gain on foreign currency transactions on Australian dollar denominated assets and liabilities as disclosed in the table above.

     12 — PENSION AND POST-RETIREMENT BENEFIT PLANS

     The components of the net periodic pension and post-retirement benefit costs for the three and nine months ended May 31, 2011 and 2010 are as follows:

		Three months ended								Nine months ended
		May 31,								May 31,
Defined benefit pension plans		2011				2010				2011				2010
						(In thousands)
Service cost		$	404			$	389			$	1,213			$	1,167
Interest cost			674				641				2,022				1,923
Expected return on plan assets			(558	)			(506	)			(1,676	)			(1,518	)
Amortization of prior service cost			57				61				171				183
Amortization of actuarial losses			360				304				1,081				912
Net periodic benefit cost		$	937			$	889			$	2,811			$	2,667

		Three months ended								Nine months ended
		May 31,								May 31,
Post-retirement health care plans		2011				2010				2011				2010
						(In thousands)
Service cost		$	68			$	88			$	204			$	264
Interest cost			243				269				729				807
Amortization of prior service cost			(38	)			(38	)			(114	)			(114	)
Amortization of actuarial losses			16				74				49				222
Net periodic benefit cost		$	289			$	393			$	868			$	1,179

     During the third quarter of fiscal 2011, the company contributed $4.4 million to the Company’s pension plans.

     13—FAIR VALUE MEASURMENTS AND DERIVATIVE INSTRUMENTS

     Fair Value Measurements

     Presented below are the fair values of the Company’s derivatives as of May 31, 2011 and August 31, 2010:

As of May 31, 2011		(Level 1)				(Level 2)				(Level 3)				Total
						(in thousands)
Current assets (Other Current Assets):
Commodity derivatives (1)		$	(732	)		$	—			$	—			$	(732	)

As of August 31, 2010		(Level 1)				(Level 2)		(Level 3)		Total
						(in thousands)
Current assets (Other Current Assets):
Commodity derivatives (1)		$	(2,789	)		$ —		$ —		$	(2,789	)

     The three levels of inputs that may be used to measure fair value are:

	•		Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.
	•		Level 2 inputs are other than quoted prices included within Level 1 that are observable for assets and liabilities such as (1) quoted prices for similar assets or liabilities in active markets, (2) quoted prices for identical or similar assets or liabilities in markets that are not active, or (3) inputs that are derived principally or corroborated by observable market date by correlation or other means.
	•		Level 3 inputs are unobservable inputs to the valuation methodology for the assets or liabilities.

     Other Financial Instruments

     The carrying value of cash and cash equivalents, receivables and payables approximates fair value because of their short maturities. The Company’s bank debt reprices with changes in market interest rates and, accordingly, the carrying amount of such debt approximates fair value.

     In fiscal 2010, the Company received two non-interest bearing loans from the State of Iowa totaling $2.0 million. The carrying value of the debt at May 31, 2011 was $1.7 million and the fair value of the debt was estimated to be $1.4 million. See Note 6.

     The fair value of the Series A Preferred Stock was determined using the market approach in comparing yields on similar debt securities. The discount on the Series A Preferred Stock is being amortized into income using the effective interest method over the contractual life of seven years. The carrying value of the Series A Preferred Stock at May 31, 2011 was $37.7 million and the estimated fair value was $40.5 million.

     Interest Rate Swap Agreements

     The Company used interest rate swaps to manage the variability of interest payments associated with its floating-rate debt obligations. The interest payable on the debt effectively became fixed at a certain rate and reduced the impact of future interest rate changes on future interest expense. Unrealized losses on interest rate swaps were included in accumulated other comprehensive income (loss). The periodic settlements on the swaps were recorded as interest expense. At May 31, 2011, the Company had no outstanding interest rate swaps and no gains or losses remaining in other comprehensive income (loss).

     Commodity Contracts

     The Company uses forward contracts and readily marketable exchange-traded futures on corn and natural gas to manage the price risk of those inputs to its manufacturing process. The Company has designated these instruments as hedges.

     For derivative instruments designated as fair value hedges, the gain or loss on the derivative instruments as well as the offsetting gain or loss on the hedged firm commitments and/or inventory are recognized in current earnings as a component of cost of sales. For derivative instruments designated as cash flow hedges, the effective portion of the gain or loss on the derivative instruments is reported as a component of other comprehensive income (loss), net of applicable income taxes, and recognized in earnings when the hedged exposure affects earnings. The Company recognizes the gain or loss on the derivative instrument as a component of cost of sales in the period when the finished goods produced from the hedged item are sold. If it is determined that the derivative instruments used are no longer effective at offsetting changes in the price of the hedged item, then the changes in fair value would be recognized in current earnings as a component of cost of goods sold.

     To reduce the price volatility of corn used in fulfilling some of its starch sales contracts, Penford from time to time uses readily marketable exchange-traded futures as well as forward cash corn purchases. The exchange-traded futures are not purchased or sold for trading or speculative purposes and are designated as hedges. The changes in fair value of such contracts have historically been, and are expected to continue to be, effective in offsetting the price changes of the hedged commodity. Penford also at times uses exchange-traded futures to hedge corn inventories and firm corn purchase contracts. Hedged transactions are generally expected to occur within 12 months of the time the hedge is established. The deferred gain (loss), net of tax, recorded in other comprehensive income at May 31, 2011 that is expected to be reclassified into income within 12 months is $(1.0) million.

     As of May 31, 2011, Penford had purchased corn positions of 11.1 million bushels, of which 4.6 million bushels represented equivalent firm priced starch and ethanol sales contract volume, resulting in an open position of 6.5 million bushels.

     As of May 31, 2011, the Company had the following outstanding futures contracts:

Corn Futures		1,460,000 Bushels
Natural Gas Futures		1,020,000 mmbtu (millions of British thermal units)
Ethanol Swaps		6,960,000 Gallons

     The following tables provide information about the fair values of the Company’s derivatives, by contract type, as of May 31, 2011 and August 31, 2010.

		Asset Derivatives												Liability Derivatives
						Fair Value												Fair Value
		Balance Sheet				May 31				Aug. 31				Balance Sheet				May 31				Aug. 31
In thousands		Location				2011				2010				Location				2011				2010
Cash Flow Hedges:
Corn Futures		Other Current Assets				$	180			$	—			Other Current Assets				$	—			$	—
Natural Gas Futures		Other Current Assets					7				—			Other Current Assets					51				1,082
Ethanol Gas Futures		Other Current Assets					—				—			Other Current Assets					784				—
Fair Value Hedges:
Corn Futures		Other Current Assets					4				28			Other Current Assets					88				1,735
Total Derivatives Designated as Hedging Instruments						$	191			$	28							$	923			$	2,817

     The following tables provide information about the effect of derivative instruments on the financial performance of the Company for the three- and nine-month periods ended May 31, 2011 and 2010.

										Amount of Gain (Loss)
		Amount of Gain (Loss)								Reclassified from								Amount of Gain (Loss)
		Recognized in OCI								AOCI into Income								Recognized in Income
		Quarter Ended May 31								Quarter Ended May 31								Quarter Ended May 31
In thousands		2011				2010				2011				2010				2011				2010
Cash Flow Hedges:
Corn Futures (1)		$	(601	)		$	40			$	(3,862	)		$	594			$	60			$	288
Natural Gas Futures (1)			415				(845	)			(249	)			(618	)			—				—
Ethanol Futures (1)			(596	)			—				(506	)			(75	)			—				—
Interest Rate Contracts(2)			—				61				—				(93	)			—				(1,562	)
		$	(782	)		$	(744	)		$	(4,617	)		$	(192	)		$	60			$	(1,274	)
Fair Value Hedges:
Corn Futures (1) (3)																		$	(6	)		$	(117	)

										Amount of Gain (Loss)
		Amount of Gain (Loss)								Reclassified from								Amount of Gain (Loss)
		Recognized in OCI								AOCI into Income								Recognized in Income
		9 Months Ended May 31								9 Months Ended May 31								9 Months Ended May 31
In thousands		2011				2010				2011				2010				2011				2010
Cash Flow Hedges:
Corn Futures (1)		$	(7,358	)		$	384			$	(6,125	)		$	1,690			$	85			$	113
Natural Gas Futures (1)			(135	)			(2,088	)			(1,305	)			(1,724	)			—				—
Ethanol Futures (1)			(910	)			(590	)			(323	)			(514	)			—				—
Interest Rate Contracts(2)			—				(395	)			—				(662	)			—				(1,562	)
FX Contracts (1)			—				—				—				(26	)			—				-
		$	(8,403	)		$	(2,689	)		$	(7,753	)		$	(1,236	)		$	85			$	(1,449	)
Fair Value Hedges:
Corn Futures (1) (3)																		$	(229	)		$	(56	)

     14—SEGMENT REPORTING

     Financial information from continuing operations for the Company’s two segments, Industrial Ingredients and Food Ingredients, is presented below. These segments serve broad categories of end-market users. The Industrial Ingredients segment provides carbohydrate-based starches for industrial applications, primarily in the paper and packaging products and ethanol industries. The Food Ingredients segment produces specialty starches for food applications. A third item for “corporate and other” activity has been presented to provide reconciliation to amounts reported in the consolidated financial statements. Corporate and other represents the activities related to the corporate headquarters such as public company reporting, personnel costs of the executive management team, corporate-wide professional services and consolidation entries.

		Three months ended								Nine months ended
		May 31,								May 31,
		2011				2010				2011				2010
		(In thousands)
Sales:
Industrial Ingredients
Industrial Starch		$	33,535			$	27,409			$	93,721			$	87,740
Ethanol			28,061				14,601				78,395				50,643
			61,596				42,010				172,116				138,383
Food Ingredients			23,637				19,899				59,686				52,889
		$	85,233			$	61,909			$	231,802			$	191,272
Income (loss) from operations:
Industrial Ingredients		$	(734	)		$	(6,847	)		$	(1,695	)		$	(6,414	)
Food Ingredients			5,517				5,018				13,902				11,447
Corporate and other			(2,277	)			(2,262	)			(6,245	)			(7,097	)
		$	2,506			$	(4,091	)		$	5,962			$	(2,064	)

		May 31,				August 31,
		2011				2010
		(In thousands)
Total assets:
Industrial Ingredients		$	140,909			$	133,738
Food Ingredients			40,479				36,542
Corporate and other			32,665				38,128
		$	214,053			$	208,408

     At May 31, 2011, the remaining net assets of the Australia/New Zealand Operations, consisting of $0.2 million of cash and $0.8 million of other net assets, have been reported as assets of the continuing operations in “Corporate and other.” All other assets are located in the United States.

     15—EARNINGS (LOSS) PER SHARE

     All outstanding unvested share-based payment awards that contain rights to non-forfeitable dividends participate in undistributed earnings with common shareholders and, therefore, are included in computing earnings per share under the two-class method. Under the two-class method, net earnings are reduced by the amount of dividends declared in the period for each class of common stock and participating security. The remaining undistributed earnings are then allocated to common stock and participating securities, based on their respective rights to receive dividends. Restricted stock awards granted to certain employees and directors under the Company’s 2006 Incentive Plan which contain non-forfeitable rights to dividends at the same rate as common stock, are considered participating securities.

     Basic earnings (loss) per share reflect only the weighted average common shares outstanding during the period. Diluted earnings (loss) per share reflect weighted average common shares outstanding and the effect of any dilutive common stock equivalent shares. Diluted earnings (loss) per share is calculated by dividing net income (loss) by the average common shares outstanding plus additional common shares that would have been outstanding assuming the exercise of in-the-money stock options, using the treasury stock method. The following table presents the reconciliation of income from continuing operations to income from continuing operations applicable to common shares and the computation of diluted weighted average shares outstanding for the three and nine months ended May 31, 2011 and 2010.

		Three months ended								Nine months ended
		May 31,								May 31,
		2011				2010				2011				2010
		(In thousands)								(In thousands)
Numerator:
Loss from continuing operations		$	(709	)		$	(5,758	)		$	(1,948	)		$	(6,503	)
Less: Allocation to participating securities			—				—				—				(110	)
Loss from continuing operations applicable to common shares		$	(709	)		$	(5,758	)		$	(1,948	)		$	(6,613	)
Income (loss) from discontinued operations		$	—			$	(218	)		$	—			$	16,312
Less: Allocation to participating securities			—				—				—				—
Income (loss) from discontinued operations applicable to common shares		$	—			$	(218	)		$	—			$	16,312
Net income (loss)		$	(709	)		$	(5,976	)		$	(1,948	)		$	9,809
Less: Allocation to participating securities			—				—				—				(110	)
Net income (loss) applicable to common shares		$	(709	)		$	(5,976	)		$	(1,948	)		$	9,699
Denominator:
Weighted average common shares outstanding, basic			12,262				11,796				12,247				11,396
Dilutive stock options and awards			—				—				—				—
Weighted average common shares outstanding, diluted			12,262				11,796				12,247				11,396

     For the three and nine months ended May 31, 2011, there were 84,232 and 102,852 weighted-average restricted stock awards excluded from the calculation of diluted earnings (loss) per share because they were antidilutive. Weighted-average restricted stock awards of 154,707 and 143,967 shares for the three and nine months ended May 31, 2010, were excluded from the calculation of diluted earnings (loss) per share because they were antidilutive. Weighted-average stock options to purchase 1,343,455 and 1,321,822 shares of common stock for the three and nine months ended May 31, 2011, were excluded from the calculation of diluted earnings (loss) per share because they were antidilutive. Weighted-average stock options to purchase 1,370,023 and 1,374,031 shares of common stock for the

three and nine months ended May 31, 2010, were excluded from the calculation of diluted earnings (loss) per share because they were antidilutive.

     On April 7, 2010, the Company issued 100,000 shares of its Series B voting convertible preferred stock. See Note 5 for further details. At any time prior to April 7, 2020, at the option of the holder, the outstanding Series B Preferred Stock may be converted into shares of the Company’s common stock at a conversion rate of ten shares of common stock per one share of Series B Preferred Stock, subject to adjustment in the event of stock dividends, distributions, splits, reclassifications and the like. If any shares of Series B Preferred Stock have not been converted into shares of common stock prior to April 7, 2020, the shares of Series B Preferred Stock will automatically convert into shares of common stock. The holders of the Series B Preferred Stock shall have the right to one vote for each share of common stock into which the Series B Preferred Stock is convertible. These shares are convertible into common shares for no cash consideration; therefore the weighted average shares are included in the computation of basic earnings per share.

     16—LEGAL PROCEEDINGS

     On or about June 2, 2011, the Company was notified by a customer that the customer had been informed that a lawsuit had been filed against the customer by T.F.H. Publications, Inc. (“TFH”) in the United States Court for the District of New Jersey alleging that certain dog chew products supplied to the customer by the Company’s subsidiary, Penford Products Co. (“Penford Products”), infringed upon a patent owned by TFH and may infringe upon two other patents owned by TFH. The customer has requested that Penford Products assume the defense of this lawsuit. The Company believes that the products supplied to its customer did not infringe upon any TFH patents and intends to vigorously defend the lawsuit. However, 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 upon information obtained from the Company’s outside legal counsel, the ultimate resolution of these other matters will not materially affect the consolidated financial position, results of operations or liquidity of the Company.

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

Overview

     Penford generates revenue, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for food and industrial applications, including fuel grade 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 and as an ingredient in fuel.

     Penford manages its business in two segments: Industrial Ingredients and Food Ingredients. These segments are based on broad categories of end-market users. See Note 14 to the Condensed Consolidated Financial Statements for additional information regarding the Company’s business segment operations.

     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.

     This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the Company’s condensed consolidated financial statements and the accompanying notes. The notes to the Condensed Consolidated Financial Statements referred to in this MD&A are included in Part I Item 1, “Financial Statements.”

Results of Operations

     Executive Overview

     Consolidated sales for the three months ended May 31, 2011 increased 37.7%, or $23.3 million, to $85.2 million compared with $61.9 million for the three months ended May 31, 2010. Consolidated sales in the first nine months of fiscal 2011 increased $40.5 million over last year to $231.8 million. Third quarter and year-to-date sales growth was driven by improvements in ethanol volumes and unit pricing. See the discussion by business segment below for details of changes in revenues.

     Consolidated income from operations for the third quarter of fiscal 2011 increased $6.6 million to $2.5 million from an operating loss of $4.1 million in the prior year third quarter. Consolidated gross margin increased $7.2 million as higher net corn costs were more than offset by favorable ethanol pricing and lower manufacturing costs. Operating expenses increased $0.4 million on higher employee costs and an increase in the accounts receivable reserve of $0.6 million in the industrial ingredients business, partially offset by lower professional fees.

     Consolidated income from operations for the nine months ended May 31, 2011 rose $8.0 million to $6.0 million from an operating loss of $2.0 million in the same period of the prior year. Consolidated gross margin expanded $6.6 million as improvements in ethanol volume and pricing more than offset higher net corn costs. Operating expenses improved $1.8 million on lower employee costs and professional fees.

     Interest expense increased for both the third quarter and the first nine months of fiscal 2011 from the same periods in fiscal 2010 primarily due to the higher dividend rate on the Company’s Series A Preferred Stock issued in April 2010 over the interest rate under the Company’s prior bank debt. The increase was also due to the accretion of the discount on the Series A Preferred Stock since its issuance.

     The Company’s income tax expense for the third quarter of fiscal 2011 was $0.8 million on $0.1 million of pre-tax income. Income tax expense for the nine months ended May 31, 2011 was $1.0 million on a pre-tax loss of $0.9 million. The difference between the recorded income tax expense and the expected income tax expense or benefit based on the U.S. federal statutory rate is due to the non-deductibility of the dividends on the Company’s Series A Preferred Stock which are reported as interest expense in the Condensed Consolidated Statements of Operations. See the “Income taxes” section below.

     Industrial Ingredients

     Third quarter fiscal 2011 sales at the Company’s Industrial Ingredients business unit increased $19.6 million, or 46.6%, to $61.6 million from $42.0 million in the third quarter of fiscal 2010. Industrial starch sales of $33.5 million for the quarter ended May 31, 2011 grew $6.1 million from a year ago on an increase in average unit pricing, which included the effect of an increase in the cost of corn which is passed through to customers, partially offset by a 12% decline in sales volume. Sales of specialty starches, included in the industrial starch sales amount, expanded 33% on increases in both volume and average unit pricing. Sales of ethanol increased 92% from $14.6 million in the third quarter of fiscal 2010 to $28.1 million in the third quarter of fiscal 2011. Both sales volume and average unit pricing of ethanol rose at double-digit rates over the prior year quarter.

     Industrial Ingredients sales for the first nine months of fiscal 2011 increased 24.4% to $172.1 million from $138.4 million in the same period of fiscal 2010. Industrial starch sales rose 7% to $93.7 million in fiscal 2011 from $87.7 million a year ago primarily on favorable average unit pricing, which included the pass-through of higher corn costs to customers during the period. Sales of specialty starches, included in the industrial starch sales amount, for the nine months ended May 31, 2011 grew 22% resulting from favorable changes in both volume and average unit pricing. Ethanol sales expanded 55% to $78.4 million from $50.6 million a year ago on a 13% increase in volume and pricing improvements of 37%.

     The Industrial Ingredients business unit reported a loss from operations for the third quarter of fiscal 2011 of $0.7 million compared to an operating loss of $6.8 million for the third quarter of fiscal 2010. Gross margin improved by $6.5 million on higher ethanol pricing of $11.3 million, favorable industrial starch and product mix improvements of $1.5 million, and higher manufacturing yields and lower natural gas and distribution costs of $1.6 million. Higher net corn costs decreased gross margin by $7.9 million. Manufacturing volumes were comparable to last year. Operating expenses increased primarily due to a $0.6 million increase in the accounts receivable reserve related to a paper industry customer, partially offset by lower professional fees.

     The Industrial Ingredients business reported a loss from operations of $1.7 million for the nine months ended May 31, 2011 compared to an operating loss of $6.4 million for the same period of fiscal 2010. Gross margin improved $4.6 million due to higher ethanol pricing of $20.7 million, the effect of volume increases of $1.0 million and improvements in distribution and manufacturing yields and costs of $3.3 million. Unfavorable industrial starch pricing of $2.9 million and higher net corn costs of $17.5 million offset the above gains in pricing and manufacturing. Operating expenses for the nine-month period ended May 31, 2011 declined by $0.3 million on a $1.0 million decline in professional fees, partially offset by a year-to-date increase in the accounts receivable reserve of $0.7 million.

     Food Ingredients

     Fiscal 2011 third quarter sales for the Food Ingredients segment of $23.6 million increased 18.8%, or $3.7 million, over the third quarter of fiscal 2010. Sales for the first nine months of fiscal 2011 of $59.7 million increased 12.9%, or $6.8 million, from a year ago. Sales of applications to growth end markets, including the dairy, pet and bakery markets, grew 50% and 32% for the third quarter and the first nine months of fiscal 2011, respectively, on both volume and pricing improvements. Growth end markets contributed 46% of the revenue for the third quarter of fiscal 2011 and 44% of revenue year-to-date. Coating application sales declined 19% and 12% for the three- and nine-month periods ended May 31, 2011, primarily due to decreased volume.

     Operating income for the third quarter of fiscal 2011 increased 10% to $5.5 million from $5.0 million a year ago due to the impact of higher revenues of $1.0 million, partially offset by higher raw material costs of $0.4 million, and higher operating expenses of $0.1 million. Income from operations for the first nine months of fiscal 2011 increased $2.5 million, or 21.4%, to $13.9 million due to an improvement in gross margin of $2.0 million and a decrease in operating expenses of $0.6 million. Gross margin improved 11.1% in the first nine months of fiscal 2011 to $19.5 million on the impact of higher revenues. Operating expenses declined due to the collection of a receivable in the first quarter of fiscal 2011 and lower professional fees.

     Corporate operating expenses

     Corporate operating expenses for the third quarter of fiscal 2011 were comparable to the prior year period. Corporate operating expenses for the nine months ended May 31, 2011 decreased $1.0 million to $6.1 million from $7.1 million a year ago, primarily due to lower employee costs.

     Interest expense

     Interest expense for the three- and nine-month periods ended May 31, 2011 increased $0.5 million and $1.6 million, respectively, compared to the same periods last year, primarily due to the higher dividend rate under the Company’s Series A Preferred Stock issued in April 2010 over the interest rate under the Company’s prior bank debt. The increase was also due to the accretion of the discount on the Series A Preferred Stock. See Notes 5 and 6 to the Condensed Consolidated Financial Statements.

     Income taxes

     For interim periods in fiscal 2010, the Company estimated the effective income tax rate expected to be applicable for the full fiscal year ended August 31, 2010 and used that rate to calculate income tax expense or benefit on year-to-date income or loss. In fiscal 2011, the amounts of expected permanent differences between book and taxable income resulted in significant variations in the customary relationship between pretax book income and income tax expense (benefit) in interim periods. A small change in the Company’s expected annual pretax income could result in a significant change in the annual expected effective tax rate. For the three- and nine-month periods ended May 31, 2011, the Company used the year-to-date effective income tax rate. This rate is used to calculate income tax expense or benefit on current year-to-date pre-tax income or loss.

     In reviewing its effective tax rate, the Company uses estimates of the amounts of permanent differences between book and tax accounting. Adjustments to the Company’s estimated tax expense related to the prior fiscal year, amounts recorded to increase or decrease unrecognized tax benefits, changes in tax rates, and the effect of a change in the beginning-of-the-year valuation allowance are generally treated as discrete items and are recorded in the period in which they arise.

     Tax expense for the three-month period ended May 31, 2011 was $0.8 million on pre-tax income of $0.1 million. The difference between the recorded tax expense and the expected tax expense at the U.S. federal statutory rate was primarily due to federal and state income taxes on $1.9 million of non-deductible dividends and discount accretion on the Company’s Series A Preferred Stock.

     Tax expense for the nine-month period ended May 31, 2011 was $1.0 million on a pre-tax loss of $0.9 million. The difference between the recorded tax expense and the expected tax benefit at the U.S. federal statutory rate was due to federal and state income taxes on $5.7 million of non-deductible dividends and discount accretion on the Company’s Series A Preferred Stock, offset by a $0.9 million tax benefit associated with the tax credit for small ethanol producers and a $0.2 million tax credit related to research and development activities.

     The Company’s effective tax rates for the three- and nine-month periods ended May 31, 2010 were 33.1% and 30.7%, respectively. The difference between the effective tax rate and the U.S. federal statutory rate was primarily due to state income taxes offset by dividends and discount accretion on the preferred stock which are recorded as interest expense for financial reporting purposes but are not deductible in the computation of taxable income.

     At May 31, 2011, the Company had $16.9 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of May 31, 2011. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter. The Company believes that it is more likely than not that future operations and the reversal of existing taxable temporary differences will generate sufficient taxable income to realize its deferred tax assets. In addition, dividends on the Series A Preferred Stock, as well as accretion of the related discount, which are included in interest expense in the Condensed Consolidated Statements of Operations, are not deductible for U.S. federal income tax purposes. There can be no assurance that management’s current plans will be achieved or that a valuation allowance will not be required in the future.

     The Internal Revenue Code and applicable regulations contain provisions which may limit the net operating loss carryforwards available to be used in any given year upon the occurrence of certain events, including changes with respect to the Company’s capital stock that result in a cumulative ownership change of more than 50 percentage points by 5-percent stockholders over a three-year period. If changes to the Company’s ownership occur in the future, annual limitations may apply with respect to the Company’s ability to utilize its net operating loss carryforwards and certain current deductions against taxable income in future periods.

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.

     Operating Activities

     Cash used in operations was $0.2 million for the nine months ended May 31, 2011 compared with cash provided by operating activities of $9.6 million for the same period last year. The decline in operating cash flow was primarily due to an increase in working capital requirements. Working capital used $13.3 million of cash during the nine months ended May 31, 2011 compared to cash contributed by working capital of $5.4 million during the first nine months of fiscal 2010. Changes in cash working capital requirements were due to (1) increases in inventories and accounts receivable due to higher sales as well as the higher cost of corn and (2) a $4.4 million contribution to the Company’s pension plans in the third quarter of fiscal 2011.

     Investing Activities

     As of May 31, 2011, capital expenditures were $5.6 million, which were primarily for growth and productivity projects. The Company expects total capital expenditures for fiscal 2011 to be approximately $10 million. Repayments of intercompany loans by the Company’s Australian discontinued operations in fiscal 2010 are reflected as cash provided by investing activities.

     Financing Activities

     In April 2010, the Company issued $40 million of preferred stock and also entered into a $60 million Third Amended and Restated Credit Agreement (the “2010 Agreement”). See Notes 5 and 6 to the Condensed Consolidated Financial Statements for details of the refinancing and preferred stock issuance.

     Under the 2010 Agreement, the Company may borrow $60 million under a revolving line of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. At May 31, 2011, the Company had $22.9 million outstanding under its revolving credit facility. Pursuant to the 2010 Agreement, there are no scheduled principal payments prior to maturity of the 2010 Agreement on April 7, 2015. As of May 31, 2011, all of the Company’s outstanding bank debt was subject to variable interest rates.

     At May 31, 2011, the carrying value of the Series A Preferred Stock liability of $37.7 million includes $4.3 million of accrued dividends and $1.2 million of discount accretion for the period from the date of issuance to May 31, 2011. The accrued dividends represent dividends at the rate of 9% that may be paid or accrued at the option of the Company. Dividends on the Series A Preferred Stock and the discount accretion are recorded as interest expense in the Condensed Consolidated Statements of Operations.

     The Company may not declare or pay any dividends on its common stock without first obtaining approval from the holders of a majority of the Series A Preferred Stock. The holders of the Series A Preferred Stock are entitled to cash dividends of 6% on the sum of the outstanding Series A Preferred Stock plus accrued and unpaid dividends. In addition, dividends equal to 9% of the outstanding Series A Preferred Stock may be accrued or paid in cash currently at the discretion of the Company.

Contractual Obligations

     The Company is a party to various debt and lease agreements at May 31, 2011 that contractually commit the Company to pay certain amounts in the future. The Company also has open purchase orders entered into in the ordinary course of business for raw materials, capital projects and other items, for which significant terms have been confirmed. As of May 31, 2011, there have been no material changes in the Company’s contractual obligations since August 31, 2010, except for expected contributions to the Company’s pension plans for fiscal 2011. The Company expects to contribute $6.1 million during fiscal 2011, of which $5.4 million has been contributed as of July 5, 2011.

Off-Balance Sheet Arrangements

     The Company had no off-balance sheet arrangements at May 31, 2011.

Critical Accounting Policies and 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. Note 1 to the Consolidated Financial Statements in the Annual Report on Form 10-K for the fiscal year ended August 31, 2010 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. 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.

Forward-looking Statements

     This Quarterly Report on Form 10-Q (“Quarterly Report”), including but not limited to statements found in the Notes to Condensed Consolidated Financial Statements and in Item 2 — 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. Readers are cautioned not to place undue reliance on these forward-looking statements which are based on information available as of the date of this report. The Company does not undertake any obligation to publicly update or revise any forward-looking statements to reflect future events, information or circumstances that arise after the date of the filing of this Quarterly Report. Among the factors that could cause actual results to differ materially are the risks and uncertainties discussed in this Quarterly Report, including those referenced in Part II Item 1A of this Quarterly Report, and those described from time to time in other filings made with the Securities and Exchange Commission, including the Company’s Annual Report on Form 10-K for the year ended August 31, 2010, which include but are not limited to:

	•		competition;
	•		the possibility of interruption of business activities due to equipment problems, accidents, strikes, weather or other factors;
	•		product development risk;
	•		changes in corn and other raw material prices and availability;

	•		changes in general economic conditions or developments with respect to specific industries or customers affecting demand for the Company’s products including unfavorable shifts in product mix;
	•		unanticipated costs, expenses or third-party claims;
	•		the risk that results may be affected by construction delays, cost overruns, technical difficulties, nonperformance by contractors or changes in capital improvement project requirements or specifications;
	•		interest rate, chemical and energy cost volatility;
	•		changes in returns on pension plan assets and/or assumptions used for determining employee benefit expense and obligations;
	•		other unforeseen developments in the industries in which Penford operates,
	•		the Company’s ability to successfully operate under and comply with the terms of its debt instruments;
	•		other factors described in the Company’s Form 10-K Part I, Item 1A “Risk Factors.”

     Item 3: Quantitative and Qualitative Disclosures about Market Risk.

     The Company is exposed to market risks from adverse changes in interest rates and commodity prices. There have been no material changes in the Company’s exposure to market risks from the disclosure in the Company’s Annual Report on Form 10-K for the year ended August 31, 2010.

     Item 4: Controls and Procedures.

     Evaluation of Disclosure Controls and Procedures

     The Company maintains disclosure controls and procedures that are designed to ensure that material information required to be disclosed in the Company’s periodic reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. The Company’s disclosure controls and procedures are also designed to ensure that information required to be disclosed in the reports the Company files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

     Under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of May 31, 2011. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective as of May 31, 2011.

     Changes in Internal Control over Financial Reporting

     There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended May 31, 2011 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II — OTHER INFORMATION

     Item 1: Legal Proceedings

     On or about June 2, 2011, the Company was notified by a customer that the customer had been informed that a lawsuit had been filed against the customer by T.F.H. Publications, Inc. (“TFH”) in the United States Court for the District of New Jersey alleging that certain dog chew products supplied to the customer by the Company’s subsidiary, Penford Products Co. (“Penford Products”), infringed upon a patent owned by TFH and may infringe upon two other patents owned by TFH. The customer has requested that Penford Products assume the defense of this lawsuit. The Company believes that the products supplied to its customer did not infringe upon any TFH patents and intends to vigorously defend the lawsuit. However, 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 upon information obtained from the Company’s outside legal counsel, the ultimate resolution of these other matters will not materially affect the consolidated financial position, results of operations or liquidity of the Company.

     Item 1A: Risk Factors

     The information set forth in this report should be read in conjunction with the risk factors discussed in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended August 31, 2010. These risks could materially impact the Company’s business, financial condition and/or future results. The risks described in the Annual Report on Form 10-K and in this Item IA are not the only risks facing the Company. Additional risks and uncertainties not currently known by the Company or that the Company currently deems to be immaterial also may materially adversely affect the Company’s business, financial condition and/or operating results.

     Item 6: Exhibits.

     (d) Exhibits

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32		Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

EXHIBIT INDEX

Exhibit No.		Description
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32		Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002