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 26, 2010, the last business day of the Registrant’s second quarter of fiscal 2010, was approximately $121.0 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, 2010 was 11,363,272.

 

Documents Incorporated by Reference

 

Portions of the Registrant’s definitive Proxy Statement relating to the 2011 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.

 

 

PENFORD CORPORATION
FISCAL YEAR 2010 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

 

 

 

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

 

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, Industrial Ingredients and Food Ingredients. Each of the Company’s businesses utilizes the Company’s carbohydrate chemistry expertise to develop starch-based ingredients for value-added applications that improve the quality and performance of customers’ products. Financial information about Penford’s segments and geographic areas is included in Note 19 to the Consolidated Financial Statements. Additional information on Penford’s two business segments follows:

 

 

The Company’s Industrial Ingredients segment also produces and sells fuel grade ethanol from its facility in Cedar Rapids, Iowa. Ethanol production gives 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 2010, 2009 and 2008 were 37%, 29% and 3%, respectively, of this segment’s reported revenue.

 

In June 2008, the Company’s Cedar Rapids, Iowa plant 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

 

In August 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. As a result of this determination, on September 2, 2009, the Company completed the sale of its subsidiary company, Penford New Zealand Limited (“Penford New Zealand”), and on November 27, 2009, the Company completed the sale of the operating assets of another subsidiary company, Penford Australia Limited (“Penford Australia”), including its two remaining Australian plants.

 

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 through Penford New Zealand. Until November 27, 2009, the Company operated a corn wet milling facility in Lane Cove, Australia and a wheat starch manufacturing facility in Tamworth, Australia through Penford Australia.

 

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 Financial Accounting Standards Board Accounting Standards Codification 205-10, “Presentation of Financial Statements — Discontinued Operations” (“ASC 205-10”). 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 indicated, all amounts, analyses and discussions in this Annual Report on Form 10-K pertain to the Company’s 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 costs 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 $4.4 million, $4.3 million and $5.7 million for fiscal years 2010, 2009 and 2008, respectively.

 

At the end of fiscal 2010, Penford had 23 scientists, including six with a Ph.D. degree with expert knowledge of carbohydrate characteristics and chemistry.

 

Patents, Trademarks and Trade Names

 

Penford owns a number of patents, trademarks and trade names. The Company has approximately 58 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 2027. The annual cost to maintain all of the Company’s patents is not significant. 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 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 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 30-45 day terms except for trade receivables for export sales.

 

Environmental Matters

 

Penford’s operations are governed by various federal, state, and local environmental laws and regulations. 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 $1.1 million.

Penford has adopted and implemented a comprehensive corporate-wide environmental management program. The program is managed and 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 2010, compliance with environmental regulations did not have a material impact on the Company’s operations. No unusual expenditures for environmental facilities and programs are anticipated in fiscal 2011.

 

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 27%, 21% and 2% of the Company’s net sales for fiscal years 2010, 2009 and 2008, respectively. 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 8%, 11% and 15% of the Company’s net sales for fiscal years 2010, 2009 and 2008, respectively. Domtar, Inc. and Eco-Energy are customers of the Company’s Industrial Ingredients 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 grade 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, 2010, Penford had 330 employees, of which approximately 40% 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 9%, 8% and 11% of total sales in fiscal 2010, 2009 and 2008, respectively. See Note 19 to the Consolidated Financial Statements for sales by country to which the product was shipped.

 

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. 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 2010, approximately 40% 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 12% and 11%, respectively, of the cost of manufacturing the Company’s products in fiscal 2010. 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 27%, 21% and 2% of the Company’s net sales for fiscal years 2010, 2009 and 2008, respectively. 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 8%, 11% and 15% of the Company’s net sales for fiscal years 2010, 2009 and 2008, respectively. Sales to the top ten customers represented 65%, 69% and 62% of net sales for fiscal years 2010, 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.

 

As of August 31, 2010, approximately $18.9 million of its outstanding debt was subject to variable interest rates which move in direct relation to the 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 federal and various state jurisdictions in the United States. The Company’s effective tax rates could be adversely affected by changes in the mix of earnings in tax jurisdictions 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 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.

 

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 $2.3 million to its pension plans during fiscal 2011.

 

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. An 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. 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 the continuing 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 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, 2010, approximately 40% of the Company’s 330 employees were members of a trade union. Although the Company’s relations with the relevant union 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.

 

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 2010, the stock price ranged from a low of $4.83 on August 31, 2010 to a high of $12.15 on January 19, 2010. 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.

 

 

None.

 

 

Penford’s facilities as of August 31, 2010 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.

 

 

As previously reported, the Company filed suit on January 23, 2009, 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, owned by American International Group, Inc. (“AIG”), and ACE American Insurance Company (“ACE”), related to insurance coverage arising out of the flood that struck the Company’s Cedar Rapids, Iowa plant in June 2008. On January 19, 2010, the presiding judge ruled that flood coverage language contained in the applicable insurance policy was “ambiguous” and that, accordingly, the interpretation of the policy was “a question of fact reserved for a jury.” A jury trial was subsequently conducted in Cedar Rapids during mid-August 2010. After seven days of trial, the presiding judge dismissed the Company’s claims without issuing a written opinion. On September 14, 2010, the Company filed a notice of appeal with the United States Court of Appeals for the Eighth Circuit (the “Eighth Circuit”). On October 4, 2010, the Company filed a Statement of Issues with the Eighth Circuit in which it noted its intention to present for appellate review whether, among other things, the presiding judge erred in dismissing the Company’s suit. Through its appeal, the Company will continue its effort to seek additional payments from AIG and ACE for approximately $25 million for business interruption losses that occurred as a result of the flood. The Company expects the current appeal process to last through mid-2011. The Company cannot at this time determine the likelihood of any outcome of its appeal or estimate the amount of any judgment that might be awarded.

 

In October 2004, Penford Products Co. (“Penford Products”), a wholly-owned subsidiary of the Company, was sued by a customer in the Fourth Judicial District Court, Ouachita Parish, Louisiana. The customer sought monetary damages for Penford Products’ alleged breach of an agreement to supply the customer with certain starch products during the 2004 strike affecting Penford Products’ Cedar Rapids, Iowa plant. In May 2008, the trial judge ruled against Penford Products. In fiscal year 2008, the Company elected to satisfy the judgment and waive appeal rights by paying the customer approximately $3.8 million. The Company had previously reserved $2.4 million against this matter in fiscal year 2007.

 

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 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.

 

 

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, 2010, there were 440 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, the Board of Directors declared a $0.06 per share cash dividend.

 

In April 2009, the Board of Directors suspended payment of dividends. 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. See Note 7 to the Consolidated Financial Statements for further details. During fiscal year 2009, the Company declared dividends on its common stock of $1.4 million.

 

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, 2005 to August 31, 2010) 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, 2005 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, 2005
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING AUGUST 31, 2010

 

 

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, 2010. 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.

 

 

 

 

 

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.

 

Overview

 

Penford generates revenues, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for industrial and food applications and by producing and selling 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.

 

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 and Food Ingredients are broad categories of end-market users, served by operations in the United States. See Item 1 and Note 19 to the Consolidated Financial Statements for additional information regarding the Company’s business segment operations.

 

Recapitalization

 

On April 7, 2010, the Company sold $40 million of its Series A Preferred Stock in a private placement and, on April 8, 2010, used the proceeds to pay a portion of the outstanding bank debt obligations under its credit facility. Also 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.; 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 in revolving lines of credit and there are no scheduled principal payments prior to maturity on April 7, 2015. See Notes 7 and 8 to the Consolidated Financial Statements for details of the refinancing and preferred stock issuance.

 

In connection with the refinancing, the Company recorded a pre-tax non-cash charge to earnings of $1.0 million related to unamortized transaction fees associated with the prior credit facility. The Company also terminated its interest rate swaps and recorded a charge to earnings of $1.6 million related to amounts recorded in

other comprehensive income for the interest rate swaps. See Notes 7 and 8 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 made upon completion of a process involving the examination of a range of strategic and operating choices for the Company’s Australia/New Zealand Operations. The process was undertaken 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 27, 2009, the Company’s Australian operating subsidiary, Penford Australia Limited, completed the sale of substantially all of its operating assets to two unrelated parties.

 

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 the Accounting Standards Codification 205-10, “Presentation of Financial Statements — Discontinued Operations” (“ASC 205-10”). Accordingly, 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. At August 31, 2010, the remaining net assets of the Australia/New Zealand Operations, consisting of $0.3 million of cash and $1.3 million of other net assets, primarily a receivable from the purchaser of one of the Company’s Australian manufacturing facilities, have been reported as assets of the continuing operations of the Company.

 

Impact of Cedar River Flooding

 

On June 12, 2008, the Company’s Industrial Ingredients 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 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 21 to the Consolidated Financial Statements for additional information regarding this lawsuit.

 

Consolidated Results of Operations

 

Consolidated fiscal 2010 sales were comparable to the prior year, decreasing less than one percent to $254.3 million. Volume improvements in both the industrial ingredients and food ingredients businesses were offset by unfavorable pricing and product mix. Although average unit pricing for ethanol improved during fiscal 2010, the market for industrial starch remained highly price competitive.

 

Fiscal 2010 consolidated gross margin increased to $23.5 million, or 9.2% of sales, from $12.3 million, or 4.8% of sales, in fiscal 2009. Consolidated gross margin expanded primarily due to improvements in gross margin at the Industrial Ingredients business through increased volumes, favorable ethanol pricing and improved manufacturing yields and efficiencies. Consolidated operating loss was $4.9 million in fiscal 2010 compared to an operating loss of $6.4 million in fiscal 2009. The fiscal 2009 operating loss included $9.1 million of net insurance recoveries. The reduction in the operating loss in fiscal 2010 is due to the improvement in gross margin.

Interest expense in fiscal 2010 was $7.5 million compared with $5.6 million in fiscal 2009. Interest expense increased in fiscal 2010 due to the increase in the dividend rate on the Series A Preferred Stock issued in April 2010 over the interest rate for the Company’s bank debt plus the accretion of the discount on the Series A Preferred Stock.

 

The effective tax rate for fiscal 2010 was 33%. In fiscal 2010, the effective tax rate was lower than the U.S. federal statutory rate of 35% primarily due to federal tax incentives for the production of ethanol offset by nondeductible dividends, discount accretion on the Company’s preferred stock, and the effect of state taxes. See Note 17 to the Consolidated Financial Statements.

 

Accounting Changes

 

In December 2008, the Financial Accounting Standards Board (“FASB”) issued new authoritative guidance regarding employer disclosures about postretirement benefit plan assets. The new guidance requires an employer to disclose information regarding its investment policies and strategies for its categories of plan assets, its fair value measurements of plan assets and any significant concentrations of risk in plan assets. The new guidance, which was effective September 1, 2009 for the Company, only requires the revised annual disclosures on a prospective basis. See Note 13 to the Consolidated Financial Statements for the additional disclosures.

 

In June 2008, the FASB issued new authoritative guidance for determining 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 pursuant to the two-class method. The Company adopted the new guidance in the first quarter of fiscal 2010 and was required to retrospectively adjust all prior-period earnings per share data. The resulting impact of the adoption of the new guidance was to include unvested restricted shares in the computation of basic earnings per share pursuant to the two-class method which did not have a material impact on the Company’s earnings per share for the years ending August 31, 2010, 2009 and 2008. See Note 18 to the Consolidated Financial Statements.

 

In February 2008, the FASB issued new authoritative guidance delaying the portions of Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures,” which required fair value measurements for non-recurring, nonfinancial assets and liabilities that are recognized or disclosed at fair value until the Company’s fiscal year 2010. The adoption of this guidance on September 1, 2009 had no effect on the Company’s financial position or results of operations. See Note 15 to the Consolidated Financial Statements.

 

Results of Operations

 

Fiscal 2010 Compared to Fiscal 2009

 

Industrial Ingredients

 

 

Industrial Ingredients fiscal 2010 sales of $184.0 million declined $2.5 million, or 1.3%, from fiscal 2009. Industrial starch sales of $115.7 million declined 12% from fiscal 2009 sales of $131.7 million on competitive pricing and lower pass through of corn costs to customers, offset by volume increases of 5%. The industrial starch business continued to be impacted by weak demand for printing and writing paper products. Sales of the Company’s Liquid Natural Additives products, included in the industrial starch sales amount, improved 28% driven by volume increases. During fiscal 2010, the Industrial Ingredients business shifted more of its manufacturing mix to the production of ethanol. Sales of ethanol expanded 25% to $68.3 million from $54.8 million in fiscal 2009 as both volume and pricing improved.

Gross margin improved to $0.5 million in fiscal 2010 from a negative margin of $9.3 million in fiscal 2009. Margins improved due to the impact of increased volumes of both industrial starch and ethanol of $4.6 million, favorable ethanol pricing of $2.0 million, improved manufacturing yields and efficiencies of $9.0 million, favorable energy costs and yields of $6.7 million and reduced distribution costs of $2.4 million, offset by unfavorable industrial starch pricing and mix of $14.7 million.

 

The loss from operations for fiscal 2010 increased $0.4 million to $11.5 million; however, the operating loss for fiscal 2009 of $11.2 million included $9.1 million of net insurance recoveries related to the Cedar Rapids flooding in fiscal 2008. Excluding the impact of the net insurance recoveries, operating income increased by $8.8 million driven by the increase in gross margin. Operating expenses increased by $1.2 million primarily due to increased legal costs related to the litigation against the Company’s insurance carriers (see Note 21 to the Consolidated Financial Statements). Research and development expenses of $2.4 million were comparable to last year.

 

Food Ingredients

 

 

Sales of $70.3 million for the year ended August 31, 2010, increased 1.8%, or $1.2 million, on volume growth of 8% partially offset by unfavorable product mix and pricing. In the second quarter of fiscal 2009, the Company sold its dextrose product line which generated $1.9 million in sales for fiscal 2009. Excluding dextrose product sales in fiscal 2009, the Food Ingredients sales for fiscal 2010 increased $3.2 million, or 4.7%. Sales of applications to growth end markets, protein, bakery and pet chews, grew 16%.

 

Gross margin improved $1.4 million on lower raw material, distribution and energy costs. Income from operations grew 12% on an increase in gross margin. Operating expenses declined $0.4 million to $5.9 million compared to fiscal 2009 and research and development expenses increased $0.1 million to $1.9 million.

 

Corporate Operating Expenses

 

Corporate operating expenses decreased to $8.4 million in fiscal 2010 from $9.3 million in fiscal 2009, primarily due to a decrease in professional fees and employee related costs.

 

Fiscal 2009 Compared to Fiscal 2008

 

Industrial Ingredients

 

 

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

 

 

Sales at the Food Ingredients 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.

Non-Operating Income (Expense)

 

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

 

 

On April 7, 2010, the Company refinanced its bank debt. See Note 8 to the Consolidated Financial Statements. 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.

 

In the second quarter of fiscal 2009, the Company’s Food Ingredients 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 quarter. 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 $7.5 million, $5.6 million and $3.1 million in fiscal years 2010, 2009 and 2008, respectively. Interest expense for the year ended August 31, 2010 increased primarily due to the increase in the dividend rate on the Series A Preferred Stock issued in April 2010 over the interest rate for the Company’s bank debt plus the accretion of the discount on the Series A Preferred Stock. On April 7, 2010, the Company issued $40 million of preferred stock at a dividend rate of 15%, the proceeds of which were used to repay outstanding bank debt. Prior to the $40 million repayment, the Company paid interest at LIBOR (London Interbank Offered Rate) plus 5%. See Notes 7 and 8 to the Consolidated Financial Statements.

 

Interest expense for fiscal 2009 increased $2.5 million over the prior year’s expense due to a $1.1 million decrease in the interest costs capitalized in connection with the construction of the ethanol facility, an increase in average debt balances, and an increase in the applicable margin over LIBOR beginning July 2009.

 

Income taxes

 

The effective tax rates for fiscal years 2010, 2009 and 2008 were 33%, 34% and 33%, respectively. The effective tax rate for fiscal 2010 is lower than the U.S. federal statutory rate of 35% primarily due to tax incentives for the production of ethanol, 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, and

the effect of state taxes. 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 17 to the Consolidated Financial Statements.

 

At August 31, 2010, the Company had $17.8 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of August 31, 2010. 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 as the Company incurred losses in fiscal 2008, 2009 and 2010. The Company’s losses in fiscal years 2008 and 2009 were incurred as a result of severe flooding in Cedar Rapids, Iowa, which shut down the Company’s manufacturing facility for most of the fourth quarter of fiscal 2008. The tax benefits of operating losses incurred in fiscal 2008 and 2009 have been carried back to offset taxable income in prior years. The Company expects to recover its deferred tax assets through future taxable income; however, 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.

 

Results of Discontinued Operations

 

 

Fiscal 2010

 

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 transaction costs, were $15.3 million.

 

Proceeds from the sales included $2.0 million in escrow to be released in four equal installments payable at six months, ten months, twenty months and thirty months from November 27, 2009. Penford Australia received the first two installments of $0.5 million each in May 2010 and September 2010. The remaining escrowed payments are subject to the buyer’s right to make warranty claims under the sale contract. Penford Australia currently expects that all warranties will be satisfied and that it will receive the proceeds from the escrow account as scheduled. The $1.5 million receivable at August 31, 2010 is included in other current assets in the Consolidated Balance Sheets.

 

During the first six months of fiscal 2010, the Company determined that intercompany loans made by its U.S. operations to its Australian subsidiaries would not be fully collectible from the proceeds of the Australian asset sales and the liquidation of the remaining net financial assets. Accordingly, the Company recorded an impairment charge in the U.S. of $13.6 million, which was classified in discontinued operations for financial reporting purposes. The impairment charge was offset against $13.6 million of income in the Australian operations discussed below. The U.S. tax benefit of the impairment was also recorded in discontinued operations.

In fiscal years 2008 and 2009, the Company’s Australian operations reported tax losses. As of August 31, 2009, the Company’s discontinued Australian operations had recorded a valuation allowance of $14.6 million against the entire Australian net deferred tax asset because of the uncertainty of generating sufficient future taxable income. In fiscal 2010, the Australian operations recorded $13.6 million of income related to the U.S. impairment discussed above. Accordingly, the Company decreased its deferred tax asset related to the carryfoward of net operating losses and reversed the corresponding tax valuation allowance. At August 31, 2010, the valuation allowance related to the Australian net deferred tax asset was $10.9 million.

 

The liquidation of the remaining net assets of Penford Australia was substantially completed in fiscal 2010 and, as a result, $13.8 of currency translation adjustments were reclassified from accumulated other comprehensive income into earnings.

 

At August 31, 2010, the remaining net assets of the Australia/New Zealand Operations, consisting of $0.3 million of cash and $1.3 million of other net assets, primarily a receivable from the purchaser of one of the Company’s Australian manufacturing facilities, have been reported as assets of the continuing operations of the Company.

 

Fiscal 2009

 

In fiscal 2009, the Company recorded a $13.8 million non-cash goodwill impairment charge, which represented all of the goodwill allocated to its Australia/New Zealand reporting unit.

 

At August 31, 2009, in accordance with the accounting guidance regarding assets held for sale, the Company recorded 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 recorded a non-cash asset impairment charge of $33.0 million in 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.

 

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 on April 7, 2015. 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 2011.

 

Operating Activities

 

At August 31, 2010, Penford had working capital from continuing operations of $35.1 million, and $18.9 million outstanding under its credit facility. Cash flow generated from continuing operations was $10.1 million in fiscal 2010 compared with cash used in operations of $11.2 million and $1.4 million in fiscal years 2009 and 2008, respectively. Cash flow generated by operations in fiscal 2010 grew as working capital requirements, which had increased in fiscal 2009 during the flood recovery, stabilized during the year. The change in cash flow in fiscal 2009 from fiscal 2008 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.

 

Investing Activities

 

Capital expenditures were $6.0 million, $5.4 million and $38.5 million in fiscal years 2010, 2009 and 2008, respectively. Capital expenditures in fiscal 2008 included $26.9 million for construction of the ethanol production facility in Cedar Rapids, Iowa. Penford expects capital expenditures to be approximately $9.5 million in fiscal 2011. In fiscal 2009, the Company’s Food Ingredients 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

 

Bank Debt

 

In fiscal year 2007, Penford entered into a $145 million Second Amended and Restated Credit Agreement (the “2007 Agreement”) among the Company; Harris N.A. (which has been replaced by the Bank of Montreal); 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. Substantially all of the Company’s U.S. assets secured the 2007 Agreement.

 

On April 7, 2010, the Company issued $40 million of preferred stock and, on April 8, 2010, used the proceeds to pay a portion of the outstanding bank debt obligations under the 2007 Agreement. Also on April 7, 2010, the Company refinanced its bank debt. The Company entered into a $60 million Third Amended and Restated Credit Agreement (the “2010 Agreement”) among the Company; Penford Products Co.; Bank of Montreal; Bank of America National Association; and Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A., “Rabobank Nederland” New York Branch.

 

The 2010 Agreement refinanced the unpaid debt remaining under the 2007 Agreement. Under the 2010 Agreement, the Company may borrow $60 million in revolving lines of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. On August 31, 2010, the Company had $18.9 million outstanding under the 2010 Agreement. Under the 2010 Agreement, there are no scheduled principal payments prior to maturity on April 7, 2015. As of August 31, 2010, all of the Company’s outstanding bank debt was subject to variable interest rates.

 

Interest rates under the 2010 Agreement are based on either the London Interbank Offering Rates (“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).

 

The 2010 Agreement provides that the Total Funded Debt Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as defined in the 2010 Agreement) shall not exceed 3.00. In addition, the Company must maintain a Fixed Charge Coverage Ratio, as defined in the 2010 Agreement, of not less than 1.35. Annual capital expenditures are restricted to $15 million (excluding certain capital expenditures specified in the 2010 Agreement) if the Total Funded Debt Ratio is greater than 2.00 for two consecutive fiscal quarters. The Company’s obligations under the 2010 Agreement are secured by substantially all of the Company’s assets. The Company was in compliance with the covenants in the 2010 Agreement as of August 31, 2010.

 

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. The proceeds of these Iowa loans were used to repay outstanding debt under the 2007 Agreement in the first quarter of fiscal 2010. At August 31, 2010, the Company had $1.8 million outstanding related to the IDED loans.

 

In connection with the refinancing, the Company recorded a pre-tax non-cash charge to earnings of $1.0 million in the third quarter of fiscal 2010 related to unamortized transaction fees associated with the prior credit facility. The Company also terminated its interest rate swaps in the third quarter of fiscal 2010 and recorded a charge to earnings of $1.6 million.

 

Preferred Stock

 

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”). Proceeds from the preferred stock issuance of $40.0 million were used to repay bank debt on April 8, 2010. See Note 7 to the Consolidated Financial Statements.

 

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 August 31, 2010, the carrying value of the Series A Preferred Stock liability of $34.1 million includes $1.5 million of accrued dividends, and $0.4 million of discount accretion for the period from the date of issuance to August 31, 2010. The accrued dividends represent the 9% dividends 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 consolidated statements of operations.

 

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 beginning May 31, 2010.

 

Dividends

 

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

 

In April 2009, the Board of Directors suspended payment of dividends. 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. See Note 7 to the Consolidated Financial Statements for further details. During fiscal year 2009, the Company declared dividends on its common stock of $1.4 million.

 

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, 2010, the allowance for doubtful accounts receivable was $0.4 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.

 

The requirements for the designation of hedges are very complex, and require judgments and analyses to qualify as hedges as defined by generally accepted accounting principles in the United States. 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 to qualify for derivative accounting, 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 15 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 13 to the Consolidated Financial Statements. See “Defined Benefit Pension and Postretirement Benefit Plans” below.

 

Long-lived Assets

 

The Company reviews long-lived assets for impairment when events or circumstances indicate that the carrying values may not be recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows from the operation and disposition of the asset group are less than the carrying amount of the asset group. Asset groups have identifiable cash flows independent of other asset groups. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value. Fair value is measured using discounted cash flows or independent appraisals, as appropriate. Estimating future cash flows requires significant judgment by management in such areas as future economic and industry-specific conditions, product pricing and sales volume and capital expenditures.

 

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.

 

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.

 

At August 31, 2010, the Company had $17.8 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of August 31, 2010. 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 expects to recover its tax assets through future taxable income; however, there can be no assurance that management’s current plans will be achieved or that a valuation allowance will not be required against all or a portion of the net deferred tax assets in the future.

 

A tax benefit from an uncertain tax position may be recognized when it is “more likely than not” that the tax return position will be sustained upon examination by the applicable taxing authorities 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 17 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 ASC 718. 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 12 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. ASC 718 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.

Contractual Obligations

 

As more fully described in Notes 7, 8 and 11 to the Consolidated Financial Statements, the Company is a party to various debt, preferred stock and lease agreements at August 31, 2010 that contractually commit the Company to pay certain amounts in the future. The purchase obligations at August 31, 2010 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, 2010 (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 13 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 2008 (6.51%), 2009 (6.92%) and 2010 (5.98%) 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 $0.1 million. During fiscal 2010, bond yields declined and Penford has lowered the discount rate for calculating its benefit obligations at August 31, 2010, as well as net periodic expense for fiscal 2011, to 5.64%.

 

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 2010. 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, 2010. The expected return on plan assets used in calculating fiscal 2011 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, 2010, unrecognized losses from all sources are $18.0 million for the pension plans and unrecognized losses of $2.2 million for the postretirement health care plan. Amortization of unrecognized net loss amounts is expected to increase net pension expense by approximately $1.4 million in fiscal 2011. Amortization of unrecognized net losses is expected to increase net postretirement health care expense by approximately $0.1 million in fiscal 2011.

 

Penford recognized pension expense of $3.8 million, $2.0 million and $1.6 million in fiscal years 2010, 2009 and 2008, respectively. Penford expects pension expense to be approximately $3.7 million in fiscal 2011. The Company contributed $3.4 million, $1.1 million and $1.5 million to the pension plans in fiscal years 2010, 2009 and 2008, respectively. Penford estimates that it will be required to make minimum contributions to the pension plans of $2.3 million during fiscal 2011. 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 $1.6 million, $1.0 million and $1.0 million in fiscal years 2010, 2009 and 2008, respectively. Penford expects to recognize approximately $1.2 million in postretirement health care benefit expense in fiscal 2011. The Company contributed $0.5 million in each fiscal years 2010, 2009 and 2008 to the postretirement health care plans and estimates that it will contribute $0.5 million in fiscal 2011.

 

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 January 2010, the Financial Accounting Standards Board (“FASB”) issued guidance to amend the disclosure requirements relating to fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in an active market for identical assets and liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. The guidance also requires a roll forward of activities on purchases, sales, issuances, and settlements of the assets and liabilities measured in Level 3 (significant unobservable inputs). For the Company, the disclosures related to the transfers of assets and liabilities were effective for the third quarter of fiscal 2010. The Company had no transfers and no disclosure was required. The disclosure on the roll forward activities for Level 3 fair value measurements will be effective in the third quarter of fiscal 2011. Other than requiring additional disclosures, adoption of this guidance will not have an impact on the Company’s financial position, results of operations or liquidity.

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:

 

 

 

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, 2010, all of the Company’s outstanding bank debt is subject to variable interest rates, which are generally set for one or three months. The market risk associated with a 100 basis point adverse change in interest rates at August 31, 2010 is approximately $0.2 million.

Foreign Currency Exchange Rates

 

At August 31, 2009, the Company had U.S.-Australian dollar currency exchange rate risks due to debt borrowings denominated in Australian dollars. At August 31, 2010, the Australian dollar-denominated debt had been repaid and the Company has no plans to borrow funds in a foreign currency.

 

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, 2010 and 2009, the fair value of the Company’s net corn position was approximately $1.6 million and $(1.5) million, respectively. The market risk associated with a 10% adverse change in corn prices at August 31, 2010 and 2009 is approximately $161,000 and $149,000, 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, 2010 and 2009, the fair value of the natural gas exchange-traded futures and options contracts was a loss of approximately $1.2 million and a loss of approximately $1.3 million, respectively. The market risk associated with a 10% adverse change in natural gas prices at August 31, 2010 and 2009 is estimated at $125,000 and $130,000, 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 dextrin to the food manufacturing and food service industries. See Note 19 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 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 September 2, 2009, the Company completed the sale of Penford New Zealand Limited (“Penford New Zealand”). On November 27, 2009, the Company completed the sale of the operating assets of its subsidiary company Penford Australia Limited (“Penford Australia”), including its two remaining Australian plants. The financial results of the Australia/New Zealand Operations have been classified as discontinued operations in the consolidated statement of operations for all periods for which an income statement is presented. The assets and liabilities of this business were reflected as assets and liabilities of discontinued operations in the consolidated balance sheets as of August 31, 2009 and 2008. At August 31, 2010, the remaining net assets of the Australia/New Zealand Operations, consisting of $0.3 million of cash and $1.3 million of other net assets, primarily a receivable from the purchaser of one of the Company’s Australian manufacturing facilities, have been reported as assets and liabilities of the continuing operations of the Company. 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.