UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

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

For the transition period from ___________________ to ______________________

PENFORD CORPORATION

(Exact name of registrant as specified in its charter)

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

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

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

Indicate by a check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The net number of shares of the Registrant’s common stock outstanding as of April 4, 2011 was 11,346,601.

 

 

PENFORD CORPORATION AND SUBSIDIARIES

INDEX

		Page
PART I—FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets — February 28, 2011 and August 31, 2010		3
Condensed Consolidated Statements of Operations — Three and Six Months ended February 28, 2011 and 2010		4
Condensed Consolidated Statements of Cash Flows — Six Months ended February 28, 2011 and 2010		5
Notes to Condensed Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3. Quantitative and Qualitative Disclosures About Market Risk		23
Item 4. Controls and Procedures		23
PART II—OTHER INFORMATION
Item 1. Legal Proceedings		25
Item 1A. Risk Factors		25
Item 6. Exhibits		25
Signatures		26
EX-31.1
EX-31.2
EX-32

PART I — FINANCIAL INFORMATION

Item 1: Financial Statements

PENFORD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

		February 28,				August 31,
(In thousands, except per share data)		2011				2010
		(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	292			$	315
Trade accounts receivable, net			29,924				26,749
Inventories			26,198				19,849
Prepaid expenses			4,544				5,237
Income tax receivable			195				3,678
Other			7,315				5,287
Total current assets			68,468				61,115
Property, plant and equipment, net			108,824				111,930
Restricted cash value of life insurance			7,981				7,951
Deferred tax assets			16,105				16,493
Other assets			2,367				2,615
Other intangible assets, net			370				407
Goodwill, net			7,897				7,897
Total assets		$	212,012			$	208,408
Liabilities and Shareholders’ Equity
Current liabilities:
Cash overdraft, net		$	3,419			$	4,385
Current portion of long-term debt and capital lease obligations			430				429
Accounts payable			14,167				14,650
Accrued liabilities			6,182				6,536
Total current liabilities			24,198				26,000
Long-term debt and capital lease obligations			27,324				21,038
Redeemable preferred stock, Series A			36,492				34,104
Other postretirement benefits			17,208				16,891
Pension benefit liability			20,597				20,597
Other liabilities			6,406				6,206
Total liabilities			132,225				124,836
Shareholders’ equity:
Common stock, par value $1.00 per share, authorized 29,000 shares, issued 13,328 and 13,354 shares, respectively, including treasury shares			13,243				13,190
Preferred stock, Series B			100				100
Additional paid-in capital			102,584				102,303
Retained earnings			13,246				14,586
Treasury stock, at cost, 1,981 shares			(32,757	)			(32,757	)
Accumulated other comprehensive loss			(16,629	)			(13,850	)
Total shareholders’ equity			79,787				83,572
Total liabilities and shareholders’ equity		$	212,012			$	208,408

The accompanying notes are an integral part of these statements.

PENFORD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

		Three months ended								Six months ended
		February 28,								February 28,
(In thousands, except per share data)		2011				2010				2011				2010
Sales		$	74,304			$	62,293			$	146,570			$	129,363
Cost of sales			67,461				56,231				130,470				112,673
Gross margin			6,843				6,062				16,100				16,690
Operating expenses			5,235				6,054				10,430				12,542
Research and development expenses			1,120				1,124				2,214				2,121
Income (loss) from operations			488				(1,116	)			3,456				2,027
Interest expense			2,303				1,621				4,572				3,420
Other non-operating income (expense), net			(1	)			(27	)			88				609
Loss from continuing operations before income taxes			(1,816	)			(2,764	)			(1,028	)			(784	)
Income tax expense (benefit)			(241	)			(963	)			211				(39	)
Loss from continuing operations			(1,575	)			(1,801	)			(1,239	)			(745	)
Income from discontinued operations, net of tax			—				13,048				—				16,531
Net income (loss)		$	(1,575	)		$	11,247			$	(1,239	)		$	15,786
Weighted average common shares and equivalents outstanding, basic and diluted:			12,257				11,204				12,239				11,193
Earnings (loss) per common share, basic and diluted:
Loss per share from continuing operations		$	(0.13	)		$	(0.17	)		$	(0.10	)		$	(0.08	)
Earnings per share from discontinued operations		$	—			$	1.16			$	—			$	1.48
Earnings (loss) per share		$	(0.13	)		$	0.99			$	(0.10	)		$	1.40

The accompanying notes are an integral part of these statements.

PENFORD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

		Six Months Ended
(In thousands)		February 28, 2011				February 28, 2010
Cash flows from operating activities:
Net income (loss)		$	(1,239	)		$	15,786
Less: Income from discontinued operations			—				16,531
Net loss from continuing operations			(1,239	)			(745	)
Adjustments to reconcile net income from continuing operations to net cash provided by (used in) operations:
Depreciation and amortization			7,261				7,518
Non-cash interest on Series A Preferred Stock			1,886				—
Stock-based compensation			608				780
Deferred income tax expense			95				79
Non-cash gains on hedging transactions			(2,832	)			(980	)
Foreign currency transaction gain			—				(417	)
Other			—				(3	)
Change in assets and liabilities:
Trade receivable			(3,202	)			5,706
Prepaid expenses			693				805
Inventories			(3,517	)			(1,698	)
Decrease (increase) in margin accounts			(3,877	)			1,136
Accounts payable and accrued liabilities			(818	)			(1,861	)
Income tax receivable			3,577				(245	)
Other			(594	)			1,538
Net cash flow provided by (used in) operating activities — continuing operations			(1,959	)			11,613
Cash flows from investing activities:
Acquisition of property, plant and equipment, net			(3,373	)			(2,910	)
Net proceeds received from sale of discontinued operations and other			(30	)			19,812
Net cash provided by (used in) investing activities — continuing operations			(3,403	)			16,902
Cash flows from financing activities:
Proceeds from revolving line of credit			26,500				—
Payments on revolving line of credit			(20,000	)			(17,735	)
Proceeds from long-term debt			—				2,000
Payments of long-term debt			(100	)			(21,055	)
Payments under capital lease obligation			(123	)			(123	)
Payment of loan fees			—				(38	)
Increase (decrease) in cash overdraft			(966	)			2,896
Other			28
Net cash provided by (used in) financing activities — continuing operations			5,339				(34,055	)
Cash flows from discontinued operations:
Net cash provided by operating activities			—				6,150
Net cash used in investing activities			—				(1,856	)
Net cash used in financing activities			—				(3,399	)
Effect of exchange rate changes on cash and cash equivalents			—				(275	)
Net cash provided by discontinued operations			—				620
Decrease in cash and cash equivalents			(23	)			(4,920	)
Cash and cash equivalents of continuing operations, beginning of period			315				5,540
Cash balance of discontinued operations, beginning of period			—				634
Cash and cash equivalents, end of period			292				1,254
Less: cash balance of discontinued operations, end of period			—				1,254
Cash and cash equivalents of continuing operations, end of period		$	292			$	—

The accompanying notes are an integral part of these statements.

PENFORD CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

     1—BUSINESS

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

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

     Penford manages its business in two segments: Industrial Ingredients and Food Ingredients. These segments are based on broad categories of end-market users. The Industrial Ingredients segment is a supplier of chemically modified specialty starches to the paper and packaging industries and a producer of fuel grade ethanol. The Food Ingredients segment is a developer and manufacturer of specialty starches and dextrin to the food manufacturing and food service industries. See Note 14 for financial information regarding the Company’s business segments.

Discontinued Operations

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

     The financial results of the Australia/New Zealand Operations for the three- and six-month periods of fiscal 2010 have been classified as discontinued operations in the condensed consolidated statements of operations. Australian administrative expenses for the three- and six-month periods ended February 28, 2011 of $43,000 and $84,000, respectively, were included in income from continuing operations. The net assets of the Australia/New Zealand Operations as of February 28, 2011 and August 31, 2010 have been reported as assets and liabilities of the continuing operations in the condensed consolidated balance sheets. At February 28, 2011, the remaining net assets of the Australia/New Zealand Operations consist of $0.3 million of cash and $0.8 million of other net assets, primarily a receivable from the purchaser of one of the Company’s Australian manufacturing facilities. See Note 9 for additional information regarding discontinued operations. Unless otherwise indicated, amounts and discussions in these notes pertain to the Company’s continuing operations.

     2—BASIS OF PRESENTATION

     Consolidation

     The accompanying condensed consolidated financial statements include the accounts of Penford and its wholly owned subsidiaries. Intercompany accounts and transactions are eliminated in consolidation. The condensed consolidated balance sheet at February 28, 2011 and the condensed consolidated statements of operations and cash flows for the interim periods ended February 28, 2011 and February 28, 2010 have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, which are necessary to present fairly the financial information, have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles, have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The results of operations for interim periods are not necessarily indicative of the operating results of a full year or of future operations. Certain prior period amounts have been reclassified to conform to the current period presentation. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended August 31, 2010.

     Use of Estimates

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

     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, issuance, 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.

     3—INVENTORIES

     The components of inventory are as follows:

		February 28,				August 31,
		2011				2010
		(In thousands)
Raw materials		$	11,873			$	8,708
Work in progress			1,781				1,299
Finished goods			12,544				9,842
Total inventories		$	26,198			$	19,849

     4—PROPERTY, PLANT AND EQUIPMENT

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

		February 28,				August 31,
		2011				2010
		(In thousands)
Land		$	10,435			$	10,307
Plant and equipment			325,552				324,904
Construction in progress			6,880				4,272
			342,867				339,483
Accumulated depreciation			(234,043	)			(227,553	)
Net property, plant and equipment		$	108,824			$	111,930

     5—PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION

     On April 7, 2010, the Company issued $40 million of Series A 15% cumulative non-voting, non-convertible preferred stock (“Series A Preferred Stock”) and 100,000 shares of Series B voting convertible preferred stock (“Series B Preferred Stock”) in a private placement to Zell Credit Opportunities Master Fund, L.P., an investment fund managed by Equity Group Investments, a private investment firm (the “Investor”). The Company has 1,000,000 shares of authorized preferred stock, $1.00 par value, of which 200,000 shares are issued and outstanding at February 28, 2011 in two series as shown below.

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

     The Company recorded the Series A Preferred Stock and the Series B Preferred Stock at their relative fair values at the time of issuance. The Series A Preferred Stock of $32.3 million was recorded as a long-term liability due to its mandatory redemption feature and the Series B Preferred Stock of $7.7 million was recorded as equity. The discount on the Series A Preferred Stock is being amortized into income using the effective interest method over the contractual life of seven years. At February 28, 2011, the carrying value of the Series A Preferred Stock liability of $36.5 million includes $3.3 million of accrued dividends, and $0.9 million of discount accretion for the period from the date of issuance. The accrued dividends represent the 9% dividends that may be paid currently or accrued at the option of the Company. Dividends on the Series A Preferred Stock and the discount accretion are recorded as interest expense in the Condensed Consolidated Statements of Operations. During the six-month period of fiscal 2011, non-cash dividends of $1.9 million were recorded as interest expense.

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

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

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

     6—DEBT

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

     Under the 2010 Agreement, the Company may borrow $60 million under a revolving line of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. On February 28, 2011, the Company had $25.4 million outstanding under the 2010 Agreement, which is subject to variable interest rates. Under the 2010 Agreement, there are no scheduled principal payments prior to maturity on April 7, 2015. The Company’s obligations under the 2010 Agreement are secured by substantially all of the Company’s assets. Pursuant to the 2010 Agreement, the Company may not declare or pay dividends on, or make any other distributions in respect of, its common stock. The Company was in compliance with the covenants in the 2010 Agreement as of February 28, 2011.

     Interest rates under the 2010 Agreement are based on either the London Interbank Offered Rate (“LIBOR”) or the prime rate, depending on the selection of available borrowing options under the 2010 Agreement. The Company may choose a borrowing rate of 1-month, 3-month or 6-month LIBOR. Pursuant to the 2010 Agreement, the interest rate margin over LIBOR ranges between 3% and 4%, depending upon the Total Funded Debt Ratio (as defined). At February 28, 2011, the Company’s borrowing rate was 3.8%.

     During the first quarter of fiscal 2010, the Iowa Department of Economic Development (“IDED”) awarded financial assistance to the Company as a result of the temporary shutdown of the Cedar Rapids, Iowa plant in the fourth quarter of fiscal 2008 due to record flooding of the Cedar River. The IDED provided two five-year non interest bearing loans as follows: (1) a $1.0 million loan to be repaid in 60 equal monthly payments of $16,667 beginning December 1, 2009, and (2) a $1.0 million loan which is forgivable if the Company maintains certain levels of employment at the Cedar Rapids plant. At February 28, 2011, the Company had $1.7 million outstanding related to the IDED loans.

     7—INCOME TAXES

     For interim periods in fiscal 2010, the Company estimated the effective income tax rate expected to be applicable for the full fiscal year ended August 31, 2010 and used that rate to calculate income tax expense or benefit on year-to-date income or loss. In fiscal 2011, the amounts of expected permanent differences between book and taxable income resulted in significant variations in the customary relationship between pretax book income and income tax expense (benefit) in interim periods. A small change in the Company’s expected annual pretax income could result in a significant change in the annual expected effective tax rate. For the three- and six-month periods ended February 28, 2011, the Company used the year-to-date effective income tax rate. This rate is used to calculate income tax expense or benefit on current year-to-date pre-tax income or loss.

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

     The Company’s effective tax rates for the three- and six-month periods ended February 28, 2011 were 13.3% and (20.5)%, respectively. The difference between the effective tax rate and the U.S. federal statutory rate for the three-month period ended February 28, 2011 was primarily due to a $0.2 million benefit associated with the tax credit for small ethanol producers and a $0.2 million research and development activity tax credit for fiscal 2010 which was reinstated in December 2010 upon enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. These tax benefits were offset by the tax effect of non-deductible dividends and accretion of discount of $1.9 million on the Company’s Series A Preferred Stock. The difference between the effective tax rate and the U.S. federal statutory rate for the six-month period ended February 28, 2011 was primarily due to a $0.9 million benefit associated with the tax credit for small ethanol producers and a $0.2 million tax credit related to research and development activities. These tax benefits were offset by the tax effect of non-deductible dividends and accretion of discount of $3.8 million on the Company’s Series A Preferred Stock.

     For the three- and six-month periods ended February 28, 2010, the difference between the effective tax rate and the U.S. federal statutory rate was due to state income taxes offset by adjustments to prior years’ tax expense and an increase in unrecognized tax benefits of $0.1 million and $0.2 million, respectively.. The decrease in the effective tax rate for the six-month period compared with the effective rate for the second quarter is due to the change in the proportion of the prior year tax adjustments and increase in unrecognized tax benefits to pretax income or loss.

     At February 28, 2011, the Company had $19.1 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of February 28, 2011. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter and had incurred losses in fiscal years 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.

While there have been losses since 2008 for reasons indicated above, the Company believes that it is more likely than not that future operations and the reversal of existing taxable temporary differences will generate sufficient taxable income to realize its deferred tax assets. In addition, dividends on the Series A Preferred Stock, as well as accretion of the related discount, which are included in interest expense in the Condensed Consolidated Statements of Operations, are not deductible for U.S. federal income tax purposes. There can be no assurance that management’s current plans will be achieved or that a valuation allowance will not be required in the future.

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

     In the six months ended February 28, 2011, the amount of unrecognized tax benefits increased by $0.1 million. The total amount of unrecognized tax benefits at February 28, 2011 was $1.2 million, all of which, if recognized, would favorably impact the effective tax rate. At February 28, 2011, the Company had $0.2 million of accrued interest and penalties included in the long-term tax liability. The Company does not believe that the total amount of unrecognized tax benefits at February 28, 2011 will change materially in the next 12 months.

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

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

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

		Three months ended								Six months ended
		February 28,								February 28,
		2011				2010				2011				2010
		(In thousands)
Net income (loss)		$	(1,575	)		$	11,247			$	(1,239	)		$	15,786
Foreign currency translation adjustments			—				(256	)			—				930
Gain from foreign currency translation reclassified into earnings			—				(13,849	)			—				(13,420	)
Net unrealized gain (loss) on derivative instruments that qualify as cash flow hedges, net of tax			(733	)			94				(2,779	)			1,191
Total comprehensive income (loss)		$	(2,308	)		$	(2,764	)		$	(4,018	)		$	4,487

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

     9 — DISCONTINUED OPERATIONS

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

     Proceeds from the Penford Australia asset sales included $2.0 million placed in escrow to be released in four equal installments. Two installments totaling $1.0 million were received as of February 28, 2011. The remaining two installments of $0.5 million each, which are subject to the buyer’s right to make warranty claims under the sale contract, are due in July 2011 and May 2012. While no assurances can be given that the buyer will not develop and submit valid warranty claims, Penford Australia currently expects that it will receive the proceeds from the escrow account as scheduled.

     10—STOCK-BASED COMPENSATION

     Stock Compensation Plans

     Penford maintains the 2006 Long-Term Incentive Plan (the “2006 Incentive Plan”) pursuant to which various stock-based awards may be granted to employees, directors and consultants. As of February 28, 2011, the aggregate number of shares of the Company’s common stock that were available to be issued as awards under the 2006 Incentive Plan was 21,017. In addition, any shares previously granted under the 1994 Stock Option Plan which are subsequently forfeited or not exercised will be available for future grants under the 2006 Incentive Plan. Non-qualified stock options granted under the 2006 Incentive Plan generally vest ratably over four years and expire seven years from the date of grant.

     General Option Information

     A summary of the stock option activity for the six months ended February 28, 2011, is as follows:

		Number of				Weighted Average				Weighted Average				Aggregate Intrinsic
		Shares				Exercise Price				Remaining Term (in years)				Value
Outstanding Balance, August 31, 2010			1,264,564			$	15.07
Granted			95,000				6.62
Exercised			—				—
Cancelled			(12,170	)			12.26
Outstanding Balance, February 28, 2011			1,347,394				14.50				3.19			$	12,900
Options Exercisable at February 28, 2011			1,079,394			$	14.75				2.67			$	—

     Under the 2006 Incentive Plan, the Company granted 95,000 stock options during the first six months of fiscal 2011, (i) 80,000 stock options which vest one year from the date of grant, and (ii) 15,000 stock options which vest ratably over four years. The Company estimated the fair value of stock options granted during the first six months of fiscal 2011 using the following weighted-average assumptions and resulting in the following weighted-average grant date fair value:

Expected volatility			72	%
Expected life (years)			4.2
Interest rate			1.1-2.4	%
Weighted-average fair value		$	3.63

     The aggregate intrinsic value disclosed in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $5.95 as of February 28, 2011 that would have been received by the option holders had all option holders exercised on that date. No stock options were exercised during the six months ended February 28, 2011.

     As of February 28, 2011, the Company had $0.6 million of unrecognized compensation cost related to non-vested stock option awards that is expected to be recognized over a weighted average period of 1.2 years.

     Restricted Stock Awards

     The grant date fair value of each share of the Company’s restricted stock awards is equal to the fair value of Penford’s common stock at the grant date. The following table summarizes the restricted stock award activity for the six months ended February 28, 2011 as follows:

						Weighted
						Average
		Number of				Grant Date
		Shares				Fair Value
Nonvested at August 31, 2010			154,707			$	15.67
Granted			—				—
Vested			(70,475	)			16.87
Cancelled			—				—
Nonvested at February 28, 2011			84,232			$	14.67

     As of February 28, 2011, the Company had $0.3 million of unrecognized compensation cost related to non-vested restricted stock awards that is expected to be recognized over a weighted average period of 1.1 years.

     Compensation Expense

     The Company recognizes stock-based compensation expense utilizing the accelerated multiple option approach over the requisite service period, which equals the vesting period. The following table summarizes the total stock-based compensation cost for the three and six months ended February 28, 2011 and 2010 and the effect on the Company’s Condensed Consolidated Statements of Operations (in thousands):

		Three Months Ended								Six Months Ended
		February 28,								February 28,
		2011				2010				2011				2010
Cost of sales		$	33			$	39			$	62			$	86
Operating expenses			204				269				527				679
Research and development expenses			13				8				19				15
Income (loss) from discontinued operations			—				—				—				(25	)
Total stock-based compensation expense		$	250			$	316			$	608			$	755
Income tax benefit			95				120				231				287
Total stock-based compensation expense, net of tax		$	155			$	196			$	377			$	468

     11—NON-OPERATING INCOME (LOSS), NET

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

		Three months ended								Six months ended
		February 28,								February 28,
		2011				2010				2011				2010
						(In thousands)
Gain (loss) on foreign currency transactions		$	—			$	(35	)		$	—			$	417
Other			(1	)			8				88				192
Total		$	(1	)		$	(27	)		$	88			$	609

     During the three and six months ended February 28, 2010, the Company recognized a gain (loss) on foreign currency transactions on Australian dollar denominated assets and liabilities as disclosed in the table above.

     12 — PENSION AND POST-RETIREMENT BENEFIT PLANS

     The components of the net periodic pension and post-retirement benefit costs for the three and six months ended February 28, 2011 and 2010 are as follows:

		Three months ended								Six months ended
		February 28,								February 28,
Defined benefit pension plans		2011				2010				2011				2010
						(In thousands)
Service cost		$	404			$	389			$	808			$	778
Interest cost			674				641				1,348				1,282
Expected return on plan assets			(558	)			(506	)			(1,116	)			(1,012	)
Amortization of prior service cost			57				61				114				122
Amortization of actuarial losses			360				304				720				608
Net periodic benefit cost		$	937			$	889			$	1,874			$	1,778

		Three months ended								Six months ended
		February 28,								February 28,
Post-retirement health care plans		2011				2010				2011				2010
						(In thousands)
Service cost		$	68			$	88			$	136			$	176
Interest cost			243				269				486				538
Amortization of prior service cost			(38	)			(38	)			(76	)			(76	)
Amortization of actuarial losses			16				74				32				148
Net periodic benefit cost		$	289			$	393			$	578			$	786

     13—FAIR VALUE MEASURMENTS AND DERIVATIVE INSTRUMENTS

     Fair Value Measurements

     Presented below are the fair values of the Company’s derivatives as of February 28, 2011 and August 31, 2010:

As of February 28, 2011		(Level 1)				(Level 2)				(Level 3)				Total
						(in thousands)
Current assets (Other Current Assets):
Commodity derivatives (1)		$	(4,048	)		$	—			$	—			$	(4,048	)

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

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

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

     Other Financial Instruments

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

     In fiscal 2010, the Company received two non-interest bearing loans from the State of Iowa totaling $2.0 million. The carrying value of the debt at February 28, 2011 was $1.7 million and the fair value of the debt was estimated to be $1.5 million. See Note 6.

     The fair value of the Series A Preferred Stock was determined using the market approach in comparing yields on similar debt securities. The discount on the Series A Preferred Stock is being amortized into income using the effective interest method over the contractual life of seven years. The carrying value of the Series A Preferred Stock at February 28, 2011 was $36.5 million and the estimated fair value was $39.5 million.

     Interest Rate Swap Agreements

     The Company used interest rate swaps to manage the variability of interest payments associated with its floating-rate debt obligations. The interest payable on the debt effectively became fixed at a certain rate and reduced the impact of future interest rate changes on future interest expense. Unrealized losses on interest rate swaps were included in accumulated other comprehensive income (loss). The periodic settlements on the swaps were recorded as interest expense. At February 28, 2011, the Company had no outstanding interest rate swaps and no gains or losses remaining in other comprehensive income (loss).

     Commodity Contracts

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

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

     To reduce the price volatility of corn used in fulfilling some of its starch sales contracts, Penford from time to time uses readily marketable exchange-traded futures as well as forward cash corn purchases. The exchange-traded futures are not purchased or sold for trading or speculative purposes and are designated as hedges. The changes in fair value of such contracts have historically been, and are expected to continue to be, effective in offsetting the price changes of the hedged commodity. Penford also at times uses exchange-traded futures to hedge corn inventories and firm corn purchase contracts. Hedged transactions are generally expected to occur within 12 months of the time the hedge is established. The deferred gain (loss), net of tax, recorded in other comprehensive income at February 28, 2011 that is expected to be reclassified into income within 12 months is $(2.1) million.

     As of February 28, 2011, Penford had purchased corn positions of 10.5 million bushels, of which 3.2 million bushels represented equivalent firm priced starch and ethanol sales contract volume, resulting in an open position of 7.3 million bushels.

     As of February 28, 2011, the Company had the following outstanding futures contracts:

		Corn Futures		2,880,000		Bushels
		Natural Gas Futures		1,270,000		mmbtu (millions of British thermal units)
		Ethanol Swaps		2,131,500		Gallons

     The following tables provide information about the fair values of the Company’s derivatives, by contract type, as of February 28, 2011 and August 31, 2010.

		Asset Derivatives												Liability Derivatives
						Fair Value												Fair Value
		Balance Sheet				Feb, 28				Aug. 31				Balance Sheet				Feb, 28				Aug. 31
In thousands		Location				2011				2010				Location				2011				2010
Cash Flow Hedges:
Corn Futures		Other Current Assets				$	197			$	—			Other Current Assets				$	4			$	—
Natural Gas Futures		Other Current Assets					—				—			Other Current Assets					516				1,082
Ethanol Gas Futures		Other Current Assets					4				—			Other Current Assets					1,015				—
Fair Value Hedges:
Corn Futures		Other Current Assets					6				28			Other Current Assets					2,720				1,735
Total Derivatives
Designated as Hedging
Instruments						$	207			$	28							$	4,255			$	2,817

     The following tables provide information about the effect of derivative instruments on the financial performance of the Company for the three- and six-month periods ended February 28, 2011 and 2010.

										Amount of Gain (Loss)
		Amount of Gain (Loss)								Reclassified from								Amount of Gain (Loss)
		Recognized in OCI								AOCI into Income								Recognized in Income
		Quarter Ended Feb, 28								Quarter Ended Feb, 28								Quarter Ended Feb, 28
In thousands		2011				2010				2011				2010				2011				2010
Cash Flow Hedges:
Corn Futures (1)		$	(3,049	)		$	43			$	(2,580	)		$	1,119			$	11			$	(80	)
Natural Gas Futures (1)			(315	)			(547	)			(337	)			(241	)			—				—
Ethanol Futures (1)			(548	)			119				188				138				—				—
Interest Rate Contracts(2)			—				(108	)			—				(283	)			—				—
		$	(3,912	)		$	(493	)		$	(2,729	)		$	733			$	11			$	(80	)
Fair Value Hedges:
Corn Futures (1) (3)																		$	56			$	27

										Amount of Gain (Loss)
										Reclassified from								Amount of Gain (Loss)
		Amount of Gain (Loss)Recognized in OCI								AOCI into Income								Recognized in Income
		6 Months Ended Feb 28								6 Months Ended Feb 28								6 Months Ended Feb 28
In thousands		2011				2010				2011				2010				2011				2010
Cash Flow Hedges:
Corn Futures (1)		$	(6,756	)		$	344			$	(2,263	)		$	1,096			$	(171	)		$	175
Natural Gas Futures (1)			(549	)			(1,243	)			(1,056	)			(1,106	)			—				—
Ethanol Futures (1)			(315	)			(590	)			182				(439	)			—				—
Interest Rate Contracts(2)			—				(457	)			—				(569	)			—				—
FX Contracts (1)			—				—				—				(26	)			—				—
		$	(7,620	)		$	(1,946	)		$	(3,137	)		$	(1,044	)		$	(171	)		$	175
Fair Value Hedges:
Corn Futures (1) (3)																		$	42			$	61

     14—SEGMENT REPORTING

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

		Three months ended								Six months ended
		February 28,								February 28,
		2011				2010				2011				2010
						(In thousands)
Sales:
Industrial Ingredients
Industrial Starch		$	30,818			$	27,983			$	60,187			$	60,331
Ethanol			25,773				18,082				50,334				36,042
			56,591				46,065				110,521				96,373
Food Ingredients			17,713				16,228				36,049				32,990
		$	74,304			$	62,293			$	146,570			$	129,363
Income (loss) from operations:
Industrial Ingredients		$	(1,103	)		$	(1,721	)		$	(961	)		$	433
Food Ingredients			3,576				2,848				8,385				6,429
Corporate and other			(1,985	)			(2,243	)			(3,968	)			(4,835	)
		$	488			$	(1,116	)		$	3,456			$	2,027

		February 28,				August 31,
		2011				2010
		(In thousands)
Total assets:
Industrial Ingredients		$	140,661			$	133,738
Food Ingredients			37,897				36,542
Corporate and other			33,454				38,128
		$	212,012			$	208,408

     At February 28, 2011, the remaining net assets of the Australia/New Zealand Operations, consisting of $0.3 million of cash and $0.8 million of other net assets, have been reported as assets of the continuing operations in “Corporate and other.” All other assets are located in the United States.

     15—EARNINGS PER SHARE

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

     Basic earnings (loss) per share reflect only the weighted average common shares outstanding during the period. Diluted earnings (loss) per share reflect weighted average common shares outstanding and the effect of any dilutive

common stock equivalent shares. Diluted earnings (loss) per share is calculated by dividing net income (loss) by the average common shares outstanding plus additional common shares that would have been outstanding assuming the exercise of in-the-money stock options, using the treasury stock method. The following table presents the reconciliation of income from continuing operations to income from continuing operations applicable to common shares and the computation of diluted weighted average shares outstanding for the three and six months ended February 28, 2011 and 2010.

		Three months ended								Six months ended
		February 28,								February 28,
		2011				2010				2011				2010
		(In thousands)								(In thousands)
Numerator:
Loss from continuing operations		$	(1,575	)		$	(1,801	)		$	(1,239	)		$	(745	)
Less: Allocation to participating securities			—				(147	)			—				(162	)
Loss from continuing operations applicable to common shares		$	(1,575	)		$	(1,948	)		$	(1,239	)		$	(907	)
Income from discontinued operations		$	—			$	13,048			$	—			$	16,531
Less: Allocation to participating securities			—				—				—				—
Income from discontinued operations applicable to common shares		$	—			$	13,048			$	—			$	16,531
Net income (loss)		$	(1,575	)		$	11,247			$	(1,239	)		$	15,786
Less: Allocation to participating securities			—				(147	)			—				(162	)
Net income (loss) applicable to common shares		$	(1,575	)		$	11,100			$	(1,239	)		$	15,624
Denominator:
Weighted average common shares outstanding, basic			12,257				11,204				12,239				11,193
Dilutive stock options and awards			—				—				—				—
Weighted average common shares outstanding, diluted			12,257				11,204				12,239				11,193

     For the three and six months ended February 28, 2011, there were 89,780 and 112,316 weighted-average restricted stock awards excluded from the calculation of diluted earnings (loss) per share because they were antidilutive. Weighted-average restricted stock awards of 159,282 and 138,508 shares for the three and six months ended February 28, 2010, were excluded from the calculation of diluted earnings (loss) per share because they were antidilutive. Weighted-average stock options to purchase 1,347,421 and 1,312,653 shares of common stock for the three and six months ended February 28, 2011, were excluded from the calculation of diluted earnings (loss) per share because they were antidilutive. Weighted-average stock options to purchase 1,330,080 and 1,324,408 shares of common stock for the three and six months ended February 28, 2010, were excluded from the calculation of diluted earnings (loss) per share because they were antidilutive.

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

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

Overview

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

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

     In analyzing business trends, management considers a variety of performance and financial measures, including sales revenue growth, sales volume growth, and gross margins and operating income of the Company’s business segments.

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

Results of Operations

     Executive Overview

     Consolidated sales for the three months ended February 28, 2011 increased 19.3%, or $12.0 million, to $74.3 million compared with $62.3 million for the three months ended February 28, 2010. Consolidated sales in the first half of fiscal 2011 increased $17.2 million over last year to $146.6 million. Second quarter and year-to-date sales growth was driven by improvements in ethanol volumes and unit pricing. See the discussion by business segment below for details of changes in revenues.

     Consolidated income from operations for the second quarter of fiscal 2011 increased $1.6 million to $0.5 million from an operating loss of $1.1 million in the prior year second quarter. Consolidated gross margin increased $0.8 million as higher net corn costs were more than offset by favorable ethanol pricing, the effect of expanded sales volume in both businesses and lower manufacturing costs. Operating expenses decreased $0.8 million primarily due to reduced professional fees.

     Consolidated income from operations for the six months ended February 28, 2011 rose $1.4 million to $3.5 million from $2.0 million in the same period of the prior year. Gross margin declined $0.6 million on higher net corn costs. Operating expenses improved $2.1 million on lower employee costs and professional fees.

     Interest expense increased for both the second quarter and the first half of fiscal 2011 over the same periods in fiscal 2010 primarily due to the higher dividend rate under the Company’s Series A Preferred Stock issued in April 2010 over the interest rate under the Company’s prior bank debt.

     The Company’s effective tax rates for the three- and six-month periods ended February 28, 2011 were 13.3% and (20.5)%, respectively. The difference between these rates and the U.S. federal statutory rate is primarily due to federal tax credits for the production of ethanol and research and development activities. See the “Income taxes” section below for a discussion of the Company’s effective tax rates.

     Industrial Ingredients

     Second quarter fiscal 2011 sales at the Company’s Industrial Ingredients business unit increased $10.5 million, or 22.9%, to $56.6 million from $46.1 million in the second quarter of fiscal 2010. Industrial starch sales of $30.8 million for the quarter ended February 28, 2011 grew $2.8 million from a year ago on an increase in average unit pricing, which included the effect of an increase in the cost of corn which is passed through to customers, partially offset by a 2%

decline in sales volume. Sales of specialty starches, included in the industrial starch sales amount, expanded 20% on increases in both volume and average unit pricing. Sales of ethanol increased 43% from $18.1 million in the second quarter of fiscal 2010 to $25.8 million in the second quarter of fiscal 2011. Both sales volume and average unit pricing of ethanol rose at double-digit rates over the prior year quarter.

     Industrial Ingredients sales for the first half of fiscal 2011 increased 14.7% to $110.5 million from $96.4 million in fiscal 2010. Industrial starch sales were comparable to last year at $60.2 million. Average unit pricing of industrial starches was comparable to the prior year. Sales of specialty starches, included in the industrial starch sales amount, for the six months ended February 28, 2011 rose 16% on volume increases, partially offset a 1% decline in average unit pricing. First half fiscal 2010 ethanol sales expanded 40% to $50.3 million from $36.0 million a year ago on a 13% increase in volume and pricing improvements of 24%.

     The Industrial Ingredients business unit reported a loss from operations for the second quarter of fiscal 2011 of $1.1 million compared to an operating loss of $1.7 million for the second quarter of fiscal 2010. Gross margin improved by $0.2 million on volume growth of $0.4 million, pricing and product mix improvements of $5.5 million, and higher manufacturing yields and lower natural gas and distribution costs of $1.8 million. Higher net corn costs decreased gross margin by $7.5 million. Operating expenses decreased due to lower professional fees.

     The Industrial Ingredients business reported a loss from operations of $1.0 million for the six months ended February 28, 2011 compared to operating income of $0.4 million for the same period of fiscal 2010. Gross margin declined $1.9 million due to higher net corn costs of $10.5 million, offset by pricing and product mix improvements of $5.0 million, the effect of volume increases of $0.9 million, and improvements in manufacturing yields and costs of $2.7 million. Total operating and research and development expenses for 2011 declined by $0.5 million due to a decrease in professional fees.

     Food Ingredients

     Fiscal 2011 second quarter sales for the Food Ingredients segment of $17.7 million increased 9.2%, or $1.5 million, from the second quarter of fiscal 2010. Sales for the first six months of fiscal 2011 of $36.0 million increased 9.3%, or $3.1 million, from last year. For the second quarter and the first half of fiscal 2011, sales of applications to growth end markets, including the dairy, pet and bakery markets, grew 28% and 22%, respectively, on both volume and pricing improvements. Sales of coating applications declined 12% for the three months ended February 28, 2011 primarily due to decreased volume. Volume and average unit pricing declines contributed equally to a decrease in coating application sales in the first half of fiscal 2011 compared to the same period in fiscal 2010.

     Operating income for the second quarter of fiscal 2011 increased 25.6% to $3.6 million from $2.8 million a year ago due to the impact of higher revenues of $0.5 million, lower raw material costs of $0.1 million, and lower operating expenses of $0.2 million. Income from operations for the first six months of fiscal 2011 increased $2.0 million, or 30.4%, to $8.4 million due to an improvement in gross margin of $1.3 million and a decrease in operating expenses of $0.7 million. First half gross margin improved 12.1% from the same period last year to $11.7 million on the impact of higher revenues of $1.0 million and lower raw material costs. Operating expenses declined due to the collection of a receivable in the first quarter of fiscal 2011 and lower professional fees.

     Corporate operating expenses

     Corporate operating expenses declined $0.3 million for the second quarter of fiscal 2011 to $1.9 million, and declined $0.9 million for the first half of fiscal 2011 to $3.9 million, primarily due to lower employee costs.

     Interest expense

     Interest expense for the three- and six-month periods ended February 28, 2011 increased $0.7 million and $1.2 million, respectively, compared to the same periods last year, primarily due to the higher dividend rate under the Company’s Series A Preferred Stock issued in April 2010 over the interest rate under the Company’s prior bank debt. The increase was also due to the accretion of the discount on the Series A Preferred Stock.

     On April 7, 2010, the Company issued $40 million of its Series A 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 5 and 6 to the Condensed Consolidated Financial Statements.

     Income taxes

     For interim periods in fiscal 2010, the Company estimated the effective income tax rate expected to be applicable for the full fiscal year ended August 31, 2010 and used that rate to calculate income tax expense or benefit on year-to-date income or loss. In fiscal 2011, the amounts of expected permanent differences between book and taxable income resulted in significant variations in the customary relationship between pretax book income and income tax expense (benefit) in interim periods. A small change in the Company’s expected annual pretax income could result in a significant change in the annual expected effective tax rate. For the three- and six-month periods ended February 28, 2011, the Company used the year-to-date effective income tax rate. This rate is used to calculate income tax expense or benefit on current year-to-date pre-tax income or loss.

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

     The Company’s effective tax rates for the three- and six-month periods ended February 28, 2011 were 13.3% and (20.5)%, respectively. The difference between the effective tax rate and the U.S. federal statutory rate for the three-month period ended February 28, 2011 was primarily due to a $0.2 million benefit associated with the tax credit for small ethanol producers and a $0.2 million research and development activity tax credit for fiscal 2010 which was reinstated in December 2010 upon enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. These tax benefits were offset by the tax effect of non-deductible dividends and accretion of discount of $1.9 million on the Company’s Series A Preferred Stock. The difference between the effective tax rate and the U.S. federal statutory rate for the six-month period ended February 28, 2011 was primarily due to a $0.9 million benefit associated with the tax credit for small ethanol producers and a $0.2 million tax credit related to research and development activities. These tax benefits were offset by the tax effect of non-deductible dividends and accretion of discount of $3.8 million on the Company’s Series A Preferred Stock.

     For the three- and six-month periods ended February 28, 2010, the difference between the effective tax rate and the U.S. federal statutory rate was due to state income taxes offset by adjustments to prior years’ tax expense and an increase in unrecognized tax benefits of $0.1 million and $0.2 million, respectively. The decrease in the effective tax rate for the six-month period compared with the effective rate for the second quarter is due to the change in the proportion of the prior year tax adjustments and increase in unrecognized tax benefits to pretax income or loss.

     At February 28, 2011, the Company had $19.1 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of February 28, 2011. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter and has incurred losses in fiscal years 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. While there have been losses since 2008 for reasons indicated above, the Company believes that it is more likely than not that future operations and the reversal of existing taxable temporary differences will generate sufficient taxable income to realize its deferred tax assets. In addition, dividends on the Series A Preferred Stock, as well as accretion of the related discount, which are included in interest expense in the Condensed Consolidated Statements of Operations, are not deductible for U.S. federal income tax purposes. There can be no assurance that management’s current plans will be achieved or that a valuation allowance will not be required in the future.

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

limitations may apply with respect to the Company’s ability to utilize its net operating loss carryforwards and certain current deductions against taxable income in future periods.

Liquidity and Capital Resources

     The Company’s primary sources of short- and long-term liquidity are cash flow from operations and its revolving line of credit.

     Operating Activities

     Cash used in operations was $2.0 million for the six months ended February 28, 2011 compared with cash provided by operating activities of $11.6 million for the same period last year. The decline in operating cash flow was primarily due to working capital requirements, including cash payments on derivative positions. Working capital used $7.7 million of cash during the six months ended February 28, 2011 compared to cash contributed by working capital of $5.4 million during the first six months of fiscal 2010.

     Investing Activities

     During the first half of fiscal 2011, capital expenditures were $3.4 million, which were primarily for growth and productivity projects. The Company expects total capital expenditures for fiscal 2011 to be $10-15 million. Repayments of intercompany loans by the Company’s Australian discontinued operations in fiscal 2010 are reflected as cash provided by investing activities.

     Financing Activities

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

     Under the 2010 Agreement, the Company may borrow $60 million under a revolving line of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. At February 28, 2011, the Company had $25.4 million outstanding under its revolving credit facility. Pursuant to the 2010 Agreement, there are no scheduled principal payments prior to maturity of the 2010 Agreement on April 7, 2015. As of November 30, 2010, all of the Company’s outstanding bank debt was subject to variable interest rates.

     At February 28, 2011, the carrying value of the Series A Preferred Stock liability of $36.5 million includes $3.3 million of accrued dividends and $0.9 million of discount accretion for the period from the date of issuance to February 28, 2011. The accrued dividends represent dividends at the rate of 9% that may be paid or accrued at the option of the Company. Dividends on the Series A Preferred Stock and the discount accretion are recorded as interest expense in the Condensed Consolidated Statements of Operations.

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

     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 caused by 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 February 28, 2011 the Company had $1.7 million outstanding related to the IDED loans.

Contractual Obligations

     The Company is a party to various debt and lease agreements at February 28, 2011 that contractually commit the Company to pay certain amounts in the future. The Company also has open purchase orders entered into in the ordinary course of business for raw materials, capital projects and other items, for which significant terms have been confirmed. As of February 28, 2011, there have been no material changes in the Company’s contractual obligations since August 31, 2010, except for expected contributions to the Company’s pension plans for fiscal 2011. The Company expects to contribute $6.1 million during fiscal 2011, of which $4.8 million has been contributed as of April 7, 2011.

Off-Balance Sheet Arrangements

     The Company had no off-balance sheet arrangements at February 28, 2011.

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, issuance, 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.

Critical Accounting Policies and Estimates

     The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The process of preparing financial statements requires management to make estimates, judgments and assumptions that affect the Company’s financial position and results of operations. These estimates, judgments and assumptions are based on the Company’s historical experience and management’s knowledge and understanding of the current facts and circumstances. Note 1 to the Consolidated Financial Statements in the Annual Report on Form 10-K for the fiscal year ended August 31, 2010 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. Management believes that its estimates, judgments and assumptions are reasonable based upon information available at the time this report was prepared. To the extent there are material differences between estimates, judgments and assumptions and the actual results, the financial statements will be affected.

Forward-looking Statements

     This Quarterly Report on Form 10-Q (“Quarterly Report”), including but not limited to statements found in the Notes to Condensed Consolidated Financial Statements and in Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains statements that are forward-looking statements within the meaning of the federal securities laws. In particular, statements pertaining to anticipated operations and business strategies contain forward-looking statements. Likewise, statements regarding anticipated changes in the Company’s business and anticipated market conditions are forward-looking statements. Forward-looking statements involve numerous risks and uncertainties and should not be relied upon as predictions of future events. Forward-looking statements depend on assumptions, dates or methods that may be incorrect or imprecise, and the Company may not be able to realize them. Forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” or “anticipates,” or the negative use of these words and phrases or similar words or phrases. Forward-looking statements can be identified by discussions of strategy, plans or intentions. Readers are cautioned not to place undue reliance on these forward-looking statements which are based on information available as of the date of this report. The Company does not undertake any obligation to publicly update or revise any forward-looking statements to reflect future events, information or circumstances that arise after the date of the filing of this Quarterly Report. Among the factors that could cause actual results to differ materially are the risks and uncertainties discussed in this Quarterly Report, including those referenced in Part II Item

1A of this Quarterly Report, and those described from time to time in other filings made with the Securities and Exchange Commission, including the Company’s Annual Report on Form 10-K for the year ended August 31, 2010, which include but are not limited to:

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

     Item 3: Quantitative and Qualitative Disclosures about Market Risk.

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

     Item 4: Controls and Procedures.

     Evaluation of Disclosure Controls and Procedures

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

     Under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of February 28, 2011. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures were effective as of February 28, 2011.

     Changes in Internal Control over Financial Reporting

     There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended February 28, 2011 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II — OTHER INFORMATION

     Item 1: Legal Proceedings

     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.

     Item 1A: Risk Factors

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

     Item 6: Exhibits.

     (d) Exhibits

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

SIGNATURES

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

EXHIBIT INDEX

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