Overview

Penford generates revenues, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for industrial and food applications. 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, potatoes, and wheat and are used principally as binders and coatings in paper and food production.

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 three segments. The first two, Industrial Ingredients - North America and Food Ingredients - North America, are broad categories of end-market users, served by operations in the United States. The third segment is comprised of the Company's operations in Australia and New Zealand, which operations are engaged primarily in the food ingredients business. See Item 1 and Note 17 to the Consolidated Financial Statements for additional information regarding the Company's business segment operations.

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

Under the terms of the Company's revolving credit facility, which expires on December 31, 2011, the Company may borrow up to $60 million. At August 31, 2008, the Company had $45.7 million of unused loan commitments from its lenders under its existing revolving credit facility to fund flood restoration costs as discussed below and to fund other corporate cash flow requirements.

Impact of Cedar River Flooding

On June 12, 2008, the Company's Industrial Ingredients - North America plant in Cedar Rapids, Iowa was temporarily shut down due to record flooding of the Cedar River and government-ordered mandatory evacuation of the plant and surrounding areas. The Company resumed production of certain Liquid Natural Additive products in mid-July using its pilot plant facility, which was not heavily damaged by the flood. By the end of August 2008, the Company had begun manufacturing industrial starch in Cedar Rapids. During September 2008, the Company resumed the commercial production and sale of ethanol, and expects that its ethanol assets will be in a position to achieve full design production capability of 45 million gallons per year by the end of calendar year 2008. By the beginning of October 2008, the Company had substantially completed the restoration of the Cedar Rapids plant and the facility's current processing rate had reached pre-flood levels. The Company has begun to resupply its industrial starch customers under existing contracts. The systematic recovery and transition to resupply substantially all of the customers' contracted requirements are expected to be completed by the end of the calendar year.

The Company's potato starch operations of its Food Ingredients - North America segment were not affected by the flood in Cedar Rapids. Food corn starches were supplied from other Company locations. Dextrose manufacturing, which occurred in Cedar Rapids, was suspended at the time of the flooding and production was restarted in September 2008.

During the fourth quarter of fiscal 2008, the Company recorded costs of flood restoration of $27.6 million, net of insurance recoveries of $10.5 million. See Note 2 to the Consolidated Financial Statements for details of the restoration costs.

The Company continues to assess damages caused by the flood and estimates are subject to assumptions regarding the costs and timing to replace or refurbish equipment and processes. The Company estimates that direct costs of the flood will total $45 million to $47 million, which include ongoing expenses during the time the plant is shut down, but do not include lost profits.

The Company maintains property damage and business interruption insurance coverage applicable to the Cedar Rapids plant. The Company intends to claim for all covered losses, including $15 million in business interruption losses identified through August 31, 2008. The actual amount ultimately recovered from insurers may be materially more or less than the Company's estimate of total losses, and, as a result, the Company does not provide assurance as to the amount or timing of the ultimate recoveries under its policies.

Of the total estimated recoveries discussed above, the Company has received $10.5 million of insurance recoveries related to its property damage insurance policies. The Company received $8.0 million subsequent to August 31, 2008 which has been recorded as a receivable at that date. These recoveries have been recorded as an

offset in the financial statements to the losses caused by the flooding. Insurance proceeds are recognized in the financial statements when realization of the recoveries is deemed probable.

The effect of the flood on the financial results of the Company on a quarter-to-quarter basis in fiscal 2009 will depend on the timing and amount of the remaining expenditures and insurance recoveries. The actual amounts of expenditures and insurance recoveries may vary from the above estimates, and, as a result, the Company does not provide assurance as to the amount or timing of the total expenditures or ultimate recoveries under its insurance policies.

Operations

Consolidated fiscal 2008 sales decreased 4.6% to $345.6 million from $362.4 million in fiscal 2007 on volume declines, primarily in the Industrial Ingredients - North America business due to the fourth quarter production suspension discussed above and in the Australian/New Zealand operations due to a strategic decision to migrate product offerings to those with higher returns. The volume decline impact on revenue of $58.3 million was partially offset by improvements in unit pricing and product mix worldwide of $30.7 million, and $11.5 million resulting from stronger average foreign currency exchange rates in fiscal 2008. Gross margin as a percent of sales declined 330 basis points from 17.7% in fiscal 2007 to 14.4% in fiscal 2008. The margin reduction reflects reduced volumes, including the production disruption arising from the Cedar Rapids flood, increased manufacturing input costs, manufacturing variances arising from processing imported raw material into Australia, and start-up expenses related to the commencement of ethanol production in May 2008.

Consolidated operating income of $23.6 million in fiscal 2007 declined to an operating loss of $20.9 million in fiscal 2008. Consolidated operating expenses increased 3% from last year, primarily due to stronger average foreign currency exchange rates of $0.7 million. Research and development expenses increased $1.1 million due to increased headcount and new product trial expenses totaling $0.8 million and stronger currency exchange rates of $0.3 million. In connection with reconfiguring their operations, the Company's Australian and New Zealand businesses implemented workforce reductions during fiscal 2008 and $1.4 million in employee severance costs and related benefits were charged to operating income. In fiscal years 2008 and 2007, the Company recorded litigation settlement costs of $1.4 million and $2.4 million, respectively. See Note 19 to the Consolidated Financial Statements.

Interest expense of $4.1 million in fiscal 2008 was $1.6 million less than in fiscal 2007 due to a decline in U.S. interest rates from a year ago and lower average debt balances, excluding interest costs which were capitalized on debt related to the construction of the ethanol facility. Interest costs of $1.1 million and $0.4 million were capitalized in fiscal years 2008 and 2007, respectively, related to construction of the ethanol facility.

The effective tax rate for fiscal 2008 was 35%. In fiscal 2008, the effect of lower foreign statutory tax rates was offset by permanent differences between book and tax accounting. These differences, consisting primarily of research and development tax incentives in Australia and nontaxable foreign income, increased the taxable loss for fiscal 2008 and increased the computed effective tax rate. See Note 14 to the Consolidated Financial Statements.

Accounting Changes

The Company adopted the provisions of Emerging Issues Task Force ("EITF") Issue No. 06-2, "Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43," effective September 1, 2007. EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. Upon adoption, the Company recognized a $0.1 million charge to beginning retained earnings as a cumulative effect of a change in accounting principle.

Effective September 1, 2007, the Company adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109" ("FIN 48"), which clarifies the accounting for the uncertainty in income taxes recognized by prescribing a recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, classification, interest and penalties, interim period accounting and disclosure. The impact of adopting FIN 48 is discussed in Note 14 to the Condensed Consolidated Financial Statements.

Results of Operations

Fiscal 2008 Compared to Fiscal 2007

Industrial Ingredients - North America


                                                Year Ended August 31,
                                                 2008            2007
                                               (Dollars in thousands)

             Sales                           $     173,320     $ 194,957
             Cost of sales                   $     147,072     $ 159,851
             Gross margin                             15.1 %        18.0 %
             Income (loss) from operations   $     (16,541 )   $  19,251

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

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

Loss from operations for fiscal 2008 includes $27.6 million of flood remediation costs incurred in the fourth quarter, net of $10.5 million of insurance recoveries, as discussed above. See Note 2 to the Consolidated Financial Statements for a discussion of the costs recorded in fiscal 2008. Included in operating results for fiscal years 2008 and 2007 are expenses of $1.4 million and $2.4 million related to the settlement of a lawsuit. See Note 19 to the Consolidated Financial Statements. Operating expenses and research and development expenses increased $0.4 million.

Food Ingredients - North America


                                             Year Ended August 31,
                                              2008             2007
                                            (Dollars in thousands)

                 Sales                    $     66,261       $ 62,987
                 Cost of sales            $     47,921       $ 44,036
                 Gross margin                     27.7 %         30.1 %
                 Income from operations   $     10,178       $ 10,684

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

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

Australia/New Zealand Operations


                                                Year Ended August 31,
                                                 2008            2007
                                               (Dollars in thousands)

             Sales                           $     107,532     $ 105,244
             Cost of sales                   $     102,523     $  95,141
             Gross margin                              4.7 %         9.6 %
             Income (loss) from operations   $      (4,556 )   $   3,269

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

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

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

The segment's operating loss for fiscal 2008 included $1.4 million of employee severance costs and related benefits that were paid in connection with workforce reductions implemented during the reconfiguring of the Australian and New Zealand businesses. These costs are classified as "Restructure Costs" in the Consolidated Statements of Operations.

Corporate Operating Expenses

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

Fiscal 2007 Compared to Fiscal 2006

Industrial Ingredients - North America


                                             Year Ended August 31,
                                              2007            2006
                                            (Dollars in thousands)

                 Sales                    $     194,957     $ 165,850
                 Cost of sales            $     159,851     $ 144,656
                 Gross margin                      18.0 %        12.8 %
                 Income from operations   $      19,251     $   9,121

Industrial Ingredients' fiscal 2007 sales of $195.0 million increased $29.1 million, or 18%, over fiscal 2006, primarily driven by unit price increases and the positive effects on revenue of passing through higher corn costs. Combined, these factors added $34 million to fiscal 2007 sales. Offsetting these increases was a 6% decline in volume due to softness in the paper market as customers closed or temporarily shuttered plants.

Gross margin increased $13.9 million, or 66%, over fiscal 2006 to $35.1 million, and, as a percentage of sales, expanded to 18.0% in fiscal 2007 compared to 12.8% in fiscal 2006. Approximately $12 million of the margin growth was due to higher unit pricing and favorable product mix. Improvements in energy unit costs of $0.3 million, favorable corn procurement costs of $3.3 million and reductions in manufacturing overhead of $1.2 million also

contributed to increased margin. These favorable effects were partially offset by increased chemical costs of $0.7 million and the margin effect of a volume decline of $2.7 million.

Income from operations increased $10.1 million over fiscal 2006 due to the increase in the gross margin, partially offset by $2.4 million related to an estimated loss contingency for litigation. Operating expenses declined to 5.2% of sales in fiscal 2007, compared to 5.5% of sales in fiscal 2006. Research and development expenses remained comparable to fiscal 2006 at 1.7% of sales.

Food Ingredients - North America


                                             Year Ended August 31,
                                              2007             2006
                                            (Dollars in thousands)

                 Sales                    $     62,987       $ 57,156
                 Cost of sales            $     44,036       $ 41,954
                 Gross margin                     30.1 %         26.6 %
                 Income from operations   $     10,684       $  7,819

Sales at the Food Ingredients - North America business expanded 10.2% over the prior year driven by an 8.8% increase in average unit sales prices. Volumes increased slightly, adding 120 basis points to the revenue increase. Annual sales in the protein end market grew 17% over last year and sales of applications for the pet chew and treats product lines rose from $.05 million in fiscal 2006 to $2.4 million in fiscal 2007.

Gross margin improved by $3.7 million in fiscal 2007, due to higher unit selling prices and favorable product mix, offset by a 14% increase in the average unit cost of raw materials. Fiscal 2007 operating income increased 37% over last year on the expansion in gross margin partially offset by $0.5 million in higher employee-related expenses and increased research and development expenses of $0.1 million.

Australia/New Zealand Operations


                                             Year Ended August 31,
                                              2007             2006
                                            (Dollars in thousands)

                 Sales                    $     105,244      $ 96,121
                 Cost of sales            $      95,141      $ 87,575
                 Gross margin                       9.6 %         8.9 %
                 Income from operations   $       3,269      $  1,735

The Australian business reported a 9.5% increase in sales in fiscal 2007 over fiscal 2006. Favorable foreign currency rates and favorable unit pricing contributed 730 basis points and 140 basis points, respectively, to the revenue increase. Sales volumes increased less than 1% and sales in local currency increased 2%.

Gross margin expanded to 9.6% of sales in fiscal 2007 from 8.9% in fiscal 2006 on lower distribution costs and improved production yields and volumes. Escalating wheat costs of $1.6 million were fully offset by improved product pricing.

Total operating expenses for fiscal 2007 were comparable to fiscal 2006, but declined to 4.9% of sales from 5.6% in fiscal 2006. Research and development expenses increased by $0.2 million and, as a percent of sales, were comparable to fiscal 2006 at 1.6%. Increases in these expenses were due to enhancements to the segment's commercial and research capabilities. Operating expenses in fiscal 2006 included $0.9 million of employee severance costs.

Corporate Operating Expenses

Corporate operating expenses increased to $9.6 million in fiscal 2007 from $9.4 million in fiscal 2006. Employee related costs increased by $0.6 million partially offset by declines in legal and professional fees.

Non-Operating Income (Expense)

Other non-operating income consists of the following:


                                                          Year Ended August 31,
                                                      2008        2007        2006
                                                         (Dollars in thousands)

      Royalty and licensing income                   $ 1,874     $ 1,902     $ 1,827
      Gain (loss) on foreign currency transactions      (217 )         3         (46 )
      Gain on sale of New Zealand land                   701           -           -
      Gain on cash flow hedges                         2,890           -           -
      Other                                              186        (260 )       115

                                                     $ 5,434     $ 1,645     $ 1,896

In fiscal 2008, the Company sold a parcel of land in Auckland, New Zealand to a third-party purchaser and recognized a gain of approximately $0.7 million.

In fiscal 2003, the Company exclusively licensed to National Starch and Chemical Investment Holdings Corporation ("National Starch") certain rights to its resistant starch patent portfolio for applications in human nutrition. Under the terms of the licensing agreement, the Company received royalties during the years noted above.

As discussed in Note 2, 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 $4.1 million, $5.7 million and $5.9 million in fiscal years 2008, 2007 and 2006, respectively. Interest expense for fiscal 2008 declined $1.6 million from fiscal 2007 due to a decline in U.S. interest rates from a year ago and lower average debt balances, excluding interest costs which were capitalized on debt related to the construction of the ethanol facility. Interest costs related to construction of the ethanol manufacturing plant were capitalized until May 2008, when the facility began commercial production. Approximately $44.2 million of debt outstanding at August 31, 2008 was attributable to the construction of the ethanol production plant. Interest costs of $1.1 million and $0.4 million were capitalized in fiscal years 2008 and 2007, respectively, related to construction of the ethanol facility.

As of August 31, 2008, all of the Company's outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, was subject to variable interest rates. As of August 31, 2008, under interest rate swap agreements with several banks, the Company has fixed its interest rates on U.S. dollar denominated term debt of $28.0 million at 4.18% and $5.0 million at 5.08%, plus the applicable margin under the Company's credit facility.

Income taxes

The effective tax rates for fiscal years 2008, 2007 and 2006 were 35%, 31% and 20%, respectively. In fiscal 2008, the effect of lower foreign statutory tax rates was offset by permanent differences between book and tax accounting. These differences, consisting primarily of research and development tax incentives in Australia and nontaxable foreign income, increased the taxable loss for fiscal 2008 and increased the computed effective tax rate. See Note 14 to the Consolidated Financial Statements.

The effective tax rate for fiscal 2007 varied from the U.S. federal statutory rate of 35% primarily due to Australian and U.S. tax incentives related to research and development, the favorable tax effect of domestic (U.S.)

production activities, and the effect of a tax settlement. The tax benefits previously available to the Company related to the extraterritorial income exclusion expired in December 2006. In May 2007, the Company settled the outstanding Internal Revenue Service ("IRS") audits of the Company's U.S. federal income tax returns for the fiscal years ended August 31, 2001 and 2002. Under the settlement, the Company received a cash refund of $0.3 million. In addition, in connection with the settlement of these audits, the Company reversed a current tax liability in the amount of $0.7 million, which represented its estimate of the probable loss on certain tax positions being examined.

The effective tax rate for fiscal 2006 is lower than the statutory tax rate due to the tax benefits of the extraterritorial income exclusion ("EIE") deduction, lower tax rates on foreign earnings and research and development tax credits.

Liquidity and Capital Resources

The Company's primary sources of short- and long-term liquidity are cash flow from operations and its revolving line of credit, which expires in 2011. The Company expects to generate sufficient cash flow from operations and to have sufficient borrowing capacity and ability to fund its cash requirements during fiscal 2009. In addition, in fiscal 2009, the Company expects to receive insurance proceeds for property damage and business interruption in excess of $20 million to fund flood restoration costs.

Operating Activities

. . .