† 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;

† the amount and timing of expenditures for flood restoration costs and related insurance recoveries;

† 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;

† foreign currency exchange rate fluctuations;

† 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, or

† other factors described in Part I, Item 1A "Risk Factors."

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

In analyzing business trends, management considers a variety of performance and financial measures, including sales revenue growth, sales volume growth, 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 Notes 1 and 16 to the Condensed Consolidated Financial Statements for additional information regarding the Company's business segment operations.
Impact of Cedar Rapids Flood
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. By the end of the first quarter of fiscal 2009, the facility's processing rate had reached pre-flood levels.
During the second quarter of fiscal 2009, the Company recorded $0.6 million of flood restoration costs which are recognized, net of insurance recoveries of $4.4 million, in loss from operations in the financial statements. For the six months ended February 28, 2009, the Company recorded $7.4 million of flood restoration costs which are recognized, net of insurance recoveries of $15.5 million, in loss from operations in the financial statements. The total direct costs of the flood since June 2008 were $45.5 million, which included ongoing expenses during the time the plant was shut down, but did not include lost profits. See Note 3 to the Condensed Consolidated Financial Statements for details of the restoration costs.
During the second quarter of fiscal 2009, the Company recognized $4.4 million of insurance recoveries. These recoveries have been recorded as an offset to the losses caused by the flooding. The insurance recoveries recognized to date total $26.0 million.
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 Company will continue to process its claim for flood losses under its insurance policies, but is unable to estimate the amount or timing of future recoveries. The amount ultimately recovered from the Company's insurers may be materially more or less than the Company's direct costs of the flood.
Goodwill
During the second quarter of fiscal 2009, the Company continued to experience a worsening demand outlook, a decline in its sales and operating income, as well as a reduction in its expected future cash flows. In addition, Penford experienced a sustained, significant decline in its stock price. During the second quarter of fiscal 2009, the Company concluded that there were sufficient indicators to perform an interim goodwill impairment analysis in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets." Based on the analysis, the Company recorded a $13.8 million non-cash goodwill impairment charge, which represented all of the goodwill allocated to its Australia/New Zealand Operations segment. See Note 4 to the Condensed Consolidated Financial Statements.
Accounting Changes
Effective September 1, 2008, the Company adopted FASB Statement No. 157, "Fair Value Measurements" ("SFAS 157"), for financial assets and liabilities carried at fair value that are recognized or disclosed at fair value in the financial statements on a recurring basis. SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. The adoption did not have a material impact on the company's financial statements. See Note 14 to the Condensed Consolidated Financial Statements. Due to the issuance of FASB Staff Position No. 157-2 ("FSP 157-2"), the effective date of SFAS 157 has been deferred to fiscal years beginning after November 15, 2008 (fiscal 2010 for the Company) for non-recurring, nonfinancial assets and liabilities that are recognized or disclosed at fair value. The Company is continuing to evaluate the impact of adopting these provisions in fiscal 2010. In October 2008, the FASB issued FSP FAS 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active" ("FSP 157-3"). FSP 157-3 clarifies the application of SFAS 157 and addresses how the fair value of a financial asset is determined when the

market for that financial asset is inactive. FSP 157-3 was effective upon issuance. The implementation of this standard did not have an impact on the Company's consolidated financial statements.
In February 2007, the FASB issued Statement No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FASB No. 115" ("SFAS 159") which allows companies the option to measure certain financial assets and financial liabilities at fair value at specified election dates. The Company adopted SFAS 159 and elected not to measure any additional financial instruments and other items at fair value.
In March 2008, the FASB issued Statement No. 161, "Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB No. 133" ("SFAS 161"). SFAS 161 requires additional disclosures about the objectives for using derivative instruments and hedging activities, the method of accounting for such instruments under SFAS 133 and its related interpretations, the effect of derivative instruments and related hedged items on financial position, results of operations, and cash flows, and a tabular disclosure of the fair values of derivative instruments and their gains and losses. Effective December 1, 2008, the Company adopted SFAS 161. See Note 14 to the Condensed Consolidated Financial Statements.
Results of Operations
Executive Overview
Consolidated sales for the three months ended February 28, 2009 declined 9.2% to $79.8 million from $87.9 million in the second quarter of fiscal 2008, primarily due to a significant decline in the demand for paper and writing products, a shift in the manufacturing mix in the Industrial Ingredients - North America business to produce ethanol which sells at lower average prices than industrial starches, and lower foreign currency exchange rates in the Australia/New Zealand operations. These factors were partially offset by favorable unit pricing in the Australia/New Zealand operations and the Food Ingredients - North America segments. Consolidated second quarter gross margin declined $15.6 million to a loss of $4.1 million, primarily due to a decline in ethanol selling prices which caused a gross margin loss at the Industrial Ingredients - North America segment, as well as lower plant utilization in the Australia/New Zealand business. Loss from operations was $23.0 million, $25.7 million lower than the second quarter operating income of $2.7 million for fiscal 2008 due to gross margin declines and a $13.8 million non-cash goodwill impairment charge related to its Australian and New Zealand business segment. See Note 4 to the Condensed Consolidated Financial Statements.
Consolidated sales for the six months ended February 28, 2009 decreased 12.2% to $160.5 million from $182.7 million in the same period last year on lower foreign currency exchange rates and a decline in sales volumes in the Australia/New Zealand Operations, and, in the Industrial Ingredients - North America business, on lower average unit selling prices for ethanol than for industrial starches. These factors were partially offset by higher average unit pricing in the Australia/New Zealand and Food Ingredients - North America businesses. Gross margin as a percent of sales was 0.8%, compared to 15.2% last year, on higher grain costs in Australia and New Zealand, revenue declines, and lower plant utilization in the Australia/New Zealand business. Operating loss for the first half of fiscal 2009 declined to $22.2 million from operating income of $8.4 million for the first half of fiscal 2008 due to decreased gross margins and a $13.8 million non-cash goodwill impairment charge related to its Australian and New Zealand business segment. See Note 4 to the Condensed Consolidated Financial Statements. Included in operations for the three- and six-month periods ended February 28, 2009 were net insurance proceeds of $3.8 million and $8.0 million, respectively. See Note 3 to the Condensed Consolidated Financial Statements. Operating income for the first six months of fiscal 2008 included $1.3 million of severance costs related to reconfiguring the Australia/New Zealand business. See Note 15 to the Condensed Consolidated Financial Statements. A discussion of segment results of operations and the effective tax rate follows.
Industrial Ingredients-North America
In the second quarter of fiscal 2009, U.S. economic activity contracted significantly and demand for our customers' paper and packaging products declined sharply. The paper industry balanced manufacturing capacity with decreased demand by taking downtime or permanently closing mills and operating rates at paper mills decreased. Declines in the prices for gasoline and other fuels have also depressed prices for ethanol.
Second quarter fiscal 2009 sales at the Company's Industrial Ingredients-North America business unit declined $1.8 million, or 3.6%, to $47.3 million. Starch volumes decreased as demand declined for paper and packaging products. Average unit selling prices improved for the core starch product lines by 8.5% and sales and pricing for the

Company's specialty Liquid Natural Additives applications improved modestly from a year ago. Sales of ethanol, which the Company began producing in the third quarter of last fiscal year, were $14.3 million in the second quarter of fiscal 2009. Sales for the first half of fiscal 2009 decreased 9% to $89.2 million as double-digit improvements in unit pricing in all starch categories were not able to offset volume declines. Sales of ethanol, which was not produced in the first half of fiscal 2008, were $24.0 million for the first six months of fiscal 2009.
Income from operations for the second quarter of fiscal 2009 at the Company's Industrial Ingredients-North America business unit decreased from $4.6 million a year ago to an operating loss of $6.7 million in fiscal 2009. Second quarter fiscal 2009 gross margin was a loss of $7.4 million compared to positive margin of $7.4 million for the second quarter of fiscal 2008. Unit margins on ethanol are lower than industrial starch and the decline in ethanol selling prices as well as the unfavorable mix in revenues decreased gross margin for the industrial business. Margin and operating losses of $7.3 million and $4.9 million, respectively, for the six months ended February 28, 2009 were also driven by the increase in lower margin ethanol sales and the reduction in starch sales to the paper markets. See Note 3 to the Condensed Consolidated Financial Statements for a discussion of the insurance recoveries and costs associated with the flooding in the summer of 2008. The Company recorded net insurance recoveries of $3.8 million and $8.0 million for the second quarter and first half of fiscal 2009, respectively.
Food Ingredients-North America
Fiscal 2009 second quarter sales for the Food Ingredients-North America segment of $16.6 million increased 6.3%, or $1.0 million, from the second quarter of fiscal 2008, due to higher average unit pricing and improved mix with 18% growth in potato coating sales and higher sales of pet chew and treats product lines. Sales for the six months ended February 28, 2009 rose 8.3%, or $2.6 million, to $34.4 million over the same period last year. Sales growth was driven by improvements in potato coatings and the pet chew and treats product lines and a 27% increase in sales of applications for the dairy/cheese end market and higher sales in the sauces and gravies end markets.
Income from operations for the second quarter of fiscal 2009 at the Food Ingredients-North America segment was $2.8 million, a 28% increase over the same period last year. Second quarter gross margin improved 15.3% to $4.8 million on favorable pricing and product mix and lower distribution costs, partially offset by lower volumes. Income from operations for the first half of fiscal 2009 improved to $6.2 million, a $1.4 million increase compared to the same period of fiscal 2008. Gross margin increased by $1.4 million, and gross margin as a percent of sales expanded 180 basis points over last year's period on improved pricing and lower distribution costs, partially offset by lower volumes. Operating expenses and research activities were comparable to the same period last year as higher employee-related costs were offset by lower expenditures for product trials.
In the second quarter of fiscal 2009, the Company's Food Ingredients - North America business segment sold assets related to its dextrose product line to a third-party purchaser for $2.9 million, net of transaction costs. The Company recorded a $1.6 million gain on the sale, reflected in "Non-operating income, net" in the statement of operations.
Australia/New Zealand Operations
Sales at the Australia/New Zealand operations declined 31.5%, or $7.4 million, in the second quarter of fiscal 2009 over the same period of fiscal 2008 primarily due to the decline in the foreign currency exchange rates compared to the U.S. dollar. Lower sales volume of 11% due to rationalization of lower-margin products, partially offset by higher average unit pricing also contributed to the decline in second quarter revenues. Second quarter sales in local currency declined by 8.8% over the same quarter of fiscal 2008 and average unit pricing in local currency increased 2.7%. Sales for the six months ended February 28, 2009 decreased 29.9% to $37.4 million from $53.4 million last year, primarily due to a 21% decrease in the average foreign currency exchange rate and an 18% decline in sales volumes, partially offset by higher average unit pricing. Sales in local currency decreased 11% and average unit pricing increased 8.7% in local currency.
In the second quarter of fiscal 2009, the Company recorded a $13.8 million non-cash goodwill impairment charge. See Note 4 to the Condensed Consolidated Financial Statements. Fiscal 2009 second quarter loss from operations at the Company's Australia/New Zealand operations was $16.8 million compared to an operating loss of $2.0 million in the same period of fiscal 2008. Second quarter fiscal 2009 gross margin declined by $1.5 million to a loss of $1.6 million. Grain costs in the quarter were $1.0 million higher than a year ago as the drought in the region continued. Unit manufacturing costs rose on lower manufacturing throughput due to product rationalization as well as lower yields and

supply interruptions on non-local grain as the Company shifts to grain produced in northern Australia. Operating loss for the six months ended February 28, 2009 was $18.3 million, compared to an operating loss of $2.1 million for the same period last year. First half 2009 gross margin declined $4.6 million from last year, from positive margin of $3.0 million to a loss of $1.6 million as raw material grain costs rose $5.4 million and unit manufacturing costs rose $2.7 million. Favorable average unit pricing of $3.4 million partially offset the increased input and production costs. Operating expenses, excluding restructuring costs, decreased $0.9 million over the second half of fiscal 2008 primarily due to the effect of a lower foreign currency exchange rate. Included in the segment's operating loss for the first half of fiscal 2008 were restructuring costs of $1.3 million. See Note 15 to the Condensed Consolidated Financial Statements.
Corporate operating expenses
Corporate operating expenses for the second quarter of fiscal 2009 were $2.4 million, a $0.3 million increase compared to the same quarter last year, primarily due to higher employee-related costs. For the six months ended February 28, 2009, corporate operating expenses increased $0.6 million to $5.2 million over the same period a year ago due to an increase in professional fees and employee-related costs.
Interest expense
Interest expense for the three and six months ended February 28 2009 increased $0.7 million and $1.0 million, respectively, compared to the same periods last year due to higher average debt balances. In addition, interest costs related to construction of the ethanol manufacturing plant were capitalized until May 2008, when the facility began commercial production. Interest costs capitalized were $0.5 million and $0.8 million for the three and six months ended February 29, 2008. In February 2009, the Company entered into the Second Amendment to the 2007 Agreement. This amendment adjusts certain covenants and other provisions in the 2007 Agreement to provide additional relief from the financial impact of the flood at the Company's Cedar Rapids, Iowa facility. Additionally, the maximum commitment fee for undrawn balances will increase by 10 basis points. The maximum LIBOR margin payable on outstanding debt will increase by 100 basis points. The incremental annual interest expense from these pricing changes is estimated at $0.8 million per annum, based on current outstanding borrowings. See Note 8 to the Condensed Consolidated Financial Statements.
Income taxes
The Company's Australian operations reported a tax loss for fiscal 2008 and for the first half of fiscal 2009. Australian tax law provides for an unlimited carryforward period for net operating losses but does not allow losses to be carried back to previous tax years. Due to the uncertainty related to generating sufficient future taxable income in Australia, the Company currently believes that it is more likely than not that the net deferred tax benefit will not be realized. Accordingly, in the second quarter of fiscal 2009 the Company recorded a $2.1 million valuation allowance against the entire Australian net deferred tax asset. A valuation allowance has not been recognized on the net U.S. deferred tax asset as there is sufficient taxable income in carryback years to realize the net deferred tax asset.
The Company's effective tax rates for the three- and six-month periods ended February 28, 2009 were 1.1% and 3.2%, respectively. The reduction in the effective tax rates from the U.S. federal statutory rate is primarily due to
(1) a $2.1 million valuation allowance recognized against the Australian net deferred tax assets as discussed above, and (2) no recognition of a tax benefit in connection with the Australian goodwill impairment charge of $13.8 million as this charge is not deductible for tax purposes, and (3) an increase in the amount of unrecognized tax benefits as discussed below. The amount of unrecognized tax benefits determined in accordance with Financial Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"), increased by $0.7 million and $0.8 million for the three and six months ended February 28, 2009. The total amount of unrecognized tax benefits at February 28, 2009 was $1.5 million, all of which, if recognized, would favorably impact the effective tax rate. The Company has been notified by one state taxing jurisdiction that its tax return will be audited beginning in the third quarter of fiscal 2009. None of the Company's other income tax returns are under examination by taxing authorities. The Company does not believe that the total amount of unrecognized tax benefits at February 28, 2009 will change materially in the next 12 months. On a quarterly basis, the Company reviews its estimate of the effective income tax rate expected to be applicable for the full fiscal year. This rate is used to calculate income tax expense or benefit on current year-to-date pre-tax income or

loss. Income tax expense or benefit for the current interim period is the difference between the computed year-to-date income tax amount and the tax expense or benefit reported for previous quarters. In reviewing its effective tax rate, the Company uses estimates of the amounts of permanent differences between book and tax accounting and projections of fiscal year pre-tax income or loss. Adjustments to the Company's tax expense related to the prior fiscal year, amounts recorded in accordance with FIN 48 and changes in tax rates are treated as discrete items and are recorded in the period in which they arise.
The determination of the annual effective tax rate applied to current year income or loss before income tax is based upon a number of estimates and judgments, including the estimated annual pretax income of the Company in each tax jurisdiction and the amounts of permanent differences between the book and tax accounting for various items. The Company's interim tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits, judgments regarding uncertain tax positions and other items that cannot be estimated with any certainty. Therefore, there can be significant volatility in the interim provision for income tax expense.
Non-operating income, net
Non-operating income, net consists of the following:

                                                           Three months ended                          Six months ended
                                                   February 28,          February 29,         February 28,         February 29,
                                                       2009                  2008                 2009                 2008
                                                                                   (In thousands)
Royalty and licensing income                      $          377         $         405        $         787        $         855
Gain on sale of dextrose product line                      1,562                     -                1,562                    -
Gain (loss) on foreign currency transactions                 (28 )                 434                 (641 )                444
Other                                                         13                   (48 )                  6                  (45 )

Total                                             $        1,924         $         791        $       1,714        $       1,254

In February 2009, the Company's Food Ingredients - North America business segment sold assets related to its dextrose product line to a third-party purchaser for $2.9 million, net of transaction costs. The Company recorded a $1.6 million gain on the sale.
During the three and six months ended February 28, 2009, the Company recognized a net foreign currency transaction loss on Australian dollar denominated assets and liabilities as disclosed in the table above. See Note 12 to the Condensed Consolidated Financial Statements for information on the Company's royalty and licensing income.
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. In the first half of fiscal 2009, the Company received $15.5 million of insurance proceeds related to the damages sustained in the flooding in Cedar Rapids, Iowa in June 2008. Costs incurred in the same period associated with the flood recovery were $7.4 million. See the "Overview" section of this Part I, Item 2 and Note 3 to the Condensed Consolidated Financial Statements for a discussion of the impact of the flooding on the Company's liquidity. The Company also sold its assets related to its dextrose product line in the second quarter of fiscal 2009 for cash proceeds of $2.9 million. In February and March 2009, the Company's Industrial Ingredients business reduced its workforce by nearly 20%.
Penford had working capital of $43.5 million and $38.1 million at . . .