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, packaging 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 12 to the Condensed Consolidated Financial Statements for additional information regarding the Company's business segment operations. In January 2012, the Company acquired, through purchase or lease, the net assets and operations of Carolina Starches, which manufactures and markets industrial potato starch products and blends for the paper and packaging industries. The net assets and results of operations since acquisition have been integrated into the Company's existing business segments. The acquired net assets, consisting primarily of property, plant and equipment and working capital, are being managed by and included in the reported balance sheet amounts of the Company's Food Ingredients business. Consolidated assets at May 31, 2012 included $10.5 million of assets related to the acquisition.

The sales and marketing functions of the acquired operations are being managed by the Industrial Ingredients business; therefore, the sales, cost of sales and a majority of the operating expenses are included in the Industrial Ingredients segment's results of operations in the Condensed Consolidated Financial Statements and this Part I Item 2.

At the end of April 2012, the Company redeemed $20.0 million of its outstanding Series A 15% Cumulative Non-voting Non-Convertible Preferred Stock ("Series A Preferred Stock"). The redemption amount included 41,250 shares of preferred stock at the original issue price of $16.5 million plus accrued dividends of $3.5 million. The redemption was funded with available balances on the Company's existing revolving credit facility.

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

Quarters ended May 31, 2012 and 2011

• Consolidated sales increased 9% to $92.9 million from $85.2 million.

• Sales growth was driven by volume increases in both Industrial and Food Ingredients businesses and sales contributed by the Carolina Starches operations acquisition.

• Consolidated gross margin as a percent of sales was comparable to a year ago at 12%. Gross margin was higher by $1.0 million.

• Company redeemed $16.5 million of the Series A Preferred Stock plus $3.5 million of accrued dividends. In connection with the redemption, the Company recorded $2.3 million of discount accretion and $0.5 million of issuance cost amortization as a loss on the redemption in other non-operating income (expense).

• Income tax expense was $3.9 million on a pre-tax loss of $1.6 million, reflecting non-deductible preferred stock dividends, discount accretion and issuance cost amortization, and a $1.8 million tax valuation allowance.

Nine months ended May 31, 2012 and 2011

• Consolidated sales increased 16% to $269.9 million from $231.8 million.

• Sales growth driven by volume increases in the Food Ingredients business and improvements in pricing and product mix in both businesses. The acquisition of the Carolina Starches operations expanded year-to-date sales by $9.0 million.

• Consolidated gross margin expanded by $6.1 million and income from operations improved by $3.6 million.

Industrial Ingredients

Third quarter fiscal 2012 sales at the Company's Industrial Ingredients business unit increased $5.2 million, or 8.4% to $66.8 million from $61.6 million during the third quarter of fiscal 2011. This increase was primarily due to revenue of $5.3 million from the acquisition of the Carolina Starches business. Ethanol sales declined $4.9 million, or 17.6%, to $23.1 million from $28.1 million on lower average unit selling prices. Industrial corn starch sales in the three months ended May 31, 2012 increased $4.8 million, or 14.3%, to $38.3 million from $33.5 million last year. Approximately 60% of this increase is attributable to higher volume and the remaining increase due to favorable pricing and product
mix. Sales of the Company's bio-products, included in the industrial corn starch sales amount, grew 22%, driven by a volume increase of 14% and a 7% improvement in average unit pricing and product mix.

Industrial Ingredients sales for the nine months ended May 31, 2012 increased $20.7 million, or 12.1%, to $192.9 million from $172.1 million for the same period in fiscal 2011. Sales of industrial potato starch products and blends of $9.0 million related to the acquisition of the Carolina Starches business in mid-January 2012 were included in the year-to-date segment operating results for fiscal 2012. Industrial corn starch sales expanded $10.4 million, or 11%, to $104.1 million on higher average unit pricing of 16%. Sales volume of industrial corn starch declined 5% from the first nine months of fiscal 2011. Sales of bio-products, included in the industrial corn starch sales amount, for the nine months ended May 31, 2012 rose 29% on volume increases of 20% and favorable pricing and product mix of 8%. Year-to-date fiscal 2012 ethanol sales increased 2% to $79.8 million from $78.4 million a year ago on higher average unit selling prices. Year-to-date fiscal 2012 ethanol sales volume was comparable to the same period in the prior year.

Industrial Ingredients' income from operations for the third quarter of fiscal 2012 was $0.1 million compared with an operating loss of $0.7 million a year ago. Gross margin for the third quarter of fiscal 2012 increased $0.6 million due to lower net corn costs of $1.3 million and lower manufacturing costs of $0.4 million, partially offset by lower ethanol pricing. Operating and research and development expenses for the third quarter of fiscal 2012 were $0.2 million lower than a year ago due to higher expenses of $0.6 million a year ago to increase the accounts receivable reserve, partially offset by higher fiscal 2012 expenses due to the acquisition of the Carolina Starches operations.

Industrial Ingredients' loss from operations for the nine months ended May 31, 2012 was $0.2 million compared with an operating loss of $1.7 million a year ago. The decrease in the operating loss was primarily due to a $1.6 million improvement in gross margin. Gross margin expanded due to higher corn starch and ethanol pricing of $6.3 million and lower energy and other manufacturing costs of $1.5 million, offset by lower corn starch volume of $0.8 million, and an increase in corn and chemical costs of $5.4 million. Operating and research and development expenses increased by $0.1 million in the first nine months of fiscal 2012 due to higher spending on product development and expenses of the Carolina Starches operations acquired in the second quarter, partially offset by lower charges to the accounts receivable reserve of $0.6 million.

Food Ingredients

Fiscal 2012 third quarter sales for the Food Ingredients segment of $26.2 million increased 10.7%, or $2.5 million, over the third quarter of fiscal 2011. Higher volume contributed about 75% of the revenue growth with the remaining increase attributable to favorable pricing and product mix. Sales of coating applications rose 12% on favorable pricing. Sales of non-coating applications expanded 10%, led by sales to the protein and bakery/gluten free end markets. Sales of non-coating value-added applications contributed over 60% of total segment revenues and accounted for about 60% of sales growth in the third quarter.

Operating income for the third quarter of fiscal 2012 at the Company's Food Ingredients segment declined 3% to $5.3 million from $5.5 million in the same period last year due to an increase in operating and research and development expenses of $0.6 million, partially offset by an improvement in gross margin of $0.4 million. Third quarter gross margin improved 5.3% to $8.2 million from $7.8 million last year primarily on favorable average unit pricing and product mix. Operating and research and development expenses increased due to higher employee costs.

Year-to-date income from operations improved $2.7 million, or 19%, to $16.6 million. Gross margin expanded $4.5 million to $24.1 million primarily on favorable pricing and product mix. Operating and research and development expenses increased $1.9 million due to higher employee and marketing costs of $1.7 million and $0.2 million in lower expenses a year ago due to the collection of a receivable included in the Company's reserve for uncollectible accounts.

Corporate operating expenses

Corporate operating expenses for the third quarter of fiscal 2012 decreased $0.4 million to $1.8 million from $2.2 million in the third quarter last year due to a reduction in employee costs. For the nine months ended May 31, 2012, corporate operating expenses increased $0.6 million to $6.7 million from $6.1 million in the prior year due to higher professional fees, offset by lower employee costs.

Non-operating income

In the third quarter of fiscal 2012, the Company recorded $2.3 million of discount accretion and amortization of issuance costs of $0.5 million in connection with the Series A Preferred Stock redemption.

Interest expense

At the end of April 2012, the Company redeemed $20.0 million of its outstanding Series A 15% Cumulative Preferred Stock. The redemption amount included 41,250 shares of preferred stock at the original issue price of $16.5 million plus accrued dividends of $3.5 million. The redemption was funded with available balances on the Company's existing revolving credit facility.

Interest expense for the third quarter of fiscal 2012 was comparable to the last year's third quarter at $2.3 million. Lower preferred stock dividends due to the redemption in April 2012 were offset by higher interest expense on $20 million of funds borrowed on the revolving credit facility. Interest expense for the nine-month period ended May 31, 2012 increased $0.2 million compared with the same period last year, primarily due to the cumulative effect of unpaid accrued dividends on the Company's Series A Preferred Stock upon which interest expense is computed, offset by lower interest rates in May 2012 on the $20 million of bank borrowings for the preferred stock redemption. See Note 5 to the Condensed Consolidated Financial Statements and "Financing Activities" below.

Income taxes

For the first nine months of fiscal 2012, the Company recorded $5.0 million of income tax expense on pre-tax loss of $0.2 million. The difference between the recorded tax expense and the expected tax expense of $0.1 million at the U.S. federal statutory tax rate was primarily due to federal and state income taxes on $8.6 million of non-deductible dividends, accretion of discount and amortization of issuance costs on the redemption of the Series A Preferred Stock which are reported as interest expense and other non-operating expense in the Condensed Consolidated Statements of Operations, and the valuation allowance recorded of $1.8 million discussed below. For the third quarter of fiscal 2012, the Company recorded $3.9 million of income tax expense on a pre-tax loss of $1.6 million. The difference between the recorded tax expense and the expected tax benefit was due to federal and state income taxes on $4.6 million of non-deductible dividends, discount accretion and amortization of issuance costs on the redemption of the Series A Preferred Stock included in interest expense and other non-operating expense and the recording of the $1.8 million valuation allowance.

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

At May 31, 2012, the Company had $9.2 million of net deferred tax assets. These net deferred tax assets include federal net operating loss carryforwards expiring in 2030, state net operating loss carryforwards with various expiration dates, alternative minimum tax credit carryforwards with no expiration, research and development tax credit carryforwards expiring 2025 through 2032, small ethanol producer tax credit carryforwards expiring in 2014, and deductible temporary differences relating to on-going differences between book and taxable income. 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, except for the small ethanol producer tax credit carryforwards.

In the third quarter of fiscal 2012, the Company recorded a $1.8 million valuation allowance related to small ethanol producer tax credit carryforwards which expire in fiscal 2014. Tax laws require that any net operating loss carryforwards be utilized before the Company can utilize the small ethanol producer tax credit carryforwards. As a result of challenging market trends in the third quarter related to the cost of corn and ethanol pricing and the redemptions of the Company's Series A Preferred Stock discussed in Notes 5 and 16, estimates of future taxable income during the carryforward periods have been revised. Due to the near-term expiration of the small ethanol producer tax credit carryforward period, the Company does not believe it has sufficient positive evidence to substantiate that the small ethanol tax credit carryforwards are realizable at a more-likely-than-not level of assurance and has recorded a $1.8 million valuation allowance. The valuation allowance will be reversed in future periods if these tax credit carryforwards are utilized.

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 provided by operations was $7.6 million for the nine months ended May 31, 2012 compared with a use of cash of $0.2 million for the same period last year. The increase in operating cash flow was primarily due to lower working capital requirements.

Investing Activities

Capital expenditures for the first nine months of fiscal 2012 were $9.3 million. The Company expects total capital expenditures for fiscal 2012 to be approximately $12-$15 million. In January 2012, the Company acquired Carolina Starches for $8.5 million in cash which was financed through borrowing on the Company revolving credit facility. See Note 15 to the Condensed Consolidated Financial Statements.

Financing Activities

Pursuant to its existing credit facility, the Company may borrow up to $60 million under a revolving line of credit. The lenders' revolving credit loan commitment may be increased under certain conditions. At May 31, 2012, the Company had $48.2 million outstanding under its revolving credit facility, an increase of $26.1 million since August 31, 2011. There are no scheduled principal payments prior to maturity of the credit facility on April 7, 2015. As of May 31, 2012, all of the Company's outstanding bank debt was subject to variable interest rates.

At May 31, 2012, the carrying value of the Series A Preferred Stock liability of $25.2 million includes $5.0 million of accrued dividends and $1.3 million of accumulated discount accretion. 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.

On July 9, 2012 the Company completed the redemption of the 15% Series A Preferred Stock for $28.9 million which included $5.4 million of accrued dividends. Also on July 9, 2012, the Company entered into a new credit agreement which expanded the Company's revolving credit facility from $60 million to $130 million. See Note 16 to the Condensed Consolidated Financial Statements.

Contractual Obligations

The Company is a party to various debt and lease agreements at May 31, 2012 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. There have been no material changes in the Company's contractual obligations since August 31, 2011, except for a change in the cash payments for dividends on preferred stock and the redemption of the shares.

On April 27, 2012, the Company redeemed $20.0 million of its Series A 15% Cumulative Non-Voting Non-Convertible Preferred Stock ("Series A Preferred Stock"). The Company redeemed 41,250 shares at the original issue price of $16.5 million plus accrued dividends of $3.5 million. As of May 31, 2012, the contractual commitments in connection with the Series A Preferred Stock were as follows (in thousands):

                                        2012       2013-2014       2015-2016       2017 & After       Total
Dividends on preferred stock (1)        $ 427     $     3,779     $     4,516     $       21,877     $ 30,599
Redemption of preferred stock (2)          -               -               -              23,500       23,500

(1) Payments for dividends on the Series A Preferred Stock represent the 6% dividends due and payable in cash each quarter until redemption. The 9% dividends which may be paid in cash or accrued each quarter until redemption are assumed to be accrued and paid at redemption. Redemption is assumed to occur on April 7, 2017.

(2) Redemption of the Series A Preferred Stock is assumed to occur on April 7, 2017.

Off-Balance Sheet Arrangements

The Company had no off-balance sheet arrangements at May 31, 2012.

Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update No. 2011-05, Comprehensive Income ("ASU 2011-05"). To increase the prominence of items reported in other comprehensive income, the FASB eliminated the option of presenting components of other comprehensive income as part of the statement of changes in stockholders' equity. ASU 2011-05 requires that all nonowner changes in stockholders' equity

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. See the Company's Annual Report on Form 10-K for the fiscal year ended August 31, 2011 for a description of critical 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, 2011, 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;

• 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 bank credit agreement and preferred stock instruments;

• other factors described in the Company's Form 10-K Part I, Item 1A "Risk Factors."