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PENX > SEC Filings for PENX > Form 10-Q on 9-Jul-2013All Recent SEC Filings

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Form 10-Q for PENFORD CORP


9-Jul-2013

Quarterly Report


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 Industrial Ingredients segment produces certain by-products from its corn wet milling operations, including corn gluten feed, corn gluten meal and corn germ. 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 11 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 based products for the paper and packaging industries. The net assets and results of operations of the Carolina Starches business 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, which has experience, expertise and technologies related to the manufacture of potato starch products.

Since the primary end markets for Carolina Starches' products are the paper and packaging industries, 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.

In analyzing business trends, management considers a variety of performance and financial measures, including 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."

Restatement of Previously Issued Financial Statements

Previously, the Company had recorded the proceeds from the sale of by-products as a reduction of cost of sales. After consultation and review with the Staff of the Securities and Exchange Commission ("SEC"), the Company and the Company's Audit Committee concluded that the proceeds from the sale of by-products should be classified as sales rather than as a reduction of cost of sales. The Company restated its Annual Report on Form 10-K for the fiscal year ended August 31, 2012 and its Quarterly Reports on Form 10-Q for the quarterly periods ended November 30, 2012 and February 28, 2013 to classify by-product sales as sales in the consolidated statements of operations. The proceeds from the sale of by-products for the three and nine months ended May 31, 2012 have been classified as sales in the Condensed Consolidated Statements of Operations and in Note 11 "Segment Reporting." In addition to the amounts restated, the Company also corrected an error in the consolidated statement of cash flows for the nine months ended May 31, 2012 to classify payments related to a short term financing arrangement as a financing activity rather than as an operating activity. See Note 2 to the Condensed Consolidated Financial Statements for a discussion of the adjustments.

In connection with the restatements, the Company reevaluated the effectiveness of its disclosure controls and procedures. Based upon that reevaluation, a material weakness was identified as described in Part I, Item 4 of this Quarterly Report on Form 10-Q. See Item 4 for a discussion of the material weakness and management's remediation plan.


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Results of Operations

Executive Overview

Quarters ended May 31, 2013 and May 31, 2012:

Net income for the quarter ended May 31, 2013 was $2.1 million, or $0.16 per diluted share, compared to a net loss of $5.5 million, or $0.44 per diluted share last year.

Consolidated sales increased 9.4% to $121.7 million from $111.3 million for the same period last year.

Sales growth was driven by improvements in pricing and product mix in all businesses, volume growth in non-coating applications for the Food Ingredients business and increase in by-product sales at the Industrial Ingredients business.

Consolidated gross margin as a percent of sales was 10.8% compared to 10.3% a year ago. Gross margin was higher by $1.7 million.

Interest expense declined by $1.3 million due to lower interest rates available under the Company's bank credit facility compared with the higher borrowing costs under the Company's 15% Series A Preferred Stock which was redeemed in the third and fourth quarters of fiscal 2012.

Income tax expense for the third quarter of fiscal 2013 was 40% of pre-tax income. The difference between the third quarter effective tax rate and the statutory rate is due to a $0.3 million write-off of deferred tax assets related to expired stock option awards.

Nine months ended May 31, 2013 and 2012:

Net income for the nine months ended May 31, 2013 improved to $5.0 million from a loss of $5.2 million in the same period last year. Earnings per diluted share were $0.39 compared to a loss per diluted share of $0.42 for the nine-month period of fiscal 2012.

Consolidated sales increased 8.3% to $349.8 million from $322.9 million last year on pricing and mix improvements in both business segments, volume growth in non-coating applications for the Food Ingredients business and an increase in by-product sales at the Industrial Ingredients business.

Consolidated gross margin as a percent of sales was 10.7% in fiscal 2013 compared to 10.1% in fiscal 2012. Gross margin increased by $4.8 million on sales improvements discussed above and lower energy costs.

As discussed above for the third quarter of fiscal 2013, interest expense declined due to the redemption of the Company's preferred stock.

The Company's effective tax rate for the nine months ended May 31, 2013 was 37%. The difference between the year-to-date effective tax rate and the statutory tax rate was primarily due to the stock option award tax adjustment noted above in the third quarter and state income taxes, partially offset by the tax benefit associated with the research and development tax credit. See Note 6 to the Condensed Consolidated Financial Statements.

Industrial Ingredients

Third quarter fiscal 2013 sales at the Company's Industrial Ingredients business unit increased $8.1 million, or 9.5%, to $93.2 million from $85.1 million in the third quarter of fiscal 2012. This increase was primarily due to:

Industrial starch sales increased $0.9 million, or 2%, to $44.6 million from $43.6 million last year. The increase is primarily due to favorable product mix and pricing and the pass-through of net corn cost increases to customers, partially offset by industrial starch volume decline of 6%.

Ethanol sales increased $5.0 million, or 21.6%, to $28.1 million from $23.1 million on a 3% increase in volume and 18% increase in average unit selling prices.

By-product sales increased $2.1 million to $20.5 million from $18.4 million last year. The increase was equally due to favorable volume and pricing.

Sales for the nine-month period of fiscal 2013 increased $21.1 million, or 8.6%, to $267.0 million from $245.9 million in the prior year. The increase was primarily due to:

Sales increased $9.7 million attributable to the operations of Carolina Starches which were acquired in January 2012.

Industrial corn starch sales, excluding sales contributed by Carolina Starches, rose 9%, or $9.8 million, on favorable product mix and pricing, including the pass-through of increases in the net cost of corn, of 6% and a 3% increase in volume.

Ethanol sales declined $10.1 million as volume declined 14% and pricing was marginally higher.

By-product sales increased $11.6 million to $64.7 million from $53.1 million last year primarily on favorable pricing.

Industrial Ingredients' income from operations for the third quarter of fiscal 2013 was $0.6 million compared to $0.1 million in fiscal 2012. Gross margin for the third quarter of fiscal 2013 increased $0.9 million to $4.1 million. The increase was due to improvements in product mix and average unit pricing of $5.3 million, partially offset by higher net


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corn costs of $3.6 million, lower volume of $0.2 million and higher manufacturing costs of $0.6 million. Operating and research and development expenses increased $0.4 million in the third quarter of fiscal 2013 due to an increase in employee costs for additional research and development and bioproducts commercial resources.

Industrial Ingredients' income from operations for the nine months ended May 31, 2013 improved $1.7 to $1.5 million compared to an operating loss of $0.2 million in the prior year. Gross margin during this period improved $3.6 million to $12.2 million. Favorable product mix and pricing contributed $5.2 million to margin expansion. In addition, lower energy and chemical costs of $1.2 million and lower net corn costs of $0.4 million were offset by increased labor costs of $1.5 million, an increase in manufacturing costs of $0.4 million and the effect of lower volume of $1.3 million.

Food Ingredients

Fiscal 2013 third quarter sales for the Food Ingredients segment of $28.5 million increased 9.0%, or $2.4 million, over the third quarter of fiscal 2012. The increase was primarily due to 6% higher volume and a 3% improvement in average unit pricing. Sales of non-coating applications expanded by 17%, led by sales to the gluten-free, dairy, pet chews and soups/sauces/gravies end markets. Non-coating application sales contributed over 60% of total segment revenues and accounted for all of the sales growth in the third quarter.

Sales for the nine months ended May 31, 2013 improved 7.5%, or $5.8 million, over sales for the same period last year of $77.0 million. Sales volume improved 6% and average unit pricing increased 2%. Sales of non-coating applications to the protein, soups/sauces/gravies, dairy and gluten-free end markets grew at double-digit rates and contributed over 60% of total food ingredient sales and all of the segment revenue growth.

Operating income for the third quarter of fiscal 2013 at the Company's Food Ingredients segment increased 15.7% to $6.2 million from $5.4 million in the same period last year. Gross margin rose 10% to $9.1 million, a $0.8 million increase over last year on higher volumes and improved pricing and mix. Operating and research and development expenses were comparable to last year.

Food Ingredients' operating income for the nine months ended May 31, 2013 improved 3.2% to $17.1 million from $16.6 million in the same period last year. Gross margin rose 5.1%, or $1.2 million, on volume growth of $1.4 million, partially offset by higher raw potato starch costs. Operating and research and development expenses increased $0.7 million due to higher employee and legal costs.

Corporate operating expenses

Corporate operating expenses of $2.5 million for the third quarter of fiscal 2013 increased $0.7 million over the same period last year due to higher employee cost and professional fees. Corporate operating expenses for the first nine months of fiscal 2013 increased $1.0 million to $7.7 million from $6.7 million in the same period last year due primarily to an increase in employee costs.

Non-operating income (expense)

Non-operating income was approximately $0.1 million for the three- and nine-month periods ended May 31, 2013. In the third quarter of fiscal 2012, the Company recorded $2.8 million in discount accretion and amortization of issuance costs in connection with the Series A Preferred Stock redemption.

Interest expense

In the third and fourth quarters of fiscal 2012, the Company redeemed $40.0 million of its outstanding Series A 15% Cumulative Preferred Stock (the "Preferred Stock"). The redemptions were funded with available balances on the Company's revolving credit facility. Dividends and discount accretion on the Preferred Stock were recorded as interest expense in fiscal 2012. Interest expense for the three- and nine-month periods ended May 31, 2013 decreased $1.3 million and $4.1 million, respectively, from the same periods in fiscal 2012. The decrease was primarily due to the lower interest rates available to the Company under its credit facility compared with the higher dividend rate on the Preferred Stock. The interest rate on the Company bank debt was based on a margin over LIBOR (London Interbank Offered Rate).


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Income taxes

The Company's effective tax rates for the three- and nine-month periods ended May 31, 2013 were 40% and 37%, respectively. The difference between the third quarter effective tax rate and the U.S. federal statutory tax rate is primarily due to a $0.3 million write-off of deferred tax assets related to expired stock option awards. The difference between the effective tax rates and the U.S. federal statutory tax rate for the year-to-date period was primarily due to the adjustment noted above in the third quarter and state income taxes, partially offset by the tax benefit associated with the research and development tax credit. See Note 6 to the Condensed Consolidated Financial Statements.

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. The Series A Preferred Stock was redeemed in the third and fourth quarters of fiscal 2012.

In fiscal 2012, the Company recorded a $1.8 million valuation allowance primarily 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. 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 recorded a $1.8 million valuation allowance. The valuation allowance will be reversed in future periods if these tax credit carryforwards are utilized.

At May 31, 2013, the Company had $11.1 million of net deferred tax assets. Other than for the ethanol tax credit carryforwards discussed above, a valuation allowance has not been provided on the net U.S. deferred tax assets as of May 31, 2013. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter. The Company 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, for which a valuation allowance has been provided.

Liquidity and Capital Resources

The Company's primary sources of short- and long-term liquidity are cash flow from operations and its bank credit facility.

Operating Activities

Cash provided by operations was $14.6 million for the nine months ended May 31, 2013 compared with $6.6 million for the same period last year. The increase in operating cash flow was primarily due improved earnings over the prior period, partially offset by higher working capital requirements. The Company has increased its inventories of corn and corn starch finished goods in response to last year's drought conditions.

Investing Activities

Cash used in investing activities of $8.3 million was for investments in capital projects. See Note 4 to the Condensed Consolidated Financial Statements. The Company expects total capital expenditures for fiscal 2013 to be approximately $15 million. In the third quarter of fiscal 2013, the Company settled a claim against a contractor and its insurer that arose from engineering design work performed in connection with the construction of the Company's ethanol plant. Approximately $2.1 million of the settlement was reflected as a reduction of the cost of the ethanol plant. See Note 13 to the Condensed Consolidated Financial Statements.

Financing Activities

As of May 31, 2013, the Company had $77.0 million outstanding on its $130 million secured revolving credit facility (the "2012 Agreement") with a syndicate of banks. The lenders' loan commitment may be increased under certain circumstances.


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There are no scheduled principal payments prior to maturity of the credit facility on July 9, 2017. Interest rates under the 2012 Agreement are based on either LIBOR or the prime rate, depending on the selection of available borrowing options under the 2012 Agreement. Pursuant to the 2012 Agreement, the interest rate margin over LIBOR ranges between 2% and 4%, depending upon the Total Leverage Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as set forth in the 2012 Agreement).

The 2012 Agreement provides that the Total Leverage Ratio shall not exceed 3.50 through November 30, 2013; 3.25 through May 31, 2014; and 3.0 thereafter. In addition, the Company must maintain a Fixed Charge Coverage Ratio, as defined in the 2012 Agreement, of not less than 1.35. Fiscal 2013 annual capital expenditures will be restricted to $15 million if the Total Leverage Ratio is greater than 2.50 for the last two fiscal quarters. The Company's obligations under the 2012 Agreement are secured by substantially all of the Company's assets.

Pursuant to the 2012 Agreement, the Company may declare and pay dividends on its common stock in an amount not to exceed, in any consecutive four quarters, the lesser of $10 million or 50% of Free Cash Flow, as defined in the 2012 Agreement. As of May 31, 2013, the Company was not permitted to pay dividends.

Contractual Obligations

The Company is a party to various debt and lease agreements at May 31, 2013 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, 2012.

Off-Balance Sheet Arrangements

The Company had no off-balance sheet arrangements at May 31, 2013.

Recent Accounting Pronouncements

In February 2013, the FASB issued guidance requiring entities to provide information about the amounts reclassified out of accumulated other comprehensive income by component. Entities are required to present, either on the face of the financial statements or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. This guidance, which is effective prospectively for annual reporting periods beginning after December 15, 2012, do not change the current requirements for reporting net income or other comprehensive income. The Company is evaluating the impact this guidance will have on its disclosures.

In December 2011, the FASB issued guidance creating new disclosure requirements about the nature of an entity's rights of setoff and related arrangements associated with its financial instruments and derivative instruments. The disclosure requirements are effective for annual reporting periods, and interim reporting periods within those years, beginning on or after January 1, 2013 (fiscal 2014 for Penford). The Company is evaluating the impact this update will have on its disclosures.

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/A for the fiscal year ended August 31, 2012 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


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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/A for the year ended August 31, 2012, 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 or changes in government rules or incentives affecting ethanol consumption;

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 bank credit agreement, as amended; and

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

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