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PENFORD CORP - 10-Q - : Management's Discussion and Analysis of Financial Condition and Results of Operations.

July 8, 2014

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 10 to the Condensed Consolidated Financial Statements for additional information regarding the Company's business segment operations.

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

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

In March 2014, the Company acquired substantially all of the net assets and operations of Gum Technology ("Seller") for a purchase price of $9.9 million, subject to working capital and certain other adjustments. The funding of the purchase price was provided by borrowings under the Company's credit facility. In connection with the acquisition, $750,000 of the purchase price has been retained by the Company as a fund to satisfy certain of the Seller's post-closing obligations. The net assets, consisting primarily of intangible assets, and results of operations are included in the balance sheet and results of operations of the Company's Food Ingredients segment. Gum Technology, based in Tucson, Arizona, distributes and blends gums and hydrocolloids, serving primarily the food and beverage industries in North America and Asia. Gum Technology specializes in developing and producing customized stabilizers to meet customers' product formulation needs. This acquisition will broaden the Company's food ingredients portfolio of functional and specialty ingredient systems within the Food Ingredients segment.

Results of Operations Executive Overview Consolidated sales decreased 1.9% to $119.4 million in the third quarter of fiscal 2014 from $121.7 million for the quarter ended May 31, 2013. Consolidated sales for the nine months ended May 31, 2014 decreased 4.3% to $334.8 million compared to consolidated sales of $349.8 million for the same period a year ago. The decline in sales for the three and nine months ended May 31, 2014 was primarily due to lower average unit pricing in the Industrial Ingredients segment, partially offset by volume growth in the Food Ingredients segment. The decline in Industrial Ingredients pricing was due to the decrease in corn costs as discussed below. Consolidated gross margin as a percent of sales for the third quarter of fiscal 2014 was 12.4% compared to 10.8% a year ago. Consolidated gross margin as a percent of sales for the first nine months of fiscal 2014 was 11.3% compared to 10.7% in the same period last year. The Company amended one of its pension plans to eliminate benefit accruals. Pension expense for the third quarter of fiscal 2014 decreased by $0.4 million due to the amendment. See Note 8 to the Condensed Consolidated Financial Statements. The Company recorded $1.0 million in non-operating income to reflect the forgiveness of a loan from an agency of the State of Iowa. See Note 4 to the Condensed Consolidated Financial Statements. On March 25, 2014, the Company acquired the substantially all of the net assets of Gum Technology for a purchase price of $9.9 million, subject to working capital and certain other adjustments. The acquisition was funded by borrowings on the Company's credit facility. See Note 13 to the Condensed Consolidated Financial Statements. 24



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Industrial Ingredients

Third quarter fiscal 2014 sales at the Company's Industrial Ingredients business unit decreased $9.1 million, or 9.7%, to $84.1 million from $93.2 million during the third quarter of fiscal 2013. This decrease was primarily due to:

Industrial starch sales in the three months ended May 31, 2014 of $39.7 million were down 10.9% compared to last year's third quarter sales of $44.6 million. The decline in sales was primarily driven by lower unit pricing as the market price of corn continued to decrease causing a decline in the corn costs passed through to customers in revenue. Volume improved approximately 5.2%. Ethanol sales of $28.0 million were comparable to the prior year third quarter. A 4.8% increase in average unit selling price per gallon was offset by a 4.5% decline in volume. Sales of corn-based by-products declined 19.8% to $16.4 million from $20.5 million a year ago on a decrease in average unit selling prices.



Sales for the nine months ended May 31, 2014 at the Company's Industrial Ingredients business unit decreased $26.5 million, or 9.9%, to $240.5 million from $267.0 million last year. This increase was primarily due to:

Industrial starch sales in the nine months ended May 31, 2014 of $120.3 million decreased $12.3 million from $132.6 million in the same period of fiscal 2013. The decline in sales was driven by lower average unit pricing caused by a decrease in the corn costs passed through to customers. Ethanol sales increased $3.3 million, or 4.7%, to $73.0 million from $69.7 million on a 9.3% increase in volume, partially offset by a 3.8% decline in average unit selling price per gallon. Sales of by-products declined 26.9% to $47.3 million from $64.7 million a year ago primarily due to a decrease in average unit selling prices. Selling prices of corn by-products declined 28.6% as the cost of corn decreased. Sales volume increased 2.4% from last year.



Industrial Ingredients' operating income in the third quarter of fiscal 2014 of $2.0 million grew $1.4 million over the previous year's third quarter primarily due to an improvement in gross margin. Gross margin increased $1.2 million to $5.3 million from $4.1 million the previous year. Margin improvement was due to favorable pricing and mix of $0.5 million and lower corn costs of $3.5 million, partially offset by higher energy costs of $2.2 million, higher maintenance and distribution costs of $0.4 million and an increase in other manufacturing costs of $0.2 million. Operating and research and development expenses decreased $0.2 million on lower benefit costs.

During the third quarter of fiscal year 2014, the Company changed its estimates for useful lives of certain machinery and equipment used by the Industrial Ingredients segment to better match depreciation expense of these assets with the periods in which these assets are expected to generate revenue. The new estimated useful lives were established based on manufacturing engineering data and external benchmark data and were generally increased as compared to the previous estimates. The Company accounted for this as a prospective change in accounting estimate as of May 1, 2014, thereby impacting the current quarter and future periods. The change in the estimate lowered depreciation expense as compared to the amount that would have been recorded using the historical estimated useful lives. The effect of this change on Industrial Ingredient's third quarter 2014 operating income was $0.2 million. The Company expects, based on its current level of operations and investment in property, plant and equipment, that this change in the estimated useful lives of these assets will increase operating income in the fourth quarter of fiscal year 2014 by approximately $1.0 million, and, on an annualized basis, in the range of approximately $4.4 million to $4.6 million.

Industrial Ingredients' loss from operations for the nine months ended May 31, 2014 was $0.1 million, a decline of $1.6 million from operating income of $1.5 million in the first nine months of fiscal 2013. Year-to-date fiscal 2014 gross margin of $10.1 million decreased $2.1 million from gross margin of $12.2 million a year ago. The effect of higher sales volume of $1.5 million was offset by lower average unit pricing of $1.9 million. Also contributing to the margin contraction were higher energy costs of $3.8 million, higher maintenance and distribution costs of $2.0 million and other manufacturing cost increases of $0.4 million, partially offset by lower corn costs of $4.5 million. Energy, maintenance and distribution cost increases were primarily due to harsh winter conditions in the second quarter of fiscal 2014. Operating expenses decreased $0.5 million due to lower employee costs.

Food Ingredients

Fiscal 2014 third quarter sales for the Food Ingredients segment of $35.3 million increased 23.8%, or $6.8 million, over the third quarter of fiscal 2013. The addition of Gum Technology revenue contributed $2.1 million to the sales increase. Sales of coating applications, which contributed 27% of segment revenue in the quarter, improved 2.5% on an increase in volume of 5.0%, partially offset by a decrease in average unit pricing of 2.4%. Sales of other applications, including sales to the pet treats, protein and dairy end markets, expanded 34%.

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Year-to-date fiscal 2014 sales increased $11.5 million, or 13.8%, to $94.2 million from $82.8 million in the first nine months of fiscal 2013. The acquisition of Gum Technology added $2.1 million to 2014 year-to-date revenue growth. Excluding Gum Technology, sales improved 11.2% on sales volume growth. Sales of coating applications in the nine months ended May 31, 2014 were comparable to sales of coating applications for the same period last year. Sales of other end market applications, including sales to the pet treats and dairy end markets, expanded 16.7% on volume increases of 21.3% offset by lower unit pricing of 3.7%.

Operating income for the third quarter of fiscal 2014 at the Company's Food Ingredients segment decreased 2.9% to $6.0 million from $6.2 million in the same period last year due to an increase in gross margin of $0.5 million offset by an increase in operating and research and development expenses of $0.7 million. Gross margin of $9.6 million improved due to an increase in volume of $2.1 million, partially offset by an increase in raw material and manufacturing costs of $1.6 million. Operating and research and development expenses increased due to the addition of Gum Technology employees, as well as additional lease costs for new office and research laboratories in Colorado.

Operating income for the first nine months of fiscal 2014 increased 7.3%, or $1.2 million, to $18.3 million from $17.1 million in the same period last year primarily due to an increase in gross margin of $2.4 million. Gross margin improved due to the effect of improved sales of $3.5 million, partially offset by higher raw material and other manufacturing costs of $1.1 million. Operating expenses increased $1.1 million due to the acquisition of Gum Technology, additional employee costs and higher lease costs for facilities in Colorado.

Corporate Operating Expenses

Corporate operating expenses for the three- and nine-month periods ended May 31, 2014 increased $0.6 million and $1.0 million, respectively, due to increases in professional and audit fees and higher employee costs.

Pension Expense

In early 2014, the Company amended its Penford Corporation Retirement Plan, which is a defined benefit pension plan for certain salaried and other employees (the "Retirement Plan") to cease the further accrual of participant benefits. As a result of the amendment to the Retirement Plan, the Company performed a remeasurement of the Retirement Plan's pension benefit liability and the net periodic benefit cost. The discount rate for the remeasurement of the pension liability decreased from 5.24% as of August 31, 2013 to 4.91%. There was no change in the expected return on assets. Pension net periodic benefit cost decreased $0.4 million in the third quarter of fiscal 2014 as a result of the curtailment and the Company expects an additional $0.4 million in pension cost savings in the fourth quarter of fiscal 2014. The Company cannot estimate the effect the curtailment will have on net periodic benefit cost beyond fiscal 2014.

Interest Expense

Interest expense for the third quarter of fiscal 2014 was comparable to the same period a year ago. Interest expense for the nine months ended May 31, 2014 decreased $0.5 million compared to the comparable period last year due to a decrease in the average debt outstanding.

Income Taxes

The Company's effective tax rates for the three- and nine-month periods ended May 31, 2014 were 38.6% and 39.6%, respectively. The difference between the effective tax rates and the U.S. federal statutory rate was primarily due to state income taxes.

The tax valuation allowance at May 31, 2014 of $1.8 million was related primarily to the small ethanol producer tax credit carryforwards in the United States. Tax laws in the U.S. require that any net operating loss carryforwards be utilized before the Company can utilize the small ethanol producer tax credit carryforwards. Due to the expiration of the small ethanol producer tax credit carryforward period in 2014, the Company does not believe it has sufficient positive evidence to substantiate that the small ethanol producer tax credit carryforwards are realizable at a more-likely-than-not level of assurance.

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In the second quarter of fiscal 2014, the Company liquidated its Australian subsidiaries and received approval from the Australian tax authorities for the liquidation. As of August 31, 2013, the Company had provided a tax valuation allowance of $10.9 million against the entire Australian net deferred tax asset. During the second quarter fiscal 2014, as a result of the liquidation, the previously recorded deferred tax asset and corresponding valuation allowance were reversed, resulting in no net effect on current or deferred income taxes.

At May 31, 2014, the Company had $1.8 million of net U. S. 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, 2014. 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.

Acquisition

As discussed in Note 13 to the Condensed Consolidated Financial Statements, on March 25, 2014, the Company acquired the net assets of Gum Technology for a purchase price of $9.9 million, subject to working capital and certain other adjustments. The Condensed Consolidated Financial Statements reflect the Gum Technology financial position at May 31, 2014 and the results of operations since acquisition in the Food Ingredients segment.

Gum Technology, based in Tucson, Arizona, distributes and blends gums and hydrocolloids, serving primarily the food and beverage industries in North America and Asia. Gum Technology specializes in developing and producing customized stabilizers to meet customers' product formulation needs. This acquisition will broaden the Company's food ingredients portfolio of functional and specialty ingredient systems within the Food Ingredients segment.

Recent Accounting Pronouncements

On May 28, 2014, the FASB issued guidance that requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The guidance will replace most existing revenue recognition guidance when it becomes effective. The new standard is effective for the Company on September 1, 2017 and early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that this new guidance will have on its consolidated financial statements and related disclosures. The Company has not selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.

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 $11.3 million for the nine months ended May 31, 2014 compared with $14.6 million for the same period last year. The decrease in operating cash flow was due to an increase in working capital requirements.

Investing Activities

The increase in cash used in investing activities of $11.2 million was primarily due to the acquisition of Gum Technology in March 2014. See Note 13 to the Consolidated Condensed Financial Statements.

Financing Activities

Net cash provided from financing activities was $6.2 million for the nine months ended May 31, 2014, primarily from borrowings on the Company's revolving credit facility used to acquire Gum Technology. As of May 31, 2014, the Company had $76.5 million outstanding on its $130 million secured revolving credit facility (as amended, the "2012 Agreement") with a syndicate of banks. The lenders' loan commitment may be increased under certain circumstances.

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 the London Interbank Offered Rate ("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 can range between 2% and 4%, depending upon the ratio of the Company's funded debt to earnings before interest, taxes, depreciation and amortization (defined in the 2012 Agreement as the "Total Leverage Ratio").

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The 2012 Agreement provides that the Total Leverage Ratio shall not exceed 4.25 on May 31, 2014, 3.50 on August 31, 2014 and 3.0 at the end of each quarter thereafter. In addition, the Company must maintain a Fixed Charge Coverage Ratio, as defined in the 2012 Agreement of not less than 1.35. Annual capital expenditures will be restricted to $15 million ($17.5 million for fiscal 2014) if the Total Leverage Ratio is greater than 2.50 for the last two consecutive 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, 2014, the Company was not permitted to pay dividends.

Contractual Obligations

The Company is a party to various debt and lease agreements at May 31, 2014 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, 2013 except as described below.

In the third quarter of fiscal 2014, the Company entered into new leases for additional office space and research laboratories. The future minimum lease payments for new noncancelable operating leases are as follows:

(In thousands) 2014 $ 170 2015-2016 1,396 2017-2018 1,342 2019 & thereafter 4,098 $ 7,006



Off-Balance Sheet Arrangements

The Company had no off-balance sheet arrangements at May 31, 2014.

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, 2013 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. See Note 2 to the Condensed Consolidated Financial Statements for the change in estimate in the third quarter of fiscal 2014.

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

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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, 2013, 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 Part I, Item 1A "Risk Factors."


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