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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period endedFebruary 28, 2006
OR
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File No. 0-11488
PENFORD CORPORATION
(Exact name of registrant as specified in its charter)
Washington | 91-1221360 | |
(State or Other Jurisdiction of | (I.R.S. Employer | |
Incorporation or Organization) | Identification No.) | |
7094 South Revere Parkway, | ||
Centennial, Colorado | 80112-3932 | |
(Address of Principal Executive Offices) | (Zip Code) |
Registrant’s telephone number, including area code:(303) 649-1900
Indicate by a check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yesþ Noo
Yesþ Noo
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filero Accelerated Filerþ Non-Accelerated Filero
Large Accelerated Filero Accelerated Filerþ Non-Accelerated Filero
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ
The net number of shares of the Registrant’s common stock (the Registrant’s only outstanding class of stock) outstanding as of April 5, 2006 was 8,918,464.
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PENFORD CORPORATION AND SUBSIDIARIES
INDEX
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PART I — FINANCIAL INFORMATION
Item 1: Financial Statements
PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
February 28, | August 31, | |||||||
(In thousands, except per share data) | 2006 | 2005 | ||||||
(Unaudited) | ||||||||
ASSETS | ||||||||
Current assets: | ||||||||
Cash | $ | 9,832 | $ | 5,367 | ||||
Trade accounts receivable, net | 41,450 | 39,653 | ||||||
Inventories | 34,713 | 34,801 | ||||||
Prepaid expenses | 4,141 | 5,084 | ||||||
Other | 4,329 | 4,032 | ||||||
Total current assets | 94,465 | 88,937 | ||||||
Property, plant and equipment, net | 126,771 | 125,267 | ||||||
Restricted cash value of life insurance | 10,225 | 10,132 | ||||||
Goodwill, net | 21,159 | 21,420 | ||||||
Other intangible assets, net | 2,948 | 3,121 | ||||||
Other assets | 951 | 1,040 | ||||||
Total assets | $ | 256,519 | $ | 249,917 | ||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||
Current liabilities: | ||||||||
Cash overdraft, net | $ | — | $ | 777 | ||||
Current portion of long-term debt and capital lease obligations | 4,528 | 4,022 | ||||||
Accounts payable | 31,118 | 35,941 | ||||||
Accrued pension liability | 2,739 | 2,302 | ||||||
Accrued liabilities | 8,692 | 10,324 | ||||||
Total current liabilities | 47,077 | 53,366 | ||||||
Long-term debt and capital lease obligations | 74,820 | 62,107 | ||||||
Other post-retirement benefits | 13,391 | 13,091 | ||||||
Deferred income taxes | 4,737 | 4,353 | ||||||
Other liabilities | 17,084 | 16,974 | ||||||
Total liabilities | 157,109 | 149,891 | ||||||
Shareholders’ equity: | ||||||||
Preferred stock, par value $1.00 per share, authorized 1,000 shares, none issued | — | — | ||||||
Common stock, par value $1.00 per share, authorized 29,000 shares, issued 10,868 and 10,849 shares, respectively | 10,868 | 10,849 | ||||||
Additional paid-in capital | 38,442 | 37,728 | ||||||
Retained earnings | 74,658 | 76,040 | ||||||
Treasury stock, at cost, 1,981 shares | (32,757 | ) | (32,757 | ) | ||||
Accumulated other comprehensive income | 8,199 | 8,166 | ||||||
Total shareholders’ equity | 99,410 | 100,026 | ||||||
Total liabilities and shareholders’ equity | $ | 256,519 | $ | 249,917 | ||||
The accompanying notes are an integral part of these statements.
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PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three months ended | Six months ended | |||||||||||||||
February 28, | February 28, | February 28, | February 28, | |||||||||||||
(In thousands, except per share data) | 2006 | 2005 | 2006 | 2005 | ||||||||||||
Sales | $ | 77,078 | $ | 69,219 | $ | 154,981 | $ | 141,284 | ||||||||
Cost of sales | 68,534 | 62,059 | 136,037 | 130,895 | ||||||||||||
Gross margin | 8,544 | 7,160 | 18,944 | 10,389 | ||||||||||||
Operating expenses | 6,671 | 5,986 | 14,408 | 11,794 | ||||||||||||
Research and development expenses | 1,571 | 1,431 | 3,008 | 2,843 | ||||||||||||
Income (loss) from operations | 302 | (257 | ) | 1,528 | (4,248 | ) | ||||||||||
Non-operating income, net | 486 | 370 | 847 | 452 | ||||||||||||
Interest expense | 1,534 | 1,358 | 2,867 | 2,620 | ||||||||||||
Loss before income taxes | (746 | ) | (1,245 | ) | (492 | ) | (6,416 | ) | ||||||||
Income tax benefit | (235 | ) | (253 | ) | (176 | ) | (1,598 | ) | ||||||||
Net loss | $ | (511 | ) | $ | (992 | ) | $ | (316 | ) | $ | (4,818 | ) | ||||
Weighted average common shares and equivalents outstanding: | ||||||||||||||||
Basic and Diluted | 8,881 | 8,825 | 8,879 | 8,821 | ||||||||||||
Loss per share: | ||||||||||||||||
Basic and Diluted | $ | (0.06 | ) | $ | (0.11 | ) | $ | (0.04 | ) | $ | (0.55 | ) | ||||
Dividends declared per common share | $ | 0.06 | $ | 0.06 | $ | 0.12 | $ | 0.12 |
The accompanying notes are an integral part of these statements.
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PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(Unaudited)
Six Months Ended | ||||||||
February 28, | February 28, | |||||||
(In thousands) | 2006 | 2005 | ||||||
Cash flows from operating activities: | ||||||||
Net loss | $ | (316 | ) | $ | (4,818 | ) | ||
Adjustments to reconcile net loss to net cash provided by operations: | ||||||||
Depreciation and amortization | 7,671 | 8,632 | ||||||
Stock-based compensation | 600 | 76 | ||||||
Gain on sale of land | (51 | ) | — | |||||
Deferred income taxes | (413 | ) | (1,048 | ) | ||||
Other | 505 | 8 | ||||||
Change in assets and liabilities: | ||||||||
Trade accounts receivable | (2,048 | ) | 2,244 | |||||
Prepaid expenses | 938 | 765 | ||||||
Inventories | (268 | ) | 736 | |||||
Accounts payable and accrued liabilities | (5,411 | ) | (2,051 | ) | ||||
Taxes payable | (30 | ) | (1,133 | ) | ||||
Other | 940 | (171 | ) | |||||
Net cash provided by operating activities | 2,117 | 3,240 | ||||||
Cash flows from investing activities: | ||||||||
Investment in property, plant and equipment, net | (10,003 | ) | (4,309 | ) | ||||
Proceeds from sale of land | 612 | — | ||||||
Other | 4 | (113 | ) | |||||
Net cash used in investing activities | (9,387 | ) | (4,422 | ) | ||||
Cash flows from financing activities: | ||||||||
Proceeds from revolving line of credit | 15,461 | 3,000 | ||||||
Payments of long-term debt | (1,994 | ) | (2,291 | ) | ||||
Exercise of stock options | 128 | 215 | ||||||
Payment of loan fees | (16 | ) | (146 | ) | ||||
Decrease in cash overdraft | (777 | ) | — | |||||
Payment of dividends | (1,064 | ) | (1,058 | ) | ||||
Other | (5 | ) | — | |||||
Net cash provided by (used in) financing activities | 11,733 | (280 | ) | |||||
Effect of exchange rate changes on cash and cash equivalents | 2 | 6 | ||||||
Net increase (decrease) in cash and cash equivalents | 4,465 | (1,456 | ) | |||||
Cash and cash equivalents, beginning of period | 5,367 | 5,915 | ||||||
Cash and cash equivalents, end of period | $ | 9,832 | $ | 4,459 | ||||
The accompanying notes are an integral part of these statements.
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PENFORD CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1—BUSINESS
Penford Corporation (“Penford” or the “Company”) is in the business of developing, manufacturing and marketing specialty natural-based ingredient systems for various applications, including papermaking, textiles and food products. The Company operates manufacturing facilities in the United States, Australia, and New Zealand. Penford’s products provide excellent binding and film-forming characteristics that make customers’ products better through natural, convenient and cost effective solutions. Sales of the Company’s products are generated using a combination of direct sales and distributor agreements.
The Company has extensive research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and their application. In addition, the Company has specialty processing capabilities for a variety of modified starches.
2—BASIS OF PRESENTATION
Consolidation
The accompanying condensed consolidated financial statements include the accounts of Penford and its wholly owned subsidiaries. All material intercompany transactions and balances have been eliminated. The condensed consolidated balance sheet at February 28, 2006 and the condensed consolidated statements of operations and cash flows for the interim periods ended February 28, 2006 and February 28, 2005 have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, that are necessary to present fairly the financial information have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The results of operations for interim periods are not necessarily indicative of the operating results of a full year or of future operations. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended August 31, 2005.
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R, which is effective for the first annual period beginning after June 15, 2005, requires all share-based payments to employees, including grants of stock options, to be recognized in the financial statements based on their fair values. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS No. 123R. The Company adopted SFAS No. 123R and SAB 107 effective September 1, 2005. See Note 3 for further detail.
3—STOCK-BASED COMPENSATION
Stock Compensation Plans
On January 24, 2006, the shareholders approved the Penford Corporation 2006 Long-Term Incentive Plan (the “2006 Incentive Plan”) pursuant to which various stock-based awards may be granted to employees, directors and consultants. Prior to the approval of the 2006 Incentive Plan, the Company awarded stock options to employees and officers through the Penford Corporation 1994 Stock Option Plan (the “1994 Plan”) and to members of its Board under the Stock Option Plan for Non-Employee Directors (the “Directors’ Plan”). The 1994 Plan was suspended when the 2006 Plan became effective. The Directors’ Plan expired in August 2005. The aggregate number of shares of the Company’s common stock that may be issued as awards under the 2006 Incentive Plan, approved by shareholders, is 800,000 in addition to any shares not subject to a grant under the 1994 Plan and shares previously
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granted under the 1994 Plan which are subsequently forfeited or not exercised. At February 28, 2006, 22,976 options from the 1994 Plan were available for future grants under the 2006 Incentive Plan. In March 2006, an additional 100,000 options were forfeited under the 1994 Plan and became available for grant under the 2006 Incentive Plan.
General Option Information
A summary of the stock option activity for the six months ended February 28, 2006, is as follows:
Weighted | ||||||||||||||||
Weighted | Average | |||||||||||||||
Number of | Average | Remaining | Aggregate | |||||||||||||
Shares | Exercise Price | Term (in years) | Intrinsic Value | |||||||||||||
Outstanding Balance, August 31, 2005 | 1,107,535 | $ | 13.96 | |||||||||||||
Granted | 98,500 | 13.34 | ||||||||||||||
Exercised | — | — | ||||||||||||||
Cancelled | (10,000 | ) | 16.34 | |||||||||||||
Outstanding Balance, November 30, 2005 | 1,196,035 | $ | 13.88 | |||||||||||||
Granted | — | — | ||||||||||||||
Exercised | (10,000 | ) | 12.79 | |||||||||||||
Cancelled | (7,500 | ) | 12.79 | |||||||||||||
Outstanding Balance, February 28, 2006 | 1,178,535 | $ | 13.90 | 6.60 | $ | 2,772,200 | ||||||||||
Options Exercisable at February 28, 2006 | 792,035 | $ | 13.66 | 5.68 | $ | 2,122,500 |
The aggregate intrinsic value disclosed in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $15.88 as of February 28, 2006 that would have been received by the option holders had all option holders exercised on that date. The intrinsic value of options exercised during the second quarter of fiscal 2006 was $14,000 and the intrinsic value of options exercised during the three and six months ended February 28, 2005 was $6,000 and $148,000, respectively.
The weighted average grant date fair value of stock options granted under the 1994 Plan during the six months ended February 28, 2006 and 2005 was $6.93 and $7.86, respectively. The weighted average grant date fair value of stock options granted under the Directors’ Plan during the six months ended February 28, 2005 was $10.30. Options granted to directors during the six months ended February 28, 2005 were cancelled in fiscal 2005 in exchange for cash because of certain changes in the tax laws.
As of February 28, 2006, the Company had $1.5 million of unrecognized compensation costs related to non-vested stock option awards that is expected to be recognized over a weighted average period of 1.6 years.
The following table summarizes information concerning outstanding and exercisable options as of February 28, 2006:
Options Outstanding | Options Exercisable | |||||||||||||||||||||||
Wtd. Avg. | ||||||||||||||||||||||||
Remaining | Wtd. Avg. | Wtd. Avg. | ||||||||||||||||||||||
Number of | Contractual | Exercise | Number of | Exercise | ||||||||||||||||||||
Range of Exercise Prices | Options | Life (years) | Price | Options | Price | |||||||||||||||||||
$ | 6.02 — 11.00 | 131,898 | 4.88 | $ | 9.21 | 131,898 | $ | 9.21 | ||||||||||||||||
11.01 — 14.00 | 603,637 | 6.93 | 12.86 | 389,387 | 12.78 | |||||||||||||||||||
14.01 — 17.69 | 443,000 | 6.67 | 16.71 | 270,750 | 17.09 | |||||||||||||||||||
1,178,535 | 792,035 | |||||||||||||||||||||||
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Adoption of SFAS No. 123R
On September 1, 2005, the Company adopted SFAS No. 123R which requires the measurement and recognition of compensation cost for all share-based payment awards made to employees and directors based on estimated fair values.
Prior to the adoption of SFAS No. 123R, the Company accounted for its stock-based employee compensation related to stock options under the intrinsic value recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees” and the disclosure alternative prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” Accordingly, the Company presented pro forma information for the periods prior to the adoption of SFAS No. 123R and no compensation cost was recognized for the stock-based compensation plans other than the grant date intrinsic value for the options granted under the Directors’ Plan and restricted stock awards prior to September 1, 2005.
The Company has elected to use the modified prospective transition method for adopting SFAS No. 123R which requires the recognition of stock-based compensation cost on a prospective basis; therefore, prior period financial statements have not been restated. Under this method, the provisions of SFAS No. 123R are applied to all awards granted after the adoption date and to awards not yet vested with unrecognized expense at the adoption date based on the estimated fair value at grant date as determined under the original provisions of SFAS No. 123. Pursuant to the requirements of SFAS No. 123R, the Company will continue to present the pro forma information for periods prior to the adoption date.
Valuation and Assumptions
The Company utilizes the Black-Scholes option-pricing model to determine the fair value of stock options on the date of grant. This model derives the fair value of stock options based on certain assumptions related to expected stock price volatility, expected option life, risk-free interest rate and dividend yield. The Company’s expected volatility is based on the historical volatility of the Company’s stock price over the most recent period commensurate with the expected term of the stock option award. The estimated expected option life is based primarily on historical employee exercise patterns and considers whether and the extent to which the options are in-the-money. The risk-free interest rate assumption is based upon the U.S. Treasury yield curve appropriate for the term of the Company’s stock options awards and the selected dividend yield assumption was determined in view of the Company’s historical and estimated dividend payout. The Company has no reason to believe that the expected volatility of its stock price or its option exercise patterns would differ significantly from historical volatility or option exercises.
No stock options were granted under any stock option plan during the second quarter of fiscal 2006.
For the three-month period ended February 28, 2005, the fair value of the options was estimated on the date of grant using the following assumptions. No stock options were granted under the 1994 Plan in the second quarter of fiscal 2005. Options granted to directors in the second quarter of fiscal 2005 were cancelled in the third quarter of fiscal 2005 in exchange for cash because of changes in the tax laws.
Three Months Ended February 28, 2005 | ||||||||
1994 Plan | Directors’ Plan | |||||||
Expected volatility | — | 58 | % | |||||
Expected life (years) | — | 5.0 | ||||||
Interest rate (percent) | — | 3.7-4.0 | ||||||
Dividend yield | — | 1.6 | % |
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For the six months ended February 28, 2006 and 2005, the fair value of the options was estimated on the date of grant using the following assumptions.
Six Months Ended February 28, | ||||||||||||||||
1994 Plan | Directors’ Plan | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Expected volatility | 52 | % | 58 | % | — | 58 | % | |||||||||
Expected life (years) | 5.0 | 4.1 | — | 5.0 | ||||||||||||
Interest rate (percent) | 4.4-4.5 | 3.7-4.0 | — | 3.7-4.0 | ||||||||||||
Dividend yield | 1.7 | % | 1.6 | % | — | 1.6 | % |
SFAS No. 123R
The Company recognizes stock-based compensation expense utilizing the accelerated multiple option approach over the requisite service period, which equals the vesting period. For the three and six months ended February 28, 2006, the Company recognized $0.3 million and $0.6 million, respectively, in stock-based compensation costs. For the three and six months ended February 28, 2005, the Company recognized $43,000 and $76,000, respectively, of stock-based compensation cost related to Director’s discounted stock options and restricted stock awards. The following table summarizes the stock-based compensation cost under SFAS No. 123R for the three and six months ended February 28, 2006 and the effect on the Company’s Condensed Consolidated Statements of Operations (in thousands):
Three months ended | Six months ended | |||||||
February 28, 2006 | February 28, 2006 | |||||||
Cost of sales | $ | 32 | $ | 52 | ||||
Operating expenses | 242 | 504 | ||||||
Research and development expenses | 11 | 23 | ||||||
Total stock-based compensation expense | $ | 285 | $ | 579 | ||||
Tax benefit | 97 | 197 | ||||||
Total stock-based compensation expense, net of tax | $ | 188 | $ | 382 | ||||
See Note 11 for stock-based compensation costs recognized in the financial statements of each business segment.
Pro-forma Information under SFAS 123 for Periods Prior to Fiscal 2006
If the fair value recognition provisions of SFAS 123 had been applied to stock-based compensation for the three and six months ended February 28, 2005, the Company’s pro forma net loss and basic and diluted loss per share would have been as follows:
Three months ended | Six months ended | |||||||
(In thousands, except per share data) | February 28, 2005 | February 28, 2005 | ||||||
Net loss, as reported | $ | (992 | ) | $ | (4,818 | ) | ||
Add: Stock-based employee compensation expense included in reported net income, net of tax | 25 | 42 | ||||||
Less: Stock-based employee compensation expense determined under the fair value method for all awards, net of tax | (332 | ) | (607 | ) | ||||
Net loss, pro forma | $ | (1,299 | ) | $ | (5,383 | ) | ||
Loss per share: | ||||||||
Basic — as reported | $ | (0.11 | ) | $ | (0.55 | ) | ||
Basic — pro forma | $ | (0.15 | ) | $ | (0.61 | ) | ||
Diluted — as reported | $ | (0.11 | ) | $ | (0.55 | ) | ||
Diluted — pro forma | $ | (0.15 | ) | $ | (0.61 | ) | ||
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Restricted Stock
Non-employee directors receive restricted stock under the 1993 Non-Employee Director Restricted Stock Plan which provides that beginning September 1, 1993 and every three years thereafter, each non-employee director shall receive $18,000 worth of common stock of the Company, based on the last reported sale price of the stock on the preceding trading day. One-third of the shares vest on each anniversary of the date of the award. The Company recognizes compensation cost for restricted stock ratably over the vesting period.
4—INVENTORIES
The components of inventory are as follows:
February 28, | August 31, | |||||||
2006 | 2005 | |||||||
(In thousands) | ||||||||
Raw materials | $ | 15,254 | $ | 17,666 | ||||
Work in progress | 653 | 614 | ||||||
Finished goods | 18,806 | 16,521 | ||||||
Total inventories | $ | 34,713 | $ | 34,801 | ||||
5—PROPERTY, PLANT AND EQUIPMENT
February 28, | August 31, | |||||||
2006 | 2005 | |||||||
(In thousands) | ||||||||
Land | $ | 16,267 | $ | 15,943 | ||||
Plant and equipment | 306,857 | 304,247 | ||||||
Construction in progress | 16,797 | 11,022 | ||||||
339,921 | 331,212 | |||||||
Accumulated depreciation | (213,150 | ) | (205,945 | ) | ||||
Net property, plant and equipment | $ | 126,771 | $ | 125,267 | ||||
Changes in Australian and New Zealand currency exchange rates have decreased net property, plant and equipment in the first six months of fiscal 2006 by approximately $0.5 million.
6—DEBT
At February 28, 2006, the Company had $31.5 million outstanding under its revolving credit facilities and $47.8 million in term loans. Pursuant to the terms of the credit agreement, Penford’s additional borrowing ability was $13.4 million at February 28, 2006. The Company was in compliance with the covenants in its credit agreement as of February 28, 2006 and expects to be in compliance with covenants for the remainder of fiscal 2006.
As of February 28, 2006, approximately $31.5 million of the Company’s outstanding debt is subject to variable interest rates. Under interest rate swap agreements with several banks, the Company’s fixed rate debt is $38.4 million of U.S. dollar denominated term debt at 4.18% and $9.4 million of U.S. dollar equivalent Australian dollar denominated term debt at 5.54%, plus the applicable margin under the Company’s credit agreement.
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7—TAXES
The Company’s effective tax rate for the three and six months ended February 28, 2006 and 2005 varied from the U.S. federal statutory rate primarily due to U.S. and Australian tax incentives related to research and development, the favorable tax effect of export sales from the U.S. through the extraterritorial income exclusion, and, in fiscal 2006, the favorable tax effect of domestic (U.S.) production activities. The income taxes recorded for the second quarter of fiscal 2006 included $0.1 million in additional Australian tax benefits related to research and development attributable to fiscal 2005.
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 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. Currently, the Company’s best estimate of the annual effective tax rate is 13%.
8—OTHER COMPREHENSIVE INCOME
The components of total comprehensive income (loss) are as follows:
Three months ended | Six months ended | |||||||||||||||
February | February | February | February | |||||||||||||
28, 2006 | 28, 2005 | 28, 2006 | 28, 2005 | |||||||||||||
(In thousands) | ||||||||||||||||
Net loss | $ | (511 | ) | $ | (992 | ) | $ | (316 | ) | $ | (4,818 | ) | ||||
Foreign currency translation adjustments | (587 | ) | 751 | (1,080 | ) | 6,452 | ||||||||||
Change in unrealized gains on derivative instruments that qualify as cash flow hedges, net of tax | 806 | 73 | 1,113 | 16 | ||||||||||||
Total comprehensive income (loss) | $ | (292 | ) | $ | (168 | ) | $ | (283 | ) | $ | 1,650 | |||||
9—NON-OPERATING INCOME, NET
Non-operating income, net consists of the following:
Three months ended | Six months ended | |||||||||||||||
February 28, | February 28, | February 28, | February 28, | |||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
(In thousands) | ||||||||||||||||
Royalty and licensing income | $ | 412 | $ | 440 | $ | 835 | $ | 527 | ||||||||
Gain on sale of land | 51 | — | 51 | — | ||||||||||||
Other | 23 | (70 | ) | (39 | ) | (75 | ) | |||||||||
Total | $ | 486 | $ | 370 | $ | 847 | $ | 452 | ||||||||
In November 2002, the Company licensed the rights to its resistant starch intellectual property portfolio for applications in human nutrition. The initial licensing fee of $2.25 million received in November 2002 is being amortized over the life of the licensing agreement. In addition, the Company receives royalty income as a percentage of its licensee’s sales of resistant starch for a period of seven years or until a maximum of $11 million in royalties has been received by Penford. The royalty payments are subject to a minimum of $7 million over the first five years of the licensing agreement. The Company has recognized $5.2 million in royalty income from the inception of the agreement through February 28, 2006.
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In February 2006, the Company sold a parcel of land suitable only for agricultural purposes in Tamworth, New South Wales, Australia to a third-party purchaser for $0.7 million. The Company will lease-back the property from the purchaser under two lease terms and arrangements: i) a small parcel of land will be leased for 25 years beginning August 2006 with annual rent of approximately $0.015 million converted to U.S. dollars at the Australian dollar exchange rate at February 28, 2006 and ii) the majority of land sold will be leased for one year beginning August 2006 with annual rental of approximately $0.08 million converted to U.S. dollars at the Australian dollar exchange rate at February 28, 2006. The total gain on the sale was $0.3 million. The gain of $0.1 million in excess of the present value of the lease payments was recognized during the second quarter of fiscal 2006. The remaining gain of $0.2 million will be recognized proportionally over the terms of the leases discussed above.
10 — PENSION AND POST-RETIREMENT BENEFIT PLANS
The components of the net periodic pension and post-retirement benefit costs for the three and six months ended February 28, 2006 and 2005 are as follows:
Three months ended | Six months ended | |||||||||||||||
February 28, | February 28, | February 28, | February 28, | |||||||||||||
Defined benefit pension plans | 2006 | 2005 | 2006 | 2005 | ||||||||||||
(In thousands) | ||||||||||||||||
Service cost | $ | 418 | $ | 283 | $ | 836 | $ | 533 | ||||||||
Interest cost | 526 | 533 | 1,051 | 1,032 | ||||||||||||
Expected return on plan assets | (529 | ) | (467 | ) | (1,058 | ) | (934 | ) | ||||||||
Amortization of prior service cost | 46 | 67 | 93 | 97 | ||||||||||||
Amortization of actuarial losses | 150 | 118 | 301 | 240 | ||||||||||||
Net periodic benefit cost | $ | 611 | $ | 534 | $ | 1,223 | $ | 968 | ||||||||
Three months ended | Six months ended | |||||||||||||||
February 28, | February 28, | February 28, | February 28, | |||||||||||||
Post-retirement health care plans | 2006 | 2005 | 2006 | 2005 | ||||||||||||
(In thousands) | ||||||||||||||||
Service cost | $ | 98 | $ | 28 | $ | 196 | $ | 176 | ||||||||
Interest cost | 196 | 138 | 392 | 388 | ||||||||||||
Amortization of prior service cost | (38 | ) | (76 | ) | (76 | ) | (76 | ) | ||||||||
Amortization of actuarial losses | 36 | 4 | 72 | 19 | ||||||||||||
Net periodic benefit cost | $ | 292 | $ | 94 | $ | 584 | $ | 507 | ||||||||
The net post-retirement benefit costs for the second quarter of fiscal 2005 declined due to plan changes retroactive to September 1, 2004 pursuant to a union contract at the Company’s Iowa manufacturing facility.
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11—SEGMENT REPORTING
Financial information for the Company’s three segments is presented below. The first two segments, Industrial Ingredients—North America and Food Ingredients—North America, are broad categories of end-market users, primarily served by the Company’s U.S. operations. The third segment is the Company’s geographically separate operations in Australia and New Zealand, which are engaged primarily in the food ingredients business. A fourth item for “corporate and other” activity is presented to provide reconciliation to amounts reported in the condensed consolidated financial statements. Corporate and other represents the activities related to the corporate headquarters such as public company reporting, personnel costs of the executive management team, corporate-wide professional services and elimination and consolidation entries. The elimination of intercompany sales between Australia/New Zealand operations and Food Ingredients—North America of $96,000 and $399,000 for the three-and six-month periods ended February 28, 2006, respectively, and $172,000 and $718,000 in the three-and six-month periods ended February 28, 2005, respectively, is presented separately since the chief operating decision maker views segment results prior to intercompany eliminations.
Three months ended | Six months ended | |||||||||||||||
February | February | February | February | |||||||||||||
28, 2006 | 28, 2005 | 28, 2006 | 28, 2005 | |||||||||||||
(In thousands) | ||||||||||||||||
Sales: | ||||||||||||||||
Industrial Ingredients—North America | $ | 41,165 | $ | 35,634 | $ | 79,646 | $ | 70,769 | ||||||||
Food Ingredients—North America | 13,567 | 11,852 | 28,657 | 24,124 | ||||||||||||
Australia/New Zealand operations | 22,442 | 21,905 | 47,077 | 47,109 | ||||||||||||
Intercompany sales | (96 | ) | (172 | ) | (399 | ) | (718 | ) | ||||||||
$ | 77,078 | $ | 69,219 | $ | 154,981 | $ | 141,284 | |||||||||
Income (loss) from operations: | ||||||||||||||||
Industrial Ingredients—North America | $ | 781 | $ | 604 | $ | 1,355 | $ | (3,786 | ) | |||||||
Food Ingredients—North America | 1,485 | 1,103 | 3,886 | 2,495 | ||||||||||||
Australia/New Zealand operations | 98 | (327 | ) | 795 | 248 | |||||||||||
Corporate and other | (2,062 | ) | (1,637 | ) | (4,508 | ) | (3,205 | ) | ||||||||
$ | 302 | $ | (257 | ) | $ | 1,528 | $ | (4,248 | ) | |||||||
February 28, | August 31, | |||||||
2006 | 2005 | |||||||
(In thousands) | ||||||||
Total assets: | ||||||||
Industrial Ingredients—North America | $ | 104,734 | $ | 101,080 | ||||
Food Ingredients—North America | 32,585 | 33,193 | ||||||
Australia/New Zealand operations | 106,069 | 105,882 | ||||||
Corporate and other | 13,131 | 9,762 | ||||||
$ | 256,519 | $ | 249,917 | |||||
With the adoption of SFAS No. 123R on September 1, 2005, the Company recognized $0.3 million and $0.6 million in stock-based compensation expense for the three and six months ended February 28, 2006, respectively. The following table summarizes the stock-based compensation expense related to stock option awards by segment for the three and six months ended February 28, 2006.
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Three months ended | Six months ended | |||||||
February 28, 2006 | February 28, 2006 | |||||||
(In thousands) | ||||||||
Industrial Ingredients—North America | $ | 54 | $ | 120 | ||||
Food Ingredients—North America | 32 | 65 | ||||||
Australia/New Zealand operations | 2 | 13 | ||||||
Corporate | 197 | 381 | ||||||
$ | 285 | $ | 579 | |||||
Prior to September 1, 2005, the Company presented pro forma information for the periods prior to the adoption of SFAS No. 123R and no compensation expense was recognized for the stock-based compensation plans other than for the Directors’ Plan and restricted stock awards. See Note 3.
12—EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share reflects only the weighted average common shares outstanding during the period. Diluted earnings (loss) per share reflects weighted average common shares outstanding and the effect of any dilutive common stock equivalent shares.Diluted earnings per share is calculated by dividing net income by the average common shares outstanding plus additional common shares that would have been outstanding assuming the exercise of in-the-money stock options, using the treasury stock method. Weighted-average stock options to purchase 1,188,313 and 1,164,726 shares of common stock for the three and six months ended February 28, 2006, and weighted-average stock options to purchase 1,134,991 and 1,081,958 shares of common stock for the three and six months ended February 28, 2005, were excluded from the calculation of diluted earnings per share because they were antidilutive.
13—LITIGATION
In October 2004, Penford Products Co. (“Penford Products”), a wholly-owned subsidiary of the Company, was served with a lawsuit filed by Graphic Packaging International, Inc. (“Graphic”) in the Fourth Judicial District, Ouachita Parish, State of Louisiana. The petition seeks monetary damages for alleged breach of contract, negligence and tortious misrepresentation. These claims arise out of an alleged agreement obligating Penford Products to supply goods to Graphic and Penford Products’ alleged breach of such agreement, together with conduct related to such alleged breach. Penford has filed an answer generally denying all liability and has countersued for damages. During the second quarter of fiscal 2006, the parties continued to conduct discovery. The Company cannot at this time determine the likelihood of any outcome or estimate damages, if any.
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Item 2: | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
Forward-looking Statements
The statements contained in this Quarterly Report onForm 10-Q (“Quarterly Report”) that are not historical facts, 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, are forward-looking statements that represent management’s beliefs and assumptions based on currently available information. Forward-looking statements can be identified by the use of words such as “believes,” “may,” “will,” “looks,” “should,” “could,” “anticipates,” “expects,” or comparable terminology or by discussions of strategies or trends.
Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it cannot give any assurances that these expectations will prove to be correct. Such statements by their nature involve substantial risks and uncertainties that could significantly affect expected results. Actual future results could differ materially from those described in such forward-looking statements, and the Company does not intend to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Among the factors that could cause actual results to differ materially are the risks and uncertainties discussed in this Quarterly Report, including those referenced below and in the section subtitled “Risks and Uncertainties” in this Quarterly Report, and those described from time to time in other filings with the Securities and Exchange Commission, including the Company’s Annual Report onForm 10-K for the year ended August 31, 2005, 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, including labor 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 and energy cost volatility; foreign currency exchange rate fluctuations; changes in assumptions used for determining employee benefit expense and obligations; changes in the assumptions used to determine the effective income tax rate; or other unforeseen developments in the industries in which Penford operates.
Results of Operations
Executive Overview
Penford generates revenues, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for industrial and food applications. The Company develops and manufactures ingredients with starch as a base which provide value-added applications to its customers. Penford’s starch products are manufactured primarily from corn, potatoes, and wheat, and are used as binders and coatings in paper and food production.
In analyzing business trends, management considers a variety of performance and financial measures, including sales revenue growth, sales volume growth, 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 the Company’s operations in Australia and New Zealand, which operations are engaged primarily in the food ingredients business.
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Consolidated sales for the three months ended February 28, 2006 increased 11% to $77.1 million from $69.2 million in the second quarter of fiscal 2005 due to volume increases in all of the business segments. Gross margin as a percent of sales increased to 11.1% in the second quarter of fiscal 2006 from 10.3% in the same period last year due to increased sales, higher production yields and improved plant utilization. Quarterly sales gains and manufacturing efficiencies were offset by $2.8 million in higher total energy and chemical costs, $0.4 million in increased production costs resulting from an interruption in steam supply, and $0.7 million in non-recurring charges for cost reduction initiatives as discussed below.
Sales for the first half of fiscal 2006 rose 10% to $155.0 million from $141.3 million in the same period in fiscal 2005, primarily due to a 9% increase in volumes. Sales for the second half of fiscal 2006 are expected to expand over last year, however at a more moderate pace. Gross margin as a percent of sales improved to 12.2% from 7.4% last year on growth in sales volumes partially offset by $6.5 million in higher energy and chemical costs, and the second quarter fiscal 2006 steam supply interruption and non-recurring charges. Operating income for the six months ended February 28, 2005 included $4.1 million of incremental operating costs related to the Cedar Rapids strike settled mid-first quarter of fiscal 2005.
Fiscal 2006 second quarter operating expenses increased by $0.7 million, primarily due to $0.3 million in stock-based compensation expense and increased professional fees. Operating expenses for the six months ended February 28, 2006 increased $2.6 million, resulting from increased employee costs of $1.7 million, including $0.6 million in stock-based compensation expense and $0.6 million of severance costs related to managerial changes in the Industrial Ingredients and Australian operations, and increased consulting and professional fees of $0.7 million. A discussion of segment results of operations and the effective tax rate follows.
Sales
Sales of $41.2 million for the second quarter of fiscal 2006 at the Company’s Industrial Ingredients—North America business unit rose $5.5 million, or 16%, over the same quarter last year. Sales volumes improved 15% compared to the second quarter of fiscal 2005 and improved product mix and pricing contributed 1% to the sales growth. Year-to-date sales rose 13% to $79.6 million from $70.8 million last year on a sales volume increase of 11%. Improved pricing and mix contributed 2% to the sales increase.
Second quarter fiscal 2006 sales for the Australia/New Zealand operations of $22.4 million increased $0.5 million over the second quarter of last year primarily on sales volume growth of 7% in the sweetener and highly modified food starch product categories. Second quarter sales in local currency expanded by 6% over the same quarter last year. Fiscal 2006 year-to-date sales of $47.1 million were comparable to the same period last year.
Fiscal 2006 second quarter sales for the Food Ingredients—North America business of $13.6 million increased by $1.7 million, or 14%, compared to the second quarter of last year on volume growth of 16%. Sales of core potato coating applications expanded by 12% over the second quarter last year and sales of new applications for the processed meat and cheese markets grew 64% over the same period last year. Sales for the first half of fiscal 2006 grew $4.5 million, or 19%, to $28.7 million over the same period of fiscal 2005 due to a 22% increase in sales volumes, partially offset by an unfavorable product mix.
Income from operations
For the second quarter of fiscal 2006, income from operations at the Company’s Industrial Ingredients—North America business unit increased by $0.2 million, or 29%, to $0.8 million compared to the same period last year. Second quarter fiscal 2006 gross margin as a percent of sales was 9.3% compared to 9.6% for the second quarter of fiscal 2005. Improved unit pricing and mix were offset by $1.4 million in higher energy costs and $1.0 million in increased costs of chemicals. The business experienced a temporary interruption in the utility steam supply in the second quarter which increased production costs by $0.4 million. Non-recurring charges for external advice in connection with improving plant utilization and throughput increased manufacturing expenses by $0.7 million. Income from operations for the first six months of fiscal 2006 improved to $1.4 million compared to an operating loss of $3.8 million in the prior year period. Gross margin as a percent of sales was 9.3% compared to 2.3% last year. Improvements in gross margin due to sales volume increases were partially offset by $2.3 million and $3.2 million in higher costs for chemicals and energy, respectively. Operating income in fiscal 2005 included $4.1
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million in incremental operating costs associated with the labor strike at the Company’s Iowa manufacturing facility that was settled in the first quarter of fiscal 2005.
Income from operations at the Company’s Australia/New Zealand operations was $0.1 million for the second quarter of fiscal 2006 compared to an operating loss of $0.3 million in the same period last year. Gross margin as a percent of sales expanded to 6.6% from 4.2% in the prior year quarter, primarily due to improvements in production yields and plant performance. Income from operations for the first six months of fiscal 2006 was $0.8 million compared to operating income of $0.2 million in the same period in fiscal 2005. Year-to-date improvements in operating income are attributable to the same factors as the second quarter increase. Included in operating income for the first six months of fiscal 2006 were $0.4 million of severance costs related to managerial changes.
Fiscal 2006 second quarter income from operations at the Food Ingredients—North American business unit expanded 35% to $1.5 million from $1.1 million in the same period last year. Gross margin as a percent of sales was comparable to last year at 23.9%. The increase in operating income can be attributed to sales growth and improved plant utilization, partially offset by higher chemical and energy costs of $0.4 million. Year-to-date income from operations for fiscal 2006 increased to $3.9 million from $2.5 million in the same period last year on a 22% increase in sales volume and improved plant efficiencies. Gross margin as a percent of sales for the first half of fiscal 2006 grew to 26.1% from 24.1% for the same period last year as sales volume improvements and production efficiencies offset $1.0 million in increased chemical and energy costs.
Corporate operating expenses
Corporate operating expenses for the second quarter of fiscal 2006 increased $0.4 million over the prior year period due to an increase in professional fees and higher employee costs, including $0.2 million of stock-based compensation expense. For the six months ended February 28, 2006, Corporate operating expenses increased $1.3 million compared to the six-month period last year due to increased employee costs, including $0.4 million of stock-based compensation expense, as well as a $0.5 million increase in consulting and professional fees.
Interest and taxes
Fiscal 2006 interest expense for the second quarter and year-to-date increased $0.2 million over the same periods last year driven by higher average floating interest rates in the U.S. and Australia, partially offset by the effect of lower average debt balances. At February 28, 2006, the Company’s variable and fixed rate debt was $31.5 million and $47.8 million, respectively. See Note 6 to the Condensed Consolidated Financial Statements.
The Company’s effective tax rate for the three and six months ended February 28, 2006 and 2005 varied from the U.S. federal statutory rate primarily due to U.S. and Australian tax incentives related to research and development, the favorable tax effect of export sales from the U.S. through the extraterritorial income exclusion, and, in fiscal 2006, the favorable tax effect of domestic (U.S.) production activities. The income taxes recorded for the second quarter of fiscal 2006 included $0.1 million in additional Australian tax benefits related to research and development attributable to fiscal 2005.
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. Currently, the Company’s best estimate of the annual effective tax rate is 13%.
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Non-operating income, net
Non-operating income, net consists of the following:
Three months ended | Six months ended | |||||||||||||||
February | February | February | February | |||||||||||||
28, 2006 | 28, 2005 | 28, 2006 | 28, 2005 | |||||||||||||
(In thousands) | ||||||||||||||||
Royalty and licensing income | $ | 412 | $ | 440 | $ | 835 | $ | 527 | ||||||||
Gain on sale of land | 51 | — | 51 | — | ||||||||||||
Other | 23 | (70 | ) | (39 | ) | (75 | ) | |||||||||
Total | $ | 486 | $ | 370 | $ | 847 | $ | 452 | ||||||||
In November 2002, the Company licensed the rights to its resistant starch intellectual property portfolio for applications in human nutrition. The initial licensing fee of $2.25 million received in November 2002 is being amortized over the life of the licensing agreement. In addition, the Company receives royalty income as a percentage of its licensee’s sales of resistant starch for a period of seven years or until a maximum of $11 million in royalties has been received by Penford. The royalty payments are subject to a minimum of $7 million over the first five years of the licensing agreement. The Company has recognized $5.2 million in royalty income from the inception of the agreement through February 28, 2006.
In February 2006, the Company sold a parcel of land suitable only for agricultural purposes in Tamworth, New South Wales, Australia to a third-party purchaser for $0.7 million. The Company will lease-back the property from the purchaser under two lease terms and arrangements: i) a small parcel of land will be leased for 25 years beginning August 2006 with annual rent of approximately $0.015 million converted to U.S. dollars at the Australian dollar exchange rate at February 28, 2006 and ii) the majority of land sold will be leased for one year beginning August 2006 with annual rental of approximately $0.08 million converted to U.S. dollars at the Australian dollar exchange rate at February 28, 2006. The total gain on the sale was $0.3 million. The gain of $0.1 million in excess of the present value of the lease payments was recognized during the second quarter of fiscal 2006. The remaining gain of $0.2 million will be recognized proportionally over the terms of the leases discussed above.
Liquidity and Capital Resources
At February 28, 2006, the Company had $31.5 million outstanding under its revolving credit facilities and $47.8 million in term loans. Pursuant to the terms of the credit agreement, Penford’s additional borrowing ability was $13.4 million at February 28, 2006. The Company was in compliance with the covenants in its credit agreement as of February 28, 2006 and expects to be in compliance with the covenants for the remainder of fiscal 2006.
As of February 28, 2006, approximately $31.5 million of the Company’s outstanding debt is subject to variable interest rates. Under interest rate swap agreements with several banks, the Company’s fixed rate debt is $38.4 million of U.S. dollar denominated term debt at 4.18% and $9.4 million of U.S. dollar equivalent Australian dollar denominated term debt at 5.54%, plus the applicable margin under the Company’s credit agreement. As of February 28, 2006, the fair value of the interest rate swaps was $1.0 million.
Penford had working capital of $47.4 million and $35.6 million at February 28, 2006 and August 31, 2005, respectively. Accounts payable declined by $4.8 million at February 28, 2006 as disbursements were made to Australian suppliers for raw material inventories purchased prior to fiscal 2005 year end. Cash increased by $4.5 million at February 28, 2006 due to the timing of cash receipts at the end of the month. Cash flow from operations was $2.1 million and $3.2 million, respectively, for the six months ended February 28, 2006 and 2005. Total debt outstanding increased by $13.5 million during the first six months of fiscal 2006 primarily to fund $10 million of capital expenditures related to improvements in manufacturing productivity and new products and markets.
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The Company paid dividends of $1.1 million during the six months ended February 28, 2006, which represents a quarterly rate of $0.06 per share. On January 24, 2006, the Board of Directors declared a dividend of $0.06 per common share payable on March 3, 2006 to shareholders of record as of February 10, 2006. Any future dividends will be paid at the discretion of the Company’s board of directors and will depend upon, among other things, earnings, financial condition, cash requirements and availability, and contractual requirements.
Contractual Obligations
The Company is a party to various debt and lease agreements at February 28, 2006 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, 2005. The Company has no off-balance sheet arrangements at February 28, 2006.
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R, which is effective for the first annual period beginning after June 15, 2005, requires all share-based payments to employees, including grants of stock options, to be recognized in the financial statements based on their fair values. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS No. 123R. The Company adopted SFAS No. 123R and SAB 107 effective September 1, 2005. See Note 3 to the Condensed Consolidated Financial Statements for further detail.
Critical Accounting Policies
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. These accounting principles require management to make estimates, judgments and assumptions to fairly present results of operations and financial position. Note 1 to the Consolidated Financial Statements in the Annual Report on Form 10-K for the fiscal year ended August 31, 2005 describes the significant 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.
In many cases, the accounting treatment of a particular transaction is significantly dictated by generally accepted accounting principles and does not require judgment or estimates. There are also areas in which management’s judgments in selecting among available alternatives would not produce a materially different result. Management has reviewed the accounting policies and related disclosures with the Audit Committee. The accounting policies that management believes are the most important to the financial statements and that require the most difficult, subjective and complex judgments include the following:
• | Evaluation of the allowance for doubtful accounts receivable | ||
• | Hedging activities | ||
• | Benefit plans | ||
• | Valuation of goodwill | ||
• | Self-insurance program | ||
• | Income taxes | ||
• | Stock-based compensation |
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A description of each of these follows:
Evaluation of the Allowance for Doubtful Accounts Receivable
Management makes judgments about the Company’s ability to collect outstanding receivables and provide allowances for the portion of receivables that the Company may not be able to collect. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. If the estimates do not reflect the Company’s future ability to collect outstanding invoices, Penford may experience losses in excess of the reserves established. At February 28, 2006, the allowance for doubtful accounts receivable was $0.4 million.
Hedging Activities
Penford uses derivative instruments, primarily futures contracts, to reduce exposure to price fluctuations of commodities used in the manufacturing processes in the United States. Penford has elected to designate these activities as hedges. This election allows the Company to defer gains and losses on those derivative instruments until the underlying commodity is used in the production process. To reduce exposure to variable short-term interest rates, Penford uses interest rate swap agreements.
The requirements for the designation of hedges are very complex, and require judgments and analyses to qualify as hedges as defined by Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS No. 133”). These judgments and analyses include an assessment that the derivative instruments used are effective hedges of the underlying risks. If the Company were to fail to meet the requirements of SFAS No. 133, or if these derivative instruments are not designated as hedges, the Company would be required to mark these contracts to market at each reporting date. Penford had deferred gains, net of tax, of $1.4 million at February 28, 2006 which are reflected in accumulated other comprehensive income.
Benefit Plans
Penford has defined benefit plans for its U.S. employees providing retirement benefits and coverage for retiree health care. Qualified actuaries determine the estimated cost of these plans annually. These actuarial estimates are based on assumptions of the discount rate used to calculate the present value of future payments, the expected investment return on plan assets, the estimate of future increases in compensation rates and the estimate of increases in the cost of medical care. The Company makes judgments about these assumptions based on historical investment results and experience as well as available historical market data and trends. However, if these assumptions are wrong, it could materially affect the amounts reported in the financial statements.
Valuation of Goodwill
Penford is required to assess whether the value of goodwill reported on the balance sheet has been impaired on an annual basis, or more often if conditions exist that indicate that there might be an impairment. These assessments require extensive and subjective judgments to assess the fair value of goodwill. While the Company engages qualified valuation experts to assist in this process, their work is based on the Company’s estimates of future operating results and allocation of goodwill to the business units. If future operating results differ materially from the estimates, the value of goodwill could be adversely impacted.
Self-insurance Program
The Company maintains a self-insurance program covering portions of workers’ compensation and group health liability costs. The amounts in excess of the self-insured levels are fully insured by third party insurers. Liabilities associated with these risks are estimated in part by considering historical claims experience, severity factors and other actuarial assumptions. Projections of future losses are inherently uncertain because of the random nature of insurance claims occurrences and changes that could occur in actuarial assumptions. The financial results of the Company could be significantly affected if future claims and assumptions differ from those used in determining these liabilities.
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Income Taxes
The determination of the Company’s provision for income taxes requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. The Company’s provision for income taxes reflects a combination of income earned and taxed in the various U.S. federal and state, as well as Australian and New Zealand taxing jurisdictions. Jurisdictional tax law changes, increases or decreases in permanent differences between book and tax items, accruals or adjustments of accruals for tax contingencies or valuation allowances, and the Company’s change in the mix of earnings from these taxing jurisdictions all affect the overall effective tax rate.
In evaluating the exposures connected with the various tax filing positions, the Company establishes an accrual, when, despite management’s belief that the Company’s tax return positions are supportable, management believes that certain positions may be successfully challenged and a loss is probable. When facts and circumstances change, these accruals are adjusted.
Stock-Based Compensation
Beginning September 1, 2005, the Company recognizes stock-based compensation in accordance with SFAS No. 123R, “Share-Based Payment.” Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period of the award. Determining the appropriate fair value model and calculating the fair value of the share-based awards at the date of grant requires judgment, including estimating stock price volatility, forfeiture rates, the risk-free interest rate, dividends and expected option life.
If circumstances change, and the Company uses different assumptions for volatility, interest, dividends and option life in estimating the fair value of stock-based awards granted in future periods, stock-based compensation expense may differ significantly from the expense recorded in the current period. SFAS No. 123R requires forfeitures to be estimated at the date of grant and revised in subsequent periods if actual forfeitures differ from those estimated. Therefore, if actual forfeiture rates differ significantly from those estimated, the Company’s results of operations could be materially impacted.
Risks and Uncertainties
The availability and cost of agricultural products Penford purchases are vulnerable to weather and other factors beyond its control.
In the first six months of fiscal 2006, approximately 26% of Penford’s manufacturing costs are the costs of agricultural raw materials, corn, wheat flour and maize. Weather conditions, plantings and global supply, among other things, have historically caused volatility in the supply and prices of these agricultural products. The Company may not be able to pass through any increases in the cost of agricultural raw materials to its customers. To manage the price volatility in the commodity markets, the Company may purchase inventory in advance or enter into exchange traded futures or options contracts. Despite these hedging activities, Penford may not be successful in limiting its exposure to market fluctuations in the cost of agricultural raw materials. Increases in the cost of corn, wheat flour, maize and potato starch due to weather conditions or other factors beyond Penford’s control and that cannot be passed through to customers will reduce Penford’s future profitability.
Increases in energy and chemical costs will reduce the Company’s profitability.
Energy and chemicals comprise approximately 15% and 12%, respectively, of the cost of manufacturing the Company’s products in the first six months of fiscal 2006. Natural gas is used extensively in the Industrial Ingredients – North America business to dry the starch products, and, to a lesser extent, in the Company’s other business segments. Chemicals are used in all of Penford’s businesses to modify starch for specific product applications and customer requirements. The prices of these inputs to the manufacturing process fluctuate based on anticipated changes in supply and demand, weather and the prices of alternative fuels, including petroleum. Penford may use short-term purchase contracts or exchange traded futures or option contracts to reduce the price volatility of natural gas; however, these strategies are not available for the chemicals the Company purchases. Penford may not
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be able to pass on increases in energy and chemical costs to its customers and margins and profitability would be adversely affected.
The loss of a major customer could have an adverse effect on Penford’s results of operations.
None of the Company’s customers constituted 10% of sales in the last three years. However, in the first six months of fiscal 2006, sales to the top ten customers and sales to the largest customer represented 45% and 8%, respectively, of total consolidated net sales. Customers place orders on an as-needed basis and generally can change their suppliers without penalty. If the Company lost one or more of its major customers, or if one or more of its customers significantly reduced its orders, sales and results of operations would be adversely affected.
Changes in interest rates will affect Penford’s profitability.
At February 28, 2006, $31.5 million of the Company’s outstanding debt is subject to variable interest rates which move in direct proportion to the U.S. or Australian London InterBank Offered Rate (“LIBOR”), or the prime rate in the U.S., depending on the selection of borrowing options. Significant changes in these interest rates would materially affect Penford’s profitability.
Unanticipated changes in tax rates or exposure to additional income tax liabilities could affect Penford’s profitability.
Penford is subject to income taxes in the United States, Australia and New Zealand. The effective tax rates could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities or changes in tax laws. The carrying value of deferred tax assets, which are predominantly in the United States, is dependent on Penford’s ability to generate future taxable income in the United States. The amount of income taxes paid is subject to the Company’s interpretation of applicable tax laws in the jurisdictions in which Penford operates. The Company is subject to audits by tax authorities. While the Company believes it has complied with all applicable income tax laws, there can be no assurance that a tax authority will not have a different interpretation of the law or that any additional taxes imposed as a result of tax audits will not have an adverse effect on the Company’s results of operations.
Profitability is subject to risks associated with changes in foreign exchange currency rates.
In the ordinary course of business, Penford is subject to risks associated with changing foreign exchange rates. In the first six months of fiscal 2006, approximately 30% of the Company’s revenue is denominated in currencies other than the U.S. dollar. Penford’s revenues and results of operations are affected by fluctuations in exchange rates between the U.S. dollar and other currencies.
Provisions of Washington law could discourage or prevent a potential takeover.
Washington law imposes restrictions on certain transactions between a corporation and certain significant shareholders. The Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with an “acquiring person,” which is defined as a person or group of persons that beneficially owns 10% or more of the voting securities of the target corporation, for a period of five years after such acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s board of directors prior to the time of the acquisition. Such prohibited transactions include, among other things, (1) a merger or consolidation with, disposition of assets to, or issuance or redemption of stock to or from, the acquiring person; (2) a termination of 5% or more of the employees of the target corporation as a result of the acquiring person’s acquisition of 10% or more of the shares; and (3) allowing the acquiring person to receive any disproportionate benefit as a shareholder.
After the five year period, a “significant business transaction” may occur if it complies with “fair price” provisions specified in the statute. A corporation may not “opt out” of this statute. This provision may have the effect of delaying, deterring or preventing a change of control in the ownership of the Company.
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Other uncertainties
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. These accounting principles require management to make estimates, judgments and assumptions to fairly present results of operations and financial position. 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 actual results, the financial statements will be affected. See “Critical Accounting Policies” in this Item 2.
Item 3: Quantitative and Qualitative Disclosures About Market Risk.
The Company is exposed to market risks from adverse changes in interest rates, foreign currency exchange rates and commodity prices. There have been no significant changes in the Company’s exposure to market risks since August 31, 2005. See Note 6 to the Condensed Consolidated Financial Statements for details on interest rate swaps.
Item 4: Controls and Procedures.
Under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures as required by Rule 13a-15(b) of the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective as of February 28, 2006. There were no changes in the Company’s internal control over financial reporting during the quarter ended February 28, 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II — OTHER INFORMATION
Item 4: Submission of Matters to a Vote of Security Holders
The Company held its Annual Meeting of Shareholders on January 24, 2006. The first item voted upon at the meeting was the election of directors. The results of the election are shown below. Directors not elected at this meeting and whose term of office continued after the meeting are William E. Buchholz, Jeffrey T. Cook, John C. Hunter III, Thomas D. Malkoski, Sally G. Narodick and James E. Warjone.
Percent of | Percent of | |||||||||||||||
Director | Votes For | Total Shares | Votes Withheld | Total Shares | ||||||||||||
R. Randolph Devening | 8,123,123 | 91.5 | % | 59,586 | 0.7 | % | ||||||||||
Paul H. Hatfield | 7,661,255 | 86.3 | % | 521,454 | 5.9 | % |
The second item voted upon at the meeting was the adoption of the Penford Corporation 2006 Long-Term Incentive Plan, which was approved. The results of the voting on the proposal are as follows:
Votes | Broker | |||||||||||
Votes For | Against | Abstain | Non-Votes | |||||||||
6,234,429 | 971,282 | 25,264 | 1,647,062 |
Item 5: Other Information
Entry into a Material Definitive Agreement
On April 5, 2006, the Company’s new form of Change in Control Agreement (“Agreement”) was approved. The Agreement is to be executed with each of Thomas D. Malkoski, Steven O. Cordier, Wallace H. Kunerth, John R. Randall, Randy Burns (the ���named executive officers”) and certain other executive officers and key employees(collectively, with the named executive officers, the “participants”). Once executed, the new form will replace any prior change in control agreement with each of the participants. The Agreement is intended to provide for continuity of management in the event of a Change in Control and is not in response to any specific event or discussions currently in process that would constitute a Change in Control.
The following brief description summarizes the material terms and conditions of the Agreement. This summary description is not complete and is qualified in its entirety by, and should be read in conjunction with, the complete text of the form of Change in Control Agreement and Annexes, which are filed as Exhibit 10.3 to this Quarterly Report on Form 10-Q and are incorporated herein by reference. The terms of each Agreement are substantially similar, except as noted below. Except where the context indicates otherwise, capitalized terms appearing below shall have the same meaning as provided in the Agreement.
Pursuant to each Agreement, Penford agrees to provide certain benefits to the participants if they are terminated in connection with a Change in Control. Each of these Agreements is effective upon execution and continues until Penford terminates the Agreement upon twelve months prior written notice; provided, that if a Change in Control occurs prior to the termination date of the Agreement, the Agreement will remain in effect with respect to all rights accruing as a result of the occurrence of the Change in Control.
To receive the payments and benefits for a termination in connection with a Change in Control under the Agreement, participants must execute a waiver and release in favor of Penford. Under the Agreement, participants also agree to noncompetition and nonsolicitation provisions for a period extending beyond their termination of employment equal to the Compensation Period, as well as to nondisparagement and confidentiality provisions.
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Under these Agreements, participants, regardless of whether their employment is terminated in connection with a Change in Control, are entitled to vesting immediately prior to a Change in Control of all options and other equity-based rights and interests outstanding immediately prior to the Change in Control.
Under these Agreements, participants are entitled to certain benefits if they are terminated within 24 months after a Change in Control. Participants will not be considered “terminated” for purposes of these Agreements if they die, become disabled or are terminated for Cause. They will, however, be considered “terminated” if they voluntarily leave Penford’s employ for Good Reason and, in the case of Mr. Malkoski and Mr. Cordier, if they voluntarily terminate employment during the 30-day period beginning on the first anniversary of a Change in Control.
Upon a termination in connection with a Change in Control, participants will be eligible to receive 50% of the CIC Amount within 30 days after their termination of employment and 50% in equal monthly installments over the Compensation Period, which for the namedexecutive officers is 30 monthsand may be either 24 or 12 months for other participants. The CIC Amount is the product of base salary plus the participant’s Average Target Attainment Bonus times 2.5 for named executive officers (2.0 or 1.0 for other participants). In addition, participants receive a prorated target bonus for the year of termination and Penford will pay the cost of outplacement services for a period, which in the case of Mr. Malkoski and Mr. Cordier would be 12 months and for the other participants would be 6 months. Participants will also be entitled to continuation of certain medical, life and other benefits for up to the Compensation Period. Mr. Malkoski and Mr. Cordier are also entitled to an additional payment, if necessary, to make them whole as a result of excise and related taxes imposed by the Internal Revenue Code on change of control benefits. If such excise taxes would otherwise be applicable to other participants, such other participants would have the payments under the Agreement reduced such that the aggregate present value of the payments under the Agreement would not exceed one hundred dollars less than three times the participant’s base amount (generally average compensation from Penford for the preceding five years) under the Internal Revenue Code.
Item 6: Exhibits.
(d) Exhibits
10.1 | Penford Corporation 2006 Long-Term Incentive Plan (incorporated by reference to Appendix A to Registrant’s Proxy Statement filed with the Commission on December 20, 2005) | |
10.2 | Form of Penford Corporation 2006 Long-Term Incentive Plan Stock Option Grant Notice including the Stock Option Agreement and Notice of Exercise (incorporated by reference to the exhibits to the Registrant’s Current Report on Form 8-K filed with the Commission on February 21, 2006) | |
10.3 | Form of Change in Control Agreement and Annexes | |
31.1 | Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.2 | Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
32 | Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Penford Corporation | ||||
(Registrant) | ||||
April 10, 2006 | /s/ Steven O. Cordier | |||
Steven O. Cordier | ||||
Senior Vice President and Chief Financial Officer |
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EXHIBIT INDEX
Exhibit No. | Description | |
10.1 | Penford Corporation 2006 Long-Term Incentive Plan (incorporated by reference to Appendix A to Registrant’s Proxy Statement filed with the Commission on December 20, 2005) | |
10.2 | Form of Penford Corporation 2006 Long-Term Incentive Plan Stock Option Grant Notice including the Stock Option Agreement and Notice of Exercise (incorporated by reference to the exhibits to the Registrant’s Current Report on Form 8-K filed with the Commission on February 21, 2006) | |
10.3 | Form of Change in Control Agreement and Annexes | |
31.1 | Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.2 | Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
32 | Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |