Table of Contents
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 endedNovember 30, 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
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yeso Noþ
Yeso Noþ
The net number of shares of the Registrant’s common stock (the Registrant’s only outstanding class of stock) outstanding as of January 5, 2007 was 8,954,387.
Table of Contents
PENFORD CORPORATION AND SUBSIDIARIES
INDEX
Page | ||||||||
3 | ||||||||
4 | ||||||||
5 | ||||||||
6 | ||||||||
15 | ||||||||
22 | ||||||||
22 | ||||||||
23 | ||||||||
25 | ||||||||
26 | ||||||||
Certification of CEO Pursuant to Section 302 | ||||||||
Certification of CFO Pursuant to Section 302 | ||||||||
Certification Pursuant to Section 906 |
2
Table of Contents
PART I — FINANCIAL INFORMATION
Item 1: Financial Statements
PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
November 30, | August 31, | |||||||
(In thousands, except per share data) | 2006 | 2006 | ||||||
(Unaudited) | ||||||||
ASSETS | ||||||||
Current assets: | ||||||||
Cash | $ | — | $ | 939 | ||||
Trade accounts receivable, net | 48,640 | 44,593 | ||||||
Inventories | 37,419 | 34,953 | ||||||
Prepaid expenses | 4,287 | 4,649 | ||||||
Other | 4,912 | 4,782 | ||||||
Total current assets | 95,258 | 89,916 | ||||||
Property, plant and equipment, net | 129,387 | 124,829 | ||||||
Restricted cash value of life insurance | 10,311 | 10,278 | ||||||
Goodwill, net | 22,491 | 21,871 | ||||||
Other intangible assets, net | 2,786 | 2,785 | ||||||
Other assets | 1,725 | 989 | ||||||
Total assets | $ | 261,958 | $ | 250,668 | ||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||
Current liabilities: | ||||||||
Cash overdraft, net | $ | 4,140 | $ | 961 | ||||
Current portion of long-term debt and capital lease obligations | 4,051 | 4,295 | ||||||
Short-term borrowings | 9,850 | 9,541 | ||||||
Accounts payable | 29,165 | 31,686 | ||||||
Accrued liabilities | 11,658 | 11,360 | ||||||
Total current liabilities | 58,864 | 57,843 | ||||||
Long-term debt and capital lease obligations | 61,005 | 53,171 | ||||||
Other post-retirement benefits | 13,663 | 13,606 | ||||||
Deferred income taxes | 4,563 | 5,924 | ||||||
Other liabilities | 12,861 | 12,672 | ||||||
Total liabilities | 150,956 | 143,216 | ||||||
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 10,935 and 10,909 shares, respectively | 10,935 | 10,909 | ||||||
Additional paid-in capital | 40,046 | 39,427 | ||||||
Retained earnings | 80,166 | 78,131 | ||||||
Treasury stock, at cost, 1,981 shares | (32,757 | ) | (32,757 | ) | ||||
Accumulated other comprehensive income | 12,612 | 11,742 | ||||||
Total shareholders’ equity | 111,002 | 107,452 | ||||||
Total liabilities and shareholders’ equity | $ | 261,958 | $ | 250,668 | ||||
The accompanying notes are an integral part of these statements.
3
Table of Contents
PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three months ended | ||||||||
November 30, | November 30, | |||||||
(In thousands, except per share data) | 2006 | 2005 | ||||||
Sales | $ | 85,500 | $ | 77,903 | ||||
Cost of sales | 72,306 | 67,503 | ||||||
Gross margin | 13,194 | 10,400 | ||||||
Operating expenses | 7,100 | 7,738 | ||||||
Research and development expenses | 1,571 | 1,437 | ||||||
Income from operations | 4,523 | 1,225 | ||||||
Non-operating income, net | 521 | 362 | ||||||
Interest expense | 1,304 | 1,333 | ||||||
Income before income taxes | 3,740 | 254 | ||||||
Income tax expense | 1,167 | 58 | ||||||
Net income | $ | 2,573 | $ | 196 | ||||
Weighted average common shares and equivalents outstanding: | ||||||||
Basic | 8,944 | 8,877 | ||||||
Diluted | 9,072 | 8,923 | ||||||
Earnings per share: | ||||||||
Basic | $ | 0.29 | $ | 0.02 | ||||
Diluted | $ | 0.28 | $ | 0.02 | ||||
Dividends declared per common share | $ | 0.06 | $ | 0.06 |
The accompanying notes are an integral part of these statements.
4
Table of Contents
PENFORD CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW
(Unaudited)
Three Months Ended | ||||||||
November 30, | November 30, | |||||||
(In thousands) | 2006 | 2005 | ||||||
Cash flows from operating activities: | ||||||||
Net income | $ | 2,573 | $ | 196 | ||||
Adjustments to reconcile net income to net cash used in operations: | ||||||||
Depreciation and amortization | 3,843 | 3,844 | ||||||
Stock-based compensation | 299 | 304 | ||||||
Deferred income taxes | (463 | ) | (141 | ) | ||||
Other | (761 | ) | (158 | ) | ||||
Change in assets and liabilities: | ||||||||
Trade accounts receivable | (3,535 | ) | (1,968 | ) | ||||
Prepaid expenses | 385 | 702 | ||||||
Inventories | (1,763 | ) | (54 | ) | ||||
Accounts payable and accrued liabilities | (4,486 | ) | (4,784 | ) | ||||
Taxes payable | 852 | (673 | ) | |||||
Other | 115 | 736 | ||||||
Net cash used in operating activities | (2,941 | ) | (1,996 | ) | ||||
Cash flows from investing activities: | ||||||||
Investment in property, plant and equipment, net | (7,430 | ) | (5,243 | ) | ||||
Other | (33 | ) | (58 | ) | ||||
Net cash used in investing activities | (7,463 | ) | (5,301 | ) | ||||
Cash flows from financing activities: | ||||||||
Proceeds from short-term borrowings | 3,892 | — | ||||||
Payments on short-term borrowings | (3,879 | ) | — | |||||
Proceeds from revolving line of credit | 12,989 | 6,719 | ||||||
Payments on revolving line of credit | (8,820 | ) | — | |||||
Proceeds from long-term debt | 4,200 | — | ||||||
Payments of long-term debt | (1,248 | ) | (1,000 | ) | ||||
Payments under capital lease obligation | (12 | ) | — | |||||
Exercise of stock options | 319 | — | ||||||
Payment of loan fees | (805 | ) | (15 | ) | ||||
Increase in cash overdraft | 3,178 | 740 | ||||||
Payment of dividends | (536 | ) | (531 | ) | ||||
Other | 27 | (4 | ) | |||||
Net cash provided by financing activities | 9,305 | 5,909 | ||||||
Effect of exchange rate changes on cash and cash equivalents | 160 | 41 | ||||||
Net decrease in cash and cash equivalents | (939 | ) | (1,347 | ) | ||||
Cash and cash equivalents, beginning of period | 939 | 5,367 | ||||||
Cash and cash equivalents, end of period | $ | — | $ | 4,020 | ||||
The accompanying notes are an integral part of these statements.
5
Table of Contents
PENFORD CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1—BUSINESS
Penford Corporation (“Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for industrial and food ingredient applications. The Company operates manufacturing facilities in the United States, Australia and New Zealand. Penford’s products provide binding and film-forming characteristics that improve customer’s products through convenient and cost-effective solutions made from renewable sources. 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 in developing applications to address customer needs. In addition, the Company has specialty processing capabilities for a variety of modified starches.
Penford manages its business in three segments. The first two, industrial ingredients and food ingredients are broad categories of end-market users, primarily served by the U.S. operations. The third segment is the geographically separate operations in Australia and New Zealand. The Australian and New Zealand operations are engaged primarily in the food ingredients business.
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 November 30, 2006 and the condensed consolidated statements of operations and cash flows for the interim periods ended November 30, 2006 and 2005 have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, which 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, 2006.
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (“FASB”) ratified the Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for years beginning after December 15, 2006. The Company is evaluating the impact this issue may have on its consolidated financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for the uncertainty in income taxes recognized by prescribing a recognition threshold that a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, interim period accounting and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the potential impact that the adoption of FIN 48 will have on its consolidated financial statements.
6
Table of Contents
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Current Year Misstatements” (“SAB 108”). SAB 108 requires analysis of misstatements using both an income statement and a balance sheet approach in assessing materiality. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company applied the provisions of SAB 108 in the first quarter of fiscal 2007 and there was no impact on the consolidated financial statements.
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 (fiscal 2009). The Company is evaluating the impact that adopting this statement may have on its consolidated financial statements.
In September 2006, the FASB issued Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132R” (“SFAS 158”). SFAS 158 requires companies to recognize the funded status of defined benefit pension and other postretirement plans as an asset or liability in the statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income in shareholders’ equity. SFAS 158 is effective for fiscal years ending after December 15, 2006. The Company is evaluating the impact that adopting this statement will have on its consolidated financial statements.
3—STOCK-BASED COMPENSATION
Stock Compensation Plans
Penford maintains the 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 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. As of November 30, 2006, the aggregate number of shares of the Company’s common stock that are available to be issued as awards under the 2006 Incentive Plan is 735,226. In addition, any shares previously granted under the 1994 Plan which are subsequently forfeited or not exercised will be available for future grants under the 2006 Incentive Plan.
General Option Information
A summary of the stock option activity for the three months ended November 30, 2006, is as follows:
Weighted | ||||||||||||||||
Weighted | Average | |||||||||||||||
Number of | Average | Remaining | Aggregate | |||||||||||||
Shares | Exercise Price | Term (in years) | Intrinsic Value | |||||||||||||
Outstanding Balance, August 31, 2006 | 1,171,063 | $ | 13.98 | |||||||||||||
Granted | 65,000 | 16.25 | ||||||||||||||
Exercised | (26,250 | ) | 12.14 | |||||||||||||
Cancelled | (10,750 | ) | 12.92 | |||||||||||||
Outstanding Balance, November 30, 2006 | 1,199,063 | $ | 14.16 | 6.16 | $ | 2,952,700 | ||||||||||
Options Exercisable at November 30, 2006 | 762,563 | $ | 13.58 | 5.53 | $ | 2,358,200 |
The aggregate intrinsic value disclosed in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $16.52 as of November 30, 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 three months ended November 30, 2006 was $89,600. No stock options were exercised during the three months ended November 30, 2005.
7
Table of Contents
The weighted average grant date fair value of stock options granted under the 2006 Incentive Plan during the three months ended November 30, 2006 was $6.74 and under the 1994 Plan during the three months ended November 30, 2005 was $6.93.
As of November 30, 2006, the Company had $1.8 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 November 30, 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 | |||||||||||||||
$ 6.18 — 13.00 | 469,893 | 5.43 | $ | 11.93 | 421,018 | $ | 11.84 | |||||||||||||
13.01 — 16.00 | 390,670 | 6.71 | 14.61 | 155,045 | 14.10 | |||||||||||||||
16.01 — 17.69 | 338,500 | 6.55 | 16.71 | 186,500 | 17.08 | |||||||||||||||
1,199,063 | 762,563 | |||||||||||||||||||
Valuation and Expense Under 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. The Company 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. 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.
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.
For the three months ended November 30, 2006 and 2005, the fair value of the options was estimated on the date of grant using the following assumptions.
Three Months Ended November 30, | ||||||||||||||||
2006 Incentive Plan | 1994 Plan | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Expected volatility | 45 | % | — | — | 52 | % | ||||||||||
Expected life (years) | 5.5 | — | — | 5.0 | ||||||||||||
Interest rate (percent) | 4.4-4.9 | — | — | 4.4-4.5 | ||||||||||||
Dividend yield | 1.5 | % | — | — | 1.7 | % |
No stock options were granted under the 1994 Plan during the first quarter of fiscal 2007 and no stock options were granted under the 2006 Incentive Plan during the three months ended November 30, 2005.
The Company recognizes stock-based compensation expense utilizing the accelerated multiple option approach over the requisite service period, which equals the vesting period. For each of the three month periods ended
8
Table of Contents
November 30, 2006 and 2005, the Company recognized $0.3 million in stock-based compensation costs. The following table summarizes the stock-based compensation cost under SFAS No. 123R for the three months ended November 30, 2006 and 2005 and the effect on the Company’s Condensed Consolidated Statements of Operations (in thousands):
Three Months Ended November 30, | ||||||||
2006 | 2005 | |||||||
Cost of sales | $ | 24 | $ | 20 | ||||
Operating expenses | 258 | 262 | ||||||
Research and development expenses | 7 | 12 | ||||||
Total stock-based compensation expense | $ | 289 | $ | 294 | ||||
Tax benefit | 107 | 100 | ||||||
Total stock-based compensation expense, net of tax | $ | 182 | $ | 194 | ||||
See Note 11 for stock-based compensation costs recognized in the financial statements of each business segment.
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. In September 2005, 8,694 shares of restricted common stock of the Company were granted to the non-employee directors.
4—INVENTORIES
The components of inventory are as follows:
November 30, | August 31, | |||||||
2006 | 2006 | |||||||
(In thousands) | ||||||||
Raw materials | $ | 19,425 | $ | 18,531 | ||||
Work in progress | 560 | 449 | ||||||
Finished goods | 17,434 | 15,973 | ||||||
Total inventories | $ | 37,419 | $ | 34,953 | ||||
5—PROPERTY, PLANT AND EQUIPMENT
The components of property, plant and equipment are as follows:
November 30, | August 31, | |||||||
2006 | 2006 | |||||||
(In thousands) | ||||||||
Land | $ | 16,968 | $ | 16,659 | ||||
Plant and equipment | 324,512 | 322,169 | ||||||
Construction in progress | 13,489 | 7,078 | ||||||
354,969 | 345,906 | |||||||
Accumulated depreciation | (225,582 | ) | (221,077 | ) | ||||
Net property, plant and equipment | $ | 129,387 | $ | 124,829 | ||||
Changes in Australian and New Zealand currency exchange rates have increased net property, plant and equipment in the first three months of fiscal 2007 by approximately $1.2 million.
9
Table of Contents
6—DEBT
On October 5, 2006, the Company entered into a $145 million Second Amended and Restated Credit Agreement (the “Agreement”) among the Company; Harris N.A.; LaSalle Bank National Association; Cooperative Centrale Raiffeisen-Boorleenbank B.A., “Rabobank Nederland” (New York Branch); U.S. Bank National Association; and the Australia and New Zealand Banking Group Limited.
The Agreement refinanced the Company’s previous $105 million secured term and revolving credit facilities. Under the Agreement, the Company may borrow $40 million in term loans and $60 million in revolving lines of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. In addition, the Agreement provides the Company with $45 million in new capital expansion funds which may be used by the Company to finance the construction of its planned ethanol production facility in Cedar Rapids, Iowa. The capital expansion funds may be borrowed as term loans from time to time prior to October 5, 2008.
The final maturity date for the term and revolving loans under the Agreement is December 31, 2011. Beginning on December 31, 2006, the Company must repay the term loans in twenty equal quarterly installments of $1 million, with the remaining amount due at final maturity. The final maturity date for the capital expansion loans is December 31, 2012. Beginning on December 31, 2008, the Company must repay the capital expansion loans in equal quarterly installments of $1.25 million through September 30, 2009 and $2.5 million thereafter, with the remaining amount due at final maturity. Interest rates under the Agreement are based on either the London Interbank Offering Rates (“LIBOR”) in Australia or the U.S., or the prime rate, depending on the selection of available borrowing options under the Agreement.
The Agreement provides that the Total Funded Debt Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as defined in the Agreement) shall not exceed 3.25 through November 30, 2006. Subsequent to November 30, 2006, the maximum Total Funded Debt Ratio varies between 3.00 and 4.50. In addition, the Company must maintain a minimum tangible net worth of $65 million, and a Fixed Charge Coverage Ratio, as defined in the Agreement, of not more than 1.50 in fiscal 2007, 1.25 in fiscal 2008 and 1.50 in fiscal 2009 and thereafter. Annual capital expenditures, exclusive of capital expenditures incurred in connection with the Company’s ethanol production facility, are limited to $20 million.
The Company’s obligations under the Agreement are secured by substantially all of the Company’s assets and those of its principal domestic subsidiary, Penford Products Co.
At November 30, 2006, the Company had $24.9 million and $40.0 million outstanding, respectively, under the revolving credit and term loan portions of its $145 million credit facility. Pursuant to the terms of the credit agreement, Penford’s additional borrowing ability was $36.8 million at November 30, 2006. In addition, the Company has not drawn down any of the $45 million in capital expansion loans available under the credit facility for the construction of the ethanol facility. The Company was in compliance with the covenants in its credit agreement as of November 30, 2006 and expects to be in compliance with the covenants for the remainder of fiscal 2007.
The Company’s short-term borrowings consist of an Australian variable-rate revolving grain inventory financing facility with an Australian bank for a maximum of $31.4 million U.S. dollars at the exchange rate at November 30, 2006. The amount outstanding under this arrangement, which is classified as a current liability on the balance sheet, was $9.8 million at November 30, 2006.
As of November 30, 2006, all of the Company’s outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, is subject to variable interest rates. Under interest rate swap agreements with several banks, the Company has fixed its interest rates on $35.8 million of U.S. dollar denominated term debt at 4.18% plus the applicable margin under the Company’s credit agreement. As of November 30, 2006, the fair value of the interest rate swaps was $0.6 million. In the first quarter of fiscal 2007, the Company terminated an interest rate swap on approximately $9.0 million of U.S. dollar equivalent Australian dollar denominated term debt, and recognized a gain of approximately $0.1 million.
10
Table of Contents
7—TAXES
The Company’s effective tax rate for the three months ended November 30, 2006 and 2005 varied from the U.S. federal statutory rate primarily due to 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 the favorable tax effect of domestic (U.S.) production activities. The Company’s effective tax rate for the three months ended November 30, 2005 was also reduced by the favorable tax effects of U.S. tax incentives related to research and development activities.
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 for fiscal 2007 is 31%.
8—OTHER COMPREHENSIVE INCOME
The components of total comprehensive income are as follows:
Three months ended | ||||||||
November 30, | November 30, | |||||||
2006 | 2005 | |||||||
(In thousands) | ||||||||
Net income | $ | 2,573 | $ | 196 | ||||
Foreign currency translation adjustments | 1,938 | (492 | ) | |||||
Change in unrealized gains on derivative instruments that qualify as cash flow hedges, net of tax | (1,068 | ) | 306 | |||||
Total comprehensive income | $ | 3,443 | $ | 10 | ||||
9—NON-OPERATING INCOME, NET
Non-operating income, net consists of the following:
Three months ended | ||||||||
November 30, | November 30, | |||||||
2006 | 2005 | |||||||
(In thousands) | ||||||||
Royalty and licensing income | $ | 518 | $ | 423 | ||||
Other | 3 | (61 | ) | |||||
Total | $ | 521 | $ | 362 | ||||
In November 2002, the Company exclusively licensed the rights to its resistant starch intellectual property portfolio (the “RS Patents”) 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. Under the terms of the 2002 license agreement, Penford also became entitled to receive annual royalties for a period of seven years or until a maximum of $11.0 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 $7.2 million in royalty income from the inception of the agreement through November 30, 2006.
11
Table of Contents
In September 2006, in connection with the settlement of litigation in which Penford’s Australian subsidiary companies were plaintiffs, Penford received a one-time payment of $625,000 and granted a license to one of the defendants in this litigation under Penford’s RS Patents in certain non-human nutrition applications. In addition, Penford became entitled to receive additional royalties under a license of rights under the RS Patents in human nutrition applications granted to one of the defendants. As part of the settlement agreement, Penford is entitled to receive certain other benefits, including an acceleration and extension of certain royalties under its 2002 license. The Company is deferring and recognizing license income of $625,000 ratably over the remaining life of the patent license, which is estimated to be seven years.
10 – PENSION AND POST-RETIREMENT BENEFIT PLANS
The components of the net periodic pension and post-retirement benefit costs for the three months ended November 30, 2006 and 2005 are as follows:
Defined benefit pension plans
Three months ended | ||||||||
November 30, | November 30, | |||||||
2006 | 2005 | |||||||
Service cost | $ | 388 | $ | 418 | ||||
Interest cost | 584 | 525 | ||||||
Expected return on plan assets | (593 | ) | (529 | ) | ||||
Amortization of prior service cost | 46 | 47 | ||||||
Amortization of actuarial losses | 48 | 151 | ||||||
Net periodic benefit cost | $ | 473 | $ | 612 | ||||
Post-retirement health care plans
Three months ended | ||||||||
November 30, | November 30, | |||||||
2006 | 2005 | |||||||
Service cost | $ | 77 | $ | 98 | ||||
Interest cost | 205 | 196 | ||||||
Amortization of prior service cost | (38 | ) | (38 | ) | ||||
Amortization of actuarial losses | — | 36 | ||||||
Net periodic benefit cost | $ | 244 | $ | 292 | ||||
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 Industrial Ingredients segment provides carbohydrate-based starches for industrial applications, primarily in the paper and packaging products industries. The Food Ingredients segment produces specialty starches for food applications. 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 is presented separately since the chief operating decision maker views segment results prior to intercompany eliminations.
12
Table of Contents
Three months ended | ||||||||
November 30, | November 30, | |||||||
2006 | 2005 | |||||||
(In thousands) | ||||||||
Sales: | ||||||||
Industrial Ingredients—North America | $ | 43,972 | $ | 38,480 | ||||
Food Ingredients—North America | 15,240 | 15,090 | ||||||
Australia/New Zealand operations | 26,524 | 24,635 | ||||||
Intercompany sales | (236 | ) | (302 | ) | ||||
$ | 85,500 | $ | 77,903 | |||||
Income (loss) from operations: | ||||||||
Industrial Ingredients—North America | $ | 3,182 | $ | 574 | ||||
Food Ingredients—North America | 2,853 | 2,401 | ||||||
Australia/New Zealand operations | 808 | 697 | ||||||
Corporate and other | (2,320 | ) | (2,447 | ) | ||||
$ | 4,523 | $ | 1,225 | |||||
November 30, | August 31, | |||||||
2006 | 2006 | |||||||
(In thousands) | ||||||||
Total assets: | ||||||||
Industrial Ingredients–North America | $ | 108,443 | $ | 98,733 | ||||
Food Ingredients—North America | 31,886 | 31,714 | ||||||
Australia/New Zealand operations | 105,381 | 104,491 | ||||||
Corporate and other | 16,248 | 15,730 | ||||||
$ | 261,958 | $ | 250,668 | |||||
The Company recognized $0.3 million in stock-based compensation expense in each of the three month periods ended November 30, 2006 and 2005. The following table summarizes the stock-based compensation expense related to stock option awards by segment for the three months ended November 30, 2006 and 2005.
Three months ended | ||||||||
November 30, 2006 | November 30, 2005 | |||||||
(In thousands) | ||||||||
Industrial Ingredients–North America | $ | 68 | $ | 66 | ||||
Food Ingredients—North America | 43 | 33 | ||||||
Australia/New Zealand operations | 20 | 11 | ||||||
Corporate | 158 | 184 | ||||||
$ | 289 | $ | 294 | |||||
13
Table of Contents
12—EARNINGS PER SHARE
Basic earnings per share reflects only the weighted average common shares outstanding during the period. Diluted earnings 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. The following table presents the computation of diluted weighted average shares outstanding for the three months ended November 30, 2006 and 2005.
Three months ended | ||||||||
November 30, 2006 | November 30, 2005 | |||||||
(In thousands) | ||||||||
Weighted average common shares outstanding | 8,944 | 8,877 | ||||||
Dilutive stock options | 128 | 46 | ||||||
Weighted average common shares outstanding, assuming dilution | 9,072 | 8,923 | ||||||
Weighted-average stock options to purchase 434,571 and 566,450 shares of common stock for the three months ended November 30, 2006 and 2005, respectively, were excluded from the calculation of diluted earnings per share because they were antidilutive.
13—LEGAL PROCEEDINGS
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 Court, 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 first quarter of the Company’s fiscal year 2007, the parties continued to conduct discovery. Trial has been scheduled for mid-July 2007. Based upon discovery responses made by Graphic, Graphic is seeking damages of approximately $3.3 million. Penford is seeking damages of approximately $675,000. The Company is unable to assess the eventual outcome of this litigation.
The Company is involved in various other claims and litigation arising in the normal course of business. In the judgment of management, which relies in part on information from Company counsel, the ultimate resolution of these actions will not materially affect the consolidated financial statements of the Company.
14
Table of Contents
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 in Item 1A 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, 2006, 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; unanticipated ethanol facility construction or procurement delays that could result in delay in the timing of the commencement of ethanol production; technical difficulties, nonperformance by contractors or mandated changes in project requirements or specifications; changes in general economic conditions or developments with respect to specific industries or customers affecting demand for the Company’s products including unfavorable shifts in product mix; unanticipated costs, expenses or third party claims; interest rate, chemical and energy cost volatility; 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.
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.
Results of Operations
Executive Overview
Consolidated sales for the three months ended November 30, 2006 increased 10% to $85.5 million from $77.9 million in the first quarter of fiscal 2006. The increase in sales was driven by favorable pricing in the Industrial Ingredients business and volume increases in the Australian/New Zealand and Industrial Ingredients business segments. Gross margin as a percent of sales increased 210 basis points from 13.3% last year to 15.4% in the first quarter of fiscal 2007 due to improvements in unit pricing, sales volume growth, a 29% decline in the average unit cost of natural gas, and improved energy usage yields at the Industrial Ingredients business. These gains were
15
Table of Contents
partially offset by higher chemical costs in the Industrial Ingredients and Food Ingredients businesses. Income from operations for the first quarter of fiscal 2007 rose $3.3 million over the same period last year, primarily due to the increase in gross margin.
First quarter fiscal 2007 operating and research and development expenses declined 5.5% to $8.7 million from $9.2 million in the same period last year primarily due to a reduction of employee severance costs of $0.6 million. A discussion of segment results of operations and the effective tax rate follows.
In November 2006, the Company announced the groundbreaking of its new ethanol production facility. The ethanol facility is being designed to efficiently produce between 25 and 40 million gallons of ethanol per year. The Company currently expects the facility to be producing ethanol by the end of calendar 2007.
Sales
Sales during the first quarter of fiscal 2007 for the Company’s Industrial Ingredients—North America business unit was $44.0 million, a $5.5 million, or 14%, increase compared to the same period last year. Volume expanded 4%, increases in average unit selling prices contributed 3%, and the “pass through” impact from higher corn prices added another 7% to total sales.
First quarter fiscal 2007 sales for the Australia/New Zealand operations rose 8% to $26.5 million from $24.6 million over the same period of fiscal 2006. Volume growth of 9% was the primary contributor to the sales improvement, partially offset by competitive pricing on exported products.
Food Ingredients—North America sales for the first quarter of fiscal 2007 increased 1% or $0.2 million over the same period in fiscal 2006. Total volumes were comparable to last year and average unit selling prices rose 1% due to product mix. Sales growth of 16% in the processed meat product category was offset by a 6% decline in sales of potato coatings.
Income from operations
Income from operations for the first quarter of fiscal 2007 at the Company’s Industrial Ingredients—North America business unit was $3.2 million, a $2.6 million increase over the same quarter last year. First quarter fiscal 2007 gross margin as a percent of sales increased 430 basis points to 13.6% from 9.3% for the first quarter of fiscal 2006 due to favorable unit pricing and sales volume growth which contributed $1.4 million to gross margin. Lower unit natural gas costs and favorable energy usage yields positively affected the gross margin by $1.8 million. Higher chemical and other manufacturing costs of $0.7 million partially offset margin gains. Operating income for the first quarter of fiscal 2006 included $0.2 million of employee severance costs.
First quarter fiscal 2007 income from operations at the Company’s Australia/New Zealand operations was $0.8 million compared to $0.7 million for the three months ended November 30, 2005. Gross margin as a percent of sales declined from 10.5% in the first quarter of fiscal 2006 to 9.1% in the same period of fiscal 2007. The decline in gross margin was primarily associated with price concessions and unfavorable product mix, partially offset by higher sales volume. Included in operating income for the first quarter of fiscal 2006 were $0.4 million of employee severance costs.
Income from operations for the first quarter of fiscal 2007 at the Food Ingredients—North American grew 19% from $2.4 million last year to $2.9 million. Gross margin as a percent of sales increased to 31.4% from 28.1% last year on favorable product mix and lower energy costs, partially offset by higher raw material and chemical costs.
Corporate operating expenses
Corporate operating expenses for the quarter ended November 30, 2006 declined 5%, or $0.1 million to $2.3 million from $2.4 million in the same period last year due to lower consulting and professional fees.
16
Table of Contents
Interest and taxes
Fiscal 2007 interest expense for the first quarter date declined 2% on lower average debt balances, partially offset by higher average floating interest rates in the U.S. and Australia. The Company’s debt includes the amount outstanding under its grain inventory financing facility. See Note 6 to the Condensed Consolidated Financial Statements.
The Company’s effective tax rate for the three months ended November 30, 2006 and 2005 varied from the U.S. federal statutory rate primarily due to 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 the favorable tax effect of domestic (U.S.) production activities. The Company’s effective tax rate for the three months ended November 30, 2005 was also reduced by the favorable tax effects of U.S. tax incentives related to research and development activities.
The Tax Relief and Health Care Act of 2006 was enacted in the U.S. at the end of December 2006. The Company is currently evaluating the impact this new tax law will have on its consolidated financial statements.
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 for fiscal 2007 is 31%.
The determination of the annual effective tax rate is based upon a number of estimates and judgments, including the estimated annual pretax income of the Company in each tax jurisdiction and the amounts of permanent differences between the book and tax accounting for various items. The Company’s interim tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits and other items that cannot be estimated with any certainty. Therefore, there can be significant volatility in the interim provision for income tax expense.
Non-operating income, net
Non-operating income, net consists of the following:
Three months ended | ||||||||
November 30, 2006 | November 30, 2005 | |||||||
(In thousands) | ||||||||
Royalty and licensing income | $ | 518 | $ | 423 | ||||
Other | 3 | (61 | ) | |||||
Total | $ | 521 | $ | 362 | ||||
In November 2002, the Company exclusively licensed the rights to its resistant starch intellectual property portfolio (the “RS Patents”)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. Under the terms of the 2002 license agreement, Penford also became entitled to receive annual royalties for a period of seven years or until a maximum of $11.0 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 $7.2 million in royalty income from the inception of the agreement through November 30, 2006.
In September 2006, in connection with the settlement of litigation in which Penford’s Australian subsidiary companies were plaintiffs, Penford received a one-time payment of $625,000 and granted a license to one of the defendants in this litigation under Penford’s RS Patents in certain non-human nutrition applications. In addition, Penford became entitled to receive additional royalties under a license of rights under the RS Patents in human nutrition applications granted to one of the defendants. As part of the settlement agreement, Penford is entitled to
17
Table of Contents
receive certain other benefits, including an acceleration and extension of certain royalties under its 2002 license. The Company is deferring and recognizing license income of $625,000 ratably over the remaining life of the patent license, which is estimated to be seven years.
Liquidity and Capital Resources
On October 5, 2006, the Company entered into a $145 million Second Amended and Restated Credit Agreement. See Note 6 to the Condensed Consolidated Financial Statements.
At November 30, 2006, the Company had $24.9 million and $40.0 million outstanding, respectively, under the revolving credit and term loan portions of its $145 million credit facility. Pursuant to the terms of the credit agreement, Penford’s additional borrowing ability was $36.8 million at November 30, 2006. In addition, the Company has not drawn down any of the $45 million in capital expansion loans available under the credit facility for the construction of the ethanol facility. The Company was in compliance with the covenants in its credit agreement as of November 30, 2006 and expects to be in compliance with the covenants for the remainder of fiscal 2007.
The Company’s short-term borrowings consist of an Australian variable-rate revolving grain inventory financing facility with an Australian bank for a maximum of $31.4 million U.S. dollars at the exchange rate at November 30, 2006. The amount outstanding under this arrangement, which is classified as a current liability on the balance sheet, was $9.8 million at November 30, 2006.
As of November 30, 2006, all of the Company’s outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, is subject to variable interest rates. Under interest rate swap agreements with several banks, the Company has fixed its interest rates on $35.8 million of U.S. dollar denominated term debt at 4.18% plus the applicable margin under the Company’s credit agreement. As of November 30, 2006, the fair value of the interest rate swaps was $0.6 million. In the first quarter of fiscal 2007, the Company terminated an interest rate swap on approximately $9.0 million of U.S. dollar equivalent Australian dollar denominated term debt, and recognized a gain of approximately $0.1 million.
Penford had working capital of $36.4 million and $32.1 million at November 30, 2006 and August 31, 2006, respectively. Cash used in operations was $2.9 million and $2.0 million, respectively for the first quarters of fiscal 2007 and 2006. Total debt outstanding increased by $7.9 million during the first quarter of fiscal 2007 primarily due to the funding of $7 million in capital expenditures.
In June 2006, the Company announced plans to invest in an ethanol plant at its Cedar Rapids, Iowa facility. In October 2006, Penford refinanced its credit facility and obtained a $45 million capital expansion loan commitment maturing December 2012 to finance construction of the ethanol plant, none of which has been utilized as of November 30, 2006. See Note 6 to the Condensed Consolidated Financial Statements. In the first quarter of fiscal 2007, the Company had $1.3 million of capital expenditures related to the ethanol facility. As of November 30, 2006, the Company had a total of $2.0 million in capital expenditures related to the ethanol facility. Currently, the Company estimates its capital expenditures in fiscal 2007 related to the ethanol facility to be $35 million.
The Company paid dividends of $0.5 million during the three months ended November 30, 2006, which represents a quarterly rate of $0.06 per share. On October 31, 2006, the Board of Directors declared a dividend of $0.06 per common share payable on December 1, 2006 to shareholders of record as of November 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 November 30, 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. On October 5, 2006, Penford Corporation (the “Company”) entered into a $145 million Second Amended and Restated Credit Agreement. See Note 6 to the Condensed Consolidated Financial Statements. The
18
Table of Contents
following table summarizes the fiscal year contractual commitments of the Company’s long-term debt and capital lease obligations at November 30, 2006.
2007 | 2008-2009 | 2010-2011 | 2012 & After | Total | ||||||||||||||||
Long-term Debt and Capital Lease Obligations | $ | 3,040 | $ | 8,098 | $ | 8,018 | $ | 45,900 | $ | 65,056 |
The Company has no off-balance sheet arrangements at November 30, 2006.
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (“FASB”) ratified the Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for years beginning after December 15, 2006. The Company is evaluating the impact this issue may have on its consolidated financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for the uncertainty in income taxes recognized by prescribing a recognition threshold that a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, interim period accounting and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the potential impact that the adoption of FIN 48 will have on its consolidated financial statements.
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Current Year Misstatements” (“SAB 108”). SAB 108 requires analysis of misstatements using both an income statement and a balance sheet approach in assessing materiality. SAB 108 is effective for fiscal years ending after November 15, 2006. The Company applied the provisions of SAB 108 in the first quarter of fiscal 2007 and there was no impact on the consolidated financial statements.
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 (fiscal 2009). The Company is evaluating the impact that adopting this statement may have on its consolidated financial statements.
In September 2006, the FASB issued Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132R” (“SFAS 158”). SFAS 158 requires companies to recognize the funded status of defined benefit pension and other postretirement plans as an asset or liability in the statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income in shareholders’ equity. SFAS 158 is effective for fiscal years ending after December 15, 2006. The Company is evaluating the impact that adopting this statement will have on its consolidated financial statements.
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, 2006 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
19
Table of Contents
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 |
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 provides 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 November 30, 2006, the allowance for doubtful accounts receivable was $0.9 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 losses, net of tax, of $0.6 million at November 30, 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
20
Table of Contents
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, on an annual basis, whether the value of goodwill reported on the balance sheet has been impaired, 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.
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.
21
Table of Contents
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, 2006.
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 November 30, 2006. There were no changes in the Company’s internal control over financial reporting during the quarter ended November 30, 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
22
Table of Contents
PART II — OTHER INFORMATION
Item 1A Risk Factors
Increases in energy and chemical costs may reduce the Company’s profitability.
Energy and chemicals each comprised approximately 12% of the cost of manufacturing the Company’s products in the first quarter of fiscal year 2007. Natural gas is used extensively in the Industrial Ingredients – North America business to dry 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 be able to pass on increases in energy and chemical costs to its customers and margins and profitability would be adversely affected.
The availability and cost of agricultural products Penford purchases are vulnerable to weather and other factors beyond its control.
In the first quarter of fiscal 2007, approximately 30% of Penford’s manufacturing costs were 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 the increases in the cost of agricultural raw materials to its customers. To manage 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.
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 quarter of fiscal 2007, sales to the top ten customers and sales to the largest customer represented 43% 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 November 30, 2006, all of the Company’s outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, was subject to variable interest rates which move in direct relation to the U.S. or Australian London InterBank Offered Rate (“LIBOR”), the Australian bank bill rate (“BBSY”), 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 Company’s 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.
23
Table of Contents
Profitability is subject to risks associated with changes in foreign currency exchange rates.
In the ordinary course of business, Penford is subject to risks associated with changing foreign exchange rates. In the first quarter of fiscal 2007, approximately 31% of the Company’s revenue was 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.
The Company may not be able to implement ethanol production as planned or at all.
Penford’s ability to implement ethanol production as planned is subject to uncertainty. The Company recently announced this project and a considerable amount of work is only in preliminary stages. The Company has secured $45 million of financing for this project which it believes is adequate for completion; however, the Company could face financial risks if this amount of financing is not sufficient to complete the construction of the ethanol facility. The Company may be adversely affected by environmental, health and safety laws, regulations and liabilities in implementing ethanol production. Changes in the markets for ethanol and/or legislation and regulations could materially and adversely affect ethanol demand. The market for ethanol as automotive fuel has not yet been developed. As a result, there is no assurance that sufficient demand for ethanol will develop to permit profitable operation of the ethanol production facility.
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.
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.
24
Table of Contents
Item 6: Exhibits.
(d) Exhibits
10.1 | Second Amended and Restated Credit Agreement dated as of October 5, 2006 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated October 5, 2006, filed October 10, 2006) | |
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 |
25
Table of Contents
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 | ||||
January 9, 2007 | /s/ Steven O. Cordier | |||
Steven O. Cordier | ||||
Senior Vice President and Chief Financial Officer |
26
Table of Contents
EXHIBIT INDEX
Exhibit No. | Description | |
10.1 | Second Amended and Restated Credit Agreement dated as of October 5, 2006 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated October 5, 2006, filed October 10, 2006) | |
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 |
27