Penford (PENX) 10-Q 2013 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED May 31, 2013

OR

¨ 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.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer	¨	Accelerated Filer	x
Non-Accelerated Filer	¨  (Do not check if a smaller reporting company)	Smaller Reporting Company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The net number of shares of the Registrant’s common stock outstanding as of July 5, 2013 was 12,430,053.

PENFORD CORPORATION AND SUBSIDIARIES

INDEX

	Page
PART I—FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets – May 31, 2013 and August 31, 2012		3
Condensed Consolidated Statements of Operations – Three and Nine Months ended May  31, 2013 and 2012 (Restated)		4
Condensed Consolidated Statements of Comprehensive Income (Loss) – Three and Nine Months ended May 31, 2013 and 2012		5
Condensed Consolidated Statements of Cash Flows – Nine Months ended May 31, 2013 and 2012		6
Notes to Condensed Consolidated Financial Statements (Restated)		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		20
Item 3. Quantitative and Qualitative Disclosures About Market Risk		25
Item 4. Controls and Procedures		26
PART II—OTHER INFORMATION
Item 1. Legal Proceedings		27
Item 1A. Risk Factors		27
Item 6. Exhibits		27
Signatures		28

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PART I - FINANCIAL INFORMATION

Item 1: Financial Statements

PENFORD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)	May 31, 2013			August 31, 2012
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	257		$	154
Trade accounts receivable, net		39,055			36,464
Inventories		44,669			43,672
Prepaid expenses		4,262			2,826
Material and supplies		4,461			3,980
Income tax receivable		202			188
Other		2,451			4,681
Total current assets		95,357			91,965
Property, plant and equipment, net		109,035			113,191
Restricted cash value of life insurance		7,858			7,858
Deferred tax assets		10,408			13,108
Other assets		1,314			1,612
Other intangible assets, net		351			467
Goodwill		7,978			7,978
Total assets	$	232,301		$	236,179
Liabilities and Shareholders’ Equity
Current liabilities:
Cash overdraft, net	$	3,556		$	7,337
Current portion of long-term debt and capital lease obligations		281			458
Accounts payable		18,398			19,201
Short-term financing arrangements		2,019			905
Accrued liabilities		7,536			8,237
Total current liabilities		31,790			36,138
Long-term debt and capital lease obligations		78,248			84,004
Other postretirement benefits		20,102			19,707
Pension benefit liability		21,671			20,917
Other liabilities		6,548			6,563
Total liabilities		158,359			167,329
Shareholders’ equity:
Common stock, par value $1.00 per share, authorized 29,000 shares, issued 14,406 and 14,342 shares, respectively, including treasury shares		14,382			14,281
Preferred stock, par value $1.00 per share, authorized 1,000 shares, none issued		—			—
Additional paid-in capital		104,499			103,205
Retained earnings (deficit)		4,598			(286	)
Treasury stock, at cost, 1,981 shares		(32,757	)		(32,757	)
Accumulated other comprehensive loss		(16,780	)		(15,593	)
Total shareholders’ equity		73,942			68,850
Total liabilities and shareholders’ equity	$	232,301		$	236,179

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 May 31,						Nine months ended May 31,
(In thousands, except per share data)	2013			2012			2013			2012
				(As restated, see Note 2						(As restated, see Note 2
Sales	$	121,719		$	111,283		$	349,823		$	322,928
Cost of sales		108,528			99,829			312,373			290,265
Gross margin		13,191			11,454			37,450			32,663
Operating expenses		7,326			6,340			22,269			18,883
Research and development expenses		1,590			1,541			4,356			4,198
Income from operations		4,275			3,573			10,825			9,582
Interest expense		(998	)		(2,335	)		(3,062	)		(7,162	)
Other non-operating income (expense), net		146			(2,815	)		68			(2,579	)
Income (loss) before income taxes		3,423			(1,577	)		7,831			(159	)
Income tax expense		1,365			3,875			2,875			5,041
Net income (loss)	$	2,058		$	(5,452	)	$	4,956		$	(5,200	)
Weighted average common shares and equivalents outstanding:
Basic		12,395			12,300			12,349			12,292
Diluted		12,670			12,300			12,548			12,292
Earnings (loss) per common share:
Basic earnings (loss) per share	$	0.17		$	(0.44	)	$	0.40		$	(0.42	)
Diluted earnings (loss) per share	$	0.16		$	(0.44	)	$	0.39		$	(0.42	)

The accompanying notes are an integral part of these statements.

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PENFORD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

		Three months ended May 31,						Nine months ended May 31,
(In thousands)		2013			2012			2013			2012
Net income (loss)		$	2,058		$	(5,452	)	$	4,956		$	(5,200	)
Other comprehensive income (loss), net of tax:
Change in fair value of derivatives, net of tax benefit (expense) of $10, $408, $(147), and $272, respectively			(17	)		(667	)		239			(444	)
Gain from derivative transactions reclassified into earnings, net of tax expense of $(92), $(14), $(1,526), and $(586), respectively			(149	)		(22	)		(2,490	)		(957	)
Amortization of prior service cost, net of taxes of $8, $0, $25, and $0, respectively	��		13			—			41			—
Amortization of actuarial loss, net of taxes of $209, $0, $627, and $0, respectively			341			—			1,023			—
Other comprehensive income (loss)			188			(689	)		(1,187	)		(1,401	)
Total comprehensive income (loss)		$	2,246		$	(6,141	)	$	3,769		$	(6,601	)

The accompanying notes are an integral part of these statements.

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PENFORD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine months ended May 31,
(In thousands)	2013			2012
Cash flows from operating activities:
Net income (loss)	$	4,956		$	(5,200	)
Adjustments to reconcile net income (loss) to net cash provided by operations:
Depreciation and amortization		10,128			10,718
Loss on redemption of Series A Preferred Stock		—			2,777
Non-cash interest on Series A Preferred Stock		—			1,838
Stock-based compensation		1,102			893
Loss on sale of fixed assets		12			29
Deferred income tax expense		2,845			4,967
Non-cash loss on hedging transactions		1,913			3,764
Excess tax benefit from stock-based compensation		(46	)		—
Other		—			20
Change in assets and liabilities:
Trade accounts receivable		(2,591	)		(3,498	)
Prepaid expenses		(1,443	)		(1,886	)
Inventories		(2,910	)		(1,270	)
Increase in margin accounts		(3,009	)		(453	)
Accounts payable and accrued liabilities		(855	)		(2,029	)
Income tax receivable		(14	)		(389	)
Pension benefit liability		754			(1,363	)
Other receivables		2,171			(700	)
Payment of interest on Series A Preferred Stock, net		—			(2,191	)
Other		1,567			607
Net cash flow provided by operating activities		14,580			6,634
Cash flows from investing activities:
Acquisition of property, plant and equipment, net		(8,308	)		(9,252	)
Settlement of ethanol construction claim (Note 13)		2,106			—
Acquisition of Carolina Starches, net of cash acquired		—			(8,347	)
Other		1			21
Net cash used in investing activities		(6,201	)		(17,578	)
Cash flows from financing activities:
Proceeds from revolving line of credit		18,200			48,250
Payments on revolving line of credit		(23,800	)		(22,200	)
Payments of long-term debt		(150	)		(150	)
Redemption of Series A preferred stock		—			(16,500	)
Payments under capital lease obligation		(209	)		(184	)
Proceeds from financing arrangements		2,019			2,255
Payments on financing arrangements		(893	)		(1,299	)
Exercise of stock options		293			—
Excess tax benefit from stock-based compensation		46			—
Increase (decrease) in cash overdraft		(3,781	)		1,123
Other		(1	)		27
Net cash provided by (used in) financing activities		(8,276	)		11,322
Increase in cash and cash equivalents		103			378
Cash and cash equivalents, beginning of period		154			281
Cash and cash equivalents, end of period	$	257		$	659

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 (which, together with its subsidiary companies, is referred to herein as “Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for food and industrial applications, including fuel grade ethanol. Penford’s products provide convenient and cost-effective solutions derived from renewable sources. Sales of the Company’s products are generated using a combination of direct sales and distributor agreements.

The Company has significant research and development capabilities, which are used in applying 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 two segments: Industrial Ingredients and Food Ingredients. These segments are based on broad categories of end-market users. The Industrial Ingredients segment is a supplier of specialty starches to the paper, packaging and other industries, and is a producer of fuel grade ethanol. The Industrial Ingredients segment also sells the by-products from its corn wet milling manufacturing operations, primarily germ, fiber and gluten to customers who use these by-products as animal feed or to product corn oil. The Food Ingredients segment is a developer and manufacturer of specialty starches and dextrins for the food manufacturing and food service industries. See Note 11 for financial information regarding the Company’s business segments.

In January 2012, the Company completed the acquisition of the businesses operated by Carolina Starches, LLC and related entities (“Carolina Starches”) for $8.5 million in cash. Carolina Starches manufactures and markets cationic starches produced from potato, corn and tapioca. The acquisition of these businesses provided an important source of raw material to support continued growth in the Food Ingredients business and it broadened the Company’s portfolio of specialty modified industrial starches. See Note 11 for information concerning the integration of the operations of Carolina Starches into the Company’s two business segments.

2—RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS

The Company had previously recorded the proceeds from the sale of by-products from its Cedar Rapids, Iowa, manufacturing operations as a reduction of cost of sales. The Company believed that this accounting treatment was an acceptable accounting policy under accounting principles generally accepted in the United States. After several months of consultation and review with the Staff of the Securities and Exchange Commission (“SEC”), the Company and the Company’s Audit Committee concluded that the proceeds from the sale of by-products should be classified as sales rather than as a reduction of cost of sales in the Condensed Consolidated Statements of Operations.

As a result of the above, the Company restated the amounts of sales and cost of sales as previously reported.

• Condensed Consolidated Statements of Operations – increased consolidated sales and increased cost of sales for the three- and nine-month periods ended May 31, 2012

• Note 11 – Segment Reporting – increased consolidated and Industrial Ingredients segment sales for the three- and nine-month periods ended May 31, 2012

The adjustments to sales and cost of sales shown below affect the amounts previously reported for the Company’s consolidated sales and cost of sales and the sales of the Company’s Industrial Ingredients segment as previously reflected in the segment footnote. The following is a reconciliation of sales and cost of sales as previously reported to the adjusted amounts. The adjustments do not affect the Company’s previously reported gross margin, income (loss) from operations, net income (loss) or earnings (loss) per share in the Condensed Consolidated Statements of Operations for the three- and nine-month periods ended May 31, 2012 or to any items reported in the Condensed Consolidated Balance Sheets or the Condensed Consolidated Statements of Comprehensive Income (Loss) or Cash Flows.

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	As Previously Reported		Adjustment		As Restated
	(Dollars in thousands)
Quarter Ended May 31, 2012
Consolidated sales	$	92,924	$	18,359	$	111,283
Consolidated cost of sales		81,470		18,359		99,829
Industrial Ingredient sales		66,751		18,359		85,110
Nine Months Ended May 31, 2012
Consolidated sales	$	269,858	$	53,070	$	322,928
Consolidated cost of sales		237,195		53,070		290,265
Industrial Ingredient sales		192,857		53,070		245,927

In addition to the amounts restated above, the Company has also corrected an error in the consolidated statement of cash flows to properly classify proceeds and payments related to a short term financing arrangement as a financing activity rather than as an operating activity. The net amount of proceeds and repayments previously reflected as a “Change in operating assets and liabilities – accounts payable and accrued liabilities” of $956,000 for the nine months ended May 31, 2012 has been corrected within financing activities at the appropriate gross amounts of proceeds and payments.

3—BASIS OF PRESENTATION

Consolidation

The accompanying condensed consolidated financial statements include the accounts of Penford and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated. The condensed consolidated balance sheet at May 31, 2013 and the condensed consolidated statements of operations, comprehensive income (loss) and cash flows for the interim periods ended May 31, 2013 and 2012 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 accounting principles generally accepted in the United States of America (“U.S. GAAP”), 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. Certain prior period amounts have been reclassified to conform to the current period presentation. 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/A for the year ended August 31, 2012.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates are used in accounting for, among other things, the allowance for doubtful accounts, accruals, legal contingencies, the determination of fair value of net assets acquired in a business combination, the determination of assumptions for pension and postretirement employee benefit costs, useful lives of property and equipment, the assessment of a potential impairment of goodwill or long-lived assets and income taxes including the determination of a need for a valuation allowance for deferred tax assets. Actual results may differ from previously estimated amounts.

Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board (“FASB”) issued guidance requiring entities to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The amendment does not change the items that must be reported in other comprehensive income or when an item of other

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comprehensive income must be reclassified to net income under current accounting standards. The guidance was effective for the Company’s fiscal year and interim periods beginning September 1, 2012. The Company adopted this amended guidance in fiscal 2013 and presented the Condensed Consolidated Statements of Comprehensive Income (Loss) immediately following the Condensed Consolidated Statements of Operations.

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

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

4—BALANCE SHEET DETAILS

The components of inventory are as follows:

	May 31,		August 31,
	2013		2012
	(In thousands)
Raw materials	$	19,776	$	19,773
Work in progress		2,269		1,542
Finished goods		22,624		22,357
Total inventories	$	44,669	$	43,672

The components of property, plant and equipment are as follows:

	May 31,			August 31,
	2013			2012
	(In thousands)
Land	$	11,713		$	11,623
Plant and equipment		352,144			346,087
Construction in progress		7,051			7,679
		370,908			365,389
Accumulated depreciation		(261,873	)		(252,198	)
Net property, plant and equipment	$	109,035		$	113,191

At May 31, 2013 and August 31, 2012, the Company had approximately $0.4 million and $1.1 million, respectively, of payables related to property, plant and equipment which have been excluded from acquisitions of property, plant and equipment in the statements of cash flows.

Components of accrued liabilities are as follows:

	May 31,		August 31,
	2013		2012
	(In thousands)
Employee-related costs	$	3,658	$	4,837
Other accrued liabilities		3,878		3,400
Total accrued liabilities	$	7,536	$	8,237

Employee-related costs include accrued payroll, compensated absences, payroll taxes, benefits and incentives.

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5—DEBT

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

The maturity date for the revolving loans under the 2012 Agreement is July 9, 2017. Interest rates under the 2012 Agreement are based on either the London Interbank Offered Rate (“LIBOR”) or the prime rate, depending on the selection of available borrowing options under the 2012 Agreement. Pursuant to the 2012 Agreement, the interest rate margin over LIBOR can range between 2% and 4%, depending upon the ratio of the Company’s funded debt to earnings before interest, taxes, depreciation and amortization (defined in the 2012 Agreement as the “Total Leverage Ratio”).

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

At May 31, 2013, the Company also had two non-interest bearing loans from the Iowa Department of Economic Development (“IDED”). The IDED provided two five-year non interest bearing loans as follows: (1) a $1.0 million loan to be repaid in 60 equal monthly payments of $16,667 beginning December 1, 2009, and (2) a $1.0 million loan which is forgivable if the Company maintains certain levels of employment at the Cedar Rapids plant. At May 31, 2013, the Company had $1.3 million outstanding related to the IDED loans.

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

6—INCOME TAXES

Effective Tax Rates

The Company’s effective tax rates for the three- and nine-month periods ended May 31, 2013 were 40% and 37%, respectively. The difference between the third quarter effective tax rate and the U.S. federal statutory tax rate is primarily due to a $0.3 million write-off of deferred tax assets related to expired stock option awards. The difference between the effective tax rates and the U.S. federal statutory tax rate for the year-to-date period was primarily due to the adjustment noted above in the third quarter and state income taxes, partially offset by the tax benefit associated with the research and development tax credit. On January 2, 2013, the American Taxpayer Relief Act of 2012 was enacted, which retroactively reinstated, to January 1, 2012, several corporate tax provisions that had expired, including the research and development tax credit. The Company recorded $0.15 million in the second quarter of fiscal 2013 related to this tax credit for research and development activities in fiscal 2012, which reduced the effective tax rate by 2% for the nine-month period ended May 31, 2013.

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

Valuation Allowance

In fiscal 2012, the Company recorded a $1.8 million valuation allowance primarily related to small ethanol producer tax credit carryforwards which expire in fiscal 2014. Tax laws require that any net operating loss carryforwards be utilized before the Company can utilize the small ethanol producer tax credit carryforwards. Due to the near-term expiration of the small ethanol producer tax credit carryforward period, the Company does not believe it has sufficient positive evidence to substantiate that the small ethanol tax credit carryforwards are realizable at a more-likely-than-not level of assurance and recorded a $1.8 million valuation allowance. The valuation allowance will be reversed in future periods if these tax credit carryforwards are utilized.

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At May 31, 2013, the Company had $11.1 million of net deferred tax assets. Other than for the ethanol tax credit carryforwards discussed above, a valuation allowance has not been provided on the net U.S. deferred tax assets as of May 31, 2013. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter. The Company believes that it is more likely than not that future operations and the reversal of existing taxable temporary differences will generate sufficient taxable income to realize its deferred tax assets, except for the small ethanol producer tax credit carryforwards, for which a valuation allowance has been provided.

Uncertain Tax Positions

In the three- and nine month periods ended May 31, 2013, the amount of unrecognized tax benefits decreased by approximately $121,000 and $58,000, respectively. The total amount of unrecognized tax benefits at May 31, 2013 was $1.0 million, all of which, if recognized, would favorably impact the effective tax rate. At May 31, 2013, the Company had $0.2 million of accrued interest and penalties included in Other liabilities in the Condensed Consolidated Balance Sheets.

Other

The Company files tax returns in the U.S. federal jurisdiction and various U.S. state jurisdictions, and is subject to examination by taxing authorities in all of those jurisdictions. From time to time, the Company’s tax returns are reviewed or audited by U.S. federal and various U.S. state taxing authorities. The Company believes that adjustments, if any, resulting from these reviews or audits would not be material, individually or in the aggregate, to the Company’s financial position, results of operations or liquidity. It is reasonably possible that the amount of unrecognized tax benefits related to certain of the Company’s tax positions will increase or decrease in the next twelve months as audits or reviews are initiated and settled. At this time, an estimate of the range of a reasonably possible change cannot be made. The Company is not subject to income tax examinations by U.S. federal or state jurisdictions for fiscal years prior to 2007.

7—OTHER COMPREHENSIVE INCOME (LOSS) (“OCI”)

The components of accumulated other comprehensive loss and other comprehensive income (loss) are summarized as follows:

(In thousands)	Net Unrealized Gains (Losses) on Cash Flow Hedging Instruments			Gains (Losses) on Postretirement Obligations			Accumulated Other Comprehensive Loss
Balance at August 31, 2012	$	1,638		$	(17,231	)	$	(15,593	)
Other comprehensive income (loss), net of taxes		(2,251	)		1,064			(1,187	)
Balance at May 31, 2013	$	(613	)	$	(16,167	)	$	(16,780	)

(In thousands)	Net Unrealized Gains (Losses) on Cash Flow Hedging Instruments			Postretirement Obligations			Accumulated Other Comprehensive Loss
Balance at August 31, 2011	$	731		$	(8,290	)	$	(7,559	)
Other comprehensive income (loss), net of taxes		(1,401	)		—			(1,401	)
Balance at May 31, 2012	$	(670	)	$	(8,290	)	$	(8,960	)

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8—STOCK-BASED COMPENSATION

Stock Compensation Plans

Penford maintains the 2006 Long-Term Incentive Plan, as amended, (the “2006 Incentive Plan”) pursuant to which various stock-based awards may be granted to employees, directors and consultants. As of May 31, 2013, the aggregate number of shares of the Company’s common stock that were available to be issued as awards under the 2006 Incentive Plan was 374,382. In addition, any shares previously granted under the 1994 Stock Option Plan which are subsequently forfeited or not exercised will be available for future grants under the 2006 Incentive Plan. Non-qualified stock options and restricted stock awards granted under the 2006 Incentive Plan generally vest ratably over one to four years and expire seven years from the date of grant.

General Option Information

A summary of the stock option activity for the nine months ended May 31, 2013, is as follows:

	Number of Shares			Weighted Average Exercise  Price		Weighted Average Remaining Term  (in years)		Aggregate Intrinsic Value
Outstanding Balance, August 31, 2012		1,824,916		$	10.94
Granted		120,000			8.49
Exercised		(49,000	)		5.99
Cancelled		(189,964	)		15.00
Outstanding Balance, May 31, 2013		1,705,952			10.46		3.79	$	5,374,500
Options Exercisable at May 31, 2013		1,083,703		$	12.93		2.62	$	1,838,900

The aggregate intrinsic value disclosed in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $11.85 as of May 31, 2013 that would have been received by the option holders had all option holders exercised on that date.

The Company estimated the fair value of stock options granted during the first nine months of fiscal 2013 using the following weighted-average assumptions and resulting in the following weighted-average grant date fair values:

Expected volatility		68	%
Expected life (years)		4.7
Interest rate		0.5-1.0	%
Weighted-average fair values	$	4.60

As of May 31, 2013, the Company had $1.1 million of unrecognized compensation cost related to non-vested stock option awards that is expected to be recognized over a weighted average period of 1.3 years.

Restricted Stock Awards

The grant date fair value of each share of the Company’s restricted stock awards is equal to the fair value of Penford’s common stock at the grant date. The following table summarizes the restricted stock award activity for the nine months ended May 31, 2013 as follows:

	Number of Shares			Weighted Average Grant Date Fair Value
Nonvested at August 31, 2012		61,716		$	5.94
Granted		24,489			7.35
Vested		(61,716	)		5.94
Cancelled		—			—
Nonvested at May 31, 2013		24,489		$	7.35

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On January 1, 2013, each non-employee director received an award of 2,721 shares of restricted stock under the 2006 Incentive Plan at the closing stock price on December 31, 2012. The shares vest one year from the grant date of the award. The Company recognizes compensation cost for restricted stock ratably over the vesting period.

As of May 31, 2013, the Company had $0.1 million of unrecognized compensation cost related to non-vested restricted stock awards that is expected to be recognized over a weighted average period of 0.6 years.

Compensation Expense

The Company recognizes stock-based compensation expense utilizing the accelerated multiple option approach over the requisite service period, which equals the vesting period. The following table summarizes the total stock-based compensation cost and the effect on the Company’s Condensed Consolidated Statements of Operations (in thousands):

	Three months ended				Nine months ended
	May 31,				May 31,
	2013		2012		2013		2012
Cost of sales	$	—	$	2	$	—	$	34
Operating expenses		290		443		1,102		846
Research and development expenses		—		2		—		13
Total stock-based compensation expense	$	290	$	447	$	1,102	$	893
Income tax benefit		110		170		419		339
Total stock-based compensation expense, net of tax	$	180	$	277	$	683	$	554

9—PENSION AND POST-RETIREMENT BENEFIT PLANS

The components of the net periodic pension and post-retirement benefit costs are as follows:

	Three months ended						Nine months ended
	May 31,						May 31,
Defined benefit pension plans	2013			2012			2013			2012
	(In thousands)
Service cost	$	486		$	380		$	1,458		$	1,140
Interest cost		662			682			1,986			2,046
Expected return on plan assets		(717	)		(729	)		(2,151	)		(2,187	)
Amortization of prior service cost		60			57			180			171
Amortization of actuarial losses		483			193			1,449			579
Net periodic benefit cost	$	974		$	583		$	2,922		$	1,749
	Three months ended						Nine months ended
	May 31,						May 31,
Post-retirement health care plans	2013			2012			2013			2012
	(In thousands)
Service cost	$	59		$	57		$	177		$	171
Interest cost		215			243			645			729
Amortization of prior service cost		(38	)		(38	)		(114	)		(114	)
Amortization of actuarial losses		67			—			201			—
Net periodic benefit cost	$	303		$	262		$	909		$	786

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10—FAIR VALUE MEASUREMENTS AND DERIVATIVE INSTRUMENTS

Fair Value Measurements

Presented below are the fair values of the Company’s derivatives as of May 31, 2013 and August 31, 2012:

As of May 31, 2013	(Level 1)			(Level 2)		(Level 3)		Total
	(in thousands)
Current assets (Other Current Assets):
Commodity derivatives(1)	$	(636	)	$	—	$	—	$	(636	)

(1) On the condensed consolidated balance sheet, commodity derivative assets and liabilities have been offset by cash collateral due and paid under master netting arrangements which are recorded together in Other Current Assets. The cash collateral offset was $1.2 million at May 31, 2013.

As of August 31, 2012	(Level 1)			(Level 2)		(Level 3)		Total
	(in thousands)
Current assets (Other Current Assets):
Commodity derivatives(1)	$	(1,422	)	$	—	$	—	$	(1,422	)

(1) On the condensed consolidated balance sheet, commodity derivative assets and liabilities have been offset by cash collateral due and paid under master netting arrangements which are recorded together in Other Current Assets. The cash collateral offset was $2.6 million at August 31, 2012.

The three levels of inputs that may be used to measure fair value are:

• Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

• Level 2 inputs are other than quoted prices included within Level 1 that are observable for assets and liabilities such as (1) quoted prices for similar assets or liabilities in active markets, (2) quoted prices for identical or similar assets or liabilities in markets that are not active, or (3) inputs that are derived principally or corroborated by observable market data by correlation or other means.

• Level 3 inputs are unobservable inputs to the valuation methodology for the assets or liabilities.

Other Financial Instruments

The carrying value of cash and cash equivalents, receivables and payables approximates fair value because of their short maturities. The Company’s bank debt reprices with changes in market interest rates and, accordingly, the carrying amount of such debt approximates fair value.

The Company has two non-interest bearing loans from the State of Iowa. The carrying value of the debt at May 31, 2013 was $1.3 million and the fair value of the debt was estimated to be $1.2 million. See Note 5. The fair values of these loans were calculated utilizing Level 2 inputs to a discounted cash flow model. The most significant input is the discount rate which was determined by comparing yields on corporate debentures for debt issuers with financial characteristics similar to Penford’s non-interest bearing loans.

Commodity Contracts

The Company uses forward contracts and readily marketable exchange-traded futures on corn and natural gas to manage the price risk of these inputs to its manufacturing process. The Company also uses futures contracts to manage the variability of the cash flows from the forecasted sales of ethanol. The Company has designated the derivative instruments on corn and the forecasted sales of ethanol as hedges.

For derivative instruments designated as fair value hedges, the gain or loss on the derivative instruments as well as the offsetting gain or loss on the hedged firm commitments and/or inventory are recognized in current earnings as a component of cost of sales. For derivative instruments designated as cash flow hedges, the effective portion of the gain or loss on the derivative instruments is reported as a component of other comprehensive income (loss), net of applicable income taxes, and recognized in earnings when the hedged exposure affects earnings. The Company recognizes the gain or loss on the derivative instrument as a component of cost of sales in the period when the finished goods produced from

14

the hedged item are sold. If it is determined that the derivative instruments used are no longer effective at offsetting changes in the price of the hedged item, future changes in fair value would be recognized in current earnings as a component of cost of goods sold.

To reduce the price volatility of corn used in fulfilling some of its starch sales contracts, Penford uses readily marketable exchange-traded futures as well as forward cash corn purchases. The exchange-traded futures are not purchased or sold for trading or speculative purposes and are designated as hedges. Penford also uses exchange-traded futures to hedge corn inventories and firm corn purchase contracts. Hedged transactions are generally expected to occur within 12 months of the time the hedge is established. The deferred loss, net of tax, recorded in other comprehensive income at May 31, 2013 that is expected to be reclassified into income within 12 months is $0.6 million.

As of May 31, 2013, Penford had purchased corn positions of 7.4 million bushels, of which 1.8 million bushels represented equivalent firm priced starch and ethanol sales contract volume, resulting in an open position of 5.6 million bushels.

Prices for natural gas fluctuate due to anticipated changes in supply and demand and movement of prices of related or alternative fuels. To reduce the price risk caused by market fluctuations, Penford generally enters into short-term purchase contracts or uses exchange-traded futures contracts to hedge exposure to natural gas price fluctuations. In September 2011, the Company discontinued hedge accounting treatment for natural gas futures as the hedging relationship no longer met the requirements for hedge accounting. Gains and losses on natural gas futures contracts are recognized in current earnings in cost of sales.

As of May 31, 2013, the Company had the following outstanding futures contracts:

Corn Futures	��	4,465,000	Bushels
Natural Gas Futures		420,000	mmbtu (millions of British thermal units)
Ethanol Futures		3,780,000	Gallons

The following tables provide information about the fair values of the Company’s derivatives, by contract type, as of May 31, 2013 and August 31, 2012.

	Assets					Liabilities
In thousands		Fair Value					Fair Value
	Balance Sheet Location	May 31 2013		Aug 31 2012		Balance Sheet Location	May 31 2013		Aug 31 2012
Derivatives designated as hedging instruments:
Cash Flow Hedges:
Corn Futures	Other Current Assets	$	50	$	12	Other Current Assets	$	323	$	126
Ethanol Futures	Other Current Assets		—		—	Other Current Assets		567		706
Fair Value Hedges:
Corn Futures	Other Current Assets		125		—	Other Current Assets		—		602
Derivatives not designated as hedging instruments:
Natural Gas Futures	Other Current Assets		56		—	Other Current Assets		—		—
Natural Gas Options	Other Current Assets		23		—	Other Current Assets		—		—
		$	254	$	12		$	890	$	1,434

15

The following tables provide information about the effect of derivative instruments on the financial performance of the Company for the three- and nine- month periods ended May 31, 2013 and 2012.

In thousands	Amount of Gain (Loss) Recognized in OCI						Amount of Gain (Loss) Reclassified from AOCI into Income						Amount of Gain (Loss) Recognized in Income
	3 Months Ended May 31						3 Months Ended May 31						3 Months Ended May 31
	2013			2012			2013			2012			2013			2012
Derivatives designated as hedging instruments:
Cash Flow Hedges:
Corn Futures(1)	$	530		$	(1,075	)	$	596		$	91		$	(474	)	$	(138	)
Natural Gas Futures(1)		—			—			—			(37	)		—			—
Ethanol Futures(1)		(557	)		—			(355	)		(18	)		—			—
	$	(27	)	$	(1,075	)	$	241		$	36		$	(474	)	$	(138	)
Fair Value Hedges:
Corn Futures(1) (2)													$	143		$	(21	)
Derivatives not designated as hedging instruments:
Natural Gas Futures(1)													$	294		$	(34	)
FX Contracts(1)														—			(3	)
Natural Gas Options(1)														(20	)		—
Soybean Meal Futures(1)														—			(14	)
													$	274		$	(51	)

(1) Gains and losses reported in cost of sales

(2) Hedged items are firm commitments and inventory

In thousands	Amount of Gain (Loss) Recognized in OCI						Amount of Gain (Loss) Reclassified from AOCI into Income						Amount of Gain (Loss) Recognized in Income
	9 Months Ended May 31						9 Months Ended May 31						9 Months Ended May 31
	2013			2012			2013			2012			2013			2012
Derivatives designated as hedging instruments:
Cash Flow Hedges:
Corn Futures(1)	$	(43	)	$	(1,825	)	$	4,087		$	2,035		$	(589	)	$	(317	)
Natural Gas Futures(1)		—			(41	)		—			(531	)		—			—
Ethanol Futures(1)		429			1,150			(71	)		39			(11	)		—
	$	386		$	(716	)	$	4,016		$	1,543		$	(600	)	$	(317	)
Fair Value Hedges:
Corn Futures(1) (2)													$	127		$	89
Derivatives not designated as hedging instruments:
Natural Gas Futures(1)													$	(16	)	$	(1,082	)
FX Contracts(1)														—			6
Natural Gas Options(1)														(20	)		12
Soybean Meal Futures(1)														—			(14	)
													$	(36	)	$	(1,078	)

(1) Gains and losses reported in cost of sales

(2) Hedged items are firm commitments and inventory

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11—SEGMENT REPORTING (Restated)

Financial information for the Company’s two segments, Industrial Ingredients and Food Ingredients, is presented below. These segments serve broad categories of end-market users. The Industrial Ingredients segment provides carbohydrate-based starches for industrial applications, primarily paper and packaging products and fuel grade ethanol. The Industrial Ingredients segment produces certain by-products from its corn starch manufacturing process. The proceeds from the sale of these by-products are classified as sales in the table below.

The Food Ingredients segment produces specialty starches for food applications. A third item for “corporate and other” activity has been presented to provide reconciliation to amounts reported in the 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 consolidation entries.

	Three months ended						Nine months ended
	May 31,						May 31,
	2013			2012			2013			2012
				As restated. See Note 2						As restated. See Note 2
	(In thousands)
Sales:
Industrial Ingredients
Industrial Starch	$	44,572		$	43,633		$	132,610		$	113,071
Ethanol		28,111			23,118			69,710			79,786
By-Products		20,501			18,359			64,710			53,070
		93,184			85,110			267,030			245,927
Food Ingredients		28,535			26,173			82,793			77,001
	$	121,719		$	111,283		$	349,823		$	322,928
Income (loss) from operations:
Industrial Ingredients	$	565		$	75		$	1,500		$	(161	)
Food Ingredients		6,206			5,362			17,097			16,563
Corporate and other		(2,496	)		(1,864	)		(7,772	)		(6,820	)
	$	4,275		$	3,573		$	10,825		$	9,582

In January 2012, the Company acquired, through purchase or capital lease, the net assets and operations of the business generally known as Carolina Starches, which manufactures and markets industrial potato starch based products for the paper and packaging industries. The acquisition of this business provided an important source of raw material to support continued growth in the Food Ingredients business and it broadened the Company’s portfolio of specialty modified industrial starches.

The net assets and results of operations since acquisition have been integrated into the Company’s existing business segments. The acquired net assets, consisting primarily of property, plant and equipment and working capital, are being managed by and included in the reported balance sheet amounts of the Company’s Food Ingredients business, which has experience, expertise and technologies related to the manufacture of potato starch products. Consolidated assets at May 31, 2013 included $12.1 million of assets related to the acquisition. Since the primary end markets for Carolina Starches’ products are the paper and packaging industries, the sales and marketing functions of the acquired operations are being managed by the Industrial Ingredients business. Therefore, the sales, cost of sales and a majority of the operating expenses are included in the Industrial Ingredients segment’s results of operations. Included in Industrial Ingredients sales is $6.8 million and $18.7 million for the three and nine months ended May 31, 2013, respectively, and $5.3 million and $9.0 million for the three and nine months ended May 31, 2012, respectively, arising from the acquired operations.

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	May 31,		August 31,
	2013		2012
	(In thousands)
Total assets:
Industrial Ingredients	$	142,852	$	143,039
Food Ingredients		64,443		63,949
Corporate and other		25,006		29,191
	$	232,301	$	236,179

12—EARNINGS (LOSS) PER SHARE

All outstanding unvested share-based payment awards that contain rights to non-forfeitable dividends participate in undistributed earnings with common shareholders and, therefore, are included in computing earnings per share under the two-class method. Under the two-class method, net earnings are reduced by the amount of dividends declared in the period for each class of common stock and participating security. The remaining undistributed earnings are then allocated to common stock and participating securities, based on their respective rights to receive dividends. Restricted stock awards granted to certain employees and directors under the Company’s 2006 Incentive Plan, which contain non-forfeitable rights to dividends at the same rate as common stock, are considered participating securities.

Basic earnings (loss) per share reflect only the weighted average common shares outstanding during the period. Diluted earnings (loss) per share reflect weighted average common shares outstanding and the effect of any dilutive common stock equivalent shares.Diluted earnings (loss) per share is calculated by dividing net income (loss) 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 reconciliation of income from operations to income from operations applicable to common shares and the computation of diluted weighted average shares outstanding.

	Three months ended						Nine months ended
	May 31,						May 31,
	2013			2012			2013			2012
	(In thousands)						(In thousands)
Numerator:
Net income (loss)	$	2,058		$	(5,452	)	$	4,956		$	(5,200	)
Less: Allocation to participating securities		(4	)		—			(15	)		—
Net income (loss) applicable to common shares	$	2,054		$	(5,452	)	$	4,941		$	(5,200	)
Denominator:
Weighted average common shares outstanding, basic		12,395			12,300			12,349			12,292
Dilutive stock options and awards		275			—			199			—
Weighted average common shares outstanding, diluted		12,670			12,300			12,548			12,292

For the three and nine months ended May 31, 2012, there were 61,716 and 56,008 weighted-average restricted stock awards excluded from the calculation of diluted earnings (loss) per share because they were antidilutive.

Weighted-average stock options to purchase 916,463 and 967,820 shares of common stock for the three and nine months ended May 31, 2013, were excluded from the calculation of diluted earnings (loss) per share because they were antidilutive. Weighted-average stock options to purchase 1,887,592 and 1,579,673 shares of common stock for the three and nine months ended May 31, 2012, were excluded from the calculation of diluted earnings (loss) per share because they were antidilutive.

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13—LEGAL PROCEEDINGS AND CONTINGENCIES

On April 16, 2013, the Company received $3.4 million in full settlement of certain claims the Company had made against a contractor and its insurer that arose from engineering design work performed in connection with the construction of the Company’s ethanol plant completed in 2008. The Company had alleged breach of contract and negligence by the contractor, and sought recovery of its costs and damages from the contractor and its insurer due to errors and delays in the performance of the work. The settlement amount, net of contingent legal fees, expert fees and other litigation expenses incurred in the matter, of approximately $2.1 million, was reflected as a reduction of the cost of the ethanol plant. Approximately $0.3 million was recorded as a reduction of operating expenses related to the recovery of legal and other costs.

The Company is involved from time to time in various claims and litigation arising in the normal course of business. The Company expenses legal costs as incurred. In the judgment of management, which relies in part on information obtained from the Company’s outside legal counsel, the ultimate resolution of these other matters will not materially affect the consolidated financial position, results of operations, or liquidity of the Company, although the outcomes could be material to the Company’s operating results for any particular period, depending, in part, upon the operating results for such period.

The Company regularly evaluates the status of claims and any related legal proceedings in which it is involved in order to assess whether a loss is probable, whether there is a reasonable possibility that a loss may have been incurred and to determine if accruals are appropriate. Management is unable to provide additional information regarding any possible losses arising from such claims because (i) the Company currently believes that the claims are not adequately supported, and (ii) there are significant factual and legal issues to be resolved.

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Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Penford generates revenues, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for food and industrial applications, including fuel grade ethanol. The Industrial Ingredients segment produces certain by-products from its corn wet milling operations, including corn gluten feed, corn gluten meal and corn germ. The Company develops and manufactures ingredients with starch as a base, providing value-added applications to its customers. Penford’s starch products are manufactured primarily from corn and potatoes and are used principally as binders and coatings in paper, packaging and food production and as an ingredient in fuel.

Penford manages its business in two segments: Industrial Ingredients and Food Ingredients. These segments are based on broad categories of end-market users. See Note 11 to the Condensed Consolidated Financial Statements for additional information regarding the Company’s business segment operations. In January 2012, the Company acquired, through purchase or lease, the net assets and operations of Carolina Starches, which manufactures and markets industrial potato starch based products for the paper and packaging industries. The net assets and results of operations of the Carolina Starches business have been integrated into the Company’s existing business segments. The acquired net assets, consisting primarily of property, plant and equipment and working capital, are being managed by and included in the reported balance sheet amounts of the Company’s Food Ingredients business, which has experience, expertise and technologies related to the manufacture of potato starch products.

Since the primary end markets for Carolina Starches’ products are the paper and packaging industries, the sales and marketing functions of the acquired operations are being managed by the Industrial Ingredients business. Therefore, the sales, cost of sales and a majority of the operating expenses are included in the Industrial Ingredients segment’s results of operations in the Condensed Consolidated Financial Statements and this Part I Item 2.

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

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

Restatement of Previously Issued Financial Statements

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

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

20

Results of Operations

Executive Overview

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

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

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

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

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

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

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

Nine months ended May 31, 2013 and 2012:

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

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

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

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

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

Industrial Ingredients

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

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

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

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

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

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

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

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

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

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

21

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

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

Food Ingredients

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

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

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

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

Corporate operating expenses

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

Non-operating income (expense)

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

Interest expense

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

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Income taxes

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

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

In fiscal 2012, the Company recorded a $1.8 million valuation allowance primarily related to small ethanol producer tax credit carryforwards which expire in fiscal 2014. Tax laws require that any net operating loss carryforwards be utilized before the Company can utilize the small ethanol producer tax credit carryforwards. Due to the near-term expiration of the small ethanol producer tax credit carryforward period, the Company does not believe it has sufficient positive evidence to substantiate that the small ethanol tax credit carryforwards are realizable at a more-likely-than-not level of assurance and recorded a $1.8 million valuation allowance. The valuation allowance will be reversed in future periods if these tax credit carryforwards are utilized.

At May 31, 2013, the Company had $11.1 million of net deferred tax assets. Other than for the ethanol tax credit carryforwards discussed above, a valuation allowance has not been provided on the net U.S. deferred tax assets as of May 31, 2013. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter. The Company believes that it is more likely than not that future operations and the reversal of existing taxable temporary differences will generate sufficient taxable income to realize its deferred tax assets, except for the small ethanol producer tax credit carryforwards, for which a valuation allowance has been provided.

Liquidity and Capital Resources

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

Operating Activities

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

Investing Activities

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

Financing Activities

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

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

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

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

Contractual Obligations

The Company is a party to various debt and lease agreements at May 31, 2013 that contractually commit the Company to pay certain amounts in the future. The Company also has open purchase orders entered into in the ordinary course of business for raw materials, capital projects and other items, for which significant terms have been confirmed. There have been no material changes in the Company’s contractual obligations since August 31, 2012.

Off-Balance Sheet Arrangements

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

Recent Accounting Pronouncements

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

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

Critical Accounting Policies and Estimates

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The process of preparing financial statements requires management to make estimates, judgments and assumptions that affect the Company’s financial position and results of operations. These estimates, judgments and assumptions are based on the Company’s historical experience and management’s knowledge and understanding of the current facts and circumstances. See the Company’s Annual Report on Form 10-K/A for the fiscal year ended August 31, 2012 for a description of critical accounting policies and methods used in the preparation of the consolidated financial statements. Management believes that its estimates, judgments and assumptions are reasonable based upon information available at the time this report was prepared. To the extent there are material differences between estimates, judgments and assumptions and the actual results, the financial statements will be affected.

Forward-looking Statements

This Quarterly Report on Form 10-Q (“Quarterly Report”), including but not limited to statements found in the Notes to Condensed Consolidated Financial Statements and in Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains statements that are forward-looking statements within the meaning of the

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federal securities laws. In particular, statements pertaining to anticipated operations and business strategies contain forward-looking statements. Likewise, statements regarding anticipated changes in the Company’s business and anticipated market conditions are forward-looking statements. Forward-looking statements involve numerous risks and uncertainties and should not be relied upon as predictions of future events. Forward-looking statements depend on assumptions, dates or methods that may be incorrect or imprecise, and the Company may not be able to realize them. Forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” or “anticipates,” or the negative use of these words and phrases or similar words or phrases. Forward-looking statements can be identified by discussions of strategy, plans or intentions. Readers are cautioned not to place undue reliance on these forward-looking statements which are based on information available as of the date of this report. The Company does not undertake any obligation to publicly update or revise any forward-looking statements to reflect future events, information or circumstances that arise after the date of the filing of this Quarterly Report. Among the factors that could cause actual results to differ materially are the risks and uncertainties discussed in this Quarterly Report, including those referenced in Part II Item 1A of this Quarterly Report, and those described from time to time in other filings made with the Securities and Exchange Commission, including the Company’s Annual Report on Form 10-K/A for the year ended August 31, 2012, which include but are not limited to:

• competition;

• the possibility of interruption of business activities due to equipment problems, accidents, strikes, weather or other factors;

• product development risk;

• changes in corn and other raw material prices and availability;

• changes in general economic conditions or developments with respect to specific industries or customers affecting demand for the Company’s products including unfavorable shifts in product mix or changes in government rules or incentives affecting ethanol consumption;

• unanticipated costs, expenses or third-party claims;

• the risk that results may be affected by construction delays, cost overruns, technical difficulties, nonperformance by contractors or changes in capital improvement project requirements or specifications;

• interest rate, chemical and energy cost volatility;

• changes in returns on pension plan assets and/or assumptions used for determining employee benefit expense and obligations;

• other unforeseen developments in the industries in which Penford operates,

• the Company’s ability to successfully operate under and comply with the terms of its bank credit agreement, as amended; and

• other factors described in the Company’s Form 10-K/A Part I, Item 1A “Risk Factors.”

Item 3: Quantitative and Qualitative Disclosures about Market Risk.

The Company is exposed to market risks from adverse changes in interest rates and commodity prices. There have been no material changes in the Company’s exposure to market risks from the disclosure in the Company’s Annual Report on Form 10-K/A for the year ended August 31, 2012.

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Item 4: Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that material information required to be disclosed in the Company’s periodic reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. The Company’s disclosure controls and procedures are also designed to ensure that information required to be disclosed in the reports the Company files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

In connection with the restatement of previously filed financial statements discussed in Note 2 to the Condensed Consolidated Financial Statements under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer (“Certifying Officers”), the Company reevaluated the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). Based upon that reevaluation, a material weakness was identified and the Certifying Officers concluded that, as a result, the Company’s disclosure controls and procedures were not effective as of May 31, 2013.

The identified material weakness related to the Company’s controls over the accounting for the proceeds from the sale of by-products. The Company did not have an effective control to monitor the change in significance of on-going accounting policies where direct authoritative accounting guidance was not available. As a result, proceeds from the sale of by-products were incorrectly classified as a reduction of cost of sales rather than as sales in the Condensed Consolidated Statements of Operations. This material weakness resulted in a restatement of the Company’s previously issued financial statements more fully described in Note 2 to the Condensed Consolidated Financial Statements set forth herein.

Remediation of the Material Weakness

To remediate the material weakness in the Company’s internal control over financial reporting, the Company implemented additional review procedures over the monitoring and continued evaluation of the appropriateness of significant accounting policies in accordance with U.S. generally accepted accounting principles.

The Company’s remediation plan has been implemented; however, the above material weakness will not be considered remediated until the additional review procedures over the monitoring of the significance of on-going accounting policies have been operating effectively for an adequate period of time. The Company will consider the status of this remedial effort when assessing the effectiveness of the Company’s internal controls over financial reporting and other disclosure controls and procedures as of August 31, 2013. While the Company believes that the remedial efforts will resolve the identified material weakness, there is no assurance that the Company’s remedial efforts conducted to date will be sufficient or that additional remedial actions will not be necessary.

Changes in Internal Controls over Financial Reporting

There were no significant changes in the Company’s internal control over financial reporting that occurred during the quarter ended May 31, 2013 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 1: Legal Proceedings

The Company resolved or settled certain matters during the quarter that did not individually or in the aggregate have a material impact on the Company’s financial condition or results of operations in the quarter. For further information, see Note 13 to the Company’s financial statements.

Item 1A: Risk Factors

The information set forth in this report should be read in conjunction with the risk factors discussed in Part I, Item 1A of the Company’s Annual Report on Form 10-K/A for the year ended August 31, 2012. These risks could materially impact the Company’s business, financial condition and/or future results. The risks described in the Annual Report on Form 10-K/A are not the only risks facing the Company. Additional risks and uncertainties not currently known by the Company or that the Company currently deems to be immaterial also may materially adversely affect the Company’s business, financial condition and/or operating results.

Item 6: Exhibits.

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification 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
101	Financial statements from the quarterly report on Form 10-Q of the Company for the three and nine months ended May 31, 2013, filed on July 9, 2013, formatted in XBRL: (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Comprehensive Income (Loss), (iii) the Condensed Consolidated Statements of Operations, (iv) the Condensed Consolidated Statements of Cash Flows and (v) the Notes to Condensed Consolidated Financial Statements

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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)
July 9, 2013	/s/ Steven O. Cordier
	Steven O. Cordier Senior Vice President and Chief Financial Officer

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