1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [ x ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF ------------------------------------------------ THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended August 31, 1996 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 Number 0-11488 PENWEST, LTD. (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.) 777-108th Avenue N.E., Suite 2390 Bellevue, Washington 98004-5193 (Address of principal Executive Offices) (Zip Code) Registrant's telephone number, including area code: (206) 462-6000 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: Title of each class Name of each exchange of which registered None None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, $1.00 par value Common Stock Purchase Rights Indicate by 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 at least the past 90 days. Yes _X_ No ____ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Page 1 2 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (continued) The aggregate market value of the Registrant's Common Stock held by non-affiliates as of October 16, 1996 was approximately $125 million. The number of shares of the Registrant's Common Stock (the Registrant's only outstanding class of stock) outstanding (net of treasury stock) as of October 16, 1996 was 6,851,257. DOCUMENTS INCORPORATED BY REFERENCE The Registrant's definitive Proxy Statement relating to the 1997 Annual Meeting of Shareholders is incorporated by reference into Part III of this Form 10-K. Page 2 3 PART I ITEM 1: BUSINESS a) GENERAL: PENWEST, LTD. (PENWEST) was incorporated in September 1983 and commenced operations on March 1, 1984. PENWEST consists of the following business units: - Penford Products Co. (specialty carbohydrate chemicals for papermaking) - The history of Penford Products Co. can be traced to 1894. Penford Products Co. operates as a wholly-owned subsidiary of PENWEST. - Penwest Pharmaceuticals Group (pharmaceutical excipients and controlled release technology) - In March 1991, PENWEST purchased the net assets of Edward Mendell Co., Inc. (Mendell) which manufactures and distributes pharmaceutical excipients. Mendell was founded in 1946 and is a wholly-owned subsidiary of PENWEST. In 1991, the Company established TIMERx Technologies to focus on the development of controlled release technology. TIMERx Technologies is a division of PENWEST. - Penwest Foods Co. (specialty food ingredient products) - In September 1991, Penwest Foods Co. was established to manufacture and market specialty carbohydrate-based food ingredients. Penwest Foods Co. is a division of PENWEST. b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS: PENWEST's single business segment is developing, manufacturing and marketing carbohydrate-based specialty chemicals. The Company operates in three market lines: carbohydrate-based specialty chemicals used in paper manufacturing, pharmaceutical excipients and controlled release technology, and food ingredient products. c) DESCRIPTION OF BUSINESS: BUSINESS UNITS 1. SPECIALTY CHEMICALS: PENFORD PRODUCTS CO. (PENFORD), the core business of PENWEST, develops, manufactures and markets carbohydrate-based specialty chemical starches for papermaking. These starches are principally ethylated (chemically modified with ethylene oxide) and cationic (carrying a positive electrical charge) starches. Ethylated starches are used in coatings and as binders, providing strength and printability to fine white, magazine and catalog paper. Cationic starches are used at the "wet-end" of the paper machine, providing strong internal bonding of paper fibers. In addition, Penford's starch copolymers, a patented combination of synthetic and natural carbohydrate chemistry, are used in coating and binder applications in various segments of the paper industry. Penford's products, in general, are designed to improve strength, quality and runnability of coated and uncoated paper. Specialty chemicals, principally corn-based ethylated and cationic starches and starch copolymers, are produced at the Company's Cedar Rapids, Iowa facility. Potato-based cationic starches are produced at the Company's Idaho Falls, Idaho facility. Penford also sells specialty starch products to the domestic textile industry for warp sizing, which is a fiber bonding process for yarn and finished fabric, and for fabric sizing, which provides body and stiffness to textiles. Specialty chemical brand names of Penford for the paper industry include, among others, Penford(R) Gums, PENSIZE(R) and the Apollo(R) series. Page 3 4 Penford's specialty chemicals for the paper industry are manufactured by a process known as corn wet milling, which is the process by which the various parts of corn are separated, refined and modified. The corn, after it is removed from the cob and cleaned, is placed in warm steepwater treated with sulfur dioxide, which causes the corn to swell and soften. The softened kernels pass through a mill which separates the corn's germ from its endosperm. Water is added, producing a thick slurry. The germ is then separated from the slurry. After the germ has been washed and dried, the crude corn oil contained in the germ is removed and refined, yielding a fine quality salad and cooking oil, or a raw material for corn oil margarines. Germ meal is used in animal feed. The remaining mixture of hull and endosperm is then processed. Hull particles are screened out for animal feed, while the finer particles of gluten and starch pass through. The corn oil, germ meal and hull particles are all sold as by-products. The water slurry of starch and gluten is separated. The starch, which is more than 99 percent pure, is washed a third time to remove small quantities of solubles. Modified starches are created by adding chemical reagents and catalysts to the pure starch slurry. The modified starch is then filtered and dried and is ready for shipping. 2. PHARMACEUTICALS: MENDELL manufactures and supplies pharmaceutical excipients. Pharmaceutical excipients are the non-active ingredients in tablet and capsule prescription pharmaceuticals, over-the-counter drugs and vitamins. The products include binders, lubricants, fillers and disintegrates. The products provide bulk for concentrated medicines, ease of manufacture, product integrity and disintegration which aids release of the active drug in the body. Mendell's primary product, Emcocel(R), is made from wood pulp, a cellulosic carbohydrate. Mendell operates facilities at Patterson, New York, Nastola, Finland, and Cedar Rapids, Iowa. Pharmaceutical excipients' brand names include, among others, EMCOCEL(R), EXPLOTAB(R), EMCOMPRESS(R) and EMDEX(R). TIMERX TECHNOLOGIES develops controlled release technology for pharmaceuticals. Its principal product is currently included in several drug formulation development projects with licensees. These projects are in different phases of development. All development work is subject to regulatory approval. TIMERx Technologies operates at its facility in Patterson, New York. 3. SPECIALTY FOOD INGREDIENT PRODUCTS: PENWEST FOODS CO. develops, manufactures and markets specialty food ingredients to the food and confectionery industries. These ingredients include food grade potato starch products as well as dextrose-based products such as specialty dried corn syrup solids. Penwest Foods Co., headquartered in Englewood, Colorado, maintains manufacturing facilities at Richland, Washington for the food grade potato starches, and at Cedar Rapids, Iowa for the dextrose. Penwest Foods Co.'s product brand names include, among others, CanTab(R), CarriDex(TM), and PenPlus(R). RAW MATERIALS Corn: The Penford corn wet milling plant is located at Cedar Rapids, Iowa, in the middle of the U.S. corn belt. Accordingly, the plant has truck and rail-delivered corn available throughout the year from a large number of corn dealers and farmers at prices related to the principal U.S. grain markets. The cost of the corn to be purchased for fixed price business is generally hedged by entering into futures contracts. Cellulose Wood Pulp: Mendell's facilities at Nastola, Finland and Cedar Rapids, Iowa use high-grade dissolving wood pulp (cellulose) as their primary raw material to manufacture microcrystalline cellulose (EMCOCEL(R)). Mendell's suppliers of cellulose are located in North America. Chemicals: The principal chemical used in modifying starch is ethylene oxide, a petrochemical derivative. Ethylene oxide is a commodity chemical, subject to price fluctuations due to market conditions. Page 4 5 Corn, cellulose and ethylene oxide are not generally subject to availability constraints. Approximately half of total manufacturing costs are the costs of corn, cellulose, and chemicals. The remaining portion consists primarily of utility and labor costs. PATENTS, TRADEMARKS AND TRADENAMES PENWEST owns several patents, trademarks, and tradenames, none of which is considered material to current operations. RESEARCH AND DEVELOPMENT Company sponsored research and development costs of $7,297,000, $6,773,000 and $6,346,000 in fiscal 1996, 1995 and 1994, respectively, were charged to expense as incurred. ENVIRONMENTAL MATTERS The Company has adopted a Policy on Environmental Matters and has implemented a comprehensive corporate-wide environmental management program. The program is managed by the Corporate Director of Environmental, Health and Safety and is intended to ensure the Company's business is conducted in a safe and fiscally responsible manner that protects and preserves the health and safety of Company employees, the communities surrounding the Company's plants and the environment. The Company continues to monitor environmental legislation and regulations which may affect its operations. WORKING CAPITAL Working capital requirements of PENWEST are financed through operating cash flow, unsecured lines of credit, and an unsecured $35 million credit agreement. There was $15.3 million outstanding under the credit agreement at August 31, 1996. The Company also had additional uncommitted lines of credit totalling $10 million under which $5.9 million was outstanding at fiscal year end. PRINCIPAL CUSTOMERS PENWEST sells to approximately ninety major customers. One customer, Georgia Pacific, accounted for approximately 14% of total sales in fiscal 1996. No customers accounted for greater than 10% of total sales in prior periods. COMPETITION PENWEST competes with approximately five other companies that manufacture corn wet milling products, none of which is dominant in the ethylated starch business. Although Penford is one of the smaller corn wet millers, it is one of the major producers of specialty ethylated starches. Quality, service and price are the major competitive factors for Penford. PENWEST competes with approximately five other companies that manufacture pharmaceutical excipients. Mendell has the widest breadth of products in the industry, and has the second largest market share in sales of its primary product, Emocel(R), or microcrystalline cellulose. Quality, service and price are the major competitive factors for Mendell. PENWEST competes with numerous other companies in developing controlled release drug delivery systems for the pharmaceutical industry, a few of whom have larger market shares. Development expertise and proprietary technology are the major competitive factors for TIMERx Technologies. PENWEST competes with approximately four other companies that manufacture specialty food ingredients, all of whom have larger market shares. Application expertise, quality, service and price are the major competitive factors for Penwest Foods Co. Page 5 6 EMPLOYEES At October 16, 1996, PENWEST and its subsidiaries had 520 employees. PENWEST's specialty chemical and food ingredient operations, pharmaceuticals group and executive office employed 387, 115 and 18 people, respectively. Approximately 40% of the employees are represented by unions. Management believes its employee relations are good. METHODS OF DISTRIBUTION Penford, Penwest Foods Co. and Mendell use a direct sales force to market their products in North America. Mendell uses a combination of direct sales and distributors in Europe. Penford customers may purchase products through fixed-price contracts or formula-priced contracts for periods covering three months to five years or on a spot basis. Sales are approximately equally divided between fixed and formula price business with a remaining 10% consisting of spot sales. Products are shipped in either a bulk or bagged format. D) FOREIGN OPERATIONS AND EXPORT SALES: Mendell has a facility in Nastola, Finland. This operation is not significant to the consolidated Company. Sales from this facility were less than 5% of the Company's total sales in fiscal 1996. Export sales have accounted for less than 10% of the Company's total sales during each of the last three fiscal years. Page 6 7 ITEM 2: PROPERTIES (MAJOR) Registrant's executive offices, which are leased, are located at Suite 2390, 777-108th Avenue N.E., Bellevue, Washington 98004-5193. The Registrant's mailing address is, P.O. Box 1688, Bellevue, Washington 98009-1688. Other facilities are as follows: Bldg. Area Land Area Owned/ Function of (Sq. Ft.) (Acres) Leased Facility --------- ------- ------ -------- SPECIALTY CHEMICALS AND FOOD INGREDIENTS - ---------------------------------------- Cedar Rapids, Iowa 707,000 29 Owned Manufacture of corn starch products Englewood, Colorado 45,000 3 Leased -- Expires Offices and April 2000, with research renewal option laboratories Idaho Falls, Idaho 31,000 6 Owned Manufacture of industrial potato starch products Richland, Washington 16,000 2 Leased -- Expires Manufacture of November 2014, food - grade potato with renewal option starch products The corn wet milling operation in Cedar Rapids, Iowa has operating capacity, measured in bushels ground, of 65,000 bushels per day. The grind operates continuously except for periodic maintenance. PHARMACEUTICAL EXCIPIENTS - ------------------------- Patterson, New York 55,000 15 Owned Warehouse and offices Nastola, Finland 15,000 2 Leased -- Manufacture of 2 years notice pharmaceutical required excipients Cedar Rapids, Iowa 35,000 1 Owned Manufacture of pharmaceutical excipients All major properties are owned. Production facilities are well maintained and in good condition. The capacities of the plants are suitable and generally sufficient to meet current production requirements. PENWEST is continually undertaking a process of expanding and improving its property, plant and equipment. Page 7 8 ITEM 3: LEGAL PROCEEDINGS There are no material legal actions pending either for or against PENWEST and its subsidiaries. ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of shareholders during the fourth quarter of fiscal 1996. Page 8 9 EXECUTIVE OFFICERS OF THE REGISTRANT Name Age Title ---- --- ----- Tod R. Hamachek 50 President and Chief Executive Officer of Registrant 1985 - current President and Chief Operating Officer of Registrant 1983 - 1985 Jeffrey T. Cook 40 Vice President-Finance and Chief Financial Officer of Registrant 1991 - current Treasurer of Registrant 1988 - 1991 Edmund O. Belsheim, Jr. 44 Vice President-Corporate Development and General Counsel of Registrant 1996 - current Member, Bogle & Gates P.L.L.C. 1986 - 1996 Robert G. Widmaier, Ph.D. 48 Vice President-Technical Director and Chief Innovation Officer of Registrant 1990 - current Vice President-Technical Director of Registrant 1988 -1990 Jennifer L. Good 31 Corporate Director of Finance and Corporate Secretary of Registrant 1996 - current Corporate Controller of Registrant 1993 - 1996 Manager, Ernst and Young 1987 - 1993 Francis C. Rydzewski 46 Vice President of Registrant and President and General Manager, Penford Products Co., a wholly-owned subsidiary of Registrant 1996 - current Executive Vice President of Operations, Penford Products Co., a wholly-owned subsidiary of Registrant 1995 - 1996 Global Business Director, Air Products 1972 - 1995 John V. Talley, Jr. 40 Vice President of Registrant and President and General Manager, Penwest Pharmaceuticals Group, a wholly-owned subsidiary of Registrant 1993 - current Vice President of Marketing, Sanofi Winthrop Pharma- ceuticals 1992 - 1993 Vice President - Marketing, Hospital Products Division Sanofi Winthrop Pharma- ceuticals 1989 - 1992 Page 9 10 Gregory C. Horn 48 Vice President of Registrant and President and General Manager, Penwest Foods Co. 1995 - current Vice President of Marketing, Penford Products Co. 1993 - 1994 Vice President and General Manager, Sarah Lee Corporation 1992 - 1993 Vice President and General Manager, Churchill Industries 1990 - 1993 Page 10 11 PART II ITEM 5: MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS PENWEST common stock, $1.00 par value, trades on the Nasdaq National Market under the symbol "PENW". On October 16, 1996, there were 1,257 shareholders of record. The high and low closing bid prices of the Company's common shares during the last two fiscal years are set forth below. The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. MARKET PRICE HIGH LOW ------ ------ 1995/1996 Quarter Ended November 30 $26.50 $24.00 Quarter Ended February 29 $25.75 $16.00 Quarter Ended May 31 $18.75 $18.00 Quarter Ended August 31 $20.00 $18.00 1994/95 Quarter Ended November 30 $25.50 $21.00 Quarter Ended February 28 $23.00 $17.50 Quarter Ended May 31 $23.25 $20.50 Quarter Ended August 31 $26.25 $21.25 During each quarter in fiscal years 1996 and 1995, a $0.05 per share cash dividend was declared. The Company anticipates that it will continue to pay such quarterly dividends in the foreseeable future. Page 11 12 ITEM 6: SELECTED FINANCIAL DATA Year Ended August 31 ------------------------------------------------------------------------ (Thousands of dollars except per share data) 1996 1995(2) 1994 1993 1992(1) - ------------------------------------------------------------------------------------------------------------------------ Operating Data: Sales $ 194,474 $ 174,200 $ 158,787 $ 135,517 $ 125,952 Gross margin percentage 24.1% 27.5% 25.9% 26.4% 26.8% Income from operations $ 12,308 $ 14,973 $ 10,894 $ 9,110 $ 10,466 Net income $ 5,052 $ 7,217 $ 6,120 $ 6,315 $ 7,505 Earnings per share $ 0.72 $ 1.03 $ 0.86 $ 0.88 $ 1.01 Dividends declared per share $ 0.20 $ 0.20 $ 0.20 $ 0.20 $ 0.15 Average shares and equivalents outstanding 7,007,340 7,018,970 7,110,953 7,175,855 7,461,439 Balance Sheet Data: Net property, plant and equipment $ 121,173 $ 111,440 $ 99,973 $ 96,250 $ 73,742 Long-term debt 62,636 58,628 42,897 46,998 30,877 Shareholders' equity 78,138 71,982 67,165 62,490 61,447 Capital expenditures 21,472 23,019 13,259 31,266 19,450 Total assets 202,518 186,760 164,357 157,966 130,641 (1) During fiscal year 1992, the Company adopted FASB Statement No. 106 "Employer's Accounting for Post-Retirement Benefits Other Than Pensions." This change increased the annual pre-tax post-retirement benefit expense by $800,000 and decreased equity by $5,900,000 (net of tax). Also, during fiscal year 1992, the Company adopted FASB Statement No. 109 "Accounting for Income Taxes." The cumulative effect of this change resulted in a reduction of deferred taxes and an increase in equity of $1,560,000, or $0.15 per share. (2) Fiscal year 1995 results include a pretax gain of $899,000 related to the sale of assets of Pacific Cogeneration, Inc. Page 12 13 ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Comparison of Fiscal 1996 to 1995 Results of Operations Sales increased $20.3 million, or 11.7%, during fiscal 1996. The increase in sales reflects higher demand for the Company's core business. The increase is also due to unusually high corn costs, a key component used in pricing Penford's paper chemical products. Changes in corn costs are generally passed through to customers. During the year, Penford signed several multi-year contracts to sell products to customers representing significant volumes. Mendell increased sales volumes for Emcocel(R) during the year by 17%. This increase is primarily attributable to two new large customers. Potato starch volumes at Penwest Foods increased by 75% due to rapidly increasing demand for these starches for french fry coatings. For fiscal 1996 Penwest Foods was near breakeven. Gross margins were 24.1% in 1996 compared with 27.5% in 1995. The decrease in gross margin is primarily due to the historically high price of corn which affected margins several ways. First, certain of the Company's sales are based on a recent average of published corn prices. Consequently, in periods of rapidly escalating prices, the Company is not able to recover the full amount of the increase in raw material costs under such contracts. Particularly in the fourth quarter, the Company's margin on fixed price sales contracts was also negatively impacted by the high price of cash corn relative to the futures market driven by a severe supply/demand imbalance. Due to the short supply of corn, the market cash price reflected a high premium that had to be absorbed by the Company on its fixed price business. Lastly, lower margin dollars on higher unit sales prices also adversely impacted the gross margin percentage. The corn situation did improve in October as the new crop was harvested. In addition to the impact of corn, competitive and market factors put pressure on product pricing in the renewal of customer sales contracts making it difficult to maintain prior years gross margin levels. Operating expenses increased $1.6 million, or 4.8%. Research and development (R&D) expenses increased $524,000, or 7.7%, as a result of greater development spending at Penwest Pharmaceuticals Group. The Company expects to continue R&D investments at approximately 3.5% to 4.0% of sales. Net interest expense remained consistent with the prior year. The effective tax rate was 32.5% in fiscal 1996, compared with 35.0% in the prior year. The reduction in the tax rate reflects a reduction in state taxes and an increased benefit from the Company's foreign sales corporation. Page 13 14 Comparison of Fiscal 1995 to 1994 Results of Operations Sales increased $15.4 million, or 9.7%, during fiscal 1995. The increase reflects higher demand for hydroxyethylated (HES) corn starches from paper industry customers as new customers converted to Penford Gums. During the year, Penford converted the single largest customer in its history to Penford Gums(R). As a result, Penford was near production capacity. A temporary improvement in the paper industry also benefited Penford. Also contributing to the increase were higher sales of industrial potato starches to the paper industry. The Company's Idaho Falls potato starch plant capacity was essentially sold out by year-end. Sales of microcrystalline cellulose (MCC) to pharmaceutical industry customers were up sharply as PENWEST's Cedar Rapids MCC plant gained new customers and its operating results reached break-even. Specialty food-grade potato starches sold by Penwest Foods Co. (PFC) increased by 107%, reflecting new product activity and the addition of major new customers. However, PFC was not profitable in 1995. Gross margins were 27.5% in 1995 compared with 25.9% in 1994. Higher gross margins reflected renegotiated sales contracts with key customers, a shift at Penford to higher margin products, the achievement of break-even at Mendell's Cedar Rapids MCC plant and reduced losses at Penwest Foods. Operating margins grew from 6.9% to 8.6%, a gain of 24.6%. The 1995 margins, although higher than 1994, were lower than expected as a result of power interruptions and higher corn costs at Penford Product Co.'s Cedar Rapids plant. High heat and humidity in Iowa placed exceptional demand on the local electrical utility, which interrupted service to some of its industrial customers, including Penford. The plant experienced ten blackouts during the fourth quarter. This resulted in fewer units being produced and therefore a higher per unit cost. Since Penford does not maintain much inventory, most of the impact was recorded during the fourth quarter. In December 1994 the Company sold the assets of its cogeneration facility, recording a pre-tax gain of $899,000 in the second quarter. The gain effectively offset earnings the facility would have provided in fiscal 1995. Operating expenses increased $2.7 million, or 9.0%. Operating expenses in 1994 were reduced by $900,000 as the result of the curtailment of postretirement health benefits previously accrued. Research and development expenses increased $427,000, or 6.7%, as a result of greater development spending at Penwest Pharmaceuticals Group. Net interest expense increased $2.0 million reflecting a greater debt level, higher interest rates and a lower investment portfolio. The effective tax rate was 35.0% in fiscal 1995, compared with 24.3% in the prior year when PENWEST recorded a federal tax benefit relating to research and development expenditures. Page 14 15 Liquidity and Capital Resources PENWEST has strong liquidity and capital resources available. The Company had working capital of $29.4 million at August 31, 1996. The Company has an unsecured $35 million credit agreement under which there was $15.3 million outstanding at year end. The Company also has $10 million of uncommitted lines with various banks that are used for overnight borrowings. These lines were used throughout the year, and there was $5.9 million outstanding at year end. Operating cash flow was $12.9 million, $16.3 million and $12.2 million in fiscal 1996, 1995, and 1994, respectively. The decrease in fiscal 1996 was primarily due to lower net income and increases in receivables and inventory mostly related to the high cost of corn. Capital expenditures amounted to $21.5 million in fiscal 1996 compared to $23.0 million in fiscal 1995 and $13.3 million in fiscal 1994. Expenditures have been funded from operations, cash, and borrowings under uncommitted lines. Significant capital projects during fiscal 1996 included the completion of the expansion of the Penwest Foods' facility in Richland, Washington and a new corn unloading facility for Penford in Cedar Rapids, Iowa. The remainder of the expenditures were for various improvements to manufacturing facilities. Capital expenditures in fiscal 1997 should be comparable to expenditures in fiscal 1996. The only significant approved project is a $6 million capacity expansion project at Penwest Foods. The remainder is for various improvements to manufacturing facilities. The Company expects to fund these capital expenditures from operations, and the uncommitted lines of credit. The Company commenced paying a quarterly cash dividend of $0.05 per share with the quarter ended February 28, 1992, and has paid such dividend each quarter thereafter. The Board of Directors reviews the dividend policy on a periodic basis. In April 1994, the Board of Directors authorized a stock repurchase program for the purchase of up to 500,000 shares of the outstanding common stock of the Company. The Company did not repurchase any of its stock during fiscal 1996. Page 15 16 ITEM 8: PENWEST, LTD. CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS August 31 (Thousands of dollars) 1996 1995 - ---------------------------------------------------------------------------- Assets Current assets: Cash and cash equivalents $ 5,334 Trade accounts receivable $ 26,766 23,943 Inventories 22,111 14,209 Prepaid expenses and other 3,774 5,447 --------- --------- Total current assets 52,651 48,933 Property, plant and equipment: Land 4,014 3,359 Plant and equipment 185,499 175,533 Construction in progress 12,791 3,371 Less accumulated depreciation (81,131) (70,823) --------- --------- Net property, plant and equipment 121,173 111,440 Deferred income taxes 9,940 9,927 Cash value of life insurance 11,432 8,807 Other assets 7,322 7,653 --------- --------- $ 202,518 $ 186,760 ========= ========= Liabilities and shareholders' equity Current liabilities: Bank overdraft, net $ 847 Accounts payable 10,344 $ 8,749 Accrued liabilities 7,943 6,728 Current portion of long-term debt 4,127 4,270 --------- --------- Total current liabilities 23,261 19,747 Long-term debt 62,636 58,628 Other postretirement benefits 10,306 10,155 Deferred income taxes and other 28,177 26,248 Commitments and Contingencies Shareholders' equity: Common stock, par value $1.00 per share, authorized 29,000,000 shares, issued 8,677,165 shares in 1996 and 8,591,027 in 1995, including treasury shares 8,677 8,591 Additional paid-in capital 13,633 12,550 Retained earnings 88,640 84,949 Treasury stock, at cost, 1,832,752 shares in 1996 and 1995 (30,637) (30,637) Note receivable from PENWEST Savings and Stock Ownership Plan (1,742) (2,978) Cumulative translation adjustment (433) (493) --------- --------- Total shareholders' equity 78,138 71,982 --------- --------- $ 202,518 $ 186,760 ========= ========= The accompanying notes are an integral part of these statements. Page 16 17 CONSOLIDATED STATEMENTS OF INCOME Year Ended August 31 (Thousands of dollars except per share data) 1996 1995 1994 - ------------------------------------------------------------------------------------------- Sales $ 194,474 $ 174,200 $ 158,787 Cost of sales 147,711 126,341 117,734 ----------- ----------- ----------- Gross margin 46,763 47,859 41,053 Operating expenses 34,455 32,886 30,159 ----------- ----------- ----------- Income from operations 12,308 14,973 10,894 Other income 899 Investment income 277 418 636 Interest expense (5,101) (5,183) (3,444) ----------- ----------- ----------- Income before income taxes 7,484 11,107 8,086 Income taxes 2,432 3,890 1,966 ----------- ----------- ----------- Net income $ 5,052 $ 7,217 $ 6,120 =========== =========== =========== Weighted average common shares and equivalents outstanding 7,007,340 7,018,970 7,110,953 =========== =========== =========== Earnings per share $ 0.72 $ 1.03 $ 0.86 =========== =========== =========== Dividends declared per share $ 0.20 $ 0.20 $ 0.20 =========== =========== =========== The accompanying notes are an integral part of these statements. Page 17 18 CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended August 31 (Thousands of dollars) 1996 1995 1994 - ---------------------------------------------------------------------------------- Operating activities: Net income $ 5,052 $ 7,217 $ 6,120 Adjustments to reconcile net income to net cash from operating activities Depreciation and amortization 11,739 10,375 10,343 Deferred income taxes 1,174 1,504 2,676 Gain on sale of assets (899) Change in operating assets and liabilities Receivables (2,823) (3,195) (4,743) Inventories (7,902) 2,525 (6,520) Accounts payable and other 5,670 (1,181) 4,349 -------- -------- -------- Net cash from operating activities 12,910 16,346 12,225 Investing activities: Additions to property, plant and equipment (21,472) (23,019) (13,259) Proceeds from sale of assets 2,500 Other 1,158 (530) 1,594 -------- -------- -------- Net cash used by investing activities (20,314) (21,049) (11,665) Financing activities: Proceeds from unsecured line of credit 60,847 41,305 30,605 Payments on unsecured line of credit (54,962) (41,305) (30,605) Proceeds from long-term debt 15,250 20,000 Payments on long-term debt (17,270) (4,100) (3,880) Purchase of treasury stock (1,310) (1,277) Exercise of stock options 876 75 100 Purchase of life insurance for officers' benefit plans (2,501) (2,501) (1,343) Payment of dividends (1,017) (1,360) (1,371) Other (132) 1,099 -------- -------- -------- Net cash from (used by) financing activities 1,223 10,672 (6,672) -------- -------- -------- Net increase (decrease) in cash (6,181) 5,969 (6,112) Cash (bank overdrafts) and cash equivalents at beginning of year 5,334 (635) 5,477 -------- -------- -------- Cash (bank overdrafts) and cash equivalents at end of year $ (847) $ 5,334 $ (635) ======== ======== ======== Supplemental disclosure of cash flow information Cash paid during the year for: Interest $ 5,392 $ 4,976 $ 3,478 Income taxes $ 1,317 $ 2,052 $ 2,909 The accompanying notes are an integral part of these statements. Page 18 19 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Note Receive- able from PENWEST Additional Savings & Cumulative Share- Common Paid-In Retained Treasury Stock Translation holders' (Thousands of dollars) Stock Capital Earnings Stock Ownership Plan Adjustment Equity - ----------------------------------------------------------------------------------------------------------------------------------- Balances, September 1, 1993 $ 8,563 $ 12,403 $ 74,375 $(28,050) $ (4,305) $ (496) $ 62,490 Net income 6,120 6,120 Exercise of stock options 14 86 100 Purchase of treasury stock (1,277) (1,277) Savings and Stock Ownership Plan activity 965 965 Translation gain 134 134 Dividends declared (1,367) (1,367) -------- -------- -------- -------- -------- -------- -------- Balances, August 31, 1994 8,577 12,489 79,128 (29,327) (3,340) (362) 67,165 Net income 7,217 7,217 Exercise of stock options 14 61 75 Purchase of treasury stock (1,310) (1,310) Savings and Stock Ownership Plan activity 362 362 Translation loss (131) (131) Dividends declared (1,396) (1,396) -------- -------- -------- -------- -------- -------- -------- Balances, August 31, 1995 8,591 12,550 84,949 (30,637) (2,978) (493) 71,982 Net income 5,052 5,052 Exercise of stock options 86 790 876 Tax benefit of stock option exercises 293 293 Savings and Stock Ownership Plan activity 1,236 1,236 Translation gain 60 60 Dividends declared (1,361) (1,361) -------- -------- -------- -------- -------- -------- -------- Balances, August 31, 1996 $ 8,677 $ 13,633 $ 88,640 $(30,637) $ (1,742) $ (433) $ 78,138 ======== ======== ======== ======== ======== ======== ======== The accompanying notes are an integral part of these statements. Page 19 20 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Business PENWEST's business is developing, manufacturing and marketing chemically modified carbohydrate-based specialty chemicals. The Company operates in three market lines: carbohydrate-based specialty chemicals used in paper manufacturing, pharmaceutical and controlled release technology, and food ingredient products. Customers are primarily manufacturers in the paper industry, makers of prescription pharmaceuticals, over-the-counter drugs and vitamins, and processors in the food industry. Sales of the Company's products are generated using a combination of direct sales and distributor agreements. One customer accounted for approximately 14% of sales in fiscal 1996. No customers accounted for greater than 10% of total sales in prior years. Basis of Presentation The consolidated financial statements include PENWEST and its wholly-owned subsidiaries. Material intercompany balances and transactions have been eliminated. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Certain amounts in the financial statements for prior years have been reclassified to conform with current year presentation. These reclassifications had no effect on previously reported results of operations. Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of less than three months when purchased to be cash equivalents. Cash equivalents consist of money market funds, short-term deposits, and commercial paper. Amounts reported in the balance sheets represent cost which approximates market value. PENWEST's cash management system includes a cash overdraft feature for uncleared checks in the disbursing accounts. Cash in the accompanying balance sheets represents the net amounts available to the disbursing accounts. Uncleared checks of $2,177,000 are netted against cash at August 31, 1996 and are reported as bank overdrafts. Concentration of Credit Risk and Financial Instruments The Company performs ongoing credit evaluations of its customers and generally does not require collateral. The Company maintains an allowance for doubtful accounts which management believes is sufficient to cover potential credit losses. The carrying value of financial instruments, which includes cash, receivables, payables, and long-term debt approximates market value at August 31, 1996. One customer accounted for approximately 14% of sales in 1996. Page 20 21 Property, Plant and Equipment Property, plant and equipment are recorded at cost. Expenditures for maintenance and repairs are expensed as incurred. The Company uses the straight-line method to compute depreciation assuming average useful lives of three to forty years for financial reporting purposes. For income tax purposes, the Company generally uses accelerated depreciation methods. In March 1995, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of," requiring impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount. Statement No. 121 also addresses accounting for long-lived assets that are expected to be disposed. The Company adopted this Statement in fiscal 1996 with no impact on financial position or results of operations. Interest is capitalized on major construction projects while in progress. Interest of $300,000, $209,000, and $51,000 was capitalized in 1996, 1995, and 1994, respectively. Foreign Currencies Monetary assets and liabilities of the Company's foreign operations are translated into U.S. dollars at year-end exchange rates and revenue and expenses are translated at average exchange rates. Non-monetary assets and liabilities are converted at historical rates. In each instance, the functional currency is the local currency. Realized gains and losses from foreign currency transactions are reflected in the statement of income. Income Taxes The provision for income taxes includes federal and state taxes currently payable and deferred income taxes arising from temporary differences between financial and income tax reporting methods. Deferred taxes have been recorded using the liability method in recognition of these temporary differences. Revenue Recognition Sales revenue is recorded upon shipment of product. Research and Development Research and development costs of $7,297,000, $6,773,000 and $6,346,000 in 1996, 1995, and 1994, respectively, were charged to expense as incurred. Earnings Per Common Share Earnings per common share were computed by dividing net income by the weighted average number of common shares and dilutive common share equivalents outstanding during the fiscal year. Outstanding stock options and stock appreciation rights are considered to be common share equivalents. Page 21 22 Stock Compensation In October 1995, the FASB issued Statement No. 123, "Accounting for Stock Based Compensation." The Statement is effective for fiscal years beginning after December 15, 1995 and requires stock-based compensation expense to be measured using either the intrinsic-value method as prescribed by Accounting Principles Board ("APB") No. 25 or the fair-value method described in Statement No. 123. Companies choosing the intrinsic-value method will be required to disclose the pro-forma impact of the fair-value method on net income and earnings per share. The Company will adopt Statement No. 123 in fiscal 1997 using the intrinsic value method; there will be no effect of adopting the Statement on the Company's financial position or results of operations. NOTE B INVENTORIES Inventories are stated at the lower of cost or market. Cost, which includes material, labor and manufacturing overhead costs, is determined by the first-in, first-out (FIFO) method. The Company generally follows a policy of hedging corn purchases related to fixed price sales contracts and certain anticipated corn purchases to minimize price risk due to market fluctuations and risk of crop failure. The instruments used are principally readily marketable exchange traded futures contracts which are designated as hedges. The changes in market value of such contracts have a high correlation to the price changes of the hedged commodity. Also, the underlying commodity can be delivered against such contracts. Gains or losses arising from open and closed hedging transactions are included in inventory as a cost of raw materials and reflected in the income statements when the product is sold. Components of inventory are as follows: August 31 (Thousands of dollars) 1996 1995 - --------------------------------------------------------------------------- Raw materials, supplies and other $ 7,750 $ 3,828 Work in progress 685 483 Finished goods 13,676 9,898 ------- ------- Total inventories $22,111 $14,209 ======= ======= Page 22 23 NOTE C DEBT August 31 (Thousands of dollars) 1996 1995 - ---------------------------------------------------------------------------------------- Unsecured credit agreement, maturity in 1998, 6.19% interest rate at year-end $15,250 $16,000 Private placement, 7.93% interest rate, semiannual interest-only payments with principal payments beginning in fiscal 1997, final maturity in 2002 20,000 20,000 Private placement, 7.59% interest rate, semiannual interest-only payments on $10 million principal with payment in fiscal 1999, and 8.35% interest rate, semi-annual interest-only payments on $10 million principal with payment in fiscal 2007 20,000 20,000 Unsecured note, 9.4% interest rate, due in quarterly installments through December 1999 2,940 3,780 Note payable, 8.49% interest rate, quarterly principal and interest payments through October 1997 2,688 3,118 Lines of credit, average interest rate of 5.8% 5,885 ------- ------- 66,763 62,898 Less current portion 4,127 4,270 ------- ------- Net long-term debt $62,636 $58,628 ======= ======= Maturities of long-term debt for the fiscal years ending August 31, 1997 through 2001, and thereafter, are as follows (thousands of dollars): 1997 $ 4,127 1998 5,955 1999 34,832 2000 3,277 2001 2,857 Thereafter 15,715 ------- $66,763 ======= On December 22, 1995, the Company completed an unsecured $35 million credit agreement with four banks expiring on December 30, 1998 under which there was $15.3 million outstanding at fiscal year end. Borrowing rates available to the Company under the agreement are based on prime rate or the interbank offered rate depending on the selection of borrowing options. The agreement replaced an unsecured term agreement which at December 22, 1995, had $15.3 million of borrowings outstanding and an unsecured $15 million revolving line of credit under which there was no outstanding borrowings at December 22, 1995. The unsecured revolving line of credit agreement, the private placements, and other notes include, among other terms, various limitations on long-term indebtedness, minimum net worth and working capital ratios, and restrictions on PENWEST's ability to purchase or redeem its own stock. The unsecured credit agreement also requires the Company to maintain a minimum fixed charge coverage ratio. Page 23 24 The Company has uncommitted lines of credit aggregating $10 million, which provide for financing at various floating rates of which $5.9 million was outstanding at August 31, 1996. The Company enters into interest rate swap agreements to modify the interest characteristics of its outstanding debt. These agreements involve the exchange of interest payment streams without an exchange of the underlying principal amount. Net amounts paid or received are reflected as adjustments to interest expense. The fair values of the swap agreements are not recognized in the financial statements. In the event of default by a counterparty, the risk in these transactions is the cost of replacing the interest rate contract at current market rates. Management continually monitors the credit ratings of its counterparties, and believes the risk of incurring such losses is remote, and that if incurred, such losses would be immaterial. At August 31, 1996, approximately $25 million of the Company's outstanding debt was subject to interest rate swap agreements. Of this amount, $15 million involves floating rate to fixed rate swaps which effectively fix rates at approximately 9% and $10 million involves fixed rate to floating rate swaps, with the floating rate approximating 6% at August 31, 1996. The Company has hedged the interest rate risk on $8.9 million of its long-term debt using Treasury note futures. The cost of the hedge has been deferred and will be recognized as a component of interest expense over the life of the debt. The hedge results in an effective interest rate on the related long-term debt of approximately 9.5%. NOTE D LEASES Certain of the Company's property, plant, and equipment is leased under operating leases ranging from one to fifteen years with renewal options. Rental expense under operating leases was $4,482,000, $3,202,000 and $2,787,000 for fiscal years ended August 31, 1996, 1995, and 1994, respectively. Future minimum lease payments as of August 31, 1996 for noncancellable operating leases having initial lease terms of more than one year are as follows (thousands of dollars): Years ending August 31 Operating Leases - ---------------------- ---------------- 1997 $ 3,951 1998 3,379 1999 3,016 2000 1,683 2001 800 Thereafter 6,110 ------- Total minimum lease payments $18,939 ======= Page 24 25 NOTE E STOCK OPTIONS Under stock option plans, options have been granted to certain officers and key employees to purchase PENWEST common stock. Changes in stock options for the three years ended August 31 are as follows: 1996 Option 1996 1995 1994 Price Range - ------------------------------------------------------------------------------------- Outstanding at beginning of year 847,459 615,859 590,809 $ 3.31 - $27.50 Granted 74,500 271,000 59,000 18.25 - 24.75 Exercised (77,917) (13,600) (13,950) 5.59 - 22.63 Cancelled (38,300) (25,800) (20,000) 22.50 - 27.50 ------- ------- ------- Outstanding at end of year 805,742 847,459 615,859 5.83 - 24.75 ------- ======= ======= Exercisable at end of year 454,692 401,159 299,109 5.83 - 24.75 ======= ======= ======= At August 31, 1996, 62,232 stock appreciation rights (SARs) were outstanding to certain officers. The SARs were granted in December 1986 at the market price of PENWEST stock and are fully vested as of August 31, 1996. As a result of appreciation (depreciation) of PENWEST stock of the SARs, compensation expense was charged (credited) for $(451,000), $78,000 and $342,000 in 1996, 1995, and 1994 respectively. Page 25 26 NOTE F INCOME TAXES Income tax expense consists of the following: Year Ended August 31 (Thousands of dollars) 1996 1995 1994 - ------------------------------------------------------------------------------- Current Federal $1,091 $ 2,102 $ (904) Foreign 80 4 138 State 87 232 56 ------ ------- ------- 1,258 2,338 (710) Deferred Federal 1,108 1,459 2,253 State 66 93 423 ------ ------- ------- 1,174 1,552 2,676 ------ ------- ------- Total provision $2,432 $ 3,890 $ 1,966 ====== ======= ======= A reconciliation of the statutory federal tax to the actual provision is as follows: Year Ended August 31 (Thousands of dollars) 1996 1995 1994 - ------------------------------------------------------------------------------ Statutory tax rate 34% 34% 34% Statutory tax $ 2,545 $ 3,776 $ 2,749 State taxes, net of federal benefit 101 215 316 Tax credits, including research and development credits (313) (1,095) Tax advantaged investment income (36) (47) Foreign sales corporation (238) (232) (172) Other 60 491 168 ------- ------- ------- Total provision $ 2,432 $ 3,890 $ 1,966 ======= ======= ======= The significant components of deferred tax assets and liabilities are as follows: August 31 (Thousands of dollars) 1996 1995 - -------------------------------------------------------------------------------- Deferred tax assets: Alternative minimum tax credit $ 3,257 $ 2,725 Research and development credit 592 622 Postretirement benefits 3,660 3,691 Provisions for accrued expenses 2,431 2,366 Other 523 ------- ------- Total deferred tax assets 9,940 9,927 Deferred tax liabilities: Depreciation 19,453 17,650 Other 1,527 2,143 ------- ------- Total deferred tax liabilities 20,980 19,793 ------- ------- Net deferred tax liabilities $11,040 $ 9,866 ======= ======= Page 26 27 NOTE G PENSION AND OTHER EMPLOYEE BENEFITS PENWEST maintains two noncontributory defined benefit pension plans that cover substantially all employees. Benefits under the plan for hourly employees are primarily related to years of service. Benefits for salaried employees are primarily related to years of credited service and final average five-year earnings. Employees generally become eligible to participate in the plans after attaining age 21 and benefits normally become vested after five years of credited service. The Company's funding policy is to contribute amounts to the plans sufficient to meet or exceed the minimum requirements of the Employee Retirement Income Security Act of 1974. Assumptions used in the measurement of the projected benefit obligation in 1996 and 1995 included a discount rate of 8.0% and 7.5%, respectively, and a rate of increase in compensation levels of 5.0% in 1996 and 6.0% in 1995 for the salaried employees. The expected long-term rate of return on plan assets is assumed to be 9.0% for 1996 and 1995. Net periodic pension expense consisted of the following (in thousands): Year Ended August 31 1996 1995 1994 - ---------------------------------------------------------------------------------- Service cost of benefits earned during the year $ 709 $ 603 $ 591 Interest cost on projected benefit obligation 1,426 1,363 1,256 Actual return on plan assets (2,278) (2,599) (842) Net amortization and deferral 892 1,480 (253) ------- ------- ------- Net pension expense $ 749 $ 847 $ 752 ======= ======= ======= The following table sets forth the funded status of both pension plans (in thousands): August 31 1996 1995 - ------------------------------------------------------------------------------------- Actuarial present value of projected obligation, based on service to date and current salary levels: Vested $ 17,089 $ 17,081 Nonvested 529 430 -------- -------- Accumulated benefit obligation 17,618 17,511 Effect of projected salary increases 1,676 2,052 -------- -------- Projected benefit obligation 19,294 19,563 Plan assets at fair market value 19,931 18,910 -------- -------- Projected benefit obligation less (greater) than plan assets 637 (653) Unrecognized actuarial net loss (gain) (1,634) 254 Balance of unrecognized net obligation at transition being amortized over 15 years 1,010 1,137 Unrecognized prior service cost 510 534 -------- -------- Net pension asset $ 523 $ 1,272 ======== ======== Assets of the pension plans are invested in units of common trust funds managed by Frank Russell Trust Company. The common trust funds own stocks, bonds and real estate. Page 27 28 Penwest Savings And Stock Ownership Plan The Company has a savings investment plan. The savings component, available to all employees, matches 75% of the employee's contribution up to 6% of the employee's pay, in the form of PENWEST common stock. The plan held 40,929 unallocated shares of PENWEST common stock as of August 31, 1996, including shares earned but not yet allocated. During 1996, approximately 65,406 shares of stock were earned by plan participants. The savings component expense of the plan was $722,000, $520,000 and $600,000 for fiscal years 1996, 1995, and 1994, respectively. Compensation expense is recorded by the Company at the market value of shares released. The plan also includes an annual profit-sharing component that is awarded by the Board of Directors based on achievement of predetermined corporate goals. This feature of the plan is available to all employees who meet the eligibility requirements of the plan. The profit sharing expense, which reflects the market value of shares released by the plan to participants was $514,000, $402,000 and $285,000 for the fiscal years 1996, 1995 and 1994, respectively. The plan initially acquired the PENWEST common stock by issuing a note to the Company. The note is reflected as a reduction of shareholders' equity and is amortized ratably as stock is released to participants in the plan. The shares held by the plan are considered outstanding for purposes of calculating earnings per share. Supplemental Executive Retirement Plan The Company sponsors a Supplemental Executive Retirement Plan (SERP), a nonqualified plan, which covers certain employees. For 1996, 1995, and 1994, the net pension expense accrued for the SERP was $950,000, $856,000 and $347,000 respectively. Health Care And Life Insurance Benefits The Company offers health care and life insurance benefits to most active employees. Costs incurred to provide these benefits are charged to expense when paid. Health care and life insurance expense was $2,632,000, $2,501,000 and $2,649,000 in 1996, 1995, and 1994, respectively. NOTE H OTHER POSTRETIREMENT BENEFITS PENWEST maintains two postretirement benefit plans that cover substantially all salaried and hourly retirees. Benefits under the plan for hourly employees include medical coverage, prescription drug coverage, and, to a certain grandfathered group, life insurance. Hourly participants contribute to the cost of the benefits based on a pension credit formula. Benefits under the plan for salaried employees include medical coverage and vision coverage. Salaried participants contribute, for the most part, 100% of the premiums. Postretirement benefit expense was $415,000, $359,000 and $834,000 for the years ended August 31, 1996, 1995, and 1994, respectively. Presently the Company funds the current benefits on a cash basis and therefore there are no plan assets. Page 28 29 The following table sets forth the plan's status (in thousands of dollars): Accumulated postretirement benefit obligation: August 31, 1996 August 31, 1995 --------------- --------------- Retirees $ 3,838 $ 4,119 Fully eligible active plan participants 589 311 Other active plan participants 2,093 2,190 ------- ------- Accumulated post retirement benefit obligation 6,520 6,620 Unrecognized actuarial net gain 3,786 3,535 ------- ------- Accrued postretirement benefit obligation $10,306 $10,155 ======= ======= Net periodic postretirement benefit costs include the following components: Year Ended August 31 1996 1995 1994 ---- ---- ---- Service cost -- benefits earned during the period $ 238 $ 186 $ 295 Interest cost on accumulated postretirement benefit obligations 475 402 604 Net amortization and deferral (298) (229) (65) ----- ----- ----- $ 415 $ 359 $ 834 ===== ===== ===== Future benefit costs were estimated assuming medical costs would increase at a 10% annual rate for fiscal 1996, then beginning in fiscal 1997, decreasing by one half of a percent ratably over the next nine years to a rate of 5.5%. A 1% increase in this annual trend rate would have increased the accumulated postretirement benefit obligation at August 31, 1996 by $964,000, with an increase of $142,000 in the annual 1996 postretirement benefit expense. The weighted average discount rate used to estimate the accumulated postretirement obligation was 8.0% in 1996 and 7.5% in 1995. The change in discount rate had the impact of decreasing the accumulated post-retirement benefit obligation by $343,000. In fiscal 1994, the Company curtailed postretirement health benefits for salaried employees that had been previously accrued. The Company formerly paid a portion of the health insurance premiums for salaried retirees but no longer does so for eligible salaried employees retiring after May 15, 1994. As a result, in fiscal 1994, there was a $900,000 reduction of operating expenses recorded. Page 29 30 NOTE I SHAREHOLDERS' EQUITY UNISSUED PREFERRED STOCK There are 1,000,000 shares of $1.00 par value preferred stock authorized for issue; however, none are outstanding. Common Stock Purchase Rights On June 16, 1988, PENWEST distributed a dividend of one right (Right) for each outstanding share of PENWEST common stock. In addition, previously outstanding Rights were redeemed for $0.025 each. When exercisable, each Right will entitle its holder to buy one share of PENWEST's common stock at $44.00 per share. The Rights will become exercisable if a purchaser acquires 20% of PENWEST's common stock or makes an offer to acquire common stock. In the event that a purchaser acquires 20% of the common stock of PENWEST, each Right shall entitle the holder, other than the acquirer, to purchase one share of common stock of PENWEST for one half of the market price of the common stock. In the event that PENWEST is acquired in a merger or transfers 50% or more of its assets or earnings to any one entity, each Right entitles the holder to purchase common stock of the surviving or purchasing company having a market value of twice the exercise price of the Right. The Rights may be redeemed by PENWEST at a price of $0.01 per Right, and they expire in June 1998. NOTE J PACIFIC COGENERATION, INC. In fiscal 1995 the Company sold the assets of its subsidiary Pacific Cogeneration, Inc. and recognized a gain on the sale of $899,000 which is reflected as other income. NOTE K QUARTERLY FINANCIAL DATA (UNAUDITED) Fiscal 1996 First Second Third Fourth (Thousands of dollars except earnings per share data) Quarter Quarter Quarter Quarter Total - ------------------------------------------------------------------------------------------------------------- Sales $45,624 $46,313 $49,106 $53,431 $194,474 Gross margin 12,168 11,129 11,541 11,925 46,763 Income from operations 3,601 2,571 2,748 3,388 12,308 Net income 1,748 908 1,030 1,366 5,052 Earnings per common share $ 0.25 $ 0.13 $ 0.15 $ 0.20 $ 0.72 Dividends declared $ 0.05 $ 0.05 $ 0.05 $ 0.05 $ 0.20 Page 30 31 Fiscal 1995 First Second Third Fourth (Thousands of dollars except earnings per share data) Quarter Quarter(1) Quarter Quarter Total - ------------------------------------------------------------------------------------------------------------- Sales $42,771 $42,429 $43,618 $45,382 $174,200 Gross margin 11,244 11,912 12,465 12,238 47,859 Income from operations 3,716 3,504 4,225 3,528 14,973 Net income 1,757 2,153 2,000 1,307 7,217 Earnings per common share $ 0.25 $ 0.31 $ 0.29 $ 0.19 $ 1.03 Dividends declared $ 0.05 $ 0.05 $ 0.05 $ 0.05 $ 0.20 (1) Fiscal year 1995 second quarter results include a pretax gain of $899,000 related to the sale of assets of Pacific Cogeneration, Inc. Page 31 32 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Shareholders PENWEST, LTD. We have audited the accompanying consolidated balance sheets of PENWEST, LTD. as of August 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended August 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of PENWEST, LTD. at August 31, 1996 and 1995, and the consolidated results of its operations and its cash flows for each of the three years in the period ended August 31, 1996, in conformity with generally accepted accounting principles. Seattle, Washington ERNST & YOUNG, LLP October 11, 1996 Page 32 33 REPORT OF MANAGEMENT The management of PENWEST, LTD. has prepared and is responsible for the integrity and fairness of the financial statements and other financial information presented in this annual report. The statements have been prepared in accordance with generally accepted accounting principles and, to the extent appropriate, include amounts based on management's judgment and/or estimates. In order to fulfill its responsibilities for these financial statements and information, management maintains accounting systems and related internal controls. These controls are designed to provide reasonable assurance that transactions are properly authorized and recorded, that assets are safeguarded, and that financial records are reliably maintained. Ernst & Young LLP, independent auditors, is retained to audit the Company's consolidated financial statements. Their accompanying report is based on an audit conducted in accordance with generally accepted auditing standards, including a review of internal accounting controls and tests of accounting procedures and records to the extent necessary to support their audit. The Audit Committee of the Board of Directors, which is composed solely of outside directors, meets periodically with management and with the independent auditors to review the quality of financial reporting, the operation and development of the internal control systems, and the results of independent audits. The independent auditors periodically meet with the Audit Committee without the presence of management. /s/ Tod R. Hamachek - --------------------------------- Tod R. Hamachek President and Chief Executive Officer /s/ Jeffrey T. Cook - --------------------------------- Jeffrey T. Cook Vice President, Finance and Chief Financial Officer /s/ Jennifer L. Good - --------------------------------- Jennifer L. Good Corporate Director of Finance and Corporate Secretary Page 33 34 ITEM 9: CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT The information set forth under "Election of Directors" in the Company's definitive Proxy Statement for the 1997 Annual Meeting of Shareholders is incorporated herein by reference. Information regarding executive officers of the Company is set forth in Part I above and incorporated herein by reference. ITEM 11: EXECUTIVE COMPENSATION The information set forth under "Executive Compensation" in the Company's definitive Proxy Statement for the 1997 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive Proxy Statement for the 1997 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information relating to certain relationships and related transactions of the Company set forth under "Change-in-Control Arrangements" in the Company's definitive Proxy Statement for the 1997 Annual Meeting of Shareholders is incorporated herein by reference. PART IV ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements The consolidated balance sheets as of August 31, 1996 and 1995 and the related statements of income, cash flows and shareholders' equity for each of the three years in the period ended August 31, 1996 and the report of independent auditors are included in Part II, Item 8. (a) (2) Financial Statement Schedules (a) Selected quarterly financial information is included in Part II, Item 8. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted because they are not applicable or because the information is presented in the financial statements or notes thereto. Page 34 35 (a) (3) Exhibits See list of Exhibits on page 37. This list includes a subset containing each management contract, compensatory plan, or arrangement required to be filed as an exhibit to this report. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the period covered by this report. Page 35 36 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. PENWEST, LTD. Date: November 25, 1996 /s/ Tod R. Hamachek ----------------- -------------------------------------- Tod R. Hamachek, President and Chief Executive Officer Principal Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: November 25, 1996 /s/ Tod R. Hamachek ----------------- -------------------------------------- Tod R. Hamachek, President and Chief Executive Officer (Principal Executive Officer) Date: November 25, 1996 /s/ Jeffrey T. Cook ----------------- -------------------------------------- Jeffrey T. Cook, Chief Financial Officer (Principal Financial Officer) Date: November 25, 1996 /s/ Jennifer L. Good ----------------- -------------------------------------- Jennifer L. Good, Corporate Director of Finance (Principal Accounting Officer) Directors Richard E. Engebrecht Paul E. Freiman Tod R. Hamachek By /s/ Tod R. Hamachek Paul H. Hatfield -------------------------- Harry Mullikin Attorney-in-Fact Sally G. Narodick Power of Attorney Dated William G. Parzybok, Jr. N. Stewart Rogers Date October 22, 1996 William K. Street ------------------------- Page 36 37 INDEX TO EXHIBITS Exhibits identified in parentheses below, on file with the Securities and Exchange Commission, are incorporated by reference. Exhibit No. Item - ----------- ---- (3.1) Restated Articles of Incorporation of Registrant (filed as an Exhibit to Registrant's Form 10-K for fiscal year ended August 31, 1995) (3.2) Bylaws of Registrant as amended and restated as of June 27, 1995 (filed as an Exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1995) (4.1) PENWEST, LTD. Common Stock Purchase Rights, dated June 3, 1988 (filed on Form 8-A dated June 3, 1988) (10.1) Senior Note Agreement among PENWEST, LTD. as Borrower and Mutual of Omaha and Affiliates as lenders, dated November 1, 1992 (filed as an Exhibit to Registrant's Form 10-Q for the quarter ended February 28, 1993) (10.2) Term Loan Agreement among Penford Products Co., and PENWEST, LTD. as Borrowers, and First Interstate Bank of Washington, N.A. as Lender, dated September 27, 1990 (Registrant agrees to furnish a copy of this instrument to the Commission on request) (10.3) Loan Agreement among PENWEST, LTD. as Borrower and Seattle-First National Bank as Lender, dated December 1, 1989 (Registrant agrees to furnish a copy of this instrument to the Commission on request) (10.4) PENWEST, LTD. Supplemental Executive Retirement Plan, dated March 19, 1990 (filed as an Exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1991) (10.5) PENWEST, LTD. Supplemental Survivor Benefit Plan, dated January 15, 1991 (filed as an Exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1991) (10.6) PENWEST, LTD. Deferred Compensation Plan, dated January 15, 1991 (filed as an Exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1991) (10.7) Change of Control Agreements with Messrs. Hamachek, Reed, Cook, Widmaier, Talley, Horn and Rydzewski (a representative copy of these agreements is filed as an exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1995) Page 37 38 (10.8) PENWEST, LTD. 1993 Non-Employee Director Restricted Stock Plan (filed as an Exhibit to Registrant's Form 10-Q for the quarter ended November 30, 1993) (10.9) Note Agreement dated as of October 1, 1994 among PENWEST, LTD., Principal Mutual Life Insurance Company and TMG Life Insurance Company (filed as an Exhibit to Registrant's Form 10-Q for the quarter ended February 28, 1995) (10.10) PENWEST, LTD. 1994 Stock Option Plan as amended and restated as of January 23, 1996 (filed as an Exhibit to Registrant's Form 10-Q for the quarter ended May 31, 1996) (10.11) Credit Agreement dated as of December 22, 1995 among PENWEST, LTD., and its subsidiaries, Bank of America National Trust and Savings Association, ABN-AMRO Bank, N.V., The Bank of Nova Scotia, and Seattle-First National Bank (filed as an Exhibit to Registrant's Form 10-Q for the quarter ended February 29, 1996) (10.12) PENWEST, LTD. Stock Option Plan for Non-Employee Directors (filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended May 31, 1996) 11 Statement Regarding Computation of Per-Share Earnings 21 Subsidiaries of the Registrant 23 Consent of Independent Auditors 24 Power of Attorney 27 Financial Data Schedule Page 38 39 SUBSET OF THE INDEX TO EXHIBITS Executive Compensation Plans and Arrangements. This subset of the index to exhibits includes a subset containing each management contract, compensatory plan, or arrangement required to be filed as an exhibit to this Report. Exhibit No. Item - ----------- ---- (10.4) PENWEST, LTD. Supplemental Executive Retirement Plan, dated March 19, 1990 (filed as an Exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1991, Commission File No. 0-11488) (10.5) PENWEST, LTD. Supplemental Survivor Benefit Plan, dated January 15, 1991 (filed as an Exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1991, Commission File No. 0-11488) (10.6) PENWEST, LTD. Deferred Compensation Plan, dated January 15, 1991 (filed as an Exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1991, Commission File No. 0-11488) (10.7) Agreements relating to compensation in the event of a change in control of the corporation between the corporation and Messrs. Hamachek, Reed, Cook, Widmaier, Talley, Horn, and Rydzewski (a representative copy of these agreements filed as an Exhibit to Registrant's Form 10-K for the fiscal year ended August 31, 1995, Commission File No. 0-11488) (10.8) PENWEST, LTD. 1993 Non-Employee Director Restricted Stock Plan. (Filed as an Exhibit to Registrant's Form 10-Q for the quarter ended November 30, 1993, Commission File Number 0-11488) (10.10) PENWEST, LTD. 1994 Stock Option Plan as amended and restated as of January 23, 1996 (filed as an Exhibit to Registrant's Form 10-Q for the quarter ended May 31, 1996, Commission File No. 0-11488) Page 39