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Penford 10-K 2007
e10vk
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
     
(Mark One)    
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the Fiscal Year Ended August 31, 2007
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
Commission File Number 0-11488
 
 
     
Washington   91-1221360
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
7094 S. Revere Parkway
Centennial, Colorado
  80112-3932
(Zip Code)
(Address of principal Executive Offices)    
 
Registrant’s telephone number, including area code:
(303) 649-1900
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common Stock, $1.00 par value
  The Nasdaq Stock Market, LLC
Common Stock Purchase Rights
  The Nasdaq Stock Market, LLC
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o  No þ
 
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o  No þ
 
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 þ  No o
 
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.  þ
 
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one).
 
Large accelerated filer  o     Accelerated filer  þ     Non-accelerated filer  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No þ
 
The aggregate market value of the Registrant’s Common Stock held by non-affiliates of the Registrant as of February 28, 2007, the last business day of the Registrant’s second quarter of fiscal 2007, was approximately $179.3 million based upon the last sale price reported for such date on The Nasdaq Stock Market LLC. For purposes of making this calculation, Registrant has assumed that all the outstanding shares were held by non-affiliates, except for shares held by Registrant’s directors and officers and by each person who owns 10% or more of the outstanding Common Stock. However, this does not necessarily mean that there are not other persons who may be deemed to be affiliates of the Registrant.
 
The number of shares of the Registrant’s Common Stock (the Registrant’s only outstanding class of stock) outstanding as of November 1, 2007 was 9,218,923.
 
 
Portions of the Registrant’s definitive Proxy Statement relating to the 2008 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.
 


 

 
PENFORD CORPORATION
 
FISCAL YEAR 2007 FORM 10-K ANNUAL REPORT
 
 
                 
        Page
 
      Business     2  
      Risk Factors     8  
      Unresolved Staff Comments     14  
      Properties     14  
      Legal Proceedings     15  
      Submission of Matters to a Vote of Security Holders     15  
 
PART II
      Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities     16  
      Selected Financial Data     18  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     18  
      Quantitative and Qualitative Disclosures About Market Risk     30  
      Financial Statements and Supplementary Data     32  
      Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     65  
      Controls and Procedures     65  
      Other Information     65  
 
PART III
      Directors, Executive Officers and Corporate Governance     65  
      Executive Compensation     66  
      Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     66  
      Certain Relationships and Related Transactions, and Director Independence     66  
      Principal Accountant Fees and Services     67  
 
PART IV
      Exhibits and Financial Statement Schedules     67  
    68  
 Deferred Compensation Plan, Amended and Restated
 Form of 2006 Long-Term Incentive Plan Restricted Stock Award Notice and Agreement
 Non-Employee Director Compensation Term Sheet
 Subsidiaries of the Registrant
 Consent of Independent Registered Public Accounting Firm
 Power of Attorney
 Certification of CEO Pursuant to Section 302
 Certification of CFO Pursuant to Section 302
 Certification of CEO and CFO Pursuant to Section 906


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PART I
 
 
The statements contained in this Annual Report on Form 10-K (“Annual Report”) that are not historical facts, including, but not limited, to statements found in the Notes to Consolidated Financial Statements and in Item 1 — Business and Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, are forward-looking statements that represent management’s beliefs and assumptions based on currently available information. Forward-looking statements can be identified by the use of words such as “believes,” “may,” “will,” “looks,” “should,” “could,” “anticipates,” “expects,” or comparable terminology or by discussions of strategies or trends.
 
Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it cannot give any assurances that these expectations will prove to be correct. Such statements by their nature involve substantial risks and uncertainties that could significantly affect expected results. Actual future results could differ materially from those described in such forward-looking statements, and the Company does not intend to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Among the factors that could cause actual results to differ materially are the risks and uncertainties discussed in this Annual Report, including those referenced below, and those described from time to time in other filings with the Securities and Exchange Commission 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;
 
  •  expectations regarding the construction cost of the ethanol facility and the timing of ethanol production;
 
  •  changes in general economic conditions or developments with respect to specific industries or customers affecting demand for the Company’s products including unfavorable shifts in product mix;
 
  •  unanticipated costs, expenses or third-party claims;
 
  •  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;
 
  •  foreign currency exchange rate fluctuations;
 
  •  changes in assumptions used for determining employee benefit expense and obligations; or
 
  •  other unforeseen developments in the industries in which Penford operates.
 
Item 1:   Business
 
 
Penford Corporation (which, together with its subsidiary companies, is referred to herein as “Penford” or the “Company”) is a North American and Australian developer, manufacturer and marketer of specialty natural-based ingredient systems for many industrial and food applications. The Company’s strategically-located manufacturing facilities in the United States, Australia and New Zealand provide it with broad geographic coverage of its target markets. Penford is a Washington corporation originally incorporated in September 1983. The Company commenced operations as a publicly-traded company on March 1, 1984.
 
Penford operates in three business segments, each utilizing its carbohydrate chemistry expertise to develop starch-based ingredients for value-added applications in several markets that improve the quality and performance


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of customers’ products, including papermaking and food products. The first two, industrial ingredients and food ingredients, are broad categories of end-market users, primarily served by the Company’s United States operations. The third segment consists of geographically separate operations in Australia and New Zealand. The Australian and New Zealand operations are engaged primarily in the food ingredients business. Financial information about Penford’s segments and geographic areas is included in Note 15 to the Consolidated Financial Statements.
 
The Company has extensive research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and in developing applications to address customer needs.
 
Penford’s three business segments are:
 
  •  Industrial Ingredients — North America, which in fiscal 2007 generated approximately 54% of Penford’s revenue, is a supplier of chemically modified specialty starches to the paper and packaging industries. Through a commitment to research and development, Industrial Ingredients develops customized product applications that help its customers realize improved manufacturing efficiencies and advancements in product performance. Industrial Ingredients has specialty processing capabilities for a variety of modified starches. Specialty products for industrial applications are designed to improve the strength and performance of customers’ products and efficiencies in the manufacture of coated and uncoated paper and paper packaging products. These starches are principally ethylated (chemically modified with ethylene oxide), oxidized (treated with sodium hypochlorite) and cationic (carrying a positive electrical charge). Ethylated and oxidized starches are used in coatings and as binders, providing strength and printability to fine white, magazine and catalog paper. Cationic and other liquid starches are generally used in the paper-forming process in paper production, providing strong bonding of paper fibers and other ingredients. Industrial Ingredients’ products are a cost-effective alternative to synthetic, petroleum-based ingredients.
 
  •  Food Ingredients — North America, which in fiscal 2007 generated approximately 17% of Penford’s revenue, is a developer and manufacturer of specialty starches and dextrins to the food manufacturing and food service industries. Its expertise is in leveraging the inherent characteristics from potato, corn, tapioca and rice to help improve its customers’ product performance. Food Ingredients is the only North American manufacturer of modified food-grade potato starch. Food Ingredients’ specialty starches produced for food applications are used in coatings to provide crispness, improved taste and texture, and increased product life for products such as french fries sold in quick-service restaurants. Food-grade starch products are also used as moisture binders to reduce fat levels, modify texture and improve color and consistency in a variety of foods such as canned products, sauces, whole and processed meats, dry powdered mixes and other food and bakery products.
 
  •  Australia/New Zealand Operations generated approximately 29% of Penford’s revenue in fiscal 2007 and the Company believes it is the sole domestic producer of value-added modified maize starches and various starch derived products for the food, paper and mining industries in Australia and New Zealand. The Australia/New Zealand segment develops, manufactures and markets ingredient systems, including specialty starches and sweeteners for food and industrial applications. In both Australia and New Zealand, modified starch competition is generally from imports as there is only one other domestic producer. This segment’s flexible manufacturing capabilities allow the Company to manufacture products to customer specifications and to quickly respond to customers’ changing needs.
 
In June 2006, the Company announced plans to invest $42 million for up to 40 million gallons of ethanol production capacity per year at its Cedar Rapids, Iowa facility. In October 2006, Penford refinanced its credit facility and obtained a $45 million capital expansion loan commitment maturing December 2012 to finance construction of the ethanol plant. The designed capacity has been expanded to 45 million gallons with construction cost estimates maintained at $1.00 to $1.05 per gallon. Contracts valued at $40 million have been awarded for this project as of the end of October 2007. Penford has much of the infrastructure within the Cedar Rapids plant to manufacture ethanol cost effectively, with sufficient grain handling, separation processes, utilities and logistic capabilities. The factory is centrally located near rail and ground transport arteries and the ethanol facility will occupy available space within the existing site footprint. Once complete, this enhancement of the Company’s bio-refining capabilities will give management the ability to select from multiple output choices to capitalize on changing industry conditions and selling opportunities. This increased flexibility will allow the Company to direct production towards the most


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attractive mix of strategic and financial opportunities. Additionally, by improving production capacity and adding fermentation capability, Penford expects to be better positioned to participate in emerging bio-processing trends and technologies that represent potential platforms for future growth.
 
 
Corn:  Penford’s North American corn wet milling plant is located in Cedar Rapids, Iowa, the middle of the U.S. corn belt. Accordingly, the plant has truck-delivered corn available throughout the year from a number of suppliers at prices consistent with those available in the major U.S. grain markets.
 
Penford Australia’s corn wet milling facilities in Lane Cove, Australia, and Auckland, New Zealand are sourced through truck-delivered corn at contracted prices with regional independent farmers and merchants. The corn sourced in Australia and New Zealand is normally contracted prior to harvest (March — June). Corn used in Australia is purchased and stored for use in both the current and following year. The corn sourced in New Zealand is purchased in advance for future delivery. Corn is also purchased from Australia as necessary to supplement the corn sourced and processed in New Zealand.
 
Potato Starch:  The Company’s facilities in Idaho Falls, Idaho; Richland, Washington; and Plover, Wisconsin use starch recovered as by-products from potato processors as the primary raw material to manufacture modified potato starches. The Company enters into contracts typically having durations of one to five years with potato processors in the United States, Canada and Mexico to acquire potato-based raw materials.
 
Wheat Products:  Penford Australia’s Tamworth facility uses wheat flour as the primary raw material for the production of its wheat products, including wheat starch, wheat gluten and glucose syrup. The Company is currently negotiating with various suppliers for the supply of wheat flour subsequent to the expiration of its current supply contract at the end of calendar 2007.
 
Chemicals:  The primary chemicals used in the manufacturing processes are readily available commodity chemicals. The prices for these chemicals are subject to price fluctuations due to market conditions.
 
Natural Gas:  The primary energy source for most of Penford’s plants is natural gas. Penford contracts its natural gas supply with regional suppliers, generally under short-term supply agreements, and at times uses futures contracts to hedge the price of natural gas in North America.
 
Corn, potato starch, wheat flour, chemicals and natural gas are not currently subject to availability constraints, although drought conditions in Australia have periodically affected the prices of corn and wheat in that area and strong demand has substantially increased the prices of natural gas, chemicals and agricultural raw materials. Current forecasts for wheat production in Australia indicate that the existing drought will affect the future price for that raw material. Penford’s current potato starch requirements constitute a material portion of the available North American supply. Penford estimates that it purchases approximately 50-55% of the recovered potato starch in North America. It is possible that, in the long term, continued growth in demand for potato starch-based ingredients and new product development could result in capacity constraints.
 
Over half of the Company’s manufacturing costs consists of the costs of corn, potato starch, wheat flour, chemicals and natural gas. The remaining portion consists of the costs of labor, distribution, depreciation and maintenance of manufacturing plant and equipment, and other utilities. The prices of raw materials may fluctuate, and increases in prices may affect Penford’s business adversely. To mitigate this risk, Penford hedges a portion of corn and gas purchases with futures and options contracts in the U.S. and enters into short-term supply agreements for other production requirements in all locations.
 
 
Penford’s research and development efforts cover a range of projects including technical service work focused on specific customer support projects which require coordination with customers’ research efforts to develop innovative solutions to specific customer requirements. These projects are supplemented with longer-term, new product development and commercialization initiatives. Research and development expenses were $6.8 million, $6.2 million and $5.8 million for fiscal years ended August 31, 2007, 2006 and 2005, respectively.


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At the end of fiscal 2007, Penford had 39 scientists, including seven with PhD’s with expert knowledge of carbohydrate characteristics and chemistry.
 
 
Penford owns a number of patents, trademarks and tradenames.
 
Penford has approximately 200 current patents and pending patent applications, most of which are related to technologies in french fry coatings, coatings for the paper industry and animal and human nutrition. Penford’s issued patents expire at various times between 2008 and 2025. The annual cost to renew all of the Company’s patents is approximately $0.2 million. However, most of Penford’s products are currently made with technology that is broadly available to companies that have the same level of scientific expertise and production capabilities as Penford.
 
Specialty starch ingredient brand names for industrial applications include, among others, Penford® Gums, Pensize® binders, Penflex® sizing agent, Topcat® cationic additive and the Apollo® starch series. Product brand names for food ingredient applications include PenBind®, PenCling®, PenPlus®, CanTab®, MAPStm, Mazacatm and Fieldcleertm.
 
 
Penford’s revenues and operating results vary from quarter to quarter. In particular, the Company experiences seasonality in its Australian operations. The Company has lower sales volumes and gross margins in Australia and New Zealand’s summer months, which occur during Penford’s second fiscal quarter. This seasonal decline is caused by the closure of some customers’ plants for public holidays and maintenance during this period. Decreased consumption of some foods which use the Company’s products, such as packaged bread, also contributes to this seasonal trend. Sales volumes of the Food Ingredients — North America products used in french fry coatings are also generally lower during Penford’s second fiscal quarter due to decreased consumption of french fries during the post-holiday season. The cost of natural gas in North America is generally higher in the winter months than the summer months.
 
 
The Company’s growth is funded through a combination of cash flows from operations and short- and long-term borrowings. See the discussion in Liquidity and Capital Resources under Management’s Discussion and Analysis of Financial Condition and the Results of Operations in Item 7.
 
Penford generally carries a one- to 45-day supply of materials required for production, depending on the lead time for specific items. Penford manufactures finished goods to customer orders or anticipated demand. The Company is therefore able to carry less than a 30-day supply of most products. Terms for trade receivables and trade payables are standard for the industry and region and generally do not exceed 30-day terms except for trade receivables for export sales.
 
 
Penford’s operations are governed by various federal, state, local and foreign environmental laws and regulations. In the United States, these laws and regulations include the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the EPA Oil Pollution Control Act, the Occupational Safety and Health Administration’s hazardous materials regulations, the Toxic Substances Control Act, the Comprehensive Environmental Response Compensation and Liability Act, and the Superfund Amendments and Reauthorization Act. In Australia, Penford is subject to the environmental requirements of the Protection of the Environment Operations Act, the Dangerous Goods Act, the Ozone Protection Act, the Environmentally Hazardous Chemicals Act, and the Contaminated Land Management Act. In New Zealand, the Company is subject to the Resource Management Act, the Dangerous Goods Act, the Hazardous Substances and New Organisms Act and the Ozone Protection Act.


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Permits are required by the various environmental agencies which regulate the Company’s operations. Penford believes that it has obtained all necessary material environmental permits required for its operations. Penford believes that its operations are in compliance with applicable environmental laws and regulations in all material aspects of its business. Penford estimates that annual compliance costs, excluding operational costs for emission control devices, wastewater treatment or disposal fees, are approximately $1.8 million.
 
Penford has adopted and implemented a comprehensive corporate-wide environmental management program. The program is managed by the Corporate Director of Environmental, Health and Safety and is designed to structure the conduct of Penford’s business in a safe and fiscally responsible manner that protects and preserves the health and safety of employees, the communities surrounding the Company’s plants, and the environment. The Company continuously monitors environmental legislation and regulations that may affect Penford’s operations.
 
During fiscal 2007, there have been no material effects on the Company’s operations that resulted from compliance with environmental regulations. No unusual expenditures for environmental facilities and programs are anticipated in fiscal 2008.
 
 
Penford sells to a variety of customers and has several relatively large customers in each business segment. None of the Company’s customers constituted 10% of sales in fiscal years 2006 and 2005. However, for fiscal 2007, the Company’s largest customer, Domtar, Inc., represented approximately 12% of the Company’s consolidated net sales. Domtar, Inc. is a customer of the Company’s Industrial Ingredients — North America business.
 
 
In its primary markets, Penford competes directly with approximately five other companies that manufacture specialty starches for the papermaking industry and approximately six other companies that manufacture specialty food ingredients. Penford competes indirectly with a larger number of companies that provide synthetic and natural-based ingredients to industrial and food customers. Some of these competitors are larger companies, and have greater financial and technical resources than Penford. Application expertise, quality and service are the major competitive advantages for Penford.
 
 
At August 31, 2007, Penford had 596 total employees. In North America, Penford had 357 employees, of which approximately 40% are members of a trade union. The collective bargaining agreement covering the Cedar Rapids- based manufacturing workforce expires in August 2012. Penford Australia had 239 employees, of which 69% are members of trade unions in Australia and New Zealand. The union contracts for the Tamworth, Australia, and the New Zealand facilities have expiration dates of September 2008 and February 2008, respectively. The Lane Cove, Australia, union agreement expires in December 2007 and is currently being negotiated. There is no assurance that the Company will successfully renegotiate this agreement before expiration or at all.
 
 
Sales are generated using a combination of direct sales and distributor agreements. In many cases, Penford supports its sales efforts with technical and advisory assistance to customers. Penford generally ships its products upon receipt of purchase orders from its customers and, consequently, backlog is not significant.
 
Customers for industrial corn-based starch ingredients purchase products through fixed-price contracts or formula-priced contracts for periods covering three months to two years or on a spot basis. In fiscal 2007, approximately 63% of these sales were under fixed-price contracts, and the remaining 37% of the sales were under formula-priced contracts or sold on a spot basis.
 
Since Penford’s customers are generally other manufacturers and processors, most of the Company’s products are distributed via rail or truck to customer facilities in bulk, except in Australia and New Zealand where most dry product is packaged in 25kg bags.


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Penford expanded into foreign markets with its acquisition of Penford Australia in September 2000. Penford Australia is the primary producer of corn starch products in Australia and New Zealand. Penford Australia manufactures products used to enhance the quality and performance of packaged food products, generally through providing the texture and viscosity required by its customers for products such as sauces and gravies. Penford Australia’s starch products are also used in industrial applications including mining, paper, corrugating and building materials. The Company’s operations in Australia and New Zealand include three manufacturing facilities for processing specialty corn starches and wheat-related products. Competition is mainly from imported products, except in wheat flour based starches where there is one other producer in Australia. Export sales from Penford’s businesses in the U.S. and Australia/New Zealand accounted for approximately 15%, 13% and 16% of total sales in fiscal 2007, 2006 and 2005, respectively. See Note 15 to the Consolidated Financial Statements in Item 8 for sales, depreciation and amortization, income and loss from operations, net capital expenditures and total assets by geographic segment, which information is incorporated by reference.
 
 
Penford’s Internet address is www.penx.com. The Company makes available, free of charge, through its Internet site, the Company’s annual reports on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8-K; Directors and Officers Forms 3, 4 and 5; and amendments to those reports, as soon as reasonably practicable after electronically filing such materials with, or furnishing them to, the Securities and Exchange Commission (“SEC”). The information found on Penford’s web site shall not be considered to be part of this or any other report or other filing filed with or furnished to the SEC. The SEC also maintains an Internet site which contains reports, proxy and information statements, and other information regarding issuers that file information electronically with the SEC. The SEC’s Internet address is www.sec.gov.
 
In addition, the Company makes available, through the Investor Relations section of its Internet site, the Company’s Code of Business Conduct and Ethics and the written charters of the Audit, Governance and Executive Compensation and Development Committees.
 
 
             
Name
 
Age
 
Title
 
Thomas D. Malkoski
    51     President and Chief Executive Officer
Steven O. Cordier
    51     Senior Vice President, Chief Financial Officer and Assistant Secretary
Russell A. Allwell
    43     Managing Director, Penford Australia and Penford New Zealand
Timothy M. Kortemeyer
    41     Vice President and President, Penford Products Co.
Wallace H. Kunerth
    59     Vice President and Chief Science Officer
Christopher L. Lawlor
    57     Vice President — Human Resources, General Counsel and Secretary
John R. Randall
    63     Vice President and President, Penford Food Ingredients
 
Mr. Malkoski joined Penford Corporation as Chief Executive Officer and was appointed to the Board of Directors in January 2002. He was named President of Penford Corporation in January 2003. From 1997 to 2001, he served as President and Chief Executive Officer of Griffith Laboratories, North America, a formulator, manufacturer and marketer of ingredient systems to the food industry. Previously, he served in various senior management positions, including as Vice President/Managing Director of the Asia Pacific and South Pacific regions for Chiquita Brands International, an international marketer and distributor of bananas and other fresh produce. Mr. Malkoski began his career at the Procter and Gamble Company, a marketer of consumer brands, progressing through major product category management responsibilities.


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Mr. Cordier is Penford’s Senior Vice President, Chief Financial Officer and Assistant Secretary. He joined Penford in July 2002 as Vice President and Chief Financial Officer, and was promoted to Senior Vice President in November 2004. From September 2005 to April 2006, Mr. Cordier served as the interim Managing Director of Penford’s Australian and New Zealand operations. He came to Penford from Sensient Technologies Corporation, a manufacturer of specialty products for the food, beverage, pharmaceutical and technology industries, where he held a variety of senior financial management positions.
 
Mr. Allwell joined Penford as Managing Director of its Australian and New Zealand operations in April 2006. Prior to joining Penford, Mr. Allwell had been the General Manager Retail Sales for George Weston Foods, a manufacturer of baked goods and other foods, since 2003. From 1996 to 2003, Mr. Allwell served in various senior management roles with Berri Ltd., a beverage manufacturer, including as Director of Strategy from 2000 to 2003, as Marketing Director from 1997 to 2003, and as General Manager — New Ventures from 1996 to 1997. Prior to that, Mr. Allwell served in various management, sales and marketing positions with Simplot Australia, Kraft Foods, Calbecks Ltd. and Humes ARC Ltd.
 
Mr. Kortemeyer has served as Vice President of Penford Corporation since October 2005 and President of Penford Products Co., Penford’s industrial ingredients business, since June 2006. He served as General Manager of Penford Products from August 2005 to June 2006. Mr. Kortemeyer joined Penford in 1999 and served as a Team Leader in the manufacturing operations of Penford Products until 2001. From 2001 until 2003, he was an Operations Manager and Quality Assurance Manager. From July 2003 to November 2004, Mr. Kortemeyer served as the business unit manager of the Company’s co-products business, and from November 2004 until August 2005, as the director of the Company’s specialty starches product lines, responsible for sales, marketing and business development.
 
Dr. Kunerth has served as Penford’s Vice President and Chief Science Officer since 2000. From 1997 to 2000, he served in food applications research management positions in the Consumer and Nutrition Sector at Monsanto Company, a provider of hydrocolloids, high intensity sweeteners, agricultural products and integrated solutions for industrial, food and agricultural customers. Before Monsanto, he was the Vice President of Technology at Penford’s food ingredients business from 1993 to 1997.
 
Mr. Lawlor joined Penford in April 2005 as Vice President-Human Resources, General Counsel and Secretary. From 2002 to April 2005, Mr. Lawlor served as Vice President-Human Resources for Sensient Technologies Corporation, a manufacturer of specialty chemicals and food products. From 2000 to 2002, he was Assistant General Counsel for Sensient. Mr. Lawlor was Vice President-Administration, General Counsel and Secretary for Kelley Company, Inc., a manufacturer of material handling and safety equipment from 1997 to 2000. Prior to joining Kelley Company, Mr. Lawlor was employed as an attorney at a manufacturer of paper and packaging products and in private practice with two national law firms.
 
Mr. Randall is Vice President of Penford Corporation and President of Penford Food Ingredients. He joined Penford in February 2003 as Vice President and General Manager of Penford Food Ingredients and was promoted to President of the Food Ingredients division in June 2006. Prior to joining Penford, Mr. Randall was Vice President, Research & Development/Quality Assurance of Griffith Laboratories, USA, a specialty foods ingredients business, from 1998 to 2003. From 1993 to 1998, Mr. Randall served in various research and development positions with KFC Corporation, a quick-service restaurant business, most recently as Vice President, New Product Development. Prior to 1993, Mr. Randall served in research and development leadership positions at Romanoff International, Inc., a manufacturer and marketer of gourmet specialty food products, and at Kraft/General Foods.
 
Item 1A:   Risk Factors
 
 
The availability and cost of agricultural products Penford purchases are vulnerable to weather and other factors beyond its control. The Company’s ability to pass through cost increases for these products is limited by worldwide competition and other factors.
 
In fiscal 2007, approximately 33% of Penford’s manufacturing costs were the costs of corn, wheat flour and potato starch. Weather conditions, plantings, government programs and policies, and energy costs and global


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supply, among other things, have historically caused volatility in the supply and prices of these agricultural products. For example, in 2006 and 2007, growing regions in Australia experienced significant droughts, reducing crop yields and increasing acquisition costs for grain raw materials. Due to local and/or international competition, particularly in the Australia/New Zealand operations, the Company may not be able to pass through the increases in the cost of agricultural raw materials to its customers. To manage price volatility in the commodity markets, the Company may purchase inventory in advance or enter into exchange traded futures or options contracts. Despite these hedging activities, the Company may not be successful in limiting its exposure to market fluctuations in the cost of agricultural raw materials. Increases in the cost of corn, wheat flour and potato starch due to weather conditions or other factors beyond Penford’s control and that cannot be passed through to customers will reduce Penford’s future profitability.
 
 
Energy and chemicals comprised approximately 12% and 11%, respectively, of the cost of manufacturing the Company’s products in fiscal 2007. Penford uses natural gas extensively in its Industrial Ingredients business to dry starch products, and, to a lesser extent, in the other business segments. The Company uses chemicals in all of the businesses to modify starch for specific product applications and customer requirements. The prices of these inputs to the manufacturing process fluctuate based on anticipated changes in supply and demand, weather and the prices of alternative fuels, including petroleum. The Company may use short-term purchase contracts or exchange traded futures or option contracts to reduce the price volatility of natural gas; however, these strategies are not available for the chemicals the Company purchases. If the Company is unable to pass on increases in energy and chemical costs to its customers, margins and profitability would be adversely affected.
 
 
In fiscal 2006 and 2005, none of the Company’s customers constituted more than 10% of sales. However, in fiscal 2007, the Company’s largest customer, Domtar, Inc., represented approximately 12% of consolidated net sales and sales to the top ten customers represented 44% of consolidated net sales. Generally, the Company does not have multi-year sales agreements with its customers. Instead, many customers place orders on an as-needed basis and generally can change their suppliers without penalty. If Penford lost one or more major customers, or if one or more major customers significantly reduced its orders, sales and results of operations would be adversely affected.
 
 
Penford’s revenues are and will continue to be derived from the sale of starch-based ingredients that the Company’s manufactures at its facilities. The Company’s operations may be subject to significant interruption if any of its facilities experiences a major accident or is damaged by severe weather or other natural disasters. In addition, the Company’s operations may be subject to labor disruptions and unscheduled downtime, or other operational hazards inherent in the industry, such as equipment failures, fires, explosions, abnormal pressures, blowouts, pipeline ruptures, transportation accidents and natural disasters. Some of these operational hazards may cause personal injury or loss of life, severe damage to or destruction of property and equipment or environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. The Company’s insurance may not be adequate to fully cover the potential operational hazards described above or that it will be able to renew this insurance on commercially reasonable terms or at all.
 
The agreements governing the Company’s debt contain various covenants that limit its ability to take certain actions and also require the Company to meet financial maintenance tests, and Penford’s failure to comply with any of the debt covenants could have a material adverse effect on the Company’s business, financial condition and results of operations.
 
The agreements governing Penford’s outstanding debt contain a number of significant covenants that, among other things, limit its ability to:
 
  •  incur additional debt or liens;


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  •  consolidate or merge with any person or transfer or sell all or substantially all of its assets;
 
  •  make investments or acquisitions;
 
  •  pay dividends or make certain other restricted payments;
 
  •  enter into transactions with affiliates; and
 
  •  create dividend or other payment restrictions with respect to subsidiaries.
 
In addition, the Company’s revolving credit facility requires it to comply with specific financial ratios and tests, under which it is required to achieve specific financial and operating results. Events beyond the Company’s control may affect its ability to comply with these provisions. A breach of any of these covenants would result in a default under the Company’s revolving credit facility. In the event of any default that is not cured or waived, the Company’s lenders could elect to declare all amounts borrowed under the revolving credit facility, together with accrued interest thereon, due and payable, which could permit acceleration of other debt. If any of the Company’s debt is accelerated, there is no assurance that the Company would have sufficient assets to repay that debt or that it would be able to refinance that debt on commercially reasonable terms or at all.
 
 
Although the Company has fixed the interest rates on a significant portion of its outstanding debt through interest rate swaps, as of August 31, 2007, approximately $37.5 million of its outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, was subject to variable interest rates which move in direct relation to the United States or Australian London InterBank Offered Rate (“LIBOR”), the Australian bank bill rate (“BBSY”), or the prime rate in the United States, depending on the selection of borrowing options. Any significant changes in these interest rates would materially affect the Company’s profitability by increasing or decreasing its borrowing costs.
 
 
The Company is subject to income taxes in the United States, Australia and New Zealand. The Company’s effective tax rates could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities or changes in tax laws. The carrying value of deferred tax assets, which are predominantly in the United States, is dependent on the Company’s ability to generate future taxable income in the United States. The amount of income taxes paid is subject to interpretation of applicable tax laws in the jurisdictions in which the Company operates. Although the Company believes it has complied with all applicable income tax laws, there is no assurance that a tax authority will not have a different interpretation of the law or that any additional taxes imposed as a result of tax audits will not have an adverse effect on the Company’s results of operations.
 
 
In the ordinary course of business, the Company is subject to risks associated with changing foreign exchange rates. The value of the U.S. dollar against foreign currencies has been generally in decline in recent years. In fiscal year 2007, approximately 29% of the Company’s revenue was denominated in currencies other than the U.S. dollar. The Company’s revenues and profitability may be adversely affected by fluctuations in exchange rates between the U.S. dollar and other currencies.
 
 
The Company’s ability to implement ethanol production as planned is subject to uncertainty. The Company has secured $45 million of financing for this project which it believes is adequate for the project’s completion; however, the Company could face financial risks if this amount of financing is not sufficient to complete the construction of


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the ethanol facility. Penford may be adversely affected by environmental, health and safety laws, regulations and liabilities in implementing ethanol production, which could increase its costs. Changes in the markets for ethanol, including oversupply in ethanol capacity, and/or legislation and regulations could materially and adversely affect ethanol demand. There is no assurance that sufficient demand for ethanol will develop to permit profitable operation of the ethanol production facility.
 
 
The Company faces risks arising from litigation matters in which various factors or developments can lead to changes in current estimates of liabilities, such as final adverse judgments, significant settlements or changes in applicable law. A future adverse outcome, ruling or unfavorable development could result in future charges that could have a material effect on the Company’s results of operations.
 
 
Approximately 29% of the Company’s revenues are derived from its operations in Australia and New Zealand. These foreign operations subject the Company to a number of risks associated with conducting business outside the United States, including the following:
 
  •  currency fluctuations;
 
  •  transportation delays and interruptions;
 
  •  political, social and economic instability and disruptions;
 
  •  government embargoes or foreign trade restrictions;
 
  •  the imposition of duties, tariffs and other trade barriers;
 
  •  import and export controls;
 
  •  labor unrest and changing regulatory environments;
 
  •  limitations on the Company’s ability to enforce legal rights and remedies; and
 
  •  potentially adverse tax consequences.
 
Although the Company’s operations have not been materially affected by any such factors to date, no assurance can be given that its operations may not be adversely affected in the future. Any of these events could have an adverse effect on the Company’s operations in the future by reducing the demand for its products, decreasing the prices at which the Company can sell its products or otherwise having an adverse effect on its business, financial condition or results of operations.
 
 
Penford’s success depends on the management and leadership skills of its senior management team. The loss of any of these individuals, particularly Thomas D. Malkoski, the Company’s President and Chief Executive Officer, or Steven O. Cordier, the Company’s Chief Financial Officer, or the Company’s inability to attract, retain and maintain additional personnel, could prevent it from fully implementing its business strategy. There is no assurance that it will be able to retain its existing senior management personnel or to attract additional qualified personnel when needed.
 
 
Penford is subject to many federal, state, local and foreign environmental and health and safety laws and regulations, particularly with respect to the use, handling, treatment, storage, discharge and disposal of substances and hazardous wastes used or generated in its manufacturing processes. Compliance with these laws and regulations is a significant factor in the Company’s business. Penford has incurred and expects to continue to incur significant


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expenditures to comply with applicable environmental laws and regulations. The Company’s failure to comply with applicable environmental laws and regulations and permit requirements could result in civil or criminal fines or penalties or enforcement actions, including regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, installation of pollution control equipment or remedial actions.
 
The Company may be required to incur costs relating to the investigation or remediation of property, including property where it has disposed of its waste, and for addressing environmental conditions. Some environmental laws and regulations impose liability and responsibility on present and former owners, operators or users of facilities and sites for contamination at such facilities and sites without regard to causation or knowledge of contamination. Consequently, there is no assurance that existing or future circumstances, the development of new facts or the failure of third parties to address contamination at current or former facilities or properties will not require significant expenditures by the Company.
 
The Company expects to continue to be subject to increasingly stringent environmental and health and safety laws and regulations. It is difficult to predict the future interpretation and development of environmental and health and safety laws and regulations or their impact on the Company’s future earnings and operations. The Company anticipates that compliance will continue to require increased capital expenditures and operating costs. Any increase in these costs, or unanticipated liabilities arising, for example, out of discovery of previously unknown conditions or more aggressive enforcement actions, could adversely affect the Company’s results of operations, and there is no assurance that they will not have a material adverse effect on its business, financial condition and results of operations.
 
 
As of August 31, 2007, approximately 40% of the Company’s 357 North American employees, and 69% of the 239 employees of Penford Australia, were members of trade unions. Although the Company’s relations with unions are stable, there is no assurance that the Company will not experience work disruptions or stoppages in the future, which could have a material adverse effect on its business and results of operations and adversely affect its relationships with its customers. For example, in the fourth quarter of fiscal 2004 and the first quarter of fiscal 2005, Penford experienced a union strike at its Cedar Rapids manufacturing facility. The Company incurred $4.2 million and $4.1 million in additional production costs for 2004 and 2005, respectively, in connection with the strike. Additionally, the Company’s non-union workforce could be disrupted by union organizing activities and similar actions.
 
 
Lower investment performance by the Company’s pension plan assets could increase its defined benefit pension plan obligations. The Company estimates that minimum funding requirements for its qualified defined benefit pension plans will be approximately $1.6 million in fiscal 2008. However, the Company cannot predict whether changing economic conditions or other factors will lead or require it to make contributions in excess of its current expectations, diverting funds it would otherwise apply to other uses. Additionally, there is no assurance that the Company will have the funds necessary to meet any minimum pension funding requirements.
 
Risk Factors Relating to Penford’s Common Stock
 
 
The trading price of the Company’s common stock has fluctuated significantly. In 2007, the stock price ranged from a low of $16.23 on January 5, 2007 to a high of $41.30 on October 11, 2007. The trading price of Penford’s common stock may fluctuate significantly in the future as a result of a number of factors, including:
 
  •  actual and anticipated variations in the Company’s operating results;
 
  •  general economic and market conditions, including changes in demand for the Company’s products;


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  •  interest rates;
 
  •  geopolitical conditions throughout the world;
 
  •  perceptions of the strengths and weaknesses of the Company’s industries;
 
  •  the Company’s ability to pay principal and interest on its debt when due;
 
  •  developments in the Company’s relationships with its lenders, customers and/or suppliers;
 
  •  announcements of alliances, mergers or other relationships by or between the Company’s competitors and/or its suppliers and customers; and
 
  •  quarterly variations in the Company’s results of operations due to, among other things, seasonality in demand for products and fluctuations in the cost of raw materials
 
The stock markets in general have experienced broad fluctuations that have often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of the Company’s common stock. Accordingly, Penford’s common stock may trade at prices significantly below an investor’s,cost and investors could lose all or part of their investment in the event that they choose to sell their shares.
 
Provisions of Washington law and the shareholder rights plan could discourage or prevent a potential takeover.
 
Washington law imposes restrictions on certain transactions between a corporation and certain significant shareholders. The Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with an “acquiring person,” which is defined as a person or group of persons that beneficially owns 10% or more of the voting securities of the target corporation, for a period of five years after such acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s board of directors prior to the time of the acquisition. Such prohibited transactions include, among other things, (1) a merger or consolidation with, disposition of assets to, or issuance or redemption of stock to or from, the acquiring person; (2) a termination of 5% or more of the employees of the target corporation as a result of the acquiring person’s acquisition of 10% or more of the shares; and (3) allowing the acquiring person to receive any disproportionate benefit as a shareholder.
 
After the five year period, a “significant business transaction” may occur if it complies with “fair price” provisions specified in the statute. A corporation may not “opt out” of this statute.
 
In addition, Penford has adopted a shareholder rights plan, intended to discourage a potential acquisition of the Company that its board of directors believes is undesirable to the Company and its shareholders. The shareholder rights plan expires in June 2008 and the Company’s board of directors currently does not intend to renew the plan. The shareholder rights plan and the provisions under Washington law may have the effect of delaying, deterring or preventing a change of control in the ownership of Penford.


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Item 1B:   Unresolved Staff Comments
 
Not applicable.
 
Item 2:   Properties
 
Penford’s facilities as of August 31, 2007 are as follows:
 
                         
    Bldg. Area
    Land Area
    Owned/
   
    (Sq. Ft.)     (Acres)     Leased  
Function of Facility
 
North America:
                       
Centennial, Colorado
    25,200           Leased   Corporate headquarters, administrative offices and research laboratories
Cedar Rapids, Iowa
    759,000       29     Owned   Manufacture of corn starch products, administration offices and research laboratories
Idaho Falls, Idaho
    30,000       4     Owned   Manufacture of potato starch products
Richland, Washington
    45,000           Owned   Manufacture of potato and tapioca starch products
      9,600       4.9     Leased   Administrative office and warehouse
Plover, Wisconsin
    54,000       10     Owned   Manufacture of potato starch Products
Australia/New Zealand:
                       
Lane Cove, New South Wales
    75,700       7     Owned   Manufacture of corn starch products, administrative offices and research laboratories
Tamworth, New South Wales
    94,600       6     Owned   Manufacture of wheat starch and gluten Products
              477     Owned   Effluent dispersion
Tamworth, New South Wales
          425     Leased   Agricultural and effluent dispersion
              225     Leased   Agricultural use
Auckland, New Zealand
    104,700       5     Owned   Manufacture of corn starch products
            3     Leased   Manufacture of corn starch products
 
Penford’s production facilities are strategically located near sources of raw materials. The Company believes that its facilities are maintained in good condition and that the capacities of its plants are sufficient to meet current production requirements. The Company invests in expansion, improvement and maintenance of property, plant and equipment as required.


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Item 3:   Legal Proceedings
 
In October 2004, Penford Products Co. (“Penford Products”), a wholly-owned subsidiary of the Company, was sued by Graphic Packaging International, Inc. (“Graphic”) in the Fourth Judicial District Court, Ouachita Parish, Louisiana. Graphic sought monetary damages for, among other things, Penford Products’ alleged breach of an agreement during the 2004 strike affecting its Cedar Rapids, Iowa plant to supply Graphic with certain starch products. Penford Products denied all liability and countersued for damages.
 
During October 2007, this case was tried before a judge of the above-noted court. As of November 7, 2007, no decision in the matter had been rendered by the judge and the judge had not advised Penford Products of the date upon which his decision would be issued. At trial, Graphic argued that it was entitled to damages of approximately $3.27 million, plus interest. Penford Products argued that it was entitled to damages of approximately $550,000, plus interest.
 
The Company vigorously defended its position at trial. However, the Company, applying its best judgment of the likely outcome of the litigation, has established a loss contingency against this matter of $2.4 million. Depending upon the eventual outcome of this litigation, the Company may incur additional material charges in excess of the amount it has reserved, or it may incur lower charges, the amounts of which in each case management is unable to predict at this time.
 
The Company is involved from time to time in various other claims and litigation arising in the normal course of business. In the judgment of management, which relies in part on information from the Company’s outside legal counsel, the ultimate resolution of these matters will not materially affect the consolidated financial position, results of operations or liquidity of the Company.
 
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 2007.


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Item 5:   Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
 
 
Penford’s common stock, $1.00 par value, trades on The Nasdaq Stock Market LLC under the symbol “PENX.” On November 1, 2007, there were 501 shareholders of record. The high and low closing prices of Penford’s common stock during the last two fiscal years are set forth below.
 
                                 
    Fiscal 2007     Fiscal 2006  
    High     Low     High     Low  
 
Quarter Ended November 30
  $ 16.97     $ 14.55     $ 14.78     $ 12.64  
Quarter Ended February 28
  $ 21.88     $ 16.23     $ 16.48     $ 11.80  
Quarter Ended May 31
  $ 21.25     $ 18.29     $ 18.00     $ 13.62  
Quarter Ended August 31
  $ 38.65     $ 18.20     $ 17.85     $ 13.59  
 
 
During each quarter of fiscal year 2007 and 2006, the Board of Directors declared a $0.06 per share cash dividend. On October 30, 2007, the Board of Directors declared a dividend of $0.06 per common share payable on December 7, 2007 to shareholders of record as of November 16, 2007. On a periodic basis, the Board of Directors reviews the Company’s dividend policy which is impacted by Penford’s earnings, financial condition, and cash and capital requirements. Future dividend payments are at the discretion of the Board of Directors. Penford has included the payment of dividends in its planning for fiscal 2008.
 
Pursuant to its credit agreement, the Company may not declare or pay dividends on, or make any other distributions in respect of, its common stock in excess of $8 million in any fiscal year or if there exists a Default or Event of Default as defined in the credit agreement. During fiscal years 2007 and 2006, the Company declared dividends on its common stock of $2.2 and $2.1 million, respectively.
 
Issuer Purchases of Equity Securities
 
None


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The following graph compares the Company’s cumulative total shareholder return on its common stock for a five-year period (September 1, 2002 to August 31, 2007) with the cumulative total return of the Nasdaq Market Index and all companies traded on the Nasdaq Stock Market (“Nasdaq”) with a market capitalization of $100 — $200 million, excluding financial institutions. The graph assumes that $100 was invested on September 1, 2002 in the Company’s common stock and in the stated indices. The comparison assumes that all dividends are reinvested. The Company’s performance as reflected in the graph is not indicative of the Company’s future performance.
 
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Penford Corp., The NASDAQ Composite Index
And A Peer Group
 
(Performance Graph)
 
ASSUMES $100 INVESTED ON SEPTEMBER 1, 2002
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING AUGUST 31, 2007
 
                                                             
      2002     2003     2004     2005     2006     2007
PENFORD CORPORATION
      100.00         96.64         124.64         107.75         118.07         269.72  
NASDAQ MARKET INDEX (U.S.)
      100.00         136.85         141.42         164.86         170.90         203.00  
NASDAQ MARKET CAP ($100-200M)
      100.00         140.18         132.48         131.41         111.01         120.97  
                                                             
 
$100 invested on 8/31/02 in index-including reinvestment of dividends.
Fiscal year ending August 31.
 
Management does not believe there is either a published index or a group of companies whose overall business is sufficiently similar to the business of Penford to allow a meaningful benchmark against which the Company can be compared. The Company sells products based on specialty carbohydrate chemistry to several distinct markets, making overall comparisons to one of these markets misleading with respect to the Company as a whole. For these reasons, the Company has elected to use non-financial companies traded on Nasdaq with a similar market capitalization as a peer group.


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Item 6:   Selected Financial Data
 
                                         
    Year Ended August 31,  
    2007     2006(2)     2005     2004     2003  
    (Dollars in thousands, except share and per share data)  
 
Operating Data:
                                       
Sales
  $ 362,364     $ 318,419     $ 296,763     $ 279,386     $ 262,467  
Cost of sales
    298,203       273,476       263,542       241,298       218,784  
Gross margin percentage
    17.7 %     14.1 %     11.2 %     13.6 %     16.6 %
Net income(3)
  $ 13,517 (1)   $ 4,228     $ 2,574 (4)   $ 3,702 (5)   $ 8,436 (6)
Diluted earnings per share
  $ 1.46     $ 0.47     $ 0.29     $ 0.42     $ 1.03  
Dividends per share
  $ 0.24     $ 0.24     $ 0.24     $ 0.24     $ 0.24  
Average common shares and equivalents — assuming dilution
    9,283,125       9,004,190       8,946,195       8,868,050       8,227,549  
Balance Sheet Data (as of August 31):
                                       
Total assets
  $ 288,388     $ 250,668     $ 249,917     $ 252,191     $ 250,893  
Capital expenditures
    34,734       14,905       9,413       15,454       8,772  
Long-term debt
    63,403       53,171       62,107       75,551       76,696  
Total debt
    74,677       67,007       66,129       80,326       79,696  
Shareholders’ equity
    125,676       107,452       100,026       95,719       87,885  
 
 
(1) Includes pre-tax charges of $2.4 million related to an estimated loss contingency for litigation. See Note 17 to the Consolidated Financial Statements.
 
(2) The Company adopted the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment,” effective at the beginning of fiscal 2006. As a result, the results of operations for fiscal 2006 and fiscal 2007 include incremental stock-based compensation cost in excess of what would have been recorded had the Company continued to account for stock-based compensation using the intrinsic value method.
 
(3) In the fourth quarter of fiscal 2004 and the first quarter of fiscal 2005, Penford experienced a union strike at its Cedar Rapids, Iowa manufacturing facility. As a result, net income for fiscal 2004 and fiscal 2005 reflects incremental expenses for 2004 and 2005, respectively, due to the strike.
 
(4) Includes a pre-tax gain of $1.2 million related to the sale of land in Australia, a $0.7 million pre-tax gain related to the sale of an investment and a $1.1 million pre-tax write off of unamortized deferred loan costs. See Note 12 to the Consolidated Financial Statements. Includes a tax benefit of $2.5 million related to 2001 through 2004 that the Company recognized in 2005 when the Company determined that it was probable that the extraterritorial income exclusion deduction on its U.S. federal income tax returns for those years would be sustained. See Note 13 to the Consolidated Financial Statements.
 
(5) Includes pre-tax charges of $1.3 million related to the restructuring of business operations and $0.7 million related to a pre-tax non-operating expense for the write off of unamortized deferred loan costs. See Note 12 to the Consolidated Financial Statements.
 
(6) Includes a pre-tax gain of $1.9 million related to the sale of certain assets to National Starch and Chemical Investment Holdings.
 
Item 7:   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 industrial and food applications. The Company develops and manufactures ingredients with starch as a base, providing value-added applications to its customers. Penford’s starch products are


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manufactured primarily from corn, potatoes, and wheat and are used principally as binders and coatings in paper and food production.
 
In analyzing business trends, management considers a variety of performance and financial measures, including sales revenue growth, sales volume growth, and gross margins and operating income of the Company’s business segments. Penford manages its business in three segments. The first two, Industrial Ingredients — North America and Food Ingredients — North America, are broad categories of end-market users, served by operations in the United States. The third segment is comprised of the Company’s operations in Australia and New Zealand, which operations are engaged primarily in the food ingredients business. See Item 1 and Note 15 to the Consolidated Financial Statements for additional information regarding the Company’s business segment operations.
 
Consolidated fiscal 2007 sales grew 13.8% to $362.4 million from $318.4 million in fiscal 2006 due to favorable unit pricing and product mix in all business segments and stronger foreign currency exchange rates in Australia and New Zealand. Gross margin as a percent of sales expanded 360 basis points from 14.1% in fiscal 2006 to 17.7% in fiscal 2007 primarily due to revenue growth and improved manufacturing efficiencies in each of the business units. The industrial business unit contributed $13.9 million of the total $19.2 million gain in gross margin with improvements in unit pricing and product mix, energy unit costs, corn procurement and manufacturing costs.
 
Operating expenses increased $1.9 million primarily due to increases in employee-related costs, but declined as a percent of sales to 8.7% in fiscal 2007 from 9.3% in fiscal 2006. In addition, the Company recorded a pretax charge in the amount of $2.4 million related to an estimated loss contingency for litigation. See Note 17 to the Consolidated Financial Statements. Interest expense of $5.7 million in fiscal 2007 was $0.2 million less than in fiscal 2006 due to lower debt balances and interest rates. The margin over the applicable benchmark interest rate was reduced in fiscal 2007 due to the improved financial performance of the Company.
 
The effective tax rate for fiscal 2007, at 31%, is lower than the statutory tax rate of 35% due to the tax benefits from domestic (U.S.) production activities, lower tax rates on foreign earnings, research and development tax incentives in the United States and Australia, and the effects of a tax audit settled in fiscal 2007. See Note 13 to the Consolidated Financial Statements.
 
The Company, applying its best judgment of the likely outcome of litigation regarding alleged breach of contract claims against Penford Products, has established a loss contingency against this matter of $2.4 million. Depending upon the eventual outcome of this litigation, the Company may incur additional material charges in excess of the amount it has reserved, or it may incur lower charges, the amounts of which in each case management is unable to predict at this time. See Note 17 to the Consolidated Financial Statements.
 
In June 2006, the Company announced plans to invest $42 million for up to 40 million gallons of ethanol production capacity per year at its Cedar Rapids, Iowa facility. In October 2006, Penford refinanced its credit facility and obtained a $45 million capital expansion loan commitment under its credit facility maturing December 2012 to finance construction of the ethanol plant. The designed capacity has been expanded to 45 million gallons with construction cost estimates maintained at $1.00 to $1.05 per gallon. Contracts valued at $40 million have been awarded for this project as of the end of October 2007. Penford already has much of the infrastructure within the Cedar Rapids plant to manufacture ethanol cost effectively, with sufficient grain handling, separation processes, utilities and logistic capabilities. The factory is centrally located near rail and ground transport arteries and the ethanol facility will occupy available space within the existing site footprint. Once complete, this enhancement of the Company’s bio-refining capabilities will give management the ability to select from multiple output choices to capitalize on changing industry conditions and selling opportunities. This increased flexibility will allow the Company to direct production towards the most attractive mix of returns and margins. Additionally, by improving throughput capacity and adding fermentation capability, Penford is better positioned to participate in emerging bio-processing trends and technologies that may represent future platforms for growth.
 
Accounting Changes
 
As of August 31, 2007, the Company adopted the recognition and disclosure provisions of Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132R” (“SFAS 158”). The recognition provision requires an employer to recognize a plan’s funded status in the statement of financial position


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and recognize the changes in a plan’s funded status in the statement of comprehensive income in the year in which the changes occur. The effect of adoption on the consolidated balance sheet was a decrease in other assets of $2.5 million, a decrease in current accrued liabilities of $1.2 million, an increase in other liabilities of $4.3 million, a decrease in other postretirement benefits of $1.1 million, a decrease in accumulated other comprehensive income, net of tax, of $2.8 million, and an increase in deferred tax assets of $1.7 million. The adoption of SFAS 158’s recognition provision did not have an effect on the Company’s consolidated results of operations for fiscal 2007, or for any prior year presented, and it will not have an effect on the results of operations in the future. See Note 10 to the Consolidated Financial Statements.
 
As of September 1, 2005, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), utilizing the modified-prospective transition method under which prior period results were not restated. The consolidated results of operations for fiscal years 2007 and 2006 include incremental stock-based compensation cost in excess of what would have been recorded had the Company continued to account for stock-based compensation using the intrinsic value method. Pretax stock-based compensation expense included in the consolidated results of operations was $1.1 million in each of fiscal years 2007 and 2006. See Note 9 to the Consolidated Financial Statements.
 
Results of Operations
 
Fiscal 2007 Compared to Fiscal 2006
 
 
                 
    Year Ended August 31,  
    2007     2006  
    (Dollars in thousands)  
 
Sales
  $ 194,957     $ 165,850  
Cost of sales
  $ 159,851     $ 144,656  
Gross margin
    18.0 %     12.8 %
Income from operations
  $ 19,251     $ 9,121  
 
Industrial Ingredients’ fiscal 2007 sales of $195.0 million increased $29.1 million, or 18%, over fiscal 2006, primarily driven by unit price increases and the positive effects on revenue of passing through higher corn costs. Combined, these factors added $34 million to fiscal 2007 sales. Offsetting these increases was a 6% decline in volume due to softness in the paper market as customers closed or temporarily shuttered plants.
 
Gross margin increased $13.9 million, or 66%, over fiscal 2006 to $35.1 million, and, as a percentage of sales, expanded to 18.0% in fiscal 2007 compared to 12.8% in fiscal 2006. Approximately $12 million of the margin growth was due to higher unit pricing and favorable product mix. Improvements in energy unit costs of $0.3 million, favorable corn procurement costs of $3.3 million and reductions in manufacturing overhead of $1.2 million also contributed to increased margin. These favorable effects were partially offset by increased chemical costs of $0.7 million and the margin effect of a volume decline of $2.7 million.
 
Income from operations increased $10.1 million over fiscal 2006 due to the increase in the gross margin, partially offset by $2.4 million related to an estimated loss contingency for litigation. See Note 17 to the Consolidated Financial Statements. Operating expenses declined to 5.2% of sales in fiscal 2007, compared to 5.5% of sales in fiscal 2006. Research and development expenses remained comparable to fiscal 2006 at 1.7% of sales.
 
 
                 
    Year Ended August 31,  
    2007     2006  
    (Dollars in thousands)  
 
Sales
  $ 62,987     $ 57,156  
Cost of sales
  $ 44,036     $ 41,954  
Gross margin
    30.1 %     26.6 %
Income from operations
  $ 10,684     $ 7,819  


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Sales at the Food Ingredients — North America business expanded 10.2% over the prior year driven by an 8.8% increase in average unit sales prices. Volumes increased slightly, adding 120 basis points to the revenue increase. Annual sales in the protein end market grew 17% over last year and sales of applications for the pet chew and treats product lines rose from $.05 million in fiscal 2006 to $2.4 million in fiscal 2007.
 
Gross margin improved by $3.7 million in fiscal 2007, due to higher unit selling prices and favorable product mix, offset by a 14% increase in the average unit cost of raw materials. Fiscal 2007 operating income increased 37% over last year on the expansion in gross margin partially offset by $0.5 million in higher employee-related expenses and increased research and development expenses of $0.1 million.
 
 
                 
    Year Ended August 31,  
    2007     2006  
    (Dollars in thousands)  
 
Sales
  $ 105,244     $ 96,121  
Cost of sales
  $ 95,141     $ 87,575  
Gross margin
    9.6 %     8.9 %
Income from operations
  $ 3,269     $ 1,735  
 
The Australian business reported a 9.5% increase in sales in fiscal 2007 over fiscal 2006. Favorable foreign currency rates and favorable unit pricing contributed 730 basis points and 140 basis points, respectively, to the revenue increase. Sales volumes increased less than 1% and sales in local currency increased 2%.
 
Gross margin expanded to 9.6% of sales in fiscal 2007 from 8.9% in fiscal 2006 on lower distribution costs and improved production yields and volumes. Escalating wheat costs of $1.6 million were fully offset by improved product pricing.
 
Total operating expenses for fiscal 2007 were comparable to fiscal 2006, but declined to 4.9% of sales from 5.6% in fiscal 2006. Research and development expenses increased by $0.2 million and, as a percent of sales, were comparable to fiscal 2006 at 1.6%. Increases in these expenses were due to enhancements to the segment’s commercial and research capabilities. Operating expenses in fiscal 2006 included $0.9 million of employee- severance costs.
 
 
Corporate operating expenses increased to $9.6 million in fiscal 2007 from $9.4 million in fiscal 2006. Employee related costs increased by $0.6 million partially offset by declines in legal and professional fees.
 
Fiscal 2006 Compared to Fiscal 2005
 
 
                 
    Year Ended August 31,  
    2006     2005  
    (Dollars in thousands)  
 
Sales
  $ 165,850     $ 147,782  
Cost of sales
  $ 144,656     $ 136,127  
Gross margin
    12.8 %     7.9 %
Income (loss) from operations
  $ 9,121     $ (147 )
 
Industrial Ingredients fiscal 2006 sales of $165.9 million increased $18.1 million, or 12%, over fiscal 2005, primarily driven by a volume increase of 9%. More favorable pricing and product mix contributed 2% of the sales increase for the year.
 
Gross margin increased $9.5 million, or 82%, over fiscal 2005 to $21.2 million, and, as a percent of sales, expanded to 12.8% in fiscal 2006 compared to 7.9% in fiscal 2005. Approximately $8.8 million of the margin growth was due to higher unit pricing, favorable product mix and increases in manufacturing volumes.


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Improvements in energy usage of $2.6 million, favorable corn procurement of $2.2 million and recovery from $4.1 million in incremental strike-related costs incurred during fiscal 2005 also contributed to increased margin. These favorable effects were partially offset by increased unit costs of natural gas and chemicals of $3.2 million and $3.3 million, respectively, as well as $1.2 million in higher distribution expenses.
 
Income from operations for fiscal 2006 increased $9.3 million over fiscal 2005 due to the increase in the gross margin. Operating expenses, which included $0.2 million in severance costs, declined to 5.5% of sales in fiscal 2006, compared to 6.1% of sales in fiscal 2005. Research and development expenses remained comparable to fiscal 2005 at 1.8% of sales.
 
 
                 
    Year Ended August 31,  
    2006     2005  
    (Dollars in thousands)  
 
Sales
  $ 57,156     $ 53,661  
Cost of sales
  $ 41,954     $ 38,964  
Gross margin
    26.6 %     27.4 %
Income from operations
  $ 7,819     $ 7,404  
 
Sales at the Food Ingredients — North America business rose 7% in fiscal 2006 over fiscal 2005, driven by an 8% volume increase. Annual sales volumes in the dairy and protein end markets grew 42% over fiscal 2005. Sales of formulations for potato coatings and sweeteners increased 7% and 18%, respectively. Revenues from nutrition (low-carbohydrate) applications declined by $4.6 million in fiscal 2006.
 
Gross margin as a percent of sales declined by 80 basis points in fiscal 2006 from fiscal 2005, due to the decrease in sales of higher-margin nutrition products and higher chemical and energy costs of $0.7 million. Improved plant utilization from increased production volumes partially offset the unfavorable product mix. Fiscal 2006 operating and research and development expenses increased by $0.1 million and declined to 12.9% of sales compared to 13.6% in fiscal 2005.
 
 
                 
    Year Ended August 31,  
    2006     2005  
    (Dollars in thousands)  
 
Sales
  $ 96,121     $ 96,231  
Cost of sales
  $ 87,575     $ 89,362  
Gross margin
    8.9 %     7.1 %
Income from operations
  $ 1,735     $ 1,331  
 
The Australian business reported sales of $96.1 million in fiscal 2006 compared to $96.2 million in fiscal 2005. A 3% sales volume increase was offset by unfavorable foreign currency exchange rates. Sales in local currencies increased 1% as volume increases were partially offset by lower unit pricing.
 
Gross margin expanded to 8.9% of sales in fiscal 2006 from 7.1% in fiscal 2005 as the Tamworth, Australia facility improved its production yields and plant utilization upon completion of a reconfiguration of its manufacturing processes in fiscal 2005. Lower wheat and New Zealand grain costs also contributed $0.6 million to the gross margin improvements.
 
Operating expenses rose to 5.6% of sales in fiscal 2006 from 4.5% in fiscal 2005 on $0.9 million of employee severance costs incurred during fiscal 2006.
 
 
Corporate operating expenses increased to $9.4 million in fiscal 2006 from $7.6 million in fiscal 2005. The Company expensed $0.7 million in stock-based compensation costs for corporate employees during fiscal 2006


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after adoption of SFAS 123R. Legal and professional fees increased $0.4 million and employee costs, including contributions to the Company’s defined contribution plan, increased $0.5 million.
 
Non-Operating Income (Expense)
 
Other non-operating income consists of the following:
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Royalty and licensing income
  $ 1,902     $ 1,827     $ 1,386  
Gain (loss) on sale of assets
    (325 )     85       64  
Loss on extinguishment of debt
                (1,051 )
Gain on sale of Tamworth farm
    60       78       1,166  
Gain on sale of investment
                736  
Other
    8       (94 )     (92 )
                         
    $ 1,645     $ 1,896     $ 2,209  
                         
 
In fiscal 2003, the Company exclusively licensed to National Starch and Chemical Investment Holdings Corporation (“National Starch”) certain rights to its resistant starch patent portfolio for applications in human nutrition. Under the terms of the licensing agreement, the Company received an initial licensing fee and royalties during the years noted above.
 
In fiscal 2005, the Company refinanced its secured term and revolving credit facilities and wrote off $1.1 million of unamortized debt issuance costs related to this debt.
 
In fiscal 2005, Penford sold a parcel of land near its wheat starch plant in Tamworth, New South Wales, Australia, that was used for disposal of effluent from the Tamworth manufacturing process for $1.9 million, and recognized a gain on the sale of $1.2 million. A second parcel of land was sold in fiscal 2006 with leasebacks to the Company. Gain on the sale is being recognized in income proportionally over the terms of the leases.
 
In fiscal 2005, the Company sold a majority of its investment in a small Australian start-up company and recognized a $0.7 million pre-tax gain on the transaction.
 
Interest expense
 
Interest expense was $5.7 million, $5.9 million and $5.6 million in fiscal years 2007, 2006 and 2005, respectively. Interest expense for fiscal 2007 declined $0.2 million from fiscal 2006 with increases in the interest rates offset by a decline in the applicable interest rate margin pursuant to the credit agreement as a result of improved financial performance by the Company and lower average debt balances, excluding ethanol-related debt borrowings. Approximately $14.5 million of debt outstanding at August 31, 2007 was attributable to the construction of the ethanol production plant. Interest costs of $0.4 million related to construction of the ethanol facility were capitalized in fiscal 2007. Interest expense for fiscal 2006 compared to fiscal 2005 rose on higher short-term interest rates on the Company’s revolving line of credit and short-term borrowings.
 
As of August 31, 2007, all of the Company’s outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, was subject to variable interest rates. As of August 31, 2007, under interest rate swap agreements with several banks, the Company has fixed its interest rates on U.S. dollar denominated term debt of $32.8 million at 4.18% and $4.2 million at 5.08%, plus the applicable margin under the Company’s credit facility.
 
Income taxes
 
The effective tax rates for fiscal years 2007, 2006 and 2005 were 31%, 20% and 209%, respectively. The effective tax rate for fiscal 2007 varied from the U.S. federal statutory rate of 35% primarily due to Australian and U.S. tax incentives related to research and development, the favorable tax effect of domestic (U.S.) production


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activities, and the effect of a tax settlement. The tax benefits previously available to the Company related to the extraterritorial income exclusion expired in December 2006. In May 2007, the Company settled the outstanding Internal Revenue Service (“IRS”) audits of the Company’s U.S. federal income tax returns for the fiscal years ended August 31, 2001 and 2002. Under the settlement, the Company received a cash refund of $0.3 million. In addition, in connection with the settlement of these audits in the third quarter of fiscal 2007, the Company reversed a current tax liability in the amount of $0.7 million, which represented its estimate of the probable loss on certain tax positions being examined.
 
In December 2006, the Tax Relief Healthcare Act of 2006 was enacted in the United States, which retroactively reinstated and extended the research and development tax credit from January 1, 2006 through December 31, 2007. The Company recorded the tax effect of $0.2 million of U.S. research and development tax credits in 2007 related to fiscal 2006.
 
The effective tax rate for fiscal 2006 is lower than the statutory tax rate due to the tax benefits of the extraterritorial income exclusion (“EIE”) deduction, lower tax rates on foreign earnings and research and development tax credits.
 
The tax benefit recognized for fiscal 2005 of $4.9 million included a $2.5 million tax benefit relating to the Company’s incremental EIE deduction on its U.S. federal income tax returns for fiscal years 2001 through 2004. In fiscal 2005, the Company determined that it was probable that the EIE deduction would be sustained under audit by the IRS. See Note 13 to the Consolidated Financial Statements. Other factors affecting the effective tax rate for 2005 were the benefits resulting from the 2005 EIE deduction, research and development tax credits, and lower foreign tax rates.
 
 
The Company’s primary sources of short- and long-term liquidity are cash flow from operations and its five-year revolving line of credit which expires in 2011. The Company expects to generate sufficient cash flow from operations and to have sufficient borrowing capacity and ability to fund its cash requirements during fiscal 2008.
 
Operating Activities
 
At August 31, 2007, Penford had working capital of $39.0 million, and $67.3 million outstanding under its credit facility. Cash flow from operations was $22.5 million, $11.4 million and $21.1 million in fiscal years 2007, 2006 and 2005, respectively. The increase in cash flow in fiscal 2007 compared to fiscal 2006 was due to the growth in earnings in fiscal 2007. The decrease in cash flow from operations in fiscal 2006 compared to fiscal 2005 is due to a change in the Company’s financing of Australian grain purchases from vendor financing to bank financing. See “Financing Activities” below for a discussion of the grain facility in Australia.
 
Penford maintains two defined benefit pension plans in the United States. Rising discount rates have decreased the Company’s underfunded plan status (plan assets compared to benefit obligations). Based on the current underfunded status of the plans and the actuarial assumptions being used for fiscal 2008, Penford estimates that it will be required to make minimum contributions to the pension plans of $1.6 million during fiscal 2008.
 
Investing Activities
 
Capital expenditures were $34.7 million, $14.9 million and $9.4 million in fiscal years 2007, 2006 and 2005, respectively. Capital expenditures in fiscal years 2007 and 2006 include $19.3 million and $0.7 million, respectively, for the ethanol production facility. Penford expects capital expenditures, including $27 million in expenditures for the Company’s ethanol production facility, to be approximately $47 million in fiscal 2008.
 
Financing Activities
 
On October 5, 2006, Penford entered into a $145 million Second Amended and Restated Credit Agreement (the “2007 Agreement”) among the Company; Harris N.A.; LaSalle Bank National Association; Cooperative Centrale Raiffeisen-Boorleenbank B.A., “Rabobank Nederland” (New York Branch); U.S. Bank National Association; and the Australia and New Zealand Banking Group Limited.


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The 2007 Agreement refinanced the Company’s previous $105 million secured term and revolving credit facilities. Under the 2007 Agreement, the Company can borrow $40 million in term loans and $60 million under a revolving line of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. In addition, the 2007 Agreement provided the Company with $45 million in capital expansion funds which are being used by the Company to finance the construction of its planned ethanol production facility in Cedar Rapids, Iowa. The capital expansion funds may be borrowed as term loans from time to time prior to October 5, 2008.
 
The final maturity date for the term and revolving loans under the 2007 Agreement is December 31, 2011. Beginning on December 31, 2006, the Company must repay the term loans in twenty equal quarterly installments of $1 million, with the remaining amount due at final maturity. The final maturity date for the capital expansion loans is December 31, 2012. Beginning on December 31, 2008, the Company must repay the capital expansion loans in equal quarterly installments of $1.25 million through September 30, 2009 and $2.5 million thereafter, with the remaining amount due at final maturity. Interest rates under the 2007 Agreement are based on either LIBOR in Australia or the United States, or the prime rate, depending on the selection of available borrowing options under the 2007 Agreement.
 
The 2007 Agreement provides that the Total Funded Debt Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as defined in the 2007 Agreement), shall not exceed a maximum, which varies between 3.00 and 4.50 through the term of the 2007 Agreement. In addition, the Company must maintain a minimum tangible net worth of $65 million, and a Fixed Charge Coverage Ratio, as defined in the 2007 Agreement, of not more than 1.50 in fiscal 2007, 1.25 in fiscal 2008 and 1.50 in fiscal 2009 and thereafter. Annual capital expenditures, exclusive of capital expenditures incurred in connection with the Company’s ethanol production facility, are limited to $20 million, unless the Company can maintain a Total Funded Debt Ratio below 2.00 for each fiscal quarter during any fiscal year, which would result in the annual capital expenditure limit to increase to $25 million for such fiscal year.
 
The Company’s obligations under the 2007 Agreement are secured by substantially all of the Company’s U.S. assets and a majority of the shares of Penford Holdings Pty. Ltd. (Australia). The Company was in compliance with the covenants in the 2007 Agreement as of August 31, 2007 and expects to be in compliance during fiscal 2008. Pursuant to the terms of the 2007 Agreement, Penford’s additional borrowing ability as of August 31, 2007 was $30.5 million under the capital expansion facility and $44.2 million under the revolving line of credit.
 
The Company’s short-term borrowings consist of an Australian grain inventory financing facility. In fiscal 2006, the Company’s Australian subsidiary entered into a variable-rate revolving grain inventory financing facility with an Australian bank for a maximum of $32.7 million U.S. dollars at the exchange rate at August 31, 2007. This facility expires on March 15, 2008 and carries an effective interest rate equal to BBSY plus approximately 2%. Payments on this facility are due as the grain financed is withdrawn from storage. The amount outstanding under this arrangement, which is classified as a current liability on the balance sheet, was $7.2 million at August 31, 2007.
 
 
In fiscal 2007, Penford paid dividends on its common stock of $2.2 million at a quarterly rate of $0.06 per share. On October 30, 2007, the Board of Directors declared a dividend of $0.06 per common share payable on December 7, 2007 to shareholders of record as of November 16, 2007. On a periodic basis, the Board of Directors reviews the Company’s dividend policy which is affected by the Company’s earnings, financial condition and cash and capital requirements. Future dividend payments are at the discretion of the Board of Directors. Penford has included the continuation of quarterly dividends in its planning for fiscal 2008.
 
Pursuant to the 2007 Agreement, the Company may not declare or pay dividends on, or make any other distributions in respect of, its common stock in excess of $8 million in any fiscal year or if there exists a Default or Event of Default as defined in the 2007 Agreement.
 
 
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


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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. 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.
 
Management has reviewed the accounting policies and related disclosures with the Audit Committee of the Board of Directors. The accounting policies that management believes are the most important to the financial statements and that require the most difficult, subjective and complex judgments include the following:
 
  •  Evaluation of the allowance for doubtful accounts receivable
 
  •  Hedging activities
 
  •  Benefit plans
 
  •  Valuation of goodwill
 
  •  Self-insurance program
 
  •  Income taxes
 
  •  Stock-based compensation
 
A description of each of these follows:
 
Evaluation of the Allowance for Doubtful Accounts Receivable
 
Management makes judgments about the Company’s ability to collect outstanding receivables and provides allowances for the portion of receivables that the Company may not be able to collect. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. If the estimates do not reflect the Company’s future ability to collect outstanding invoices, Penford may experience losses in excess of the reserves established. At August 31, 2007, the allowance for doubtful accounts receivable was $0.8 million.
 
Hedging Activities
 
Penford uses derivative instruments, primarily futures contracts, to reduce exposure to price fluctuations of commodities used in the manufacturing processes in the United States. Penford has elected to designate these activities as hedges. This election allows the Company to defer gains and losses on those derivative instruments until the underlying commodity is used in the production process. To reduce exposure to variable short-term interest rates, Penford uses interest rate swap agreements.
 
The requirements for the designation of hedges are very complex, and require judgments and analyses to qualify as hedges as defined by Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS No. 133”). These judgments and analyses include an assessment that the derivative instruments used are effective hedges of the underlying risks. If the Company were to fail to meet the requirements of SFAS No. 133, or if these derivative instruments are not designated as hedges, the Company would be required to mark these contracts to market at each reporting date. Penford had deferred gains (losses), net of tax, of $(0.6) million and $0.5 million at August 31, 2007 and 2006, respectively, which are reflected in accumulated other comprehensive income in both years. See Note 1 and 2 to the Consolidated Financial Statements.
 
Benefit Plans
 
Penford has defined benefit plans for its U.S. employees providing retirement benefits and coverage for retiree health care. Qualified third-party actuaries assist management in determining the expense and funded status of these


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employee benefit plans. Management makes several estimates and assumptions in order to measure the expense and funded status, including interest rates used to discount certain liabilities, rates of return on plan assets, rates of compensation increases, employee turnover rates, anticipated mortality rates, and increases in the cost of medical care. The Company makes judgments about these assumptions based on historical investment results and experience as well as available historical market data and trends. However, if these assumptions are wrong, it could materially affect the amounts reported in the Company’s future results of operations. Disclosure about these estimates and assumptions are included in Note 10 to the Consolidated Financial Statements. See “Defined Benefit Plans” below.
 
Valuation of Goodwill
 
Penford is required to assess, on an annual basis, whether the value of goodwill reported on the balance sheet has been impaired, or more often if conditions exist that indicate that there might be an impairment. These assessments require extensive and subjective judgments to assess the fair value of goodwill. While the Company engages qualified valuation experts to assist in this process, their work is based on the Company’s estimates of future operating results and allocation of goodwill to the business units. If future operating results differ materially from the estimates, the value of goodwill could be adversely impacted. See Note 4 to the Consolidated Financial Statements.
 
Self-insurance Program
 
The Company maintains a self-insurance program covering portions of workers’ compensation and group health liability costs. The amounts in excess of the self-insured levels are fully insured by third-party insurers. Liabilities associated with these risks are estimated in part by considering historical claims experience, severity factors and other actuarial assumptions. Projections of future losses are inherently uncertain because of the random nature of insurance claims occurrences and changes that could occur in actuarial assumptions. The financial results of the Company could be significantly affected if future claims and assumptions differ from those used in determining these liabilities.
 
Income Taxes
 
The determination of the Company’s provision for income taxes requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. The Company’s provision for income taxes reflects a combination of income earned and taxed in the various U.S. federal and state, as well as Australian and New Zealand, taxing jurisdictions. Jurisdictional tax law changes, increases or decreases in permanent differences between book and tax items, accruals or adjustments of accruals for tax contingencies or valuation allowances, and the Company’s change in the mix of earnings from these taxing jurisdictions all affect the overall effective tax rate.
 
In evaluating the exposures connected with the various tax filing positions, the Company establishes an accrual, when, despite management’s belief that the Company’s tax return positions are supportable, management believes that certain positions may be successfully challenged and a loss is probable. When facts and circumstances change, these accruals are adjusted. Beginning in fiscal 2008, the Company will be required to adopt Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN 48”), which will change the accounting for tax positions. See discussion in Note 1 to the Consolidated Financial Statements.
 
Stock-Based Compensation
 
Beginning September 1, 2005, the Company recognizes stock-based compensation in accordance with SFAS No. 123R. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period of the award. Determining the appropriate fair value model and calculating the fair value of the share-based awards at the date of grant requires judgment, including estimating stock price volatility, forfeiture rates, the risk-free interest rate, dividends and expected option life. See Note 9 to the Consolidated Financial Statements.


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If circumstances change, and the Company uses different assumptions for volatility, interest, dividends and option life in estimating the fair value of stock-based awards granted in future periods, stock-based compensation expense may differ significantly from the expense recorded in the current period. SFAS No. 123R requires forfeitures to be estimated at the date of grant and revised in subsequent periods if actual forfeitures differ from those estimated. Therefore, if actual forfeiture rates differ significantly from those estimated, the Company’s results of operations could be materially impacted.
 
 
As more fully described in Notes 5 and 8 to the Consolidated Financial Statements, the Company is a party to various debt and lease agreements at August 31, 2007 that contractually commit the Company to pay certain amounts in the future. The purchase obligations at August 31, 2007 represent an estimate of all open purchase orders and contractual obligations through the Company’s normal course of business for commitments to purchase goods and services for production and inventory needs, such as raw materials, supplies, manufacturing arrangements, capital expenditures and maintenance. The majority of terms allow the Company or suppliers the option to cancel or adjust the requirements based on business needs.
 
The following table summarizes such contractual commitments at August 31, 2007 (in thousands):
 
                                         
    2008     2009-2010     2011-2012     2013 & After     Total  
 
Long-term Debt and Capital Lease Obligations
  $ 4,056     $ 20,597     $ 42,806     $     $ 67,459  
Short-term Borrowings
    7,218                         7,218  
Postretirement medical(1)
    596       1,353       1,495       4,649       8,093  
Operating Lease Obligations
    6,602       10,957       5,262       4,408       27,229  
Purchase Obligations
    101,574       2,642                   104,216  
                                         
    $ 120,046     $ 35,549     $ 49,563     $ 9,057     $ 214,215  
                                         
 
 
(1) Estimated contributions to the unfunded postretirement medical plan made in amounts needed to fund benefit payments for participants through fiscal 2017 based on actuarial assumptions.
 
Off-Balance Sheet Arrangements
 
The Company has no off-balance sheet arrangements.
 
 
Penford maintains defined benefit pension plans and defined benefit postretirement health care plans in the United States.
 
The most significant assumptions used to determine benefit expense and benefit obligations are the discount rate and the expected return on assets assumption. See Note 10 to the Consolidated Financial Statements for the assumptions used by Penford.
 
The discount rate used by the Company in determining benefit expense and benefit obligations reflects the yield of high quality (AA or better rating by a recognized rating agency) corporate bonds whose cash flows are expected to match the timing and amounts of projected future benefit payments. Benefit obligations and expense increase as the discount rate is reduced. The discount rates to determine net periodic expense used in 2005 (6.25%), 2006 (5.50%) and 2007 (6.15%) reflect the changes in bond yields over the past several years. Lowering the discount rate by 25 basis points would increase pension expense by approximately $0.1 million and other postretirement benefit expense by $0.01 million. During fiscal 2007, bond yields rose and Penford has increased the discount rate for calculating its benefit obligations at August 31, 2007, as well as net periodic expense for fiscal 2008, to 6.51%.
 
The expected long-term return on assets assumption for the pension plans represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. Pension


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expense increases as the expected return on plan assets decreases. In developing the expected rate of return, the Company considers long-term historical market rates of return as well as actual returns on the Company’s plan assets, and adjusts this information to reflect expected capital market trends. Penford also considers forward looking return expectations by asset class, the contribution of active management and management fees paid by the plans. The plan assets are held in qualified trusts and anticipated rates of return are not reduced for income taxes. The expected long-term return on assets assumption used to calculate net periodic pension expense was 8.0% for fiscal 2007. A 50 basis points decrease (increase) in the expected return on assets assumptions would increase (decrease) pension expense by approximately $0.2 million based on plan assets at August 31, 2007. The expected return on plan assets used in calculating fiscal 2008 pension expense is 8%.
 
Unrecognized net loss amounts reflect the difference between expected and actual returns on pension plan assets as well as the effects of changes in actuarial assumptions. Unrecognized net losses in excess of certain thresholds are amortized into net periodic pension and postretirement benefit expense over the average remaining service life of active employees. As of August 31, 2007, unrecognized losses from all sources are $3.7 million for the pension plans and $0.6 million for the postretirement health care plan. Amortization of unrecognized net loss amounts is expected to increase net pension expense by approximately $0.05 million in fiscal 2008. Amortization of unrecognized net losses is not expected to affect the net postretirement health care expense in fiscal 2008.
 
Penford recognized pension expense of $1.7 million, $2.4 million and $1.9 million in fiscal years 2007, 2006 and 2005, respectively. Penford expects pension expense to be approximately $1.6 million in fiscal 2008. The Company contributed $1.0 million, $3.3 million and $3.6 million to the pension plans in fiscal years 2007, 2006 and 2005, respectively. Penford estimates that it will be required to make minimum contributions to the pension plans of $1.6 million during fiscal 2008.
 
The Company recognized benefit expense for its postretirement health care plan of $1.0 million, $1.2 million and $1.0 million in fiscal years 2007, 2006 and 2005, respectively. Penford expects to recognize approximately $1.0 million in postretirement health care benefit expense in fiscal 2008. The Company contributed $0.6 million, $0.7 million, and $0.5 million in fiscal years 2007, 2006 and 2005 to the postretirement health care plans and estimates that it will contribute $0.6 million in fiscal 2008.
 
Future changes in plan asset returns, assumed discount rates and various assumptions related to the participants in the defined benefit plans will affect future benefit expense and liabilities. The Company cannot predict what these changes will be.
 
 
In June 2006, the Financial Accounting Standards Board (“FASB”) ratified the Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for years beginning after December 15, 2006. The Company is evaluating the impact that the adoption of EITF Issue No. 06-2 will have on its consolidated financial statements and currently does not believe the adoption will have a material impact on its consolidated financial statements.
 
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for the uncertainty in income taxes recognized by prescribing a recognition threshold that a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, interim period accounting and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is evaluating the impact that the adoption of FIN 48 will have on its consolidated financial statements and currently does not believe the adoption will have a material impact on its consolidated financial statements.
 
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after


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November 15, 2007 (fiscal 2009). The Company is currently evaluating the impact that the adoption of SFAS 157 may have on its consolidated financial statements.
 
In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB No. 115” (“SFAS 159”). SFAS 159 allows companies the option to measure financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS 159 is effective for fiscal years beginning after November 15, 2007 (fiscal 2009). The Company is currently evaluating the impact that the adoption of SFAS 159 may have on its consolidated financial statements.
 
Item 7A:   Quantitative and Qualitative Disclosures About Market Risk
 
 
Penford is exposed to market risks that are inherent in the financial instruments that are used in the normal course of business. Penford may use various hedge instruments to manage or reduce market risk, but the Company does not use derivative financial instrument transactions for speculative purposes. The primary market risks are discussed below.
 
 
The Company’s exposure to market risk for changes in interest rates relates to its variable-rate borrowings. As of August 31, 2007, all of the Company’s outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, is subject to variable interest rates, which are generally set for one or three months. Under interest rate swap agreements with several banks, the Company has fixed its interest rates on U.S. dollar denominated term debt of $32.8 million at 4.18% and $4.2 million at 5.08%, plus the applicable margin under the Company’s credit facility. The market risk associated with a 100 basis point adverse change in interest rates at August 31, 2007 is approximately $0.4 million.
 
 
The Company has U.S.-Australian and Australian-New Zealand dollar currency exchange rate risks due to revenues and costs denominated in Australian and New Zealand dollars with the Company’s foreign operation, Penford Australia. Currently, cash generated by Penford Australia’s operations is used for capital investment in Australia and payment of debt denominated in Australian dollars. At August 31, 2007, approximately 21% of total debt was denominated in Australian dollars.
 
The Company has not maintained any derivative instruments to mitigate the U.S.-Australian dollar currency exchange translation exposure. This position is reviewed periodically, and based on the Company’s review, may result in the incorporation of derivative instruments in the Company’s hedging strategy. The currency exchange rate risk between Penford’s Australian and New Zealand operations is not significant. For the year ended August 31, 2007, a 10% change in the foreign currency exchange rates compared with the U.S. dollar would have affected fiscal 2007 reported net income by approximately $0.2 million.
 
From time to time, Penford enters into foreign exchange forward contracts to manage exposure to receivables and payables denominated in currencies different from the functional currencies of the selling entities. As of August 31, 2007 and 2006, Penford did not have any foreign exchange forward contracts outstanding. At August 31, 2007, the Company had U.S. dollar denominated trade receivables of $1.9 million at Penford Australia.
 
 
The availability and price of corn, Penford’s most significant raw material, is subject to fluctuations due to unpredictable factors such as weather, plantings, domestic and foreign governmental farm programs and policies, changes in global demand and the worldwide production of corn. To reduce the price risk caused by market fluctuations, Penford generally follows a policy of using exchange-traded futures and options contracts to hedge exposure to corn price fluctuations in North America. These futures and options contracts are designated as hedges. The changes in market value of these contracts have historically been, and are expected to continue to be, highly


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effective in offsetting the price changes in corn. A majority of the Company’s sales contracts for corn-based industrial starch ingredients contain a pricing methodology which allows the Company to pass-through the majority of the changes in the commodity price of net corn.
 
Penford’s net corn position in the U.S. consists primarily of inventories, purchase contracts and exchange-traded futures and options contracts that hedge Penford’s exposure to commodity price fluctuations. The fair value of the position is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2007 and 2006, the fair value of the Company’s net corn position was approximately $1.0 million and $0.02 million, respectively. The market risk associated with a 10% adverse change in corn prices at August 31, 2007 and 2006 is estimated at $104,000 and $2,000, respectively.
 
Over the past years, prices for natural gas have increased over historic levels. 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 sudden market fluctuations, Penford generally enters into short-term purchase contracts or uses exchange-traded futures and options contracts to hedge exposure to natural gas price fluctuations. These futures and options contracts are designated as hedges. The changes in market value of these contracts have historically been, and are expected to continue to be, closely correlated with the price changes in natural gas.
 
Penford’s exchange traded futures and options contracts hedge production requirements. The fair value of these contracts is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2007 and 2006, the fair value of the natural gas exchange-traded futures and options contracts was a loss of approximately $1.9 million and a loss of approximately $0.3 million, respectively. The market risk associated with a 10% adverse change in natural gas prices at August 31, 2007 and 2006 is estimated at $188,000 and $27,000, respectively.


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Item 8:   Financial Statements and Supplementary Data
 
TABLE OF CONTENTS
 
         
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Consolidated Balance Sheets
 
                 
    August 31,  
    2007     2006  
    (Dollars in thousands)  
 
ASSETS
Current assets:
               
Cash
  $     $ 939  
Trade accounts receivable, net
    54,333       44,593  
Inventories
    39,537       34,953  
Prepaid expenses
    5,025       4,649  
Other
    6,384       4,782  
                 
Total current assets
    105,279       89,916  
Property, plant and equipment, net
    146,663       124,829  
Restricted cash value of life insurance
    10,366       10,278  
Other assets
    1,725       989  
Other intangible assets, net
    878       2,785  
Goodwill, net
    23,477       21,871  
                 
Total assets
  $ 288,388     $ 250,668  
                 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
               
Cash overdraft, net
  $ 5,468     $ 961  
Current portion of long-term debt and capital lease obligations
    4,056       4,295  
Short-term borrowings
    7,218       9,541  
Accounts payable
    32,410       31,686  
Accrued liabilities
    17,094       11,360  
                 
Total current liabilities
    66,246       57,843  
Long-term debt and capital lease obligations
    63,403       53,171  
Other postretirement benefits
    12,814       13,606  
Deferred income taxes
    3,140       5,924  
Other liabilities
    17,109       12,672  
                 
Total liabilities
    162,712       143,216  
Commitments and contingencies (Notes 8 and 17)
               
Shareholders’ equity:
               
Preferred stock, par value $1.00 per share, authorized 1,000,000 shares, none issued
           
Common stock, par value $1.00 per share, authorized 29,000,000 shares, issued 11,098,739 shares in 2007 and 10,909,153 shares , including treasury shares
    11,099       10,909  
Additional paid-in capital
    43,902       39,427  
Retained earnings
    89,486       78,131  
Treasury stock, at cost, 1,981,016 shares
    (32,757 )     (32,757 )
Accumulated other comprehensive income
    13,946       11,742  
                 
Total shareholders’ equity
    125,676       107,452  
                 
Total liabilities and shareholders’ equity
  $ 288,388     $ 250,668  
                 
 
The accompanying notes are an integral part of these statements.


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Consolidated Statements of Operations
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands, except per share data)  
 
Sales
  $ 362,364     $ 318,419     $ 296,763  
Cost of sales
    298,203       273,476       263,542  
                         
Gross margin
    64,161       44,943       33,221  
Operating expenses
    31,391       29,477       26,413  
Research and development expenses
    6,812       6,198       5,796  
Other costs
    2,400              
                         
Income from operations
    23,558       9,268       1,012  
Interest expense
    5,711       5,902       5,574  
Other non-operating income, net
    1,645       1,896       2,209  
                         
Income (loss) before income taxes
    19,492       5,262       (2,353 )
Income tax expense (benefit)
    5,975       1,034       (4,927 )
                         
Net income
  $ 13,517     $ 4,228     $ 2,574  
                         
Weighted average common shares and equivalents outstanding, assuming dilution
    9,283,125       9,004,190       8,946,195  
                         
Earnings per common share:
                       
Basic
  $ 1.50     $ 0.48     $ 0.29  
                         
Diluted
  $ 1.46     $ 0.47     $ 0.29  
                         
Dividends declared per common share
  $ 0.24     $ 0.24     $ 0.24  
                         
 
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Net income
  $ 13,517     $ 4,228     $ 2,574  
                         
Other comprehensive income (loss):
                       
Change in fair value of derivatives, net of tax benefit (expense) of $1,619, $(271) and $156
    (2,641 )     492       (303 )
Loss (gain) from derivative transactions reclassified into earnings from other comprehensive income, net of tax benefit (expense) of $950, $(152) and $350
    1,550       (294 )     679  
Foreign currency translation adjustments
    4,690       536       3,271  
(Increase) decrease in post retirement liabilities, net of applicable income tax benefit (expense) of $(864), $(1,530) and $365
    1,409       2,842       (677 )
                         
Other comprehensive income
    5,008       3,576       2,970  
                         
Total comprehensive income
  $ 18,525     $ 7,804     $ 5,544  
                         
 
The accompanying notes are an integral part of these statements.


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Consolidated Statements of Cash Flows
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Operating activities:
                       
Net income
  $ 13,517     $ 4,228     $ 2,574  
Adjustments to reconcile net income to net cash from operations:
                       
Depreciation and amortization
    15,696       15,583       17,025  
Stock-based compensation
    1,092       1,150       91  
Loss (gain) on sale of assets
    325       (85 )     (64 )
Loss on early extinguishment of debt
                1,051  
Gain on sale of investment
                (736 )
Gain on sale of land
    (60 )     (78 )     (1,166 )
Deferred income tax benefit
    (1,771 )     (293 )     (5,410 )
Loss (gain) on derivative transactions
    (946 )     40       (300 )
Excess tax benefit from stock-based compensation
    (1,001 )     (102 )      
Other
    95       38       (67 )
Change in operating assets and liabilities:
                       
Trade receivables
    (8,537 )     (4,836 )     (122 )
Inventories
    (3,136 )     (692 )     (1,177 )
Prepaid expenses
    (339 )     449       (914 )
Accounts payable and accrued liabilities
    3,148       (4,944 )     12,102  
Taxes payable
    3,334       (215 )     (2,594 )
Other
    1,112       1,142       763  
                         
Net cash flow from operating activities
    22,529       11,385       21,056  
                         
Investing activities:
                       
Acquisitions of property, plant and equipment, net
    (34,734 )     (14,905 )     (9,413 )
Proceeds from investments
                3,525  
Proceeds from sale of land
          612       1,870  
Other
    (44 )     (80 )     (150 )
                         
Net cash used by investing activities
    (34,778 )     (14,373 )     (4,168 )
                         
Financing activities:
                       
Proceeds from short-term borrowings
    4,625       13,916        
Payments on short-term borrowings
    (7,548 )     (4,744 )      
Proceeds from revolving line of credit
    54,454       22,920       57,830  
Payments on revolving line of credit
    (45,255 )     (27,907 )     (48,177 )
Proceeds from long-term debt
    4,200             22,396  
Payments on long-term debt
    (4,249 )     (3,980 )     (47,867 )
Exercise of stock options
    2,572       508       682  
Payment of loan fees
    (836 )     (224 )     (905 )
Excess tax benefit from stock-based compensation
    1,001       102        
Increase in cash overdraft. 
    4,507       184       776  
Payment of dividends
    (2,163 )     (2,132 )     (2,117 )
Other
    (59 )     (32 )     (8 )
                         
Net cash from (used by) financing activities
    11,249       (1,389 )     (17,390 )
                         
Effect of exchange rate changes on cash and cash equivalents
    61       (51 )     (46 )
                         
Net decrease in cash and cash equivalents
    (939 )     (4,428 )     (548 )
Cash and cash equivalents, beginning of year
    939       5,367       5,915  
                         
Cash and cash equivalents, end of year
  $     $ 939     $ 5,367  
                         
Supplemental disclosure of cash flow information
                       
Cash paid during the year for:
                       
Interest
  $ 5,645     $ 5,240     $ 4,754  
Income taxes, net
  $ 5,257     $ 1,342     $ 563  
Noncash investing and financing activities:
                       
Capital lease obligations incurred for certain equipment leases
  $ 72     $ 102     $ 85  
 
The accompanying notes are an integral part of these statements.


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Consolidated Statements of Shareholders’ Equity
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Common stock
                       
Balance, beginning of year
  $ 10,909     $ 10,849     $ 10,784  
Exercise of stock options
    190       51       65  
Issuance of restricted stock, net
          9        
                         
Balance, end of year
    11,099       10,909       10,849  
                         
Additional paid-in capital
                       
Balance, beginning of year
    39,427       37,728       36,911  
Exercise of stock options
    2,382       457       617  
Tax benefit of stock option exercises
    1,001       101       109  
Stock based compensation
    1,050       1,150       91  
Issuance of restricted stock, net
    42       (9 )      
                         
Balance, end of year
    43,902       39,427       37,728  
                         
Retained earnings
                       
Balance, beginning of year
    78,131       76,040       75,585  
Net income
    13,517       4,228       2,574  
Dividends declared
    (2,162 )     (2,137 )     (2,119 )
                         
Balance, end of year
    89,486       78,131       76,040  
                         
Treasury stock
    (32,757 )     (32,757 )     (32,757 )
                         
Accumulated other comprehensive income (loss):
                       
Balance, beginning of year
    11,742       8,166       5,196  
Change in fair value of derivatives, net of tax
    (2,641 )     492       (303 )
Loss (gain) from derivative transactions reclassified into earnings from other comprehensive income, net of tax
    1,550       (294 )     679  
Foreign currency translation adjustments
    4,690       536       3,271  
(Increase) decrease in postretirement liabilities, net of tax
    1,409       2,842       (677 )
Adoption of SFAS No. 158 recognition provision, net of tax
    (2,804 )            
                         
Balance, end of year
    13,946       11,742       8,166  
                         
Total shareholders’ equity
  $ 125,676     $ 107,452     $ 100,026  
                         
 
The accompanying notes are an integral part of these statements.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
Note 1 — Summary of Significant Accounting Policies
 
 
Penford Corporation (“Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for industrial and food ingredient applications. The Company operates manufacturing facilities in the United States, Australia and New Zealand. Penford’s products provide 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 extensive research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and in developing applications to address customer needs. In addition, the Company has specialty processing capabilities for a variety of modified starches.
 
Penford manages its business in three segments. The first two, Industrial Ingredients and Food Ingredients are broad categories of end-market users, primarily served by the U.S. operations. The third segment is the geographically separate operations in Australia and New Zealand. The Australian and New Zealand operations are engaged primarily in the food ingredients business.
 
 
The accompanying consolidated financial statements include the accounts of Penford and its wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated. Certain reclassifications have been made to prior years’ financial statements in order to conform to the current year presentation.
 
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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, the determination of assumptions for pension and postretirement employee benefit costs, and the useful lives of property and equipment. Actual results may differ from previously estimated amounts.
 
 
Cash and cash equivalents consist of cash and temporary investments with maturities of less than three months when purchased. Amounts are reported in the balance sheets at cost, which approximates fair value.
 
 
The allowance for doubtful accounts reflects the Company’s best estimate of probable losses in the accounts receivable balances. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. Activity in the allowance for doubtful accounts for fiscal 2007, 2006 and 2005 is as follows (dollars in thousands):
 
                                 
    Balance
    Charged to
             
    Beginning of
    Costs and
    Deductions
    Balance
 
    Year     Expenses     and Other     End of Year  
 
Year ended August 31:
                               
2007
  $ 851     $ 379     $ 475     $ 755  
2006
  $ 401     $ 359     $ (91 )   $ 851  
2005
  $ 364     $ 196     $ 159     $ 401  


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
In fiscal 2006, the increase in the allowance for doubtful accounts reflects an additional reserve of approximately $0.5 million for a bankrupt customer in the industrial ingredients segment.
 
In fiscal 2007, approximately $0.5 million was wrote-off from allowance for doubtful accounts related to an uncollectible receivable of bankrupt customer in the industrial ingredients segment.
 
Approximately half of the Company’s sales in fiscal 2007, 2006 and 2005 were made to customers who operate in the North American paper industry. This industry has suffered an economic downturn, which has resulted in the closure of a number of smaller mills.
 
 
The carrying value of financial instruments including cash and cash equivalents, receivables, payables and accrued liabilities approximates fair value because of their short maturities. The Company’s bank debt re-prices with changes in market interest rates and, accordingly, the carrying amount of such debt approximates fair value.
 
 
Inventory is stated at the lower of cost or market. Inventory is valued using the first-in, first-out (“FIFO”) method, which approximates actual cost. Capitalized costs include materials, labor and manufacturing overhead related to the purchase and production of inventories.
 
 
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized, but instead is tested for impairment at least annually or more frequently if there is an indication of impairment.
 
Patents are amortized using the straight-line method over their estimated period of benefit. At August 31, 2007, the weighted average remaining amortization period for patents is seven years. Penford has no intangible assets with indefinite lives.
 
 
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 expense assuming average useful lives of three to forty years for financial reporting purposes. Depreciation of $15,376,000, $15,527,000 and $16,326,000 was recorded in fiscal years 2007, 2006 and 2005, respectively. For income tax purposes, the Company generally uses accelerated depreciation methods.
 
Interest is capitalized on major construction projects while in progress. In fiscal 2007, the Company capitalized $0.4 million in interest costs related to the ethanol facility construction. No interest was capitalized in fiscal 2006 and 2005.
 
 
The provision for income taxes includes federal, state, and foreign taxes currently payable and deferred income taxes arising from temporary differences between financial and income tax reporting methods. Deferred taxes are recorded using the liability method in recognition of these temporary differences. Deferred taxes are not recognized on temporary differences from undistributed earnings of foreign subsidiaries, as these earnings are deemed to be permanently reinvested.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
Revenue from sales of products and shipping and handling revenue are recognized at the time goods are shipped, and title transfers to the customer. Costs associated with shipping and handling are included in cost of sales.
 
 
Research and development costs are expensed as incurred, except for costs of patents, which are capitalized and amortized over the lives of the patents. Research and development costs expensed were $6.8 million, $6.2 million and $5.8 million in fiscal 2007, 2006 and 2005, respectively. Patent costs of $48,000, $134,000 and $19,000 were capitalized in fiscal years 2007, 2006 and 2005, respectively.
 
 
Assets and liabilities of subsidiaries whose functional currency is deemed to be other than the U.S. dollar are translated at year end rates of exchange. Resulting translation adjustments are accumulated in the currency translation adjustments component of other comprehensive income. Income statement amounts are translated at average exchange rates prevailing during the year. For fiscal years 2007 and 2006, the net foreign currency transaction gain (loss) recognized in earnings was not material.
 
 
Penford uses derivative instruments to manage the exposures associated with commodity prices, interest rates and energy costs. The derivative instruments are marked-to-market and any resulting unrealized gains and losses, representing the fair value of the derivative instruments, are recorded in other current assets or accounts payable in the consolidated balance sheets. The fair value of derivative instruments included in other current assets at August 31, 2007 was $(0.6) million.
 
For derivative instruments designated as fair value hedges, the gain or loss on the derivative instruments as well as the offsetting loss or gain on the hedged firm commitments are recognized in current earnings as a component of cost of goods sold. At August 31, 2007, derivative instruments designated as fair value hedges are not material. 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, 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 goods sold in the period when the finished goods produced from the hedged item are sold or, for interest rate swaps, as a component of interest expense in the period the forecasted transaction is reported in earnings. If it is determined that the derivative instruments used are no longer effective at offsetting changes in the price of the hedged item, then the changes in market value would be recognized in current earnings as a component of cost of good sold or interest expense. There was no ineffectiveness related to the Company’s hedging activities related to interest rate swaps. At August 31, 2007, the amount in other comprehensive income related to derivative transactions which the Company expects to recognize in earnings in fiscal 2008 is not material.
 
 
The Company has several relatively large customers in each business segment. None of the Company’s customers constituted 10% of sales in fiscal 2006 and 2005. However, for fiscal 2007, the Company’s largest customer, Domtar, Inc., represented approximately 12% of the Company’s consolidated net sales. Domtar, Inc. is a customer of the Company’s Industrial Ingredients — North America business. Export sales accounted for approximately 15%, 13% and 16% of consolidated sales in fiscal 2007, 2006 and 2005, respectively.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
Beginning September 1, 2005, the Company began to recognize stock-based compensation in accordance with SFAS No. 123R, “Share-Based Payment.” The Company utilizes the Black-Scholes option-pricing model to determine the fair value of stock options on the date of grant. This model derives the fair value of stock options based on certain assumptions related to expected stock price volatility, expected option life, risk-free interest rate and dividend yield. See Note 9 for further detail.
 
 
In June 2006, the Financial Accounting Standards Board (“FASB”) ratified the Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for years beginning after December 15, 2006. The Company is evaluating the impact that the adoption of EITF Issue No. 06-2 will have on its consolidated financial statements and currently does not believe adoption will have a material impact on its consolidated financial statements.
 
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for the uncertainty in income taxes recognized by prescribing a recognition threshold that a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, interim period accounting and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is evaluating the impact that the adoption of FIN 48 will have on its consolidated financial statements and currently does not believe adoption will have a material impact on its consolidated financial statements
 
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 (fiscal 2009). The Company is currently evaluating the impact that the adoption of SFAS 157 may have on its consolidated financial statements.
 
In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB No. 115” (“SFAS 159”). SFAS 159 allows companies the option to measure financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS 159 is effective for fiscal years beginning after November 15, 2007 (fiscal 2009). The Company is currently evaluating the impact that the adoption of SFAS 159 may have on its consolidated financial statements.
 
Note 2 — Inventories
 
Components of inventory are as follows:
 
                 
    August 31,  
    2007     2006  
    (Dollars in thousands)  
 
Raw materials
  $ 17,438     $ 18,531  
Work in progress
    720       449  
Finished goods
    21,379       15,973  
                 
Total inventories
  $ 39,537     $ 34,953  
                 
 
To reduce the price volatility of corn used in fulfilling some of its starch sales contracts, Penford, from time to time, uses readily marketable exchange-traded futures as well as forward cash corn purchases. The exchange-traded


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
futures are not purchased or sold for trading or speculative purposes and are designated as hedges. As of August 31, 2007, Penford had purchased corn positions of 6.4 million bushels, of which 6.1 million bushels represented equivalent firm priced starch sales contract volume, resulting in an open position of 0.3 million bushels. The changes in market value of such contracts have historically been, and are expected to continue to be, effective in offsetting the price changes of the hedged commodity. Penford also at times uses exchange-traded futures to hedge corn inventories. Hedges are designated as cash flow hedges at the time the transaction is established and are recognized in earnings in the time period for which the hedge was established. Hedged transactions are within 12 months of the time the hedge is established. The amount of ineffectiveness related to the Company’s hedging activities was not material.
 
Note 3 — Property and equipment
 
Components of property and equipment are as follows:
 
                 
    August 31,  
    2007     2006  
    (Dollars in thousands)  
 
Land
  $ 17,694     $ 16,659  
Plant and equipment
    338,496       322,169  
Construction in progress
    27,433       7,078  
                 
      383,623       345,906  
Accumulated depreciation
    (236,960 )     (221,077 )
                 
Net property and equipment
  $ 146,663     $ 124,829  
                 
 
The above table includes approximately $0.2 million and $0.1 million of equipment under capital leases for fiscal years 2007 and 2006, respectively. Changes in Australian and New Zealand currency exchange rates have increased net property, plant and equipment in fiscal 2007 by approximately $2.9 million.
 
For fiscal 2007, the Company had $19.3 million of capital expenditures related to construction of the ethanol facility. As of August 31, 2007, the Company had a total of $20.0 million in capital expenditures related to the ethanol facility which includes $0.4 million in related capitalized interest costs.
 
Note 4 — Goodwill and other intangible assets
 
Goodwill represents the excess of acquisition costs over the fair value of the net assets of Penford Australia, which was acquired on September 29, 2000. The Company evaluates annually, or more frequently if certain indicators are present, the carrying value of its goodwill under provisions of SFAS No. 142.
 
In accordance with this standard, Penford does not amortize goodwill. The Company completed the annual update as of June 1, 2007 and determined there was no impairment to the recorded value of goodwill. In order to identify potential impairments, Penford compared the fair value of each of its reporting units with its carrying amount, including goodwill. Penford then compared the implied fair value of its reporting units’ goodwill with the carrying amount of that goodwill. The implied fair value of the reporting units was determined using primarily discounted cash flows. This testing was performed on Penford’s Food Ingredients — North America and the Australia/New Zealand operations reporting units, which are the same as two of the Company’s business segments. Since there was no indication of impairment, Penford was not required to complete the second step of the process which would measure the amount of any impairment. On a prospective basis, the Company is required to continue to test its goodwill for impairment on an annual basis, or more frequently if certain indicators arise.
 
The Company’s goodwill of $23.5 million and $21.9 million at August 31, 2007 and 2006, respectively, represents the excess of acquisition costs over the fair value of the net assets of Penford Australia. The increase in the carrying value of goodwill since August 31, 2006 reflects the impact of exchange rate fluctuations between the Australian and U.S. dollar on the translation of this asset.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Penford’s intangible assets consist of patents which are being amortized over the weighted average remaining amortization period of seven years as of August 31, 2007. There is no residual value associated with patents. The carrying amount and accumulated amortization of intangible assets are as follows (dollars in thousands):
 
                                 
    August 31,
    August 31,
 
    2007     2006  
    Carrying
    Accumulated
    Carrying
    Accumulated
 
    Amount     Amortization     Amount     Amortization  
 
Intangible assets:
                               
Patents
  $ 2,239     $ 1,361     $ 2,162     $ 1,217  
Intangible pension asset(1)
                1,840        
                                 
    $ 2,239     $ 1,361     $ 4,002     $ 1,217  
                                 
 
 
(1) Not covered by the scope of SFAS No. 142
 
Amortization expense related to intangible assets was $0.1 million in each of fiscal years 2007, 2006 and 2005. The estimated aggregate annual amortization expense for patents is approximately $0.1 million for each of the next five fiscal years, 2008 through 2012.
 
Note 5 — Debt
 
                 
    August 31,  
    2007     2006  
    (Dollars in thousands)  
 
Secured credit agreements — revolving loans, 7.37% weighted average interest rate at August 31, 2007
  $ 15,800     $ 11,188  
Secured credit agreements — term loans, 6.97% weighted average interest rate at August 31, 2007
    37,000       46,133  
Secured credit agreements — capital expansion loans, 6.82% weighted average interest rate at August 31, 2007
    14,500        
Grain inventory financing facility — revolving loan, 8.19% weighted average interest rate at August 31, 2007
    7,218       9,541  
Capital lease obligations
    159       145  
                 
      74,677       67,007  
Less: current portion and short-term borrowings
    11,274       13,836  
                 
Long-term debt
  $ 63,403     $ 53,171  
                 
 
On October 5, 2006, Penford entered into a $145 million Second Amended and Restated Credit Agreement (the “2007 Agreement”) among the Company; Harris N.A.; LaSalle Bank National Association; Cooperative Centrale Raiffeisen-Boorleenbank B.A., “Rabobank Nederland” (New York Branch); U.S. Bank National Association; and the Australia and New Zealand Banking Group Limited.
 
The 2007 Agreement refinances the Company’s previous $105 million secured term and revolving credit facilities. Under the 2007 Agreement, the Company may borrow $40 million in term loans and $60 million in revolving lines of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. In addition, the 2007 Agreement provides the Company with $45 million in new capital expansion funds which may be used by the Company to finance the construction of its planned ethanol production facility in Cedar Rapids, Iowa. The capital expansion funds may be borrowed as term loans from time to time prior to October 5, 2008.
 
The final maturity date for the term and revolving loans under the 2007 Agreement is December 31, 2011. Beginning on December 31, 2006, the Company must repay the term loans in twenty equal quarterly installments of $1 million, with the remaining amount due at final maturity. The final maturity date for the capital expansion loans


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
is December 31, 2012. Beginning on December 31, 2008, the Company must repay the capital expansion loans in equal quarterly installments of $1.25 million through September 30, 2009 and $2.5 million thereafter, with the remaining amount due at final maturity. Interest rates under the 2007 Agreement are based on either the London Interbank Offering Rates (“LIBOR”) in Australia or the United States, or the prime rate, depending on the selection of available borrowing options under the 2007 Agreement.
 
The Agreement provides that the Total Funded Debt Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as defined in the 2007 Agreement) shall not exceed 3.25 through November 30, 2006. Subsequent to November 30, 2006, the maximum Total Funded Debt Ratio varies between 3.00 and 4.50. In addition, the Company must maintain a minimum tangible net worth of $65 million, and a Fixed Charge Coverage Ratio, as defined in the 2007 Agreement, of not more than 1.50 in fiscal 2007, 1.25 in fiscal 2008 and 1.50 in fiscal 2009 and thereafter. Annual capital expenditures, exclusive of capital expenditures incurred in connection with the Company’s ethanol production facility, are limited to $20 million, unless the Company can maintain a Total Funded Debt Ratio below 2.00 for each fiscal quarter during any fiscal year, which would result in the annual capital expenditure limit to increase to $25 million for such fiscal year. The Company’s obligations under the 2007 Agreement are secured by substantially all of the Company’s U.S. assets.
 
At August 31, 2007, the Company had $15.8 million and $37.0 million outstanding, respectively, under the revolving credit and term loan portions of its credit facility. In addition, the Company has borrowed $14.5 million of the $45 million in capital expansion loans available under the credit facility for the construction of the ethanol facility. Pursuant to the terms of the 2007 Agreement, Penford’s additional borrowing ability as of August 31, 2007 was $30.5 million under the capital expansion facility and $44.2 million under the revolving credit facility. The Company was in compliance with the covenants in the Agreement as of August 31, 2007 and expects to be in compliance during fiscal 2008.
 
The Company’s short-term borrowings consist of an Australian revolving line of credit. On March 1, 2006, the Company’s Australian subsidiary entered into a variable-rate revolving grain inventory financing facility with an Australian bank for a maximum of $32.7 million U.S. dollars at the exchange rate at August 31, 2007. This facility expires on March 15, 2008 and carries an effective interest rate equal to the Australian one-month bank bill rate (“BBSY”) plus approximately 2%. Payments on this facility are due as the grain financed is withdrawn from storage. The amount outstanding under this arrangement, which is classified as a current liability on the balance sheet, was $7.2 million at August 31, 2007.
 
As of August 31, 2007, all of the Company’s outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, is subject to variable interest rates. Under interest rate swap agreements with several banks, the Company has fixed its interest rates on U.S. dollar denominated term debt of $32.8 million at 4.18% and $4.2 million at 5.08%, plus the applicable margin under the 2007 Agreement.
 
As of August 31, 2007, Penford borrowed $37.0 million in term loans and $30.3 million under its revolving lines of credit, of which $8.1 million U.S. dollar equivalent was denominated in Australian dollars. The maturities of debt existing at August 31, 2007 for the fiscal years beginning with fiscal 2008 are as follows (dollars in thousands):
 
         
2008
  $ 11,274  
2009
    7,821  
2010
    12,776  
2011
    6,006  
2012
    36,800  
         
    $ 74,677  
         
 
Included in the Company’s long-term debt at August 31, 2007 is $159,000 of capital lease obligations, of which $56,000 is considered current portion of long-term debt. See Note 8.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Note 6 — Stockholders’ Equity
 
 
                         
    Year Ended August 31,  
    2007     2006     2005  
 
Common shares outstanding
                       
Balance, beginning of year
    10,909,153       10,849,487       10,784,200  
Exercise of stock options
    189,586       50,972       65,287  
Issuance of restricted stock, net
          8,694        
                         
Balance, end of year
    11,098,739       10,909,153       10,849,487  
                         
 
 
On June 16, 1988, Penford distributed a dividend of one right (“Right”) for each outstanding share of Penford common stock. The Rights will become exercisable if a purchaser acquires 15% of Penford’s common stock or makes an offer to acquire common stock. In the event that a purchaser acquires 15% of the common stock of Penford, each Right shall entitle the holder, other than the acquirer, to purchase one share of common stock of Penford at a price of $100. In the event that Penford 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 Penford at a price of $0.01 per Right and expire on June 16, 2008.
 
Note 7 — Accumulated Other Comprehensive Income (Loss)
 
The components of accumulated other comprehensive income (loss) are as follows:
 
                 
    August 31,  
    2007     2006  
    (Dollars in thousands)  
 
Net unrealized gain (loss) on derivatives, net of tax
  $ (611 )   $ 480  
Foreign currency translation adjustments
    18,083       13,393  
Minimum pension liability, net of tax
    (722 )     (2,131 )
Impact of adoption of SFAS No. 158, net of tax
    (2,804 )     NA  
                 
    $ 13,946     $ 11,742  
                 
 
The earnings associated with the Company’s investment in Penford Australia are considered to be permanently invested and no provision for U.S. income taxes on the related translation adjustment has been provided.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Note 8 — Leases
 
Certain of the Company’s property, plant and equipment is leased under operating leases generally ranging from one to twenty years with renewal options. Rental expense under operating leases was $6.6 million, $6.3 million and $5.4 million in fiscal years 2007, 2006 and 2005, respectively. Future minimum lease payments for fiscal years beginning with fiscal year 2008 for noncancelable operating and capital leases having initial lease terms of more than one year are as follows (dollars in thousands):
 
                 
    Capital
    Operating
 
    Leases     Leases  
 
2008
  $ 69     $ 6,602  
2009
    77       6,138  
2010
    28       4,819  
2011
    6       2,983  
2012
          2,279  
Thereafter
          4,408  
                 
Total minimum lease payments
    180     $ 27,229  
                 
Less: amounts representing interest
    (21 )        
                 
Net minimum lease payments
  $ 159          
                 
 
Note 9 — Stock-based Compensation Plans
 
Penford maintains the 2006 Long-Term Incentive Plan (the “2006 Incentive Plan”) pursuant to which various stock-based awards may be granted to employees, directors and consultants. Prior to the 2006 Incentive Plan, the Company awarded stock options to employees and officers through the Penford Corporation 1994 Stock Option Plan (the “1994 Plan”) and to members of its Board under the Stock Option Plan for Non-Employee Directors (the “Directors’ Plan”). The 1994 Plan was suspended when the 2006 Plan became effective in the second quarter of fiscal 2006. The Directors’ Plan expired in August 2005. As of August 31, 2007, the aggregate number of shares of the Company’s common stock that are available to be issued as awards under the 2006 Incentive Plan is 736,976. In addition, any shares previously granted under the 1994 Plan which are subsequently forfeited or not exercised will be available for future grants under the 2006 Incentive Plan.
 
Non-qualified stock options granted under the 1994 Plan generally vest ratably over four years and expire ten years from the date of grant. Non-qualified stock options granted under the 2006 Incentive Plan generally vest ratably over four years and expire seven years from the date of grant. Non-qualified options granted under the Directors’ Plan were granted at 75% of the fair market value of the Company’s common stock on the date of grant. Options granted under the Directors’ Plan vested six months after the grant date and expire at the earlier of ten years after the date of grant or three years after the date the non-employee director ceases to be a member of the Board.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
A summary of the stock option activity for the three years ended are as follows:
 
                                         
                Weighted
    Weighted
       
                Average
    Average
    Aggregate
 
    Number of
    Option Price
    Exercise
    Remaining Term
    Intrinsic
 
    Shares     Range     Price     (In Years)     Value  
 
Outstanding Balance, August 31, 2004
    972,663     $ 5.77 - 17.69     $ 13.31                  
Granted
    224,235       12.75 - 16.34       15.69                  
Exercised
    (62,378 )     5.77 - 14.50       10.45                  
Cancelled
    (26,985 )     12.75 - 14.50       12.99                  
                                         
Outstanding Balance, August 31, 2005
    1,107,535       6.02 - 17.69       13.96                  
Granted
    248,500       13.32 - 16.03       14.81                  
Exercised
    (50,972 )     6.02 - 13.92       15.35                  
Cancelled
    (134,000 )     12.79 - 17.69       16.75                  
                                         
Outstanding Balance, August 31, 2006
    1,171,063       6.18 - 17.69       13.98                  
                                         
Granted
    75,000       16.25 - 19.77       16.72                  
Exercised
    (189,586 )     6.18 - 17.69       13.57                  
Cancelled
    (22,500 )     12.14 - 16.34       14.10                  
                                         
Outstanding Balance, August 31, 2007
    1,033,977       7.59 - 19.77       14.25       5.62     $ 21,760,168  
                                         
Options Exercisable at August 31,
                                       
2005
    689,735       6.02 - 17.69       13.57                  
2006
    721,938       6.18 - 17.69       13.38                  
2007
    696,352     $ 7.59 - 17.69     $ 13.60       5.12     $ 15,108,798  
 
The aggregate intrinsic value disclosed in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $35.30 as of August 31, 2007 that would have been received by the option holders had all option holders exercised on that date. The intrinsic value of options exercised during fiscal years 2007, 2006 and 2005 was $2,761,400, $274,700 and $327,400, respectively.
 
The following table summarizes information concerning outstanding and exercisable options as of August 31, 2007:
 
                                         
    Options Outstanding              
          Wtd. Avg.
          Options Exercisable  
          Remaining
    Wtd. Avg.
          Wtd. Avg.
 
    Number of
    Contractual
    Exercise
    Number of
    Exercise
 
Range of Exercise Prices
  Options     Life (Years)     Price     Options     Price  
 
$ 7.59 - 13.00
    397,307       4.83     $ 12.01       397,307     $ 12.01  
 13.01 - 16.00
    341,170       6.20       14.71       157,795       14.55  
 16.01 - 19.77
    295,500       6.03       16.75       141,250       17.02  
                                         
      1,033,977                       696,352          
                                         


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
On September 1, 2005, the Company adopted SFAS No. 123R which requires the measurement and recognition of compensation cost for all share-based payment awards made to employees and directors based on estimated fair values.
 
Prior to the adoption of SFAS No. 123R, the Company accounted for its stock-based employee compensation related to stock options under the intrinsic value recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and the disclosure alternative prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” Accordingly, the Company presented pro forma information for the periods prior to the adoption of SFAS No. 123R and no compensation cost was recognized for the stock-based compensation plans other than the grant date intrinsic value for the options granted under the Directors’ Plan and restricted stock awards prior to September 1, 2005.
 
The Company elected to use the modified prospective transition method for adopting SFAS No. 123R which requires the recognition of stock-based compensation cost on a prospective basis; therefore, prior period financial statements have not been restated. Under this method, the provisions of SFAS No. 123R are applied to all awards granted after the adoption date and to awards not yet vested with unrecognized expense at the adoption date based on the estimated fair value at grant date as determined under the original provisions of SFAS No. 123. Pursuant to the requirements of SFAS No. 123R, the Company will continue to present the pro forma information for periods prior to the adoption date.
 
 
The Company utilizes the Black-Scholes option-pricing model to determine the fair value of stock options on the date of grant. This model derives the fair value of stock options based on certain assumptions related to expected stock price volatility, expected option life, risk-free interest rate and dividend yield. The Company’s expected volatility is based on the historical volatility of the Company’s stock price over the most recent period commensurate with the expected term of the stock option award. The estimated expected option life is based primarily on historical employee exercise patterns and considers whether and the extent to which the options are in-the-money. The risk-free interest rate assumption is based upon the U.S. Treasury yield curve appropriate for the term of the Company’s stock options awards and the selected dividend yield assumption was determined in view of the Company’s historical and estimated dividend payout. The Company has no reason to believe that the expected volatility of its stock price or its option exercise patterns would differ significantly from historical volatility or option exercises.
 
Under the 2006 Incentive Plan, the Company estimated the fair value of stock options using the following assumptions and resulting in the following weighted-average grant date fair values:
 
                         
    2007     2006     2005  
 
Expected volatility
    45 %     51 %      
Expected life (years)
    5.5       5.5        
Interest rate (percent)
    4.5-4.9       4.9-5.1        
Dividend yield
    1.5 %     1.6 %      
Weighted-average fair values
  $ 6.88     $ 7.18        


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Under the 1994 Plan, the Company estimated the fair value of stock options using the following assumptions and resulting in the following weighted-average grant date fair values:
 
                         
    2007     2006     2005  
 
Expected volatility
          52 %     58 %
Expected life (years)
          5.0       4.1  
Interest rate (percent)
          4.4-4.5       3.7-4.0  
Dividend yield
          1.7 %     1.6 %
Weighted-average fair values
        $ 6.01     $ 6.95  
 
There were no stock options granted under the Directors’ Plan in fiscal years 2007 and 2006 and options granted to directors in fiscal 2005 were cancelled in exchange for cash because of changes in the tax laws.
 
As of August 31, 2007, the Company had $1.1 million of unrecognized compensation costs related to non-vested stock option awards that are expected to be recognized over a weighted average period of 1.5 years.
 
The Company recognizes stock-based compensation expense utilizing the accelerated multiple option approach over the requisite service period, which equals the vesting period. For each of fiscal years 2007 and 2006, the Company recognized $1.1 million in stock-based compensation costs. In fiscal years 2007, 2006 and 2005, the Company recognized $42,000 per year of stock-based compensation cost related to directors’ restricted stock awards. The following table summarizes the stock-based compensation cost under SFAS No. 123R for fiscal years 2007 and 2006 and the effect on the Company’s consolidated statements of operations (in thousands):
 
                 
    2007     2006  
 
Cost of sales
  $ 104     $ 70  
Operating expenses
    926       999  
Research and development expenses
    20       38  
                 
Total stock-based compensation expense
  $ 1,050     $ 1,107  
Tax benefit
    399       410  
                 
Total stock-based compensation expense, net of tax
  $ 651     $ 697  
                 
 
See Note 15 for stock-based compensation costs recognized in the financial statements of each business segment.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
If the fair value recognition provisions of SFAS 123 had been applied to stock-based compensation for fiscal 2005, the Company’s pro forma net income and basic and diluted earnings per share would have been as follows:
 
         
    2005  
    (In thousands, except
 
    per share data)  
 
Net income, as reported
  $ 2,574  
Add: Stock-based employee compensation expense included in reported net income, net of tax
    36  
Less: Stock-based employee compensation expense determined under the fair value method for all awards, net of tax
    (898 )
         
Net income, pro forma
  $ 1,712  
         
Earnings per share:
       
Basic — as reported
  $ 0.29  
         
Basic — pro forma
  $ 0.19  
         
Diluted — as reported
  $ 0.29  
         
Diluted — pro forma
  $ 0.19  
         
 
 
Non-employee directors receive restricted stock under the 1993 Non-Employee Director Restricted Stock Plan, which provides that beginning September 1, 1993 and every three years thereafter, each non-employee director shall receive $18,000 worth of common stock of the Company, based on the last reported sale price of the stock on the preceding trading day. One-third of the shares vest on each anniversary of the date of the award. The Company recognizes compensation cost for restricted stock ratably over the vesting period. On September 1, 2005, 8,694 shares of restricted common stock of the Company were granted to the non-employee directors. As of October 30, 2007, this plan has been terminated and no additional restricted stock will be granted under this plan.
 
Note 10 — Pensions and Other Postretirement Benefits
 
Penford maintains two noncontributory defined benefit pension plans that cover substantially all North American employees and retirees.
 
The Company also maintains a postretirement health care benefit plan covering its North American bargaining unit hourly retirees.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
In September 2006, the FASB issued Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132R” (“SFAS No. 158”). SFAS 158 requires companies to recognize the funded status of defined benefit pension and other postretirement plans as an asset or liability in the statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income in shareholders’ equity. In addition, a company is required to measure plan assets and benefit obligations as of the date of its fiscal year-end statement of financial position. The Company currently measures its plan assets and benefit obligations as of the end of its fiscal year. The incremental effects of adopting SFAS No. 158 on the Company’s consolidated balance sheet as of August 31, 2007 are presented in the following table. The adoption of SFAS No. 158 had no effect on the Company’s consolidated results of operations for the fiscal year ended August 31, 2007, or for any prior period presented, and it will not affect the Company’s consolidated results of operation in future periods. Prior to the adoption of SFAS No. 158 on August 31, 2007, the Company recognized an additional minimum pension liability pursuant to the provisions of SFAS Nos. 87 and 106, which is reflected in the “Balance Before SFAS No. 158 Adoption” column in the following table.
 
                         
          As of August 31,
       
          2007
       
          SFAS No. 158
       
    Balance Before SFAS
    Adoption
    Balance After SFAS
 
    No. 158 Adoption     Adjustments     No. 158 Adoption  
    (Dollars in thousands)  
 
Intangible Asset
  $ 2,522     $ (2,522 )   $  
Current accrued benefit liability
    1,776       (1,180 )     596  
Non-current accrued benefit liability — pensions
    1,316       4,298       5,614  
Other postretirement benefits
    13,932       (1,118 )     12,814  
Accumulated other comprehensive loss, net of tax
    722       2,804       3,526  
Deferred income tax liability
    7,095       1,719       8,814  


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Obligations and Funded Status
 
The following represents information summarizing the Company’s pension and other postretirement benefit plans. A measurement date of August 31, 2007 was used for all plans.
 
                                 
    Year Ended August 31,  
    Pension Benefits     Other Benefits  
    2007     2006     2007     2006  
    (Dollars in thousands)  
 
Change in benefit obligation:
                               
Benefit obligation at September 1
  $ 36,735     $ 39,132     $ 13,621     $ 15,041  
Service cost
    1,467       1,673       309       391  
Interest cost
    2,207       2,102       818       785  
Plan participants’ contributions
                151       148  
Amendments
    873                    
Actuarial (gain) loss
    (387 )     (1,052 )     (1,218 )     (840 )
Change in assumptions
    175       (3,312 )     529       (1,104 )
Benefits paid
    (1,829 )     (1,808 )     (800 )     (800 )
                                 
Benefit obligation at August 31
  $ 39,241     $ 36,735     $ 13,410     $ 13,621  
                                 
Change in plan assets:
                               
Fair value of plan assets at September 1
  $ 30,521     $ 26,759     $     $  
Actual return on plan assets
    3,945       2,262              
Company contributions
    990       3,308       649       652  
Plan participants’ contributions
                151       148  
Benefits paid
    (1,829 )     (1,808 )     (800 )     (800 )
                                 
Fair value of the plan assets at August 31
  $ 33,627     $ 30,521     $     $  
                                 
Funded status:
                               
Plan assets less than projected benefit obligation
  $ (5,614 )   $ (6,214 )   $ (13,410 )   $ (13,621 )
Unrecognized net actuarial loss
    NA       5,655       NA       1,234  
Unrecognized prior service cost
    NA       1,840       NA       (1,219 )
                                 
Net asset (liability)
  $ (5,614 )   $ 1,281     $ (13,410 )   $ (13,606 )
                                 
Recognized as:
                               
Intangible asset
  $     $ 1,840     $     $  
Current accrued benefit liability
          (1,090 )     (596 )      
Non-current accrued benefit liability
    (5,614 )     (2,748 )     (12,814 )     (13,606 )
Other comprehensive income
    NA       3,279       NA        
                                 
Net Amount Recognized
  $ (5,614 )   $ 1,281     $ (13,410 )   $ (13,606 )
                                 
 
Accumulated other comprehensive loss as of August 31, 2007 consists of the following amounts that have not yet been recognized as components of net benefit cost (dollars in thousands):
 
                 
    Pension Benefits     Other Benefits  
 
Unrecognized prior service cost (credit)
  $ 2,522     $ (1,067 )
Unrecognized net actuarial loss
    3,687       545  
Total
  $ 6,209     $ (522 )


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Selected information related to the Company’s defined benefit pension plans that have benefit obligations in excess of fair value of plan assets is presented below (dollars in thousands):
 
                 
    August 31,  
    2007     2006  
 
Projected benefit obligation
  $ 39,241     $ 36,735  
Accumulated benefit obligation
  $ 36,719     $ 34,359  
Fair value of plan assets
  $ 33,627     $ 30,521  
 
Effective August 1, 2004, the Company’s postretirement health care benefit plan covering bargaining unit hourly employees was closed to new entrants and to any current employee who did not meet minimum requirements as to age plus years of service.
 
The defined benefit pension plans for salary and hourly employees were closed to new participants effective January 1, 2005 and August 1, 2004, respectively.
 
 
                                                 
    Year Ended August 31,  
    Pension Benefits     Other Benefits  
    2007     2006     2005     2007     2006     2005  
    (Dollars in thousands)  
 
Components of net periodic benefit cost
                                               
Service cost
  $ 1,467     $ 1,673     $ 1,066     $ 309     $ 391     $ 352  
Interest cost
    2,207       2,102       2,065       818       785       775  
Expected return on plan assets
    (2,379 )     (2,150 )     (1,868 )                  
Amortization of transition obligation
                                   
Amortization of prior service cost
    191       187       194       (152 )     (152 )     (152 )
Amortization of actuarial loss
    190       602       480             143       38  
                                                 
Benefit cost
  $ 1,676     $ 2,414     $ 1,937     $ 975     $ 1,167     $ 1,013  
                                                 
 
Assumptions
 
The Company assesses its benefit plan assumptions on a regular basis. Assumptions used in determining plan information are as follows:
 
                                                 
    August 31,  
    Pension Benefits     Other Benefits  
    2007     2006     2005     2007     2006     2005  
 
Weighted-average assumptions used to calculate net periodic expense:
                                               
Discount rate
    6.15 %     5.50 %     6.25 %     6.15 %     5.50 %     6.25 %
Expected return on plan assets
    8.00 %     8.00 %     8.00 %                        
Rate of compensation increase
    4.00 %     4.00 %     4.00 %                        
Weighted-average assumptions used to calculate benefit obligations at August 31:
                                               
Discount rate
    6.51 %     6.15 %     5.50 %     6.51 %     6.15 %     5.50 %
Expected return on plan assets
    8.00 %     8.00 %     8.00 %                        
Rate of compensation increase
    4.00 %     4.00 %     4.00 %                        
 
The expected long-term return on assets assumption for the pension plans represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. In


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
developing the expected rate of return, the Company considers long-term historical market rates of return as well as actual returns on the Company’s plan assets, and adjusts this information to reflect expected capital market trends. Penford also considers forward looking return expectations by asset class, the contribution of active management and management fees paid by the plans. The plan assets are held in qualified trusts and anticipated rates of return are not reduced for income taxes. The expected long-term return on assets assumption used to calculate net periodic pension expense was 8.0% for fiscal 2007. A decrease (increase) of 50 basis points in the expected return on assets assumptions would increase (decrease) pension expense by approximately $0.2 million based on the assets of the plans at August 31, 2007. The expected return on plan assets to be used in calculating fiscal 2008 pension expense is 8%.
 
The discount rate used by the Company in determining pension expense and pension obligations reflects the yield of high quality (AA or better rating by a recognized rating agency) corporate bonds whose cash flows are expected to match the timing and amounts of projected future benefit payments. The discount rates to determine net periodic expense used in 2005 (6.25%), 2006 (5.50%) and 2007 (6.15%) reflect the change in bond yields over the last several years. During fiscal 2007, bond yields rose and Penford has increased the discount rate for calculating its benefit obligations at August 31, 2007, as well as net periodic expense for fiscal 2008, to 6.51%. Lowering the discount rate by 25 basis points would increase pension expense by approximately $0.1 million and other postretirement benefit expense by $0.01 million.
 
Unrecognized net loss amounts reflect the difference between expected and actual returns on pension plan assets as well as the effects of changes in actuarial assumptions. Unrecognized net losses in excess of certain thresholds are amortized into net periodic pension and postretirement benefit expense over the average remaining service life of active employees. Amortization of unrecognized net loss amounts is expected to increase net pension expense by approximately $0.05 million in fiscal 2008. Amortization of unrecognized net losses is not expected to impact the net postretirement health care expense in fiscal 2008.
 
                         
    2007     2006     2005  
 
Assumed health care cost trend rates:
                       
Current health care trend assumption
    9.00 %     10.00 %     10.00 %
Ultimate health care trend rate
    4.75 %     4.75 %     4.75 %
Year ultimate health care trend is reached
    2015       2015       2014  
 
The assumed health care cost trend rate could have a significant effect on the amounts reported. A one-percentage-point change in the assumed health care cost trend rate would have the following effects:
 
                 
    1-Percentage-
    1-Percentage-
 
    Point
    Point
 
    Increase     Decrease  
    (Dollars in thousands)  
 
Effect on total of service and interest cost components in fiscal 2007
  $ 190     $ (154 )
Effect on postretirement accumulated benefit obligation as of August 31, 2007
  $ 1,984     $ (1,629 )
 
 
The weighted average asset allocations of the investment portfolio for the pension plans at August 31 are as follows:
 
                         
    Target
    August 31,  
    Allocation     2007     2006  
 
U.S. equities
    60 %     55 %     55 %
International equities
    10 %     15 %     15 %
Fixed income investments
    25 %     25 %     25 %
Real estate
    5 %     5 %     5 %


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The assets of the pension plans are invested in units of common trust funds actively managed by Russell Trust Company, a professional fund investment manager. The investment strategy for the defined benefit pension assets is to maintain a diversified asset allocation in order to minimize the risk of large losses and maximize the long-term risk-adjusted rate of return. No plan assets are invested in Penford shares. There are no plan assets for the Company’s postretirement health care plans.
 
 
The Company’s funding policy for the defined benefit pension plans is to contribute amounts sufficient to meet the statutory funding requirements of the Employee Retirement Income Security Act of 1974. The Company contributed $1.0 million, $3.3 million and $3.6 million in fiscal 2007, 2006 and 2005, respectively. The Company expects to contribute $1.6 million to its defined benefit pension plans during fiscal 2008. Penford funds the benefit payments of its postretirement health care plans on a cash basis; therefore, the Company’s contributions to these plans in fiscal 2008 will approximate the benefit payments below.
 
Expected benefit payments are based on the same assumptions used to measure the benefit obligations and include benefits attributable to estimate future employee service.
 
                 
          Other
 
    Pension     Postretirement  
    (Dollars in millions)  
 
2008
  $ 2.0     $ 0.6  
2009
    2.0       0.7  
2010
    2.0       0.7  
2011
    2.1       0.7  
2012
    2.2       0.8  
2013-2017
  $ 12.6     $ 4.6  
 
Note 11 — Other Employee Benefits
 
 
The Company has a defined contribution savings plan by which eligible North American-based employees can elect a maximum salary deferral of 16%. The plan provides a 100% match on the first 3% of salary contributions and a 50% match on the next 3% per employee. The Company’s matching contributions were $920,000, $882,000 and $750,000 for fiscal years 2007, 2006 and 2005, respectively.
 
 
The Company provides its directors and certain employees the opportunity to defer a portion of their salary, bonus and fees. The deferrals earn interest based on Moody’s current Corporate Bond Yield. Deferred compensation interest of $180,000, $184,000 and $188,000 was accrued in fiscal years 2007, 2006 and 2005, respectively.
 
 
The Company sponsors a supplemental executive retirement plan, a non-qualified plan, which covers certain employees. No current executive officers participate in this plan. For fiscal 2007, 2006 and 2005, the net periodic pension expense accrued for this plan was $320,000, $305,000 and $302,000, respectively. The accrued obligation related to the plan was $4.0 million and $3.9 million for fiscal years 2007 and 2006, respectively.
 
 
The Company offers health care and life insurance benefits to most active North American employees. Costs incurred to provide these benefits are charged to expense as incurred. Health care and life insurance expense, net of


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
employee contributions, was $4.4 million, $4.3 million and $4.7 million in fiscal years 2007, 2006 and 2005, respectively.
 
 
The Company contributes to superannuation funds on behalf of the employees of Penford Australia. Australian law requires the Company to contribute at least 9% of each employee’s eligible pay. In New Zealand, the Company sponsors a superannuation benefit plan whereby it contributes 7.5% and 5% of eligible pay for salaried and hourly employees, respectively. The Company contributions to superannuation funds were $1.1 million, in each of fiscal years 2007, 2006 and 2005.
 
Note 12 — Other Non-operating Income
 
Other non-operating income consists of the following:
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Royalty and licensing income
  $ 1,902     $ 1,827     $ 1,386  
Gain (loss) on sale of assets
    (325 )     85       64  
Loss on extinguishment of debt
                (1,051 )
Gain on sale of Tamworth farm
    60       78       1,166  
Gain on sale of investment
                736  
Other
    8       (94 )     (92 )
                         
    $ 1,645     $ 1,896     $ 2,209  
                         
 
In fiscal 2003, the Company exclusively licensed to National Starch and Chemical Investment Holdings Corporation (“National Starch”) certain rights to its resistant starch patent portfolio (the “RS Patents”) for applications in human nutrition. Under the terms of the licensing agreement, the Company received an initial licensing fee of $2.25 million ($1.6 million net of transaction expenses) which is being amortized over the life of the royalty agreement. The Company recognized $1.9 million, $1.8 million and $1.4 million in income during fiscal 2007, 2006 and 2005, respectively, related to the licensing fee and royalties. The Company has recognized $8.5 million in royalty income from the inception of the agreement through August 31, 2007.
 
In the first quarter of fiscal 2007, in connection with the settlement of litigation in which Penford’s Australian subsidiary companies were plaintiffs, Penford received a one-time payment of $625,000 and granted a license to one of the defendants in this litigation under Penford’s RS Patents in certain non-human nutrition applications. In addition, Penford became entitled to receive additional royalties under a license of rights under the RS Patents in human nutrition applications granted to one of the defendants. As part of the settlement agreement, Penford is entitled to receive certain other benefits, including an acceleration and extension of certain royalties under its license with National Starch. The Company is deferring and recognizing license income of $625,000 ratably over the remaining life of the patent license, which is estimated to be seven years.
 
In 2005, the Company refinanced its secured term and revolving credit facilities and wrote off $1.1 million of unamortized debt issuance costs related to these credit agreements.
 
In fiscal 2005, Penford sold a parcel of land near its wheat starch plant in Tamworth, New South Wales, Australia, that was used for disposal of effluent from the Tamworth manufacturing process for $1.9 million, and recognized a gain on the sale of $1.2 million.
 
In fiscal 2006, the Company sold a parcel of land suitable only for agricultural purposes in Tamworth, New South Wales, Australia to a third-party purchaser for $0.7 million. The Company leases back the property from the purchaser under two lease terms and arrangements: i) a small parcel of land will be leased for 25 years beginning August 2006 with annual rent of approximately $0.016 million converted to U.S. dollars at the Australian dollar


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
exchange rate at August 31, 2007 and ii) the majority of land sold was leased for one year beginning August 2006 with annual rental of approximately $0.09 million converted to U.S. dollars at the Australian dollar exchange rate at August 31, 2007. The total gain on the sale was $0.3 million. The gain of $0.1 million in excess of the present value of the lease payments was recognized during the second quarter of fiscal 2006. The remaining gain of $0.2 million is being recognized proportionally over the terms of the leases discussed above.
 
In fiscal 2005, the Company sold a majority of its investment in a small Australian start-up company and recognized a $0.7 million pre-tax gain on the transaction.
 
Note 13 — Income Taxes
 
Income (loss) before income taxes is as follows:
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Domestic
  $ 16,335     $ 3,502     $ (4,635 )
Foreign
    3,157       1,760       2,282  
                         
Total
  $ 19,492     $ 5,262     $ (2,353 )
                         
 
Income tax expense (benefit) consists of the following:
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Current:
                       
Federal
  $ 4,630     $ 68     $ (353 )
State
    1,051       709       170  
Foreign
    2,065       550       666  
                         
      7,746       1,327       483  
Deferred:
                       
Federal
    78       529       (4,579 )
State
    (644 )     (536 )     (573 )
Foreign
    (1,205 )     (286 )     (258 )
                         
      (1,771 )     (293 )     (5,410 )
                         
Total
  $ 5,975     $ 1,034     $ (4,927 )
                         
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Comprehensive tax expense (benefit) allocable to:
                       
Income (loss) before taxes
  $ 5,975     $ 1,034     $ (4,927 )
Comprehensive income (loss)
    (195 )     1,649       (871 )
                         
    $ 5,780     $ 2,683     $ (5,798 )
                         


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
A reconciliation of the statutory federal tax to the actual provision (benefit) for taxes is as follows:
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Statutory tax rate
    35 %     34 %     34 %
Statutory tax on income
  $ 6,822     $ 1,789     $ (800 )
State taxes, net of federal benefit
    79       114       (245 )
Domestic production exclusion benefit
    (202 )     (14 )      
Tax credits, including research and development credits
    (382 )     (136 )     (247 )
Extraterritorial income exclusion benefit
    (5 )     (546 )     (2,970 )
Lower statutory rate on foreign earnings
    (66 )     (82 )     (449 )
Other
    (271 )     (91 )     (216 )
                         
Total provision (benefit)
  $ 5,975     $ 1,034     $ (4,927 )
                         
 
The significant components of deferred tax assets and liabilities are as follows:
 
                 
    August 31,  
    2007     2006  
    (Dollars in thousands)  
 
Deferred tax assets:
               
Alternative minimum tax credit
  $     $ 466  
Postretirement benefits
    8,814       7,957  
Provisions for accrued expenses
    2,902       1,988  
Stock-based compensation
    735       389  
Other
    2,627       1,274  
                 
Total deferred tax assets
    15,078       12,074  
                 
Deferred tax liabilities:
               
Depreciation
    15,502       16,513  
Other
    434       393  
                 
Total deferred tax liabilities
    15,936       16,906  
                 
Net deferred tax liabilities
  $ 858     $ 4,832  
                 
Recognized as:
               
Other current assets
  $ 1,985     $ 1,092  
Other assets
    297        
Long-term deferred income tax liability
    (3,140 )     (5,924 )
                 
Total net deferred tax liabilities
  $ 858     $ 4,832  
                 
 
At August 31, 2007, the Company had no federal alternative minimum tax credit or research and development carry forwards.
 
Deferred taxes are not recognized on temporary differences from undistributed earnings of foreign subsidiaries of approximately $16.9 million, as these earnings are deemed to be permanently reinvested. The amount of unrecognized deferred tax liability associated with these temporary differences is approximately $6.4 million.
 
The Company has not provided for U.S. federal income and foreign withholding taxes on undistributed earnings from non-U.S. operations as of August 31, 2007 because the Company intends to reinvest such earnings indefinitely outside of the United States.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
In August 2005, the Company received a report from the Internal Revenue Service (“IRS”) regarding the audit of the Company’s U.S. federal income tax returns for fiscal years ended August 31, 2001 and 2002. In May 2007, the Company settled the outstanding IRS audits of the Company’s U.S. federal income tax returns for the fiscal years ended August 31, 2001 and 2002. Under the settlement the Company received a cash refund of $0.3 million. In addition, in connection with the settlement of these audits in the third quarter of fiscal 2007, the Company reversed a current tax liability in the amount of $0.7 million, which represented its estimate of the probable loss on certain tax positions being examined.
 
In December 2006, the Tax Relief Healthcare Act of 2006 was enacted in the U.S., which retroactively reinstated and extended the research and development tax credit from January 1, 2006 through December 31, 2007. The Company recorded the tax effect of $0.2 million of U.S. research and development tax credits in 2007 related to fiscal 2006.
 
In 2004, the Company filed amended U.S. federal income tax returns for fiscal years ended August 31, 2001 and 2002, increasing the extraterritorial income exclusion (“EIE”) deduction. The methodology that was used to determine the incremental EIE deduction for those years was also utilized for the federal income tax returns for fiscal years ended August 31, 2003, 2004 and 2005. Penford had not recognized the tax benefit associated with the incremental EIE deduction for fiscal years 2001 through 2004 because the Company had concluded that it was not probable, as defined in FASB Statement No. 5, “Accounting for Contingencies,” that the deduction would be sustained. In its tax audits of the fiscal 2001 and 2002 federal income tax returns, the IRS did not challenge the Company’s EIE deduction for those years. Accordingly, in 2005, the Company recognized the incremental tax benefit of this deduction for fiscal years 2001 through 2004. The amount of tax benefit recognized for years prior to 2005 was $2.5 million.
 
In evaluating the exposures connected with the various tax filing positions, the Company establishes an accrual, when, despite management’s belief that the Company’s tax return positions are supportable, management believes that certain positions may be successfully challenged and a loss is probable. When facts and circumstances change, these accruals are adjusted. Beginning in fiscal 2008, the Company will adopt FIN 48, which will change the accounting for tax positions. See discussion in Note 1.
 
Note 14 — Earnings Per Common Share
 
The following table presents the computation of basic and diluted earnings per share:
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Amounts in thousands, except share and
 
    per share data)  
 
Net income
  $ 13,517     $ 4,228     $ 2,574  
                         
Weighted average common shares outstanding
    8,986,413       8,899,999       8,826,916  
Net effect of dilutive stock options
    296,712       104,191       119,279  
                         
Weighted average common shares and equivalents outstanding, assuming dilution
    9,283,125       9,004,190       8,946,195  
                         
Earnings per common share:
                       
Basic
  $ 1.50     $ 0.48     $ 0.29  
                         
Diluted
  $ 1.46     $ 0.47     $ 0.29  
                         
 
Weighted-average stock options omitted from the denominator of the earnings per share calculation because they were antidilutive were 57,159, 536,775 and 346,388 for 2007, 2006 and 2005, respectively.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Note 15 — Segment Reporting
 
Financial information for the Company’s three segments is presented below. The first two segments, Industrial Ingredients — North America and Food Ingredients — North America, are broad categories of end-market users served by the Company’s U.S. operations. The Industrial Ingredients segment provides carbohydrate-based starches for industrial applications, primarily in the paper and packaging products industries. The Food Ingredients segment produces specialty starches for food applications. The third segment is the geographically separate operations in Australia and New Zealand. The Australian and New Zealand operations produce specialty starches used primarily in the food ingredients business. See Part 1, Item 1, “Business,” for a description of the products for each segment. A fourth 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. The elimination of intercompany sales between Australia/New Zealand operations and Food Ingredients — North America is presented separately since the chief operating decision maker views segment results prior to intercompany eliminations. The accounting policies of the reportable segments are the same as those described in Note 1.
 
                         
    Year Ended August 31,  
    2007     2006     2005  
    (Dollars in thousands)  
 
Sales
                       
• Industrial ingredients — North America
  $ 194,957     $ 165,850     $ 147,782  
• Food ingredients — North America
    62,987       57,156       53,661  
• Australia/New Zealand operations
    105,244       96,121       96,231  
• Corporate and other
    (824 )     (708 )     (911 )
                         
    $ 362,364     $ 318,419     $ 296,763  
                         
Depreciation and amortization
                       
• Industrial ingredients — North America
  $ 7,830     $ 7,812     $ 8,832  
• Food ingredients — North America
    2,944       3,301       3,311  
• Australia/New Zealand operations
    4,605       4,199       4,306  
• Corporate and other
    317       271       576