Penford Corporation F4Q08 (Qtr End 08/31/08) Earnings Call Transcript

Nov.25.08 | About: Penford Corporation (PENX)

Penford Corporation (NASDAQ:PENX)

F4Q08 Earnings Call

November 13, 2008 11:00 am ET

Executives

Steve Cordier Chief Financial Officer

Tom Malkoski President and Chief Executive Officer

Analysts

Ken Zaslow – BMO Capital

Jonathan Lichter – Sidoti & Company

Tyson Bauer – Wealth Monitors

Joe Gomes – Oppenheimer & Company

Lawrence Alexander – Jefferies & Company

Robert Kosowsky – OFI Institutional Asset Management

Tom Spiro – Spiro Capital

Operator

Greetings and welcome to the Penford Corporation fourth quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Steve Cordier, Chief Financial Officer for Penford Corporation. Thank you, you may begin.

Steve Cordier

Thank you, good morning everyone. Thank you for participating in our conference call to discuss fourth quarter and full year fiscal 2008 financial results. Joining me on the call is Tom Malkoski, President and Chief Executive Officer of Penford Corporation.

Before we get started, let me caution you about any forwardlooking comments we might make this morning. Any forwardlooking statements regarding future events or the financial performance of the company are just predictions, and actual events or results may differ materially. These forwardlooking statements are subject to numerous risks and uncertainties. These include the performance of the economy as a whole and its impact on Penford's customers, customer acceptance of new products or technologies at less than anticipated rates, issues impacting customer demand or orders, the amount and timing of expenditures for flood restoration costs and related insurance recoveries, increased competition, raw material costs, litigation, interest rate changes, changes in returns on pension plan assets and/or assumptions used for determining employee benefit expense and obligations, chemical and energy cost volatility, as well as foreign exchange rate fluctuations.

Please refer to the documents that we file from time to time with the Securities and Exchange Commission for a discussion of these and other risks and uncertainties. Finally, we do not undertake to update publicly any forwardlooking statements to reflect new information, events, or circumstances after the date of this call or to reflect the occurrence of unanticipated events.

I will start by reviewing the company's consolidated financial results and offering comments on each of our business segments for fiscal 2008. Tom will then offer perspectives on important events and achievements last year, as well as challenges and opportunities facing us this year.

Fiscal 2008 consolidated sales were $345.6 million compared with $362.4 million last year. Sales in the North American food ingredients and Australian segments reached record levels for the year. Our strong 9month trend toward historical peaks in the Iowabased industrial ingredients business was derailed by the record flooding in June that interrupted production for most of the fourth quarter.

Average selling prices improved at all three business units in fiscal 2008. Product mix improved as well with highly modified ethylated industrial starches; advanced formulations for pet, dairy, protein, and bakery food applications; and a concentration toward better margin categories in Australia, all representing a higher proportion of the sales base. The Australian dollar appreciated by about 13% over fiscal 2007, and this also made a positive contribution to the yearoveryear reported revenue comparison.

Annual gross margin of $49.6 million was $14.6 million lower than a year ago and, as a percent of revenue, declined to 14.4% from 17.7%. The margin reduction reflected lower volumes worldwide, including the production disruption caused by the flood at Cedar Rapids, a small decline in potato coating applications in North America food, and the planned emphasis to a higher margin categories in Australia.

Total operating expenses in fiscal 2008 were $70.5 million compared with $40.6 million a year ago. The 2008 expense includes $27.6 million of net charges attributable to the flood response efforts in Cedar Rapids. This net expense is separately captioned on our income statement and contains $38.1 million of charges directly related to the flood as well as $10.5 million in insurance recoveries. The net charges do not include profits that were forfeited during the interruption of operations due to the flood.

Fiscal 2008 operating expense includes $1.4 million in severance costs for a reduction in force in Australia during the first half of the year and another $1.4 million for litigation expense in the third quarter that represents the final resolution of a lawsuit filed in 2004.

R&D expenses rose $1.1 million, or 16%, to $17.9 million as we invested in additional technical staff and conducted customer trials to advance commercialization of new products.

Loss from operations was $20.9 million versus a profit of $23.6 million last year. Interest expense decreased from $5.7 million last year to $4.1 million in fiscal 2008. Floating interest rates fell in the U.S. during the year and total debt outstanding declined to $68.6 million from $74.7 million last year, mainly on lower working capital requirements due to the flood impact on the industrial ingredients business.

Remember that in May 2008, upon commencement of commercial production of ethanol, we ceased capitalizing interest expense on that $47 million project. The incremental interest expense related to that specific expenditure will be approximately $3 million per year.

We anticipate that borrowing levels will increase as we fund payments related to the flood recovery and other corporate requirements. At August 31, the company had $45.7 million of unused commitments under its revolving credit facility. That credit agreement does not expire until December 31, 2011. At the end of August, our debttoinvested capital ratio was 30%, compared with 37% at the same time last year.

Nonoperating income increased to $5.4 million from $1.6 million a year ago. The main elements of the change were $700,000 from the sale of property in New Zealand and the recognition of $2.9 million in hedge contract gains on corn and natural gas positions supporting sales that were originally contracted for delivery during the fourth quarter but suspended due to the flood.

Income taxes were a benefit of $6.9 million compared with an expense of $6 million in fiscal 2007. The effective tax rate was 35.1% versus 30.7% last year.

Net loss for the year was $12.7 million compared with a profit of $13.5 million a year ago. Diluted loss per share was $1.20 in fiscal 2008 versus earnings of $1.46 in 2007. The public stock offering completed last December added 2.0 million weighted average diluted shares for the fourth quarter and 1.4 million shares for the 12 months of fiscal 2008.

Consolidated financial results for the three months ended August 31 were materially affected by the flood that shut down production for most of the quarter at our largest manufacturing facility in Cedar Rapids. Sales fell 38% to $60 million from $96.2 million a year ago. Gross margin was $6.3 million versus $20 million last year. And loss from operations was $34.2 million compared with a profit of $7.1 million in 2007.

Loss per share for the fourth quarter was $1.87 compared with a profit of $0.45 for the same period a year ago. I will provide additional commentary for the separate business units shortly.

Capital spending was $3.2 million for the fourth quarter down from $12.6 million last year reflecting the completion of the ethanol construction project and the shifting of resources to repair and refurbish the Cedar Rapids facility after the flood.

Operations provided $11.7 million in cash during the fourth quarter of fiscal 2008, up slightly from $11 million a year ago, primarily from drawing down working capital balances, which more than offset the reported cash effect of operating losses in the industrial ingredients and Australian segments.

About this time last year, we reported that continuing drought conditions in Australia were driving grain prices to record levels in the region. We predicted that rising input prices would add $15 million to our manufacturing costs and outlined a multipoint response to address that issue and maintain operating profits comparable with fiscal 2007. Looking back, the grain price forecast was accurate in scope and impact.

Now I would like to recap the outcomes from the business reconfiguration response program. The first task was to recover 50% of the higher input costs through price increases. By raising average selling prices about 13% in local currency, our recoveries were sufficient to consider this initiative a success.

The next assignment was to offset 15% of the total additional expense by reducing consumption of highpriced grain through concentrating production on those product categories that offered potential for reasonable return in this difficult cost environment. This meant selectively reducing volumes and lowering related fixed costs through head count reductions and other efficiency programs. This was also accomplished.

The third initiative was to address another 15% of the challenge by changing manufacturing processes and sources choices. Progress toward this objective was disrupted as insufficient physical stocks of maize required purchasing and processing of imported starch and grain that exceeded targeted cost parameters. Several national governments abruptly changed from supporting grain exports to preserving reserves through sharp increases in tariffs and duties.

In addition, our operation encountered difficulty in cost effectively managing through stringent local requirements for inspecting, segregating, and treating inbound raw material. This swung the net impact for this effort to a net penalty of nearly 15%.

The final element in the plan was to address 20% of the $15 million recovery goal by accelerating the commercialization of new differentiated food and industrial products. As we have discussed throughout the second half of the fiscal year, our customers have shifted internal focus and resources away from evaluation of innovation opportunities toward cost containment measures. This has slowed acceptance of new introductions in several developed markets worldwide.

The timetable for success this year was not met, and these products did not materially contribute to the cost recovery program in fiscal 2008. However, customer trial activity and interest has strengthened as our marketing efforts gained traction and currency rate changes create a more favorable value comparison.

Summing the results from these efforts indicates that ultimately only half of the fiscal 2008 target was accomplished, and about $7.8 million of higher grain costs flowed through the P&L. The business reported an operating loss of $4.5 million versus a profit of $3.2 million last year.

The current wheat harvest is approaching historical yields, and prices for the new crop are falling. Prices for maize remain high as alternative crops compete for irrigated farmland throughout Australia. Total grain input costs for fiscal 2009 are likely to remain high. Nonetheless, benefits from cost reduction programs and process improvements launched during fiscal 2008 remain in place. Also, adequate stocks of local grain have been located.

Importantly, the Australian dollar has fallen by nearly 30% since the end of the fiscal year, creating opportunities to export new and existing products, while establishing a more competitive position with domestic customers who compare our products with imports into Australia and New Zealand.

We targeted maintaining profit margins while expanding our revenue base in the food ingredients North America business during fiscal 2008. Annual sales grew 5% over prior year, primarily in higher average selling prices across nearly every category and double digit gains in several strategically important categories, including dairy, bakery, and pet.

Potato coating revenue was flat versus a year ago, primarily reflecting the impact of one customer choice to reformulate some of their products earlier in fiscal 2008. Raw material and transportation costs rose sharply through fiscal 2008, and we slipped from our margin targets as these expenses outpaced price changes achieved at the annual contract renewals early in the year.

Annual operating profit decreased 5% to $10.1 million from $10.7 million a year ago. Our potato starch operations have not been affected by the flooding of the Cedar River in Iowa, which shut down manufacturing for our industrial corn starch business.

Dextrose production was part of the Cedar Rapids operation and was interrupted by the flood. Volume levels for that product category fell by 16% from fiscal 2007. Dextrose manufacturing has resumed in Cedar Rapids in the first quarter of fiscal 2009.

The ingredients business is off to a strong start in fiscal 2009, with good demand for potato coating applications and vigorous trial activity for a solid pipeline of product formulations that emphasize customer focus on functionality, performance, and low cost in use.

The North America industrial ingredients business performed strongly through the first nine months of fiscal 2008. The new ethanol facility was commissioned as planned and was ramping up to designed production levels. Demand for highly modified ethylated starches was strong, mix was improving, and average selling prices were favorable. Operating profits were higher than the previous year.

The record flooding of the Cedar River quickly changed the prospects for a record year, and the business was forced to scramble to assist customers' supply needs while cleaning, repairing, and restarting the entire manufacturing facility. We've reported on the progress of these efforts over the past several months and do not intend to recount them in detail now.

A few important points should be made. The plant is now substantially at manufacturing levels achieved before the flood and the full range of industrial starches is being produced. Liquid natural additive accounts were supplied without interruption by transferring production to the pilot plant facility, which was minimally damaged by the flood. We announced the termination of the force majeure event for the industrial starch customers on September 15 and are transitioning our customers back to Penford. Ethanol production recommenced in late September, and output levels now exceed preflood benchmarks.

The total direct cost estimate for flood recovery remains at approximately $45 million. This does not include profits lost during suspended production periods. We have recognized $38.1 million of the direct costs during the fourth quarter of fiscal 2008. We continue to process our loss with insurance carriers. The claim will include property damage and business interruption losses. The allrisk insurers have paid $10.5 million, and this has been applied against the loss as at August 31, 2008.

Insurance company representatives have not affirmed coverage for all aspects of the claim, so the company cannot provide assurance regarding the amount or timing of the ultimate recoveries under its policies. I will now turn the call over to Tom for some comments on 2008 and the outlook for 2009.

Tom Malkoski

Thank you, Steve. Fiscal 2008 has been an extremely challenging year for the company. We saw massive volatility in global commodity markets that played out in record high grain costs in Australia, escalated raw material and transportation costs in North American food ingredients, and rapidly changing co-product values and higher chemical and energy in our industrial group.

We managed through these supply and cost challenges, delivering solid results through the first three quarters of our fiscal year. Industrial business was devastated by an unprecedented natural disaster with the Cedar Rapids flood in our fourth quarter, the flood waters covering the entire site.

The immediate need for crisis management required an even deeper level of determination, execution, and character. On the day of the evacuation, we established priorities for managing through the crisis, take care of our people, protect and restore the company's assets, safely return the facility to operating performance, and to recover our business.

Our people are safe and taken care of. The entire facility was cleaned and sanitized. We rebuilt or replaced thousands of pumps, motors, and electrical switches. With our full work force on site, supported by hundreds of outside contractors, we experienced only one recordable injury. The facility is now operating at preflood production levels, and the transition to resupplying starch customers is well under way.

Despite these external factors, our businesses did make important operating and strategic progress. Industrial ingredients leverage the differentiating benefits and superior performance of ethylated starch to expand volume of our flagship product group, which allows customers to meet market demand for higher quality standards in finished paper, while contributing attractive cost and use processing characteristics.

The liquid natural products business remains strong with several promising customer trials under way. Industrial ingredients also completed construction and started up an expansion into ethanol on time and on budget at $1.05 per gallon of capacity.

This initiative creates additional output choices that will permit optimization of profit opportunities and increases total plant throughput and improves capacity utilization and offers highly competitive operating costs as part of an integrated [inaudible].

Importantly, our established infrastructure for sourcing and risk management avoids the procurement and hedging problems that have surfaced from some competitors. Finally, the business recovered from the flood in a remarkably condensed time period.

Penford food ingredients maintain their strong coating business and added new growth in several attractive segments as noted by Steve. Increased investments in technical resources have led to a more robust pipeline of applications and customer trial activity, some of which are on the verge of commercialization.

This business is well positioned for the challenging economy. The product portfolio offers a substantial range of high functionality and attractive cost and use performance. Our customer base is balanced between quick service restaurants and food manufacturers who sell into the grocery industry.

Too much water in Iowa, yet not enough in Australia. Unprecedented drought conditions in Australia drove grain prices to record levels. We implemented a comprehensive restructuring of the business designed to counter these input costs and to establish a more sustainable position for the future.

The execution of the restructure program was not satisfactory in that it recovered only half of the impact of record grain costs. However, customer trial activity with our new products is improving with strong interest in clean label and health and wellness applications.

Wheat production and costs are normalizing, which should benefit the second half of fiscal 2009. Corn input costs remain high, depending greatly on the rebuilding of water reserves.

The dramatic drop in Australian dollar against most major currencies offers significant opportunities in supporting the introduction of new products into export markets, defense against import competition in domestic markets, and margin improvement.

Penford faced tremendous external adversity in fiscal 2008, as did many other companies. And we're mindful of slowing economic activity worldwide altering opportunities or creating constraints for our businesses. However, our business model is designed to deliver solutions and value across a broad spectrum of customers and market conditions.

Our employees have demonstrated extraordinary commitment, flexibility, and character in the face of setbacks. We are more resilient, focused, and determined to deliver value for all stakeholders than ever before. Thank you for your interest in Penford; 'we'll now open the call for questions.

QuestionandAnswer Session

Operator

(Operator Instructions) Our first question is from Ken Zaslow BMO Capital.

Ken Zaslow BMO Capital

I had a couple of questions, some a little housekeeping. From my understanding, the total cost that will be incurred because of the flooding is $45 to $47 million plus the $15 million? So it's a total of $60 million to $62 million? Or is the $15 million included in the $45 million to $47 million?

Steve Cordier

Let me separate that into what I will call direct costs, that's the $45 million to $47 million. Then there will be a claim for business interruption for profits forfeited during the period of shutdown. $15 million relates to the interruption through August 31. Then as we scale up through the first quarter, there will also be some interrupted business that we will claim for. So your total, what I will call penalty to the business, in the range of $60 million to $65 million is the sum of those elements.

Ken Zaslow BMO Capital

Then your insurance will cover up to $35 million or has that changed?

Steve Cordier

We've reviewed our policies, and we are pursuing a claim for the total amount.

Ken Zaslow BMO Capital

Then just going to the business side of it, how has the economy affected your customer trial rate on new products? Has that changed at all?

Tom Malkoski

I have to separate that into three business units and say that from the industrial business, the level of activity with our specialty products, where most of the trial activity would be occurring, is very strong. At this point, the advantages that our products offer there in terms of renewable resource material and cost and use performance against synthetics still remain and that is the basis for the customer interest.

On the food side, we simply have a large amount of activity in several segments that is coming to a head at the end of fiscal year and going into the first quarter. We have seen, there is more interest in cost reduction opportunities. There is a huge amount of interest in naturalbased materials and clean label which we have several product offerings and formulations that address those needs. Those go beyond the cost and use interest with some of our customers. The level of activity is very strong, and we are very encouraged right now with the pacing of that in the food business.

From the Australian perspective, we have talked about in the past and even on this call that through the end of the fiscal year, the level of activity in new products has been behind our expectations. Part of that is a worldwide focus of many of our customers more on cost reduction. Some of these new products are not cost reduction plays; they're actually enhanced performance plays.

What we're seeing now, though, is a renewed level of interest in naturalbased materials and health and wellness in several markets. Some of that is based on the change in currency which has made the Australian products much more competitive than they were 3, 4, or 5 months ago. We're seeing a lot more interest in the trial activity now than we were just that short period ago.

Ken Zaslow BMO Capital

I think you said in the past that the second half of 2009 would be in line or stronger than the second half of 2007. Is that still a fair comment despite the economy? Is that still how you would play it out?

Steve Cordier

We're still looking for that type of performance. Again we can't guarantee the demand that will come through on our customer side due to the changing economic conditions, but we're viewing that second half performance in 2009 along that level that you just described.

Operator

Our next question comes from Jonathan Lichter Sidoti & Company.

Jonathan Lichter Sidoti & Company

You talked about Australia. Have you seen any actual sales come through yet because of the lower Australian dollar or is it just interest at this point and what kind of time frame do you think it will take to convert that into sales?

Tom Malkoski

We've seen only marginal sales that we have been able to record at this point. However, the level of activity is much more encouraging. Our expectation is that the customers have already seen initial quantities of the product for trial activities over the past few months. So our expectation is we will start to see that certainly by our second quarter and third quarter.

Jonathan Lichter Sidoti & Company

On the industrial side, are the customers all returning as you had expected?

Tom Malkoski

As expected, yes. We believe there would have been a pacing for them coming back to resupply from us. Some of them had inventories in mill locations that extended them through the month of December. So those are the ones that we'll be concentrating on as we get to the end of the calendar year.

Jonathan Lichter Sidoti & Company

Are the prices similar to those that were under contract previously?

Steve Cordier

Contract renewal period is really beginning in January. So the pricing on the transition period through the end of this calendar year is similar to what was in place prior to the flood. The negotiation for the upcoming calendar year is under way. Those aren't completely finished yet.

Jonathan Lichter Sidoti & Company

Early talks, would you think that there would be similar to, for those under contract?

Steve Cordier

Right now, I think that it's a little bit difficult to predict. Certainly, we're trying to recover some of the higher input costs that we've seen for natural gas and chemicals and so forth. Ultimately, this is going to be a typical contract renewal where the supply and demand balance is important for the customer's receptivity to our pricing overtures. Remember, too, that a good bit of the contracts in the industrial business had been set for multiyear. Those are, what I will call a formulabased approach. So we will see some pricing increase on that scale for that amount of the capacity, which is about 50% of the total production capacity in the industrial segment.

Jonathan Lichter Sidoti & Company

What are you assuming for fiscal 2009, in terms of uncoated free sheet volumes? How much do you expect them to decline?

Steve Cordier

You mean overall for the industry? Or for Penford specifically?

Jonathan Lichter Sidoti & Company

For the industry.

Tom Malkoski

We still expect that we will see a 5% or 6% decline in uncoated free sheet consumption. So this would be demand for our customers' business. The trend going into the end of our fiscal year was a little bit less than that. Our expectation is that the economy will continue to be soft, and the demand characteristics will be somewhat lumpy because when production is taken out, it's usually a machine goes down or mill locations curtail as opposed to just a general weakness across all producers.

Jonathan Lichter Sidoti & Company

Is ethanol still profitable here?

Steve Cordier

If you look at the current levels for inputs and outputs, we still have positive gross margin on that business. Remember that importantly it contributes to the overall capacity utilization in the plant. If you think about the overall industry prospects, we carefully watch the price of ethanol relative to the price of gasoline. Right now, ethanol is at a premium to gasoline near the blender level. That's a metric that we watch carefully.

Also, specific to Penford, both in the company and in the region, the harvest for corn in the areas that we draw our corn from for production for ethanol is behind schedule in Iowa, due to a variety of conditions, particularly the weather and so forth. They're only at about 50% versus a normal year of 90%. That, combined with the sharp drop in the corn prices on a gross basis per bushel, has made the delivery or the willingness of the farmers to bring corn to market less.

In our area, we actually have an inversion on the basis, which is the historical relationship between corn purchased in Iowa versus the Chicago Board of Trade. We expect that as the farmers get the harvest back in and that corn comes into more ready availability in the market, we will return to normal historical basis levels and that should improve the overall margin in our ethanol facility by anywhere from $0.03 to $0.06 a gallon.

Jonathan Lichter Sidoti & Company

When would you expect that to return to historical norms?

Steve Cordier

We're thinking somewhere in the January time frame.

Jonathan Lichter Sidoti & Company

Lastly, you talked about new products. How big are the markets for those new products that you talked about?

Tom Malkoski

Again, you have to look at the three operating segments. In the industrial business, the market opportunities for our liquid natural products that compete against primarily synthetics remain very large. We are concentrating our efforts on where our products can make the biggest difference and have the most relevance in the market in sustainability. So we believe there's plenty of market opportunities there.

From is food perspective, with a lot of the technologies that we have and some of the segments that are showing great interest in health and wellness and natural and glutenfree and some of the pet and dairy, we continue to see a wide range after opportunities.

From the Australian perspective, the markets for some of these naturalbased products and wellness products are very significant, not so much in Australia as they are in Europe and the U.K. and parts of Asia.

Operator

Our next question comes from Tyson Bauer Wealth Monitors.

Tyson Bauer Wealth Monitors

Couple of quick questions. In regards to Australia, can you describe a little more in quantitative terms that turnabout potential now that we will eliminate some of that raw material procurement, saving the moneys there. And also with that decline on the Australian dollar, what is that range that we could see pick up in the absolute gross profit dollars by the time we get into the second half of fiscal 2009?

Steve Cordier

Two separate elements there. Certainly one is on the cost side. For magnitude, I will mention that what I said in the past is that about a $10 swing in net grain costs impacts the cost of manufacturing the Australian segment by about $1 million to $1.2 million.

The grain costs in Australia were really subject to calendar and harvests. The wheat harvest is being collected now. We have contracts for flour that run through the end of calendar 2009. The positive effect of lower wheat prices should begin to reflect in our financial statements as the new harvest is brought in and consumed. That won't be until the second half of fiscal 2009. Now the magnitude of change is easiest reflected by looking at the milling wheat contracts on the Australian exchange, the ASX. During fiscal 2008, they peaked at nearly $400. They're down, they moved $200 or $300; and they're slightly below $300 a ton now.

If you look at corn, as I said in my prepared comments earlier, we expect those costs to remain high because that's an irrigated crop and the water reserves have not replenished sufficiently for that upcoming harvest to be greatly affected or get any benefit.

The ratio of corn to wheat is about even in consumption throughout Australia and in New Zealand businesses. Overall, we think that grain costs for Australia will remain fairly high 2009 versus 2008 and that benefit of lower prices, although begun in the second half for wheat, will be largely felt in the next fiscal year, 2010, when those crop harvests are fully integrated into the cost structure of the consuming companies.

When you look at the Australian dollar, it's a little bit hard to measure that because of the sharp fall. It's down and since the end of the fiscal year to levels that we haven't seen for nearly 5 years. I will fall back on commentary that I have made in the past, that as that exchange rate falls through the 60s, the mid60s, where it is trading today, we view that has a very competitive tradeoff for Penford's products for new and existing products against import competition into Australia and New Zealand and for the establishment of a value proposition for export products.

How much that will hit gross margin is greatly dependent on the appetite for our customers to switch out based on our new value proposition and currency exchange, we think that's quite significant. The other element that I think is very hard for us to predict is what our customers' demand will be based on their situation in the selling market. So you can tell by how long this answer is, I am quite reluctant to put a dollar amount on it for you.

Tyson Bauer Wealth Monitors

All things moving, many variables. On the customer attrition question or situation, is it going to take until we get through December and January to get a better sense of where that is going to fall or have you been able, with those relationships with those customers, get a fairly good feel that it will come back to previous flood levels that losses would be minimal, at best?

Tom Malkoski

I think it will take us through until the end of December to know the answer to that definitively. Our expectation is that we will see some minor losses from some existing customers going into the 2009 contract season. We have planned for that. We have other customer opportunity that we certainly will be pursuing in the course of the contract negotiations. Having said that, some of this volume attrition for 2009 that may happen, is planned as part of our manufacturing configuration.

When we turned on the ethanol portion of the plant, part of our planning process would actually have us taking out a certain portion of starch drying capacity. So our expectation going into 2009 was that we would have some carefully monitored, measured, controlled attrition of customer business, either through normal market demand or through choices in the negotiation with customers. All of what is happening now has been expected, anticipated, and planned for.

Tyson Bauer Wealth Monitors

On the operating expense line, do you have a sense of what we should be modeling in as far as kind of a normalized quarterly rate as we go forward?

Steve Cordier

As a percent of overall revenues, if you look at the operating expense line, I think you probably are going to see somewhere around a 10% level for operating expenses.

Tyson Bauer Wealth Monitors

And the last question, where do you stand currently on your ethanol production levels and do you anticipate that changing in the next 3 months?

Steve Cordier

The ethanol production levels are now running at close to 90% of the design capacity. The final 10% or so is dependent upon the repair of one of our tanks that was damaged during the flood. We are working on that project now and expect to be able to complete that in the next several weeks.

Tom Malkoski

It also will depend on the market opportunities going beyond the repair and the level of starch demand. We will balance that carefully in determining how much ethanol to produce.

Tyson Bauer Wealth Monitors

It seems like in your industry a lot of the players have something that they're dealing with. Whether it's the whole CPO/Bunge split, what happens with Lyle and Tate, MGPI, obviously, severe difficulties they're facing. What is the health of the industry and how are you fitting in? Are you relatively in a better shape than some of these other competitors?

Tom Malkoski

Let's look at generally the industry and many of the companies that you named have had some fairly strong earnings. When you see ADM, Cargill, Bunge, had strong earnings. When you look at the fundamentals of the business, they had something that was accountingrelated on hedging and market positions that affected their numbers. Corn products has had very strong performance. MGPI has not and [inaudible] obviously are struggling.

Then you have to step back and say, how is Penford different? We have a different business model because we're not a basic agricultural processor. We do that function, but then we move beyond that and formulate with our products. So, I think we are somewhat different from the larger competitors.

Doesn't mean we're insulated from swings in commodity prices, including the effects on chemicals and natural gas or energy, it just means that as we formulate and strengthen our selling propositions for our products, we need to have relevant products that work in our customers' systems and that is the basic portfolio that we offer in the majority of our businesses. It is somewhat different than what the competitors do. We still see there's plenty of opportunity for a company like Penford in this industry even with a lot of these moving parts.

Operator

Our next question comes from Joe Gomes – Oppenheimer & Company.

Joe Gomes – Oppenheimer & Company

I was wondering if you might be able to provide any kind of detail or more in depth color on what are the insurers waiting for to affirm coverage? Is there some big hangup there or just kind of looking at the fine print?

Steve Cordier

The process is on the insurer's side thorough and measured. For example, today, they have several process engineers who are on site in Cedar Rapids reviewing the way the production flows through our plant. I wouldn't describe any of it at this point as a hangup. It's a large claim. They're moving through the process, I would say at their own pace, although we've been, as you would expect, requesting a good deal of urgency with regard to getting the claim resolved.

I would say at this point that we've submitted the bulk of the documentation required on the direct costs. We've submitted a significant fraction of the documentation required for the business interruption claim, and it's a matter of them sorting through. Now, when I say they haven't affirmed coverage yet, they haven't come to a position with regard to our review of the policy and declared on that. That's something that lies ahead for resolution.

Joe Gomes – Oppenheimer & Company

For 2009, fiscal 2009, what kind of CapEx are you expecting?

Steve Cordier

At this point, I think we'll probably be in the range of $10 million to $15 million for total CapEx for fiscal 2009.

Operator

Our next question comes from Lawrence Alexander Jefferies & Company.

Lawrence Alexander Jefferies & Company

I guess just first of all on Australia, just wanted to parse the answer you didn't want to pin down on 2009 and 2010. It sounds as if what you're getting at is, given the current pricing, you probably have about a $5 million to $6 million tailwind in 2010 already spread in 2009 and 2010 from crop prices. In 2009, you would also have a headwind from FX on your reported Australian profits because your products are going to be ramping up in the back half of 2009 and 2010. Is that what you were trying to get at or did I?

Steve Cordier

The reported aspect of the FX didn't come into my comment. Although you're correct. On a reported basis, currencies will shift the translated results down, mainly on the top line because you remember that we have a reported operating loss for 2008. Unfortunately, it won't reduce the profits because there aren't a lot there. When you look at the costs, I would agree with your scheduling of the costs, that fiscal 2010 will see a tailwind, probably in the magnitude that I described.

We continue to have headwinds from crop costs in 2009 because we won't expire the highcost flour contracts for wheat until about January, so we won't see benefit from the lower wheat cost until the second half of the year and that maize cost will remain high for the balance of 2009 because their harvest doesn't really finish off until the second half of the fiscal year. If they see any price reduction as their water reservoirs fill, it won't hit in 2009, it should show up in 2010.

Lawrence Alexander Jefferies & Company

With the food ingredient and industrial ingredient segments, could you revisit your long standing margin target and how comfortable you are with those in the current operating environment and given the order patterns you're seeing with customers?

Steve Cordier

I think if you look at the North America food ingredients business, the gross margin area of that has always been in the high 20s, targeting the 30% area a little bit higher if we can squeeze some of the mix out of the business.

If you look at the industrial ingredients business, I think that on a gross margin basis, they're operating in the mid to high teen levels. As we have said with the second half of fiscal 2009 relative to 2008, they should bring those home. Now, what could play off in that factor is ultimate demand from the customers as they see their end markets show the impact of a slower economic activity.

What I would say is that the potential for that to affect our business on the industrial ingredient side would show up mainly in the mix, where we would end up selling more of our lesser modified grades of industrial starches because our customers would shift to that on a cost basis. You would see probably more ethanol in the mix, which is not comparable to our highest grade ethylated starches. That impact could be in the range of 200 to 400 basis points, depending on the depth of that switch.

On the food ingredient side, as we mentioned in our prepared comments, their end markets are largely toward quick service restaurants and food manufacturers serving the grocery retail outlets and we have seen those actually quite resilient in this and prior economic slowdown activity as people change from purchasing restaurant meals to prepared meals, but often in quick service restaurants or now more recently from grocery store chains. I would not see the margin contraction due to economic activity slowdown as dramatic in that business as it might be in the industrial ingredients. Does that help?

Lawrence Alexander Jefferies & Company

And then lastly, on the other income line, the gain on the hedges, can you discuss whether that was voluntary or not? I just wanted to have an understanding to what degree you have discretion or put capital at risk on the hedging side.

Steve Cordier

Let me answer the specific entry you have right now. I will describe how we operate with those hedges. We receive customer indication to determine a price for the customer and then we go into the marketplace and we lay off that physical risk in the forward market. It's essentially what the market would call a backtoback trade.

We were doing that in the normal course prior to the flood for production that was due to be processed in the fourth quarter. The flood occurred. And so we went to our physical suppliers of grain and we said let's defer delivery of that product until we come back into production sometime in fiscal 2009. Now, originally, we would have taken that gain period or the hedge, and moved it to that same revised end date schedule.

But there are some accounting pronouncements that are quite technical with regard to FAS 133 and APB 138 that determined, upon interpretation, that we could not link the gain on the hedge to the revised delivery of the physical product in fiscal 2009. We had to take that $2.9 million and recognize it in the fourth quarter.

Now I am going through that because what that will do is it will mean that we have some highpriced inputs in the first and some, a little bit, in the second quarter of fiscal 2009 that normally would have been offset with some of this hedging.

Lawrence Alexander Jefferies & Company

So just to be clear on that, from a normalized perspective, we should then assume about a $2.9 million headwind in the first half of next year?

Steve Cordier

Yes.

Operator

Our next question comes from Robert Kosowsky – OFI Institutional Asset Management.

Robert Kosowsky - OFI Institutional Asset Management

I just had on Australia a couple questions. First, was there a gain or loss from that property sale this quarter?

Steve Cordier

Gain.

Robert Kosowsky OFI Institutional Asset Management

How big was it?

Steve Cordier

$700,000.

Robert Kosowsky OFI Institutional Asset Management

If you look at the Q3 to Q4 sequential decline in operating profit, does that quarter also have some higher costs to transporting from the far reaches of Australia and so forth? Or kind of could you shed some more light about the sequential decline?

Steve Cordier

If you think about that description in the prepared comments about the recovery of the grain costs, all right, the net effect is that because the new product development did not occur on the original schedule and that there was a penalty for processing grains, the high cost grain that we talked about, the $15 million flowed through with more impact in the second half of fiscal 2008 in Australia.

So, you didn't see any of the offsetting benefits, particularly in the fourth quarter. So, the grain costs, not additional transportation costs or incremental costs, but the original $15 million headwind of grain costs showed more explicitly in the fourth quarter.

Robert Kosowsky OFI Institutional Asset Management

With maize, is that high and getting higher? Or is it just kind of high and kind of flat running?

Steve Cordier

It's a little bit higher actually in 2009 relative to 2008 because the guys using the irrigated crops are still in a waterpoor situation. It's not moving down. It's moving up.

Robert Kosowsky OFI Institutional Asset Management

Then on some of the new customer trials that you are doing, are these going to be contract structures or are they going to be basically customer is buying your product, I guess, on a more of a spot basis or is it a volume you can lock in for a sustained period of time?

Tom Malkoski

Usually what happens is we would contract for a period of time. Many of the contracts would run for about a year.

Robert Kosowsky OFI Institutional Asset Management

So any kind of customer pick up wins are going to be somewhat meaningful over the course of the year.

Tom Malkoski

We believe so, yes, and that's normally the way we structure our business relationships.

Robert Kosowsky OFI Institutional Asset Management

Is your insurer in good shape right now? Good financial shape?

Steve Cordier

Yes, our two insurance companies are Ace American and AIG.

Robert Kosowsky OFI Institutional Asset Management

And AIG is still doing okay?

Steve Cordier

Yes.

Robert Kosowsky OFI Institutional Asset Management

Finally, did you guys pick up any good productivity improvements on the rebuild of the Cedar Rapids plant? Can you quantify any of that?

Tom Malkoski

We can't quantify it yet, but we are seeing some improvements in some areas and we're very encouraged by it.

Operator

Our next question comes from Tom Spiro Spiro Capital Management.

Tom Spiro Spiro Capital Management

I note on the press release that total debt as of August 31 was about $69 million. Couple of sentences down, we learn that the borrowing requirements will go up. I am curious where that stands today?

Steve Cordier

We've got probably close to $75 million to $80 million on the books in total. The other important factor, remember, there is that we have $45 million of unused capacity at August 31. That should be sufficient for our needs.

Tom Spiro Spiro Capital Management

And the reference to the $45 million of unused loan commitments, I don't know a heck of a lot of nomenclature folks use here, does that mean that as of August 31, if you called up the bank and said send us $45.7 million they would have, or are there limitations we need to think about with respect to that $45 million?

Steve Cordier

As long as you're in compliance with the covenants, the answer to that is yes. It is an unused commitment.

Tom Spiro Spiro Capital Management

Secondly, kind of a big picture question on the paper side, the last year or two it seemed to me the world was short of starch capacity with folks devoting starch capacity to ethanol, the paper industry being soso. Is the world short of starch capacity today? Does that situation pertain today?

Tom Malkoski

I think the shortness has certainly moderated. Right now, those who can make starch are certainly looking to negotiate their contracts for not just starch, but for high fructose corn syrup and others right now that are on the same timing. The other thing I mentioned of course is that while there are 8 or 9 people that make the unmodified starches, there are only 3 others beyond Penford who can make the high end ethylated starches. That's certainly where we concentrate.

Operator

Our next question is a followup from Lawrence Alexander with Jefferies & Company.

Lawrence Alexander Jefferies & Company

One other question, what would you need to see to embark on a broader restructuring program at Penford and, if you did, do you have the flexibility to do so?

Tom Malkoski

Could you perhaps clarify that a little bit? What do you mean by broader restructuring?

Lawrence Alexander Jefferies & Company

Just, what levers would you have to pull if the current economic environment continues to deteriorate? Your customers, people continue to migrate back towards grocery stores, pressure on the margin. Under what situation would you even consider in trying to trim costs incrementally in the segment? If you did, what levers do you have, what opportunities are there, if any, it is a pretty lean ship.

Steve Cordier

I think overall what you're really saying is, what is the ability inside the business to move reasonably quickly to align costs with the prospect for either reduced volumes or margin squeeze? I think we've demonstrated in the last several years the capability and the willingness of the business units to move quite quickly to rationalize and align their cost structures.

I think the caveat I will put in that is that, many times, these choices about cost reductions would involve either an upfront charge or the prospect that you would forfeit significant strategic growth down the line. So, I think we have to evaluate that very carefully. We have put in place, if you will note over the last several years, significant capital investments that make us a more progressive and efficient business overall.

I think that, as far as other, what I will call typical, levers that you see in the cost structure of P&L, head count, and so forth. I would echo your comment that we're a fairly lean business operation with regard to those elements. It would really require an assessment for us to concentrate on specific product categories while just simply being more efficient with discretionary spending. I think we're capable of that and it would really be the depth of the challenge that would be the tradeoff.

Operator

Your last question comes from Ken Zaslow BMO Capital.

Ken Zaslow BMO Capital

Just wanted to get a feel a little about the insurance stuff. This quarter, it seems like about $38.1 million of the $60 million to $62 million is the flood. The remainder will be incurred in this quarter?

Steve Cordier

Be careful now because you're jumping to the $60 million. You're not going to incur lost profits. The lost profits just aren't there. So the first thing to remember is that the business interruption aspect doesn't show up in the financial statements because it really was reflected in the fourth quarter with the sales that didn't occur and the profits that didn't get shown, right?

When you talk about incurred losses, or additional expense, it would be the difference between the $38 million that we've expensed in the fourth quarter and the total estimate of $45 million that we talked about. That additional or incremental $8 million or so is likely to be incurred and expensed in the first half of fiscal 2009.

Ken Zaslow BMO Capital

And with two and a half weeks left in this quarter, how is this quarter going?

Steve Cordier

If you look at the business prospects, business by business, I will go back to the comment that I made with, I believe it was one of the other callers, where they pointed out the headwind that we're going to have in the industrial business due to that realization of the hedge contracts. We had looked at the first quarter for the industrial business and expected them to have a positive operating margin of close to 5%.

With this headwind, that will swing by that $3 million decrement; and it will be below breakeven unless we're able to scramble with some offsetting contingencies in the remaining few weeks of the quarter.

We think that the food ingredients business will be strong. They've shown a strong start to the fiscal year and that they will have a good quarter. The performance in the Australian business will be similar to the fourth quarter of fiscal 2008, probably not quite as difficult a quarter because they have put in some of the cost containment measures and they'll continue to flow through. But with the high grain costs and the slower ramp-up of the new product developments, they'll struggle to achieve breakeven.

Ken Zaslow BMO Capital

Just because we’re going to exclude it out, the $27.6 million in food ingredients that's related to dextrose, how much was that within that division? So that I could just take it out.

Steve Cordier

The flood impact?

Ken Zaslow BMO Capital

Yes, because I want to take it out.

Steve Cordier

In the process of allocating the insurance recoveries, we made the dextrose business largely whole from a profit perspective. The 16% decrease was in volumes of similar revenue impact. So when you're trying to adjust for the flood, it really affected primarily the top line in the North America food business in the fourth quarter.

Ken Zaslow BMO Capital

So the $27.6 million, I just take out of the ingredients business?

Steve Cordier

The industrial ingredients.

Operator

There are no further questions at this time. I would like to turn the floor back over to management for any closing comments.

Steve Cordier

I appreciate your participation in the call. If you have any follow-up, please call me, Steve Cordier, at the number at the top of the press release. Thanks.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.

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