Penford Corporation F1Q09 (Qtr End 11/30/08) Earnings Call Transcript

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 |  About: Penford Corporation (PENX)
by: SA Transcripts

Penford Corporation (NASDAQ:PENX)

F1Q09 Earnings Call

January 8, 2009 11:00 am ET

Executives

Steven O. Cordier - Chief Financial Officer

Thomas D. Malkoski - President and Chief Executive Officer

Analysts

Jonathan Lichter - Sidoti & Company

Lucy Watson for Laurence Alexander - Jefferies & Co.

Kenneth Zaslow - BMO Capital Market

Joseph Gomes - Oppenheimer & Co.

Robert Kosowsky - OFI Institutional Asset Management

Rob Felice - Gabelli & Company

Jonathan Lichter - Sidoti & Company

Tyson Bauer - Wealth Monitors

Tom Spiro – Spiro Capital

Operator

Greetings and welcome to the Penford Corporation first quarter 2009 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Steve Cordier, Chief Financial Officer for Penford Corporation.

Steven O. Cordier

Thank you, good morning everyone. Thank you for participating in our conference call to discuss the first quarter fiscal 2009 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 forward-looking comments we might make this morning. Any forward-looking statements regarding future events or the financial performance of the company are just predictions, and actual events or results may differ materially. These forward-looking 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. And finally, we do not undertake to update publicly any forward-looking 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 the first quarter . Tom will then provide our observations on business conditions and prospects for fiscal 2009.

First quarter fiscal 2009 consolidated sales were $80.7 million compared with $94.9 million a year ago on lower volumes due to following factors: the sequencing for resumption of operations in Cedar Rapids after the flood in the fourth quarter; plan changes in product offerings from Australia; and, slower order flow from paper industry customers responding to the global downturn in business activity.

U.S. dollar reported revenue was also impacted by an 18% decrease in Australian dollar exchange rates from last year. These were partly offset by higher pricing worldwide.

First quarter fiscal 2009 gross margin of $5.4 million declined as a percent of revenue to 6.7% from 17.1 % a year ago. The margin reduction reflected a number of elements. Lower revenues, higher grain costs in Australia, increased manufacturing outlays for energy and chemical inputs, higher maintenance expenses as the Industrial Ingredients business restarted manufacturing processes, and additional depreciation for the ethanol assets.

Gross margin also reflects the impact of the accounting requirement to recognize in fiscal 2008 $2.9 million in gains on hedges for natural gas and corn positions that were actually consumed during the first quarter of fiscal 2009.

Total operating expenses in the first quarter were comparable to the prior-year quarter at $7.3 million and R&D expenses were $1.5 million.

First quarter 2009 operating income included $6.8 million of direct flood restoration costs which were offset by $11.0 million of insurance recoveries.

Income from operations was $800,000 compared with $5.8 million a year ago. Operating income for the first quarter last year included $1.2 million in severance costs for reduction in force in Australia.

Interest expense increased to $1.5 million from $1.3 million a year ago primarily due to higher average debt balances related to the funding of the ethanol facility in Cedar Rapids that was commissioned last May.

During the year-end conference call we mentioned that borrowing levels were expected to increase as we funded payments related to the flood recovery and other corporate requirements.

Our outstanding debt has increased by $6.0 million over August 31, 2008, levels to $74.6 million. We continue to carefully manage expenditures in capital projects to optimize our balance sheet flexibility.

Income taxes were a benefit of $0.5 million compared with an expense of $1.8 million in the first quarter of fiscal 2008. The effective tax rate was 57% versus 36% last year due to an additional tax benefit for research and development activities recognized in accordance with new tax legislation enacted in the first quarter of 2009.

Net loss for the quarter was $400,000 compared with a profit of $3.2 million a year ago.

Quarterly diluted loss per share was $0.03 in fiscal 2009 and diluted earnings per share were $0.33 per share in 2008.

The public stock offering completed last December added 2.0 million weighted average shares for the first quarter of 2009.

Capital spending was $1.5 million in the first quarter, down from $17.4 million last year, reflecting the completion of the ethanol construction project and the reprioritizing of engineering and operating personnel to restore the Cedar Rapids operations after the flood last June.

The operations used $7.2 million in cash during the first quarter of fiscal 2009 compared with providing $13.6 million a year ago, primarily due to a decrease in earnings and the impact of investments and working capital as the company’s Industrial Ingredients business resumed full manufacturing capability in Cedar Rapids.

First quarter sales in the Food Ingredients North America business expanded $1.7 million, or 10.4%, to a record $17.7 million primarily on higher average selling prices across nearly every category.

Potato coating revenue improved 2% and sales of non-coating applications expanded 20%. Volumes were comparable to last year. Operating profit grew 28% to $3.4 million over last year’s first quarter on revenue increases.

The North American Industrial Ingredients sales decreased to $41.8 million from $49.2 million last year. Volumes were below prior year as the business restarted manufacturing processes after the flood in the fourth quarter of fiscal 2008.

The business also encountered lower order flow from printing and writing industry customers who curtailed production through market-related downtime as demand decreased for coated and uncoated paper.

Ethanol production resumed in late September 2008 for two full months of sales achieved during the quarter.

Improvements in pricing and the impact from passing through higher corn costs to industrial starch customers did not completely offset volume comparisons and quarterly revenues declined 15%.

Gross margin fell to $100,000 from $8.6 million a year ago. About one half of the reduction in margin was caused by the decrease in revenue. The remaining decrease is due to higher chemical costs, additional maintenance expenses as the business restarted its manufacturing activities, and incremental depreciation on the new ethanol production assets.

The gross profit in the first quarter of 2009 also reflects a $2.9 million negative effect of separating and recognizing gains on commodity hedges in fiscal 2008 from the delivery of the natural gas and corn which were consumed in the first quarter, as we mentioned earlier.

Operating income of $1.8 million includes $6.8 million of direct flood-recovery expenses offset by $11.0 million of payments received from insurers this quarter. The direct costs of the flood incurred to date are $44.8 million and are now approaching the total amount we project for this event, ranging from $45.0 million to $47.0 million.

These expenses do not include more than $15.0 million in profits lost due to the flood last June. The company has now received $21.5 million in recoveries from the insurance carriers and we continue to process claims for both direct flood costs and lost profits. However, at this time we cannot estimate the amount or timing of additional insurance proceeds.

The Australian business reported sales of $21.4 million for the first quarter of fiscal 2009 compared with $29.9 million a year ago. The impact of improved local currency pricing and product mix of $3.0 million in the first quarter was more than offset by lower Australian foreign exchange rates as this translation reduced sales in the U.S. dollar terms by $4.8 million.

Lower volumes also impacted revenue by $6.7 million as the business refocused commercial activities on applications and customers that would provide higher long-term returns. The volume change from the prior year includes competitor activity in fiscal 2008 when the Australian dollar traded at historical peaks, providing offshore manufacturers with relative cost advantage.

Gross margin decreased $3.2 million to a break-even level. Grain costs rose $3.5 million from last year. These higher input costs, combined with increased chemical and manufacturing costs and the effect from lower plant utilization rates, could more than offset improved pricing and rationalization programs.

In fiscal 2009 corn is being sourced from new farming areas in northern Australia where water supplies remain available for this crop. We experienced low initial field yields and delivery interruptions as our new suppliers oriented to strict manufacturing specifications and dealt with poor harvesting weather. These factors added nearly $1.0 million to quarterly costs and are expected to rebalance by February.

Loss from operations was $1.5 million compared to an operating loss in the prior-year quarter of about $100,000. The prior year included $1.2 million in severance expenses for a reduction in force in Australia.

I will now turn the discussion over to Tom.

Thomas D. Malkoski

General economic conditions have dominated the news of late and the slowdown in global and domestic demand in manufacturing output is negatively impacting our Industrial business but has not, at this point, materially affected our Australian and North American Food Ingredients segments.

The trend of declining consumption of printing and writing papers accelerated in our fiscal 2009 first quarter. In response to the downturn, industry producers, including several of Penford’s customers, took extended market-related downtime to better match demand and balance inventories.

In addition, uncoated free sheet producers announced the closure of 4% of industry capacity.

Earlier during 2008 coated free sheet manufactures removed 4% of industry capacity.

While inventories of both grades of paper remain relatively low compared to historical levels, they represent an increase in days supplied based on usage rates.

We are prepared for difficult market conditions in the near term and continue to believe that our highly modified industrial starches contribute important finished product and processing characteristics to our customers’ businesses.

The current ethanol market conditions are also challenging. Gasoline demand and pricing are down. Ethanol pricing has declined but is trading at a premium to gasoline, resulting in substantially less discretionary blending and, therefore, weaker demand.

Penford’s first quarter 2009 ethanol gross margin was positive but below targets. Several published industry reports forecast improvements in ethanol pricing and margins as we move through calendar 2009. We expect to be in position to capitalize on profit opportunities should they materialize.

The value proposition of our liquid natural additives business remains compelling and the level of trial activity is good.

We have initiated a restructuring of our Industrial Ingredients business which will remove approximately 8% of our salaried and union work force. Most elements of the restructuring were planned prior to the economic slowdown but the plan has been enhanced to reflect current conditions.

The restructuring is driven by four factors: the idling of certain starch dryers with the scale-up of ethanol to comply with environmental permits; the streamlining of specialized production assets confirmed during the flood recovery; reallocation of commercial resources in support of value-added new business activities; and, the adjustment for the broader economic and industry slowdown.

The work force reductions will come from a combination of position eliminations, retirement, and not filling vacant jobs. The estimated cost of the restructure program is $200,000 with a projected annualized cost reduction of $1.5 million.

The plan implementation will occur in our second and third fiscal quarters and we do regret that these necessary steps will result in the loss of some valued employees and we appreciate their past contributions.

Performance in the Australian and New Zealand businesses continues to be challenged by high grain input costs and below-target plant efficiencies, partly created by a variability in the drought-affected coating supply.

Wheat production has returned to near normal and growing conditions are showing modest improvement for corn.

The recent softening in the Australian dollar against many world currencies is creating opportunity for Australian-made products.

This business is focused on improving our new product acceptance rates with customers, grain procurement, and achieving targeted plant efficiencies.

Customer trial activity is ahead of year-ago in terms of the number of trials and in the commercial phase of these trials.

A more favorable currency environment should contribute to commercial success.

The North American Food Ingredients segment continues to be a model for success based on differentiated products that deliver important benefits for customers and an organizational culture that lives this specialized business model.

The business is demonstrating effective resiliency in today’s turbulent economic conditions with attractive growth prospects.

This concludes our prepared remarks and I thank you for our interest in Penford and please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jonathan Lichter - Sidoti & Company.

Jonathan Lichter - Sidoti & Company

Based on what you know now do you expect to be profitable in Q2?

Steven O. Cordier

Right now, as we look at conditions, I think with seven or eight weeks left in the quarter, we expect our Industrial business and our North American Food businesses to be profitable.

We think the Australian business, which typically has the second quarter as their most difficult quarter, will have operating losses, not in the amount they had in the first quarter, probably about half of that level.

And that’s primarily because of the changes in demand that occur in Australia because of the combination of their school holidays and Christmas holidays, as well as the fact that they still have some rebalancing that’s going to occur by drawing the corn down from the northern growing regions that we sourced earlier in the year.

Jonathan Lichter - Sidoti & Company

So that would tend to indicate that you would show a profit?

Steven O. Cordier

I think we will have close to break-even conditions. It depends on how fast we are able to implement some of these contingency plans that Tom has described.

Jonathan Lichter - Sidoti & Company

The $2.9 million that was a gain last quarter, was that fully recognized as a cost in this quarter?

Steven O. Cordier

Yes.

Jonathan Lichter - Sidoti & Company

So there won’t be anything extending into Q2 there?

Steven O. Cordier

No.

Operator

Your next question comes from Lucy Watson for Laurence Alexander - Jefferies & Co.

Lucy Watson for Laurence Alexander - Jefferies & Co.

Have you established a raw material cost outlook for Australia for the full year?

Steven O. Cordier

At this point what we have is most of the wheat has been procured at levels favorable to the prior year. The corn, as we said, is still coming through the balance of the fiscal year. Most of it has been secured at prices at or above the prior-year levels, so on an overall basis, we think that we will have grain costs slightly above the fiscal 2008 levels for fiscal 2009, primarily due to our projections for the cost to acquire corn from New Zealand and Australia.

Lucy Watson for Laurence Alexander - Jefferies & Co.

In North America are you getting much push-back on price from your Food Ingredients customers?

Thomas D. Malkoski

Certainly, as always, we do get a fair amount of push-back on price and it’s part of the negotiation with each contract that we have. We have been successful in working with customers on the price increases, which they understand are justified, and the value of our products is allowing us, I think, to succeed in that.

It is certainly a difficult environment to negotiate pricing but in many cases it is necessary.

Lucy Watson for Laurence Alexander - Jefferies & Co.

And do you have balance sheet targets for 2009 and 2010 and as a follow up to that questions, what is your maintenance capex level?

Steven O. Cordier

We do have balance sheet targets. They range across a number of elements. For example, working capital and fixed assets and so forth. Our projections for capital expenditures at the maintenance level are approximately $10.0 million.

Operator

Your next question comes from Kenneth Zaslow - BMO Capital Market.

Kenneth Zaslow - BMO Capital Market

I know it’s early days, but how is the Industrial contracting renewal process going?

Thomas D. Malkoski

We have actually completed virtually all of the Industrial contracting for 2009 calendar year. We still have two or three contracts that are right now in the initial stage of negotiation and at least one of them has a timing that is not a January start. The majority of the contracts have been negotiated.

Kenneth Zaslow - BMO Capital Market

And at what levels? What are we looking at?

Thomas D. Malkoski

Well, we are not commenting on the specific pricing, but in terms of the environment we are certainly struggling to push the price increases that are justified by chemical costs through. And in some cases we have and others we have not.

We also, I might mention, as part of our contracting are actively involved in some new business opportunities with some of our customers that are not as directly competitive and so there are further opportunities there, I think, to negotiate.

Kenneth Zaslow - BMO Capital Market

If I look into the ethanol business, how do you see the margin outlook? It sounds like the margins were positive but not as positive, I couldn’t understand exactly what you were trying to get at in the comments. Could you talk about how the ethanol business performed, what utilizations you’re at, are you fully operational, and just give us a bit of an outlook on that?

Steven O. Cordier

First of all, with regard to the capabilities inside the ethanol facility, there was, as we mentioned, one additional piece of equipment that had to be brought online to get to full design capability. That should be coming online within the next seven to ten days and then we will be at 100% capability.

Because we didn’t have that piece of equipment, we’ve been running at somewhere between 85% and 90% of design capability, which is 45.0 million gallons per annum.

When you look at the margin, as you well know, it’s really a function of the crush element, and that’s the revenue per gallon from ethanol, which is a commodity product. Then the input costs, primarily for corn and natural gases.

If you look at the first quarter of our year, the ethanol operation provided a positive gross margin contribution and it was not as significant as our original model nor was it as high as our industrial starch business, but it did provide us with cash flow and certainly absolute profit levels.

We think that as you look forward and you say, well, where is that business going to operate, if you say at this moment in time and you look at existing pricing for ethanol, existing pricing for the other inputs which are corn and natural gas, for Penford, we’re at pretty close to a neutral gross margin situation but yet benefits from contributions to fixed overheads and other costs, by flowing production through.

When you look at forward rates for ethanol, out four, five, six months, that prospect becomes attractive if you don’t get extraordinary increases in the cost for corn.

Kenneth Zaslow - BMO Capital Market

And I guess because you are running at as full utilization as you could, given the absence of that one piece of equipment, that would mean that the reason that you’re doing that is because the other business is slowing down, not so much because of the margin is better, is that the interpretation?

Steven O. Cordier

Yes, that is reasonable.

Kenneth Zaslow - BMO Capital Market

In terms of the commodity outlook, you talked a bit about Australia, but aren’t natural gas prices, chemical prices coming down? Is there some sort of benefit that we would probably get to see in the next couple of quarters or have you already locked in everything?

Steven O. Cordier

Let me come back to one other point, too, when you mentioned what I’ll call the displacement, remember that we put the ethanol operation in as an additional outlet choice for our production capabilities and one of the advantages we see is that as a commodity we will be able to choose how much we can dial up or down the production for ethanol.

So as we pursue and as we expect to achieve some additional opportunities in industrial starches, we would say that that business, because it’s a better margin attraction, would displace some of the ethanol production.

Now with regard to the input cost, if you look at some of the major elements between the end of our fiscal year on August 31 and the end of the calendar year on December 31, there were some dramatic changes.

Natural gas fell by nearly 25%, you saw certain chemicals drop, like EO and quat, by nearly a similar amount. Corn has fallen by almost 30%. Ethanol pricing has fallen by more than that, it’s fallen by about 35%. The chemicals that have remained sticky in price are really caustic, which is a widely-used chemical, and that is primarily because it’s a chemical that is produced in conjunction with the manufacturing for chlorine and demand for chlorine has dropped dramatically because of the drop in housing activity and so producers have raised the price for caustic by almost 40% over the time frame I just talked about.

Now we are looking for that to continue to drop and we applied some new measures in our processing to reduce our usage but the cost for chemicals on average is not down as much as you would expect, based on general market barometers.

Kenneth Zaslow - BMO Capital Market

So you are basically saying that the advantages are there.

Steven O. Cordier

It’s almost neutralized because caustic has gone up by as much as the other ones have gone down.

Operator

Your next question comes from Joseph Gomes - Oppenheimer & Co.

Joseph Gomes - Oppenheimer & Co.

You had mentioned last quarter you thought the second half of 2009 would be like the second half of 2007. Given what we know today are you still sticking to that outlook or has that been changed?

Steven O. Cordier

If you look at the second half of 2009 versus 2007 you have to make some pretty important assumptions. So if you look at the effect of those assumptions, I will try to lay it out for you.

If you said that the world is going to be about the same today for the second half of our fiscal year and that Penford is unable to implement successfully any of the elements of improvement that Tom has described for both the commercial and the cost side, then the second half of fiscal 2009 would be below fiscal 2007, and might be on the order of half the amount of contribution, particularly from the Industrial business.

If we are able to implement the business-specific initiatives that Tom has described, we should be within 10% of that fiscal 2007 second half performance for the industrial business.

All of this, of course, is enveloped by the external conditions and whether the slowdown elements improve. We think that there was a sharp cliff effect in the last few months of the calendar year on demand for our customers’ products and so they understandably had a sharp reaction.

If you assume that you are going to get a moderation of that, external conditions should improve and, therefore, we would end up with, I would say, a higher probability toward the comparability to second half fiscal 2007.

If your personal, internal models call for a deteriorating economic condition, then Penford will have to add some additional initiatives and contingencies, which we are capable of doing, or those business results will probably suffer more.

Joseph Gomes - Oppenheimer & Co.

In the Australian business you said that grain costs were up $3.5 million year-over-year. What would that look like quarter-over-quarter? Are we starting to see any type of moderation there?

Steven O. Cordier

Yes. If you look sequentially, their grain costs are only up slightly. I would say they are probably within 10% of the sequential prior quarter. So they are beginning to stabilize.

Operator

Your next question comes from Robert Kosowsky - OFI Institutional Asset Management.

Robert Kosowsky - OFI Institutional Asset Management

As far as Australia and the portfolio repositioning there, where are we on this product rationalization process because it looks like we have a little bit of a let-down in this quarter.

Thomas D. Malkoski

We have taken out the products that we have made choices on exiting and that is already in place so there is no further change in that portion of the product mix.

The other part of the product mix though, on the more positive side, is some of the new products that have been developed and are in various stages of commercial trials, that as these products flow into our business we will obviously manufacture these products and in some cases cut back on the manufacture of certain other products that are less attractive to us strategically or financially.

Steven O. Cordier

Let me give you a little bit of scope on the changes. As I mentioned, two elements to the volume changes in the Australian business, certainly the more important one was the planned choices for rationalization to pursue products and concentrate on those that give better return.

And that probably if you look at on what I will call an annualized basis, had a negative impact on the volumes of probably 10% or 15%. The balance of the change that you saw in the quarter, another 10% or so, was primarily due to increased competition that was cemented and occurred in fiscal 2008, nearly six or seven months ago, because the Australian dollar was trading at that time nearly at $0.95 to the $1.00.

What we have been working on since the Australian dollar has now declined to nearly $0.70, and again, some currencies like the Japanese yen by almost 35%, on regaining those pricing competition volumes that we had to surrender a few quarters ago.

Robert Kosowsky - OFI Institutional Asset Management

Have you started to see that in your results through late December into January?

Steven O. Cordier

We have not seen the impact of those initiatives on the foreign currency side hit the P&L yet. That takes a little bit of time to get the customer to switch back and change his sourcing and supply and so forth. We expect that to begin to show sometime in the second half of the fiscal year.

Robert Kosowsky - OFI Institutional Asset Management

What is capex in Australia going to be? I don’t know if you give that level of detail or not.

Steven O. Cordier

Capex will probably be $2.0 million or $3.0 million.

Robert Kosowsky - OFI Institutional Asset Management

For the year?

Steven O. Cordier

Yes. Maintenance levels, primarily.

Robert Kosowsky - OFI Institutional Asset Management

Can you comment on starch inventories with your paper customers? You mentioned that the paper inventories are where they are, but do they have a lot of starch sitting around?

Thomas D. Malkoski

From our standpoint, as we monitor the inventories at each of our customers, they’re not unusually different than what they should be.

The question, though, is the paper customers inventory of their finished product and I mentioned that the inventory levels are low on a historical basis but there is a fair amount of inventory of paper products at printers for coated product. And that, I think, will have to work its way out of the system over the next few months.

For uncoated, I think there has been a lot more balancing of inventories, both at the producer and at the end customer.

Operator

Your next question comes from Rob Felice - Gabelli & Company.

Rob Felice - Gabelli & Company

Australia and New Zealand, it seems that you've got a couple of dynamics going there. You’ve got the positive shift in mix that you’re orchestrating by weeding out some of the lower margin product, you have the potential benefit of the Australian dollar over the next couple of months, and all of that is balanced by higher grain costs on a year-over-year basis. When we factor all those together, would you still expect to show a profit on an operating income basis, in this segment for the full year?

Steven O. Cordier

Yes. The second half should begin to show improvements and positive operating profit as you lap the grain costs, the new product developments begin to show some impact, and we get some momentum behind our efforts on the sales side to realize geographic opportunities based on the lower Australian dollar.

Rob Felice - Gabelli & Company

And what do you see as the likelihood that we get that to second half 2007 levels in second half 2009? For Australia.

Steven O. Cordier

There is a prospect for that.

Rob Felice - Gabelli & Company

It doesn’t sound like a very high one at this point.

Steven O. Cordier

It’s dependent upon the pace of customer acceptance and the reason I’m hesitant is I’m a little less clear on the global economic situation than I would have been in the second half of fiscal 2007. And that means how fast will customers accept the new product developments. We’ve talked about that in the past. It’s just been a little bit slower and it’s also a little bit of an open question, as I mentioned earlier, for your personal forecast, if the global economic business activity is going to be stable, deteriorate, or improve.

If you say that it’s going to be stable or improve, I think our prospects are good. If you think that deterioration is going to continue into the second half of our fiscal year, it will be a little more difficult for our sales people to get the attention of the buyers and the R&D teams so that we can get our products back into their portfolio.

Rob Felice - Gabelli & Company

And then looking to Industrial, can you discuss your ability to maintain price there, especially in light of one, a reduced demand from paper customers, and two, a reduced ethanol profitability, which obviously weights on Penford because you’ve got the switching dynamic?

Steven O. Cordier

Let me talk about ethanol first. Certainly with regard to ethanol, it’s pretty much a commodity market and it’s dependent on a number of factors as we have seen it and we have seen studies and published analyses that try to link the ethanol price to either the price of oil and gasoline or the price of corn. And at different times it seems to be more important for a linkage to gasoline and oil and at other times more important to see a high correlation between ethanol and corn.

Right now I believe we are seeing a higher correlation with ethanol and gasoline and oil prices, which have dropped dramatically in the last few months, nearly 60% to 65% over the last three, four, five months.

If you look again at published statistics and forecasts there is an expectation that those prices will be higher in three, four, five months than they are right now and that is being reflected in the futures prices.

So in a sense, the ethanol pricing is more driven by external factors than by Penford’s specific factors.

Thomas D. Malkoski

As I mentioned, we have a balance of contracts that have been completed for negotiation that show both price improvements and price decreases and we still have a few opportunities out there that are being negotiated at this time. Some of the contracts do have certain triggers for change in price and particularly increase as it relates to a couple of the chemicals.

But no question, it is a very difficult market place right now, from a pricing perspective. But the other thing to remember is that starch, as a percentage of the cost, of producing a ton of paper, is still a very low percentage relative to the other raw materials and chemicals that are used in production.

So we have, I think, reasonable prospects for continuing to recover some of the increases that we see in some of the other elements of our P&L.

Steven O. Cordier

The other element that I want to mention is that we are very conscious, and we remind our customer, that our high-modified starches are low cost in use. And so one of the critical elements to factor into the equation is how hard they are running their machines and we have seen evidence, as Tom has mentioned, with raw capacity, in both coated and uncoated free sheet categories, that our customers are sensitive to trying to maintain high operating rates and that would underscore the value proposition for our highly modified starches which provide them with benefit under those circumstances.

Rob Felice - Gabelli & Company

So you’re not seeing a negative shift to lower-margin industrial starch?

Steven O. Cordier

We’re not, and in some cases we’re seeing it go the other way, more towards the higher value starches.

Rob Felice - Gabelli & Company

And on average are your prices for industrial starch flat, up? I know you said you said you still have some renegotiation going on, but I guess best sensitive point.

Thomas D. Malkoski

They’re roughly flat.

Rob Felice - Gabelli & Company

If ethanol economics do not improve, in terms of optimizing your mix would you shift production toward industrial starches at this point? I’m just trying to get a sense as to how you might dial that knob.

Thomas D. Malkoski

The answer is yes. It’s not an overnight shift but we would shift some because in every period there is a spot business available and if the margins are more attractive on the starch side then we certainly would consider that.

Rob Felice - Gabelli & Company

In terms of the second quarter, would you expect to show year-over-year improvement? You shouldn’t have any of the variance in terms of the flood in the second quarter.

Steven O. Cordier

Year-over-year improvement in overall consolidated results?

Rob Felice - Gabelli & Company

No, Industrial.

Steven O. Cordier

I think that with six or seven weeks left and you look at last year’s operating profit of almost $4.5 million, we won’t reach that level. Below that.

Rob Felice - Gabelli & Company

By a large magnitude? Just some guidance there.

Steven O. Cordier

Right now I think most of the conditions that we’ve talked about on this call that are challenging that business and being dealt with will be responded to in the second half of the year. There is a time element for the changes to flow through the financial statements and so given that factor and trying to be conservative, I would say we are probably at a level now of about half of the second quarter operating profit for Industrial.

Rob Felice - Gabelli & Company

So with six or seven weeks left maybe you get to two-thirds.

Steven O. Cordier

Right.

Operator

Your next question comes from Your next question is a follow-up from Jonathan Lichter - Sidoti & Company.

Jonathan Lichter - Sidoti & Company

You talked about after the flood that you thought that some of your customers might not give you as much of their production as they had previously. Are you seeing that? And are you also getting some newer business from customers who are trying to split their suppliers?

Thomas D. Malkoski

The answer is yes to both questions. We have seen some modest level of what I call second or third sourcing with certain customers. And I think it could have been related to the flood but it could just be that their policy has been to move in that directions.

But on the other side of it we have seen the same happening with business that has been picked up with customers that we had not served, with the same rationale.

Jonathan Lichter - Sidoti & Company

And on food ingredients, it seems like in the first quarter there is sometimes some pipeline going on on the part of restaurants. Did you see that this quarter at all?

Thomas D. Malkoski

It isn’t so much the pipeline pillage in the coatings business that the paper processors run hard because they’re harvesting the crop and what they’re doing is they’re building their own inventories, in some cases. But that happens every year. And we did not see anything abnormal on the coating side and the coating volume was flat year-over-year for the quarter.

Steven O. Cordier

And I would make the point that of our three segments, the North American Food Ingredients is the least subject to seasonality. And so when you look at performance of the first quarter and you try to understand how that will vary over the balance of the next three quarters for the full fiscal year, it’s pretty marginal, quarter-to-quarter.

Jonathan Lichter - Sidoti & Company

So is that margin sustainable throughout the year or pretty close to it?

Thomas D. Malkoski

We believe so.

Jonathan Lichter - Sidoti & Company

Would you expect an operating profit in Australia in Q3?

Steven O. Cordier

Yes.

Jonathan Lichter - Sidoti & Company

The benefit of corn, would that have to wait until fiscal 2010?

Steven O. Cordier

Yes.

Jonathan Lichter - Sidoti & Company

So this is just because wheat has come down?

Steven O. Cordier

Wheat and then these other efforts. Remember that we had put in cost reduction efforts in 2008 that should continue into 2009 and some of these higher costs that we talked about this quarter for obtaining corn from northern regions because of the change under water availability will be finished in the first half of the fiscal year.

Jonathan Lichter - Sidoti & Company

And going back to what you had said previously, the second quarter loss will be smaller because of getting additional business because of the currency?

Steven O. Cordier

Not as much that as, remember, we said it was almost a $1.0 million hit for the logistics and difficulties of getting that corn in and at $1.5 million, when you think about that, two-thirds of that was probably from that logistical issue. We expect that to be far less of an impact in Q2.

Operator

Your next question comes from Tyson Bauer - Wealth Monitors.

Tyson Bauer - Wealth Monitors

What was the depreciation and amortization during the quarter?

Steven O. Cordier

$4.7 million.

Tyson Bauer - Wealth Monitors

At this point what is providing more angst for management right now? Is it the paper industry and your customers, the uncertainties of how 2009 is going to turn out? Or is it in Australia, where you still have some uncertainties but seemingly have at least a plan in place to deal with those variables there?

Thomas D. Malkoski

I think right now, with the uncertainty in the global and domestic markets and how they’re impacting the paper industry and the type of reaction that we saw in the first quarter, that very strong reaction to rationalize their output, that to me is the largest concern right now.

Although we certainly have concerns with Australia and we believe that we have action plans in place that can address some of the issues and also capitalize on opportunities. But believe me, we do stay awake a lot with some of the uncertainty in the markets and the timing of some of the initiatives that we have already in place.

Steven O. Cordier

And I would like to emphasize that we do have a solid plan for the Industrial business to respond to these current economic conditions. Not just cost reduction issues that are being addressed but commercial opportunities, as well, where we are trying to leverage . Not our value proposition to specific customers. We are finding new markets that are available to us. And our customers are more interested in working with us to leverage the low cost and use proposition of our products.

And finally, let’s not overlook the fact that half of our revenue stream and more than half of our profits historically come from the food side of the business, whether that’s North America Food or Australia, and while we are quite concerned and unable to predict the impact of general business activity on our customers or our business any better than anyone else, it is notable that there is a significant difference in the effect and impact of general business conditions on our food business relative to our industrial customers.

Tyson Bauer - Wealth Monitors

Given some of the industry metrics that have been going on for the last quarter plus, you have Verison, Bunge splitting, MGPI hanging on by a thread, are you viewing or seeing any opportunities within the industry or are those things really on the back table as you try to manage and control your own operations internally?

Steven O. Cordier

Certainly our focus is Penford’s business plan, executing that business plan in a very volatile and changing environment. We are always aware of general industry activity and not only from what I will call an ownership standpoint but from a competitive standpoint as changes or potential changes in structures and ownership may have implications for our ability to deliver and compete.

I would say that generally there is a high level of activity on the starch industry and grain-processing industry generally but that it isn’t significantly different than it was actually six or twelve months ago.

Thomas D. Malkoski

I’ll build on Steve’s comments, which I think are quite accurate, that regardless of the economic uncertainty and some of the challenges that our business particularly faces and recovering from the flood and regaining our customers, we have plans in place that we believe will deliver better results whether the economy stays as negative as it has been or improves.

Having said that though, I believe that the environment is more conducive to strategic opportunities today than it has been in quite some time simply because there are a lot of companies that will have parts of business available or that may not have plans that are as robust to control their own destiny.

Tyson Bauer - Wealth Monitors

It seems like you are in a far better position, given your management style, than some of your competitors. This may be something, that once we work through it, you may end up in a far better position than you were when we entered this situation or environment.

Steven O. Cordier

I would hope you are correct.

Operator

Your next question comes from Tom Spiro – Spiro Capital.

Tom Spiro – Spiro Capital

Are there any financial covenants that we need to start thinking about?

Steven O. Cordier

If you look at projections for our business and the fact that we had a waiver from our bank group shortly after the flood, we are certainly paying close attention to projections for business results vis-à-vis the covenants that are in place on an amended basis from our bank group. I think that we watch that as closely, constantly as anyone else and I think that we will be working with our banks to make sure they understand our forecast and that we are able to obtain sufficient liquidity to execute our business plan.

Tom Spiro – Spiro Capital

I don’t recall those amendments. Do they tighten up in the near term so that we will have to go back to our bank group for further relief?

Steven O. Cordier

Yes, as with any bank covenant waivers, they step back to original levels over a period of time. Typically that is over a one-year period of time.

Tom Spiro – Spiro Capital

And when will that tightening occur?

Steven O. Cordier

They go every quarter. They tighten up every quarter.

Tom Spiro – Spiro Capital

When do you expect to have to have those discussions?

Steven O. Cordier

We talk to our banks all the time. We are in constant discussions with our banks. I have always thought it is sensible to keep your banks fully informed about your business plans. As a matter of fact, we talk to them regularly.

Tom Spiro – Spiro Capital

When do you expect you will need relief?

Steven O. Cordier

I haven’t projected that at this point.

Tom Spiro – Spiro Capital

On the subject of insurance, as I recall, there was a press release a number of months ago, in the early days, that suggested we thought we might have potential insurance available to us in the range of $30.0 million to $35.0 million. Is that range one you are still comfortable with? Has it changed?

Steven O. Cordier

That was broken into two elements, if you recall. One is that we would have about $15.0 million in coverage limits through the NFIP, which is the primary layer. And then that we would have at least $20.0 million of all-risk coverage available with our insurance carriers beyond that.

We have collected the $20.0 million from the all-risk carriers and we have collected a couple of million from the NFIP.

Our current view is that we should be able to continue to process claims that are answered by the NFIP and their level of $5.0 million to $10.0 million.

What has also changed is that a prime review of our insurance policies and advice from coverage experts, we think that there is a strong argument for reimbursement for the company for amounts that include business interruption and additional property damage.

So as I said on the last conference call, we will continue to pursue reimbursement for the full value of the claim, which is somewhere between $60.0 million and $65.0 million.

Operator

Your next question comes from Your next question is a follow-up from Robert Kosowsky - OFI Institutional Asset Management.

Robert Kosowsky - OFI Institutional Asset Management

What was the volume of the non-coating part of the food business? Is that up?

Steven O. Cordier

Yes, it was up about 10%.

Robert Kosowsky - OFI Institutional Asset Management

And is this coming from new platforms or just more demand growth from existing platforms?

Steven O. Cordier

Primarily from the existing platforms, although we have some introductions of new platforms that have assisted.

Thomas D. Malkoski

Out of the 9.0+% increase just over half of it is from our existing business. The other half is similar products introduced to new customers.

Robert Kosowsky - OFI Institutional Asset Management

If we could step back and compare the opportunities or challenges you see with Australia, repositioning that product portfolio, today versus what you saw five or six years ago when you came over to work on the food ingredients business and tried to reposition that to higher margins products, are there any kind of parallels you can draw or kind of compare or contrast?

Steven O. Cordier

I think there are a couple of differences. When we arrived and trying to compare those two businesses. The most important difference is the proportion of differentiated high margin products that existed in the North America Food business when we arrived.

It was largely specialized, high-value products that we were able to accelerate and leverage across nearby markets and into new channels and categories.

The Australian business, when we arrived and still to a certain extent today, has a large proportion of their products that are substitutable. And so there is a mix occurrence that has to be affected where you hopefully replace, migrate from substitutable products to a model that is closer to what was in existence at the North American Food business.

And that takes a little bit more time and is also subject to some of these what I will call dislocations, as we’ve talked about, where you rationalize and withdraw from lower-margin, less attractive product lines and then work to replace them.

And so that process is probably the most notable in differences between the two. And it just simply takes longer to affect change.

Thomas D. Malkoski

And the ideal program to do that is, as you develop the new products and commercial them, you substitute them in and replace substitutable products or commodities like products.

But in each of the last three years, to some degree, the grain costs have been much higher than normalized levels and so the pacing of needing to weed out products that are no longer attractive puts a great burden on the success rate of new products.

And the issues that we also ran into over the past couple of years are related to the pace of commercialization and the very high FX rate that made it very difficult to gain customer interest in even trialing some of these new products.

Some of that certainly has moderated on the FX and we are seeing signs of the moderation on the grain side. But it does not mean that we would want to go back to the type of product mix that existed five or six years ago in that business.

We still think the model for success is our Food business where we have differentiated products, where there are not directly substitutable, competitive products that can replace ours. And so we will continue to work towards that model.

Robert Kosowsky - OFI Institutional Asset Management

How far along do you think you are on having the technology in order to make these new products? Do you think you are at a flashing point where you can meaningfully go commercial? Relative to a couple of years ago.

Steven O. Cordier

Definitely. We have been pressing hard on three specific product platforms we think have great appeal. Natural or clean label products, products that improve dietary health, and then again our continuing theme where we have some industrial products that are replacements for, on a very competitive basis, renewable source raw material for petro chemical products that are out in the market place now.

Operator

Your next question comes from Your next question is a follow-up from Kenneth Zaslow - BMO Capital Market.

Kenneth Zaslow - BMO Capital Market

If I wanted to exclude the $4.2 million, what tax rate should I use on that?

Steven O. Cordier

If you are modeling your tax rate, I think we’re at about 35% to 37%.

Kenneth Zaslow - BMO Capital Market

So if I do that it’s kind of a loss of like $0.27 or so?

Steven O. Cordier

Yes.

Operator

Your next question comes from Your last question is a follow-up from Lucy Watson for Laurence Alexander - Jefferies & Co.

Lucy Watson for Laurence Alexander - Jefferies & Co.

With the new piece of equipment coming in the next seven to ten days for ethanol production, what can we assume would be a reasonable production run rate in the second half of 2009? And what would be swing factors that might adjust that run rate?

Steven O. Cordier

The run rate for the second half will be somewhere close to 20.0 million gallons to 25.0 million gallons, which is 50% of the annual design capacity. The swing factor will certainly be the ability to execute some of these commercial initiatives that Tom has talked about to pursue and obtain new product opportunities or new business opportunities with existing customers for industrial starch.

Operator

There are no further questions at this time.

Steven O. Cordier

Thanks for your interest. If there are follow up questions please call me at the number at the top of the press release.

Operator

This concludes today’s conference call.

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