Penford Management Discusses Q3 2013 Results - Earnings Call Transcript

| About: Penford Corporation (PENX)

Penford (NASDAQ:PENX)

Q3 2013 Earnings Call

July 09, 2013 10:00 am ET

Executives

Steven O. Cordier - Chief Financial Officer, Principal Accounting Officer, Senior Vice President and Assistant Secretary

Thomas D. Malkoski - Chief Executive Officer, President and Director

Analysts

Laurence Alexander - Jefferies & Company, Inc., Research Division

Frank F. Rango - BKF Asset Management, Inc.

Tom Spiro

Operator

Greetings, and welcome to the Penford Corporation Fiscal Year 2013 Third Quarter Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Steven Cordier, Chief Financial Officer of Penford. Thank you, sir, you may begin.

Steven O. Cordier

Thank you, Christine. Good morning, everyone. Thank you for joining our conference call to discuss Penford Corporation's Third Quarter fiscal 2013 financial results.

Before we get started, let me caution you about any forward-looking comments we might make today. 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. Any 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, increased competition and raw material prices, chemical and energy costs. 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.

Today, we reported financial results for our fiscal 2013 third quarter, with year-over-year improvements in revenue, gross margin, operating and net income and earnings per share. Consolidated sales for the third quarter of fiscal 2013 rose 9% over the previous year to $121.7 million. Both our Food Ingredients and Industrial Products segments posted a higher quarterly revenue, driven primarily by improved pricing and product mix. Net income was $2.1 million for the quarter compared to a loss of $5.5 million a year ago. Diluted earnings per share improved to $0.16 from a loss per share of $0.44 in last year's third quarter. Gross margin expanded $1.7 million or 15% from a year ago to $13.2 million, and gross margin as a percent of sales expanded 50 basis points to 10.8%. Improvements in pricing and product mix contributed to higher margins.

Operating expenses increased by $1 million to $7.3 million in the third quarter, primarily due to higher pension expense and additional employee cost to support growth in new business initiatives. Consolidated operating income for the third quarter increased 20% to $4.3 million as higher revenue and margin expansion outpaced operating costs.

Improvements to our capital structure in the second half of fiscal 2012 have resulted in lower interest expense and income taxes. Third quarter interest expense was $1 million, less than 1/2 of last year's expense of $2.3 million. The interest rate in the company's bank debt at May 31, 2013 was 3.7%. The company's effective income tax rate was 37% for the first 9 months of fiscal 2013, which approximates the combined federal and state statutory tax rates.

Cash of $11.2 million was generated by operations during the third quarter compared to a use of cash of $2.7 million in the same period last year on higher earnings and lower working capital requirements. Capital spending for fiscal 2013 is projected to be close to $15 million as we complete projects in the fourth quarter to support growth and productivity initiatives planned in future quarters.

The company's balance sheet remained strong, with total bank debt outstanding at May 31, 2013 at $77 million, down $7 million from the second quarter. The debt-to-invested-capital ratio was 52% at May 31st, down 3 percentage points from year end.

As you may have read, Penford filed an 8-K with the SEC a few weeks ago, announcing that it was restating its financial statements and the 2012 10-K and the quarterly filings for the first 2 quarters of fiscal 2013. In March 2013, the SEC staff inquired about our classification of the proceeds from the sale of corn co-products in the income statements, which Penford has historically recognized as a reduction of the cost of corn. After correspondence and discussion with our auditors, our attorneys and the staff of the SEC, Penford agreed to classify the proceeds from the sale of co-products as sales. And we restated financial reports with the SEC on July 8. The reclassification increased the amounts we previously reported as Industrial Ingredients sales and cost of sales by the same amount and did not affect margins, operating income, net income or earnings per share or any amounts reported on the balance sheet or cash flow statements. Our third quarter earnings release and the 10-Q we will file later today reflect the classification of co-products sales as revenue.

At this time, I would like to introduce Tom Malkoski.

Thomas D. Malkoski

Thank you, Steve. Our Food Ingredients division posted record quarterly sales, gross margin and operating income. Sales grew by 9% over last year to $28.5 million, with 2/3 of the growth coming from volume gains and the remaining 1/3 through pricing, some of which came from mix changes. On balance, the improvement in revenue was driven largely by new business gains in several of our specialty categories, including dairy, gluten-free, sauces and companion pet products. Gross margin grew in line with sales and rose 10% to $9.1 million. Operating income for the third quarter rose 16% to $16.2 million.

Industrial Ingredients segment posted third quarter revenue of $93.2 million, an increase of 9% from a year ago. Reported sales figures, as Steve discussed earlier, include co-products of corn germ, fiber and meal produced from our manufacturing operations in Cedar Rapids. Gross margin improved by 28% to $4.1 million and operating income grew by $600,000. Gains in revenue and margin reflected higher industrial starch and ethanol pricing than a year ago.

Penford's third quarter ethanol sales were $28.1 million, increased $5 million or 22% from last year, mostly from unit pricing which was up 18% over the year-ago quarter.

General business conditions remained challenging, and these conditions affect customers, consumers, competitors and Penford to varying degrees. Yet despite this environment, our focus on bringing value to customers through specialized products and technical support has been a significant contributor to our top line and margin growth over the first 3 quarters of the fiscal year.

Better margins since the beginning of fiscal 2013 are providing funds for reinvestment back into the business in the forms of capital expenditures for new products and productivity enhancements in our plants and for human capital to grow in targeted directions. Improvements to our capital structure noted by Steve today and in recent quarters are continuing to bring benefits to the company and our balance sheet is solid and showing improvement. Progress with implementing our strategy, consistent improvements in executing our business plans and continuous strengthening of our financial condition should contribute to our goal of generating value for all shareholders.

We thank you for your interest in the company, and please, open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Laurence Alexander with Jefferies.

Laurence Alexander - Jefferies & Company, Inc., Research Division

I guess, first, on the Industrial segments, I guess 2 questions. One, can you give a rough breakdown of your run rate sales for that segment, like how much is going to ethanol, how much is going to the new product categories? And I guess, secondly, on that segment, can you just discuss a little bit your sort of levers to improve the EBIT margin into next year?

Steven O. Cordier

I can answer the first part. With regard to revenues, ethanol in the quarter was about 30% of the overall revenue base. If you look at our specialty products in the Industrial business, I would say that you have, overall, approximately, we don't normally give all the numbers out, but between 15% and 20% of the revenue base is in the specialty category.

Thomas D. Malkoski

And then, Laurence, as we look forward into next year, several of the specialty categories, which include wet-end starches that go into the paper process, as well as the bio-products, several of these have a fairly strong level of trial activity that we continue to work to build into our run rate. And we continue to see opportunities in other segments related to the specialty side of our businesses.

Laurence Alexander - Jefferies & Company, Inc., Research Division

And then I guess just to sort of follow up on that, as you think about the 3- to 5-year trajectory for the mix shift in that business, do you have -- what's your updated thinking about sort of margin lift, either sort of incremental annual margin lift or sort of a longer-term target for what you think you can get to?

Thomas D. Malkoski

Well, we think the specialty products have room to double or triple or even go further, and the value on the specialty products generally, the margins are in the vicinity of our food margins. And so the replacement of the material balance coming from ethanol to the specialty products has, I think, a very good leveraging effect on both margins and absolute profitability. And so we see very strong opportunities, growth opportunities in all of those specialty categories.

Steven O. Cordier

When you look at the way that changes this mix and the margins, you're moving from one end of the margin spectrum to the other, from the lowest to the highest, with the ethanol at the bottom end. But even between, where we can move more of our historical and legacy, starch sales to industrial will improve the product mix as we move more toward that from the ethanol mix.

Laurence Alexander - Jefferies & Company, Inc., Research Division

And then lastly, can you update your thoughts about sort of about CapEx spending for the next couple of years and progress evaluating potential partners who might want to use some of your capacity for trialing their processes.

Steven O. Cordier

Yes, with regard to CapEx, we expect spending next year to be approaching $20 million and stay there probably for the next year or 2 at least. We have additional projects coming online that are going to help us both with growth and productivity and we intend to get them into the queue next year and the year after. And after that, I think it's a little bit hard to project what's going to come up in the way of capital. But we look at our maintenance capital spend at somewhere between $5 million and $8 million and beyond better growth and return projects.

Thomas D. Malkoski

And then Laurence, looking at both our internal needs for some of our new products, both in specialty and bio-products, over the next 2 or 3 years and external opportunities to partner at least to initiate trial activity, we still have strong plans internally for our own growth, and we also see several possibilities in partnering that would be highly specialized chemical processes and quite possibly, advanced fermentation processes that could benefit from the equipment that we already have in place. So we see it as an opportunity to streamline both cost and the time to market for some of these new products.

Operator

[Operator Instructions] Our next question comes from the line of Frank Rango with Purchase Capital.

Frank F. Rango - BKF Asset Management, Inc.

Tom, can you help us with the profitability in the ethanol side? How much are you actually making -- or how much do you actually make a gallon in the quarter? And what do you think you're going to be doing in ethanol this quarter?

Steven O. Cordier

Yes, we don't give the specifics for the company out because of competitive reasons. This is Steve, by the way. But generally speaking, the margins in ethanol in the industry mirror what we do. There's probably a range around the industry margin of $0.10 to $0.15 per gallon, depending on the company's -- the manufacturing site location and the company's production efficiencies. You can see it even during the quarter, a range of industry margins per gallon from about $0.45 a gallon up to somewhere around $0.70 a gallon. Most companies are operating marginally in the profit section at the upper end of that spectrum and are still cash flow positive. By that, I mean they contribute to positive cash flow in the business at the lower end of that spectrum. When you get below the $0.40 range, you begin to see a significant withdrawal of capacity in the industry because they are no longer contributing cash flows to their business systems. But I would argue that you're going to see positive EBIT and positive margin improvement when you get above $0.65 to $0.75 a gallon, depending on, again, the company's specific location and their production efficiencies.

Frank F. Rango - BKF Asset Management, Inc.

And Steve, how do you see this quarter compared to the just reported quarter in terms of the industry environment?

Steven O. Cordier

I think right now, we're operating a little bit better on margins per gallon. There's going to be a tensed period in our fiscal quarter come August and September, the last month of our fiscal quarter and the first month of next year, as we move into the new crop corn and see how that relates to the movement of ethanol prices. And if they stay correlated, then you should have at least a reasonable return. If those 2 don't stay correlated, if corn moves up and ethanol doesn't, you're going to see a penalty to the ethanol margin.

Frank F. Rango - BKF Asset Management, Inc.

Right. And do you think we should be a little concerned about the sugar harvest in Brazil and possible importation of ethanol from Brazil affecting pricing?

Thomas D. Malkoski

Frank, we're expecting to see imports from Brazil in the month of July and continuing through until November. So the question will be, what is the arbitrage value of exporting the ethanol to the U.S.? And right now, the incentive is fairly flat, meaning, there isn't much incentive for Brazilians to export the ethanol. Things could change depending on the market value of ethanol here in the U.S., FX rates, or as you said, production of sugar in Brazil. You probably are aware that the Brazilian mandate moved from 20% to 25% lend in the month of May. And there is some short-term challenges for Brazil to meet that mandate. So I think that's been holding back some of the imports that we typically would see. And in the U.S., obviously, one of the factors that Steve mentioned is the differential between the old crop and new crop corn right now and that in the month of August and early, probably all the way through September, we could see some variability and some jumpiness, both in the crush margins and also the spot opportunities for ethanol in the U.S.

Frank F. Rango - BKF Asset Management, Inc.

Right. And one other question, Steve, you threw out this number of 30% of your revenues on the industrial side coming from ethanol in the [indiscernible] fourth quarter.

Steven O. Cordier

Right.

Frank F. Rango - BKF Asset Management, Inc.

How does that compare with the same quarter of last year?

Steven O. Cordier

Last year was 27%.

Frank F. Rango - BKF Asset Management, Inc.

27%. And how high has it ever been? What's the historical high?

Steven O. Cordier

I would say, it was close to 40%. At one point, 38% to 40%.

Frank F. Rango - BKF Asset Management, Inc.

And when was that?

Steven O. Cordier

In the first quarter of our fiscal 2011, I believe, when margins were running really high.

Frank F. Rango - BKF Asset Management, Inc.

Right. And it gets down as low as what?

Steven O. Cordier

Well, we can -- in theory, we can dial the plant back to about 25%. The question is, do you have starch sales to offset that because you don't want to just take capacity out of the plant and let it be idle. So if we have starch sales that can make up some of that difference, we can dial it back down to 25% or so.

Operator

[Operator Instructions] Our next question is a follow-up question from Laurence Alexander with Jefferies.

Laurence Alexander - Jefferies & Company, Inc., Research Division

Can you talk a little bit about the order trend that you're seeing in Food Ingredients?

Thomas D. Malkoski

Sure. Laurence, we're seeing some pretty good demand for many of our new products. We're seeing fairly stable outlook for what I would call our base or existing products that go into coatings and proteins. They've been fairly stable the last 2 or 3 months. We follow the restaurant industry very carefully and also the retail industry, grocery retail. And we're seeing that the grocery retail side or branded products are doing a little bit better than the restaurant trade. Restaurant trade trends are appearing very marginally better than they were 3 months ago, but they're still only up maybe 1% compared to the year-ago period. And so we carefully monitor that, but remember that many of our products actually offer cost savings to existing products for many of our customers. And then we also have several products that create product news. And we have a pretty good split right now between customers looking for product news and those looking for cost savings or cost reduction. And so we have a full range of products to offer them. We're also interestingly finding some customers who are interested in both at the same time. So they want product news to bring people into the store, but they're also going to be offering some lower-priced menu items and they're driving for cost savings for those. So right now, the pattern of orders and the interest on a lot of our new products has been very strong.

Steven O. Cordier

We continue to see successful migration or change in mix to a more diverse product offering, and you will note that our coatings, as a percentage of revenue now, our coating sales are down to about 1/3 where they were a couple of years ago, nearly 1/2. And it continues to migrate toward the broader mix of products that we're introducing in the marketplace, so we're happy to see that mix change with the broader and more stable diversity of offerings.

Operator

Our next question comes from the line of Tom Spiro with Spiro Capital.

Tom Spiro

Tom Spiro, Spiro Capital. Tom, how's bio-latex doing?

Thomas D. Malkoski

The trial activity is very good. We continue to run into, I wouldn't call them delays as much as just a very long cycle of adoption moving away from the straight latex products, but we still have very good interest and a lot of trial activity, and we're making a lot of products in our pilot plant right now for these multiple trials.

Tom Spiro

Are commercial volumes growing?

Thomas D. Malkoski

We have some commercial volumes, and yes, they are growing. Some of the big accounts that we expect are still in the pipeline and trial stage.

Tom Spiro

I see. And our industrial cornstarch volumes, how did they fare during the quarter?

Steven O. Cordier

Industrial cornstarch -- cornstarch, industrial?

Tom Spiro

Yes.

Steven O. Cordier

They were about flat.

Tom Spiro

And as we talk to our paper customers, what sense are you getting off over the couple of quarters?

Steven O. Cordier

;

I think that they're in another area of challenge, it depends on where your demand side in the picture is in the paper industry. But I would say, overall, this has not been a robust year for demand on paper products and their pricing has remained reflective of that. So I think it's kind of a stable game right now and the capacity in the paper industry where they're realigning demand and supply is something that everybody in the industry is having to deal with.

Tom Spiro

I see. When we had our Q2 conference call, in our discussion of ethanol, I came away with the sense that ethanol profitability at that time look like it was going to increase dramatically in Q3. Perhaps my impression was wrong, but did it increase dramatically in Q3?

Steven O. Cordier

It went up, but not -- I wouldn't characterize it as dramatically. We thought that supply-demand fundamentals would favor the supplier. And point of fact, the demand was not quite as strong, and particularly with gasoline consumption. And so you've got a balance. The other thing that was interesting that we did not predict was that inventory levels of ethanol still remain very, very low historically. And there was always a linkage between better margins and lower inventory levels as companies reestablish safety stock and drove up demand for ethanol. Apparently, the industry, and by that, I mean the blenders and refiners, have grown more comfortable with the much thinner level of inventory. And so that effect of correlation between low inventory days and better margins has just not manifested. So there's been a couple of fundamental changes in the technical side of the industry.

Tom Spiro

I see. As I recall from Q2, we had ramped our ethanol production down well below the 10 million or 11 million gallons per quarter we can do. Did we ramp it back up or did we keep it down at a much lower level?

Steven O. Cordier

We've ramped it up from the sequential prior quarter a little bit because we did get better margins as I said in the quarter. But we haven't turned to dial all the way back up.

Tom Spiro

I see. And did we run Cedar Rapids at full capacity?

Steven O. Cordier

Yes.

Thomas D. Malkoski

Remember, Tom, we also have food corn running out of Cedar Rapids too.

Tom Spiro

I see, I see. And lastly, and my standard a quarter, Tom, can you give us a sense of how we're progressing on identifying some strategic partners?

Thomas D. Malkoski

Well, as I've said before, it's quite a lengthy process, and we certainly have made some progress with some. And with others, we've decided that their pathways and ours are not going to be consistent over time, and that's a good thing because we're narrowing in on those that we think can partner better with us and what our capabilities are and what our interests are in market participation as well. And as soon as we have something more substantial to report on, we will let everyone know.

Operator

Our next question is a follow-up question from Frank Rango with Purchase Capital.

Frank F. Rango - BKF Asset Management, Inc.

Steve, did you say that capital expenditures next year was going to be $20 million again?

Steven O. Cordier

About that.

Frank F. Rango - BKF Asset Management, Inc.

So just quick back-of-the-envelope, based on your cash flow, you're going to be digging deeper into credit line to finance that, or what are your plans? I mean...

Steven O. Cordier

We expect to drop more cash flow from the business. We do expect higher earnings and revenue from the business to help with the provision of the cash flow for capital projects. And as I said, we've actually been de-leveraging and we dropped our debt down by $7 million in the quarter. So we're managing the credit line pretty carefully.

Frank F. Rango - BKF Asset Management, Inc.

Any thinking about maybe issuing some stock here?

Steven O. Cordier

We'll look at all our options on the capital structure at any given time. We don't have a shelf registration out there right now, so we'd have to do some filings in order to get that lined up, but -- whereas anybody in the marketplace that the share price has moved up nicely, but I do -- would maintain right now the credit facility where we have plenty of appetite from people to lend to us and we have plenty of availability in our credit line is still at 3.7% interest rates, the cheapest capital that we can obtain for our shareholders.

Operator

[Operator Instructions] Our next question comes from the line of Dennis Johnson [ph], a private investor.

Unknown Shareholder

I've been a long-term investors since 2007, and one of my continuing questions is, have you ever thought about selling parts of the lower-margin Industrial Ingredients division and focusing heavily on the Food Ingredients?

Thomas D. Malkoski

Dennis, this is Tom. Yes, from a strategic standpoint, we look at a number of scenarios on a regular basis and assess the merits of transactions, both for M&A on our side, being able to acquire things, as well as the possible sale of certain assets or the possible partnership using certain assets. And so that is always in the mix.

Unknown Shareholder

And just -- I mean, how serious have you gotten about it? Has it gotten to the point of doing deals, or you just talk about it in the board room?

Thomas D. Malkoski

There have been lots of discussions within our internal group. And at this point, external discussions have been on the surface in many of these directions, and nothing interesting so far to us or for shareholders has surfaced.

Operator

Our next question is a follow-up question from Tom Spiro with Spiro capital.

Tom Spiro

Tom, I understand that one of the company's largest stockholders is seeking a board seat. Could you update us on the company's thinking with respect to that request?

Thomas D. Malkoski

Well, with regard to that '13 defiling by a shareholder, we have an established governance process that we have available for the nomination of all people, including interested shareholders, and we're following that process and adhering to that with regard to this particular situation.

Operator

It appears we have no further questions at this time. I would now like to turn the floor back over to management for closing comments.

Steven O. Cordier

That's all we have from our end. If there are any follow-up questions, you can reach me at the top of the -- at the number at the top of the press release. Thanks very much.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!