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Penford Corporation (NASDAQ:PENX)

Q3 2014 Earnings Conference Call

July 7, 2014 10:00 AM ET

Executives

Tom Malkoski - CEO

Steve Cordier - CFO

Analysts

George D'Angelo - Jefferies

Andrew Fleming – Heart land Advisors

Tom Spiro - Spiro Capital

Paul Orlin - Amici Capital

Operator

Greetings, and welcome to the Penford Corporation Fiscal Year 2014 Third Quarter Results Conference Call. At this time all participants are in a listen only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder this conference is being recorded. It is now my pleasure to introduce your host Mr. Steve Cordier, CFO. Thank you, you may now begin.

Steve Cordier

Thank you, Jessie. Good morning everyone. Thank you for joining our conference call to discuss Penford Corporation’s third quarter 2014 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, 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 third quarter of fiscal 2014 with the highest quarterly earnings per share since 2008. Third quarter net income increased 49% to $3.1 million compared to last year’s quarter. We also completed our acquisition of Gum Technology during the quarter. Consolidated sales for the third quarter were $119.4 million compared with $121.7 million in last year’s third quarter as lower corn prices reduced bio-product revenues and affected pass through provisions to paper industry customers. Revenues from our Food business jumped 24% to a record $35.3 million and double-digit increases in volumes. Gross margin increased to 12.4%, the highest gross margin in the last eight quarters, and higher profitability in the Industrial Ingredients division.

Our research, sales and administration expenses rose 12% to $9.9 million with the greater investments we are making in our business. We are expanding our research and development capabilities and have added sales and business development staff in the Food business to support future growth. We also incurred some higher expenses relating to the Gum Technology acquisition. The Company benefited from a one-time non-operating income gain. The Company satisfied conditions of forgivable government loan. Remaining repayment obligations were waived. That loan was extended to the Industrial Ingredients division following the 2008 flood at our Cedar Rapids manufacturing site.

Depreciation expenses were reduced by $200,000 in the quarter after the Company determined that the useful lives of certain long-term manufacturing assets should be extended. We expect based on current levels of operations and investments in property, plant and equipment that this change in the estimated useful lives of these assets will increase operating income by about a $1.0 million in the fourth quarter and on an annual basis approximately $4.4 million to $4.6 million.

Consolidated operating income rose to $4.9 million, up 15% from last year’s comparable quarter. Net income rose to $3.1 million, increasing 49% from last year’s third quarter. Diluted earnings per share were $0.24 compared to $0.16 per diluted share in the same period of 2013. This is the highest recorded quarterly results since our Cedar Rapids plant flooded in 2008.

Interest expense declined slightly to $935,000 from $998,000 a year ago. The Company’s effective income tax rate was 39.6% for the nine months ended May 31, 2014 which was above the combined federal and state statutory rates. Cash flow contributed by operations was $2.9 million. Our total debt fell by $1.2 million from last year to $77.3 million, despite spending $23.1 million on capital projects and acquisitions over the past 12 months. Sequential performance was robust as well, with sales increasing $13.3 million or 13%, gross margins up $2.7 million or 22%, and operating income rising by $2 million or 69% from the second quarter.

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

Tom Malkoski

Thank you, Steve. The Food Ingredients division reported record revenues again this quarter, increasing, as Steve noted 24% to $35.3 million from last year’s fiscal third quarter. Growth was broad based with strong performance in several application segments where we see good long-term consumer and customer interest.

Operating income was $6 million versus $6.2 million last year. Operating expenses rose 25% from three factors. First, we added resources in sales, marketing, and R&D; second, we’re expanding our R&D facilities; and third, the Gum Technology acquisition added about $400,000 in costs to the quarter, largely from the stepped up value of acquired inventory which will be extinguished as those products are sold into the marketplace. Revenue in our Industrial Ingredients business was off 10% at 84.1 million in the third quarter as lower corn market prices were reflected in corn-based pass through contracts to paper industry customers as well as reducing by-product revenues.

Gross margins improved 28% to $5.3 million. Operating income was $2 million compared to $600,000 in last year’s third quarter. Higher margins in the Industrial Ingredients business were driven by better ethanol crush margins, greater by-product sales, and stronger paper starch shipments. We expect ethanol market prices to remain relatively strong during the rest of the fiscal year. Our performance bio-products platform continues to expand with a number of attractive growth prospects in several end-market segments. This quarter we commercialized six new applications in addition to the nine new applications in the first half of the fiscal year.

Industrial business’ first half performance was challenged by high energy and transportation cost associated with harsh winter as well as unusually volatile corn prices in the beginning of our fiscal year. These weather related costs and inefficiencies have settled back to more typical patterns as we enter the last quarter of our fiscal year. The integration of Gum Technology’s staff and operations into our businesses is proceeding as planned. We’ve already seen some of the benefits from the complementary nature of starches and gums as we work on new formulations to expand our product line. The combination of our businesses is accelerating the growth of specialty products in food and beverage and we have begun to explore the potential for performance starch-gum blends in consumer products and in industrial applications.

This concludes our prepared remarks on the quarter. Please open the call for questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. (Operator Instructions). Thank you. Our first question is coming from the line of Laurence Alexander with Jefferies. Please proceed with your question.

George D'Angelo - Jefferies

Hi, this is George D'Angelo on for Laurence today. First, can you guys provide any more detail on the change to the extended price assumptions in Industrial Ingredients?

Steve Cordier

Sure, this is Steven Cordier. As you recall, in the Industrial Ingredients business we had a significant flood in 2008 where we basically revoked the plan to refurbish much of the equipment in there. At that time, we took a look at the useful lives and took a conservative approach, setting them at about 12 years on average with the commitment that halfway through that we would revalue, do a study and re-estimate what those useful lives might be. When they were in service for a period of time and we conducted a study, we hired a third-party firm, well experienced in this type of an endeavor and they concluded that as we concurred that those useful lives should be extended.

George D'Angelo - Jefferies

How far were they extended?

Steve Cordier

Some of them were extended as far as 24 additional years of the full live was gone up to 30 years from the original six.

George D'Angelo - Jefferies

And in terms of the nature of order trends in food ingredients, are there any shifts in the type of orders that you’re seeing?

Steve Cordier

No, I think the pattern is actually pretty stable, quite strong and customer demand is consistent.

Operator

Thank you. The next question is coming from the line of Andrew Fleming with Heartland Advisors. Please proceed with your questions.

Andrew Fleming - Heartland Advisors

My first question is just on the Food Ingredients segment. I am curious of that 24% year-over-year growth, how much of that is coming from the Gum acquisition and how much of that is coming from organic growth?

Tom Malkoski

If we strip out the Gum acquisition then the organic growth will be 16% in the quarter.

Andrew Fleming - Heartland Advisors

Okay, great. And I understand there were some M&A related charges incurred this quarter in that segment. As we move forward, is it good run rate to think of or should we get back to that 20% operating margin going forward within that segment?

Steve Cordier

In that business, yes. I think that the Gum Technology business generally conforms with the profit margins in the existing business, so we expect that the margin in the combined businesses will be about the same as they were prior to the acquisition.

Tom Malkoski

And Andy, we’ll finish through the higher valued inventory sometime during our fourth quarter.

Andrew Fleming - Heartland Advisors

Okay. Then moving on to the Industrial segment, great to see the improvements there, it feels like we’re finally hitting the inflexion point there. I’m just curious as we move forward, what your thoughts are on the gross profit margin there? And I understand that the real driver here is lower corn prices coupled by mix improvements as we ramp up the bio-products, but just curious on your thoughts on the gross profit margin profile of industrial ingredients moving forward.

Steve Cordier

Well the stability in the corn prices certainly removed some of the volatility that we’ve seen in the past several quarters with regards to the ingredients, industrial ingredients gross margins. I think the underlying strength of the bio-products platform, the mix change into the higher margin products including our specialty areas should allow that business with continued stability in input side to achieve at least high single-digit gross margins going forward. And as you would expect our program calls through that to continue to expand and improve beyond that in the future.

Andrew Fleming - Heartland Advisors

Okay, so high single-digits gross profit margin near term but possibly double-digit in the medium term within that segment?

Steve Cordier

Yes.

Tom Malkoski

Yes and I think Andy it does reflect the pacing of the growth in parts of the Food business that are produced in Cedar Rapids and also the pacing in growth of the bio-products business, because those generally are very attractive margins and they are substituting out some of the lower value products.

Andrew Fleming - Heartland Advisors

Great, and then just final question. What percentage of industrial sales are bio-products today?

Steve Cordier

If you take a look at that overall segments and its clouded a bit by the inclusion of bio-products now or I mean by-product sales which are a significant part of the sales of the segment at about 20%, the bio-products are under 10% between 5% and 10%. Now if you compare that to prior discussion we had before we included the co-products or by-products as part of the revenue stream it would on a comparable basis back to those comments be somewhere between 10% and 15%.

Tom Malkoski

And the other attractive industrial specialty products that we have in our, what we call our specialty products group, also are relatively similar in size to the bio-products, maybe slightly larger at this moment but bio-products are outpacing them at this point.

Andrew Fleming - Heartland Advisors

Okay and just now clear the margins and the bio-products business line is on par with that of food ingredients?

Steve Cordier

Yes.

Andrew Fleming - Heartland Advisors

Okay, thank you.

Operator

Thank you. The next question is coming from the line of Tom Spiro with Spiro Capital. Please proceed with your question.

Tom Spiro - Spiro Capital

First on the food side, how was the coatings business?

Tom Malkoski

It was up, over the year ago, both in terms of revenue and volume.

Tom Spiro - Spiro Capital

That’s great, Secondly, on the Gum transaction, Tom you mentioned in the last call, I think in response to one of my questions that gum sales had been moving up quite sharply in the last year or two and I was curious whether that rate of more rapid growth is continuing as we expect?

Tom Malkoski

We expect that there will be growth and we referenced that we’ve had some early successes on introducing gums into some of our customers that Gum Technology did not call on and we’ve actually made some sales in the quarter. So, we expect that it will still take us another three or four months before we start to see some of the new projects kick in.

Tom Spiro - Spiro Capital

Are we now offering some gum-starch combinations for sale?

Tom Malkoski

Yes.

Tom Spiro - Spiro Capital

That’s great. You also mentioned in the last conference call, Tom, that over on the food side and the potato portion of the business capacity utilization was creeping up, how do we stand there?

Tom Malkoski

It is creeping up and we indicated that we’re introducing new capital projects into one of our industrial potato plants in order to be able to make certain modification to food.

Tom Spiro - Spiro Capital

I see, and is our CapEx budget for the year, the current fiscal year still about 17 million, Steve?

Steve Cordier

That’s correct.

Tom Spiro - Spiro Capital

And now your guesstimate for the next fiscal year?

Steve Cordier

Between 20 million and 25 million.

Tom Spiro - Spiro Capital

And is a bulk of the capital both for this fiscal and next to go into the food?

Steve Cordier

It’s about evenly split between food and industrial but importantly two-thirds to three-quarters are for growth and productivity return project.

Tom Malkoski

Right, so most of the industrial capital is related to the specialty bio-products.

Tom Spiro - Spiro Capital

I see. Just to stick with food for one more moment, the gross margin food down this quarter and Steve I think I understood you say that we should expect food’s gross margin to go back up to the sort of 31-ish percent range once we run through some of this high cost inventory?

Steve Cordier

That’s right.

Tom Spiro - Spiro Capital

That’s great. Over on the industrial side, I was little surprised by the additional energy cost, I guess I have come away from our last conference call in April with the sense that the extraordinary costs rose in maybe part of March but we were basically through it by the time of the quarter. Did I misunderstand or is something else happened?

Steve Cordier

No, the timing is right but magnitude of that impact was so profound. If you look on the spot price for Chicago Citygate Natural Gas which is where we buy our gas that ran up to $30 mmbtu and as you can see today it’s about $4.50 mmbtu. So for the early part of March that stewed the whole quarter with regard to average natural gas prices. In addition, our electricity rates are based partly on the natural gas multiplier and because they use natural gas as a source of energy for them and pass that through to the customers there was a lingering effect; electricity rates were about 23% higher than the prior year for the quarter as well.

Tom Spiro - Spiro Capital

I see. Here we are about one-third of the way to Q4. At this point, do we see any similar kinds of expenses in the quarter, logistical, manufacturing, energy those kinds of things, anything else?

Steve Cordier

No, as Tom mentioned in his prepared remarks, we think that the fourth quarter is finally seeing some stability.

Tom Spiro - Spiro Capital

Tom, bio-products, we see bio-products grow at wildly the similar rates of the last, I don’t know couple of years or I think quarters where it has grown 40%. Several quarters it didn’t grow at all, now it seems to be forking up. Why is it forking up? What’s driving that?

Tom Malkoski

Well, first of all I think generally when you’re selling-in novel proprietary technologies, they are literally inventions that our customers have not seen before. The growth profile would generally be fairly lumpy, where you’ll have larger increases in a quarter when you’re selling-in to new distribution and then some of that would show up in the denominator of the following year. What we’re seeing also is that the level of activity is higher, so the odds of bringing something in during the quarter could really distort the predictable pattern of growth. And so we expect that we’re going to see some quarters that have relatively low growth but some that also have relatively high growth in the coming four or five quarters.

Steve Cordier

And as a final note, Tom, that it’s a relatively small business although emerging and growing nicely and so small amounts tend to have big percentage point impacts on the results.

Tom Spiro - Spiro Capital

Sure, if we were to use a year as a measuring rod or even two years as a measuring rod. What kind of growth would it be reasonable to expect?

Tom Malkoski

I think we would expect something between 25% and north of that.

Tom Spiro - Spiro Capital

Annually, you mean for year?

Steve Cordier

Yes.

Tom Spiro - Spiro Capital

How did our core industrial starch volumes look in the quarter?

Steve Cordier

On a volume side they were up nicely.

Tom Spiro - Spiro Capital

Why?

Steve Cordier

I think that you are just seeing some nice demand in the marketplace with shipments on the more advanced starches, our ethylated starches or cationic starches and even the oxidized starches to some extent. The other part of it is that we had some fewer shipments that helped out in the quarter.

Tom Malkoski

Tom, inventories were also relatively low coming into the calendar year and with the dislocations of weather affecting not only us but also affecting some of our customers business, we think that there was some forgone business in the in the first calendar quarter that has come back and some of that is rebuilding some of the inventories.

Tom Spiro - Spiro Capital

And what’s the rate of long-term decline, secular decline that you guys are using for that business?

Tom Malkoski

We’re counting on 3% to 4% on average and some quarters we’re not seeing that, some we are.

Operator

Thank you. (Operator Instructions). Our next question is coming from the line of Paul Orlin with Amici Capital. Please proceed with your question.

Paul Orlin - Amici Capital

Tom and Steve, two questions. One, if you have an adjusted number for the one-time items in the quarter just so we have that for comparison on the net income and EPS, that’ll be great. And then secondly I wanted to ask about the RS&A investment and still you gave some explanations but to see that kind of 16% organic growth with volumes, one would have expected a lot more margin expansion in the food despite any one-time items. So, if you could help me understand that and when we’re going to see leverage from that investment?

Steve Cordier

I think I would categorize your first question is items that are typically not going to recur and we don’t provide that calculated down to earnings per share and otherwise but you can do it simply by adding up the algebra. As we said in our disclosures, there is a $1 million of forgivable loan that was non-operating income. There was offsetting that about $400,000 of higher expenses related to Gum Tech acquisition. There was about $2.5 million of unusual energy cost in the quarter. And if you wanted to look a little further I would argue that our ethanol margins were a little bit stronger than historical but not much over the long run average rate. And so all those factors together probably tilt a little bit toward more expense than income on a non-recurring basis in the quarter.

Paul Orlin - Amici Capital

The unusual energy cost, as you are talking about or you just discussed that $30 versus $4 on the gas.

Steve Cordier

Yes, in the press release we enumerated that at about $2.5 million.

Paul Orlin - Amici Capital

Okay. That seems to happen every second or third quarter is that really unusual?

Steve Cordier

I think you got to make your own judgment on that, I would call it unusual when we have $30 mmbtu natural gas cost, I mean you can take a look, pretty remarkable to have that level of expense in a quarter. And if you look at other peer disclosures they all remarked on the same factor across the industries, in their quarterly conference call remarks.

Paul Orlin - Amici Capital

Okay, well we’ll look forward to that, not being there in the future. On the margins on the food side, if you’re talking about particularly a volume increase of 16% organic I would have expected a lot more margin improvement there. Can you just touch on a little more of the nature of the investment in RS&A and what you expect that to do to sales growth and margin growth?

Steve Cordier

Well, the investments in research and development as well as the commercial staff, have raised the percentage of RS&A as a percent of revenues. We do expect that as our previous investments in this area in the food business will generate not only a higher top-line growth but support the high margins that they have in business, little bit hard for us at this point to project forward where you’re going to have dollar-to-dollar ROI on those investments but the typical returns to those have been north of 30% to 40% ROI investments in the business. It’s a generally high margin business and to your point about a little bit of disconnect between the growth rate and the margin expansion, part of it is that investment and part of it is that as we grow that business and try to maintain high margins, we will see some mix shifts.

As we said in the past, we are selling a lot of corn based substrates raw materials which are a little bit lower margin than the potato based products that offers an excellent entrée into new basis for customers where we can sell both corn and potato blends as well as other products. So, it’s a strategy we are undertaking to make sure we can grow the food business while maintaining those appealing margins.

Paul Orlin - Amici Capital

Okay. I too think it will be helpful from your perspective if you could give a number for the continuing operations that would really help us compare as we go forward. It’s a little hard to have the one-timer, so if you think about doing that but thank you.

Steve Cordier

Thanks for your comments.

Operator

Thank you. We do have an additional question coming from the line of Tom Spiro, Spiro Capital. Please proceed with your question.

Tom Spiro - Spiro Capital

Steve, if I try to back out the corporate expenses from the numbers, I did it quickly. It did look like corporate expenses are quite a lot from the quarter last year, I don’t know $600,000-$700,000 if I got it right and if I am right, why?

Steve Cordier

We added some staff and there was some cost to adding that staff, that are headhunter fees and so forth that are up a little bit, but we will have some higher corporate expenses because we have additional people in the group to help with the accounting finance side of the business.

Tom Spiro - Spiro Capital

So, is this sort of a new plateau you think?

Steve Cordier

Most of it, not all of it. As I said some of that are one-time expenses because of the recruiting fees.

Tom Spiro - Spiro Capital

I see. Tom, the corn wet mill industry what's your sense of the industry’s capacity utilization these days?

Tom Malkoski

I think it’s slightly off the peak that we were seeing a couple of quarters ago, three quarters ago but it’s actually higher than the historical averages for corn wet milling. And we’re seeing projections within the industry of very slight growth in utilization over the next two or three quarters.

Tom Spiro - Spiro Capital

We have the flexibility to shift a little bit of our production from starch into ethanol. Is this your sense Tom that that's common throughout the industry, I mean how much can the industry shift towards ethanol?

Tom Malkoski

Well, it is common for wet mills to be able to do that and I think most wet mills would have the capabilities to do in a given short term period probably 5% to 10% shipped between the mix. I think for the most part, those who are set up to produce a variety of products like some of our larger competitors, they would be running most of their assets pretty full out and they will pick up opportunities that I call on the margins. So, there might be small swings during the course of the short term opportunity for capturing these locations.

Tom Spiro - Spiro Capital

I see. Just to return to bio-product for a moment, Tom, what are the most attractive near-term product opportunities in bio-product? Where do you think we will find the newest, the latest product offerings?

Tom Malkoski

Yes. We actually think in the short term we will probably have more to talk about both in paper and paperboard, so either as surface preparation or coating type applications, there’s a lot going on there. We have a number of activities going on in what we call construction and agriculture and our sense is that the conversion timeline maybe shorter in that industry than certainly in paper and board where there’s a lot of risk conversion to any change. And then the other area where we are seeing a lot more interest in our products is what I call the oil and gas industry. There are several different phases within that. We all require different project or products, but we also see that the appetite for moving with more urgency is greater in those segments.

And then finally, I think not in the short term but in a little bit longer term lot of promising developments in personal care and consumer products that are high performance, very high performance polymers.

Tom Spiro - Spiro Capital

Tom, just hypothetically if corn were 5 bucks instead of 4, would the near term outlook for bio-product change dramatically as you think it’s really been driven by that or other product attributes?

Tom Malkoski

No. I don’t think that would change all that much because the ag raw material cost portion in cost of goods for bio-products is more similar to food, so it’s not as big factor as it is in industrial paper starch.

Tom Spiro - Spiro Capital

I see. And Steve, ethanol, you mentioned I think that the Q4 is pretty well locked-in, I think if I understood you Steve, it locked-in at the margins that are good but slightly lower than we’ve enjoyed in Q3?

Steve Cordier

I would say that’s a correct statement.

Operator

Thank you. It appears there are no further questions at this time. I would now like to turn the floor back over to management for any additional concluding comments.

Steve Cordier

Thank you everyone for participating. If you have follow-up questions you can reach me, Steve Cordier and the number is on top of the press release.

Operator

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

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