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Penford Corporation (NASDAQ:PENX)

F1Q08 Earnings Call

January 9, 2008 11:00 am ET

Executives

Steven O. Cordier - Sr. Vice President, Chief Financial Officer and Assistant Secretary

Thomas D. Malkoski - President and Chief Executive Officer

Analysts

Jonathan Lichter - Sidoti and Company

Jean Gentile - Newland Capital Management

Lawrence Alexander - Jeffries and Company

Tom Spiro - Spiro Capital Management

Operator

Greetings, and welcome to the Penford Corporation’s first quarter fiscal 2008 earnings conference call. At this time all participants are in a listen-only mode. A brief 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 for Penford Corporation. Thank you, sir. You may begin.

Steven O. Cordier

Thank you, Ryan. Good morning, everyone. Thank you for participating in our conference call to discuss first quarter fiscal 2008 financial results. Joining me on the call is Tom Malkoski, President and Chief Executive Officer of Penford Corporation. Before we get started, let me caution you about any 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, unexpected delays in construction or procurement related to the ethanol facility, increased competition, raw material costs, litigation, interest rate changes, chemical and energy cost volatility, as well as foreign exchange rate fluctuations. Please refer to the documents that we file from time to time with the Securities and Exchange Commission for a discussion of these and other risks and uncertainties. Finally, we do not undertake to update publicly any 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’ll start by reviewing the company’s consolidated financial results for the first quarter of fiscal 2008. Tom will then comment on each of our business segments and provide our outlook for the rest of the fiscal year.

Consolidated sales rose 11% to a record first quarter level of $94.9 million from $85.5 million last year. Revenues grew $9.4 million, higher unit pricing and a more favorable product mix worldwide, $2.8 million from the positive impact of passing through higher corn prices to industrial customers, and $4 million from stronger foreign currency exchange rates.

Average selling prices increased at double digit rates and in all three business segments, a ramp up of new products in the North American food business is continuing while specialty products in the industrial business expanded by more than 35%. Lower volumes of $6.8 million, impacted mainly in the industrial business as some of our paper customers closed mills to optimize manufacturing efficiencies and manage inventory levels. These capacity reductions were anticipated in our planning process and we expect these actions will ultimately improve the sustainability of the North American paper industry and favor Penford’s high performance specialty products which permit mills to run more effectively at higher utilization rates.

Gross margin expanded by 23% to $16.3 million from $13.2 million last year on sales increases and improving mix in North America. Gross margin as a percent of sales widened to 17.1% from 15.4% a year ago. Operating expenses were comparable to the prior year at $7.2 million and declined as a percent of revenue to 7.6% from 8.3% in fiscal 2007. R&D expenses rose $500,000 as we continue to invest in projects that expand our value added differentiated products into nearby market opportunities.

Operating income grew 27% to $5.8 million from $4.5 million last year and this result includes the impact of $1.2 million in severance charges incurred in Australia as part of the program to reposition the business in fiscal ’08. Non-operating income at $0.5 million and increase expense at $1.3 million were similar to last year. Income tax expenses at $1.8 million versus $1.2 million a year ago and the effective tax rate rose to 36.2% from 31.2% in fiscal 2007 as earnings increased in higher tax rate jurisdictions.

Reported net income for the first quarter was $3.2 million or $0.33 per diluted share. This includes the $1.2 million or $0.09 per share severance charge just mentioned. Net income was $2.6 million or $0.28 per share a year ago.

Capital spending was significant in the first quarter at $17.4 million, including

$12.6 million for the ethanol project. We are entering the final construction stages for the build out of the Cedar Rapids facility to produce up to 45 million gallons of ethanol annually. As mentioned last November during our conference call, strong contracted demand from our industrial starch customers has prompted us to develop a process to dial down the minimum efficient operating threshold for the facility outside the original design range of 25 to 45 million gallons per year. These changes have extended the completion date for the project and we plan to commission the plant during the second half of this fiscal year.

Total capital spending for the expansion project was $32.7 million at the end of November. We also plan to spend between $15 million and $20 million during fiscal 2008 on a range of growth productivity and sustainability projects within each of our three business segments. These strategic projects are designed to expand our end markets, improve returns from existing assets, and assure reliability within our manufacturing processes.

Operations provided $13.7 million in cash during the first three months of the fiscal year compared with a $2.9 million use of cash last year. This improvement was caused by stronger earnings and lower working capital balances. Total debt was $83.4 million, including balances applicable to the ethanol facility. Total borrowings at the end of the first quarter of fiscal 2007 were $74.9 million.

The debt to invested capital ratio declined to 38% from 40% a year ago. We have capitalized $1 million in interest and other costs for the ethanol construction project as of the end of November. Depreciation and interest expense related to the project will begin to be recognized when manufacturing commences. Anticipated incremental quarterly charges will be approximately $1 million for depreciation and $800,000 for interest expense.

I also want to mention an important event that concluded after the end of the first quarter. In December, the company sold 2 million shares of its common stock through a secondary public offering. Net proceeds were $47.2 million which were used to repay outstanding debt. This transaction improves our balance sheet and provides flexibility to fund additional growth for the company. Additional details are available in our SEC filings and in the company’s 10-Q which will be filed today.

In summary, double digit revenue gains and higher average selling prices and mix improvements led to first quarter records for revenue at $94.9 million. Gross margin was at $16.3 million and operating income was at $5.8 million, including a charge of $1.2 million for severance costs in Australia. We are pleased with the strong start for the year.

Tom will now comment on segment results. We’ll both be available for questions later in the call.

Thomas D. Malkoski

Thank you, Steve. The company is off to a good start in implementing our 2008 business plan. As mentioned during the year end conference call this past November, we entered the year with better visibility on many elements of our business, including the early completion of sales contracts and securing of many input costs in the industrial business, the ramp up of product introductions in the North American food segment, and the implementation of programs in Australia that recognize the challenge facing the segment caused by a continuing drought in the region.

While the general business environment is challenging, our businesses are operating as expected. Australian business reported quarterly sales of $29.9 million, a 13% increase over last year, on higher selling prices and a 16% appreciation in the Australian dollar currency value.

Volumes were 10% a year ago as we rationalized production across the three manufacturing sites in the region and migrate our mix to products with satisfactory returns. Gross margins expanded 30.3% to $3.1 million. The majority of raw material procurement contracts through the next harvest cycle had been set for this business. Grain costs were $1.8 million higher than the same quarter a year ago. We project total quarterly grain costs comparisons to prior year to be higher by approximately $2.5 million in the second quarter, $3.0 million in the third quarter, and $3.5 million in the fourth quarter.

We described at the last conference call elements of a business improvement program to contain dramatically higher grain input costs and position the business for the future. These initiatives include higher pricing, manufacturing rationalization, workforce reductions, and new product introductions. Each of the four elements has been implemented and is currently tracking satisfactorily.

We recorded $1.2 million in severance expense during the first quarter reflecting work reductions in the two Australian plants. The first quarter operating loss of $100,000 includes that charge. Operating income was $800,000 a year ago.

First quarter sales at the food ingredient North American business grew by 6% to $16.1 million on improved pricing and favorable product mix changes. The pet category continues to accelerate with sales up more than a third from the level for the fourth quarter of fiscal 2007.

Year over year sales levels for coating applications were comparable while non-coating formulations including the pet category increased by 12%. Gross margin fell slightly to $4.6 million from $4.8 million a year ago on higher spend for annual preventative maintenance programs, expenditures for new product trials, and increased raw material costs.

New supply contracts with several customers begin this month at higher pricing that should mitigate these costs. Operating income was $2.7 million versus $2.9 million last year. Industrial ingredients sales reached a first quarter record of $49.2 million, an increase of 12% over last year on favorable pricing and improved product mix changes. The specialty products category which is successfully positioning our renewable resource products against [chemical] alternatives grew by over 30%.

Gross margin increased 45% to $8.6 million from $6 million a year ago and operating income rose 79% to another first quarter record of $5.7 million. I am encouraged that the industrial ingredients team has aligned our high quality product offerings and performance value proposition for the industry consolidation occurring in the North American paper markets that we serve.

Our customers need to deliver to their consumers high quality finished paper products. Our customers also require processing aids that support high plant utilization rates. Penford’s commitment to high quality products supported by trained technical service teams has led to stronger customer relationships and higher demand for our value added products.

We are nearing the completion of the construction of the ethanol facility within the Cedar Rapids manufacturing site. This investment will broaden our finished product output choices, expand capacity of the site efficiently, tap into some unused capacity within the plant, and provide us with the fermentation platform for future product extensions into biomaterials. While the demand for our starch products is strong, we will look for opportunities to enhance shareholder value through participation in the ethanol market should the appropriate conditions develop during 2008.

The management teams in each of our three business segments have embraced strategic and operating changes over the last couple of years that have improved financial results and the competitiveness of Penford. This organizational commitment to change as well as careful investments in processes, equipment, and people should deliver sustainable results and shareholder results in the coming quarters.

I thank you for your interest in Penford and please open the call up for questions.

Question-and-Answer Session

Operator

Thank you, ladies and gentlemen. At this time we’ll be conducting a question and answer session. (Operator Instructions) Our first question comes from the line of Jonathan Lichter of Sidoti and Company.

Jonathan Lichter - Sidoti and Company

Good morning, guys. In the food ingredients segment, you mentioned that the non-coating businesses were up 12%. I guess that means that the starch for fat replacement has slowed? Is there any reason for that?

Steven O. Cordier

If you look at the categories for the growth, we’ve got expansion in both the protein and the dairy and cheese areas. Combined they were up at double digit rates so I think we’ve got good growth. The specifics of each product line within the categories, particularly where you’re talking about protein, move around from quarter to quarter and so I don’t have exact statistics on that particular product line but we do show good growth in those categories overall quarter over quarter.

Jonathan Lichter - Sidoti and Company

So there’s no reason to think that overall segment is slowing for any particular reason?

Steven O. Cordier

No, actually the largest negative change on that business is a conscious decision on modified starches that we have available to the market. We simply restricted the supply of the unmodified starches because the economics were less attractive than they have been in recent quarters.

Jonathan Lichter - Sidoti and Company

And then moving to the industrial ingredients business, I think on the last call you had indicated that you expected the operating margins to expand by about 400 basis points if I remember correctly. Do you think that is still achievable?

Steven O. Cordier

Remember that we also said that you’d have a first half, second half phenomenon in that business driven by a couple of things. One is we have higher costs in the first half of the fiscal year. The winter’s stripped for natural gas and maintenance costs and so forth and the second half of the fiscal year will start to realize the impact from the contracts that begin in January which include more favorable pricing. So we expect that margin expansion will primarily occur in the second half of the year.

Jonathan Lichter - Sidoti and Company

Okay and in Australia, how have the price increases gone so far? Have they been generally accepted?

Steven O. Cordier

Yes, they have. In that area, first of all it’s the second draught in the region so most of the demand and most of the customers have been conditioned for that type of price increase. Secondarily, we’ve been very forthright about the situation for the last several months and so they expected it to be there and finally our competitors are also raising prices worldwide so conditions are favorable for that type of a price change.

Jonathan Lichter - Sidoti and Company

And lastly, can you talk specifically about what’s in the R&D, the additional cost there?

Steven O. Cordier

Many of that expenditures were for trial activity where we go into our customers with new product introductions and we have to spend a little bit more, it’s more labor intensive for us to conduct those trials with our customers, whether it’s on our sights or on their sites and that’s the bulk of the change in the R&D expenditures.

Jonathan Lichter - Sidoti and Company

Was that in all divisions or in food ingredients?

Steven O. Cordier

Yes, actually it was. We have new products going in in Australia as we mentioned. We have activity in North America in both the food and industrial business.

Jonathan Lichter - Sidoti and Company

Thank you.

Operator

Our next question comes from the line of [Jean Gentile - Newland Capital Management].

[Jean Gentile - Newland Capital Management]

Hey, it’s Jean. How you guys doing?

Steven O. Cordier

Good, how are you?

[Jean Gentile - Newland Capital Management]

Great. Just kind of going over the strength that you saw in the specialty business driven by L&A of 35% on super margins, I mean, this seems like this is going to be the next growth leg for Penford as you understand the utilization of your existing capacity for the L&A and also identify and market uses for this. Could you characterize the types of opportunities that Penford is assessing with regard to this platform?

Thomas D. Malkoski

This is Tom. I would say that as we talk about our business, we talk about the investment we are putting into technology platforms and the specialty products and in particular the liquid natural additive technology platform is a perfect example of that because when we talked about the basis for technology platform, we said “What is the relevance of the product or the applications? How sustainable and defensible are they? How expendable are they?” If we can answer those questions satisfactorily then we believe we can invest in a technology platform rather than simply create an application for something and the difference would be that we invest significant resources to develop the technology platforms. L&A has grown to that level of technology platform with significant revenues now being generated by that business. Consistent growth quarter after quarter and in increase in the amount of trial activity and the direction of those trials is a range from various recycled materials in paperboard and newsprint to adhesive applications and we’re now finding that as an addition to many other processes that we had not originally targeted for this product that it in combination with other additives and starch materials can create some unique properties for our customers, so it really is opening significant opportunities and we would expect to continue to invest resources, both capital and people, in that business going forward.

[Jean Gentile - Newland Capital Management]

Great and then which regard to.. It seems as if you have the wheat situation in Australia solidly under control given pricing and other structural changes that you’ve made. Could you identify for us the better margin platforms that are coming out of the Australian market and where you’re identifying the incremental product extension opportunities that you mentioned as kind of offsetting some of the less return generating products that you have there?

Steven O. Cordier

Generally speaking as with all of our businesses, the more advanced proprietary formulation which adds more modifications provide us with higher margins and that’s simply because they’re more functional to our customers. They provide better performance and we have those in both our corn and our wheat based products. Our gluten products in the wheat based side have pretty unique characteristics that are in high demand both within Australia and in the Asian export markets and on the corn side, we also have a number of products that are pregelatinized or highly modified for specific performance characteristics that we want to accelerate the growth for our movement to nearby markets. On the new products side, we’ve been positioning and expect in the second half of the fiscal year to start to see some growth in the financial statements from three main platforms. One is in the area of natural starches. Another one is in products where again we’re aligning our renewable source materials against synthetics, and then the third area is an interesting one where we’re positioning the product in the area of what I’ll call dietary health and caloric density areas, so these are platforms that we’ve had success with in other parts of the business already and we’re moving them through different regions of the world out of the Australian business.

[Jean Gentile - Newland Capital Management]

Excellent and just finally, if you look at the structure of probably upwards of 75% of your business, industrial starches and food ingredients, you suggested in the press release that you locked in more favorable terms to offset some higher pricing on the food ingredients side, plus you already locked in very favorable terms for the majority of your Penford products segment and you have the ethanol optionality at 1.2 times tangible book and this level of platform growth at Penford, it seems as if things are moving in the right direction there from the margin expansion and organic top line growth perspective.

Steven O. Cordier

We leave the valuation conclusions to the experts in Wall Street, but certainly the business positioning over the last couple of quarters have put us in a spot where we’re able to look at the next several quarters with good visibility and also begin to plan the business for extension into fiscal 2009 in the industrial business for example, a significant portion of our capacity with the industrial starch customers is also under contract at good margins through calendar 2009 so we do have good clarity beyond 2008 for a good portion of our business.

[Jean Gentile - Newland Capital Management]

If you look at the malaise that we’re seeing in the market, it seems like Penford is a pretty safe spot.

Steven O. Cordier

I would hope that other investors agree.

Operator

Our next question comes from the line of Lawrence Alexander with Jeffries and Company.

Lawrence Alexander - Jeffries and Company

Good morning. On the food business, does the price increases that you’re implementing fully offset the R&D or are you going to see lumpiness on the R&D going forward?

Thomas D. Malkoski

I think that the price increases that we have in place should offset not only the R&D costs but some of the higher starch costs that we had in the potato starch side. Historically what goes on within a business and remember that’s our smallest business, there is some lumpy expenditures as we get interest from customers on new trial activity but our anticipation is for the next several quarters that the higher pricing will cover all of that.

Lawrence Alexander - Jeffries and Company

At this point have you seen any shift in the emphasis from customers in favor of either cost reduction versus performance or are they still focusing on trial in products and performance?

Thomas D. Malkoski

I think we’ve seen a shift in direction from new product news to value promotions that started back as early as the beginning of our summer, so this shouldn’t be a revelation I don’t think to many in the ingredients business. Part of what we have to do in our R&D efforts is to develop applications and concepts that extend our customers into new territory before they have thought of it and so we have to be careful that we’re a step ahead of them and at the same time we have to have formulations that work in a more cost competitive environment yet protect our margins and so our people are constantly working in our core categories to make sure that we have a range of potential applications for customer needs, and should the customer requirements change like this transition that is becoming apparent, then our products are equally as relevant because we’re providing the functionality that’s needed and we’re giving our customers opportunity to meet their operating needs as well. So it’s always more exciting to be in the game of creating product news but the reality in the food business is the cycles go on that have gone on in all of my 26 or 27 years of food experience and it goes for about every three years that you end up with a high of product news and no interest in cost containment and then 2 to 3 years later you’re exactly opposite. I think we’re partly into that now. Again, it doesn’t mean that our products are any less relevant.

Steven O. Cordier

Lawrence, I’d also like to mention that because of the way we sell our products as a three part sale where we work with both the ultimate retail quick service restaurant or the processor, both of them we work with, there’s two ways we can increase the value proposition for our products. Certainly the performance aspects which are of primary interest to the restaurant or the packaged food company but also on a yield basis for example in the dairy and poultry categories including yields for the processors provides our value proposition an advantage so even in areas where they are shifting to more value over new product news, we’ll see opportunities for expansion.

Thomas D. Malkoski

Right, and that was some of what I was relating to when I talked about the relevance of our products so some of our binding products and food actually retain more moisture and therefore help the processor who is selling on weight. In others where we are in coating applications, some of our coating applications actually help the pick up so there’s less waste or fines in a manufacturing process. So there are lots of ways our products can add relevance and still provide the consumer functionality that is required.

Lawrence Alexander - Jeffries and Company

And at this point you don’t see any shifting urgency compared to what you saw since last summer on that front?

Thomas D. Malkoski

No, I wouldn’t say that. We haven’t seen that in... Our labs are very stressed right now with all kinds of projects that are going both on new and reformulation activities.

Lawrence Alexander - Jeffries and Company

Perfect. In the industrial segment, how much of your starch bargain have you presold into 2009 now?

Thomas D. Malkoski

More than half.

Lawrence Alexander - Jeffries and Company

And in terms of the visibility that you have on the margins, now that you in both Australia and in the US, what’s your confidence interval around the ranges that you discuss on the last conference call for margins?

Steven O. Cordier

They’re pretty solid for a couple of reasons. One is that in the Australian business, the procurement contracts for the grains have now been set for fiscal ’08. The harvests are underway and our pricing is set and our volumes are assured so the numbers that we gave on the call just now for comparison as to prior year quarters are pretty well known. The impact of the four point program for offsetting those grain costs as we mentioned is proceeding satisfactorily so we have decent clarity on both the inbound and the outbound side of that. On the industrial business, we have the same situation where we’ve got contracted volume for our customers as I said through ’08 as I said but also into ’09 and then that’s a pass through situation for the major raw material which is corn and our other inputs such as chemicals and gas are for the most part hedged so we have pretty good clarity on the inbound and the outbound side for that as well and finally as we’ve mentioned the new product growth in the North American food business is on plan and we expect that business to perform well.

Lawrence Alexander - Jeffries and Company

And for the liquid natural additive, are you seeing any sort of lumpiness? What’s your expected full year growth rate for that business? What’s the conservative target which you’d be happy to be? Clearly you can have some lumpiness quarter to quarter

Steven O. Cordier

There’s lumpiness because when we bring on new accounts or have large trials it will show in our numbers but I would think the types of growth rates that we have had over the last 4 to 6 quarters in our L&A business which have ranged from around 20% to 30% growth rates, that’s very much in line with what our expectations are. I can’t say that some of us would be completely satisfied if that’s all we achieve, but in terms of the for planning purposes, we’ve been fairly consistent in that type of growth rate. Yes, there will be some lumpiness where quarters will be on the high end or maybe the low end of that range but I think that’s fairly reasonable.

Lawrence Alexander - Jeffries and Company

Can you give an update on the market acceptance or market interest in the biodegradable plastic substitute?

Thomas D. Malkoski

I think that at this point the formulations that we have are relatively expensive in their current application and yet I think the market acceptance of that type of product is going to be very strong in the coming quarters. I think the challenge will be for the bio based biodegradable materials to become cost competitive, not equal to, but cost competitive, and that would mean within probably 10% of the synthetic product.

Lawrence Alexander - Jeffries and Company

Thank you.

Operator

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

Tom Spiro - Spiro Capital Management

Tom Spiro, Spiro Capital. Good morning. Focusing on Australia first, as I recall, we were in the midst of negotiations with one of the unions down there. Can you give us an update please?

Steven O. Cordier

That’s progressed. What’s occurring in Australia is there’s a change of government from conservative to labor government and the requirement to renew the contracts in Australia are not the same as they are in the US. You can go open ended without any adverse consequences either for the employer or the union as long as you operate under the existing contract so that’s where we are right now. We’re operating under the contract that was in place and I think everybody’s waiting to sort out what the new government regulations will be surrounding industrial relations in Australia, so it’s a little bit of a status quo at the moment.

Tom Spiro - Spiro Capital Management

I see. Shifting to the food business and North American food, I think you mentioned, perhaps I misunderstood you, that the category you’ve often described is soup, sauce, and proteins? That’s grown at double digit rates in the quarter just ended. Is that correct, did I understand that correctly?

Steven O. Cordier

I don’t think I mentioned that one. What I said was that the combination of protein and dairy have grown at double digit rates and certainly the pet category is expanding rapidly.

Tom Spiro - Spiro Capital Management

I see and on the paper side, the industrial side, could you update us on international opportunity, our international sales, and what’s the outlook?

Thomas D. Malkoski

From our business, our international sales have actually been lower in the past three quarters compared to the year ago period and largely that’s by design in that... We look at the financial opportunities or economic opportunities and returns of the demand in North America and while we are maintaining current certain positions with key customers in key countries to allow us to expand those positions in the future if we choose, we’ve been very selective in pursuing certain opportunities in international markets and comparing them relative to the domestic demand.

Tom Spiro - Spiro Capital Management

Unit volume for the paper segment obviously was down in the quarter. What was the decline?

Thomas D. Malkoski

Six.

Tom Spiro - Spiro Capital Management

And what are you hearing from your customers?

Thomas D. Malkoski

What we’re seeing from our customers is they are operating at very high utilization rates. Right now they’re matched up very closely with the demand. The industry forecast for uncoated and coated presheet continue to be similar to what we’ve seen in the last couple of quarters where it’s been down anywhere from 3% to 6% in terms of demand. The utilization rates are very high and the inventories are relatively tight, so we would expect that that type of trend line would continue but that is part of our planning.

Steven O. Cordier

And also I’d add to that that their pricing has held so that the new ownership changes in the paper industry overall are displaying what I would call very disciplined business approaches and modeling out their forecasts which I think is all to the good for the sustainability of that industry so nothing unusual in our view of what’s going on in that marketplace.

Tom Spiro - Spiro Capital Management

Thanks much and good luck.

Operator

As there are no further questions, I’d like to turn the call over back to management for any concluding remarks.

Steven O. Cordier

Thanks, this is Steve Cordier. I appreciate everyone listening in. Any follow up questions can be directed to me at the number at the top of the press release. Thanks.

Operator

Ladies and gentlemen, this concludes today’s teleconference. Thank you all for your participation.

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Source: Penford Corporation F1Q08 (Qtr End 11/30/07) Earnings Call Transcript

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