Penford Corporation F3Q08 (Quarter End 05/31/08) Earnings Call Transcript

Jul.10.08 | About: Penford Corporation (PENX)

Penford Corporation (NASDAQ:PENX)

F3Q08 Earnings Call

July 11, 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

Lawrence Alexander - Jeffries and Company

James Gentile - Newland Capital Management

Robert [Sinese] – Sidoti & Co.

Jonathan Lichter - Sidoti & Co.

[Brent Modulus – Rudabaker Capital]

Ken Zaslow – BMO Capital Markets

[Robert Krasowski – OFI Institute]

Tom Spiro – Spiro Capital

Operator

Welcome to the Penford Corporation’s third quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to introduce your host, Steve Cordier, Chief Financial Officer.

Steven Cordier

Thank you for participating in our conference call to discuss third 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 and offer comments on each of our business segments for the third quarter of fiscal 2008. Tom will then update you on the progress of recovering from the effects of the flooding in Cedar Rapids, Iowa.

Third quarter consolidated sales rose 7.7% over last year to a record $102.8 million. Revenues expanded $7.4 million on higher unit pricing worldwide and product mix improvements in the North America food ingredients business as well as $2.7 million from stronger foreign currency exchange rates.

Revenue from ethanol production which began in our Cedar Rapids facility in May 2008 added $4.7 million to consolidated third quarter sales. Quarterly gross margin of $15.5 million was down $3 million from last year and as a percent of revenue declined to 15.1% from 19.5% a year ago. The margin reduction reflected higher raw material and manufacturing costs in Australia and industrial ingredients as well as expensing start up costs supporting commercial production of ethanol during May in Cedar Rapids, Iowa.

Operating expenses of $7.3 million decreased by $1.1 million from last year and declined as a percent of revenue to 7.1% from 8.8% in fiscal 2007. R&D expenses rose $300,000 or 15% to $2 million as we continue to invest in people and projects that bring value added applications to our customers.

Third quarter interest expense decreased from $1.4 million last year to $800,000 in fiscal 2008 on lower debt balances and declining interest rates in the U.S. During the third quarter we capitalized $300,000 in interest expense applicable to the ethanol construction project. In May 2008 upon commencement of commercial production of ethanol we ceased capitalizing interest expense related to the project.

Net income for the third quarter was $2.7 million compared with $5 million a year ago. Diluted earnings per share were $0.24 and $0.54 for the third quarters of fiscal 2008 and fiscal 2007 respectively. Net income for the first nine months of fiscal 2008 was $8.2 million or $0.76 per diluted share compared with $9.2 million or $1.01 per diluted share in 2007. The public stock offering completed last December added 2 million weighted average diluted shares for the third quarter and 1.2 million shares for the first nine months of fiscal 2008.

Capital spending was $8.1 million in the quarter including $5.2 million for the ethanol construction project. The operations used $5.9 million in cash during the third quarter of fiscal 2008 primarily on larger working capital balances reflecting the increasing costs for raw materials and our inventories.

Our balance sheet remains strong with good liquidity. The $47.2 million net proceeds from the public offering of equity last December was used to pay down outstanding loan balances. Total debt at the end of May was $76 million. This includes $43.2 million applicable to the construction of the ethanol production facility. At the end of the third quarter our debt to invested capital ratio was 28% compared to 40% for the same time last year.

Our credit agreement with several commercial banks was amended effective this week to temporarily adjust the calculation of selected governance formulas for the effects of the flood damage and expected insurance recoveries. To provide liquidity until the Cedar Rapids plant is fully operational we have $34 million available for borrowing under the credit facility, at least $30-35 million of insurance proceeds, collections of receivables for industrial products sold prior to the flood and cash generated by our food ingredients and Australian businesses.

We believe that our liquidity is adequate to restore the Cedar Rapids plant and meet all of our other financial obligations.

Before commenting on the business segments I would like to provide some of our perspective on the unusual business environment we are currently operating in. Open market input price comparison against a year ago have increased rapidly with oil and natural gas up 80%, diesel fuel rising 60%, average electricity charges up more than 20%, chemical increases ranging from 30-55%, foreign prices doubling and wheat rising by 40%.

While our procurement practices hedge programs and cost plus selling arrangements have mitigated these price changes the pace and persistence of the escalating prices has increased unit costs. We will continue to extend efficiency programs, invest in productivity improvements and pursue cost relief to offset these input price movements.

At the same time many economic measures indicate slowing business and consumer activity. In our own end markets we have noted that industry specifics show that calendar year-to-date shipments for uncoated and coated free sheet paper have fallen by nearly 9% from a year ago. Paper manufacturers have retained or increased price levels in uncoated free sheet paper by reducing inventories 8% and contracting capacity by 7%. This activity should reinforce the cost-in-use value proposition for our high performance products. In fact, sales by the industrial ingredients segment into this category has actually expanded through the first nine months of fiscal 2008.

Also, market survey services have indicated that the pace of new product introduction in the food industry has slowed and that there is an accelerating shift towards reformulating products or line extensions into proportion of total activity. This trend reflects our customers’ expanded focus on addressing the same market conditions and input cost increases as we face, shifting internal resources away from true menu and product innovation towards cost reduction initiatives.

These factors have slowed and extended the schedule for Penford’s newer applications including pet as well as natural and resistance starches developed in Australia. We will continue to emphasize the specialized attributes delivered from these applications and develop additional channels for distribution pipeline of new products.

Sales at the Australia/New Zealand operation have decreased 2.2% or $600,000 in the third quarter of fiscal 2008 compared with the same period of 2007. The business continues to experience the impact of a regional drought that reduced the harvest for critical grain inputs and contributed to a 30% increase in the gross price of wheat and corn raw materials compared with the same quarter a year ago.

Limited grain supplies also required temporarily importing starch and corn from outside Australia. Processing materials from these sources increased manufacturing costs by $1 million over planned levels during the quarter. Additionally, the Australian dollar and New Zealand dollar have appreciated by 51% and 41% respectively over the past five years supporting increased price competition for the company’s domestic products and restricting export opportunities.

The business has responded to these conditions to a multi-point program that included raising selling prices, changing the sales mix to focus on those products which will produce higher long-term returns for the company and reconfiguring its manufacturing processes to reduce production costs.

New applications have also been developed as part of the program just mentioned that focus on higher margin formulations that are more dependable and can extend the geographic functional markets. As described in earlier communications, the new product element is expected to contribute approximately $3 million in the second half of fiscal 2008 towards mitigating higher grain costs.

Commercialization of these new product introductions is behind schedule as customer development teams have concentrated on cost optimization projects. The delayed product introductions sparked implementation of additional contingency measures. A planned sale of unused property in New Zealand as part of that contingency program was unexpectedly extended and completed in June for gross proceeds of approximately $1 million. This transaction will be reflected in the fourth quarter of fiscal 2008.

Gross margin increased by $1.4 million to $1.2 million. Loss from operations in the company’s Australia/New Zealand business for the quarter ended May 31, 2008 was $900,000 compared to operating income of $900,000 in the same period of fiscal 2007.

Third quarter sales of food ingredients North America business were comparable to last year at $17.1 million. Average selling prices improved in nearly every category and we sold a greater proportion of higher margin products than a year ago. Sales of products supplied in the bakery, dairy and cheese segments rose a healthy double-digit rate from last year. Potato coating revenue decreased 3% as one customer reformulated some of their products earlier in fiscal 2008.

Third quarter gross margin of $4.9 million decreased $200,000 from a year ago as improvements in the manufacturing process partially offset higher raw material and chemical costs. Operating expense as a percent of sales declined to 9.2% from 9.8% last year and operating income was comparable to last year at $2.8 million.

Fiscal year-to-date sales of potato coating applications were comparable to prior year while non-categories grew by 9% with the pet category expanding by nearly 25%. Our potato starch operations have not been affected by the flooding of the Cedar River in Iowa which shut down manufacturing for our industrial corn starch business. Dextrose production in Cedar Rapids has been suspended. Food grade corn starches are being supplied from other locations.

North America industrial ingredient sales in the third quarter rose 15% over last year to $60.9 million on higher pricing, the effect on revenue from passing through higher corn costs and the contribution from ethanol sales. Following the completion of equipment and process testing, the business began manufacturing ethanol in May 2008 with sales of $1.9 million for the quarter. The production ramp up was extremely smooth with yields and metrics meeting or exceeding planned benchmarks.

Segment volumes were 12% above a year ago due to new ethanol production and stronger ethylated starch demand. Gross margin as a percent of sales were 15.4% versus 12% a year ago and operating income was $5.1 million compared to $7.1 million last year. The decrease in operating income includes three unplanned items; a pre-tax charge of $1.4 million reflecting the resolution of litigation, ethanol start up costs of $1 million and repair and maintenance costs as well as higher unit energy levels of about $800,000 due to severe weather that ultimately led to the mid-west flooding we will discuss shortly.

Note that higher volumes improved pricing and mix changes offset some of these costs as well as the impact from higher prices on input led chemicals, natural gas and utilities.

Tom will now comment on the situation caused by the Cedar River flood. We will both be available for questions later in the call.

Thomas Malkoski

As we previously reported on June 12, 2008, record flooding of the Cedar River forced the temporary shut down of the company’s manufacturing plant and administrative offices in Cedar Rapids, Iowa. This facility produces starch products and ethanol for our industrial ingredients business as well as dextrose and certain corn starches for our food ingredient segment.

Prior to this date the record for a flood in Cedar Rapids was 20 feet set in 1851 and equaled in 1929. Penford levy was constructed to a level 25% above the record flood at 25 feet, nearly to the 500 year flood plain. The Cedar River crested on June 13, 2008 above 31 feet, more than 55% above the previous record. Our priorities in managing through the crisis were clear; to take care of our people, protect the company’s assets and to safely return our facility to full operating performance as soon as possible in order to serve our customers’ needs.

Our response was immediate. We engaged outside resources to assist Penford employees in the clean up and assessment of damages. The majority of our employees are back at the facility and over 200 contractors are onsite assisting with the safe restoration of operations. Clean up and sanitation is over 80% completed. Re-conditioning and testing of equipment and process control systems is well underway. Utility services, electricity, gas and water have been restored and are available when the facility is ready for them.

Salaried workers have reoccupied the office and R&D goings. We expect that start up of the facility will progress in stages as equipment and key processes become operational. We are on track to resume production of certain liquid natural additives products in a few days and our pilot plant facility which was not heavily damaged by flood, however we continue to project that our main production assets will not be in a position to manufacture significant industrial starch or ethanol volumes prior to the end of August and that full recovery of sales volumes could extend through the balance of calendar 2008.

As a result, we do not expect the industrial ingredients business to contribute meaningfully to earnings before the end of fiscal 2008. The company continues to assess damage caused by the flood. Preliminary estimates are subject to many assumptions regarding cost and timing to repair or replace numerous items and processes. Further, estimates are dependent on the availability of materials and resources, some of which are outside Penford’s control.

Factoring in these considerations we estimate the cost to restore and recover the Cedar Rapids facility at approximately $45 million. This estimate includes several categories of spending which I will briefly outline. Site remediation to clean out and sanitize all areas of the facility; electrical which includes restoration of the electrical infrastructure from incoming power to distribution throughout the plant; mechanical which represents craft labor to remove, clean, reinstall and test motors and pumps; instrumentation which is the testing and repair or replacement of instrument components and process controls; rentals and new equipment.

This includes rental of generators, for example, and the purchase of furniture and tools; professional service fees not accounted for in some of the above categories; repairs to major equipment such as tanks, conveyors, packing and load up systems; inventory write off for damaged raw materials or work-in-process and continuing to expense for ongoing expenses such as wages and salaries, benefit costs and depreciation.

Representatives from the insurance carriers are working with Penford personnel to expedite the adjustments of the company’s property loss claims. Penford has property damage and business interruption insurance policies in place and subject to the terms of the company’s policies and applicable deductibles the company estimates that it should be able to recover at least $30-35 million. The actual amount ultimately recovered may vary from this estimate and as a result we are not in a position to provide assurance as to the amount or timing of insurance recoveries.

The effects of the flood on the financial results of the company on a quarter-by-quarter or year-to-year basis will depend on the amount and timing of both expenditures of both insurance recoveries. We estimate most of the costs will be incurred in the fourth quarter and be charged to expense. Insurance recoveries will be reflected in our financial statements as received or as determined to be highly probable of being received.

Successful organizations require certain elements to achieve their potential. First it takes talented people who work well together to achieve common goals and I believe Penford has a strong team of people. Secondly, success requires clarity of direction or vision backed by defined, strategic choices on how the company will win. The company’s performance over the past several quarters would suggest this element is in place.

Finally, consistent success depends on how well an organization responds to, manages through or recovers from unplanned or crisis situations. While Penford is still recovering from a natural disaster caused by the Cedar Rapids flood our people have attacked the situation with extraordinary character, leadership and determination and urgency. Based on what I see personally in our people I am confident in the full recovery of our industrial business.

This unprecedented crisis has placed difficult pressures on many stakeholders. I want thank our employees for their commitment and contractors for their dedication to recovery as soon as possible. I also want to thank our valued customers and suppliers for their understanding and loyalty.

Finally, we appreciate the support we have received from our lenders and other service providers as well as from peer companies. Thank you for your interest in Penford and we will now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Lawrence Alexander - Jeffries and Company.

Lawrence Alexander - Jeffries and Company

Can you give a little bit more detail on the slow down in product introductions in both North America and in Australia and to what extent you are seeing projects delayed or are customers canceling projects at this point?

Thomas Malkoski

I would say that the slow down is largely in gaining the attention of our customers for trial activity and particularly for follow-up after initial trials that we are just seeing periods of delay. There is no predictable pattern to say how much each one is but our belief is once our customers get into this type of cycle it is pretty difficult to break in to their cost reduction efforts in order to try some of these new products.

Lawrence Alexander - Jeffries and Company

With respect to the ethanol facility that was up and running, when you look at the incremental profit contributions from that facility from the 1.9 million gallons was that sufficient to offset the $1 million in start up costs or is the $1 million a net figure?

Steven Cordier

The $1 million is a separate figure and not netted against the margin contribution from the ethanol facility.

Lawrence Alexander - Jeffries and Company

Were they roughly balanced or disproportionate?

Steven Cordier

They were disproportioned.

Operator

Your next question comes from James Gentile - Newland Capital Management.

James Gentile - Newland Capital Management

We can press the reset button following the issues in Cedar Rapids and look at the underlying trends from both a sales and incremental operating margin expansion perspective and look at the underlying earnings power of a company like Penford and what we see is an industrial starch company with reasonably dominant market share with some of its key customers and adoption of somewhat new products and appropriate price recovery that would articulate a sales number in a normalized type of environment ranging between $210-230 million in revenue. Given the underlying “managed forward” strategies that Penford has put in place the last couple of years you have seen some sizable operating margin improvement to the tune of upwards of 500 basis points.

In addition we have seen reasonably consistent double-digit top line growth in the food ingredients business driven by the adoption of new products and you all appropriately are spending your R&D dollars to suggest a business that is on trend in a normalized year, call it 2009, about $72-75 million all else equal. Then you have the Australia business which seems to be holding up quite well given some of the lower margin contract-type businesses that aren’t earning appropriate returns being exited. You are still holding this $100 million in annual sales in Australia.

First and foremost excluding the unfortunate situation in Cedar Rapids that will likely be rectified, the key earnings driver would be the renegotiation of your green contracts for use in Australia through 2009. First, when do you see those cost changes unfold and when do you expect a recovery of some of the higher grain costs that significantly squeezed operating profitability in 2008?

Thomas Malkoski

The contract for grain procurement in Australia come up in various stages throughout the next six months or so. The wheat contracts which represent about half of the exposure to grain in Australia are fixed through December of this calendar year and then will be renewed after that. The harvest projection for wheat for the upcoming harvest remains quite robust and pricing in the Australia market for wheat has changed reflecting that more robust harvest as well as higher costs for wheat worldwide on a global basis. We would expect the impact of that new contract would begin to reflect on our financial statement in the second fiscal quarter.

Corn is a raw material that gains its water through irrigation which is a separate issue in Australia from the wheat crop which gets its water by rainfall. As we have looked at the change in pricing in corn that will occur over several time frames as we try to procure corn from various growing regions throughout Australia which is a large continent and we expect the impact from that to occur later in the fiscal year, more toward the beginning of the third quarter and throughout the balance of the second half.

The outlook for pricing on corn or maize in Australia and New Zealand is a bit more uncertain due to the fact that the sourcing of water is from irrigation as opposed to the rainfall and so we have yet to be able to get clear indication about the scope, magnitude and direction of the price relief we would like to see.

James Gentile - Newland Capital Management

Understood but as it stands right now the global wheat market we are not seeing the tightness we saw last year so could you just give us a wide range of what you would expect the net cost savings from the Australia sourcing agreements at the end of fiscal 2009 roughly? That is as of today.

Thomas Malkoski

I think the easier way to do that would be to indicate that a $10 swing per ton change in the price of either of the underlying raw materials, corn and wheat, impacts the cost of goods sold for the Australia segment by $1-1.2 million, net grain cost. So it is a pretty significant shift. As an indicator of magnitude, earlier in this year in the March time frame wheat costs in Australia were as high as $4.25 to $4.40 per ton and they range down to $3.25 a ton now.

James Gentile - Newland Capital Management

For every $1-1.2 million in profit equals about $0.10 in earnings for Penford. With regard to your business interruption insurance and perhaps your ability to recover the costs from the challenges you have encountered in Cedar Rapids do you think that some of that $30-35 million includes the business interruption insurance where you basically recover full fourth quarter operating profit in industrial starches which could be upwards of $8 million? Is the business interruption included in your $30-35 million recovery estimate at this time?

Steven Cordier

Yes it is included in that $30-35 million limit. It is a combined aggregate coverage. I would emphasize that the delta that you are referring to against the normalized or historical run rate for the industrial business in the fourth fiscal quarter of last year is different from the full amount and that is why Tom emphasized we do not expect that will contribute meaningfully to earnings. So the delta is back above that.

James Gentile - Newland Capital Management

With food ingredients you have articulated some delays in customer adoption but at the same time with your core potato coating business being a little bit slower, and it has historically been lumpy from quarter to quarter, do you still expect some level of organic growth through 2009 for that segment?

Thomas Malkoski

Yes, we do. We continue to expect that. Just a note on the potato coating side, the reason for a slight decline in volume in revenue in potato coatings is really related to one customer who has reformulated some of their products but some of the other growth categories had very healthy double-digit rates of increase and we believe we can continue particularly in some of those specialty categories.

James Gentile - Newland Capital Management

Just another comment on your…you can see a trailing underlying asset value here of about $14.80 per share, that is tangible book including good will. Penford is a profitable enterprise. If I take into account let’s just say your estimates of $45 million are true and your cost recovery call it $35 million, that would be a $10.00 gain on tangible book plus we are losing $0.25 per share in contribution. I still calculate something in the high $13 or low $14 range from a tangible book value perspective. You aren’t losing money generally. It is an interesting value here.

Operator

Your next question comes from Robert [Sinese] – Sidoti & Co.

Robert [Sinese] – Sidoti & Co.

Prior to the Cedar Rapids flood on the last quarters call you had reaffirmed your expectation of the industrial ingredients business to deliver 400 basis point improvement in EBIT margins. Given the first half performance that was heavily weighted to the back half of this year and obviously that is out of the question now because of the Cedar Rapids situation. But it seems to me that absent that event the business was running short of that target. I was hoping you could discuss what changed during the quarter versus your prior expectations to negatively impact earnings and perhaps provide a bridge for that business between last year’s operating income and this year’s third quarter operating income?

Steven Cordier

I just want to mention that at the end of the last conference call a question was asked about the margin expansion and at that time we did bring that down to reflect the impact in the second quarter for weather related issues that were incurred in that quarter and we said that it would probably shrink that projection by at least 100 basis points. Now when you look at the run rates or occurrences in the business overall in the third quarter additional items have to be factored in.

They center primarily around three unplanned items that I discussed on the conference call earlier today. That includes the $1.4 million of litigation costs, the additional expensing of start up costs for ethanol which shouldn’t recur and that is $1 million and then the higher costs related to repair and maintenance efforts and higher energy usage in that facility again that were primarily related to an unusually severe winter weather condition and through the spring which ultimately ended up in the flooding conditions and that was another $800,000.

If you look back at the absolute dollar impact from those items and you aggregate them into weather related litigation and ethanol start up you will come to the total that we think is affecting the business on a comparison or bridge between 2008 and 2007. As you look forward in the business when they get it to full recovery we are going to have the benefit from additional volumes and output streams from ethanol as well as what we consider and articulated a strong value proposition for our highest margin ethylated starches into a marketplace that appreciates that type of performance and value use proposition.

Robert [Sinese] – Sidoti & Co.

I know you don’t give guidance but in light of all of the uncertainty around the Cedar Rapids facility and the slightly lower than expected results for that business during this past quarter I was hoping you could highlight your expectations for the industrial ingredients business in fiscal 2009. I know there are a lot of moving pieces there but maybe just rough ranges on the op income line?

Steven Cordier

I’m going to couch my response in every qualifier I can reach for simply because of the amount of uncertainty you pointed out and that involves first and foremost about the immediacy of the impact of the flood and the impact on reported earnings.

Robert [Sinese] – Sidoti & Co.

Let’s just assume for a moment the facility is up and running and it doesn’t impact volumes at all in fiscal 2009. I just want to get a sense as to the underlying earnings power absent the Cedar Rapids shut down. What the underlying earnings potential of that business is in fiscal 2009 as we look out.

Steven Cordier

Well what I call the secular earnings power of the industrial business should be stronger than the second half. We have to look again and I will emphasize that our first half and second half comparisons are different from each other. The first half tends to be less than the second half but if you say in the second half of fiscal 2009 that business will have fully recovered and will begin operating on an expected trend line that would be a stronger performance than you would have seen in the second half of fiscal 2007 because we have, again, additional volumes of ethanol and improved product performance from the ethylated starches contributing to the overall business.

The business that when we began the production in May of ethanol volumes we were able to increase the volume overall, the capacity in that plant, by about 15-20% almost immediately. Then the contribution from a stronger mix of products that reflect the higher performance products that we are selling into the paper industry should provide the delta against the second half of fiscal 2007.

Robert [Sinese] – Sidoti & Co.

So if I understand your comments correctly absent delayed volume into fiscal 2009 from the Cedar Rapids shut down the business should deliver operating income exceeding 2007 levels?

Thomas Malkoski

That is what we intend with a full recovery.

Robert [Sinese] – Sidoti & Co.

Switching gears, I know you just issued equity not too long ago but the stock where it is today and as a signal to the market that you are confident in your earnings potential of Penford, have you considered buying back stock?

Steven Cordier

Yes, we talk about that almost on a daily basis.

Robert [Sinese] – Sidoti & Co.

Any additional insight there?

Steven Cordier

I refuse to offer any valuation commentary. I think that is up to Wall Street. But as you pointed out the share price has moved in a significant fashion and the underlying prospects for the business in our opinion are no different than they were a year ago and perhaps stronger because of the elements that we have been able to avail ourselves in the industrial business and on the earlier conversations with James Gentile he pointed out that asset value underline the business as well.

Robert [Sinese] – Sidoti & Co.

Lastly I noticed a change in wording in this press release versus the last one on the Cedar Rapids flood. It had previously stated your insurance policies would cover approximately $30-35 million and in this release you stated at least $30-35 million. Do you see upside from that amount?

Steven Cordier

It is more a matter of careful reflection on the policy language. It is another unknown and uncertainty that I don’t want to comment on much further than that. Certainly what I would model for the current information available is what we provided in the communication of today.

Operator

Your next question comes from Jonathan Lichter - Sidoti & Co.

Jonathan Lichter - Sidoti & Co.

What are your customers saying about their return to Penford?

Steven Cordier

We have had frequent conversations with our customers. The other fact is that our technical support teams still support the mill activities of our customers even without our products being used. We have met with senior members of many of our customers and have many more of those meetings continuing during this month. All of them have been very supportive of the situation and appreciative of how we have scrambled to work with them and with our peer companies to keep them supplied so they can continue to run their facilities.

It is certainly a difficult challenge to manage that into work with our customers on the logistics but they completely understand the situation and are supportive and have all expressed great interest in returning to our supply agreements in a normal way.

Jonathan Lichter - Sidoti & Co.

You mentioned these issues could extend through calendar 2008. Why would they last more than lets say through October?

Steven Cordier

It is just largely because of the timing of inventory that would be in the pipeline. Some locations and some mill locations might have 10 weeks of inventory in the supply line that is not supplied by us right now that is now supplied by a peer company. The customers would simply need to work off that inventory. When we talk about a phase in, particularly on the sales side, it really is simply recognizing the pipelines that will be in place at the time when we can fully supply.

Jonathan Lichter - Sidoti & Co.

You also mentioned the reformulation in the potato coatings. They were formulating your product out? Is that what you were saying?

Thomas Malkoski

It is one customer that we continue to serve with a significant amount of volume that in some of their product line they reformulated away from our product to another type of product, not even a potato based product.

Jonathan Lichter - Sidoti & Co.

On the Australia business, when now do you expect the new products to help? Will it be some time during fiscal 2009?

Steven Cordier

We will see some impact during fiscal 2009. The question will be the magnitude and the gearing of how quickly. All three of the products we talked about are industrial products that go into specialized industrialized products that are going into fiberglass sizing application. We have a customer that is already ordering that although at this point it is not significant. Then for the natural based products and the new type of resistant starches we actually have some commercial activity and some commercial accounts but it is not significant at this time. I want to be cautious about how quickly that gears into the PNL.

Operator

Your next question comes from [Brent Modulus – Rudabaker Capital].

[Brent Modulus – Rudabaker Capital]

I was wondering about your comments with regard to some of the shortages through the end of the year. Contract season is normally in the fall. Any issues with folks who maybe have some exclusive contracts with you? How do you think contract season will go, obviously this is “act of God” stuff. I understand that and maybe this hasn’t shaken your customers up too much but are they going to be looking to diversify their sources of supply going forward?

Steven Cordier

That is possible. They have not given us that indication but that is possible they will. Still, if they are looking at and typically in the industrial segment it is fairly common for a peer company to be supplying a given mill location exclusively with a certain type of product. It is very likely though that customers throughout their mill system would have multiple suppliers of similar materials.

I think as is the case with most of our customers there are competitors who can offer the same product and the same would be true at some of our peer companies mill locations where they are supplying exclusively. It might cause customers to decide they want some secondary supply at locations we serve but also at locations some of our competitors might supply as well.

I don’t think it is going to change much the level of demand. I think it might change the shipping points, the actual locations perhaps a small amount.

[Brent Modulus – Rudabaker Capital]

It seems in terms of timing the contract renewals will be well after when you should be back up and running?

Steven Cordier

Yes.

[Brent Modulus – Rudabaker Capital]

In terms of the general mix again, sorry maybe this is a question by the slow kid here, but when you ramp up production on the ethanol facility it is not as if you have got an increased supply of some higher margin products going into industrial. Where do you stand on ethanol production? I know you can vary the production. What do you think it is going to be next year in terms of gallons, just an estimate? Where do the economics of ethanol stand right now with where energy, grain and actual ethanol price is today?

Thomas Malkoski

Let me handle the first part of that question. The level of volume we would expect on ethanol. When we started up our system in May it was actually during the month of May not at the beginning of May when we were producing for commercial, we were running it at what we call our lower end of the capacity range so that would equate to roughly 25 million gallons a year on an annualized run rate. What we were doing was testing the efficiencies in our model for a cost estimate and confirmed the efficiencies and key elements of the model.

At that point, remember, the industrial starch demand remained fairly strong and we had obligations to supply our customers and in fact we talked about our ethylated starch being up fairly strongly in Q3 versus a year ago. We have the capability to continue to run the plant at that newly established level which is roughly 25% higher than where we had been running before.

The marketplace will help us determine the mix between the starch side and the ethanol. Going forward I would expect at a minimum that the ethanol would run in that turn down rate of 2 million gallons a month or so. But as opportunities surface to run that harder we certainly would look at that. I’ll turn it over to Steve to discuss a little bit of the economics to give you some perspective.

[Brent Modulus – Rudabaker Capital]

I was also going to ask about whether you are hedging any of your inputs at this point for that production next year.

Steven Cordier

We have hedged for production prior to the flood. Since the flood we have paused in the hedging program until we can determine the exact and specific dates we will begin production. When you look at the economic modeling and remember we are comparing this against a period over two years ago when we announced that we were going to begin the construction of the ethanol facility and that was back in June 2006.

We had already constructed a model for the crush margin plus company specific costs and when you look at the crush margin which is the revenue from ethanol less the cost of corn and less the cost of energy at that point you certainly on a look back basis had significantly lower costs for corn and for natural gas. But you also had significantly lower costs for pricing for ethanol.

All three of those elements have changed dramatically and if you looked at pricing just yesterday that same crush margin for us would have been 25% more favorable yesterday than it was a full two years ago when we decided it was an attractive opportunity to invest in the construction of the ethanol facility.

So for us right now ethanol is even more attractive than it was when it made a sensible decision to build the facility to produce the ethanol. That reflects not just the spot prices but a combination of spot and forward prices for the ethanol, for the corn, for the energy. So for us it is a very solid margin proposition and we don’t see any reason for that to change. We sold the output in May at a margin that was positive against that original model and all indications are that because you will have what I’ll call a natural balancing market with corn, gas and ethanol the margins continue to be attractive for us as an alternate output.

[Brent Modulus – Rudabaker Capital]

I was just curious about the hedging into next year given that it is actually reasonably favorable. I don’t blame you for pausing given where the plant is. I was just curious as to the outlook on that.

Going back a moment to industrial, do your customers have supply? Again, I am a little bit surprised, are the inventories way down? Are they working them off? I assume that you guys in this market has to be real tight regardless. I don’t think your peers have that capacity.

Thomas Malkoski

The answer is yes our customers are in supply and a pure combination of very similar products where some peer companies have actually contracted out production of certain items they would normally make in order to ramp up production in order to supply in this crisis situation. The other factor is many customers have had to switch to a different type of starch for a period of time and that would be a lesser modified starch. It is not something they’d like to remain on but during this period to continue to run their mills they have chosen to make that.

[Brent Modulus – Rudabaker Capital]

So basically they are taking in terms of run ability and so forth they prefer your products?

Thomas Malkoski

Yes, and I think in terms of fundamentals in the industrial paper industry where the capacity utilization rates remain high many of our customers have been able to sustain some pricing in the marketplace and the quality standards are higher than they were a year or two ago in two ways. One is the optical brightness of the papers. The second is the print quality where at least two major players are really pushing hard on the print resolution and the quality of the paper and I think that is an important strategic shift in the industry.

[Brent Modulus – Rudabaker Capital]

Steve you mentioned you think you have got enough liquidity. In terms of when you expect receipts, you mentioned how you are going to account for everything. You are going to expense what you have got in put through in terms of getting the plant up and running and then you’ll take the proceeds from the insurance company as you get them.

Any sense of timing there? In theory when do they have to start giving you money? You couldn’t conceivably squeeze by them jogging along or litigating or complaining or arguing over the terms of some of this? I think with business interruption it can be an interesting conversation but obviously with the equipment and so forth I would think that would be pretty straightforward. Can you just talk a little bit about cash flow timing?

Thomas Malkoski

First of all I’d like to mention that the changes to the covenant formulation were partly done to reflect the uncertainty between the matching of expense and collection of insurance reimbursement so that contemplates what I’ll call a very, very conservative mismatch between expense or cash flow out go and then receipt of insurance proceeds and it ensures us we will be able to avail ourselves the liquidity within the credit facility to make up any of that timing gap.

There is based on my personal history, the potential for some parts…the more complex parts of the claim to drag on but generally speaking the National Flood Insurance Program policies which total approximately $15 million typically are settled within 60-90 days and as you said the more straight forward parts of the rest of the Aldridge policy as it addresses another $20 million or so has different levels of complexity and I have already asked the adjusters and the insurance carriers to consider advances against the more clear cut parts of the claim and we are waiting for their response which I should get shortly.

Operator

Your next question comes from Ken Zaslow – BMO Capital Markets.

Ken Zaslow – BMO Capital Markets

Was your R&D or any efforts delayed because of the flooding in terms of the project development of what you were working on going forward, the next generation and all that stuff, how does that all play out? Does that divert your attention away from that or is it a separate process?

Thomas Malkoski

A separate process, Ken, and nothing on the R&D side from the industrial business was delayed in any way. The interesting part is we had trial activity going on with some customers where our personnel were offsite anyway. So the technical sales and R&D folks were already supporting those trials at customers during the early part of the flood recovery.

As I mentioned we have reoccupied the R&D building and the pilot plant and we will be starting up in a couple of day’s production in our pilot plant of many of our liquid natural additives products. Through a combination of products we had in storage tanks in the plant that were not damaged and we checked the specifications of the product and shipped out to customers and the production that will begin in a couple of days we do not expect to miss on any of the supply chain to one key part of our existing customer supply with the liquid natural products and then two, continue the R&D efforts so that none of those projects slow down.

Ken Zaslow – BMO Capital Markets

Going two years forward, would the event of the flood or anything change…as you forecast, I assume you forecast models a few years out, would there be any change to your forecast to what would have happened either way? You said R&D change, customers, anything that would change how you think about a few years down the road when this whole thing is over?

Steven Cordier

No material changes two years down the line looking back at this event.

Ken Zaslow – BMO Capital Markets

In terms of the corn hedge do you actually make money on your hedges as you are unwinding your corn now? I’m assuming that you are in the process. With the site you make a little extra money there?

Steven Cordier

We are working right now with both our suppliers and hedge programs to utilize the corn that we had planned to use during this period of manufacturing that has been suspended later on when we come back on stream. We are not realizing and then buying corn new. We are trying to push it back into when we begin production.

Ken Zaslow – BMO Capital Markets

Would you expect Australia to be profitable without any prices or do you need the wheat prices to come down, which they have? Do you need that? If we were to flat line wheat prices at today’s level would that prevent you from being able to be profitable next year?

Steven Cordier

If you look at the impact of grain prices 2008 to 2007 we said it would be a nearly $15 million penalty. The four part program we outlined at the beginning of the fiscal year to overcome that $15 million has largely been realized. The higher selling prices that were designed to get 50%, the headcount reductions 15%, manufacturing reconfigurations for another 15-20% absent the unusual cost for procuring and processing the starch and imported maize into Australia.

The part that we have talked about that is gapping is the new product development and its contribution of about 20% of that $15 million higher grain cost. So if I take what you are seeing to me and you say flat line the grains and you say again you have that high $15 million cost relative to fiscal 2007 and everything else holds the same we’d have a gap because of the new product development contribution uncertainty.

What I have also said is we have implemented contingency plans that we’re trying to implement against that shortfall. A long way of saying we have to scramble hard without grain relief but that we would try to implement additional measures to get that back.

Ken Zaslow – BMO Capital Markets

So if I’m hearing you right basically without the grain relief there is a little bit. If you get grain relief you could end up a little bit positive depending on where the grains go. Is that fair?

Steven Cordier

Yes, there is a lot of emphasis on the ultimate grain price as was discussed earlier on this call.

Ken Zaslow – BMO Capital Markets

The last question I have and I don’t know how much detail you can give on this. You talked about stages and when you come on line. You said different time periods. Can you give better stage of what percent…will the end of the year everything will be on? How does it work? Most of us have never been in the processing…we haven’t managed the plants. So how does it work? Do they come on slowly – 15%, 20%? How does that work?

Thomas Malkoski

Many of the key parts of the manufacturing process when they come back up those portions will be fully operational. So for example getting power supply into the facility, then distributing that power supply to all of the key areas, those are required before we can actually start back up. The buildings the power would go to are what would more likely be staged.

Let me give you perspective there. We have a building that contains certain processing and drying facilities that sustained less damage than another building that also has processing and drying facilities. The difference in timing between when those two buildings would come up could be short, a matter of a few days, and it could be a short number of weeks between the two buildings. We don’t know that yet.

That is why we say it would be more of a phased start up where some buildings that sustained less damage to particularly some of the process controls and instrumentation, those are things we have to make sure and test out and until we have the power supply distributed in the plan it is hard to know.

Steven Cordier

I want to follow-up by just emphasizing though that the planning process by the entire management team there from the very outset has been designed toward getting full production in specific categories accomplished so we can actually ship. So we are not thinking of a turnkey or a flip the light switch approach where we build the plant up and up and up and on the third week in August turn the whole plant on.

The idea here is to say okay we’ve got, as Tom has mentioned, liquid natural additives coming on stream in the next few days. Then we’re going to be working on specific product categories in the areas of starches whether they are cationic, oxidized or ethylated and we’ll also be separately trying to advance the restoration of the ethanol. So we are working on whole processes so we can actually ship rather than try to move the whole plant a bit at a time.

Operator

Your next question comes from [Robert Krasowski – OFI Institute].

[Robert Krasowski – OFI Institute]

I was just wondering on the ethanol side would you prefer to hedge to the lenders or on the options market.

Steven Cordier

We typically use our third-party distributors as part of our hedge program. The reason for that is it is both more effective from a cost standpoint and we are able to tighten the cash flows a little bit more effectively with them. We can use the options or futures if we judge them to be sensible.

[Robert Krasowski – OFI Institute]

How far out would you want to go if you are in a normal ethanol producing environment?

Steven Cordier

That has been determined more by the availability of offsetting positions in the forward market until recently there was a very big discount in the forward markets nearby so it wasn’t really that attractive to push your hedges out very long. No more than 30-90 days. You’ve seen that forward discount begin to narrow as I believe that some of the buyers of ethanol have begun to enter the marketplace and think it is more balanced. So, as you get a tighter spread, if you will, we may extend out in our normal hedge program of 6-9 months out for at least half of the position.

Thomas Malkoski

Robert, just think of the range in production for that particular asset and roughly we’d like to be able to hedge forward with some certainty the low end of our turn down range.

[Robert Krasowski – OFI Institute]

$20 million or so? $24 million?

Thomas Malkoski

Right and we’d like to be able to hedge forward in no uncertainty the economics for that decision and then look at the opportunities more on a spot basis for the balance of that production. So that gets to where Steve is saying our target is being able to manage it where roughly half of the position would be more certain and then if the spot market falls out we are still within our turn down range with something that is secured.

[Robert Krasowski – OFI Institute]

You prefer to have that lower end of the volume hedged out for 6-9 months or so at least?

Thomas Malkoski

Yes.

[Robert Krasowski – OFI Institute]

Could you give us an update on the gross profit progression of Australia, maybe by month, and do you expect to have a profitable fourth quarter?

Steven Cordier

The fourth quarter for that business let me attack it backwards and I’ll look more at the operating line than the gross margin line. Right now we think absent some changes in new product landscape that business will be probably close to break-even on an operating margin basis for the fourth quarter. If you look at it month by month it is fairly evenly spread. Sometimes in the last month of the quarter or fiscal year there is some clean up but generally speaking it is a business model that is pretty even month to month. Does that answer your question?

[Robert Krasowski – OFI Institute]

So it should be somewhat near break-even in the fourth quarter?

Steven Cordier

That is our expectation.

[Robert Krasowski – OFI Institute]

Are you expecting some margin pressure in the food ingredients business over the next few quarters as the industry slows down?

Thomas Malkoski

Robert I don’t think we’ll see the margin progression on the products we are serving now.

[Robert Krasowski – OFI Institute]

Finally, I just hope you would consider giving us an update because I know it is a long time before we get the fourth quarter. Can you give us an update on the progress of the turning feeder back online?

Steven Cordier

Yes, we’re going to try to provide timely updates. We have given the marketplace information as it has been received by us with a reasonable amount of clarity since the flood and we’ll try to continue that so that people know the progress as we gain recovery in the site.

Operator

Your next question comes from Tom Spiro – Spiro Capital.

Tom Spiro – Spiro Capital

To the extent that the losses in Cedar Rapids are not reimbursed by insurance what is the tax treatment of that deficit?

Steven Cordier

The typical accounting treatment for events like this are that they are not extraordinary. It is an event that occurs over time in business places and so the approach from our accounting perspective is simply that. You’ll have expenses that are incurred, offsetting reimbursements that will come in and be accounted for in the statements at normal accounting practices and tax rates.

Tom Spiro – Spiro Capital

Is there some type of casualty claim you can submit to the IRS for a refund?

Thomas Malkoski

There have been no special programs that we have become aware of at this point but we are constantly looking for programs that already exist or may come about as the government responds to this significant event.

Tom Spiro – Spiro Capital

Was the $30-35 million insurance coverage expanded in connection with the ethanol expansion?

Steven Cordier

It wasn’t expanded in connection with the ethanol it included the ethanol production. If you look at the typical flood cover limits for companies that operate in flood zone A, and with our plant being in place for more than a century along the banks of the Cedar River it definitely is in flood zone A, Penford had typical insurance or even robust insurance coverage and limits of flood coverage compared to companies in Iowa or any other companies that are in flood zone A. We did reflect the ethanol coming on stream within the all risk policy but didn’t make any specific changes for flood.

Tom Spiro – Spiro Capital

Lastly, on the reformulation of the potato side, why did that customer reformulate? What was his logic?

Thomas Malkoski

I think the customer is looking for some cost benefit and looked to some other materials to do that and our understanding is that it required some capital that the competitive product supplied for that contract of supply.

Tom Spiro – Spiro Capital

Did the switch involve any diminution of the customer’s quality? The quality of the customer’s product?

Thomas Malkoski

From what we have seen in the comparable products that we make there would be a product difference, yes, but we don’t know what their objectives were with substituting those products and we don’t know if they were reformulating for a different product in the end market.

Operator

There are no further questions in queue at this time.

Steven Cordier

Thanks very much. If there are any follow-up questions please call us.

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