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 Management's Discussion and Analysis
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Cashflows
Consolidated Statements of Shareholder's Equity
Notes to Consolidated Financial Statements
Report of Ernst & Young LLP, Independent Auditors
Report of Management
Directors
a. summary of significant accounting policies
business Penford Corporation (Penford or the Company) is in the business of developing, manufacturing and marketing chemically modified carbohydrate-based specialty chemicals. The Company operates in three market lines: carbohydrate-based specialty chemicals used in paper manufacturing, pharmaceutical excipients and controlled release technology, and food ingredient products. Customers are primarily manufacturers in the paper industry, makers of prescription pharmaceuticals, over-the-counter drugs and vitamins, and processors in the food industry. Sales of the Company's products are generated using a combination of direct sales and distributor agreements.
basis of presentation Certain amounts in the financial statements for prior years have been reclassified to conform with the current year presentation. These reclassifications had no effect on previously reported results of operations.
cash and cash equivalents Penford's cash management system includes a cash overdraft feature for uncleared checks in the disbursing accounts. Cash in the accompanying balance sheets represents the net amounts available to the disbursing accounts. Uncleared checks of $1,446,000 and $2,177,000 are netted against cash at August 31, 1997 and 1996, respectively.
concentration of credit risk and financial instruments Penford Products' two largest customers accounted for approximately 15% and 10 % of sales in fiscal 1997 and one customer represented approximately 14% of sales in fiscal 1996. No customers accounted for greater than 10% of total sales in years prior to 1996.
property, plant and equipment Interest is capitalized on major construction projects while in progress. Interest of $724,000, $300,000 and $209,000 was capitalized in 1997,1996 and 1995, respectively.
foreign currencies
income taxes
revenue recognition
research and development
earnings per common share In February 1997, the Financial Accounting Standards Board (FASB) issued Statement No. 128, "Earnings per Share," which is required to be adopted in the second quarter of fiscal 1998. At that time, the Company will be required to change the method currently used to compute earnings per share and to restate all prior periods. Under the new requirements for calculating primary earnings per share, the dilutive effect of stock options will be excluded. The impact is expected to result in increases of $0.02, $0.02 and $0.04 to primary earnings per share for the fiscal years, ended August 31, 1997, 1996 and 1995, respectively. The impact of Statement 128 on the calculation of fully diluted earnings per share is not expected to be material.
stock compensation
recent accounting standards b. inventories Inventories are stated at the lower of cost or market. Cost, which includes material, labor and manufacturing overhead costs, is determined by the first-in, first-out (FIFO) method. The Company generally follows a policy of hedging corn purchases related to fixed price sales contracts and certain anticipated corn purchases to minimize price risk due to market fluctuations and risk of crop failure. The instruments used are principally readily marketable exchange traded futures contracts which are designated as hedges. The changes in market value of such contracts have a high correlation to the price changes of the hedged commodity. Also, the underlying commodity can be delivered against such contracts. Gains or losses arising from open and closed hedging transactions are included in inventory as a cost of raw materials and reflected in the statements of income when the product is sold. Components of inventory are as follows:
c. debt
The unsecured credit agreement is a $35 million facility involving four banks. There was $20.3 million outstanding at fiscal year end, and borrowings mature on December 30, 1999. Borrowing rates available to the Company under the agreement are based on prime rate or the interbank offered rate depending on the selection of borrowing options. The unsecured credit agreement, the private placements, and other notes include, among other terms, various limitations on long-term indebtedness, minimum net worth and working capital ratios, and restrictions on Penford's ability to purchase or redeem its own stock. The unsecured credit agreement also requires the Company to maintain a minimum fixed charge coverage ratio. The Company has uncommitted lines of credit aggregating $15 million, which provide for financing at various floating rates of which $6.0 million was outstanding at August 31, 1997. The Company enters into interest rate swap agreements to modify the interest characteristics of its outstanding debt. These agreements involve the exchange of interest payment streams without an exchange of the underlying principal amount. Net amounts paid or received are reflected as adjustments to interest expense. The fair values of the swap agreements are not recognized in the financial statements. In the event of default by a counterparty, the risk in these transactions is the cost of replacing the interest rate contract at current market rates. Management continually monitors the credit ratings of its counterparties, and believes the risk of incurring such losses is remote, and that if incurred, such losses would be immaterial. At August 31, 1997, approximately $25 million of the Company's outstanding debt was subject to interest rate swap agreements. Of this amount, $15 million involves floating rate to fixed rate swaps which effectively fix rates at approximately 9.0% and $10 million involves fixed rate to floating rate swaps, with the floating rate approximating 6.3% at August 31, 1997. The Company has hedged the interest rate risk on $8.9 million of its long-term debt using Treasury note futures. The cost of the hedge has been deferred and will be recognized as a component of interest expense over the life of the debt. The hedge results in an effective interest rate on the related long-term debt of approximately 9.5%. d. leases Certain of the Company's property, plant, and equipment is leased under operating leases ranging from one to fifteen years with renewal options. Rental expense under operating leases was $4,418,000, $4,482,000 and $3,202,000 for fiscal years ended August 31, 1997, 1996 and 1995, respectively. Future minimum lease payments as of August 31, 1997 for noncancellable operating leases having initial lease terms of more than one year are as follows:
e. stock options The Company has two stock option plans for which 1,500,000 shares of Common Stock have been authorized for grants of options: the 1994 Stock Option Plan (the "1994 Plan") and the Stock Option Plan for Non-Employee Directors (the "Directors' Plan"). The 1994 Plan replaced the 1984 Stock Option Plan (143,000 shares outstanding at August 31, 1997) which expired in February 1994, and provides for the granting of stock options at the fair market value of the Company's Common Stock on the date of grant. Either incentive stock options or non-qualified stock options are granted under the 1994 Plan. The incentive stock options generally vest over five years at the rate of 20% each year and expire 10 years from the date of grant. The non-qualified stock options generally vest over four years at the rate of 25% of each year and expire 10 years and 10 days from the date of grant. The Directors' Plan provides for the granting of non-qualified stock options at 75% of the fair market value of the Company's Common Stock on the date of grant for annual retainers and meeting fees in lieu of cash compensation at eachDirector's annual election. Options granted under the Directors' Plan vest six months after the grant date and expire at the earlier of 10 years after the date of grant or three years after the date the non-employee director ceases to be a member of the Board. In addition, non-employee directors receive restricted stock under a restricted stock plan every three years. The restricted stock may be sold or otherwise transferred at the rate of 33.3% each year. Effective September 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," using the intrinsic-value method prescribed by APB Opinion No. 25, as allowed for in the Statement. Accordingly, no compensation expense has been recognized for the stock-based compensation plans other than for the Directors' Plan and restricted stock awards. Had compensation cost been recognized based on the fair value at the date of grant for options awarded in 1997 and 1996 under the Plans, pro forma amounts of the Company's net income and net income per share would have been as follows:
The fair value of each option grant was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions: risk-free interest rates of 5.6% to 6.1%; expected option life of each vesting increment of 2.8 years for employees and 3.0 years for non-employee directors; expected volatility of 49%; and expected dividends of $0.20 per share. The weighted average fair value of options granted under the 1994 Plan during fiscal years 1997 and 1996 was $9.46 and $10.57, respectively. This weighted average fair value of options granted under the Directors' Plan during fiscal years 1997 and 1996 was $9.29 and $11.66, respectively. The effect of applying Statement No. 123 for providing pro forma disclosures for fiscal years 1997 and 1996 is not likely to be representative of the effects in future years because the amounts above reflect only the options granted in 1997 and 1996 that vest over four to five years, and additional grants are made annually. Changes in stock options for the three years ended August 31 follow:
Stock appreciation rights (SARs) to certain officers of the Company that were granted in December 1986 and were fully vested as of August 31, 1996 were fully exercised during the first half of fiscal 1997. As a result of appreciation (depreciation) of Penford stock, compensation expense was charged (credited) for $(28,000), $(451,000) and $78,000 in 1997, 1996 and 1995, respectively. f. income taxes
g. pension and other employee benefits Penford maintains two noncontributory defined benefit pension plans that cover substantially all employees. Benefits under the plan for hourly employees are primarily related to years of service. Benefits for salaried employees are primarily related to years of credited service and final average five-year earnings. Employees generally become eligible to participate in the plans after attaining age 21 and benefits normally become vested after five years of credited service. The Company's funding policy is to contribute amounts to the plans sufficient to meet or exceed the minimum requirements of the Employee Retirement Income Security Act of 1974. Assumptions used in the measurement of the projected benefit obligation included a discount rate of 7.5% in 1997 and 8.0% in 1996, and a rate of increase in compensation levels of 4.0% in 1997 and 5.0% in 1996 for the salaried employees. The expected long-term rate of return on plan assets is assumed to be 10.0% for 1997 and 9.0% for 1996 and 1995. Changes in assumptions used in the measurement of the projected benefit obligation had the effect of reducing pension expense by $268,000 in 1997.
Assets of the pension plans are invested in units of common trust funds managed by Frank Russell Trust Company. The common trust funds own stocks, bonds and real estate.
savings and stock ownership plan The plan also includes an annual profit-sharing component that is awarded by the Board of Directors based on achievement of predetermined corporate goals. This feature of the plan is available to all employees who meet the eligibility requirements of the plan. The profit-sharing expense, which reflects the market value of shares released by the plan to participants was $212,000, $514,000 and $402,000 for the fiscal years 1997, 1996 and 1995, respectively. The plan initially acquired the Penford common stock by issuing a note to the Company. The note is reflected as a reduction of shareholders' equity and is amortized ratably over the note term which expires in December 1999. The shares held by the plan are considered outstanding for purposes of calculating earnings per share. Dividends on shares held by the plan are allocated to participant accounts.
supplemental executive retirement plan
health care and life insurance benefits h. other postretirement benefits Penford maintains two postretirement benefit plans that cover substantially all salaried and hourly retirees. Benefits under the plan for hourly employees include medical coverage, prescription drug coverage, and, to a certain grandfathered group, life insurance. Hourly participants contribute to the cost of the benefits based on a pension credit formula. Benefits under the plan for salaried employees include medical coverage and vision coverage. Salaried participants contribute, for the most part, 100% of the premiums. Presently the Company funds the current benefits on a cash basis and therefore there are no plan assets. The following table sets forth the plan's status:
Future benefit costs were estimated assuming medical costs would increase at a 9.5% annual rate for fiscal 1997, decreasing by one half of a percent ratably over the next eight years to a rate of 5.5%. A 1% increase in this annual trend rate would have increased the accumulated postretirement benefit obligation at August 31, 1997 by $1.1 million, with an increase of $128,000 in the annual 1997 postretirement benefit expense. The weighted average discount rate used to estimate the accumulated postretirement obligation was 7.5% and 8.0% in 1997 and 1996, respectively. The change in discount rate had the impact of decreasing the accumulated post-retirement benefit obligation by $343,000. i. shareholders' equity
unissued preferred stock
common stock purchase rights j. other events
sale of air emission credits
pacific cogeneration, inc. k. quarterly financial data (unaudited)
* First quarter fiscal 1997 results include a gain of $800,000 after-tax, or $0.11 per share, from the sale of Southern California air emission credits l . subsequent event On October 9, 1997, Penford announced a two stage plan designed to foster the growth potential of its pharmaceuticals business and separately, its paper and food ingredients businesses. Under the first stage of the plan, Penwest Pharmaceuticals Co. (Penwest) would sell up to 20% of its common stock through an initial public offering. Under the second stage of the plan, Penford would effect a tax-free spin-off to its shareholders of its remaining ownership of Penwest common shares, contingent upon satisfying certain conditions, including receipt of a tax ruling from the Internal Revenue Service or a written opinion from Ernst & Young LLP to the effect that, among other things, the spin-off will qualify as a tax-free distribution. The spin-off is anticipated to occur in the second quarter of calendar 1998. If the spin-off occurs, Penwest will no longer be a subsidiary of Penford. On October 21, 1997, Penwest filed a registration statement with the Securities and Exchange Commission for an initial public offering of 2,500,000 shares of common stock (approximately 15% of its outstanding common stock). The estimated initial public offering price is between $10.00 to $12.00 per share. An option will be granted to the underwriters to purchase up to 375,000 additional shares for the purpose of covering over-allotments, if any. Penford and Penwest have entered into a Separation Agreement setting forth the agreement of the parties with respect to the principal corporate transactions required to effect the separation of Penford's pharmaceutical business from its paper and food ingredients businesses, the initial public offering and the spin-off, and certain other agreements governing the relationship of the parties prior to and after the spin-off. Penford and Penwest will, prior to the completion of the initial public offering, also enter into other agreements that govern various interim and ongoing relationships. Penwest will retain the proceeds from the planned initial public offering. In addition, Penford will forgive all intercompany advances as of the closing of the offering. As of August 31,1997, the intercompany balance approximated $35.2 million. Had the proposed plan been effected as of August 31, 1997, it is estimated that consolidated assets and shareholders' equity of Penford would have reflected a reduction of approximately $35.0 to $40.0 million, representing the net effects of the proposed distribution.
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