recent developments

On October 9, 1997, Penford Corporation (Penford, formerly PENWEST, LTD.) 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 specialty paper chemicals and food ingredients business, 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.

comparison of fiscal 1997 to 1996
results of operations

Sales increased $2.2 million or 1.1% in fiscal 1997. The increase reflects higher volumes in each of the Company's divisions. The sales increase is partially offset by lower corn prices in 1997. Corn is a key component in Penford Products' paper chemical products, and changes in corn costs are generally passed through to customers. During 1997, corn prices generally trended down from the historical highs of late fiscal 1996. During 1997, Penford Products increased shipments of corn-based products by 6.0%, reflecting increased marketing efforts to certain key customers. Penford Food Ingredients volume increased by 31.0% primarily as a result of new customers for its french fry coating products. Penwest excipient sales were up slightly from 1996. Gross margin was 25.7% in 1997 compared to 24.0% in 1996. The increase reflects higher volumes primarily at Penford Products and Penford Food Ingredients, better corn pricing and the impact of manufacturing efficiencies implemented during the year. Operating expenses increased $2.1 million or 6.2%. General and administrative costs rose by $1.4 million primarily for company-wide information technology support and to build the infrastructure to support anticipated growth for the pharmaceuticals operations. Research and development expenses increased $700,000 or 10.4%, primarily due to increased spending at Penwest. These costs reflect an increased R&D headcount and greater expenditures for bioequivalence studies in the drug formulation development area at Penwest. Consolidated R&D expenditures will be reduced significantly if the planned spin-off of Penwest is completed. Other income of $1.2 million represents a gain on the sale of Southern California air emission credits. Interest expense increased $222,000 or 4.4%, primarily due to higher outstanding debt balances. The effective tax rate was 33.2% in fiscal 1997 compared to 32.5% in the prior year. The effective rate is lower than the statutory rate primarily due to tax credits and the effects of the Company's foreign sales corporation.

comparison of fiscal 1996 to 1995
results of operations

Sales increased $20.3 million, or 11.7%, during fiscal 1996. The increase in sales reflects higher demand for the Company's core business. The increase is also due to unusually high corn costs, a key component used in pricing Penford Products' paper chemical products. Changes in corn costs are generally passed through to customers. During the year, Penford Products signed several multi-year contracts to sell products to customers representing significant volumes. Penwest increased sales volumes for EMCOCEL^® during fiscal 1996 by 17%. This increase was primarily attributable to two new large customers. Potato starch volumes at Penford Food Ingredients increased by 75% in 1996 due to rapidly increasing demand for these starches for french fry coatings. Gross margins were 24.1% in 1996 compared with 27.5% in 1995. The decrease in gross margin is primarily due to the historically high price of corn which affected margins several ways. First, certain of the Company's sales are based on a recent average of published corn prices. Consequently, in periods of rapidly escalating prices, the Company is not able to recover the full amount of the increase in raw material costs under such contracts. Particularly in the fourth quarter, the Company's margin on fixed price sales contracts was also negatively impacted by the high price of cash corn relative to the futures market driven by a severe supply/demand imbalance. Due to the short supply of corn, the market cash price reflected a high premium that had to be absorbed by the Company on its fixed price business. Lastly, lower margin dollars on higher unit sales prices also adversely impacted the gross margin percentage. The corn situation did improve in October, 1996 as the new crop was harvested. In addition to the impact of corn, competitive and market factors put pressure on product pricing in the renewal of customer sales contracts making it difficult to maintain prior years gross margin levels. Operating expenses increased $1.6 million, or 4.8%. Research and development (R&D) expenses increased $524,000, or 7.7%, as a result of greater development spending at Penwest. Other income in 1995 reflects a gain on the sale of assets of the Company's subsidiary, Pacific Cogeneration, Inc. of $899,000. Net interest expense remained consistent with the prior year. The effective tax rate was 32.5% in fiscal 1996, compared with 35.0% in fiscal 1995. The reduction in the tax rate reflects a reduction in state taxes and an increased benefit from the Company's foreign sales corporation.

liquidity and capital resources

The Company had working capital of $30.2 million at August 31, 1997. The Company has an unsecured $35 million credit agreement under which there was $20.3 million outstanding at the end of fiscal 1997. The Company also has $15 million of uncommitted lines with various banks that are used for overnight borrowings. These lines were used throughout the year, and there was $6.0 million outstanding at the end of fiscal 1997. Operating cash flow was $20.2 million, $12.9 million and $16.3 million in fiscal 1997, 1996 and 1995, respectively. Subsequent to the proposed spin-off, Penford Corporation will retain all rights and obligations under its various short and long-term borrowing arrangements, including amounts available under the credit agreement and uncommitted lines. Capital expenditures amounted to $21.5 million in fiscal 1997 compared to $21.5 million in fiscal 1996 and $23.0 million in fiscal 1995. Capital expansion has been funded from operating cash flows and borrowings under uncommitted lines. Significant capital projects during fiscal 1997 included capacity expansion at the Penford Food Ingredients' facility in Richland, Washington and the completion of a new corn unloading facility for Penford Products in Cedar Rapids, Iowa. The remainder of the expenditures were for various improvements to manufacturing facilities. Planned capital expenditures in fiscal 1998 will primarily be directed to upgrades and modernization of certain Penford Products machinery and equipment and the expansion of processing capabilities at Penford Food Ingredients. Assuming completion of the proposed spin-off, capital expenditures in 1998 should be no greater than in fiscal 1997. The Company expects to fund capital expenditures from operating cash flows and from uncommitted lines of credit. The Company commenced paying a quarterly cash dividend of $0.05 per share with the quarter ended February 28, 1992, and has paid such dividend each quarter thereafter. The Board of Directors reviews the dividend policy on a periodic basis. In April 1994, the Board of Directors authorized a stock repurchase program for the purchase of up to 500,000 shares of the outstanding common stock of the Company. The Company did not repurchase any of its common stock during fiscal 1997.

forward-looking statements

The above discussion contains forward-looking statements concerning the proposed public offering and spin-off of Penwest and the anticipated activities and results of Penford. There are a variety of factors which could cause actual events to differ materially from those projected in the forward-looking statements, including without limitation, the risks that the public offering of the spin-off may not be completed as the result of future developments in Penford's or Penwest's business or conditions in the securities markets, failure to obtain necessary government rulings or approvals or third party consents or agreements or other unforeseen developments; competition; product development risk; patents and intellectual property matters (including patent infringement litigation, including the patent infringement suit brought by Bayer and Pfizer against Mylan); dependence on collaborators; regulatory and manufacturing issues including the difficulties of obtaining FDA or other regulatory approvals; changes in raw material prices; or other unforeseen developments in the industries in which Penford operates. Accordingly, there can be no assurance that the public offering or spin-off will be completed, or that future activities or results described will be as anticipated. The registration statement filed by Penwest with the Securities and Exchange Commission has not yet become effective. The securities may not be sold nor may offers to buy be accepted prior to the time the registration statement becomes effective. The discussion included herein shall not constitute an offer to sell or a solicitation of an offer to buy nor shall there be any sale of these securities in any state or jurisdiction, in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state