The original plan, announced in October 1997, called for PPCO to complete an initial public offering ("IPO"), followed by a tax-free distribution of the Company's shares of PPCO. PPCO's IPO was postponed in December 1997 due to market conditions for new issues in general, as well as for health care and technology stocks in particular. Subsequently, the Company concluded that the objective of enhancing shareholder value could best be achieved through a tax-free distribution of PPCO to Penford Corporation shareholders, rather than wait for improvement in the initial public offering market. The spin-off required that a bank line of credit of $15 million be obtained by PPCO and guaranteed by Penford Corporation. On September 1, 1998 shares of PPCO began trading on the Nasdaq National Market under the symbol "PPCO."

As a result of the plan, Penford Corporation has reported PPCO as a discontinued operation in the accompanying financial statements. One time charges totaling $5.6 million ($3.6 million after-tax) were included as a component of discontinued operations reflecting the costs of separating the two businesses including direct costs such as professional fees, investment banking fees and other costs of establishing PPCO as a separate public company of approximately $3.3 million and operating losses of $2.3 million from May 31, 1998 to the distribution date, August 31, 1998. The PPCO loss from operations through May 31, 1998 of $7.9 million ($5.1 million after-tax) includes the write-off of certain costs incurred in connection with the previously planned IPO of approximately $1.7 million. In addition, the Company incurred restructuring costs of $1.9 million charged to continuing operations consisting primarily of estimated costs associated with implementing the spin-off, severance costs and facilities charges incurred in connection with the downsizing of the corporate headquarters. The Company continues to believe the estimate is reasonable and expects the majority of related obligations remaining at August 31, 1998 of $1.8 million will be settled in the first half of fiscal 1999.

On a consolidated basis, gross margin was 28.0% in 1998 compared to 25.2% in 1997. The increase reflects an emphasis on cost controls and lower raw material costs at both Penford Products and PFI, increased manufacturing efficiency associated with higher volumes at PFI, and the impact of Company-wide process improvements implemented during the year.

Excluding restructuring costs, operating expenses increased $100,000 or less than 1.0% in 1998. General and administrative cost reductions, primarily a result of lower corporate office expenses in the second half of the year, were offset by higher research and development costs of $200,000, or 4.3%, mainly due to new product development expenditures at Penford Products. Restructure costs of $1.9 million were
recorded in the third quarter of fiscal 1998, in conjunction with the spin-off of PPCO. See "Spin-off of Penwest Pharmaceuticals Co."

Interest expense increased $471,000, or 8.8%, due to higher outstanding debt balances and lower capitalized interest in the current year.

As a result, income from continuing operations before income taxes, excluding the restructuring charge, increased $982,000, or 7.3%, in 1998. After the restructuring charge, income from continuing operations before income taxes declined $949,000, or 7.1%.

The effective tax rate in 1998 was 35.0%, compared to 33.4% in 1997 when the Company benefited from tax credits. The effective tax rate for fiscal 1999 is expected to increase to approximately 36% primarily due to higher state income taxes. See "Forward-looking Statements."

Loss from discontinued operations of $5.1 million, net of tax, reflects the operating losses of PPCO for the nine months ended May 31, 1998 including the write-off of certain costs incurred in connection with the previously planned initial public offering of PPCO. Operating losses at PPCO increased due to a decrease in licensing fee income, higher general and administrative costs associated with the hiring of additional employees required for the Company to operate on a stand-alone basis after the spin-off, and higher research and development expenses related to the development of TIMERx controlled release formulations.

Gross margin was 25.2% in 1997 compared to 23.4% in 1996. The increase reflects higher volumes at Penford Products and Penford Food Ingredients, lower corn costs and the impact of manufacturing efficiencies implemented during the year.

Operating expenses increased $1.3 million, or 5.3%. General and administrative costs rose by $0.9 million primarily for company-wide information technology support. Research and development expenses increased $371,000, or 9.7%, primarily due to increased headcount at Penford Food Ingredients.

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 Company had $34.3 million of Senior Notes outstanding at August 31, 1998. The Company intends to refinance approximately $13 million of fiscal 1999 maturities under these Notes, through additional borrowings under the $75 million Credit Agreement. See "Forward-looking Statements."

The Company has guaranteed repayment of principal and interest and other obligations under a $15 million revolving credit facility obtained by PPCO. The Company's obligations under the guarantee are capped at $18 million and are reduced by the amount of certain sales of securities by PPCO. The Company is not liable for obligations of PPCO incurred after August 31, 2000. As of August 31, 1998 there were no amounts owed by PPCO under the facility.

Operating cash flow from continuing operations was $21.6 million, $20.8 million and $14.9 million in fiscal 1998, 1997 and 1996, respectively. The Company used operating cash flow and debt to finance capital expenditures and expenses relating to the distribution of PPCO in fiscal 1998.

Capital expenditures related to continuing operations were $10.8 million, $18.3 million and $19.4 million in 1998, 1997 and 1996, respectively. Capital expansion has been funded from operating cash flows and borrowings under lines of credit. Capital projects in 1998 were directed to increasing capacity, improving operational efficiency, and upgrading and modernizing equipment at Penford Products. In addition, the production capabilities of the Penford Food Ingredients facility in Plover, Wisconsin were expanded. The Company expects the amount of capital expenditures in fiscal 1999 will be similar to fiscal 1998. Projects will be primarily directed to equipment modernization, process improvements and the completion of projects started in 1998. The Company intends to fund capital expenditures primarily from operating cash flows.

The Company began paying a quarterly cash dividend of $0.05 per share in 1992, and has paid dividends each quarter since then. The Board of Directors reviews the dividend policy on a periodic basis.

The Board of Directors has 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 1998.

It is anticipated that total expenses for Year 2000 remediation efforts may range from $500,000 to $700,000, approximately 50% of which had been expended as of August 31, 1998. See "Forward-looking Statements."

The Company does not anticipate significant delays in finalizing internal Year 2000 remediation efforts. However, third parties having a material relationship with the Company may be a potential risk based on their Year 2000 preparedness, which is not within the Company's control. The Company is in the process of identifying and evaluating the Year 2000 preparedness of critical customers, suppliers, and service providers. This review should be completed early in calendar 1999. Pending the results of that review, the Company will, if necessary, consider alternatives to its planned course of efforts.

Management of the Company believes it has an effective program in place to resolve the Year 2000 issue in a timely manner. As noted above, the Company has not yet completed all necessary phases of the Year 2000 program. The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of certain normal business activities. Such failures could adversely affect the Company's results of operations, liquidity and financial condition. In addition, disruptions in the economy generally resulting from Year 2000 issues could also materially adversely affect the Company. Due to the uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of critical third-parties, the Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Company.

The Company has contingency plans for certain critical applications and is working on such plans for others. These contingency plans involve, among other actions, manual workarounds, increasing inventories, and adjusting staffing strategies.

market risk sensitive instruments and positions

The market risk associated with the Company's market risk sensitive instruments is the potential loss from adverse changes in interest rates and commodities prices.