The decline in revenues reflects the impact from lower Australian foreign currency exchange rates, reduced demand for industrial starches serving paper markets (partly offset by increased ethanol production) and volume changes in the Australian operations. The quarterly operating loss was mainly driven by lower volumes of industrial starch, which led to a mix shift toward ethanol just as falling prices for that product pushed margins below break-even.
The Company’s business model, which emphasizes products that deliver customer solutions through functionality and cost-in-use performance, is sound and is reinforced by the continuing solid results in our North America Food segment. However, the severe economic downturn has greatly impacted our Industrial segment. This business had limited time to adjust to the abrupt erosion of paper customer demand during the quarter caused by sharply reduced consumption of our customers’ products and inventory de-stocking. In addition, ethanol margins were compressed due to sharply lower fuel prices, said Tom Malkoski, Penford president and chief executive officer. We have now implemented cost reduction programs that we expect will decrease manufacturing and operating expenses by more than $5 million in the second half of the fiscal year.
The company’s board of directors believes the trading price of its common shares does not currently reflect the underlying value of its assets and opportunities. The companyhas appointed Merrill Lynch to assist in reviewing potential strategic choices to enhance shareholder value. The companydoes not plan to release additional information on this subject at this time.
Segment Results
Food Ingredients – North America
The North American Food Ingredients segment continues to report higher sales and profits despite the difficult economic situation. Second quarter fiscal 2009 revenues rose 6.3% over last year to $16.6 million. Product mix improved and average unit selling prices increased. Coating applications revenue expanded and sales into the pet segment rose significantly. Gross margin grew $0.6 million to $4.8 million on revenue gains and lower manufacturing costs. Income from operations was $2.8 million compared with $2.2 million a year ago.
In addition, the segment contributed to cash flow efforts by divesting its dextrose business for a $1.6 million gain during the second quarter after a determination was made that the dextrose business was not part of the Company’s core strategic focus. The North American Food business remains the model for leveraging successful ingredient solutions into growing market opportunities.
Industrial Ingredients – North America
Second quarter Industrial revenue declined due to weak demand for printing and writing paper products. Many paper industry customers have reacted by implementing extended market related downtime, closing mills and dramatically reducing inventory levels. Penford’s industrial starch volumes declined accordingly and as a result, the manufacturing mix has shifted increasingly toward ethanol production. Total sales in the Industrial Ingredients business declined 3.6% to $47.3 million from $49.1 million last year. Sales of Liquid Natural Additive applications grew modestly from a year ago.
Ethanol margins became negative during the second quarter when the selling price for ethanol fell along with the sharp drop in energy and gasoline values. A higher than planned proportion of this product in the mix reduced absorption of fixed costs and contributed to the $6.7 million operating loss, net of insurance recoveries.
Costs for chemicals and energy will be lower for third quarter as the companyhas secured lower prices for these inputs. In addition, the business has reduced the workforce by nearly 20% and renegotiated supply contracts for materials, contractors and distribution services. These efforts are expected to improve costs by more than $5 million during the second half of the fiscal year. The business is also implementing process changes and efficiency programs designed to further control manufacturing expenses. Nonetheless, this business will remain exposed to the effects of the economic recession on the paper and ethanol markets.
Flood costs since June 2008 have totaled $45.5 million, including continuing costs while the plant was shut down. These direct flood expenses do not include more than $15.0 million in profits forfeited due to the flood. The business has recorded a total of $26.0 million of insurance recoveries to date. The Company is continuing its ongoing efforts to recover additional amounts under its insurance policies.
Australia/New Zealand Operations
Second quarter sales in the Australia/New Zealand business declined to $16.1 million from $23.5 million a year ago, primarily on a 25% to 30% decrease in average Australian and New Zealand foreign currency exchange rates. Local currency selling prices rose 3% from a year ago. Grain input costs were $1.5 million higher than a year ago. Plant operating rates declined resulting in higher unit manufacturing costs. The business reported a second quarter operating loss of $16.8 million compared to a loss of $2.0 million last year. This loss includes a non-cash goodwill impairment charge of $13.8 million. The business also recorded an income tax valuation allowance of $2.1 million against the Australian net deferred tax assets. These charges have no direct impact on the company’s liquidity and are excluded from calculations of financial covenants under the company’s credit facility. The company expects the impairment charge to be non-deductible for income tax purposes.
The company continues to explore operating and strategic options for this business. Non-binding expressions of interest from multiple parties for all or parts of Penford Australia and New Zealand Limited have been received or are in the process of being submitted for consideration.
Summary
The Industrial segment has built a sustainable business that has been enormously impacted by fluctuating order patterns and a challenging pricing environment caused by the current economic conditions. Our workforce is committed to executing specific plans to secure new business, eliminate costs and regain a stable profit base, Malkoski stated. We are advancing programs to improve upon the low returns from the Australian segment. Beyond the execution of business plans, the exposure to industry factors beyond the Company’s control has led our Board to initiate a broader review of strategic alternatives. Decisions regarding these alternatives should strengthen our competitive situation and increase shareholder value.
