Forward-looking Statements
This Quarterly Report on Form 10-Q ("Quarterly Report"), including, but not limited, to statements found in the Notes to Condensed Consolidated Financial Statements and in Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations, contains statements that are forward-looking statements within the meaning of the federal securities laws. In particular, statements pertaining to anticipated operations and business strategies contain forward-looking statements. Likewise, statements regarding anticipated changes in the Company's business and anticipated market conditions are forward-looking statements. Forward-looking statements involve numerous risks and uncertainties and should not be relied upon as predictions of future events. Forward-looking statements depend on assumptions, dates or methods that may be incorrect or imprecise, and the Company may not be able to realize them. Forward-looking statements can be identified by the use of forward-looking terminology such as "believes," "expects," "may," "will," "should," "seeks," "approximately," "intends," "plans," "estimates," or "anticipates," or the negative use of these words and phrases or similar words or phrases. Forward-looking statements can be identified by discussions of strategy, plans or intentions. Readers are cautioned not to place undue reliance on these forward-looking statements which are based on information available as of the date of this report. The Company does not take any obligation to publicly update or revise any forward-looking statements to reflect future events, information or circumstances that arise after the date of the filing of this Quarterly Report. Among the factors that could cause actual results to differ materially are the risks and uncertainties discussed in this Quarterly Report, including those referenced in Part II Item 1A of this Quarterly Report, and those described from time to time in other filings made with the Securities and Exchange Commission, including the Company's Annual Report on Form 10-K for the year ended August 31, 2009, which include, but are not limited to:
• competition;

• the possibility of interruption of business activities due to equipment problems, accidents, strikes, weather or other factors;

• product development risk;

• changes in corn and other raw material prices and availability;

• the amount and timing of flood insurance recoveries;

• changes in general economic conditions or developments with respect to specific industries or customers affecting demand for the Company's products including unfavorable shifts in product mix;

• unanticipated costs, expenses or third-party claims;

• the risk that results may be affected by construction delays, cost overruns, technical difficulties, nonperformance by contractors or changes in capital improvement project requirements or specifications;

• interest rate, chemical and energy cost volatility;

• foreign currency exchange rate fluctuations;

• changes in returns on pension plan assets and/or assumptions used for determining employee benefit expense and obligations;

• other unforeseen developments in the industries in which Penford operates,

• the Company's ability to successfully operate under and comply with the terms of its bank credit agreement, as amended;

• the Company's ability to renew or replace its bank credit agreement for periods following the agreement's November 30, 2010 maturity date; or

• other factors described in Part I, Item 1A "Risk Factors."

Overview
Penford generates revenues, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for industrial and food applications and by producing and selling ethanol. The Company develops and manufactures ingredients with starch as a base, providing value-added applications to its customers. Penford's starch products are manufactured primarily from corn and potatoes and are used principally as binders and coatings in paper and food production.
Penford manages its business in two segments: Industrial Ingredients and Food Ingredients. These segments are based on broad categories of end-market users. See Note 13 to the Condensed Consolidated Financial Statements for additional information regarding the Company's business segment operations.
In May 2008, the Company's Industrial Ingredients segment began commercial production and sales of ethanol from its facility in Cedar Rapids, Iowa. This ethanol plant gives the Company the ability to select from multiple output choices to capitalize on changing industry conditions and selling opportunities. This increased flexibility allows the Company to direct production towards the most attractive mix of strategic and financial opportunities.
In analyzing business trends, management considers a variety of performance and financial measures, including sales revenue growth, sales volume growth, and gross margins and operating income of the Company's business segments.
On August 27, 2009, the Company's Board of Directors made a determination that the Company would exit from the business conducted by the Company's Australia/New Zealand Operations. This determination was made upon completion of a process involving the examination of a range of strategic and operating choices for the Company's Australia/New Zealand Operations. The process was undertaken as part of a continuing program to maximize the Company's asset values and returns. On September 2, 2009, the Company completed the sale of Penford New Zealand Limited. On November 27, 2009, the Company's Australian operating subsidiary, Penford Australia Limited, completed the sale of substantially all of its operating assets to two unrelated parties.
The financial data for the Australia/New Zealand Operations have been presented as discontinued operations. The financial statements have been prepared in compliance with the provisions of the Accounting Standards Codification 205-10, "Presentation of Financial Statements - Discontinued Operations" ("ASC 205-10"). Accordingly, for all periods presented herein, the Condensed Consolidated Balance Sheets, Statements of Operations and Statements of Cash Flows have been conformed to this presentation. The Australia/New Zealand Operations was previously reported as the Company's third operating segment. See Note 3 to the Condensed Consolidated Financial Statements for further details.
This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the Company's consolidated financial statements and the accompanying notes. The notes to the Condensed Consolidated Financial Statements referred to in this MD&A are included in Part I Item 1, "Financial Statements." Unless otherwise noted, all amounts and analyses are based on continuing operations.
Accounting Changes
In June 2009, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 168, "The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles - a replacement of FASB Statement No. 162 ("SFAS 168"). SFAS 168 establishes the FASB Accounting Standards Codification ("ASC" or the "Codification") as the source of authoritative U.S. generally accepted accounting principles recognized by the FASB. SFAS 168 was effective for financial statements issued for interim and annual periods ending after September 15, 2009. Beginning in the first quarter of fiscal 2010, all references made to U.S. generally accepted accounting principles will use the new Codification numbering system prescribed by the FASB. The FASB will issue new standards in the form of Accounting Standards Updates ("ASU") which will serve to update the Codification.
In April 2009, the FASB issued new authoritative guidance requiring disclosures regarding financial instruments for interim reporting periods of publicly traded companies. The guidance requires that disclosures provide quantitative and

qualitative information on fair value estimates for all financial instruments not measured on the balance sheet at fair value, when practicable, with the exception of certain financial instruments listed in ASC 825 "Financial Instruments." The Company adopted this guidance in the first quarter of fiscal 2010 and has included the required disclosures in this Form 10-Q for the quarter ended November 30, 2009.
In December 2008, the FASB issued new authoritative guidance regarding employer disclosures about postretirement benefit plan assets. The new guidance requires an employer to disclose information regarding its investment policies and strategies for its categories of plan assets, its fair value measurements of plan assets and any significant concentrations of risk in plan assets. The new guidance, which was effective September 1, 2009 for the Company, only requires the revised annual disclosures on a prospective basis. Accordingly, the Company will provide the additional disclosures in its fiscal 2010 Annual Report on Form 10-K.
In June 2008, the FASB issued new authoritative guidance for determining whether unvested share-based payment awards that contain rights to nonforfeitable dividends are participating securities prior to vesting and, therefore, included in the computation of earnings per share pursuant to the two-class method. The Company adopted the new guidance in the first quarter of fiscal 2010 and was required to retrospectively adjust all prior-period earnings per share data. The resulting impact of the adoption of the new guidance was to include unvested restricted shares in the computation of basic earnings per share pursuant to the two-class method which did not have a material impact on the Company's earnings per share for the three-month periods ended November 30, 2009 and 2008. See Note 14 to the Condensed Consolidated Financial Statements.
In February 2008, the FASB issued new authoritative guidance delaying the portions of ASC 820, "Fair Value Measurements and Disclosures," which required fair value measurements for non-recurring, nonfinancial assets and liabilities that are recognized or disclosed at fair value until the Company's fiscal year 2010. The adoption of this guidance on September 1, 2009 had no effect on the Company's financial position or results of operations. See Note 12 to the Condensed Consolidated Financial Statements. Results of Operations
Executive Overview
Consolidated sales for the three months ended November 30, 2009 increased 12.6%, or $7.5 million, to $67.1 million compared with $59.6 million for the three months ended November 30, 2008. In the first quarter of fiscal 2009, production in Cedar Rapids, Iowa was still recovering from the severe flooding that occurred in June 2008. First quarter fiscal 2010 revenues improved primarily due to industrial volume increases in both starch products and ethanol, partially offset by a $0.9 million reduction in food ingredients revenues as a result of the sale of the Company's dextrose product line in February 2009.
In the first quarter of fiscal 2010, consolidated gross margin as a percent of sales rose to 15.8% from 9.1% in the prior year's first quarter, due to the favorable effect of higher industrial volumes on production costs and lower manufacturing unit costs in both the industrial and food ingredients businesses. Consolidated income from operations for the quarter ended November 30, 2009 increased $0.7 million due to higher gross margins. Fiscal 2009 first quarter operating income included $4.2 million of net insurance recoveries.
On June 12, 2008, the Company's Industrial Ingredients plant in Cedar Rapids, Iowa was temporarily shut down due to record flooding of the Cedar River and government-ordered mandatory evacuation of the plant and surrounding areas. The Company sustained substantial damage to this facility and the plant was shut down from mid-June 2008 until the end of August 2008. By the end of August 2008, the Company began manufacturing industrial starch in Cedar Rapids. In late September 2008, the Company resumed the commercial production and sale of ethanol.
The Company maintains property damage and business interruption insurance coverage applicable to the Cedar Rapids plant. The Company is seeking additional payments from its insurers for damages arising from the flooding that occurred in June 2008 and has filed a lawsuit against the insurers. The Company does not provide assurance as to any amount or timing of the potential recoveries under its insurance policies. The effect of the flood on the financial results of the Company on a quarter-to-quarter basis in fiscal 2010 will depend on the timing and amount of additional

insurance proceeds received, if any, which the Company is currently unable to estimate. The amount ultimately recovered from the Company's insurers may be materially more or less than the Company's direct costs of the flood.
Industrial Ingredients
First quarter fiscal 2010 sales at the Company's Industrial Ingredients business unit rose $8.5 million, or 20.2%, to $50.3 million from $41.8 million in the first quarter of fiscal 2009. Industrial starch sales of $32.3 million for the quarter ended November 30, 2009 were comparable to the prior year's first quarter sales as an 18% increase in volume was offset by a decline in average unit pricing. Sales of ethanol increased 86% from $9.6 million in the first quarter of fiscal 2009 to $18.0 million in the first quarter of fiscal 2010. Ethanol volumes increased 95%, partially offset by a decline in average unit pricing. Quarterly volumes of both industrial starches and ethanol increased over the prior year as the Company was still recovering from the June 2008 flooding in Cedar Rapids, Iowa in the first quarter of fiscal 2009. Ethanol production was not restarted until the end of September 2008.
Income from operations for the first quarter of fiscal 2010 at the Company's Industrial Ingredients business unit increased to $2.2 million from $1.8 million a year ago on an increase in gross margin of $4.9 million, a decrease in net insurance recoveries of $4.2 million, and an increase in operating and research and development expenses of $0.3 million. First quarter fiscal 2010 gross margin improved due to higher volumes and lower unit energy and chemical costs. In the first quarter of fiscal 2009, the Company recorded $6.8 million of costs associated with flood restoration offset by $11.0 million of insurance recoveries. No insurance recoveries were recorded in the first quarter of fiscal 2010.
Food Ingredients
Fiscal 2010 first quarter sales for the Food Ingredients segment of $16.8 million decreased 5.5%, or $1.0 million, from the first quarter of fiscal 2009 due to the sale of the dextrose product line in the second quarter of fiscal 2009. First quarter fiscal 2009 dextrose sales were $0.9 million.
Income from operations for the first quarter of fiscal 2010 at the Food Ingredients segment was $3.6 million, a 5.4% increase over last year's $3.4 million due to gross margin improvements. First quarter gross margin improved 6.9% from $5.3 million last year to $5.6 million on lower manufacturing and raw material costs.
Corporate operating expenses
Corporate operating expenses for the first quarter of fiscal 2010 were $2.5 million, a $0.3 million decrease compared to the same quarter last year, primarily due to lower professional fees and travel costs.
Interest expense
Interest expense for the three months ended November 30, 2009 increased $0.5 million compared to the same period last year due to higher average debt balances. In connection with the third amendment to the Company's credit agreement in the fourth quarter of fiscal 2009, the Company paid additional arrangement and commitment fees to its lenders of $1.0 million. The amortization of these costs and existing deferred loan fees over the shortened maturity of the debt increased interest expense by approximately $0.4 million in the first quarter of fiscal 2010 compared to the same period last year. The remaining increase in interest expense is due to higher average debt balances. See Note 7 to the Condensed Consolidated Financial Statements.
Income taxes
The Company's effective tax rates for the three-month periods ended November 30, 2009 and 2008 were 46.7% and 5.6%, respectively. The difference between the effective tax rate and the U.S. federal statutory rate for the three months ended November 30, 2009 is due to state income taxes and adjustments to prior years' tax expense.
The difference between the effective tax rate and the U.S. federal statutory rate for the quarter ended November 30, 2008 is due to the favorable tax benefit of a retroactive research and development tax credit. In October 2008, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 retroactively reinstated and extended the research and

development tax credit from January 1, 2008 through December 31, 2009. The effective tax rate for the first quarter of fiscal 2009 also reflected a tax benefit of $0.2 million applicable to fiscal 2008.
At November 30, 2009, the Company had $13.8 million of net deferred tax assets. In the first quarter of fiscal 2010, the Company recorded a tax benefit related to an impairment charge related to a loan to the Company's Australian subsidiary which was considered not fully collectible. See Note 3 to the Condensed Consolidated Financial Statements. A valuation allowance has not been provided on the net deferred tax assets as the Company expects to recover its tax assets through future taxable income. The Company's losses in fiscal years 2008 and 2009, which are not expected to recur, were incurred as a result of severe flooding in Cedar Rapids, Iowa, which shut down the Company's manufacturing facility for most of the fourth quarter of fiscal 2008. The Company's continuing operations in the U.S. generated income before income taxes in the fourth quarter of fiscal 2009 and the first quarter of fiscal 2010.
On a quarterly basis, the Company reviews its estimate of the effective income tax rate expected to be applicable for the full fiscal year. This rate is used to calculate income tax expense or benefit on current year-to-date pre-tax income or loss. Income tax expense or benefit for the current interim period is the difference between the computed year-to-date income tax amount and the tax expense or benefit reported for previous quarters. The determination of the annual effective tax rate applied to current year income or loss before income tax is based upon a number of estimates and judgments, including the estimated annual pretax income of the Company in each tax jurisdiction and the amounts of permanent differences between the book and tax accounting for various items. The Company's interim tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits, judgments regarding uncertain tax positions and other items that cannot be estimated with any certainty. Therefore, there can be significant volatility in the interim provision for income tax expense.
Non-operating income (loss), net
Non-operating income (loss), net consists of the following:

                                                                                Three months ended
                                                                   November 30, 2009           November 30, 2008
                                                                                  (In thousands)
Gain (loss) on foreign currency transactions                                      452                        (613 )
Other                                                                             184                           7

Total                                                             $               636         $              (606 )

During the three months ended November 30, 2009 and 2008, the Company recognized a gain (loss) on foreign currency transactions on Australian dollar denominated assets and liabilities as disclosed in the table above.

Results of Discontinued Operations

                                                               Quarter Ended
                                                                November 30
                                                             2009         2008
     Sales                                                 $ 16,963     $ 21,360
     Cost of sales                                           15,877     $ 21,376

     Gross margin                                             1,086          (16 )
     Operating expenses                                       2,326        1,224
     Research and development expenses                          285          396

     Loss from operations                                    (1,525 )     (1,636 )
     Non-operating income                                        57          396
     Interest expense                                           315          223
     Gain on sale of assets                                     351            -

     Loss on discontinued operations before income taxes     (1,432 )     (1,463 )
     Income tax benefit                                      (4,914 )       (531 )

     Income (loss) on discontinued operations              $  3,482     $   (932 )

On August 27, 2009, the Company's Board of Directors made a determination that the Company would exit from the business conducted by the Company's Australia/New Zealand Operations. On September 2, 2009, the Company completed the sale of Penford New Zealand Limited. On November 27, 2009, the Company's Australian operating subsidiary, Penford Australia Limited, completed the sale of substantially all of its operating assets to two unrelated parties. The Australia/New Zealand Operations was previously reported in the consolidated financial statements as an operating segment. See Note 3 to the Condensed Consolidated Financial Statements.
The Australian business reported first quarter fiscal 2010 sales of $17.0 million, a decrease of $4.4 million from the prior year sales, primarily due to the sale of Penford New Zealand at the beginning of the quarter. Gross margin expanded $1.1 million on the cessation of recording depreciation expense, which contributed $0.8 million to the gross margin improvement, and reductions in the cost of wheat. Depreciation expense was not recorded on the long-lived assets which were classified as "held for sale" at August 31, 2009. Operating expenses increased in fiscal 2010 by $1.1 million due to employee severance costs.
In the first quarter of fiscal 2010, the Company determined that intercompany loans made by its U.S. operations to its Australian subsidiaries would not be fully collectible from the proceeds of the Australian asset sales and the liquidation of the remaining net financial assets. Accordingly, the Company recorded an impairment charge in the U.S. of $13 million, which was recorded in discontinued operations. The tax benefit of the impairment was also recorded in discontinued operations.
In fiscal years 2008 and 2009, the Company's Australian operations reported tax losses. As of August 31, 2009, the Company's discontinued Australian operations had recorded a valuation allowance of $14.6 million against the entire Australian net deferred tax asset because of the uncertainty of generating sufficient future taxable income. In the quarter ended November 30, 2009, the Australian operations recorded $13 million of income related to the U.S. impairment discussed above. Accordingly, the Company decreased its deferred tax asset related to the carryfoward of net operating losses and reversed the corresponding tax valuation allowance. At November 30, 2009, the valuation allowance related to the Australian net deferred tax asset was $10.9 million. Liquidity and Capital Resources
The Company's primary sources of short- and long-term liquidity are cash flow from operations and its revolving line of credit, which expires on November 30, 2010, the last day of the first quarter of fiscal 2011.
Cash provided by continuing operations was $20.8 million for the three months ended November 30, 2009 compared with cash used in continuing operations of $8.2 million for the first quarter last year. The improvement in operating cash flow was primarily due to changes in working capital. In the first quarter of fiscal 2009, trade and insurance receivables expanded as the Company's Industrial Ingredients business restarted production and recovered from the flooding that occurred in Iowa in June 2008. Also, accounts payable and accrued liabilities declined during last year's first quarter as a result of payments for flood restoration services.

On September 2, 2009, the Company completed the sale of Penford New Zealand Limited. Proceeds from the sale, net of transaction costs, of approximately $4.8 million, were used to repay debt outstanding in the first quarter of fiscal 2010.
On November 27, 2009, the Company's Australian operating subsidiary, Penford Australia Limited, completed the sale of substantially all of its operating assets to two unrelated parties. In accordance with the Company's credit facility, in December 2009, the net proceeds received of $10.9 million were used to repay outstanding debt. Additional cash to be received from the sale will be used to repay outstanding debt upon receipt. Amounts to be received are (1) $2.0 million payable from an escrow account in four equal installments over thirty months from the date of sale, and (2) $0.7 million payable in equal monthly installments through May 2010.
During the first quarter of fiscal 2010, the Iowa Department of Economic Development ("IDED") awarded financial assistance to the Company as a result of the temporary shutdown of the Cedar Rapids, Iowa plant in the fourth quarter of fiscal 2008 caused by record flooding of the Cedar River. The IDED provided two five-year non interest bearing loans as follows: (1) a $1.0 million loan to be repaid in 60 equal monthly payments of $16,667 beginning December 1, 2009, and
(2) a $1.0 million loan which is forgivable if the Company maintains certain levels of employment. The proceeds of these Iowa loans were used to repay outstanding debt in the first quarter of fiscal 2010. At November 30, 2009, the Company had $46.4 million and $0.6 million outstanding, respectively, under the revolving credit and term loan portions of its credit facility. In addition, the Company had $37.4 million outstanding under its capital expansion credit facility on November 30, 2009. Due to the maturity date of the loans, all debt under the credit facility is classified as current liabilities on the condensed consolidated balance sheet. The Company was in compliance with the covenants in its credit agreement, as amended, as of November 30, 2009. The Company's ability to borrow under its revolving credit facility is subject to the Company's compliance with, and is limited by, the covenants in its credit agreement, as amended. See Note 7 to the Condensed Consolidated Financial Statements for details of the Company's credit agreement. . . .