UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2015

 

OR

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number 001-32563

 

Orchids Paper Products Company

(Exact name of Registrant as Specified in its Charter)

 

Delaware

 

23-2956944

(State or Other Jurisdiction of

 

(I.R.S. Employer

Incorporation or Organization)

 

Identification No.)

 

4826 Hunt Street

Pryor, Oklahoma 74361

(Address of Principal Executive Offices and Zip Code)

 

(918) 825-0616

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days.  Yes    No  

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months. Yes     No  

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer 

 

Accelerated filer 

 

 

 

Non-accelerated filer 

 

Smaller reporting company 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes    No  

 

Number of shares outstanding of the issuer’s Common Stock, par value $.001 per share, as of October 31, 2015: 10,268,891 shares.

 

 

 
 

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

TABLE OF CONTENTS

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2015

 

 

 

Page

 

PART I. FINANCIAL INFORMATION

 

 

 

 

ITEM 1.

Financial Statements

3

 

 

 

 

Consolidated Balance Sheets as of September 30, 2015 (Unaudited) and December 31, 2014

3

 

 

 

 

Consolidated Statements of Income for the three months ended September 30, 2015 and 2014 (Unaudited) and the nine months ended September 30, 2015 and 2014 (Unaudited)

4

 

 

 

 

Consolidated Statements of Cash Flows for the nine months ended September 30, 2015 and 2014 (Unaudited)

5

 

 

 

 

Notes to Unaudited Consolidated Interim Financial Statements

6

 

 

 

ITEM 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

 

 

 

ITEM 3.

Quantitative and Qualitative Disclosures about Market Risk

32

 

 

 

ITEM 4.

Controls and Procedures

32

 

 

 

 

PART II. OTHER INFORMATION

 

 

 

 

ITEM 1.

Legal Proceedings

32

 

 

 

ITEM 1A.

Risk Factors

32

 

 

 

ITEM 2.

Unregistered Sales of Equity Securities and Use of Proceeds

33

 

 

 

ITEM 3.

Defaults Upon Senior Securities

33

 

 

 

ITEM 4.

Mine Safety Disclosures

33

 

 

 

ITEM 5.

Other Information

33

 

 

 

ITEM 6.

Exhibits

33

 

 

 

 

Signatures

34

   

 

 

 

 
2

 

 

PART I. FINANCIAL INFORMATION

 

ITEM 1.  Financial Statements

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except share data)

 

   

September 30,

   

December 31,

 
   

2015

   

2014

 
   

(Unaudited)

         

ASSETS

 

Current assets:

               

Cash

  $ 8,550     $ 1,021  

Accounts receivable, net of allowance of $155 in 2015 and 2014

    12,763       9,109  

Receivables from related party

    1,032       1,086  

Inventories, net

    12,047       9,650  

Income taxes receivable

    -       634  

Prepaid expenses

    1,626       1,285  

VAT receivable

    1,735       1,734  

Other current assets

    157       899  

Deferred income taxes

    592       614  

Total current assets

    38,502       26,032  
                 

Property, plant and equipment

    205,036       169,551  

Accumulated depreciation

    (56,807 )     (49,831 )

Net property, plant and equipment

    148,229       119,720  
                 

Intangible assets, net of accumulated amortization of $1,883 in 2015 and $753 in 2014

    16,107       17,237  

Goodwill

    7,560       7,560  

Deferred debt issuance costs, net of accumulated amortization of $72 in 2015 and $20 in 2014

    872       190  

Total assets

  $ 211,270     $ 170,739  
                 
                 
                 

LIABILITIES AND STOCKHOLDERS' EQUITY

 

Current liabilities:

               

Bank overdrafts

  $ -     $ 1,706  

Accounts payable

    4,705       4,796  

Accounts payable to related party

    4,846       6,595  

Accrued liabilities

    5,668       3,747  

Current portion of long-term debt

    3,025       2,700  

Total current liabilities

    18,244       19,544  
                 

Long-term debt, less current portion

    43,600       33,662  

Deferred income taxes

    16,175       17,020  

Stockholders' equity:

               

Common stock, $.001 par value, 25,000,000 shares authorized, 10,268,891 and 8,757,975 shares issued and outstanding in 2015 and 2014, respectively

    10       9  

Additional paid-in capital

    97,410       64,275  

Retained earnings

    35,831       36,229  

Total stockholders' equity

    133,251       100,513  

Total liabilities and stockholders' equity

  $ 211,270     $ 170,739  

 

See notes to unaudited consolidated interim financial statements. 

 

 

 

 

 
3

 

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except share and per share data)

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 
   

(unaudited)

   

(unaudited)

   

(unaudited)

   

(unaudited)

 

Net sales

  $ 46,832     $ 44,429     $ 126,542     $ 101,384  
                                 

Cost of sales

    36,987       35,645       104,192       81,092  

Gross profit

    9,845       8,784       22,350       20,292  
                                 

Selling, general and administrative expenses

    2,437       2,541       7,174       9,127  

Intangibles amortization

    376       322       1,130       430  

Operating income

    7,032       5,921       14,046       10,735  
                                 

Interest expense

    11       90       289       215  

Other (income) expense, net

    (169 )     147       (507 )     141  

Income before income taxes

    7,190       5,684       14,264       10,379  
                                 

Provision for income taxes:

                               

Current

    2,708       3,041       5,230       4,858  

Deferred

    (260 )     (1,187 )     (822 )     (1,498 )
      2,448       1,854       4,408       3,360  
                                 

Net income

  $ 4,742     $ 3,830     $ 9,856     $ 7,019  
                                 

Net income per common share:

                               

Basic

  $ 0.46     $ 0.44     $ 1.02     $ 0.84  

Diluted

  $ 0.45     $ 0.44     $ 1.02     $ 0.83  
                                 

Shares used in calculating net income per common share:

                               

Basic

    10,367,026       8,753,308       9,613,412       8,363,913  

Diluted

    10,425,485       8,823,937       9,672,961       8,442,057  
                                 

Dividends per share

  $ 0.35     $ 0.35     $ 1.05     $ 1.05  

 

See notes to unaudited consolidated interim financial statements.

  

 
4

 

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 

   

Nine Months

   

Nine Months

 
   

Ended

   

Ended

 
   

September 30,

   

September 30,

 
   

2015

   

2014

 

 

 

(unaudited)

   

(unaudited)

 
Cash Flows From Operating Activities                

Net income

  $ 9,856     $ 7,019  

Adjustments to reconcile net income to net cash provided by operating activities:

               

Depreciation and amortization

    8,255       7,286  

Provision for doubtful accounts

    -       1  

Deferred income taxes

    (823 )     (1,498 )

Stock compensation expense

    777       1,609  

Loss on disposal of property, plant and equipment

    -       8  

Changes in cash due to changes in operating assets and liabilities:

               

Accounts receivable

    (3,600 )     (4,727 )

Inventories

    (2,397 )     777  

Income taxes receivable

    634       -  

Prepaid expenses

    (341 )     (300 )

Other current assets

    741       (2,579 )

Accounts payable

    (1,840 )     6,913  

Accrued liabilities

    1,921       1,362  

Net cash provided by operating activities

    13,183       15,871  
                 

Cash Flows From Investing Activities

               

Acquisition of Fabrica assets and U.S. business

    -       (16,700 )

Purchases of property, plant and equipment

    (35,485 )     (13,346 )

Purchases of short-term investments

    -       (2 )

Proceeds from the sale of investment securities

    -       5,037  

Net cash used in investing activities

    (35,485 )     (25,011 )
                 

Cash Flows From Financing Activities

               

Borrowings under long-term debt

    20,000       30,000  

Principal payments on long-term debt

    (2,025 )     (15,754 )

Decrease in bank overdrafts

    (1,706 )     -  

Net borrowings (repayments) on revolving credit line

    (7,712 )     -  

Dividends paid to stockholders

    (10,254 )     (8,716 )

Net proceeds from follow on stock offering

    32,155       -  

Proceeds from the exercise of stock options

    210       79  

Excess tax benefit (deficit) of stock options exercised

    (6 )     20  

Deferred debt issuance costs

    (831 )     (203 )

Net cash provided by financing activities

    29,831       5,426  
                 

Net increase (decrease) in cash

  $ 7,529     $ (3,714 )

Cash, beginning

    1,021       7,205  

Cash, ending

  $ 8,550     $ 3,491  

Supplemental Disclosure:

               

Interest paid

  $ 490     $ 350  

Income taxes paid

  $ 4,470     $ 3,671  

Tax benefits realized from stock options exercised

  $ 23     $ 16  

Stock issued for Fabrica assets and U.S. business

  $ -     $ 16,000  

 

See notes to unaudited consolidated interim financial statements.

 

 
5

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

 

Note 1 — Basis of Presentation

 

Orchids Paper Products Company and its subsidiaries (collectively, “Orchids” or the “Company”) produces bulk tissue paper, known as parent rolls, and converts parent rolls into finished products, including paper towels, bathroom tissue and paper napkins. The Company predominately sells its products for use in the “at-home” market under private labels to a customer base consisting primarily of dollar stores, discount retailers and grocery stores that offer limited alternatives across a wide range of products, and, to a lesser extent, the “away-from-home” market. The Company has owned and operated its manufacturing facility in Pryor, Oklahoma since 1998. On June 3, 2014, the Company completed the acquisition of certain assets from Fabrica de Papel San Francisco, S.A. de C.V. (“Fabrica”) pursuant to an Asset Purchase Agreement (see Note 2). In connection with the acquisition of these assets, the Company formed three wholly-owned subsidiaries: Orchids Mexico DE Holdings, LLC, Orchids Mexico DE Member, LLC, and OPP Acquisition Mexico, S. de R.L. de C.V (“Orchids Mexico”).  The accompanying consolidated financial statements include the accounts of Orchids and these wholly-owned subsidiaries.  All significant intercompany transactions and balances have been eliminated in consolidation.

 

The Company’s common stock trades on the NYSE MKT under the ticker symbol “TIS.”

 

The accompanying financial statements have been prepared without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States have been condensed or omitted pursuant to the rules and regulations.  However, the Company believes that the disclosures made are adequate to make the information presented not misleading when read in conjunction with the audited financial statements and the notes in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2014, filed with the SEC on March 9, 2015.  Management believes that the financial statements contain all adjustments necessary for a fair presentation of the results for the interim periods presented.  All adjustments were of a normal, recurring nature.  The results of operations for the interim period are not necessarily indicative of the results for the entire fiscal year.

 

Certain prior period amounts in the accompanying financial statements have been reclassified to conform to the current period presentation. These reclassifications did not affect previously reported amounts of net income.

 

Note 2 — Acquisition of Fabrica Assets and U.S. Business

 

On May 5, 2014, Orchids Paper Products Company and its wholly owned subsidiary, Orchids Mexico, entered into an asset purchase agreement (“APA”) with Fabrica to acquire certain assets and 100% of the U.S. business of Fabrica.  On June 3, 2014, the Company closed on the transaction set forth in the APA, and in connection therewith, entered into a supply agreement (“Supply Agreement”) and a lease agreement (“Equipment Lease Agreement”) (collectively, the “Fabrica Transaction”).

 

Related Party Transactions

 

The Company incurred the following transactions with Fabrica during the three and nine-month periods ended September 30:

 

   

Three months ended September 30,

   

Nine months ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 
    (in thousands)     (in thousands)  

Products purchased under the Supply Agreement

  $ 9,472     $ 8,393     $ 29,025     $ 12,271  

Amounts billed to Fabrica under the Equipment Lease Agreement

  $ 666     $ 779     $ 1,590     $ 977  

Parent rolls purchased by Fabrica

  $ 3,094     $ -     $ 4,464     $ -  

 

 
6

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

Intangibles and Goodwill

 

Intangible assets at September 30, 2015 were:

 

   

Life

   

Gross Carrying

   

Accumulated

   

Net Carrying

 
   

(in years)

   

Amount

   

Amortization

   

Value

 
           

(in thousands)

 

Intangible Asset - Supply and Equipment Lease Agreement

    20     $ 12,800     $ 800     $ 12,000  

Intangible Asset - Licenses/Trademarks

    20       1,350       84       1,266  

Intangible Asset - Non-Compete Agreement

    2       1,150       719       431  

Intangible Asset - Customer Relationships

    12       2,690       280       2,410  
            $ 17,990     $ 1,883     $ 16,107  

 

Intangible assets at December 31, 2014 were:

 

   

Life

   

Gross Carrying

   

Accumulated

   

Net Carrying

 
   

(in years)

   

Amount

   

Amortization

   

Value

 
           

(in thousands)

 

Intangible Asset - Supply and Equipment Lease Agreement

    20     $ 12,800     $ 320     $ 12,480  

Intangible Asset - Licenses/Trademarks

    20       1,350       34       1,316  

Intangible Asset - Non-Compete Agreement

    2       1,150       287       863  

Intangible Asset - Customer Relationships

    12       2,690       112       2,578  
            $ 17,990     $ 753     $ 17,237  

 

There were no changes to the $7.6 million goodwill recognized from the Fabrica Transaction during the three and nine-month periods ending September 30, 2015 and 2014. No goodwill impairment has been recorded as of September 30, 2015.

 

 
7

 

  

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

Note 3 — Fair Value Measurements

 

The Company does not report any assets or liabilities at fair value in the financial statements.  However, the fair value of the Company’s long-term debt is estimated by management to approximate the carrying value of $46,625,000 and $36,362,000 at September 30, 2015 and December 31, 2014, respectively.  Management’s estimates are based on periodic comparisons of the characteristics of the Company’s obligations, including floating interest rates, credit rating, maturity and collateral, to current market conditions as stated by an independent third-party financial institution.  Such valuation inputs are considered a Level 2 measurement in the fair value valuation hierarchy.

 

Note 4 — Commitments and Contingencies

 

The Company may be involved from time to time in litigation arising from the normal course of business. In management’s opinion, as of the date of this report, the Company is not engaged in legal proceedings which individually or in the aggregate are expected to have a materially adverse effect on the Company’s results of operations or financial condition.

 

In October 2008, the Company entered into a contract to purchase 334,000 MMBTU per year of natural gas.  This contract has been extended through December 2016. In September 2014, the Company entered into a similar contract with a different vendor for natural gas requirements in 2017. Commitments remaining under these contracts are as follows:

 

Period

 

MMBTUs

   

Price per MMBTU

   

Management fee per MMBTU

 

October 2015 - December 2015

    91,900     $ 4.50     $ 0.07  

January 2016 - March 2016

    95,900     $ 4.53     $ 0.07  

April 2016 - June 2016

    93,600     $ 4.17     $ 0.07  

July 2016 - September 2016

    92,300     $ 4.26     $ 0.07  

October 2016 - December 2016

    91,900     $ 4.42     $ 0.07  

January 2017 - December 2017

    467,505     $ 4.06     $ -  

 

 
8

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

Purchases under the gas contract were $0.5 million for each of the three-months periods ended September 30, 2015 and 2014, respectively, and $1.3 million and $1.4 million for the nine-month periods ended September 30, 2015 and 2014, respectively.  If the Company is unable to purchase the contracted amounts and the market price at that time is less than the contracted price, the Company would be obligated under the terms of the agreement to reimburse an amount equal to the difference between the contracted amount and the amount actually purchased, multiplied by the difference between the contract price and a price designated in the contract (approximates spot price).

 

In the second quarter of 2015, the Company began construction on a new manufacturing facility in Barnwell, South Carolina, which has a total estimated cost of $110.0 million to $127.0 million. As of September 30, 2015, we had $61.7 million of obligations under significant purchase orders related to this facility.

 

Note 5 — Inventories

 

Inventories at September 30, 2015 and December 31, 2014 were as follows:

 

   

September 30,

   

December 31,

 
   

2015

   

2014

 
   

(in thousands)

 

Raw materials

  $ 3,698     $ 4,392  

Bulk paper rolls

    1,453       861  

Converted finished goods

    7,136       4,595  

Inventory valuation reserve

    (240 )     (198 )
    $ 12,047     $ 9,650  

 

Note 6 — Property, Plant and Equipment

 

Property, plant and equipment at September 30, 2015 and December 31, 2014 was:

 

   

September 30,

   

December 31,

 
   

2015

   

2014

 
   

(in thousands)

 
                 

Land

  $ 1,127     $ 1,119  

Buildings and improvements

    23,770       23,190  

Machinery and equipment

    141,225       107,251  

Vehicles

    1,489       1,489  

Nondepreciable machinery and equipment (parts and spares)

    9,931       9,121  

Construction-in-process

    27,494       27,381  
    $ 205,036     $ 169,551  

 

 
9

 

  

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

Note 7 — Long-Term Debt and Revolving Line of Credit

 

In June 2015, the Company entered into the Second Amended and Restated Credit Agreement (the “Credit Agreement”), with U.S. Bank National Association (“U.S. Bank”) consisting of the following:

 

 

a $25.0 million revolving credit line due June 2020;

 

a $47.3 million Term Loan with a 5-year term due June 2020 and payable in quarterly installments of $675,000 through June 2016 and $1.0 million per quarter thereafter;

 

a $115.0 million delayed draw term loan with a 2-year draw period due June 2020 and payable in quarterly installments beginning in September 2017 of 1.5% of the June 30, 2017 outstanding balance; and

 

an accordion feature allowing the revolving credit line and/or delayed draw commitment under the Credit Agreement to be increased by up to $50.0 million at any time on or before the expiration date of the Credit Agreement.

 

The Credit Agreement has the effect of (i) combining the Company’s existing $20 million revolving line of credit designated for the purchase and construction of a paper machine and converting line in Pryor, Oklahoma and $27.3 million currently outstanding under the Company’s existing term loan into a $47.3 million term loan, (ii) increasing the delayed draw facility from $40 million to $115 million, (iii) extending the maturity of the delayed draw facility from August 2015 to June 2020, and (iv) adding a $50 million accordion feature. Proceeds from the delayed draw term loan must be utilized solely to finance the purchase and installation of new equipment and construction at the Company’s Barnwell, South Carolina facility.

 

Under the terms of the Credit Agreement, amounts outstanding will bear interest at a variable rate of LIBOR plus a specified margin, or the base rate plus a specified margin, at the Company’s option. The specified margin is based on the Company’s quarterly Leverage Ratio, as defined in the Credit Agreement.  The following table outlines the specified margins and the commitment fees payable under the Credit Agreement:

 

   

LIBOR

   

Base

   

Commitment

 

Leverage Ratio

 

Margin

   

Margin

   

Fee

 

Less than 1.00

    1.25 %     0.00 %     0.15 %

Greater than or equal to 1.00 but less than 2.00

    1.50 %     0.00 %     0.20 %

Greater than or equal to 2.00 but less than 3.00

    1.75 %     0.00 %     0.25 %

Greater than or equal to 3.00 but less than 3.50

    2.25 %     0.00 %     0.30 %

Greater than or equal to 3.50

    2.50 %     0.25 %     0.35 %

 

The Company’s leverage ratio at September 30, 2015 was approximately 1.55.

 

Long-term debt at September 30, 2015 and December 31, 2014 consists of:

 

   

September 30,

   

December 31,

 
   

2015

   

2014

 
   

(in thousands)

 
                 

Revolving line of credit, maturing on June 3, 2019

  $ -     $ 7,712  

Term Loan, maturing on June 3, 2020, due in quarterly installments of $675,000 for the first two years and $1,000,000 thereafter, excluding interest paid separately

    -       28,650  

Term Loan, maturing on June 25, 2020, due in quarterly installments of $675,000 for the first year and $1,000,000 thereafter, excluding interest paid separately

    46,625       -  
    $ 46,625     $ 36,362  

Less current portion

    3,025       2,700  
    $ 43,600     $ 33,662  

 

The amount available under the revolving credit line may be reduced in the event that the Company’s borrowing base, which is based upon qualified receivables and qualified inventory, is less than $25 million.

 

 
10

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

Obligations under the Credit Agreement are secured by substantially all of the Company’s assets.  The Credit Agreement contains representations and warranties, and affirmative and negative covenants customary for financings of this type, including, but not limited to, limitations on additional borrowings, additional investments and asset sales.  The financial covenants, which are tested as of the end of each fiscal quarter, require the Company to maintain the following specific ratios: fixed charge coverage (minimum of 1.20 to 1.0) and leverage (maximum of 4.00 to 1.0 through June 2017; maximum of 3.75 to 1.0 on September 30, 2017; maximum of 3.50 to 1.0 on December 31, 2017, and thereafter). The Company was in compliance with these financial covenants at September 30, 2015.

 

Note 8 — Income Taxes

 

As of September 30, 2015, our annual estimated effective income tax rate is 33.9%. The annual estimated effective tax rate for 2015 differs from the statutory rate due primarily to U.S. manufacturing tax credits and foreign and state income taxes.  Our actual effective income tax rate was 34.0% and 30.9% for the three and nine-month periods ended September 30, 2015, respectively. These rates differ from the estimated effective income tax rate primarily due to a change in our estimated state tax liabilities in the second quarter of 2015. As of September 30, 2014, our annual estimated effective income tax rate is 32.4%.  The actual effective tax rate for the three and nine-month periods ended September 30, 2014 was 32.6% and 32.4%, respectively.  The annual estimated effective tax rate for 2014 differs from the statutory rate due primarily to U.S. manufacturing tax credits. 

 

Note 9 — Earnings per Share

 

During the first quarter of 2013, the Company granted restricted stock to certain employees. These awards include a nonforfeitable right to receive dividends and therefore are considered to participate in undistributed earnings with common shareholders.  Therefore, the Company calculates basic and diluted earnings per common share using the two-class method, under which net earnings are allocated to each class of common stock and participating security.  The computation of basic and diluted net income per common share for the three-month and nine-month periods ended September 30, 2015 and 2014 is as follows:

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 

Net income - ($ thousands)

  $ 4,742     $ 3,830     $ 9,856     $ 7,019  

Less: distributed earnings allocable to participating securities

    (1 )     (2 )     (2 )     (6 )

Less: undistributed earnings allocable to participating securities

    -       -       -       1  

Distributed and undistributed earnings allocable to common shareholders

  $ 4,741     $ 3,828     $ 9,854     $ 7,014  
                                 

Weighted average shares outstanding

    10,367,026       8,753,308       9,613,412       8,363,913  

Effect of stock options

    58,459       70,629       59,549       78,144  

Weighted average shares outstanding - assuming dilution

    10,425,485       8,823,937       9,672,961       8,442,057  

Net income per common share:

                               

Basic

  $ 0.46     $ 0.44     $ 1.02     $ 0.84  

Diluted

  $ 0.45     $ 0.44     $ 1.02     $ 0.83  
                                 

Stock options not considered above because they were anti-dilutive

    563,600       560,000       535,000       520,000  

 

Note 10 — Stock Incentives

 

In April 2014, the Orchids Paper Products Company 2014 Stock Incentive Plan (the “2014 Plan”) was approved. The 2014 Plan replaced the Orchids Paper Products Company 2005 Stock Incentive Plan (the “2005 Plan”) and provides for the granting of stock options and other stock based awards to employees and Board members selected by the Board’s Compensation Committee.  A total of 400,000 shares may be issued pursuant to the 2014 Plan.  As of September 30, 2015, there were 286,400 shares available for issuance under the 2014 Plan.

 

 
11

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

Stock Options with Time-Based Vesting Conditions

 

The grant date fair value of the following option grants was estimated using the Black-Scholes option valuation model.  Option valuation models require the input of highly subjective assumptions including the expected stock price volatility.  The following table details the options granted to certain members of the Board of Directors and management that were valued using the Black-Scholes valuation model and the assumptions used in the valuation model for those grants during the nine months ended September 30, 2015 and 2014:

 

Grant

 

Number

   

Exercise

   

Grant Date

   

Risk-Free

   

Estimated

   

Dividend

   

Expected

 

Date

 

of Shares

   

Price

   

Fair Value

   

Interest Rate

   

Volatility

   

Yield

   

Life (years)

 

May-14

    35,000     $ 29.65     $ 7.50       2.62 %     41 %     4.72 %     5  

June-14

    5,000     $ 30.09     $ 7.67       2.63 %     41 %     4.65 %     5  

May-15

    40,000     $ 22.485     $ 4.64       2.13 %     40 %     6.23 %     5  

 

The Company expenses the cost of these options granted over the vesting period of the option based on the grant-date fair value of the award.

 

Stock Options with Market-Based Vesting Conditions

 

During the first nine months of 2015 and 2014, the Board of Directors granted options to purchase 28,600 and 145,000 shares, respectively, of the Company’s common stock to certain members of management.  These options will become exercisable in four equal tranches, if at all, if and when the share price of the common stock closes at a certain percentage of the purchase price of the option for three consecutive business days, in accordance with the following vesting schedule:

 

Share price required to achieve vesting

 

2014 options

   

2015 options

 

Tranche 1

  $ 34.788     $ 29.560  

Tranche 2

  $ 42.350     $ 36.000  

Tranche 3

  $ 51.425     $ 43.710  

Tranche 4

  $ 60.500     $ 51.430  

 

Any unvested portion of the 2014 options shall expire five years from the date of grant. Any unvested portion of the 2015 options shall expire on November 8, 2018. Both the 2014 options and the 2015 options shall terminate ten years after the date of grant.  As these options include a market condition, the grant date fair value and implicit service period of these option grants were estimated using a Monte Carlo option valuation model.  The following table details the options granted to certain members of management that were valued using the Monte Carlo valuation model and the assumptions used in the valuation model for those grants during the nine months ended September 30, 2015 and 2014:

 

                                              Derived  
                      Risk-Free                       Service  

Grant

 

Number

   

Exercise

   

Grant Date

   

Interest

   

Estimated

   

Dividend

   

Expected

   

Period

 

Date

 

of Shares

   

Price

   

Fair Value

   

 Rate

   

Volatility

   

Yield

   

Life (years)

   

(years)

 

January 14 - Tranche 1

    10,000     $ 31.125     $ 5.64       1.98 %     31 %     4.50 %     5.15       0.31  

January 14 - Tranche 2

    10,000     $ 31.125     $ 5.46       1.98 %     31 %     4.50 %     5.58       1.15  

January 14 - Tranche 3

    10,000     $ 31.125     $ 5.03       1.98 %     31 %     4.50 %     5.97       1.94  

January 14 - Tranche 4

    10,000     $ 31.125     $ 4.27       1.98 %     31 %     4.50 %     6.25       2.50  

February 14 - Tranche 1

    25,000     $ 30.88     $ 5.51       1.98 %     31 %     4.60 %     5.17       0.35  

February 14 - Tranche 2

    25,000     $ 30.88     $ 5.35       1.98 %     31 %     4.60 %     5.60       1.19  

February 14 - Tranche 3

    25,000     $ 30.88     $ 4.88       1.98 %     31 %     4.60 %     5.99       1.98  

February 14 - Tranche 4

    25,000     $ 30.88     $ 4.15       1.98 %     31 %     4.60 %     6.27       2.54  

May 14 - Tranche 1

    1,250     $ 28.185     $ 5.06       2.03 %     31 %     4.70 %     5.36       0.71  

May 14 - Tranche 2

    1,250     $ 28.185     $ 4.74       2.03 %     31 %     4.70 %     5.78       1.56  

May 14 - Tranche 3

    1,250     $ 28.185     $ 4.02       2.03 %     31 %     4.70 %     6.14       2.29  

May 14 - Tranche 4

    1,250     $ 28.185     $ 3.29       2.03 %     31 %     4.70 %     6.39       2.79  

September 15 - Tranche 1

    7,150     $ 25.24     $ 4.44       1.82 %     34 %     5.20 %     5.20       0.40  

September 15 - Tranche 2

    7,150     $ 25.24     $ 3.92       1.82 %     34 %     5.20 %     5.51       1.02  

September 15 - Tranche 3

    7,150     $ 25.24     $ 3.11       1.82 %     34 %     5.20 %     5.77       1.54  

September 15 - Tranche 4

    7,150     $ 25.24     $ 2.36       1.82 %     34 %     5.20 %     5.93       1.87  

 

The Company expenses the cost of these options granted over the implicit, or derived, service period of the option based on the grant-date fair value of the award.

 

 
12

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

Options Issued Outside of the 2014 Plan

 

In April 2014, the Company’s stockholders voted to approve the options granted to Mr. Jeffrey S. Schoen, the Company’s President and Chief Executive Officer, on November 8, 2013.  Upon his appointment as an officer of the Company, Mr. Schoen was granted an option to purchase up to 400,000 shares of the common stock of the Company at a purchase price of $30.25 per share.  The option will become exercisable, if at all, if and when the share price of the Company’s common stock closes at a certain percentage of the purchase price of the option for three consecutive business days, in accordance with the following vesting schedule:

 

Share price closes at or above the following

percentage of the purchase price for the Option

 

Number of shares that become vested

 

115% (share price $34.788)

    100,000  

140% (share price $42.35)

    100,000  

170% (share price $51.425)

    100,000  

200% (share price $60.50)

    100,000  

 

These options were granted outside of the 2005 Plan or the 2014 Plan.  Any unvested portion of the option shall expire five years from the date of grant and the option shall terminate ten years after the date of grant.  The Company used a Monte Carlo option valuation model to estimate the grant date fair value of each tranche of 100,000 options, as they include a market condition.  The Company will expense the cost of the options granted over the implicit service period of the options based on the completed Monte Carlo models. The following table details the assumptions used in the valuation model for the options granted to Mr. Schoen:

 

   

 

   

 

   

 

   

 

   

 

   

 

   

 

   

 

 
   

Number

of Shares

   

Exercise

Price

   

Grant Date

Fair Value

   

Risk-Free

Interest

Rate

   

Estimated

Volatility

   

Dividend

Yield

   

Expected

Life (years)

   

Derived

Service

Period

(years)

 

Tranche 1

    100,000     $ 30.25     $ 5.18       2.10 %     30 %     4.60 %     4.99       0.40  

Tranche 2

    100,000     $ 30.25     $ 5.04       2.10 %     30 %     4.60 %     5.42       1.25  

Tranche 3

    100,000     $ 30.25     $ 4.31       2.10 %     30 %     4.60 %     5.79       2.00  

Tranche 4

    100,000     $ 30.25     $ 3.50       2.10 %     30 %     4.60 %     6.04       2.50  

 

Total Option Expense

 

The Company recognized the following expenses related to all options granted under the 2005 Plan, the 2014 Plan and the Schoen options:

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 

Time-Based Vesting Options

  $ 1,000     $ 1,000     $ 188,000     $ 307,000  

Market-Based Vesting Options

    77,000       427,000       555,000       1,264,000  

Total compensation expense related to stock options

  $ 78,000     $ 428,000     $ 743,000     $ 1,571,000  

 

 

 
13

 

  

Future Expected Market-Based Stock Option Expense

 

The grant of options that vest based on a market condition will have a material impact on the Company’s results of operations.  Based on the derived service periods of the options, the Company expects to expense the compensation cost related to these options as shown in the following table.  However, if the market condition is achieved for any tranche of these options prior to the end of the derived service period, all remaining expense related to that tranche would be recognized in the period in which the market condition is achieved.

 

   

2015

   

2015

   

2016

   

2017

 
   

Q1

   

Q2

   

Q3

   

Q4

   

Total

   

Total

   

Total

 
   

(in thousands)

 

Tranche 1

  $ -     $ -     $ -     $ 26     $ 26     $ 5     $ -  

Tranche 2

    134       104       1       10       249       19     $ -  

Tranche 3

    73       72       47       73       265       73     $ 3  

Tranche 4

    47       48       30       48       173       138     $ 5  

Total expense

  $ 254     $ 224     $ 78     $ 157     $ 713     $ 235     $ 8  

 

Restricted Stock

 

In February 2013, the Company granted 16,000 shares of restricted stock to certain employees under the 2005 Plan.  These awards were valued at the arithmetic mean of the high and low market price of the Company’s stock on the grant date, which was $21.695 per share, and vest ratably over a three year period beginning on the first anniversary of the grant date.  During the nine months ended September 30, 2015 and 2014, 334 and 667 of these shares were forfeited, respectively. In 2013, 8,000 of these shares were forfeited. The first third of unforfeited shares, or 2,666 shares, vested in February 2014.  The second third of unforfeited shares, or 2,333 shares, vested in February 2015. The Company expenses the cost of restricted stock granted over the vesting period of the shares based on the grant-date fair value of the award.  The Company recognized expense of $8,000 and $9,000 for the three-month periods ended September 30, 2015 and 2014, respectively, and $34,000 and $38,000 for the nine-month periods ended September 30, 2015 and 2014, respectively, related to shares of restricted stock granted.

 

 
14

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

Note 11 — Major Customers and Concentration of Credit Risk

 

The Company sells its paper production in the form of parent rolls and converted products.  Revenues from converted product sales and parent roll sales in the three and nine months ended September 30, 2015 and 2014 were:

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 
   

(in thousands)

   

(in thousands)

 
                                 

Converted product net sales

  $ 43,675     $ 43,157     $ 120,877     $ 97,042  

Parent roll net sales

    3,157       1,272       5,665       4,342  

Net sales

  $ 46,832     $ 44,429     $ 126,542     $ 101,384  

 

Credit risk for the Company in the three and nine months ended September 30, 2015 and 2014 was concentrated in the following customers who each comprised more than 10% of the Company’s total net sales:

 

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 
                                 

Converted product customer 1

    29 %     35 %     33 %     42 %

Converted product customer 2

    15 %     13 %     12 %     10 %

Converted product customer 3

    15 %     13 %     15 %     11 %

Total percent of net sales

    59 %     61 %     60 %     63 %

 

 

No additional customers accounted for more than 10% of sales during the three or nine-month periods ended September 30, 2015 or 2014.

 

At September 30, 2015 and December 31, 2014, the significant customers accounted for the following amounts of the Company’s accounts receivable (in thousands):

 

   

September 30,

           

December 31,

         
   

2015

           

2014

         
                                 

Converted product customer 1

  $ 2,162       17 %   $ 2,634       28 %

Converted product customer 2

    2,203       17 %     1,410       15 %

Converted product customer 3

    1,859       15 %     813       9 %

Total of accounts receivable

  $ 6,224       49 %   $ 4,857       52 %

 

At September 30, 2015, one additional parent roll customer, a related party, accounted for approximately 15% of the Company’s accounts receivable. This customer did not account for more than 10% of accounts receivable as of December 31, 2014.

 

Note 12 — Follow-On Stock Offering

 

In April 2015, the Company completed an underwritten public follow-on offering of 1,500,000 shares of its common stock at $23.00 per share. The underwriters were granted an option to purchase up to an additional 225,000 shares for a period of 30 days, which was not exercised. Net proceeds to the Company were $32.2 million, after giving effect to expenses incurred related to the offering.

 

Note 13 – ODFA Pooled Financing

 

In September 2014, the Company entered into an agreement with the Oklahoma Development Finance Authority (“ODFA”) whereby the ODFA agreed to provide the Company up to $3.5 million to fund a portion of the cost of a new paper production line before September 1, 2020. The agreement provides for the Oklahoma state withholding payroll taxes withheld by the Company from its employees to be placed into the Community Economic Development Pooled Finance Revolving Fund – Orchids Paper Products (“Revolving Fund”). Each year on September 1, beginning in 2015 and ending in 2020, the ODFA will return these state withholding taxes in the Revolving Fund to the Company, up to an amount totaling $3.5 million. These amounts are recognized as a note receivable in other current assets in the consolidated balance sheet and in other income in the consolidated statements of income as they are withheld from employees.

 

As of September 30, 2015, the Company had a note receivable of $157,000 related to amounts due under the ODFA pooled financing agreement. The Company recognized $169,000 and $56,000 of other income in the consolidated statement of income for the three-month periods ended September 30, 2015 and 2014, respectively, related to this agreement. The Company recognized $514,000 and $56,000 of other income in the consolidated statement of income for the nine-month periods ended September 30, 2015 and 2014, respectively, related to this agreement. The increase in other income for the 2015 periods is due to the fact that the agreement with the ODFA was effective on September 1, 2014 and was in effect for the entire three-month and nine-month periods in 2015 rather than the one-month of September in 2014.

 

 
15

 

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued) 

 

Note 14 — Registration of Securities

 

On September 16, 2015, the Company’s shelf Registration Statement on Form S-3 (the “Registration Statement”) was declared effective by the Securities and Exchange Commission. Pursuant to the Registration Statement, the Company, from time to time, may sell common stock, warrants or units comprised of the other securities described in the Registration Statement, in a single or multiple offerings up to a total dollar amount of $50,000,000, at prices and terms that will be determined at the time of the offering.

 

The Company’s willingness and ability to raise capital pursuant to the Registration Statement will depend upon a number of circumstances, including, without limitation, the Company’s need for additional capital to fund operations, organic growth or acquisitions, the Company’s financial and operating performance and the receptiveness of the capital markets to potential offerings by the Company. As of the date of this report, the Company does not have any agreements with respect to the issuance of securities pursuant to the Registration Statement.

 

Note 15 — New Accounting Pronouncements

 

In May 2014, the FASB issued Accounting Standards Update 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”).  ASU 2014-09 clarifies the principles for recognizing revenue and develops a common revenue standard under U.S. GAAP under which an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  Due to the issuance of Accounting Standards Update 2015-14, “Revenue from Contracts with Customers – Deferral of the Effective Date” (“ASU 2015-14), in July 2015, the effective date of ASU 2014-09 was deferred for one year and becomes effective for the Company for interim and annual periods beginning on or after December 15, 2017.  Management is currently assessing the impact ASU 2014-09 will have on the Company, but it is not expected to have a material effect on the Company’s financial position, results of operations or cash flows.

 

In April 2015, the FASB issued Accounting Standards Update 2015-03, “Interest – Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs” (“ASU 2015-03”).  ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts.  ASU 2015-03 is effective for annual and interim periods beginning after December 15, 2015.  This standard is not expected to have a material effect on the Company’s financial position, results of operations or cash flows, as it simply requires a change in presentation and does not affect the recognition and measurement guidance for debt issuance costs.

 

In April 2015, the FASB issued Accounting Standards Update 2015-05, “Intangibles – Goodwill and Other – Internal-Use Software – Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement” (“ASU 2015-05”).  ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license.  If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses.  If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract.  The guidance does not change the accounting for a customer’s service contracts.  ASU 2015-05 is effective for annual and interim periods beginning after December 15, 2015.  Management is currently assessing the impact ASU 2015-05 will have, if any, on the Company’s financial position, results of operations and cash flows.

 

In July 2015, the FASB issued Accounting Standards Update 2015-11, “Inventory – Simplifying the Measurement of Inventory” (“ASU 2015-11”). ASU 2015-11 requires inventory measured using all methods other than the last-in, first-out (LIFO) or retail methods to be measured at the lower of cost or net realizable value. Net realizable value is defined as the estimated selling price in the ordinary course of business less reasonably predictable costs of completion, disposal and transportation. ASU 2015-11 is effective for public companies for annual and interim periods beginning after December 15, 2016. Management is currently assessing the impact ASU 2015-11 will have, if any, on the Company’s financial position, results of operations and cash flows.

 

In August 2015, the FASB issued Accounting Standards Update 2015-15, “Interest – Imputation of Interest: Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements” (“ASU 2015-15). ASU 2015-15 states that since ASU 2015-03, as discussed above, does not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements, the SEC staff will not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. Management is currently assessing the impact ASU 2015-15 will have, if any, on the Company’s financial position, results of operations and cash flows.

  

Note 16 — Subsequent Events

 

On October 21, 2015, the Board of Directors authorized a quarterly cash dividend of $0.35 per outstanding share of the Company’s common stock.  The Company expects to pay this dividend on November 16, 2015 to stockholders of record at the close of business on November 2, 2015.

 

On November 6, 2015, the Company entered into Amendment No. 1 to Second Amended and Restated Credit Agreement (“Amendment 1”) with U.S. Bank to amend the definition of “Change in Control” in the Credit Agreement. Amendment 1 did not have a material impact on the terms of the Credit Agreement.

 

 
16

 

 

ITEM 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking Information

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements.  These statements relate to, among other things:

 

our business strategy;

the market opportunity for our products, including expected demand for our products;

our estimates regarding our capital requirements; and

any of our other plans, objectives, and intentions contained in this report that are not historical facts.

 

These statements relate to future events or future financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements.  In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “would,” “target,” “expects,” “plans,” “intends,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of such terms or other comparable terminology, or by discussion of strategy that may involve risks and uncertainties.  Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.  The forward-looking statements contained in this Form 10-Q reflect our views and assumptions only as of the date hereof. You should not place undue reliance on forward-looking statements. We caution you that these forward-looking statements are only predictions, which are subject to risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements.

 

Some factors that could materially affect our actual results are detailed under the caption “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, as filed with the SEC on March 9, 2015, subsequent filings made with the SEC, and those identified in Part II, Item 1A of this Form 10-Q, which include but are not limited to:

 

failure to complete in a timely and cost efficient manner the construction planned in Barnwell, South Carolina;

intense competition in our markets and aggressive pricing by our competitors could force us to decrease our prices and reduce our profitability;

a substantial percentage of our converted product revenues are attributable to a small number of customers who may decrease or cease purchases at any time;

disruption in our supply or increase in the cost of fiber;

Fabrica’s failure to execute under the Supply Agreement;

changes in our retail trade customers’ policies and increased dependence on key retailers in developed markets;

excess supply in the market may reduce our prices;

the availability of, and prices for, energy;

failure to purchase the contracted quantity of natural gas may result in financial exposure;

our exposure to variable interest rates;

the loss of key personnel;

labor interruption;

natural disaster or other disruption to our facilities; and

other factors discussed from time to time in our filings with the SEC.

 

If any of these risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary significantly from what we projected.  Any forward-looking statement you read in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations reflects our current views with respect to future events and is subject to the risks listed above and other risks, uncertainties, and assumptions relating to our operations, results of operations, growth strategy, and liquidity.  We assume no obligation to publicly update or revise these forward-looking statements for any reason, whether as a result of new information, future events, or otherwise.

 

 
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Overview of the Business

 

We are a customer focused, national supplier of high quality consumer tissue products.  We produce bulk tissue paper, known as parent rolls, and convert parent rolls into finished products, including paper towels, bathroom tissue and paper napkins. We sell any parent rolls not required by our converting operation to other converters.  Our integrated manufacturing facilities have flexible production capabilities, which allow us to produce high quality tissue products with short production times across all quality tiers for customers in our target regions. We predominately sell our products under private labels to our core customer base in the “at home” market, which consists primarily of dollar stores, discount retailers and grocery stores that offer limited alternatives across a wide range of products.  Our focus to date has been the dollar stores (which are also referred to as discount retailers) and the broader discount retail market because of their overall market growth, consistent order patterns and low number of stock keeping units (“SKUs”).  The “at-home” tissue market consists of several quality levels, including a value tier, premium tier and ultra-premium tier. To a lesser extent, we service customers in the “away from home” market. Our core customer base in the “away from home” market consists of companies in the janitorial market and food service market. Most of the products we sell in the “away from home” market are included in the value tier. While we expect to continue to service this market in the near term, we do not consider the “away from home” market a growth vehicle for us.

 

Our strategy is to capitalize on positive market trends by leveraging our industry experience, customer relationships and low cost, strategic operating footprint to drive growth and profitability for the business. Our facilities have been designed to have the flexibility to produce and convert parent rolls across different product tiers and to use both virgin and recycled fibers to maximize quality and to control costs. We own an integrated facility in Pryor, Oklahoma which has the capacity to supply 74,000 tons of parent rolls per year primarily to service the central United States. Since 2006, we have consistently invested to modernize the paper making and converting equipment at this location and provide the flexibility discussed above. Furthermore, over the past several years, we have invested approximately $39 million at this facility for a new paper machine and a new converting line. The new paper machine commenced operations in March 2015. We believe the new paper machine will improve our margins by reducing our manufacturing cost and by providing us additional parent roll capacity. Our new converting line commenced operations in June 2015 and is expected to add 12,500 tons of capacity, for a total of 83,000 tons of converting capacity in our Pryor facility. In June 2014, we expanded our geographic presence to service the United States West coast through a strategic transaction with Fabrica de Papel San Francisco, S.A. de C.V. (“Fabrica”), one of the largest tissue manufacturers by capacity in Mexico. The Fabrica Transaction provided us access to its U.S. customers, which we believe will allow us to further penetrate the region, and the supply agreement (“Supply Agreement”) we entered into with Fabrica has provided access to up to 19,800 tons of product each year (up to 27,500 tons in the first two years of the agreement).

 

As part of our strategy to be a national supplier of high quality consumer tissue products, we began construction on our plans to build a world-class integrated tissue operation in Barnwell, South Carolina in the second quarter of 2015. We believe that this new facility will allow us to better serve our existing customers in the Southeast United States, while also enabling us to penetrate new customers in this region. The facility is designed to provide highly flexible, cost competitive production across all quality tiers with paper making capacity of between 35,000 and 40,000 tons per year and converting capacity of between 30,000 and 32,000 tons per year. The first converting line is expected to be operational by the end of the first quarter of 2016 and the second converting line is expected to be operational by the end of the second quarter of 2016. The paper machine will utilize a highly versatile process capable of producing ultra-premium tier products, and is expected to be operational by the beginning of 2017. We estimate the total costs of the project to be approximately $110 to $127 million, which will be financed through a combination of bank debt and the proceeds from our recent follow-on stock offering.

 

Since our inception, we have strategically expanded capacity in both paper manufacturing and finished product converting to meet market demand and customers’ quality requirements. The installation of a new paper machine in our Oklahoma facility, which started up in early March 2015, and installation of a new converting line in our Oklahoma facility, which started up in June 2015, is expected to bring our manufacturing capacity in line with our paper production capacity, at approximately 74,000 tons. However, any parent rolls in excess of converting production requirements are sold into the market.  We adjust our paper making production based on our internal converting needs for parent rolls and the open market demand for parent rolls. Our strategy is to sell all of the parent rolls we manufacture as converted products (such as paper towels, bathroom tissue and napkins), which generally carry higher margins than non-converted parent rolls. The capacity obtained under the previously described Fabrica Transaction will be sold in converted product form and we do not plan to sell any excess capacity arising from this transaction in parent roll form.   Parent rolls are a commodity product and thus are subject to market pricing.  We plan to continue to sell any excess parent roll capacity from Oklahoma on the open market as long as market pricing is profitable.  When converting production requirements exceed paper mill capacity, we will purchase parent rolls in the open market to meet those converting requirements.

 

 
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We supply both national and regional customers, with a focus on regions of the United States with high population growth. We focus our sales efforts on areas within approximately 500 miles of either our manufacturing facility in Oklahoma or Fabrica’s manufacturing facility in Mexicali, Mexico, as we believe this radius maximizes our freight cost advantage. Because we are one of the few integrated tissue paper manufacturers in the areas around both our Oklahoma facility and Fabrica’s Mexicali facilities, we believe we typically have lower freight costs to our customers’ distribution centers located in our target regions. Our target region around our Oklahoma facility includes Texas, Oklahoma, Kansas, Missouri and Arkansas. The Fabrica Transaction has allowed us to more effectively service customers that are located on the West Coast by directly shipping them products that are produced in Mexico under the Supply Agreement. As a result, we have expanded our target region to include California, Nevada, Arizona, New Mexico and Utah. Our planned manufacturing facility in Barnwell, South Carolina is intended to help us meet the growing demand in the South Eastern region of the United States. Demand for tissue in the “at-home” tissue market has historically been closely correlated to population growth and as such, performs well in a variety of economic conditions. Our expanded target region has experienced strong population growth for the past fourteen years relative to the national average, and these trends are expected to continue.

 

Our products are sold primarily under our customers’ private labels and, to a lesser extent, under our brand names such as Colortex®, My Size®, Velvet®, Big Mopper®, Linen Soft®, Soft & Fluffy®, and Tackle®. The Fabrica Transaction gave us the exclusive right to sell products under Fabrica’s brand names into the United States, including under the names Virtue®, Truly Green®, Golden Gate Paper® and Big Quality®. All of our converted product net sales are derived through truck load purchase orders from our customers.  Parent roll net sales are derived from purchase orders that generally cover a one-month time period. We do not have supply contracts with any of our customers, which is normal practice within our industry.  Because our products are a daily consumable item, the order stream from our customer base is fairly consistent with limited seasonal fluctuations. However, we typically experience some mild seasonal softness in the first and fourth quarters of each year, primarily due to the effects of winter weather on consumers’ buying habits and occasional effects of holidays on shipping schedules.  Changes in the national economy, in general, do not materially affect the market for our converted products due to their non-discretionary nature and high degree of household penetration.

 

Our profitability depends on several key factors, including but not limited to:

 

the volume of converted product sales;

the cost of fiber used in producing paper;

the market price of our products;

the efficiency of operations in both our paper mill and converting facility; and

the cost of energy.

 

The private label market of the tissue industry is highly competitive, and many discount retail customers are extremely price sensitive. As a result, it is difficult to affect price increases.  We expect these competitive conditions to continue.

 

Our Strategy

 

Our strategy is to be a customer focused national supplier of high quality consumer tissue products.  We believe we will achieve this strategy by:

 

strengthening and expanding our customer base through cooperative and innovative product development and superior customer service;

focusing on higher growth geographic regions and private label channels;

maintaining flexible, low cost integrated facilities able to produce a broad product spectrum;

expanding our manufacturing footprint via the Fabrica Transaction and our expansion in South Carolina; and

employing a disciplined capital strategy by focusing on growing free cash flow and targeting high return capital projects.

  

 
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Part of our strategy is to increase our volume of premium and ultra-premium tier products shipped to customers, as these products typically have a higher gross margin than value tier products. The following graph shows shipments of our premium tier and ultra-premium tier products as a percentage of total cases shipped. Shipments of premium tier and ultra-premium tier products as a percentage of total cases shipped decreased following the Fabrica Transaction in June 2014 as a majority of the products shipped under the Supply Agreement are considered value tier products.

 

 

 

   

 
20

 

 

Comparative Three-Month Periods Ended September 30, 2015 and 2014

 

Net Sales

 

   

Three Months Ended September 30,

 
   

2015

   

2014

 
   

(in thousands, except tons)

 
                 

Converted product net sales

  $ 43,675     $ 43,157  

Parent roll net sales

    3,157       1,272  

Total net sales

  $ 46,832     $ 44,429  
                 

Converted product tons shipped

    23,001       21,528  

Parent roll tons shipped

    3,162       1,494  

Total tons shipped

    26,163       23,022  

 

Net sales in the quarter ended September 30, 2015 increased $2.4 million, or 5%, from $44.4 million in 2014 to $46.8 million in 2015. Net sales figures represent the gross selling price, including freight, less discounts and pricing allowances. The increase in net sales is due to a $518,000 increase in the sales of converted products and a $1.9 million increase in the net sales of parent rolls.

 

Net sales of converted product increased $518,000, or 1%, from $43.2 million in 2014 to $43.7 million in 2015. The increase in converted product net sales is primarily due to a 7% increase in tonnage shipped, which was partially offset by a 5% decrease in net selling price per ton.  Converted product tons shipped increased due to higher shipment volumes from both our Pryor location and under the Supply Agreement. Net selling price per ton decreased due to the mix of products sold.

 

Net sales of parent rolls increased $1.9 million, or 148%, from $1.3 million in 2014 to $3.2 million in 2015.  The increase in parent roll net sales is primarily due to a 112% increase in parent roll tons shipped and a 17% increase in the net selling price per ton.  Parent roll tons shipped increased primarily due to higher production volumes resulting from our new paper machine, which started up in March 2015.  The increase in selling price per ton is primarily due to a stronger market for parent rolls and the higher quality from our new paper machine.

 

Cost of Sales

 

   

Three Months Ended September 30,

 
   

2015

   

2014

 
   

(in thousands, except gross profit margin %)

 
                 

Cost of goods sold

  $ 34,432     $ 33,276  

Depreciation

    2,555       2,369  

Cost of sales

  $ 36,987     $ 35,645  
                 

Gross profit

  $ 9,845     $ 8,784  

Gross profit margin %

    21.0 %     19.8 %

 

 
21

 

 

The major components of cost of sales are the cost of internally produced paper, raw materials, direct labor and benefits, freight costs of products shipped to customers, insurance, repairs and maintenance, energy, utilities, depreciation and the cost of converted products purchased under the Supply Agreement with Fabrica.

 

Cost of sales increased $1.3 million, or 4%, to $37.0 million, compared to $35.6 million in the same period of 2014, due primarily to increased sales, higher fiber costs, and higher depreciation expense.  As a percentage of net sales, cost of sales decreased to 79.0% in the 2015 quarter from 80.2% in the 2014 quarter.

 

Paper production costs in Oklahoma decreased primarily due to the effect of the start-up of the new paper machine. The new paper machine is an energy efficient machine which provides lower production costs than the two machines it replaced, and increased total production by 37%, which had a positive effect on absorption of fixed costs. Average fiber prices across our fiber basket were higher in the third quarter of 2015 compared to the same period in 2014, resulting in an approximate $680,000 decrease in gross profit.

  

Gross Profit

 

Gross profit in the quarter ended September 30, 2015 increased $1.1 million, or 12%, to $9.8 million compared to $8.8 million in the same period last year.  Gross profit as a percentage of net sales in the 2015 quarter was 21.0% compared to 19.8% in the 2014 quarter.  The gross profit increase as a percent of net sales was primarily the result of higher gross margins under the Supply Agreement and on parent roll sales. A strong U.S. dollar exchange rate with the Mexican peso, coupled with SKU optimization and price increases in the “away-from-home” business improved the margins under the Supply Agreement in the three months ended September 30, 2015 compared with the same quarter of 2014. Lower paper production costs in Oklahoma, along with a 17% increase in parent roll selling price per ton improved parent roll margins. These factors were partially offset by higher fiber costs, as discussed above.

 

Selling, General and Administrative Expenses

 

   

Three Months Ended September 30,

 
   

2015

   

2014

 
    (in thousands, except SG&A as a % of net sales)  
                 

Commission expense

  $ 280     $ 371  

Other S,G&A expenses

    2,157       2,170  

Selling, General & Adm exp

  $ 2,437     $ 2,541  

SG&A as a % of net sales

    5.2 %     5.7 %

 

Selling, general and administrative expenses include salaries, commissions to brokers and other miscellaneous expenses.  Selling, general and administrative expenses decreased $104,000, or 4%, in the quarter ended September 30, 2015 as compared to the same period in 2014 primarily due to $84,000 of costs related to the Fabrica Transaction incurred in 2014, a $365,000 decrease in non-cash compensation expense related to options granted and a decrease in commissions due to the mix of products sold. These decreases were partially offset by increased professional fees and increased artwork costs. As a percentage of net sales, selling, general and administrative expenses decreased to 5.2% in the third quarter of 2015 compared to 5.7% in the same period of 2014.

 

Amortization of Intangibles

 

The Company recognized $376,000 and $322,000 of amortization expense related to the intangible assets acquired in the Fabrica Transaction during the quarter ended September 30, 2015 and 2014, respectively.

 

 
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Operating Income

 

As a result of the foregoing factors, operating income for the quarter ended September 30, 2015, was $7.0 million compared to operating income of $5.9 million for the same period of 2014.

 

Interest Expense and Other Income

 

   

Three Months Ended September 30,

 
   

2015

   

2014

 
   

(in thousands)

 

Interest expense

  $ 11     $ 90  

Other (income) expense, net

  $ (169 )   $ 147  
                 

Income before income taxes

  $ 7,190     $ 5,684  

 

Interest expense includes interest on all debt and amortization of deferred debt issuance costs.  Interest expense for the third quarter of 2015 totaled $11,000 compared to interest expense of $90,000 in the same period in 2014. Interest expense for 2015 and 2014 excludes $299,000 and $43,000, respectively of interest capitalized on significant projects during the quarter. The higher level of total interest in 2015 resulted from higher debt balances due primarily to additional debt incurred in conjunction with the Fabrica Transaction and additional borrowings to finance capital expenditures.

 

Other (income) expense for the three months ended September 30, 2015 and 2014 includes $169,000 and $56,000, respectively, of income related to the Company’s pooled financing agreement with the Oklahoma Development Financing Authority (ODFA). The increase in other income for the 2015 period is due to the fact that the agreement with the ODFA was effective on September 1, 2014 and was in effect for the entire three-month period in 2015 rather than the one-month of September in 2014. Other (income) expense for the three months ended September 30, 2014 includes $207,000 of expense related to the demolition of two paper machines.

 

Income Before Income Taxes

 

As a result of the foregoing factors, income before income taxes increased $1.5 million to $7.2 million in the quarter ended September 30, 2015, compared to $5.7 million in the same period in 2014.

 

Income Tax Provision

 

As of September 30, 2015, our annual estimated effective tax rate for the full year is estimated to be 33.9%, as compared to the 33.8% effective tax rate estimated at the end of the second quarter of 2015. The actual effective tax rate for the quarter ended September 30, 2015 was 34.0%. The annual estimated effective tax rate for 2015 differs from the statutory rate due primarily to U.S. manufacturing tax credits and foreign and state income taxes.  As of September 30, 2014, our annual estimated effective income tax rate is 32.4%.  The actual effective tax rate for the quarter ended September 30, 2014 was 32.6%.  The annual estimated effective tax rate for 2014 differs from the statutory rate due primarily to U. S. manufacturing tax credits. 

 

Comparative Nine-Month Periods Ended September 30, 2015 and 2014

 

Net Sales

 

   

Nine Months Ended September 30,

 
   

2015

   

2014

 
   

(in thousands, except tons)

 
                 

Converted product net sales

  $ 120,877     $ 97,042  

Parent roll net sales

    5,665       4,342  

Net sales

  $ 126,542     $ 101,384  
                 

Converted product tons shipped

    62,172       47,006  

Parent roll tons shipped

    5,682       4,922  

Total tons shipped

    67,854       51,928  

 

 
23

 

 

Net sales increased 25% to $126.5 million in the nine months ended September 30, 2015, compared to $101.4 million in the same period of 2014. Net sales figures represent gross selling price, including freight, less discounts and pricing allowances.  The increase in net sales is due to a $23.8 million increase in the sales of converted products and a $1.3 million increase in the net sales of parent rolls.

 

Net sales of converted product for the nine months ended September 30, 2015 increased by $23.8 million, or 25%, to $120.9 million compared to $97.0 million in the same period last year. The increase in net sales of converted products is primarily due to a 32% increase in converted product tonnage shipped, which was partially offset by a 6% decrease in net selling price per ton.  Converted product tons shipped increased due to higher shipment volumes from our Pryor location and due to the effect of the U.S. business acquired from Fabrica, which accounted for 72% of the increase in tonnage shipped. Net selling price per ton decreased due to the mix of products sold.

 

Net sales of parent rolls increased $1.3 million, or 30%, to $5.7 million in the nine months ended September 30, 2015, compared to $4.3 million in the same period last year.  Net sales of parent rolls increased due to a 15% increase in parent roll tonnage shipped and a 13% increase in net selling price per ton.  The increase in parent roll tonnage shipped was due to the start-up of our new Oklahoma paper machine in March 2015. The increase in selling price per ton is primarily due to a stronger market for our parent rolls and higher quality from our new paper machine.

 

Cost of Sales

 

   

Nine Months Ended September 30,

 
   

2015

   

2014

 
   

(in thousands, except gross profit margin %)

 
                 

Cost of goods sold

  $ 97,216     $ 74,282  

Depreciation

    6,976       6,810  

Cost of sales

  $ 104,192     $ 81,092  
                 

Gross profit

  $ 22,350     $ 20,292  

Gross profit margin %

    17.7 %     20.0 %

 

The major components of cost of sales are the cost of internally produced paper, raw materials, direct labor and benefits, freight costs of products shipped to customers, insurance, repairs and maintenance, energy, utilities, depreciation, and the cost of converted products purchased under the Supply Agreement with Fabrica.

 

Cost of sales increased approximately $23.1 million, or 28%, to $104.2 million for the nine months ended September 30, 2015, compared to $81.1 million in the same period of 2014, due primarily to increased sales, the effects of the Oklahoma paper machine project on our first quarter results, higher fiber costs, and higher labor and maintenance and repair costs in our converting operation. As a percentage of net sales, cost of sales increased to 82.3% of net sales in the nine-month period ended September 30, 2015, compared to 80.0% of net sales in the nine-month period ended September 30, 2014. The increase in cost of sales as a percentage of net sales in the nine months ended September 30, 2015, was primarily attributed to the costs mentioned above.

 

In the nine months ended September 30, 2015, paper production costs in Oklahoma increased primarily due to the effects of our new paper machine project in Oklahoma on our first quarter results, which included the consumption of approximately 3,000 tons of purchased parent rolls at a cost of approximately $3.4 million as we ramped up production on the new paper machine, and higher fiber costs. Average fiber prices across our fiber basket increased by 6% compared to the same period in 2014, resulting in an approximate $2.2 million decrease in gross profit.

  

Gross Profit

 

Gross profit in the nine months ended September 30, 2015 increased $2.1 million, or 10%, to $22.4 million compared to $20.3 million in the same period last year.  Gross profit as a percentage of net sales in the 2015 period was 17.7% compared to 20.0% in the 2014 period.  The gross profit decrease as a percent of net sales was primarily the result of the effects of our new paper machine project as discussed above, including external paper purchases, and higher fiber costs.

 

 
24

 

 

Selling, General and Administrative Expenses

 

   

Nine Months Ended September 30,

 
   

2015

   

2014

 
    (in thousands, except SG&A as a % of net sales)  
                 

Commission expense

  $ 911     $ 1,204  

Other S,G&A expenses

    6,263       7,923  

Selling, General & Adm exp

  $ 7,174     $ 9,127  

SG&A as a % of net sales

    5.7 %     9.0 %

 

Selling, general and administrative expenses include salaries, commissions to brokers and other miscellaneous expenses.  Selling, general and administrative expenses decreased $2.0 million, or 21%, in the nine-month period ended September 30, 2015 as compared to the same period in 2014 primarily due to $1.6 million of costs related to the Fabrica Transaction incurred in 2014 and a $725,000 decrease in non-cash compensation expense related to options granted.  Commissions also decreased due to the mix of products sold. As a percentage of net sales, selling, general and administrative expenses decreased to 5.7% in the nine-month period of 2015 compared to 9.0% in the same period of 2014.

 

Amortization of Intangibles