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, 2016

 

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 Incorporation or Organization)

 

(I.R.S. Employer 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 28, 2016: 10,296,891 shares .

 

 
 

 

   

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

TABLE OF CONTENTS

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2016

 

 

 

Page

 

PART I. FINANCIAL INFORMATION

 

 

 

 

ITEM 1.

Financial Statements

3

 

 

 

 

Consolidated Balance Sheets as of September 30, 2016 (Unaudited) and December 31, 2015

3

 

 

 

 

Consolidated Statements of Income for the three months ended September 30, 2016 and 2015 and the nine months ended September 30, 2016 and 2015 (Unaudited)

4

 

 

 

 

Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2016 and 2015 (Unaudited)

5

 

 

 

 

Notes to Unaudited Consolidated Interim Financial Statements

6

 

 

 

ITEM 2.

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

18

 

 

 

ITEM 3.

Quantitative and Qualitative Disclosures about Market Risk

29

 

 

 

ITEM 4.

Controls and Procedures

30

 

 

 

 

PART II. OTHER INFORMATION

 

 

 

 

ITEM 1.

Legal Proceedings

30

 

 

 

ITEM 1A.

Risk Factors

30

 

 

 

ITEM 2.

Unregistered Sales of Equity Securities and Use of Proceeds

30

 

 

 

ITEM 3.

Defaults Upon Senior Securities

30

 

 

 

ITEM 4.

Mine Safety Disclosures

30

 

 

 

ITEM 5.

Other Information

30

 

 

 

ITEM 6.

Exhibits

31

 

 

 

 

Signatures

32

 

 

 
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,

 
   

2016

   

2015

 
   

(Unaudited)

         

ASSETS

               

Current assets:

               
Cash   $ 8,561     $ 4,361  
Accounts receivable, net of allowance of $155 in 2016 and 2015     12,197       10,509  
Receivables from related party     1,178       1,325  
Inventories, net     20,449       13,501  
Income taxes receivable     3,000       5,628  
Prepaid expenses     3,889       1,136  
Other current assets     372       1,853  

Total current assets

    49,646       38,313  
                 

Property, plant and equipment

    306,604       232,925  

Accumulated depreciation

    (68,183 )     (59,547 )

Net property, plant and equipment

    238,421       173,378  
                 

Restricted cash

    1,335       12,005  

VAT receivable

    1,742       1,751  

Intangible assets, net of accumulated amortization of $3,246 in 2016 and $2,260 in 2015

    14,744       15,730  

Goodwill

    7,560       7,560  

Total assets

  $ 313,448     $ 248,737  
                 

LIABILITIES AND STOCKHOLDERS' EQUITY

               

Current liabilities:

               
Accounts payable   $ 10,358     $ 7,211  
Accounts payable to related party     4,057       3,887  
Accrued liabilities     2,155       3,880  
Current portion of long-term debt     5,462       3,882  

Total current liabilities

    22,032       18,860  
                 

Long-term debt, less current portion

    124,737       70,357  

Other long-term liabilities

    5,152       5,098  

Deferred income taxes

    27,263       20,639  

Stockholders' equity:

               
Common stock, $.001 par value, 25,000,000 shares authorized, 10,296,891 and 10,268,891 shares issued and outstanding in 2016 and 2015, respectively     10       10  
Additional paid-in capital     98,922       97,834  
Retained earnings     35,332       35,939  

Total stockholders' equity

    134,264       133,783  

Total liabilities and stockholders' equity

  $ 313,448     $ 248,737  

 

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,

 
   

2016

   

2015

   

2016

   

2015

 
   

(unaudited)

   

(unaudited)

   

(unaudited)

   

(unaudited)

 

Net sales

  $ 39,628     $ 46,832     $ 126,785     $ 126,542  
                                 

Cost of sales

    33,413       36,987       102,316       104,192  

Gross profit

    6,215       9,845       24,469       22,350  
                                 

Selling, general and administrative expenses

    2,557       2,437       7,783       7,174  

Intangibles amortization

    233       376       986       1,130  

Operating income

    3,425       7,032       15,700       14,046  
                                 

Interest expense

    639       11       1,187       289  

Other (income) expense, net

    (162 )     (169 )     (527 )     (507 )

Income before income taxes

    2,948       7,190       15,040       14,264  
                                 

Provision for (benefit from) income taxes:

                               

Current

    (3,670 )     2,708       (1,772 )     5,230  
Deferred     4,405       (260 )     6,622       (822 )
Total provision for (benefit from) income taxes      735       2,448       4,850       4,408  
                                 

Net income

  $ 2,213     $ 4,742     $ 10,190     $ 9,856  
                                 

Net income per common share:

                               
Basic   $ 0.21     $ 0.46     $ 0.99     $ 1.02  
Diluted   $ 0.21     $ 0.45     $ 0.98     $ 1.02  
                                 

Shares used in calculating net income per common share:

                               
Basic     10,296,891       10,266,891       10,282,841       9,613,412  

Diluted

    10,367,660       10,325,350       10,351,415       9,672,961  
                                 

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)

  

   

Three Months

   

Three Months

   

Nine Months

   

Nine Months

 
   

Ended

   

Ended

   

Ended

   

Ended

 
   

September 30,

   

September 30,

   

September 30,

   

September 30,

 
   

2016

   

2015

   

2016

   

2015

 

 

 

(unaudited)

   

(unaudited)

   

(unaudited)

   

(unaudited)

 
Cash Flows From Operating Activities                                

Net income

  $ 2,213     $ 4,742     $ 10,190     $ 9,856  

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

                               

Depreciation and amortization

    3,220       2,979       9,865       8,255  

Deferred income taxes

    4,407       (260 )     6,624       (823 )

Stock compensation expense

    69       87       604       777  

Gain on disposal of property, plant and equipment

    (9 )     -       (18 )     -  

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

                               
Accounts receivable     (3,335 )     (1,065 )     (1,541 )     (3,600 )
Inventories     (228 )     1,053       (6,948 )     (2,397 )
Income taxes receivable     2,628       -       2,628       634  
Prepaid expenses     (2,119 )     (678 )     (2,753 )     (341 )
Other assets     444       587       1,490       741  
Accounts payable     791       (634 )     1,843       (1,840 )
Accrued liabilities     (4,231 )     1,438       (1,725 )     1,921  

Net cash provided by operating activities

    3,850       8,249       20,259       13,183  
                                 

Cash Flows From Investing Activities

                               

Purchases of property, plant and equipment

    (28,348 )     (11,223 )     (74,115 )     (35,485 )

Sale of property, plant and equipment

    12       -       21       -  

Decrease in restricted cash

    3,560       -       10,670       -  

Net cash used in investing activities

    (24,776 )     (11,223 )     (63,424 )     (35,485 )
                                 

Cash Flows From Financing Activities

                               

Proceeds from economic incentive

    -       -       1,900       -  

Borrowings under long-term debt

    -       -       -       20,000  

Principal payments on long-term debt

    (1,132 )     (675 )     (2,745 )     (2,025 )

Decrease in bank overdrafts

    -       -       -       (1,706 )

Net borrowings (repayments) on revolving credit lines

    27,987       -       58,627       (7,712 )

Dividends paid to stockholders

    (3,604 )     (3,594 )     (10,797 )     (10,254 )

Net proceeds from follow on stock offering

    -       -       -       32,155  

Proceeds from the exercise of stock options

    -       -       314       210  

Excess tax benefit (deficit) of stock options exercised

    -       (1 )     171       (6 )

Deferred debt issuance costs

    -       (8 )     (105 )     (831 )

Net cash provided by (used in) financing activities

    23,251       (4,278 )     47,365       29,831  
                                 

Net increase (decrease) in cash

  $ 2,325     $ (7,252 )   $ 4,200     $ 7,529  

Cash, beginning

    6,236       15,802       4,361       1,021  

Cash, ending

  $ 8,561     $ 8,550     $ 8,561     $ 8,550  

Supplemental Disclosure:

                               

Interest paid

  $ 827     $ 194     $ 1,971     $ 490  

Income taxes paid

  $ 6     $ 2,936     $ 6     $ 4,470  

Tax benefits realized from stock options exercised

  $ -     $ -     $ 211     $ 23  

Capital expenditures invoiced but not yet paid

  $ -     $ -     $ 1,464     $ -  

 

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 and Significant Accounting Policies

 

Orchids Paper Products Company and its subsidiaries (collectively, “Orchids” or the “Company”) produce bulk tissue paper, known as parent rolls, and convert 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”).  In April 2015, the Company announced the construction of a new manufacturing facility in Barnwell, South Carolina. In conjunction with this project, the Company established a wholly-owned subsidiary: Orchids Paper Products Company of South Carolina. Furthermore, in connection with a New Market Tax Credit (“NMTC”) transaction in December 2015 (see Note 12), the Company created Orchids Lessor SC, LLC, another wholly-owned subsidiary. 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, 2015, filed with the SEC on March 7, 2016.  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 (see Note 15). These reclassifications did not affect previously reported amounts of net income.

 

Significant Accounting Policies

 

Business Interruption Insurance

 

In June 2016, the Company received $1.1 million of proceeds under a business interruption insurance policy for an incident that occurred in its Oklahoma converting operation in the fourth quarter of 2015. This amount is recorded as a reduction of cost of sales in the accompanying consolidated statements of income in the nine-month period ended September 30, 2016.

 

Note 2 — Fabrica Transaction

 

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”).

 

 

 
6

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

 

Related Party Transactions

 

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

  

   

Three months ended September 30,

   

Nine months ended September 30,

 
   

2016

   

2015

   

2016

   

2015

 
   

(in thousands)

   

(in thousands)

 

Products purchased under the Supply Agreement

  $ 8,003     $ 9,472     $ 26,447     $ 29,025  

Amounts billed to Fabrica under the Equipment Lease Agreement

  $ 518     $ 666     $ 1,242     $ 1,590  

Parent rolls purchased by Fabrica

  $ -     $ 3,094     $ 867     $ 4,464  

 

Intangibles

 

The carrying value of intangible assets, net of amortization, at September 30, 2016 was $14.7 million. $233,000 of amortization was recognized in third quarter 2016. The non-compete agreement with Fabrica, which was valued at $1,150,000 had a two-year term with quarterly amortization of $143,000 and expired on June 30, 2016.

  

Goodwill

 

There were no changes to the $7.6 million goodwill recognized from the Fabrica Transaction during the three-month and nine-month periods ended September 30, 2016 and 2015. No goodwill impairment has been recorded as of September 30, 2016.

 

 

 
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 (before deducting unamortized debt issuance costs) of $131,462,000 and $75,581,000 at September 30, 2016 and December 31, 2015, 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 2016 - December 2016

    91,900     $ 4.42     $ 0.07  

January 2017 - December 2017

    467,505     $ 4.06     $ -  

 

Purchases under the gas contract were $0.4 and $0.5 million for the three-month periods ended September 30, 2016 and 2015, respectively, and $1.2 and $1.3 million for each of the nine-month periods ended September 30, 2016 and 2015, 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 an integrated paper converting facility in Barnwell, South Carolina, which has a total estimated cost of $150 million. As of September 30, 2016, obligations under purchase orders related to construction of this facility totaled $20.1 million.

 

 

 
8

 

  

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

 

Note 5 — Inventories

 

Inventories at September 30, 2016 and December 31, 2015 were as follows:

  

   

September 30,

   

December 31,

 
   

2016

   

2015

 
   

(in thousands)

 

Raw materials

  $ 6,084     $ 4,467  

Bulk paper rolls

    3,974       3,789  

Converted finished goods

    10,556       5,386  

Inventory valuation reserve

    (165 )     (141 )
Total Inventories   $ 20,449     $ 13,501  

 

Note 6 — Property, Plant and Equipment

 

Property, plant and equipment at September 30, 2016 and December 31, 2015 was:

 

   

September 30,

   

December 31,

 
   

2016

   

2015

 
   

(in thousands)

 

Land

  $ 1,316     $ 1,316  

Buildings and improvements

    37,146       24,321  

Machinery and equipment

    172,302       141,811  

Vehicles

    1,801       1,796  

Nondepreciable machinery and equipment (parts and spares)

    11,546       10,250  

Construction-in-process

    82,493       53,431  
    $ 306,604     $ 232,925  

 

In January 2016, the Company received $1.9 million of proceeds from an economic incentive related to the construction of the South Carolina facility. While there currently are no US GAAP pronouncements relating to the accounting treatment of government grants, the Company recorded these proceeds as a reduction in the property, plant and equipment related to this project in accordance with non-authoritative guidance issued by the American Institute of Certified Public Accountants, which recommended that grants related to developing property be recognized over the useful lives of the assets by recognizing receipt as the related asset is depreciated.

 

Interest expense for three months ended September 30, 2016 and 2015 excludes $348,000 and $299,000, respectively, of interest capitalized on significant projects during the quarter. Interest expense for the nine months ended September 30, 2016 and 2015 excludes $1.2 million and $423,000, respectively, of interest capitalized on significant projects during the period.

  

 
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.

 

In December 2015, in connection with the NMTC transaction (see Note 12), the maximum borrowing capacity under the delayed draw term loan was reduced from $115.0 million to $99.6 million.

 

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, 2016 was approximately 3.71. The Company’s weighted-average interest rate was 2.53% at September 30, 2016.

 

Additionally, in connection with the NMTC transaction discussed in Note 12, the Company entered into an $11.1 million term loan with U.S. Bank. This loan bears interest at a fixed rate of 4.4% and matures on December 29, 2022. The loan requires quarterly payments of principal and interest of approximately $255,000, beginning on March 29, 2016, with a balloon payment due on the maturity date.

  

 

 
10

 

  

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

 

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

 

Long-term debt at September 30, 2016 and December 31, 2015 consists of:

  

   

September 30,

   

December 31,

 
   

2016

   

2015

 
   

(in thousands)

 

Revolving line of credit, maturing on June 25, 2020

  $ 16,447     $ -  

Delayed draw term loan, maturing on June 25, 2020

    60,702       18,522  

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

    43,600       45,950  

Term Loan, maturing on December 29, 2022, due in quarterly installments of $255,006, including interest

    10,713       11,109  

Less: unamortized debt issuance costs

    (1,263 )     (1,342 )
Total debt   $ 130,199     $ 74,239  

Less current portion

    5,462       3,882  
Total long term debt   $ 124,737     $ 70,357  

 

Unamortized debt issuance costs consist of:

 

   

September 30,

   

December 31,

 
   

2016

   

2015

 
   

(in thousands)

 

Revolving line of credit

  $ 234     $ 285  

Delayed draw term loan

    149       344  

Term Loan, maturing on June 25, 2020

    284       182  

Term Loan, maturing on December 29, 2022

    596       531  
    $ 1,263     $ 1,342  

 

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. As of September 30, 2016, the Company’s borrowing base was $19.3 million, including $9.6 million of eligible accounts receivable and $9.7 million of eligible inventory.

 

Obligations under the Credit Agreement and the NMTC loan 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, 2016.

 

Note 8 — Income Taxes

 

As of September 30, 2016, our annual estimated effective income tax rate is 32.25%. The annual estimated effective tax rate for 2016 differs from the statutory rate due primarily due to U.S. Indian employment credit, the foreign tax credit, and state investment tax credits.  As of September 30, 2015, our annual estimated effective income tax rate was 33.9%. The annual estimated effective tax rate for 2015 differs from the statutory rate primarily due to U.S. manufacturing tax credits and foreign and state income taxes. Our actual effective income tax rate was 24.9% and 34.0% for the three-month periods ended September 30, 2016 and 2015, respectively, and 32.2% and 30.9% for the nine-month periods ended September 30, 2016 and 2015, respectively.

 

During the first quarter of 2016, we elected to early adopt ASU 2015-17, “Income Taxes: Balance Sheet Classification of Deferred Taxes” (“ASU 2015-17”) on a retrospective basis. ASU 2015-17 requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. As such, we reclassified $1.9 million and $1.3 million of current deferred tax assets to noncurrent (netted within noncurrent liabilities) on the consolidated balance sheets as of September 30, 2016 and December 31, 2015. The adoption of ASU 2015-17 did not affect our consolidated statements of income.

    

 

 
11

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

 

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, 2016 and 2015 is as follows:

  

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2016

   

2015

   

2016

   

2015

 

Net income - ($ thousands)

  $ 2,213     $ 4,742     $ 10,190     $ 9,856  

Less: distributed earnings allocable to participating securities

    -       (1 )     -       (2 )

Less: undistributed earnings allocable to participating securities

    -       -       -       -  

Distributed and undistributed earnings allocable to common shareholders

  $ 2,213     $ 4,741     $ 10,190     $ 9,854  
                                 

Weighted average shares outstanding

    10,296,891       10,266,891       10,282,841       9,613,412  

Effect of stock options

    70,769       58,459       68,574       59,549  

Weighted average shares outstanding - assuming dilution

    10,367,660       10,325,350       10,351,415       9,672,961  

Net income per common share:

                               

Basic

  $ 0.21     $ 0.46     $ 0.99     $ 1.02  

Diluted

  $ 0.21     $ 0.45     $ 0.98     $ 1.02  
                                 

Stock options not considered above because they were anti-dilutive

    511,250       563,600       516,250       535,000  

 

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, 2016, there were 164,200 shares available for issuance under the 2014 Plan.

 

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-month periods ended September 30, 2015 and 2016.

  

Grant

 

Number

   

Exercise

   

Grant Date

   

Risk-Free

   

Estimated

   

Dividend

 

Expected

Date

 

of Shares

   

Price

   

Fair Value

   

Interest Rate

   

Volatility

   

Yield

 

Life (Years)

May-15

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

 

January-16

    5,000     $ 27.77       $6.56         2.00%         40%         5.04 %   5

 

May-16

    40,000     $ 31.33       $7.57         1.74%         40%         4.47 %   5

 

September-16

    20,000     $ 28.48     $4.28  - 4.83     1.21 - 1.50%     29 - 31%       4.92 % 5 -

7

 

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

 

There were 0 and 28,600 options with market-based vesting conditions granted during the nine-month periods ended September 30, 2016 and 2015, respectively. During the nine months ended September 30, 2016, 22,500 options with market-based vesting conditions vested when the Company’s stock price closed above $34.788 per share for three consecutive business days. Additionally, 20,550 options with market-based vesting conditions were forfeited when three employees left the Company.

 

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)

 

 

Note 10 — Stock Incentives (continued)

 

Options Issued Outside of the 2014 Plan

 

There were no stock options granted outside of the 2014 Plan during the nine-month periods ended September 30, 2016 or 2015. During the nine months ended September 30, 2016, 100,000 options with market-based vesting conditions vested when the Company’s stock price closed above $34.788 per share for three consecutive business days.

 

Total Option Expense

 

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

  

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2016

   

2015

   

2016

   

2015

 

Time-Based Vesting Options

  $ 47,000     $ 1,000     $ 409,000     $ 188,000  

Market-Based Vesting Options

    22,000       77,000       191,000       555,000  

Total compensation expense related to stock options

  $ 69,000     $ 78,000     $ 600,000     $ 743,000  

 

Total compensation expense related to stock options is included in selling, general and administrative expense. 

 

  Future Expected Market-Based Stock Option Expense

 

The grant of options that vest based on a market condition have had a material effect and will have a lesser effect on the Company’s results of operations in 2016.  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.

  

   

2016

   

2016

   

2017

 
   

Q1

   

Q2

   

Q3

   

Q4

   

Total

   

Total

 
   

(in thousands)

 

Tranche 1

  $ -     $ -     $ -     $ -     $ -     $ -  

Tranche 2

    6       7       4       -       17       -  

Tranche 3

    60       4       3       3       70       3  

Tranche 4

    47       45       16       2       110       4  

Total expense

  $ 113     $ 56     $ 23     $ 5     $ 197     $ 7  

 

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.  The second third of unforfeited shares, or 2,333 shares, vested in February 2015 and the final third of unforfeited shares, or 2,000 shares, vested in February 2016. 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 $0 and $8,000 for the three-month periods ended September 30, 2016 and 2015, respectively, and $4,000 and $34,000 for the nine-month periods ended September 30, 2016 and 2015, respectively, related to shares of restricted stock granted. Such expense is included in selling, general and administrative expense.

 

 

 
13

 

 

  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 products in the form of parent rolls and converted products.  Revenues from converted product sales and parent roll sales in the three-month and nine-month periods ended September 30, 2016 and 2015 were:

  

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2016

   

2015

   

2016

   

2015

 
   

(in thousands)

   

(in thousands)

 
                                 

Converted product net sales

  $ 38,284     $ 43,675     $ 122,867     $ 120,877  

Parent roll net sales

    1,344       3,157       3,918       5,665  

Net sales

  $ 39,628     $ 46,832     $ 126,785     $ 126,542  

 

Credit risk for the Company in the three-month and nine-month periods ended September 30, 2016 and 2015 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,

 
   

2016

   

2015

   

2016

   

2015

 
                                 

Converted product customer 1

    34 %     29 %     35 %     33 %

Converted product customer 2

    15 %     15 %     14 %     12 %

Converted product customer 3

    6 %     15 %     9 %     15 %

Total percent of net sales

    55 %     59 %     58 %     60 %

 

No additional customers accounted for more than 10% of sales during the three-month or nine-month periods ended September 30, 2016 and 2015.

 

At September 30, 2016 and December 31, 2015, the significant customers accounted for the following amounts of the Company’s accounts receivable (in thousands):

 

   

September 30,

           

December 31,

         
   

2016

           

2015

         
                                 

Converted product customer 1

  $ 4,971       41 %   $ 3,434       32 %

Converted product customer 2

    2,079       17 %     931       9 %

Converted product customer 3

    101       1 %     2,071       19 %

Total of accounts receivable

  $ 7,151       59 %   $ 6,436       60 %

 

At September 30, 2016 and December 31, 2015, no additional customers accounted for more than 10% of the Company’s accounts receivable.

  

 

 
14

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)

 

 

Note 12 — New Market Tax Credit

 

In December 2015, the Company received approximately $5.1 million in net proceeds from financing agreements related to capital expenditures at its Barnwell, South Carolina facility. This financing arrangement was structured with a third party financial institution (the “NMTC Investor”) associated with U.S. Bank, an investment fund, and two community development entities (the “CDEs”) majority owned by the investment fund. This transaction was designed to qualify under the federal New Market Tax Credit (“NMTC”) program, pursuant to Section 45D of the Internal Revenue Code of 1986, as amended. Through this transaction, the Company has secured low interest financing and the potential for future debt forgiveness related to the South Carolina facility. Upon closing of the NMTC transaction, the Company provided an aggregate of approximately $11.1 million, which was borrowed from U.S. Bank, to the investment fund, in the form of a loan receivable, with a term of 25 years, bearing an interest rate of 1.0% per annum. This $11.1 million in proceeds plus $5.1 million of net capital from the NMTC Investor were contributed to and used by the CDEs to make loans in the aggregate of $16.2 million to a subsidiary of the Company, Orchids Lessor SC, LLC (“Orchids Lessor”). These loans bear interest at a fixed rate of 1.275%. Orchids Lessor is using the loan proceeds to partially fund $18.0 million of the Company’s capital assets associated with the Barnwell facility. These capital assets will serve as collateral to the financing arrangement. This transaction also includes a put/call feature whereby, at the end of a seven-year compliance period, we may be obligated or entitled to repurchase the NMTC Investor’s interest in the investment fund. The value attributable to the put price is nominal. Consequently, if exercised, the put could result in the forgiveness of the NMTC Investor’s interest in the investment fund, and result in a net non-operating gain of up to $5.1 million. The call price will be valued at the net present value of the cash flows of the lease inherent in the transaction.

 

The NMTC Investor is subject to 100% recapture of the New Market Tax Credits it receives for a period of seven years as provided in the Internal Revenue Code and applicable U.S. Treasury regulations.  The Company is required to be in compliance with various regulations and contractual provisions that apply to the New Market Tax Credit arrangement.  Noncompliance with applicable requirements could result in the NMTC Investor’s projected tax benefits not being realized and, therefore, require the Company to indemnify the NMTC Investor for any loss or recapture of New Market Tax Credits related to the financing until such time as the recapture provisions have expired under the applicable statute of limitations.  The Company does not anticipate any credit recapture will be required in connection with this financing arrangement. 

  

At September 30, 2016 and December 31, 2015, the NMTC Investor’s interest of $5.1 million is recorded in other long-term liabilities on the consolidated balance sheet, while the outstanding balance of the amount borrowed from U.S. Bank to loan to the investment fund of $10.7 and $11.1 million, respectively, is recorded in long-term debt, net of the current portion.  Unspent proceeds from the arrangement of approximately $1.3 million and $12.0 million at September 30, 2016 and December 31, 2015, respectively, are obligated for funding the specified capital assets at the Barnwell facility and are included in restricted cash.

 

Note 13 – 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 14 – 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, 2016 and December 31, 2015, the Company had a note receivable of $372,000 and $328,000, respectively, related to amounts due under the ODFA pooled financing agreement. The Company recognized $153,000 and $169,000 of other income in the consolidated statements of income for the three-month periods ended September 30, 2016 and 2015, respectively, and $500,000 and $514,000 of other income in the consolidated statement of income for the nine-month periods ended September 30, 2016 and 2015, respectively, related to this agreement. From September 2014, the Company recognized a total of $1,398,000 of other income through September 30, 2016.

  

 

 
15

 

 

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)  

 

 

Note 15 — New and Recently Adopted Accounting Pronouncements

 

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.  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 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. ASU 2015-03 became effective for the Company on January 1, 2016. As such, we reclassified $1.3 million of unamortized debt issuance costs, including costs associated with our revolving lines of credit, as of September 30, 2016 and December 31, 2015, to offset long-term debt in the consolidated balance sheets. Adoption of ASU 2015-03 and ASU 2015-15 did not affect our consolidated statements of income.

   

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 became effective for the Company on January 1, 2016. Adoption of ASU 2015-05 did not have a material effect on our consolidated financial statements.

 

In November 2015, the FASB issued Accounting Standards Update 2015-17, “Income Taxes: Balance Sheet Classification of Deferred Taxes” (“ASU 2015-17”). ASU 2015-17 requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. ASU 2015-17 is effective for public companies for annual and interim periods beginning after December 15, 2016. During the first quarter of 2016, we elected to early adopt ASU 2015-17 on a retrospective basis. As such, we reclassified $1.9 million and $1.3 million of current deferred tax assets to noncurrent (netted within noncurrent liabilities) on the consolidated balance sheets as of September 30, 2016 and December 31, 2015. The adoption of ASU 2015-17 did not affect our consolidated statements of income.

 

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.  In March 2016, the FASB issued Accounting Standards Update 2016-08, “Revenue from Contracts with Customers: Principal versus Agent Considerations” (“ASU 2016-08”). ASU 2016-08 clarifies implementation guidance on principal versus agent considerations in ASU 2014-09. In April 2016, the FASB issued Accounting Standards Update 2016-10, “Revenue from Contracts with Customers: Identifying Performance Obligations and Licensing” (“ASU 2016-10”). In May 2016, the FASB issued Accounting Standards Update 2016-12, “Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients” (“ASU 2016-12”). ASU 2016-10 and ASU 2016-12 do not change the guidance under ASU 2014-09, but clarify certain aspects of this guidance. In May 2016, the FASB issued Accounting Standards Update 2016-11, “Revenue Recognition and Derivatives and Hedging” (“ASU 2016-11”). ASU 2016-11 rescinds certain SEC accounting guidance that is inconsistent with guidance in ASU 2014-09. Management is currently assessing the impact these ASUs will have on the Company, but they are not expected to have a material effect on the Company’s financial position, results of operations or 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.

  

 

 
16

 

    

ORCHIDS PAPER PRODUCTS COMPANY AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (continued)  

 

 

Note 15 — New and Recently Adopted Accounting Pronouncements (continued)

 

In January 2016, the FASB issued Accounting Standards Update 2016-01, “Financial Instruments – Overall: Recognition and Measurement of Financial Assets and Financial Liabilities” (“ASU 2016-01”). ASU 2016-01 addresses certain aspects of recognition, measurement, presentation and disclosure of financial instruments, specifically equity investments and financial instruments measured at amortized cost. ASU 2016-01 is effective for public companies for annual and interim periods beginning after December 15, 2017. Management is currently assessing the impact ASU 2016-01 will have, if any, on the Company’s financial position, results of operations and cash flows.

 

In February 2016, the FASB issued Accounting Standards Update 2016-02, “Leases” (“ASU 2016-02”). ASU 2016-02 requires lessees to recognize lease assets and lease liabilities on the balance sheet but did not make significant changes to the effects of lessee accounting on the income statement or statement of cash flows. ASU 2016-02 is effective for public companies for annual and interim periods beginning after December 15, 2018. Management is currently assessing the impact ASU 2016-02 will have on the Company’s financial position.

 

In March 2016, the FASB issued Accounting Standards Update 2016-09, “Compensation – Stock Compensation: Improvements to Employee Share-Based Payment Accounting” (“ASU 2016-09”). ASU 2016-09 requires, among other things, that excess tax benefits and tax deficiencies be recognized as income tax expense or benefit in the income statement rather than as additional paid-in capital, changes the classification of excess tax benefits from a financing activity to an operating activity in the statement of cash flows, and allows forfeitures to be accounted for when they occur rather than estimated. ASU 2016-09 is effective for public companies for interim and annual periods beginning after December 15, 2016. Management is currently assessing the impact ASU 2016-09 will have on the Company’s financial position, results of operations and cash flows.

 

In June 2016, the FASB issued Accounting Standards Update 2016-13, “Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). ASU 2016-13 replaces the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. ASU 2016-113 is effective for public companies for interim and annual periods beginning after December 15, 2019. Management is currently assessing the impact ASU 2016-13 will have on the Company, but it is not expected to have a material impact on the Company’s financial position, results of operations and cash flows.

 

In August 2016, the FASB issued Accounting Standards Update 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments” (“ASU 2016-15”). ASU 2016-15 will make eight targeted changes to how cash receipts and cash payments are presented and classified in the statement of cash flows. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017. The new standard will require adoption on a retrospective basis unless it is impracticable to apply, in which case it would be required to apply the amendments prospectively as of the earliest date practicable. Management is currently assessing the impact ASU 2016-15 will have on the Company, but it is not expected to have a material impact on the Company’s cash flows.

 

The Company does not believe that any other recently issued, but not yet effective, accounting standards if currently adopted would have a material effect on the accompanying consolidated financial statements.

  

Note 16 — Subsequent Events

 

On October 26, 2016, 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 21, 2016 to stockholders of record at the close of business on November 7, 2016.

  

 

 
17

 

 

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, 2015, as filed with the SEC on March 7, 2016, subsequent filings 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 the construction of our South Carolina facility on schedule or at all;

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;

the additional indebtedness incurred to finance the construction of our South Carolina facility;

new competitors entering the market and increased competition in our region;

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;

ability to meet loan covenant conditions or renegotiate such conditions with lenders;

ability to finance the capital requirements of our business; 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.

 

 

 
18

 

   

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 typically sell parent rolls not required by our converting operations 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 markets. We predominately sell our products to our core customer-base in the “at home” market under private labels. Our customer base consists primarily of dollar stores, discount retailers and grocery stores that offer limited alternatives across a wide range of products. The “at home” tissue market consists of several quality levels, including a value tier, a premium tier and an ultra-premium tier.  

 

Part of our strategy is to increase our volume of premium and ultra-premium tier products sold 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.

 

 

Comparative Three-Month Periods Ended September 30, 2016 and 2015

 

Net Sales

 

   

Three Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands)

 
                 

Converted product net sales

  $ 38,284     $ 43,675  

Parent roll net sales

    1,344       3,157  

Net sales

  $ 39,628     $ 46,832  

 

 
19

 

  

Net sales in the quarter ended September 30, 2016 decreased $7.2 million, or 15%, from $46.8 million in 2015 to $39.6 million in 2016. Net sales figures represent the gross selling price, including freight, less discounts and pricing allowances. The decrease in net sales is due to a $5.4 million decrease in the sales of converted products and a $1.8 million decrease in the net sales of parent rolls.

 

Net sales of converted product decreased $5.4 million, or 12%, from $43.7 million in 2015 to $38.3 million in 2016. The decrease in converted product net sales is primarily due to a 12% decrease in tonnage shipped. Net selling prices per ton remained approximately the same between the two periods, other than for product-line mix impacts. For example, the proportion of bathroom tissue sold, at a lower average price per ton than for towels, was greater in third quarter 2016. Converted product tons sold decreased primarily due to competitive pressures, including those upon our principal customers.

   

Net sales of parent rolls decreased $1.8 million, or 57%, in 2016. Parent roll production at Pryor, though 3% higher than in 2015, was used in part for the Barnwell, South Carolina start-up and in part to increase finished-goods inventory, thereby foregoing margin we would have received on parent roll sales in favor of margin we expect to gain when we sell this tonnage as converted product. In order to improve upon cash flows, Management is planning to resume the practice of selling excess parent rolls in the fourth quarter.

 

Cost of Sales

 

   

Three Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands, except gross profit margin %)

 
                 
Cost of goods sold   $ 30,504     $ 34,432  
Depreciation     2,909       2,555  

Cost of sales

  $ 33,413     $ 36,987  
                 

Gross profit

  $ 6,215     $ 9,845  

Gross profit margin %

    15.7 %     21.0 %

 

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

 

Cost of sales decreased $3.5 million, or 10%, to $33.4 million, compared to $36.9 million in the same period of 2015, due primarily to decreased sales.  As a percentage of net sales, cost of sales increased to 84.3% in the 2016 quarter from 79.0% in the 2015 quarter due largely to increased depreciation related to the Barnwell converting facility, the addition of Barnwell’s overhead costs as a precursor to ramping-up production, and the spreading of fixed and semi-variable costs over decreased converted sales volumes.

 

Gross Profit

 

As a result of the foregoing factors, gross profit in the quarter ended September 30, 2016 decreased $3.6 million, or 37%, to $6.2 million compared to $9.8 million in the same period last year. Gross profit as a percentage of net sales in the 2016 quarter was 15.7% compared to 21.0% in the 2015 quarter. As a partial offset to items noted above, lower fiber prices contributed approximately $0.6 million more gross profit in the third quarter of 2016.

 

Selling, General and Administrative Expenses

 

   

Three Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands, except SG&A as a 

% of net sales)

 
                 

Commission expense

  $ 271     $ 280  

Other S,G&A expenses

    2,286       2,157  

Selling, General & administrative exp

  $ 2,557     $ 2,437  
SG&A as a % of net sales     6.5 %     5.2 %

 

 
20

 

  

Selling, general and administrative expenses include salaries, commissions to brokers and other expenses.  Selling, general and administrative expenses increased $0.1 million, or 4.9%, in the quarter ended September 30, 2016 as compared to the same period in 2015 as the net result of various miscellaneous changes such as the hiring of sales personnel; lower administrative salaries, in part due to temporary vacancies; an increase in advertising; and a late-payment penalty.

 

Amortization of Intangibles

 

The Company recognized $233,000 and $376,000 of amortization expense related to the intangible assets acquired in the Fabrica Transaction during the quarters ended September 30, 2016 and 2015, respectively. 

 

Operating Income

 

As a result of the foregoing factors, operating income for the quarter ended September 30, 2016 was $3.4 million compared to operating income of $7.0 million for the same period of 2015.

 

Interest Expense and Other Income

 

   

Three Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands)

 

Interest expense

  $ 639     $ 11  

Other (income) expense, net

  $ (162 )   $ (169 )
                 

Income before income taxes

  $ 2,948     $ 7,190  

 

Interest expense includes interest on all debt and amortization of deferred debt issuance costs.  Interest expense for the third quarter of 2016 totaled $639,000 compared to interest expense of $11,000 in the same period in 2015. Interest expense for third quarter 2016 excludes $348,000 of interest capitalized on significant projects during the quarter, compared to $299,000 of capitalized interest in the same period of 2015. The higher level of total interest in 2016 resulted from higher debt balances, due primarily to additional borrowings to finance construction of the Barnwell, South Carolina facility.

 

Other (income) expense for the three months ended September 30, 2016 and 2015 includes $153,000 and $169,000, respectively, of income related to the Company’s pooled financing agreement with the Oklahoma Development Financing Authority (ODFA).

 

Income Before Income Taxes

 

As a result of the foregoing factors, income before income taxes decreased $4.2 million to $2.9 million in the quarter ended September 30, 2016, compared to $7.2 million in the same period in 2015.

 

Income Tax Provision

 

As of September 30, 2016, our annual estimated effective tax rate for the full year is estimated to be 32.25%, as compared to the 34.1% effective tax rate estimated at the end of the second quarter of 2016. The annual estimated effective tax rate for 2016 differs from the statutory rate due principally to Oklahoma, South Carolina, Indian Employment, and Foreign tax credits.  The actual effective tax rate for the quarter ended September 30, 2016 was 24.9% as a result of a one-off adjustment to the tax credits. The actual effective tax rate for the third quarter of 2015 was 34.0%, as compared to an annual estimated effective tax rate of 33.9% as of September 30, 2015. The annual estimated effective tax rate for 2015 differed from the statutory rate due primarily to U. S. manufacturing tax credits and foreign and state income taxes. 

 

 

 
21

 

 

Comparative Nine -Month Periods Ended September 30, 2016 and 2015

 

Net Sales

  

   

Nine Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands)

 
                 

Converted product net sales

  $ 122,867     $ 120,877  

Parent roll net sales

    3,918       5,665  

Net sales

  $ 126,785     $ 126,542  

 

Net sales in the nine-month period ended September 30, 2016 increased $0.2 million, or 0.2%, from $126.5 million in 2015 to $126.8 million in 2016. Net sales figures represent the gross selling price, including freight, less discounts and pricing allowances. The increase in net sales is due to a $1.9 million increase in the sales of converted products and offset by a $1.7 million decrease in the net sales of parent rolls.

  

Net sales of converted product increased $1.9 million, or 2%, from $120.8 million in 2015 to $122.8 million in 2016 primarily due to a 3% increase in tonnage shipped. Net sales of parent rolls decreased $1.75 million, or 31%, in the nine months ended September 30, 2016. Parent roll production, though 26% higher than in 2015, was used in part for the Barnwell, South Carolina start-up and in part to increase finished-goods inventory, thereby foregoing margin we would have received on parent roll sales in favor of margin we expect to gain when we sell this tonnage as converted product.

 

Cost of Sales

  

   

Nine Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands, except gross profit margin %)

 
                 
Cost of goods sold   $ 93,675     $ 97,216  
Depreciation     8,641       6,976  

Cost of sales

  $ 102,316     $ 104,192  
                 

Gross profit

  $ 24,469     $ 22,350  

Gross profit margin %

    19.3 %     17.7 %

 

Cost of sales decreased $1.8 million, or 1.8%, to $102.3 million, compared to $104.2 million in the same period of 2015, due primarily to lower fiber costs of $1.7 million, favorable costs from Fabrica due to the Mexican peso devaluation, the $1.1 million of business interruption proceeds received in second quarter 2016, favorable production overhead absorption in the Pryor paper mill of approximately $0.6 million, and other favorable cost reductions, partially offset by unfavorable overhead absorption in Pryor converting of approximately $2.1 million and $3.0 million in Barnwell. As a percentage of net sales, cost of sales decreased to 80.7% in the 2016 period from 82.3% in the 2015 period.

 

Gross Profit

 

As a result of the foregoing factors, Gross profit in the nine-month period ended September 30, 2016 increased $2.1 million, or 9.5%, to $24.5 million compared to $22.4 million in the same period last year.  Gross profit as a percentage of net sales in the 2016 period was 19.3% compared to 17.7% in the 2015 period.

  

Selling, General and Administrative Expenses

 

   

Nine Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands, except SG&A as a % 

of net sales)

 
                 
Commission expense   $ 884     $ 911  
Other S,G&A expenses     6,899       6,263  

Selling, General & administrative exp

  $ 7,783     $ 7,174  

SG&A as a % of net sales

    6.1 %     5.7 %

 

 

 
22

 

  

Selling, general and administrative expenses include salaries, commissions to brokers and other miscellaneous expenses.  Selling, general and administrative expenses increased $0.6 million, or 8.5%, in the nine-month period ended September 30, 2016 as compared to the same period in 2015 primarily due to higher professional and consulting fees, artwork and design fees, payroll processing fees, recruitment and relocation costs, travel, and advertising, partially offset by reduced administrative salaries. As a percentage of net sales, selling, general and administrative expenses increased to 6.1% in the 2016 period compared to 5.7% in the same period of 2015.

 

Amortization of Intangibles

 

The Company recognized $1.0 million and $1.1 million of amortization expense related to the intangible assets acquired in the Fabrica Transaction during the nine-month periods ended September 30, 2016 and 2015, respectively.

 

Operating Income

 

As a result of the foregoing factors, operating income for the nine-month period ended September 30, 2016 was $15.7 million compared to operating income of $14.0 million for the same period of 2015.

 

Interest Expense and Other Income

  

   

Nine Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands)

 

Interest expense

  $ 1,187     $ 289  

Other (income) expense, net

  $ (527 )   $ (507 )
                 

Income before income taxes

  $ 15,040     $ 14,264  

 

Interest expense includes interest on all debt and amortization of deferred debt issuance costs. Interest expense for the nine-month period ended September 30, 2016 totaled $1.2 million compared to interest expense of $0.3 million in the same period in 2015. Interest expense for 2016 excludes $1.2 million of interest capitalized on significant projects during the period, compared to $423,000 of capitalized interest in the same period of 2015. The higher level of total interest in 2016 resulted from higher debt balances due primarily to additional debt incurred to finance capital expenditures.

 

Other (income) expense for the nine-month period ended September 30, 2016 and 2015 includes $500,000 and $514,000, respectively, of income related to the Company’s pooled financing agreement with the ODFA.

 

Income Before Income Taxes

 

As a result of the foregoing factors, income before income taxes increased $776,000 to $15.0 million in the nine-month period ended September 30, 2016, compared to $14.3 million in the same period in 2015.

 

Income Tax Provision

 

As of September 30, 2016, our annual estimated effective tax rate for the full year is estimated to be 32.25%, as compared to the 34.1% effective tax rate estimated at the end of the second quarter of 2016. The actual effective tax rate for the nine-month period ended September 30, 2016 was 32.2%.  Primarily as a result of a change in our estimated state tax liabilities, the actual effective tax rate for the nine-month period ended September 30, 2015 was 30.9%, as compared to an annual estimated effective tax rate of 33.9% as of September 30, 2015. The annual estimated effective tax rates for 2015 and for 2016 differ from the statutory rate due primarily to U. S. manufacturing tax credits and foreign and state income taxes.  

  

Liquidity and Capital Resources

 

Liquidity refers to the liquid financial assets available to fund our business operations and pay for near-term obligations.  These liquid financial assets consist of cash as well as unused borrowing capacity under our credit facility. Our cash requirements have historically been satisfied through a combination of cash flows from operations and debt and equity financings. We expect this trend to continue.

 

 

 
23

 

    

Currently, the most significant event effecting liquidity and capital needs is the construction of our integrated converting facility in Barnwell, South Carolina, which has a total estimated cost of $150 million. In April 2015, we issued and sold 1,500,000 shares of common stock at $23.00 per share in an underwritten public offering resulting in aggregate net proceeds to us of approximately $32.2 million, after giving effect to the underwriting discount and estimated expenses. We used the net proceeds from the offering, together with new bank financing and cash generated through operations, to construct the Barnwell facility, consisting of two converting lines, a converting building, a paper mill building, a paper machine capable of producing structured tissue, equipment capable of utilizing recycled paper, warehouse facilities, and other supporting equipment and facility-space. In June 2015, we entered into an agreement with US Bank National Association which: (i) combined our then 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 then outstanding under our existing term loan into a $47.3 million term loan due in 2020; (ii) increased our delayed draw term loan facility from $40 million to $115 million; (iii) extended the maturity of the delayed draw facility from August 2015 to June 2020; and (iv) added a $50 million accordion feature. Proceeds from the delayed draw term loan must be used solely to finance the acquisition and construction of buildings and equipment at our Barnwell facility. Advances under the facility bear interest at variable rates. The term loan is payable in quarterly installments of $675,000 through June 2016 and $1 million per quarter thereafter, while borrowings against the delayed draw term loan facility are payable in quarterly installments of 1.5% of the June 30, 2017 outstanding balance beginning in September 2017.

 

In December 2015, we entered into a NMTC transaction, which provided $16.2 million of loan proceeds to be used to finance capital expenditures associated with the Barnwell, South Carolina facility. This transaction allowed the Company to fix the interest on $11.1 million of its long-term debt for seven years and includes the potential for future debt forgiveness of approximately $5.1 million in seven years. In connection with this transaction, the maximum borrowing capacity under our delayed draw facility was reduced from $115 million to $99.6 million.

 

During the nine-month period ended September 30, 2016, cash increased $4.2 million, to $8.6 million at September 30, 2016, compared to $4.4 million at December 31, 2015.  During the 2016 period, we incurred $74.1 million of capital expenditures, removed restrictions on $10.7 million of cash, received $1.9 million of proceeds from economic incentives related to the construction of our South Carolina facility, received $58.6 million of borrowings under our revolving credit lines (including our delayed draw loan), paid $2.7 million of principal payments on long-term debt, and paid $10.8 million in dividends to stockholders. In August and September 2016, we received $1.46 million of invoices for equipment purchased for our South Carolina facility, which were paid in October 2016.

 

As of September 30, 2016, Debt outstanding was $131.5 million.  Cash as of September 30, 2016 totaled $8.6 million. This compares to $75.6 million in Debt and cash of $4.4 million as of December 31, 2015. We had $16.4 million and $60.7 million outstanding under our $25.0 million revolving line of credit and our $99.6 million delayed draw term loan, respectively, as of September 30, 2016. “Debt” as used here means the sum of current and long-term debt, not having been netted with unamortized deferred debt issuance costs. The Adjusted EBITDA leverage ratio reportable to the banks at September 30, 2016 was 3.71, as compared to a covenant limitation of 4.0. The Company does not expect to exceed the 4.0x limitation in the fourth quarter of 2016. The ratio calculation is calculated using Debt and a rolling historic 12-month period of Adjusted EBITDA. Given the Adjusted EBITDA performance in the second and third quarters of 2016, there is an increased risk of exceeding the leverage covenant threshold, particularly in the first and second quarters of 2017. As this leverage ratio is temporary in nature, we expect that the risk that the Company exceeds the covenant limitation will be confined to approximately two quarters. Furthermore, the Company expects to be able to negotiate a favorable temporary waiver of the covenant with the lenders and does not expect to have to curtail dividends. The Company is prepared to commit to a more rapid repayment of the debt that previously agreed upon if necessary to satisfy the lenders. There is no assurance that the lenders will work with the Company on this temporary issue or that the Company’s expectations in this regard will be realized, in which event the lenders could pursue other remedies.

 

The following table summarizes key cash flow information for the nine-month periods ended September 30, 2016 and 2015:

 

   

Nine Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands)

 

Cash flows provided by (used in):

               

Operating activities

  $ 20,259     $ 13,183  
                 

Investing activities

  $ (63,424 )   $ (35,485 )
                 

Financing activities

  $ 47,365     $ 29,831  

 

 

 
24

 

  

Cash flows provided by operating activities were $20.3 million in the nine-month period ended September 30, 2016. For the nine months ended September 30, 2016, operating cash flows following from changes in cash due to changes in operating assets and liabilities used $7.0 million while all other sources and uses of operating cash flows provided $27.3 million. $6.9 million of the use of cash from changes in operating assets and liabilities related to increased inventories due to the start-up of converting operations at the Barnwell, South Carolina facility and an increase in inventories, planned to be worked-down through future sales. Other than net income and the depreciation add-back, other cash flows from operations were driven by a $6.6 million deferral of income tax payments into future periods. For the nine months ended September 30, 2015, operating cash flows following from changes in cash due to changes in operating assets and liabilities used $4.9 million while all other sources and uses of operating cash flows provided $18.1 million, the latter principally driven by net income and the depreciation add-back. The use of $4.9 million for changes in operating assets and liabilities was principally driven by a $3.6 million increase in receivables and a $2.4 million increase in inventories. The variation in the receivables in 2015 was a normal timing difference and did not indicate any significant issue with late or delinquent accounts.

 

Cash flows used in investing activities in the first nine months of 2016 included $74.1 million of expenditures on capital projects during the period, partially offset by the release of $10.7 million of restricted cash to finance capital expenditures associated with our South Carolina facility. Cash flows used in investing activities in the first nine months of 2015 consisted entirely of $35.5 million in expenditures on capital projects during the period.

 

Cash flows provided by financing activities were $47.4 million in the nine-month period ended September 30, 2016, primarily due to $58.6 million of borrowings under our credit facility and $1.9 million of proceeds from economic incentives associated with our South Carolina facility, which were partially offset by $2.7 million of principal payments on long-term debt and $10.8 million of cash dividends paid to stockholders. While we expect to continue to declare quarterly dividends, the payment of future dividends is at the discretion of the Board of Directors and the timing and amount of any future dividends will depend upon many factors, including our financial condition, earnings, cash requirements of our business, legal requirements, regulatory constraints, industry practice and other factors that the Board deems relevant. Our credit agreement contains an indirect restriction on the amount of cash dividends we pay in that the amount of dividends paid is included in the calculation of our fixed charge coverage ratio. Cash flow provided by financing activities was $29.8 million in the nine-month period ended September 30, 2015, primarily due to $32.2 million of net proceeds received from our follow-on stock offering in April 2015, and $12.3 million of net borrowings under our credit facility, which were partially offset by $10.3 million of cash dividends paid to stockholders, $2.0 million of debt principal repayments, and a $1.7 million reduction in bank overdrafts.

 

Critical Accounting Policies and Estimates

 

The preparation of our financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and judgments that affect our reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates and assumptions based upon historical experience and various other factors and circumstances.  Management believes that our estimates and assumptions are reasonable under the circumstances; however, actual results may vary from these estimates and assumptions under different future circumstances.  We have identified the following critical accounting policies that affect the more significant judgments and estimates used in the preparation of our financial statements: 

 

Accounts Receivable.  Accounts receivable consist of amounts due to us from normal business activities.  Our management must make estimates of accounts receivable that will not be collected.  We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and the customer’s creditworthiness as determined by our review of their current credit information.  We continuously monitor collections and payments from our customers and maintain a provision for estimated losses based on historical experience and specific customer collection issues that we have identified.  Trade receivables are written-off when all reasonable collection efforts have been exhausted, including, but not limited to, external third-party collection efforts and litigation.  While such credit losses have historically been within management’s expectations and the provisions established, there can be no assurance that we will continue to experience the same credit loss rates as in the past.   During the nine-month periods ended September 30, 2016 and 2015, no accounts receivable were written off against the allowance for doubtful accounts, nor was the provision for bad debts increased or decreased based on sales levels, historical experience and an evaluation of the quality of existing accounts receivable, resulting in no change to the allowance.

 

Inventory.  Our inventory consists of converted finished goods, bulk paper rolls and raw materials and is stated at the lower of cost or market based on standard cost, specific identification, or FIFO (first-in, first-out).  Standard costs approximate actual costs on a FIFO basis.  Material, labor and factory overhead necessary to produce the inventories are included in the standard cost.  Our management regularly reviews inventory quantities on hand and records a provision for excess and obsolete inventory based on the age of the inventory and forecasts of product demand.  A significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand.  During the first nine months of 2016, the inventory allowance was increased $253,000 based on a specific review of estimated slow moving or obsolete inventory items and was decreased $229,000 due to actual write-offs of obsolete and unrealizable inventory items, resulting in a net increase in the allowance of $24,000. During the first nine months of 2015, the inventory allowance was increased $181,000 based on a specific review of estimated slow moving or obsolete inventory items and was decreased $139,000 due to actual write-offs of obsolete inventory items, resulting in a net increase in the allowance of $42,000.

 

 

 
25

 

 

Property, Plant and Equipment.   Significant capital expenditures are required to establish and maintain paper mills and converting facilities. Our property, plant and equipment consists of land, buildings and improvements, machinery and equipment, vehicles, parts and spares and construction-in-process, which are stated at cost, net of accumulated depreciation. Depreciation of property, plant and equipment is calculated using the straight-line method over the estimated useful lives of the assets. Our management regularly reviews estimated useful lives to determine whether any changes are necessary to reflect the related assets’ actual productive lives. The lives of our property, plant and equipment currently range from 2.5 to 40 years.

 

Stock-based Compensation. U.S. GAAP requires equity-classified, share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant and to be expensed over the applicable vesting period. We recognize this expense on a straight-line basis over the options’ expected terms. We issue stock options that vest over a specified period (time-based vesting) and stock options that vest when the price of the Company’s common stock reaches a certain price (market-based vesting).  We also issue restricted stock.

 

We granted options to purchase 65,000 and 68,600 shares of our common stock in the first nine months of 2016 and 2015, respectively. We recorded stock-based compensation expense of $600,000 and $743,000 during the nine-month periods ended September 30, 2016 and 2015, respectively, in connection with the option grants.  In February 2013, we granted 16,000 shares of restricted stock. We recorded stock-based compensation expense of $4,000 and $34,000 during the nine–month periods ended September 30, 2016 and 2015, respectively, in connection with the restricted stock grants. Grants of restricted stock are valued using the closing market price of our common stock on the date of grant. 

 

We estimate the grant date fair value of time-based stock option awards using the Black-Scholes option valuation model, which requires assumptions involving an estimate of the fair value of the underlying common stock on the date of grant, the expected term of the options, volatility, discount rate and dividend yield. Separate values were determined for options having exercise prices ranging from $5.18 to $31.33.

 

Prior to July 1, 2016, we calculated volatility using the daily volatilities of our common stock since our Initial Public Offering (“IPO”), while the discount rate was estimated using the interest rate for a treasury note with the same contractual term as the options granted. Dividend yield is estimated at our current dividend rate, with adjustments for any known future changes in the rate.

 

Effective July 1, 2016, we calculated expected option terms based on the “simplified” method for “plain vanilla” options, due to the Company’s limited exercise information. The “simplified method” calculates the expected term as the average of the vesting term and the original contractual term of the options. Such expected option terms were used to estimate volatility and the discount rate. 

 

We have engaged a valuation specialist to estimate the grant date fair value of market-based stock option awards.  Separate values were determined for options having exercises prices ranging from $25.24 to $31.125. The specialist utilizes a Monte Carlo valuation method to estimate the grant date fair value of the options granted in order to simulate a range of our possible future stock prices.  Significant assumptions to the Monte Carlo method include the expected life of the option, volatility and dividend yield.  The expected life of the option is based on the average of the service period and the contractual term of the option, using the “simplified” method for “plain vanilla” options.  Volatility is calculated based on a mix of historical and implied volatility during the expected life of the options.  Historical volatility is considered since our IPO and implied volatility is based on the publicly traded options of a three company peer group within the paper industry.  Dividend yield is estimated based on our average historical dividend yield and our current dividend yield as of the grant date.  The Monte Carlo analysis is performed under a risk-neutral premise, under which price drift is modeled using treasury-note yields matching the expected life of the options.

 

Under U.S. GAAP, we expense the compensation cost related to the marked-based stock option awards on a straight-line basis over the derived service periods of the options as calculated under the Monte Carlo valuation method.  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.  Additionally, if the service period is met but the share price target required for the options to become exercisable is never achieved, no compensation cost may be reversed.  As such, we may recognize expense for options that never become exercisable. 

 

In addition, we are required to develop an estimate of the number of share-based awards that will be forfeited due to employee turnover. The guidance on stock compensation requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates in order to derive our best estimate of awards ultimately expected to vest. We estimate forfeitures based on historical experience related to our own stock-based awards granted. We anticipate that these estimates will be revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

Intangible Assets and Goodwill. We allocate the cost of business acquisitions to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition (commonly referred to as the purchase price allocation). As part of the purchase price allocations for our business acquisitions, identifiable intangible assets are recognized as assets apart from goodwill if they arise from contractual or other legal rights, or if they are capable of being separated or divided from the acquired business and sold, transferred, licensed, rented or exchanged. 

 

 

 
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We have engaged a valuation specialist to estimate the fair value of our purchase price and the related intangible assets acquired.

In June 2014, we acquired certain assets and the U.S. business of Fabrica.  Due to these transactions, we separately recognized the fair values of a combined Supply and Lease Agreement, trademarks, a non-compete agreement and customer relationships. The fair value of these assets was determined using an income approach, as follows: Supply and Lease Agreement - discounted cash flows method, trademarks — “relief from royalty” method, non-compete agreement - “with and without” method, and customer relationships - excess earnings method.  An income approach requires estimates of future income.  Under the discounted cash flow method, we utilized assumptions related to the term of the agreements, the net benefit from the agreements and any changes in that benefit over the term of the agreement, future tax rates and discount rates.  Under the relief from royalty method, we estimated the useful lives of the trademarks, future revenues associated with the trademarks, a royalty rate and a discount rate.  The “with and without” method requires assumptions related to the probability of competition in the absence of the non-compete agreement, the loss of future revenues due to competition and discount rates.  Under the excess earnings method, we must estimate future revenues, including growth and attrition rates, income tax rates, a rate of return on assets, and discount rates.  Future revenues and estimated benefits from the agreements are based on management’s knowledge of the industry, customers, operations and the agreements.  Tax rates are based on current effective tax rates. The royalty rate is based on analysis of current royalty rates for corporate and product trademarks for similar products and evaluation of factors such as alternative trademarks available, legal defensibility, remaining useful life, licensing power, net revenue margin, market share, barriers to entry, capital requirements and customers’ bargaining power.  The discount rate used to determine the present value of future cash flows was based on the weighted average cost of capital method.

 

The value assigned to goodwill equals the amount of the purchase price of the business acquired in excess of the sum of the amounts assigned to identifiable acquired assets, both tangible and intangible, less liabilities assumed. At September 30, 2016, we had goodwill of $7.6 million and identifiable intangible assets, net of accumulated amortization, of $14.7 million.

 

Intangible assets are amortized over their respective estimated useful lives ranging from two to twenty years. The useful life of an intangible asset is the period over which the asset is expected to contribute directly or indirectly to our future cash flows rather than the period of time that it would take us to internally develop an intangible asset that would provide similar benefits. The estimate of the useful lives of our intangible asset is based on an analysis of all pertinent factors, in particular:

 

the expected use of the asset by the entity;

the expected useful life of another asset or group of assets to which the useful life of the intangible asset may relate;

any legal, regulatory or contractual provisions that may limit the useful life;

any legal, regulatory, or contractual provisions that enable renewal or extension of the asset’s legal or contractual life without substantial cost (provided there is evidence to support renewal or extension and renewal or extension can be accomplished without material modifications of the existing terms and conditions);

the effects of obsolescence, demand, competition and other economic factors (such as the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels); and

the level of regular maintenance expenditures (but not enhancements) required to obtain the expected future cash flows from the asset (for example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a limited useful life).

 

If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an intangible asset, the useful life of the asset is considered to be indefinite. The term indefinite does not mean infinite. An intangible asset with a finite useful life is amortized over that useful life; an intangible asset with an indefinite useful life is not amortized. We have no intangible assets with indefinite useful lives. Under U.S. GAAP, goodwill is not amortized.

 

Impairment of Goodwill and Other Long-Lived Assets. We review long-lived assets such as property, plant and equipment, intangible assets and goodwill for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also review goodwill annually.  U.S. GAAP requires that goodwill be tested, at a minimum, annually for each reporting unit. The first step in testing goodwill to assess qualitative factors to determine whether it is more likely than not that goodwill is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test.  If the first step indicates a quantitative test must be performed, the second step is to identify any potential impairment by comparing the carrying value of the reporting unit to its fair value. If a potential impairment is identified, the third step is to measure the impairment loss by comparing the implied fair value of goodwill with the carrying value of goodwill of the reporting unit. Alternatively, the Company may bypass the qualitative assessment in any period and proceed directly to performing the second step.

 

The Company performed its initial goodwill impairment test on October 1, 2015 by performing the first step, a qualitative impairment test, to determine whether it was more likely than not that goodwill was impaired.

 

 

 
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Goodwill is tested at a level of reporting referred to as the “reporting unit”. The Company has two reporting units, which are defined as the “at home” business and the “away from home” business. Based on this qualitative test, we determined it was more likely than not that the fair value of the Company’s reporting units were greater than their carrying amounts; as such, we determined that performing the second and third steps of the impairment test were not necessary and that goodwill was not impaired. In performing this qualitative assessment, we considered factors including, but not limited to, the following:

 

Macroeconomic conditions, including general economic conditions, limitations on accessing capital, and other developments in equity and credit markets;

Industry and market considerations, including any deterioration in the environment in which we operate, an increased competitive environment, a decline in market-dependent multiples or metrics, a change in the market for our products or services, and regulatory or political developments;

Cost factors such as increases in raw materials, labor, exchange rates or other costs that have a negative effect on earnings and cash flows;

Overall financial performance, including negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods;

Other relevant entity-specific events, such as changes in management, key personnel, strategy, customers, or litigation; and

Whether a sustained, material decrease in share price had occurred.

 

Subsequent to October 1, 2015 we did not note any additional qualitative factors that would indicate that the Company’s goodwill was impaired.

 

New Accounting Pronouncements

 

Refer to the discussion of recently adopted/issued accounting pronouncements under Part I, Notes to Unaudited Interim Financial Statements Note 15 — New and Recently Adopted Accounting Pronouncements.

 

Non-GAAP Discussion

 

In addition to our GAAP results, we also consider non-GAAP measures of our performance for a number of purposes.  The two non-GAAP financial measures used within this report are: (1) EBITDA and (2) Adjusted EBITDA.

 

We use EBITDA and Adjusted EBITDA as a supplemental measure of our performance that is not required by, or presented in accordance with GAAP. EBITDA and Adjusted EBITDA should not be considered as an alternative to net income, operating income or any other performance measure derived in accordance with GAAP, or as an alternative to cash flows from operating activities as a measure of our liquidity.

 

EBITDA represents net income before net interest expense, income tax expense, depreciation and amortization. Amortization of deferred debt issuance costs is included in net interest expense.  Adjusted EBITDA represents EBITDA before non-cash stock compensation expense.  We believe EBITDA and Adjusted EBITDA facilitate operating performance comparisons from period to period and company to company by eliminating potential differences caused by variations in capital structures (affecting relative interest expense), tax positions (such as the impact on periods or companies of changes in effective tax rates or net operating losses), the age and book depreciation of facilities and equipment (affecting relative depreciation expense), and non-cash compensation and valuation (affecting stock compensation expense).

  

EBITDA and Adjusted EBITDA have limitations as an analytical tool, and you should not consider them in isolation, or as a substitute for any of our results as reported under GAAP.  Some of these limitations are:

 

they do not reflect our cash expenditures for capital assets;

they do not reflect changes in, or cash requirements for, our working capital requirements;

they do not reflect cash requirements for cash dividend payments;

they do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments on our indebtedness;

although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA and Adjusted EBITDA do not reflect cash requirements for such replacements; and

other companies, including other companies in our industry, may calculate these measures differently than we do, limiting their usefulness as a comparative measure.

 

Because of these limitations, EBITDA and Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business or to reduce our indebtedness.  We compensate for these limitations by relying primarily on our GAAP results and using EBITDA and Adjusted EBITDA on a supplemental basis.

 

 

 
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The following table reconciles EBITDA and Adjusted EBITDA to net income for the three months ended September 30, 2016 and 2015:

  

   

Three Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands, except % of net sales)

 
                 
Net income   $ 2,213     $ 4,742  

Plus: Interest expense, net

    639       11  

Plus: Income tax expense

    735       2,448  

Plus: Depreciation

    2,909       2,555  

Plus: Intangibles amortization

    233       376  
EBITDA   $ 6,729     $ 10,132  

% of net sales

    17.0 %     21.6 %
                 

Plus: Stock compensation expense

    69       87  
Adjusted EBITDA   $ 6,798     $ 10,219  

% of net sales

    17.2 %     21.8 %

 

Adjusted EBITDA decreased $3.4 million, or 33.4%, to $6.8 million in the quarter ended September 30, 2016, compared to $10.2 million in the same period in 2015.  Adjusted EBITDA as a percent of net sales decreased to 17.2% in the third quarter of 2016 from 21.8% in the third quarter of 2015.  EBITDA decreased $3.4 million, or 33.6%, to $6.7 million in the quarter ended September 30, 2016, compared to $10.1 million in the same period in 2015.  EBITDA as a percent of net sales decreased to 17.0% in the third quarter of 2016 from 21.6% in the third quarter of 2015.  The foregoing factors discussed in the net sales, cost of sales and selling, general and administrative expenses sections are the reasons for the decrease. 

 

 The following table reconciles EBITDA and Adjusted EBITDA to net income for the nine months ended September 30, 2016 and 2015:

  

   

Nine Months Ended September 30,

 
   

2016

   

2015

 
   

(in thousands, except % of net sales)

 
                 
Net income   $ 10,190     $ 9,856  

Plus: Interest expense, net

    1,187       289  

Plus: Income tax expense

    4,850       4,408  

Plus: Depreciation

    8,641       6,976  

Plus: Intangibles amortization

    986       1,130  
EBITDA   $ 25,854     $ 22,659  

% of net sales

    20.4 %     17.9 %
                 

Plus: Stock compensation expense

    604       777  
Adjusted EBITDA   $ 26,458     $ 23,436  

% of net sales

    20.9 %     18.5 %

 

Adjusted EBITDA increased $3.0 million, or 13%, to $26.5 million in the nine-month period ended September 30, 2016, compared to $23.4 million in the same period in 2015. Adjusted EBITDA as a percent of net sales increased to 20.9% in the 2016 period from 18.5% in the same period of 2015.  EBITDA increased $3.2 million, or 14%, to $25.9 million in the nine-month period ended September 30, 2016, compared to $22.7 million in the same period in 2015.  EBITDA as a percent of net sales increased to 20.4% in the 2016 period from 17.9% in the same period of 2015.  The foregoing factors discussed in the net sales, cost of sales and selling, general and administrative expenses sections are the reasons for the increase.

  

ITEM 3.  Quantitative and Qualitative Disclosures about Market Risk  

 

There has been no material change in the information provided in response to Item 7A of the Company’s Form 10-K for the year ended December 31, 2015.

 

 

 
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ITEM 4. Controls and Procedures

 

Our management, under the supervision and with the participation of our chief executive and interim principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended), as of the end of the period covered by this Quarterly Report on Form 10-Q.  Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.  Based on such evaluation, our chief executive and interim principal financial officer has concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of September 30, 2016.

 

There were no significant changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during the quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

PART II.  OTHER INFORMATION

 

ITEM 1.  Legal Proceedings

 

From time to time, we may become party to various legal proceedings arising in the ordinary course of business. There can be no assurance that we will prevail in any such litigation. 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. 

 

ITEM 1A. Risk Factors

 

We operate in a changing environment that involves numerous known and unknown risks and uncertainties that could materially affect our operations.   Factors that could materially affect our actual results, levels of activity, performance or achievements include, but are not limited to, those detailed below, those under the caption “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, as filed with the SEC on March 7, 2016, and those in our subsequent filings with the SEC. Such risks, uncertainties and other factors may cause our actual results, performances and achievements to be materially different from those expressed or implied by our forward-looking statements.  If any of these risks or events occur, our business, financial condition or results of operations may be adversely affected.

 

ITEM 2.  Unregistered Sales of Equity Securities and Use of Proceeds

 

(a) Unregistered Sales of Equity Securities

 

None.

 

(b) Initial Public Offering and Use of Proceeds from the Sale of Registered Securities

 

None.

 

(c) Repurchases of Equity Securities

 

We do not have any programs to repurchase shares of our common stock and no such repurchases were made during the three months ended September 30, 2016.

 

ITEM 3.  Defaults Upon Senior Securities

 

None.

 

ITEM 4.  Mine Safety Disclosures

 

Not applicable.

 

ITEM 5.  Other Information

 

None.

 

ITEM 6.  Exhibits

 

See the Exhibit Index following the signature page to this Form 10-Q, which Exhibit Index is hereby incorporated by reference herein.

 

 
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Exhibit Index

   

Exhibit

 

Description

 

 

 

3.1

 

Amended and Restated Certificate of Incorporation of the Registrant dated May 17, 2013, incorporated by reference to Exhibit 3.1 to the Registrant’s Form 10-Q (SEC Accession No. 0001104659-13-058279) filed with the SEC on July 31, 2013.

 

 

 

3.2

 

Amended and Restated Bylaws of the Registrant amended May 17, 2013, incorporated by reference to Exhibit 3.2 to the Registrant’s Form 10-Q (SEC Accession No. 0001104659-13-058279) filed with the SEC on July 31, 2013.

 

 

 

31.1

 

Certification of Chief Executive Officer Pursuant to Section 302.

 

 

 

31.2

 

Certification of Chief Financial Officer Pursuant to Section 302.

 

 

 

32.1

 

Certification of Chief Executive Officer Pursuant to Section 906.

 

 

 

32.2

 

Certification of Chief Financial Officer Pursuant to Section 906.

 

 

 

101

 

The following financial information from Orchids Paper Products Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2016, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Statements of Income for the three and nine months ended September 30, 2016 and 2015, (ii) Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015, (iii) Consolidated Statements of Cash Flows for the three and nine months ended September, 2016 and 2015, and (iv) Notes to Consolidated Unaudited Interim Financial Statements.

  

 

 
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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

ORCHIDS PAPER PRODUCTS COMPANY

   

 

 

 

Date: November 2, 2016

By:

/s/ Rodney D. Gloss

   

Rodney D. Gloss

   

Principal Financial Officer

  

 

 

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