UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission File Number: 001-32563

 

 

ORCHIDS PAPER PRODUCTS COMPANY

 

 

4826 Hunt Street

Pryor, Oklahoma 74361

(Address of principal executive offices)

 

Registrant’s telephone number, including area code:

(918) 825-0616

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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):

 

 

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

 

The aggregate market value of the registrant’s common equity held by non-affiliates was $32.0 million as of June 30, 2007.

 

As of February 29, 2008, there were outstanding 6,328,986 shares of common stock, none of which are held in treasury.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Proxy Statement for the Registrant’s 2008 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

 

Throughout this Form 10-K report we “incorporate by reference” certain information from parts of other documents filed with the Securities and Exchange Commission (the “SEC”). The SEC allows us to disclose important information by referring to it in that manner. Please refer to such information.

 

In Item 1A., we discuss some of the business risks and factors that could cause actual results to differ materially from those stated in the forward-looking statements and from our historical results.

 

 

Overview of Our Business

 

We manufacture bulk tissue paper, known as parent rolls, and convert parent rolls into a full line of tissue products, including paper towels, bathroom tissue and paper napkins, for the consumer, or “at-home,” market. We market our products primarily to the private label segment of the consumer tissue market and have focused on serving the discount retail market. Our primary concentration within this market is the value retailers or dollar stores. We focus on the discount retail market because of the consistent order patterns and low number of stock keeping units or SKUs in this market. By value retailers, we mean retailers typically known as dollar stores, which offer a limited selection across a broad range of products at everyday low prices in a smaller store format. While we have customers located throughout the United States, we distribute most of our products within an approximate 900-mile radius of our Oklahoma facility. Our products are sold primarily under our customers’ private labels and, to a lesser extent, under our brand names such as Colortex^® and Velvet^®.

 

In 2007, we generated revenue of $74.6 million, of which 44% came from paper towels, 36% came from bathroom tissue, 8% came from paper napkins and 12% came from parent rolls. In 2007, 69% of our converted product revenue came from six value retailers: Dollar General, Family Dollar, Fred’s, Dollar Tree, Variety Wholesale and Big Lots and 12% came from Wal-Mart. The balance of 2007 converted product revenue came from other discount retailers, grocery stores, grocery wholesalers and cooperatives, and convenience stores.

 

We manufacture parent rolls in our paper mill located in Pryor, Oklahoma. Our facility manufactures parent rolls from recycled waste paper using four paper machines. Parent rolls are converted into finished tissue products at our converting facility, which contains ten lines of converting equipment and is located adjacent to our paper mill.

 

In June 2006, we started up a new paper machine with a rated capacity of 33,000 tons per year. Our total papermaking capacity from our new machine and the three older machines is approximately 54,000 tons per year. Prior to June 2006, we made open market purchases of parent rolls to supply our converting facility. Soon after start-up, we were able to eliminate open market purchases of parent rolls, except for limited special purpose applications. The additional paper making capacity has exceeded the current demands of our converting operation and, as a result, we sold 10,277 tons of parent rolls on the open market during 2007 and 1,191 tons in the last four months of 2006.

 

History

 

We were formed in April 1998 to acquire our present facilities located in Oklahoma out of a predecessor company’s bankruptcy and subsequently changed our name to Orchids Paper Products Company.

 

In March 2004, Orchids Acquisition Group, Inc. acquired us for a price of $21.6 million. Orchids Acquisition Group, Inc. was formed exclusively for the purpose of acquiring all of the outstanding shares of Orchids Paper Products Company, and was subsequently merged into us.

 

In July 2005, we completed our initial public offering of 2,156,250 shares of common stock. Following the offering, 4,156,250 shares of common stock were outstanding. In July 2006, we effected a 3-for-2 stock split resulting in outstanding shares of 6,234,346. The results of operations presented herein for all periods prior to our acquisition by Orchids Acquisition Group, Inc. in March 2004 are referred to as the results of operations of the “predecessor.” The results of operations presented herein for all periods subsequent to the acquisition are referred to as the results of operations of the “successor.”

Our Competitive Strengths

 

Focus on supplying value retailers.  Since 1995, when our predecessor company developed a new business plan, we have focused on supplying value retailers with private label tissue products. We believe we were among the first manufacturers to adopt this strategic focus. As a result of our long-term commitment to these customers, we believe we have developed a strong position as a reliable and responsive supplier to value retailers and built our competitive position in this market segment.

 

Proximity to key customers.  We believe we are well situated to serve our existing customer base, as well as many prospective customers. We are one of the few paper mills located in the south central United States. In addition, Pryor, Oklahoma is situated in close proximity to three major interstate highways and is close to regional transportation hubs for several of the nation’s largest trucking companies. As a result, many of the major population centers and our customers’ distribution centers are within our cost-effective shipping area.

 

Experienced management team and trained workforce.  Our senior management team of Robert Snyder and Keith Schroeder has a combined 52 years of experience in the paper business. The average tenure of our hourly workers at the paper mill is eleven years and the average tenure of our hourly workers at the converting facility is seven years. We believe that this depth of experience creates operational efficiencies and better enables us to anticipate and plan for changes in our industry.

 

Low cost tissue manufacturers.  Based on a number of critical cost components, we believe we are one of the lowest cost tissue producers in our market. We have an advantageous local employment market and relatively low wage rates. In addition, we qualify for special tax incentives under the Internal Revenue Code as a result of our location on former Indian land in Oklahoma, which further reduces our effective cost of labor and increases our rate of depreciation for tax purposes on new capital expenditures. In December 2006, this special tax incentive was extended through 2007. Whether this incentive will once again be extended is uncertain at this point in time. We are located in an industrial park that operates an onsite water treatment facility that offers water at reasonable rates. We also have low property tax rates and access to electricity at relatively low and stable rates.

 

Our Strategy

 

Our goal is to be recognized as the supplier of choice of private label tissue products for the discount retail market, especially value retailers, within our geographic area and to increase our presence in the grocery store market. While the value retail channel is extremely competitive and price sensitive and several of our competitors are located in close proximity to our facility, we have targeted the value retail channel of the consumer market because it is a growing retail channel and follows a basic marketing strategy of stocking a low number of high turnover SKUs. The combination of a low number of SKUs and consistent product movement enables us to operate our facilities at a relatively low cost. Based on this target market, we have sought to establish a low-cost manufacturing platform and programs and practices necessary to provide outstanding customer service to our value retail customers. We believe significant opportunities exist to continue to increase our revenue and profitability by:

 

 

Increasing the efficiency of our operating assets.  During 2006, we completed the installation and start-up of our new paper machine with a rated production capacity of 33,000 tons per year. The start-up of the new machine went according to plan during 2006. The new paper machine produced approximately 29,000 tons in 2007 and we expect to further increase production in 2008. This facility enabled us to essentially cease the purchase of parent rolls on the open market, which were previously required to support our converting operations and to sell 10,277 tons of parent rolls on the open market in 2007 and 1,191 tons in 2006. We purchased 1,675, 6,970, and 12,153 tons of parent rolls on the open market in 2007, 2006 and 2005, respectively, at an average cost of $1,162, $1,062 and $1,024 per ton, respectively. We anticipate having parent roll capacity that exceeds our internal converting needs during 2008. In 2007, we added depth to our operating team particularly in the areas of engineering and reliability maintenance. We believe this additional depth will help to further increase the efficiency of our paper making and

converting operations. In addition, we initiated a $4.75 million automation project in our converting operation which will lower our operating costs by replacing manual operations with automated processes. Following the completion of the project in the fourth quarter of 2008, we expect annualized net cash savings to approximate $2 million.

 

Leveraging Our Existing Customer Relationships in the Value Retail Channel.  The value retail channel has experienced growth over the past several years and we believe it continues to offer an attractive opportunity in the private label tissue market. Overall, the value retail channel is projected to continue growing.

 

We have developed key customers in the value retail channel by capitalizing on our full line of products, focusing on value retailers and improving our low-cost manufacturing capabilities. As a result, we believe we are among the suppliers of choice for retailers who seek value tissue products. With the lower costs achieved through the addition of the new paper machine, we believe we have opportunities to increase sales to our existing customers by expanding the number of distribution centers that we supply and expanding our product offering at distribution centers where we do not currently supply the complete private label line. The ability to produce all of our own paper at lower costs allows us to compete more effectively to supply these distribution centers. We also have opportunities to serve new distribution centers that may be opened by our customers in our cost-effective shipping area.

 

Selectively Expanding Our Customer Base in Other Retail Channels.  In addition to the preceding growth opportunities identified with several of our key customers, we believe we have growth opportunities with certain discount retailers, grocery stores, grocery wholesalers and cooperatives, and various other merchandisers. We intend to penetrate these other important retail channels by replicating the model we used to successfully establish our value retail business. This model is based on customers that require a limited number of SKUs and sell high volumes of those products.

 

Competitive Conditions

 

We believe the principal competitive factors in our market segments are price and service, and that our competitive strengths with respect to other private label manufacturers include long-standing relationships with value retailers, a full line of products and flexible converting capabilities, which enables us to produce tissue products in a variety of sizes, packs and weights. This flexibility allows us to meet the particular demands of individual retailers.

 

Competition in the value-end of the market is significantly affected by geographic location, as freight costs represent a material portion of end product costs. We believe it is generally economically feasible to ship within approximately a 900-mile radius of the production site. In Oklahoma and the immediately surrounding area, we believe that Georgia-Pacific’s Muskogee, Oklahoma plant and Cascades’ Memphis, Tennessee plant are the only competitors’ plants in this region. However, we face greater competition in the Southeast and Midwest regions of the U.S. Georgia-Pacific has additional plants in Georgia and Wisconsin and Cascades has plants in Pennsylvania and Wisconsin. We also face competition from other suppliers who have facilities in the Southwest, upper Midwest and Southeast regions of the United States.

 

We believe the number of competitors in private label segments will not significantly increase in the near future because of the large capital expenditures required to establish a paper mill and difficulties in obtaining environmental and local permits for tissue manufacturing facilities.

 

Product Overview

 

We offer our customers an array of private label products, including bathroom tissue, paper towels and paper napkins. In 2007, 50% of our finished case shipments were paper towels, 41% were bathroom tissue and 9% were paper napkins. Of our converted products sold in 2007, 82% were packaged as private label products in accordance with our customers’ specifications. The remaining 18% were packaged under our brands Velvet^®, Colortex^®, Ultra Valu^®, Dri-Mop^®, Big Mopper ^®, Soft & Fluffy^® and Tackle ^®. We do not actively promote our brand names and do not believe our brand names have significant market recognition. Our branded products are primarily sold to smaller customers, who use them as their in-store labels.

Customers

 

Our customers include discount retailers, primarily value retailers or dollar stores, grocery stores, grocery wholesalers and cooperatives, and convenience stores. Our recent growth has come from serving customers in the value retail channel. We were among the first to focus on serving this retail channel and we have benefited from their increased emphasis on consumables, like tissue products, as part of their merchandising strategies. By seeking to provide consistently low prices, superior customer service, and improved product quality, we believe we have differentiated ourselves from our competitors and generated momentum with value retailers. In 2007, approximately 69% of our converted product revenue was derived from sales to the value retail channel.

 

Our ability to increase revenue depends significantly upon our ability to increase business with other discount retailers, increase business in the grocery chain market, our ability to take market share from our competitors and the growth of our largest customers. We are attempting to diversify our customers and reduce customer concentration by implementing private label programs with new discount retail customers and with several regional supermarket chains, but it is likely our business will remain concentrated among value retailers for the foreseeable future.

 

We service the value retail channel primarily by supplying distribution centers within our cost-effective shipping area. Freight is a significant cost component which limits the competitive geography of a given manufacturing facility. We consider our current cost-effective shipping area to be within an approximate 900-mile radius of our facility. We supply private label products to over half of the value retail distribution centers located within our cost-effective shipping area.

 

Our largest retail customers are Dollar General, Family Dollar and Wal-Mart, representing 64% of our converted product sales in 2007.

 

The following provides additional details regarding our relationships with our largest customers.

 

Dollar General.  Dollar General is our largest customer, accounting for approximately 31% of our converted product sales in 2007. With annual revenue of $9.2 billion and more than 8,000 stores, Dollar General is the largest value retailer. We currently supply substantially all of the value private label tissue products for three of Dollar General’s nine distribution centers. We believe we have a good relationship with Dollar General.

 

Family Dollar.  Family Dollar is our second largest customer, accounting for approximately 21% of our converted product sales in 2007. Family Dollar has become one of the leading value retailers in the industry with more than 6,400 stores in 44 states. Family Dollar currently has nine distribution centers. We currently supply substantially all of the value private label tissue products to three of the distribution centers and supply approximately half of the value private label tissue products to two other distribution centers.

 

Wal-Mart.  Wal-Mart is our third largest customer, accounting for approximately 12% of our converted product sales in 2007. Shipments to Wal-Mart commenced in September 2006. We currently serve 19 distribution centers with bath tissue and, to a lesser extent, paper towels. Wal-Mart is the largest discount retailer in the United States.

 

Sales and Marketing Team

 

We have attracted and retained an experienced sales staff and have established a network of independent brokers. Our sales staff and broker network are instrumental in establishing and maintaining strong relationships with our customers.

 

The sales staff directly services four customers representing approximately 33% of our sales in 2007. We also use a network of approximately 40 brokers. Our management team recognizes that these brokers have relationships with many of our customers and we work with these brokers in an effort to increase our business with these accounts. Our sales and marketing organization seeks to partner with our brokers to leverage these relationships. With each of our key customers, however, our senior management team participates with the independent brokers in all critical customer meetings to establish direct customer relationships.

A majority of our brokers provide marketing support to their retail accounts which includes shelf placement of products and in-store merchandising activities to support our product distribution. We generally pay our brokers commissions ranging from 1% to 3% of revenue. Sales through our largest volume broker accounted for nearly one-third of our converted product revenue for 2007. Total commissions paid in the twelve months ended December 31, 2007 and 2006, were $959,000 and $840,000, respectively.

 

Manufacturing

 

We own and operate a paper mill and converting facility at our headquarters in Pryor, Oklahoma. Our two paper mill facilities, which total 162,000 square feet, produce parent rolls that are then converted into tissue products at our adjacent converting facility or are sold to other converters. The paper mill facilities include four paper machines that produce paper made entirely from preconsumer solid bleached sulfate paper, or “SBS paper.”

 

The mill operates 24 hours a day, 362 days a year, with a three-day annual planned maintenance shutdown. The following table sets forth our volume of parent rolls manufactured, purchased and converted for each of the past five years:

 

 

In order to expand our capacity and eliminate our need to purchase third-party parent rolls to meet the requirements of our converting plant, in 2006 we constructed and installed a new paper machine in a new building adjacent to our existing mill. Our new paper machine and the older machines have the capacity to produce approximately 54,000 tons of paper per year or an increase of approximately 100% over the amount produced prior to adding the new machine. This additional capacity allowed us to eliminate purchases of recycled parent rolls from third parties beginning in the third quarter of 2006, and to produce and sell parent rolls on the open market. The mill operated at less than rated capacity during 2007 due to the ramp-up curve associated with the start-up of our new paper machine and the decision not to operate one of the older machines during the first half of 2007.

 

We convert parent rolls into finished tissue products at our converting facility. The converting process, which varies slightly by product category, generally includes embossing, laminating, and perforating or cutting the parent rolls as they are unrolled; pressing two or more plies together in the case of multiple-ply products; printing designs for certain products and cutting into rolls or stacks; wrapping in polyethylene film; and packing in corrugated boxes for shipment.

 

Our 300,000 square-foot converting facility has the capacity to produce approximately 7.7 million cases of retail tissue products a year. To meet our current demand of approximately 6.7 million cases a year, we operate the converting facility on a 24 hour a day, 362-day-a-year schedule. We designed the ten production lines in the plant to enhance capacity and maximize efficiency. Our converting operation utilizes relatively modern equipment and one of our towel lines, originally acquired under an operating lease in 2001, is high speed and offers four-color and process printing capabilities. One of the key advantages of our converting plant is its flexible manufacturing capabilities, which enables us to provide our customers with a variety of package sizes and format options and enables our customers to fit products into particular price categories. We believe our converting facility, together with our low direct labor costs and overhead, combine to produce relatively low overall operating costs. In addition, the previously discussed automation project in the converting facility will allow us to lower our labor costs by replacing manual operations with automated processes.

 

Distribution

 

Our products are delivered to our customers in truck-load quantities. Most of our customers arrange for transportation of our products to their distribution centers. We have established a drop-and-hook program where the customer returns its empty trailer to our warehouse and departs with a full, preloaded trailer. This provides a means

for several key customers to minimize freight costs. For our remaining customers, we arrange for third-party freight companies to deliver the products.

 

Raw Materials and Energy

 

The principal raw materials used to manufacture our parent rolls are recycled waste paper and water. Recycled waste paper accounts for 100% of the fiber requirement for our parent rolls. The de-inking process at the paper mill is currently configured to process a particular class of recycled waste paper known as SBS paper. Prior to 2008, we sourced the majority of our SBS paper from two paper brokers. On February 20, 2008, we signed an exclusive supply agreement with Dixie Pulp and Paper, Inc. to supply all of our waste paper needs. This agreement is effective beginning April 1, 2008 and carries a five-year term. We entered into the agreement to help ensure our long-term supply of quality waste paper. If we were unable to purchase a sufficient quantity of SBS paper or if prices materially increased, we could reconfigure the de-inking process to process other forms of waste paper or use an alternative type of waste paper with our existing de-inking process. Reconfiguring our de-inking plant would require additional capital expenditures, which could be substantial. Alternative types of waste paper could result in higher costs. We also seek to assure adequate supplies of SBS paper by maintaining approximately a three-week inventory.

 

Energy is a key cost factor. While we experienced significant increases in electricity rates during the second half of 2006, our electrical rates decreased somewhat during 2007. We source our electricity from the Grand River Dam Authority. As part of our new paper machine project, we installed a boiler to supply our own steam. Our natural gas is purchased through a broker. We do not have any fixed price contracts or hedges in place with natural gas suppliers. Our broker purchases natural gas using a combination of fixed price contracts, options, spot purchases and other means to reduce our risk.

 

Backlog

 

Our tissue products generally require short production times. Typically, we have a backlog of approximately two weeks of sales. As of December 31, 2007, our backlog of customer orders was 150,000 cases of finished converted products and 1,267 tons of parent rolls or approximately $3.0 million. As of December 31, 2006, our backlog was approximately $2.9 million.

 

Trademarks and Trade Names

 

Our tissue products are sold under various brand names, including Colortex^®, Velvet^®, Ultra Valu^®, Dri-Mop^®, Big Mopper^®, Soft & Fluffy^® and Tackle^®. We intend to renew our registered trademarks prior to expiration. We do not believe these trademarks are significant corporate assets. Our branded products are primarily sold to smaller customers, who use them as their in-store labels.

 

Employee and Labor Relations

 

As of December 31, 2007, we had approximately 345 full time employees of whom 293 were union hourly employees and 52 were non-union salaried employees. Of our employees, approximately 322 were engaged in manufacturing and production, 19 were engaged in sales, clerical and administration, and four were engaged in engineering. Our hourly employees are represented under collective bargaining agreements with the United Steel, Paper and Forestry, Rubber, Manufacturing, Energy, Allied Industrial & Service Workers International Union Local 5-930 and Local 5-1480 at the mill and converting facilities, respectively. The current contract with our hourly employees at the mill facility expires February 2, 2011, while the contract with our hourly employees at the converting facility expires June 23, 2010. We have not experienced a work stoppage or request for arbitration in the last ten years and no requests for arbitration, grievance proceedings, labor disputes, strikes or labor disturbances are currently pending or threatened against us. We believe we have good relations with our union employees at each of our facilities.

Environmental, Health and Safety Matters

 

Our operations are subject to various environmental, health and safety laws and regulations promulgated by federal, state and local governments. These laws and regulations impose stringent standards on us regarding, among other things, air emissions, water discharges, use and handling of hazardous materials, use, handling and disposal of waste, and remediation of environmental contamination. Since our products are made from SBS paper, we do not make extensive use of chemicals.

 

The U.S. Environmental Protection Agency (the “EPA”) requires that certain pulp and paper mills meet stringent air emissions and wastewater discharge standards for toxic and hazardous pollutants. These standards are commonly known as the “Cluster Rules.” Our operations are not subject to further control as a result of the current “Cluster Rules” and, therefore, we do not anticipate any need for related capital expenditures.

 

We believe our manufacturing facilities are in compliance in all material respects with all existing federal, state and local environmental regulations, but we cannot predict whether more stringent air, water and solid waste disposal requirements will be imposed by government authorities in the future. Pursuant to the requirements of applicable federal, state and local statutes and regulations, we believe that we possess, either directly or through the Oklahoma Ordinance Works Authority (“OOWA”) all of the environmental permits and approvals necessary for the operation of our facilities.

 

OOWA, the operator of the industrial park in which we operate, holds the waste water permit that covers our facility and controls, among other things, the level of biological oxygen demand (“BOD”) and total suspended solids (“TSS”) we are allowed to send to the OOWA following pre-treatment at our facility. The OOWA has reduced our BOD and TSS limits effective with a permit issued effective August 1, 2007. Under the terms of the permit, we are required to meet the lower limits by August 1, 2009. As a result, we will be required to expand our pre-treatment facility to meet the stricter standards. The expansion project is in the pre-engineering phase and is expected to cost approximately $3 million.

 

Executive Officers and Key Employees

 

Set forth below is the name, age as of February 29, 2008, position and a brief account of the business experience of each of our executive officers.

 

 

Robert A. Snyder, 59, Chief Executive Officer and President, Director

 

Mr. Snyder has been our Chief Executive Officer and President since August 2007. Prior to his current appointment, Mr. Snyder was General Manager of KTG USA, an integrated paper manufacturer and a subsidiary of Kruger, Inc. He was responsible for a premium grade tissue mill from October 2005 to July 2007 and a newsprint mill, timberlands and power company where he served as Vice-President and general manager from October 2002 to October 2005. Prior to his tenure at KTG USA, Snyder served in various capacities with Kruger, Inc., Great Northern Paper, Inc., Alliance Forest Products U.S. Corporation and Bear Island Paper Company, including as a mill manager for most of 2002, a general manager of a paper business unit from 1999 to 2002, a Vice-President and general manager from 1992 to 1999 and a production manager from 1985 to 1992. Mr. Snyder holds a BS degree in Paper Science and Engineering from the State University of New York at Syracuse University.

 

Keith R. Schroeder, 52, Chief Financial Officer

 

Mr. Schroeder has been our Chief Financial Officer since January 2002. Prior to joining us, he served as Corporate Finance Director for Kruger, Inc.’s tissue operations from October 2000 to December 2001 and as Vice President of Finance and Treasurer of Global Tissue from 1996 to October 2000. Global Tissue was acquired by Kruger, Inc. in 1999. Prior to joining Global Tissue, Mr. Schroeder held a number of finance and accounting positions with Cummins Engine Company and Atlas Van Lines. Mr. Schroeder is a certified public accountant and holds a BS degree in Business Administration with an accounting major from the University of Evansville.

Available Information

 

We file annual, quarterly and current reports and other information with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information that issuers (including Orchids Paper Products Company) file electronically with the SEC. The SEC’s internet site is www.sec.gov.

 

 

We operate in a changing environment that involves numerous known and unknown risks and uncertainties that could materially affect our operations. The risks, uncertainties and other factors set forth below may cause our actual results, performances or 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. We may amend or supplement the risk factors described below from time to time in other reports we file with the SEC in the future.

 

Risks Related To Our Business

 

We face intense competition and if we cannot successfully compete in the marketplace, our business, financial condition and operating results may be materially adversely affected.

 

The consumer market for private label tissue products is highly competitive. Many of our competitors have greater financial, managerial, sales and marketing and capital resources than we do, which may allow them to respond more quickly to new opportunities or changes in customer requirements. These competitors may also be larger in size or scope than us, which may allow them to achieve greater economies of scale or allow them to better withstand periods of declining prices and adverse operating conditions.

 

Our ability to compete successfully depends upon a variety of factors, including:

 

 

Our paper products are commodity products, and if we do not maintain competitive prices, we may lose significant market share. Our ability to keep our prices at competitive levels depends in large part on our ability to control our costs. In addition, consolidation among retailers in the value retail channel may put additional pressure on us to reduce our prices in order to maintain market share. If we are unable to effectively adjust our cost structure to address such increased competitive pressures, our sales level and profitability could be harmed and our operations could be materially adversely affected.

 

A substantial percentage of our converted product revenues are attributable to three large retail customers, which may decrease or cease purchases at any time.

 

Our largest customer, Dollar General, accounted for 31% of our converted product revenue in 2007. Family Dollar and Wal-Mart, accounted for approximately 21% and 12%, respectively of our converted product revenue in 2007. We currently supply substantially all of the value private label tissue products at three of Dollar General’s eight distribution centers, substantially all of the value private label tissue products at three of Family Dollar’s nine distribution centers and approximately half of the value private label tissue products at two other Family Dollar distribution centers. We served 19 of Wal-Mart’s distribution centers with bath tissue and, to a lesser extent, paper towels during 2007. We expect that sales to a limited number of customers will continue to account for a substantial portion of our revenues for the foreseeable future. Sales to these customers are made pursuant to purchase orders and not supply agreements. We may not be able to keep our key customers or these customers may cancel purchase

orders or reschedule or decrease their level of purchases from us. Any substantial decrease or delay in sales to one or more of our key customers would harm our sales and financial results. In particular, the loss of sales to one or more distribution centers would result in a sudden and significant decrease in sales. If sales to current key customers cease or are reduced, we may not obtain sufficient orders from other customers necessary to offset any such losses or reductions.

 

We have significant indebtedness which limits our free cash flow and subjects us to restrictive covenants relating to the operation of our business.

 

At December 31, 2007, we had $25.6 million of indebtedness. In 2008, we anticipate making principal payments of approximately $2.4 million and interest payments of approximately $1.8 million. Operating with this amount of leverage requires us to direct a significant portion of our cash flow from operations to make payments on our debt, which reduces the funds otherwise available for operations, capital expenditures, future business opportunities and other purposes. It also limits our flexibility in planning for, or reacting to, changes in our business and our industry and impairs our ability to obtain additional financing.

 

The terms of our loan agreements require us to meet specified financial ratios and other financial and operating covenants which restrict our ability to incur additional debt or place liens on our assets, make capital expenditures, effect mergers or acquisitions, dispose of assets or pay dividends in certain circumstances. If we fail to meet those financial ratios and covenants and our lenders do not waive them, we will be required to pay fees and penalties and our lenders could also accelerate the maturity of our debt and proceed against any pledged collateral, which would force us to seek alternative financing. If this were to happen, we may be unable to obtain additional financing or it may not be available on terms acceptable to us.

 

The availability of and prices for energy will significantly impact our business.

 

All of the energy necessary to produce our paper products is purchased on the open market and, as a result, the price and other terms of those purchases are subject to change based on factors such as worldwide supply and demand and government regulation. We rely primarily on natural gas and electric energy. In particular, natural gas prices are highly volatile. Our consumption of both natural gas and electricity increased substantially following the start-up of our new paper machine in mid-2006. During the twelve months ending December 31, 2007, we consumed 515,000 MMBTU of natural gas at a total cost of $3.9 million and 59.5 million kilowatt hours of electricity at a total cost of $2.6 million. If our energy costs increase, our cost of sales will increase, and our operating results may be materially adversely affected. Furthermore, we may not be able to pass increased energy costs on to our customers if the market does not allow us to raise the prices of our finished products. If price adjustments significantly trail the increase in energy costs or if we cannot effectively hedge against price increases, our operating results may be materially adversely affected.

 

Our exposure to variable interest rates may affect our financial health.

 

Debt incurred under our existing revolving credit and term loan agreements accrues interest at a variable rate. During 2007, our weighted average bank debt interest rate decreased to 7.46% compared to a weighted average of 9.36% at year-end 2006. Any increase in the interest rates on our debt would result in a higher interest expense which would require us to dedicate more of our cash flow from operations to make payments on our debt and reduce funds available to us for our operations and future business opportunities which could have a material adverse effect on our results of operations. For more information on our liquidity, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

 

We exclusively use preconsumer solid bleached sulfate paper, or SBS paper, to produce parent rolls and any disruption in our supply or increase in the cost of preconsumer SBS paper could disrupt our production and harm our ability to produce tissue at competitive prices.

 

We do not produce any of the waste paper we use to produce our parent rolls. We depend heavily on access to sufficient, reasonably-priced quantities of waste paper to manufacture our tissue products. Our paper mill is configured to convert waste paper, specifically SBS paper, into paper pulp for use in our paper production lines. In

2007, we purchased approximately 60,600 tons of SBS paper at a total cost of $15.6 million compared to 41,500 tons of SBS paper at a total cost of $8.7 million in 2006. The additional waste paper requirements necessitated by the start-up of our new paper machine have resulted in additional demand on the SBS waste paper market and could have an effect on the market prices of this commodity. During 2007 we purchased all of our SBS paper from two paper brokers and, to a lesser extent, directly from a SBS paper converter. The brokers in turn source SBS paper from numerous producers of preconsumer SBS paper. In February 2008, we entered into an exclusive waste paper supply agreement with Dixie Pulp and Paper, Inc., effective April 1, 2008, to supply 100% of our waste paper supply.

 

Prices for SBS paper have fluctuated significantly in the past and will likely continue to fluctuate significantly in the future, principally due to market imbalances between supply and demand. In addition, the market price of SBS waste paper can also be influenced by market swings in the price of virgin pulp and other waste paper grades. If either the available supply of SBS paper diminishes or the demand for SBS paper increases, it could substantially increase the cost of SBS paper, require us to purchase alternate waste paper grades at increased costs, or cause a production slow-down or stoppage until we are able to identify new sources of SBS paper or reconfigure our de-inking facilities to process other available forms of waste paper or other sources of paper fiber. We could experience a material adverse effect on our business, financial condition and results of operations should the price or supply of SBS paper be disrupted.

 

We depend on our management team to operate the Company and execute our business plan.

 

We are highly dependent on the principal members of our management, in particular Robert Snyder, our President and Chief Executive Officer, and Keith Schroeder, our Chief Financial Officer. We have entered into employment agreements with Robert Snyder and Keith Schroeder that expire in 2012 and 2009, respectively. Mr. Snyder was recently appointed President and Chief Executive Officer following the retirement of Michael Sage in July 2007. While Mr. Snyder has extensive management experience in the paper industry, this is his first appointment as chief executive officer and he has no prior experience at the Company. If we are unable to retain Mr. Snyder and Mr. Schroeder or to attract and retain other qualified personnel, our business and our ability to compete could be significantly harmed.

 

Labor interruptions would adversely affect our business.

 

All of our hourly paid employees are represented by the United Steel, Paper and Forestry, Rubber, Manufacturing, Energy, Allied Industrial & Service Workers International Union. The collective bargaining agreement with Local 5-930, which represents the paper mill workers, will expire in February 2011, and the collective bargaining agreement with Local 5-1480, which represents the converting facility workers, will expire in June 2010. Negotiations of new collective bargaining agreements may result in significant increases in the cost of labor or could breakdown and result in a strike or other disruption of our operations. If any of the preceding were to occur, it could impair our ability to manufacture our products and result in increased costs and/or decreased operating results. In addition, some of our key customers and suppliers are also unionized. Disruption in their labor relations could also have an adverse effect on our business.

 

Our paper mill may experience shutdowns adversely affecting our financial position and results of operations.

 

We currently manufacture and process our paper at a single facility in Pryor, Oklahoma. Any natural disaster or other serious disruption to this facility due to tornado, fire or any other calamity could damage our capital equipment or supporting infrastructure and materially impair our ability to manufacture and process paper. Even a short-term disruption in our production output could damage relations with our customers, causing them to reduce or eliminate the amount of finished products they purchase from us. Any such disruption could result in lost revenues, increased costs and reduced profits.

 

Three of our four paper machines are approximately 50 years old. Unexpected production disruptions could cause us to shut down our paper mill. Those disruptions could occur due to any number of circumstances, including shortages of raw materials, disruptions in the availability of transportation, labor disputes and mechanical or process failures.

If our mill is shut down, it may experience a prolonged start up period, regardless of the reason for the shutdown. Those start up periods could range from several days to several months, depending on the reason for the shutdown and other factors. The shutdown of our mill for a substantial period of time for any reason could have a material adverse effect on our financial position and results of operations.

 

Our operations require substantial capital, and we may not have adequate capital resources to provide for all of our cash requirements.

 

Our operations require substantial capital. Expansion or replacement of existing facilities or equipment may require substantial capital expenditures. For example, under new environmental standards we are required to build a water treatment facility costing approximately $3 million to reduce biological oxygen demand and total suspended solids from our discharge water. In addition, we plan to install equipment that automates certain portions of our converting plant processes at a cost of $4.75 million in 2008. We may also need to acquire additional converting equipment to utilize our excess parent roll capacity and to supply new customers, which we currently estimate would cost $10 million to $15 million. If our capital resources are inadequate to provide for our operating needs, capital expenditures and other cash requirements, this shortfall could have a material adverse effect on our business and liquidity.

 

Our business is subject to extensive governmental regulations and any imposition of new regulations or failure to comply with existing regulations could involve significant additional expense.

 

Our operations are subject to various environmental, health and safety laws and regulations promulgated by federal, state and local governments. These laws and regulations impose stringent standards on us regarding, among other things, air emissions, water discharges, use and handling of hazardous materials, use, handling and disposal of waste, and remediation of environmental contamination. Any failure to comply with applicable environmental laws, regulations or permit requirements may result in civil or criminal fines or penalties or enforcement actions. These may include regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, installing pollution control equipment or remedial actions, any of which could involve significant expenditures. Future development of such laws and regulations may require capital expenditures to ensure compliance. We may discover currently unknown environmental problems or conditions in relation to our past or present operations, or we may face unforeseen environmental liabilities in the future. These conditions and liabilities may require site remediation or other costs to maintain compliance or correct violations of environmental laws and regulations; or result in governmental or private claims for damage to person, property or the environment, either of which could have a material adverse effect on our financial condition and results of operations. In addition, we may be subject to strict liability and, under specific circumstances, joint and several liability for the investigation and remediation of the contamination of soil, surface and ground water, including contamination caused by other parties, at properties that we own or operate and at properties where we or our predecessors arranged for the disposal of regulated materials.

 

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud and, as a result, our business could be harmed and current and potential stockholders could lose confidence in us, which could cause our stock price to fall.

 

We have recently completed an evaluation of our internal control systems to allow management to report on, and our independent auditors to attest to, our internal controls over financial reporting in compliance with the management assessment and auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002. In our report under Section 404 which is included in Item 9A. of this report, we have concluded that our internal control over financial reporting is effective.

 

A material weakness or deficiency in internal controls over financial reporting could materially impact our reported financial results and the market price of our stock could significantly decline. Additionally, adverse publicity related to the disclosure of a material weakness or deficiency in internal controls could have a negative impact on our reputation, business and stock price. Although the management’s assessment and auditor’s attestation may provide some level of comfort to the investing public, even the best designed and executed systems of internal controls can only provide reasonable assurance against misreported results and the prevention of fraud.

Risks Related To Our Common Stock

 

We do not pay cash dividends on our capital stock, and we do not anticipate paying any cash dividends in the future.

 

Since January 2003, we have not paid cash dividends on our capital stock and we do not anticipate paying any cash dividends in the foreseeable future. Instead, we intend to retain our future earnings to fund the development and growth of our business. In addition, the terms of our loan agreement prohibit us from declaring dividends without the prior consent of our lender.

 

Our certificate of incorporation and bylaws, and Delaware law contain provisions that could discourage a takeover.

 

Our certificate of incorporation and bylaws and Delaware law contain provisions that might enable our management to resist a takeover. These provisions may:

 

 

Our future operating results may be below securities analysts’ or investors’ expectations, which could cause our stock price to decline.

 

Our revenue and income potential depends on expanding our production capacity and finding buyers for our additional production, and we may be unable to generate significant revenues or grow at the rate expected by securities analysts or investors. In addition, our costs may be higher than we, securities analysts or investors expect. If we fail to generate sufficient revenues or our costs are higher than we expect, our results of operations will suffer, which in turn could cause our stock price to decline. Our results of operations will depend upon numerous factors, including:

 

 

Our operating results in any particular period may not be a reliable indication of our future performance. In some future quarters, our operating results may be below the expectations of securities analysts or investors. If this occurs, the price of our common stock will likely decline.

 

Our common stock has low average trading volume, and we expect that the price of our common stock could fluctuate substantially, possibly resulting in class action securities litigation.

 

Before our initial public offering on July 15, 2005, there was no public market for shares of our common stock. Since the 3-for-2 stock split effected in July 2006, the average daily trading volume of our common stock has been approximately 3,500 shares. The market price for our common stock is affected by a number of factors, including:

 

 

The stock prices of many companies in the paper products industry have experienced wide fluctuations that have often been unrelated to the operating performance of these companies. Because of the low trading volume, our stock price is subject to greater volatility. Following periods of volatility in the market price of a company’s securities, stockholders have often instituted class action securities litigation against those companies. Class action

securities litigation, if instituted against us, could result in substantial costs and a diversion of our management resources, which could significantly harm our business.

 

Our directors have limited personal liability and rights of indemnification from us for their actions as directors.

 

Our certificate of incorporation limits the liability of directors to the maximum extent permitted by Delaware law. Delaware law provides that directors of a corporation will not be personally liable for monetary damages for breach of their fiduciary duties as directors, except liability for:

 

 

This limitation of liability does not apply to liabilities arising under the federal securities laws and does not affect the availability of equitable remedies such as injunctive relief or rescission.

 

Our certificate of incorporation and bylaws provide that we will indemnify our directors and executive officers and other officers and employees and agents to the fullest extent permitted by law.

 

We entered into separate indemnification agreements with each of our directors and officers which are broader than the specific indemnification provision under Delaware law. Under these agreements, we are required to indemnify them against all expenses, judgments, fines, settlements and other amounts actually and reasonably incurred, in connection with any actual, or any threatened, proceeding if any of them may be made a party because he or she is or was one of our directors or officers.

 

If any litigation or proceeding were pursued against any of our directors, officers, employees or agents where indemnification is required or permitted, we could incur significant legal expenses and be responsible for any resulting settlement or judgment.

 

 

None.

 

 

We own a 36-acre property in Pryor, Oklahoma and conduct all of our business from that location. Parent roll production is housed in two facilities. The older facility comprises approximately 135,000 square feet and houses three paper machines and related processing equipment. The newer facility housing the new paper machine comprises approximately 27,000 square feet. Adjacent to our parent roll production facilities, we have a converting facility which has ten lines of converting equipment and comprises approximately 300,000 square feet.

 

 

We believe our facilities are well maintained and adequate to serve our present and near term operating requirements.

 

 

From time to time, we are involved in litigation relating to claims arising out of our operations in the normal course of business. As of the date of this report, we were not engaged in any legal proceedings which are expected, individually or in the aggregate, to have a material adverse effect on us.

 

No matters were submitted to a vote of stockholders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended December 31, 2007.

 

 

Market Information

 

Our common stock has been traded on the American Stock Exchange under the symbol “TIS” since July 15, 2005. The following table sets forth the high and low closing prices of our common stock for the periods indicated and reported by the American Stock Exchange. Prices have been adjusted for the 3-for-2 stock split that was effected in July 2006.

 

 

As of February 29, 2008, there were approximately 1,000 beneficial owners of our common stock. On February 29, 2008, the last reported sale price of our common stock on the American Stock Exchange was $7.71.

Performance Graph

 

The following graph compares the cumulative total stockholder return on our common stock since the first day of trading following our initial public offering on July 14, 2005, with the cumulative total return of the Standard & Poor’s Small Cap Price Index, the Standard & Poor’s Paper and Paper Products Index and our selected peer group comprised of Potlatch, Wausau Paper, and Cascades. These comparisons assume the investment of $100 on July 15, 2005, and the reinvestment of dividends.

 

These indices are included only for comparative purposes as required by the SEC and do not necessarily reflect management’s opinion that such indices are an appropriate measure of the relative performance of the common stock. They are not intended to forecast possible future performance of the common stock.

 

 

 

Common Stock Dilution

 

The Company has outstanding options to purchase shares of its common stock which, once fully vested, represent approximately 7% of the outstanding shares. As of December 31, 2007 the Company had options outstanding to purchase 460,000 shares of its common stock at an exercise price ranging from $5.33 to $9.23. The options expire on various dates from 2015 to 2018.

 

In addition, the Company has warrants outstanding to purchase 342,573 shares of its common stock, representing approximately 5% of the outstanding shares. The underwriters received 225,000 shares at an exercise price of $6.40 in connection with our initial public offering, which warrants expire on July 14, 2010. The remaining warrants were issued in connection with our 12% subordinated debentures and have an exercise price of $2.53. As of February 29, 2008 117,573 warrants are outstanding. While the debentures were retired in December 2008, the warrants remain outstanding until March 1, 2009.

Dividends

 

Since January 2003, we have not paid cash dividends on our capital stock. We anticipate that we will retain any earnings to support operations and to finance the growth and development of our business. Additionally, under our credit facilities, we are prohibited from declaring dividends without the prior consent of our lender. Therefore, we do not expect to pay cash dividends in the foreseeable future. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including future earnings, capital requirements, financial conditions, future prospects and other factors that the board of directors may deem relevant.

 

Recent Sales of Unregistered Securities

 

None.

 

Repurchase of Equity Securities

 

We do not have any programs to repurchase shares of our common stock, however, in connection with the exercise of stock options by our former president and chief executive officer, we purchased 51,198 shares of stock owned by Mr. Sage at the date of exercise. We paid Mr. Sage $405,000 or $7.91 per share, the market price on the date he exercised his option. No other repurchases were made during the quarter ended December 31, 2007.

 

 

The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” following this section and our financial statements and related notes included in Item 8 of this Form 10-K. The following tables set forth selected financial data as of and for the years ended December 31, 2007, 2006 and 2005, the period from March 1, 2004 through December 31, 2004, the period from January 1, 2004 through February 29, 2004, and the year ending December 31, 2003. The selected financial data as of and for the years ended December 31, 2007, 2006 and 2005, the period from March 1, 2004 through December 31, 2004, the period from January 1, 2004 through February 29, 2004, and as of and for the year ended December 31, 2003, were derived from our and the Predecessor’s audited financial statements. Orchids, as it existed prior to its acquisition by Orchids Acquisition Group, Inc., is referred to as “predecessor.” The consolidated financial information of Orchids and Orchids Acquisition Group, Inc. as it existed on and after March 1, 2004, is referred to as “successor.” Our audited financial statements as of December 31, 2007 and 2006, and for each of the

three years in the period ended December 31, 2007, are included below under Item 8 of this Form 10-K. The historical results are not necessarily indicative of the operating results to be expected in any future period.

 

 

 

 

 

 

You should read the following discussion of our financial condition and results of operations in conjunction with the audited financial statements and the notes to those statements included elsewhere in this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. You should specifically consider the various risk factors identified in this filing that could cause actual results to differ materially from those anticipated in these forward-looking statements.

Executive Overview

 

What were our key 2007 financial results?

 

 

What did we focus on in 2007?

 

Our focus in 2007 was on increasing efficiency and productivity of our operating assets and increasing sales of converted product. As a result, we produced more tons of parent rolls and converted products in 2007 than in any previous year. We benefited from previous years’ strategies to reduce reliance on open market purchases of parent rolls by installing and starting up our new paper machine. In addition, in May 2007 we began operating all of our older paper machines on a full-time basis to take advantage of a tight parent roll market and selling excess parent rolls on the open market at increasing selling prices. We are confident in our ability to sell converted products, so much of our focus has been on increasing throughput from the converting facility. Mr. Mike Sage, our former president and chief executive officer elected to retire July 15, 2007. Mr. Robert Snyder was appointed president and chief executive officer effective August 22, 2007. In late 2007, we began the process of increasing the depth and talent level of our operating management team to aid in our continued quest to improve the efficiencies of our operating assets.

 

Our second initiative was to continue to profitably grow the business. We were able to achieve significant growth in our converted product business during 2007. In addition, running all of our older machines on a full-time basis beginning in May 2007 allowed us to take advantage of higher parent roll sales prices. Our goal is to attain a level of converted product business that consumes our total paper-making capacity.

 

What challenges and opportunities did our business face in 2007?

 

We experienced significant cost pressures during the year, primarily in the cost of our waste paper. The price of waste paper increased approximately 23% in 2007 over the 2006 period.

 

What will we focus on in 2008?

 

In 2008, we will continue to pursue profitable growth of our converted product business by utilizing internally more of our paper-making capacity. We will pursue this strategy through a combination of increased sales to existing customers and sales to new customers in grocery and drug store retail channels. Any paper-making capacity that is not consumed by the converting business will be sold as parent rolls in the market.

 

Optimizing the operation of our new paper machine and other assets is another major focus for 2008. We expect the changes and additions to the operating management team that began in late 2007 to aid in our operations improvement efforts. Continuous improvement of our operations will be critical in helping combat cost pressures. We intend to improve the efficiency of our converting operations, thereby increasing sales opportunities and lowering production costs. We intend to further lower our labor costs in our converting facility through the automation of certain processes. In this project we will purchase and install case packers, conveyors and unitizing equipment at a cost of approximately $4.75 million. Installation of the equipment is expected to begin in the second quarter of 2008 and be finalized and fully operational by the fourth quarter of 2008.

Business Overview

 

We are a manufacturer and converter of tissue paper for the private label segment of the value retail consumer tissue market. We have focused our product design and manufacturing on the discount retail market, primarily the dollar stores, due to their consistent order patterns, limited number of stock keeping units, or SKUs, offered and the growth being experienced in this channel of the retail market. All of our revenue is derived pursuant to truck load purchase orders from our customers. We do not have supply contracts with any of our customers. Revenue is recognized when title passes to the customer. Because our product is a daily consumable item, the order stream from our customer base is fairly consistent with no significant seasonal fluctuations. Changes in the national economy, in general, do not materially affect the market for our products.

 

Our profitability depends on several key factors, including:

 

 

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

 

In June 2006, we began operating a new paper machine with a rated annual capacity of approximately 33,000 tons. The capacity of the new machine in addition to the capacity of our older paper machines increased our total production capacity to approximately 54,000 tons per year. As a result, beginning in the third quarter of 2006, we were able to eliminate the requirement to purchase recycled parent rolls on the open market and commenced the sale of parent rolls on the open market. Prior to the third quarter of 2006, we had purchased parent rolls on the open market since 1998 because our own parent roll production had not adequately supplied the requirements of our converting facility. We purchased approximately 1,675, 6,970 and 12,200 tons of paper on the open market in 2007, 2006 and 2005, respectively, to supplement our paper-making capacity. Beginning in the third quarter of 2006, essentially all of our third party purchases were of virgin pulp fiber required for a premium towel line we produce for one of our customers. Parent rolls are a commodity product and thus are subject to market price and availability. We experienced significantly higher parent roll prices beginning in early 2004, as well as limited availability, which negatively affected our profitability.

 

Comparative Years Ended December 31, 2007, 2006 and 2005

 

Net Sales

 

 

Net sales increased $14.5 million, or 24%, to $74.6 million for the year ended December 31, 2007, compared to $60.2 million for the year ended December 31, 2006. Net sales figures include gross selling price, including freight, less discounts and pricing allowances. The increase in net sales was attributable primarily to increased volumes of parent rolls sold to third parties and an 11% increase in net sales of converted products, resulting from both higher prices and increased shipment volumes. For the twelve months ended December 31, 2007, the volume of parent rolls sold to third parties increased by approximately 9,100 tons. The net sales prices per ton for converted product shipments for the twelve months ended December 31, 2007 increased 6% over the same period of 2006 while converted product shipments volumes increased 5% in the year over year comparison.

Net sales increased $2.5 million, or 4.3%, to $60.2 million for the year ended December 31, 2006, compared to $57.7 million for the year ended December 31, 2005. The increase in net sales experienced in 2006 was due primarily to higher sales of both converted products and parent rolls. For the twelve months ended December 31, 2006, net sales of converted products increased approximately 2.4% as compared to the same period in 2005, the result of higher selling prices and increased shipments. The increase in net selling prices is primarily due to sales price increases implemented in the first and second quarters of 2005. On a per ton basis, selling prices increased 1.4% in the twelve months ended December 31, 2006, compared to the same period in 2005. Tons of converted product shipped in the 2006 period increased approximately 1% compared to the 2005 period. In addition, we shipped approximately 1,200 tons of parent rolls to third parties in the 2006 period following the mid-year 2006 start-up of our new paper machine and we did not ship any parent rolls in the 2005 period.

 

Cost of Sales

 

 

Major components of cost of sales are the cost of internally produced paper, parent rolls purchased from third parties, raw materials, direct labor and benefits, freight on products shipped to customers, insurance, repairs and maintenance, energy, utilities and depreciation.

 

Cost of sales increased approximately $9.7 million, or 18%, to $63.7 million for the year ended December 31, 2007, compared to $54.0 million for the same period in 2006. Cost of sales as a percentage of net sales declined to 85.4% in the 2007 period compared with 89.7% in the 2006 period. Cost of sales as a percentage of net sales was favorably affected by the higher sales volume and prices discussed above as well as a lower overall cost of paper, excluding depreciation. Partly offsetting these factors was higher depreciation expense and higher converting labor costs. Depreciation for the year ended December 31, 2007 increased $747,000 to $3.0 million, primarily the result of recognizing a full year of depreciation on the $34.6 million paper machine project started-up in June 2006.

 

Cost of sales increased approximately $3.6 million, or 7%, to $54.0 million for the year ended December 31, 2006, compared to $50.4 million for the same period in 2005. As a percentage of net sales, cost of sales increased to 89.7% in the 2006 period compared to 87.3% in the 2005 period. Cost of sales as a percentage of net sales in the year ended December 31, 2006, was unfavorably affected by higher converting labor costs, depreciation, an unfavorable sales mix and higher costs of packaging materials, which were partially offset by lower overall paper costs. The unfavorable mix is the result of an increase in bathroom tissue shipments as compared to towel shipments. A change in the level of overall business with certain large customers is the primary reason for the mix swing. Depreciation for the year ended December 31, 2006 increased approximately $753,000 to $2.3 million as a result of the start-up of the $34.6 million paper machine project in June 2006.

 

The following chart depicts the major factors that influence our paper costs.

 

 

Our overall cost of paper was $753 per ton for the twelve months ended December 31, 2007, compared to $788 per ton in the same period of 2006. Reduced purchases of parent rolls on the open market, attributable to the successful start-up and ramp-up of our new paper machine in the second half of 2006, partially offset by higher costs of internally produced paper were the reasons for the decrease in overall cost per ton. For the year ended December 31, 2007, approximately 96% of the paper consumed in our converting operation was internally produced compared to 82% in the same period in 2006. The cost per ton of paper produced internally was $741 in 2007 compared to $730 in the same period of 2006. Higher waste paper costs were partially offset by lower per ton costs of fixed and semi-variable costs. Waste paper prices began to increase in the third and fourth quarters of 2006 and experienced a more rapid increase during the first and second quarters of 2007. Waste paper prices were generally level in the last half of 2007. Overall, the price paid for waste paper increased 23% in the 2007 period compared to the same period in 2006.

 

Our overall cost of paper was $788 per ton in the twelve months ended December 31, 2006, compared to $822 per ton in the year ended December 31, 2005. The reduction in our overall per ton cost of paper is due to an increase in the consumption of internally produced paper in the last half of 2006, following the start-up of our new paper machine. For the year ended December 31, 2006, approximately 82% of the paper consumed in our converting operation was internally produced compared to 68% for the same period in 2005. Beginning in the third quarter of 2006, parent roll production from our new paper machine eliminated the need to purchase recycled parent rolls from third parties and allowed us to sell approximately 1,200 tons of parent rolls during the last four months of 2006. For the twelve months ended December 31, 2006, our internal cost of paper production, excluding depreciation, was $730 per ton which was slightly higher than the $729 per ton experienced in the same period of 2006. Increased waste paper and electrical costs were mostly offset by lower per ton costs of fixed and semi-variable costs. An increase in waste paper costs experienced during the 2006 period, primarily in the third and fourth quarters, and lower yields in the first three quarters of the 2006 period during the final construction and start-up period of our new paper machine resulted in an 8% increase per ton in this component of our paper costs.

 

Gross Profit

 

Gross profit increased by $4.7 million to $10.9 million in the twelve months ended December 31, 2007, compared to $6.2 million in the prior year. As a percentage of net sales, gross profit increased to 14.6% in 2007 compared to 10.3% in 2006. The major reasons for the increase in gross profit as a percentage of net sales is the lower overall cost of paper and higher selling prices for converted products being partially offset by higher depreciation expense and higher converting labor costs.

 

Gross profit decreased by $1.1 million, or 15.2%, to $6.2 million for the year ended December 31, 2006, compared to $7.3 million for the year ended December 31, 2005. As a percent of net sales, gross profit dropped to

10.3% in 2006 compared to 12.7% in 2005. The major reasons for the reduction in gross profit as a percentage of net sales were the previously discussed higher cost of converting labor, increased level of depreciation, unfavorable sales mix and higher packaging costs being partially offset by a lower overall cost of parent rolls.

 

Selling, General and Administrative Expenses

 

 

Selling, general and administrative expenses include salaries, commissions to brokers and other miscellaneous expenses. Selling, general and administrative expenses increased by 26% to $5.2 million in the twelve months ended December 31, 2007, compared to $4.2 million in the prior year. Costs related to the hiring of our new chief executive officer, other additions to our senior management team, increased costs related to our first-year implementation of Section 404 of the Sarbanes Oxley Act of 2002, and higher director fees and expenses were the major reasons for the increase. Nonrecurring selling, general and administrative costs incurred in 2007 included the first year stock option expense and recruitment and relocation costs associated with the hiring of our new chief executive officer, as well as recruitment and relocation costs associated with other additions to the senior management team totaling $430,000. Our costs to complete our first year implementation of Section 404 of the Sarbanes Oxley Act of 2002 increased our fees paid to our external auditors and outside consultants that assisted in the management assessment process by $240,000.

 

Selling, general and administrative expenses for the year ended December 31, 2006, increased $140,000, or 3.5%, to $4.2 million, compared to $4.0 million in the same period in 2005. As a percentage of net sales, selling, general and administrative expenses were essentially flat at 6.9% of net sales for the year ended December 31, 2006, compared with the same period in 2005. An increase in costs directly related to being a public company and higher artwork-related expenditures were partially offset by lower costs related to a management services agreement and a lower level of stock option expense. Public company expenses were approximately $624,000 in the year ended December 31, 2006, compared with $152,000 in the same period in 2005. Public company expenses were lower in 2005 because we were a privately-held company until July 2005. Artwork-related expenditures increased approximately $118,000 in the 2006 period compared to the 2005 period due to a higher than normal number of packaging changes by existing customers and packing development with new customer accounts. Costs related to our management services agreement were lower in the twelve months ended December 31, 2006, by $250,000 as compared to the same period in 2005 due to a $150,000 lump sum payment made in 2005 which reduced our annual costs under the agreement from $325,000 to $125,000. The management services agreement was terminated effective March 2, 2007. In the twelve months ended December 31, 2006, we recognized approximately $260,000 of stock option expense, including $186,000 of ongoing expense for options issued to management in April 2005 and $74,000 for options issued to certain members of the board of directors in February 2006, June 2006 and December 2006. In the twelve months ended December 31, 2005, we recognized approximately $368,000 in stock option expense, including $337,000 for options issued to management and $31,000 for options issued to certain members of the board of directors in September 2005 and December 2005. In April 2005, the 2005 Stock Incentive Plan was approved by the board of directors and stockholders and options for an aggregate of 405,000 shares of common stock were awarded to certain members of management. The management options vested 20% on the date of grant and 20% on each anniversary of the grant over the succeeding four years. The board options vested 100% on the date of the grant.

Operating Income

 

As a result of the foregoing factors, operating income for the twelve months ended December 31, 2007, 2006 and 2005 was $5.7 million, $2.0 million, and $3.3 million, respectively.

 

Interest and Other Expense

 

 

Interest expense includes interest paid and accrued on all debt and amortization of both deferred debt financing costs and of the discount on our subordinated debt related to warrants issued with the debt. See “Liquidity and Capital Resources” below. Interest expense for the twelve months ended December 31, 2007 was $2.8 million, an increase of $848,000 compared to the same period in 2006. This increase resulted primarily from the absence of interest capitalization in 2007 compared to interest capitalization of $992,000 in 2006 in connection with the new paper machine. Including the capitalized interest in 2006, total interest costs in the 2007 period decreased $144,000, or 5%, compared with the same period of 2006. Lower LIBOR interest rates during 2007 and reduced margins over LIBOR following the April 2007 refinancing all contributed to the lower interest costs. Partly offsetting these factors was a 6% increase in average bank borrowings in the 2007 period reflecting the drawdown of the construction loan during the first half of 2006.

 

Interest expense for the year ended December 31, 2006, was $2.0 million, net of $992,000 of capitalized interest, compared to interest expense in the 2005 period of $1.2 million, net of $411,000 of capitalized interest. Including the capitalized interest, total interest cost, including amortization, increased $1.4 million, to $3.0 million in the 2006 period compared to $1.6 million in the 2005 period. Gross interest expense increased as a result of borrowings in 2006 under our construction loan to fund our new paper machine, higher average borrowings under our revolving credit agreement, and higher interest rates. During 2006, we borrowed $15.0 million on the construction loan, the full amount available under the loan agreement. We capitalized interest under the requirements of SFAS No. 34 “Capitalization of Interest Cost” in relation to our new paper machine project.

 

Other income was $36,000 in the twelve months ended December 31, 2007, compared to $99,000 in the same period of 2006. The decrease reflects the absence of a $39,000 net currency transaction gain recorded in 2006 and lower interest income as a result of eliminating the restricted certificate of deposit after the bank debt refinancing in April 2007, which was used to pay down amounts outstanding under the revolving credit agreement.

 

Other income was $99,000 in the twelve months ended December 31, 2006, compared to $102,000 in the same period of 2005. Other income in the 2006 period was mainly comprised of $66,000 in interest income earned from a restricted certificate of deposit with our lending institution and a $39,000 foreign currency transaction gain. Other income in the 2005 period was mainly comprised of $138,000 of income earned from the investment of our unused proceeds from our initial public offering which was partially offset by a net foreign currency exchange loss of $39,000. In 2004, we entered into certain purchase agreements related to our new paper machine project. One of these purchase agreements was denominated in Euros. We entered into foreign currency exchange contracts in the second quarter of 2005 to fix the price of this purchase agreement. We made the final payment under the exchange contract and on the purchase order in the second quarter of 2006. The exchange contracts were carried at fair value and any adjustments to fair value affected net income. In the 2005 period, the net proceeds of our initial public offering were used to fund the monthly construction costs of our new paper machine project. The unused proceeds were invested in short-term instruments such as high-grade commercial paper and bank certificates of deposit until such time as they were required for construction funding. As of December 31, 2005, the remaining unused net proceeds totaled $373,000, which were consumed in January 2006.

Income Before Income Taxes

 

As a result of the foregoing factors, income before income taxes increased $2.7 million to $2.9 million for the year ended December 31, 2007, compared to $168,000 for the year ended December 31, 2006. Income before income taxes decreased by $2.0 million for the year ended December 31, 2006 compared to $2.2 million for the year ended December 31, 2005.

 

Income Tax Provision (Benefit)

 

For the year ended December 31, 2007, income tax expense amounted to $307,000, resulting in an effective tax rate of 10.6%. The largest contributor to the reduced tax burden was Oklahoma Investment Tax Credits (“OITC”) associated with our 2006 investment in a new paper machine. The federal Indian Employment Credit (“IEC”), which was reinstated in December 2006 and extended through year-end 2007, contributed to the reduced tax burden. Also benefiting the 2007 tax provision was the recognition of tax benefits associated with management and directors’ stock options not qualifying as Incentive Stock Options under the Internal Revenue Code. In accordance with SFAS 123R, the Company has established a deferred tax asset to account for the future deductibility of the value of these grants upon exercise by the holder.

 

For the year ended December 31, 2006, the income tax benefit amounted to $564,000, resulting in an effective tax rate of a negative 336%. The current tax benefit of $1.0 million primarily resulted from the carryback of net operating losses for tax purposes to tax years 2005 and 2004. The deferred provision of $483,000 was the result of substantial tax depreciation in excess of financial depreciation, partially offset by the recognition of investment, employment and other tax carryforwards for financial reporting purposes. The law extending the IEC also reinstated accelerated depreciation deductions, the most important of which was a four-year tax life on investments in machinery and equipment placed in service on former Indian lands in Oklahoma. Accelerated depreciation will continue to benefit our current tax position for the next few years, as will the OITC, which is earned ratably over five years.

 

For the year ended December 31, 2005, income tax expense was $799,000 resulting from an effective tax rate of 36.5%. It is higher than the statutory rate because of non-deductible stock option expense being partially offset by the utilization of federal Indian employment credits.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Overview

 

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 short-term investments. Our cash requirements have historically been satisfied through a combination of cash flows from operations and debt financings. Our strategy to eliminate the need to purchase paper from third-party suppliers through the purchase of a new paper machine was funded through the net proceeds of our initial public offering, additional bank financing and cash flows from operations. The total cost of the paper machine project was $34.6 million, exclusive of capitalized interest.

 

On July 20, 2005, we completed our initial public offering of 2,156,250 shares of common stock, which included the exercise in full of the underwriter’s option to purchase 281,250 shares of common stock to cover overallotments. The shares were registered on Form S-1 (file number 333-124173), which the SEC declared effective on July 14, 2005. The public offering price of the shares was $8.00. Following the offering, 4,156,250 shares of common stock, par value $.001 per share, were outstanding. In July 2006, we effected a 3-for-2 stock split increasing the shares of common stock outstanding to 6,234,346 shares outstanding. Net proceeds from the offering were $15.0 million with gross proceeds totaling $17.25 million and with costs related to offering totaling $2.25 million as follows:

 

• underwriting discount of 8% or $1.4 million (charged against additional paid-in-capital); and

 

 

As of December 31, 2005, all but $373,000 of the net proceeds had been used to fund expenditures for our new paper machine project. The remaining funds were invested in short-term investment grade, interest-bearing instruments. In January 2006, we expended the remaining $373,000 on the paper machine project and we began to draw on the construction loan facility at that time.

 

The Company estimates NOL carryforwards of $6.2 million (federal) and $6.6 million (state) which are available to offset future taxable income. In addition, the Company plans to claim $1.9 million in Oklahoma Investment Tax Credit (OITC) carryforward as of December 31, 2007, which is available to offset future Oklahoma income tax liability. The OITC carryforward is expected to grow over the next three years as it is earned ratably over five years at two percent per year on qualified investments. We expect to claim $720,000 in OITC in each of the next three years related to the new paper machine. The combination of accelerated depreciation deductions and the OITC will likely eliminate all Oklahoma income tax liability for the next few years.

 

Cash was level at $3,000 from December 31, 2006 to December 31, 2007. We generated sufficient cash during the first three quarters of 2007 to pay off all amounts outstanding under our revolving credit agreement. We used a cash build-up in the fourth quarter and borrowings under our revolving credit line to retire all of our outstanding 12% subordinated debentures in December 2007 totaling $2.15 million.

 

Cash decreased by $375,000 during 2006 to $3,000 at December 31, 2006. The decrease was attributable to the application of remaining funds from the public offering to the paper machine project.

 

Cash decreased by $107,000 during 2005 to $378,000 at December 31, 2005. In addition to the cash balances, we maintained $1.5 million of short-term investments in certificates of deposit at December 31, 2006 and 2005. The $1.5 million was restricted under the provisions of our term loan agreement until April 30, 2007, the term date of our existing credit agreement during those periods. The $1.5 million was applied to our revolving credit when the bank debt was refinanced in April 2007.

 

The following table summarizes key cash flow information for the years ended December 31, 2007, 2006 and 2005.

 

 

Cash flow from operating activities increased by $5.8 million, to $8.4 million, more than three times the amount reported for 2006. Stronger earnings before non-cash charges for depreciation, deferred taxes and stock option expense was the primary reason for the increase. The realization of $1.2 million in carryback claims for federal taxes paid in 2005 and 2004 also contributed to the increased cash flow. An increase in the level of business activity resulted in higher accounts payable and accrued liabilities, partially offset by increases in inventory and accounts receivable.

 

Cash flow used in investing activities was for capital expenditures, mainly of maintenance projects. Offsetting these outflows was the release of the $1.5 million restricted certificate of deposit in connection with the April 2007 refinancing of our bank debt. Annual maintenance capital expenditures are estimated to be $1.5 million per year over the next several years which we expect to fund from operating cash flow. In order to improve our operating costs, we plan to purchase equipment during 2008 to automate certain portions of our converting facility at a cost of approximately $4.75 million. Expenditures for this project will begin in the first quarter of 2008 and continue through the fourth quarter. Following the completion of the project in the fourth quarter of 2008, we expect annualized net cash savings to approximate $2 million. In either 2008 or 2009, per the terms of our wastewater pretreatment agreement with the OOWA, we are required to expand our wastewater pre-treatment facility at an estimated cost of $3 million. Funding for the converting automation equipment is expected to come from a combination of borrowings under our revolving loan facility and operating cash flow, while funding for the pretreatment expansion is contemplated in the current debt facility in an amount up to $3 million.

Cash flows used in financing activities was $8.1 million, primarily attributable to a $4.3 million reduction in amounts outstanding under our revolving credit facility, $2.5 million in normally scheduled principal payments on our bank term loans and the retirement of all of our 12% subordinated debentures at a cost of $2.15 million. Our April 2007 refinancing of our credit facility resulted in a net increase in borrowings of $634,000.

 

Cash provided by operations totaled $2.6 million in the year ended December 31, 2006, essentially level with the same period in 2005. An increase in income taxes receivable in 2006 was mainly attributable to accelerated depreciation on the new paper machine. The recently extended tax benefits for property placed in service on former Indian lands added to the net operating loss for tax purposes. This increase was largely offset by the absence of the inventory increase incurred during 2005. The absence was due to a scarcity of third party parent rolls available on the open market at year-end 2004. Accounts receivable increased during the year ended December 31, 2006, reflecting higher sales volumes. Accounts payable increased during the year ended December 31, 2006, reflecting higher levels of purchasing.

 

Cash used in investing activities in the year ended December 31, 2006, was $18.1 million, mostly related to the new paper machine project. Capital expenditures for the new machine amounted to $17.5 million in 2006, inclusive of capitalized interest of $992,000. The start-up date for the project was June 9, 2006.

 

Cash provided from financing activities amounted to $15.2 million in the year ended December 31, 2006, mainly attributable to borrowings under a construction loan agreement with established bank creditors. Cash provided from financing activities decreased from $16.5 million in the year ended December 31, 2005 due to the absence of the proceeds from the initial public offering and reduced borrowings under the revolving credit line. Principal payments on the bank debt remained level at $1.6 million in each period.

 

On April 9, 2007, we re-financed our existing credit facility with the existing bank group. On March 6, 2008, we amended the facility to increase the revolving credit facility and capital expenditures limits for 2008. Following the amendment, the credit facility consists of the following:

 

 

Under the terms of the agreement, amounts outstanding under the revolving credit facility bear interest at our election at the prime rate or LIBOR plus a margin and amounts outstanding under Term Loan B and the capital expenditures facility will bear interest at LIBOR plus a margin, which is set quarterly and based on the ratio of funded debt to EBITDA less income taxes paid. Amounts outstanding under Term Loan A will bear interest at LIBOR plus 180 basis points. For the revolving credit facility, the margin ranges from a negative 50 basis points to 150 basis points for prime rate loans and 200 to 375 basis points for LIBOR-based loans. For Term Loan B, the margin ranges from 200 basis points to 300 basis points over LIBOR. For the capital expenditures facility, the margin ranges from 150 basis points to 250 basis points over LIBOR.

 

The credit agreement contains covenants that, among other things, require us to maintain a specific funded debt to EBITDA ratio, debt service coverage ratio and an annual limit on un-financed capital expenditures. In connection with the re-financing, the $1.5 million restricted certificate of deposit was released and applied to the revolving credit facility. The amount available under the revolving credit line may be reduced in the event that our borrowing base, which is based upon our qualified receivables and qualified inventory, is less than $8.0 million. Obligations under the amended and restated credit agreement are secured by substantially all of our assets. The agreement contains representations and warranties, and affirmative and negative covenants customary for financings of this type, including, but not limited to, a covenant prohibiting us from declaring or paying dividends. The financial covenants in the agreement require us to maintain specific ratios of funded debt to EBITDA and debt

service coverage which are tested as of the end of each quarter and places a limit on the amount of annual non-financed capital expenditures. The maximum allowable funded debt to EBITDA ratio is 4.0-to-1.0 and the minimum allowable debt service coverage ratio is 1.25-to-1.0. Following the March 2008 amendment, our annual expenditures for non-financed capital equipment are limited to $6.25 million for the fiscal year 2008 and $1.5 million per fiscal year thereafter. The increased capital expenditures limit in 2008 will be used to complete the previously discussed automation project in our converting facility.

 

The capital expenditures facility is intended to fund an expansion of our wastewater pre-treatment. A new water discharge permit was issued effective August 1, 2007 which requires us to expand our existing pre-treatment facility to reduce biological oxygen demand and total suspended solids from our effluent stream. Under the new permit, we are required to complete the expansion and make operational our pre-treatment facility by August 1, 2009. The project is in the pre-engineering phase and is expected to cost approximately $3 million.

 

If an event of default occurs, the agent may declare the banks’ obligation to make loans terminated and all outstanding indebtedness, and all other amounts payable under the credit agreement, due and payable.

 

Contractual Obligations

 

As of December 31, 2007, our contractual cash obligations were limited to our long-term debt. We do not have any leasing commitments or debt guarantees outstanding as of December 31, 2007. We do not have any defined benefit pension plans nor do we have any obligation to fund any postretirement benefit obligations for our work force.

 

Maturities of these contractual obligations consist of the following:

 

 

 

 

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. Accounts receivable balances that have been written-off, net of recoveries, in the years ended December 31, 2007, 2006, and 2005 were $0, $6,000, and $11,000, respectively.

 

Inventory.  Our inventory consists of converted finished goods, bulk paper rolls and raw materials and is based on standard cost, specific identification, or FIFO (first-in, first-out). Standard costs approximate actual costs on a first-in, first-out 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 years ended December 31, 2007 and 2006, we increased the inventory valuation reserve by $7,000 and $1,000, respectively. During the year ended December 31, 2005, we decreased the inventory valuation reserve by $15,000.

 

New Accounting Pronouncements

 

The Financial Accounting Standards Board (“FASB”) periodically issues new accounting standards in a continuing effort to improve standards of financial accounting and reporting. We have reviewed the recently issued pronouncements and concluded that the following new accounting standards are applicable to us. In September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements” which amends and puts in one place guidance on the use of fair value measurements which had been spread through four APB Opinions and 37 FASB Standards. No extensions of the use of fair value measurements are contained in this new pronouncement and, with some special industry exceptions (e.g., broker-dealers), no significant changes in practice should ensue. The standard is to be applied to financial statements beginning after November 15, 2007. The adoption of SFAS No. 157 is not expected to have a material impact on our financial position or results of operations.

 

In February 2007, the FASB issued SFAS No. 159 “Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 115”. This standard permits the use of fair value measurement of financial assets and liabilities in the balance sheet with the net change in fair value recognized in periodic net income. The Standard is effective for fiscal years beginning after November 15, 2007. The adoption of this standard is not expected to have a material effect on the Company’s financial position or results of operations because the majority of its debts and investment assets are variable rate and thus fair value approximates recorded value.

 

In December 2007, the FASB revised SFAS No. 141 “Business Combinations” to clarify certain issues regarding business combinations. The major impact on Orchids could be the requirement to write-off certain costs of completing an acquisition as incurred. The standard is effective for periods beginning after December 15, 2008.

 

Also in December 2007, the FASB issued SFAS No. 160 “Non-controlling Interests in Consolidated Financial Statements”. At present this standard is inapplicable to Orchids as we have no subsidiaries. The standard is effective for minority interest accounting for periods beginning after December 15, 2008.

 

Non-GAAP Discussion

 

In addition to our GAAP results, we also consider non-GAAP measures of our performance for a number of purposes. We use EBITDA as a supplemental measure of our performance that is not required by, or presented in accordance with, GAAP. EBITDA is not a measurement of our financial performance under GAAP and 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 flow from operating activities or a measure of our liquidity.

 

EBITDA represents net income before net interest expense, income tax expense, depreciation and amortization.

We believe EBITDA facilitates operating performance comparisons from period to period and company to company by backing out 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) and the age and book depreciation of facilities and equipment (affecting relative depreciation expense).

 

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

 

 

Because of these limitations, 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 only supplementally.

 

The following table reconciles EBITDA to net income for the years ended December 31, 2007, 2006 and, 2005:

 

 

EBITDA increased $4.3 million to $8.7 million for the year ended December 31, 2007, compared to $4.4 million in the same period in 2006. EBITDA as a percent of net sales increased from 7.3% in 2006 to 11.7% in 2007. The foregoing factors discussed in the net sales, cost of sales and selling, general and administrative expenses sections are the reasons for the change.

 

EBITDA decreased $503,000 to $4.4 million, or 7.3% of net sales, for the year ended December 31, 2006, compared to $4.9 million, or 8.5% of net sales, for the year ended December 31, 2005. The foregoing factors discussed in the net sales, cost of sales and selling, general and administrative expenses sections are the reasons for the change.

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Form 10-K, including the sections entitled “The Business,” “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements. These statements relate to, among other things:

 

 

 

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 achievement 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,” “should,” “could,” “expects,” “plans,” “intends,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of such terms or other comparable terminology. 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. These statements are only predictions.

 

Factors that may cause our actual results to differ materially from our forward-looking statements include, among others:

 

 

You should read this Form 10-K completely and with the understanding that our actual results may be materially different from what we expect. We undertake no duty to update these forward-looking statements after the date of this Form 10-K, even though our situation may change in the future. We qualify all of our forward-looking statements by these cautionary statements.

 

 

Our market risks relate primarily to changes in interest rates. Our revolving line of credit and our term loans carry a variable interest rate that is tied to market indices and, therefore, our statement of income and our cash flows will be exposed to changes in interest rates. As of December 31, 2007, we had floating-rate borrowings of $25.2 million, excluding bank overdrafts, which are classified with bank debt in the balance sheet, but which bear no interest. Outstanding balances under our line of credit and term loans bear interest at the prime rate or LIBOR, plus a margin based upon the debt service coverage ratio. We considered the historical volatility of short-term interest rates and determined that it would be reasonably possible that an adverse change of 100 basis points could be experienced in the near term. Based on the current borrowing, a 100 basis point increase in interest rates would result in a pre-tax $252,000 increase to our annual interest expense.

 

INDEX TO FINANCIAL STATEMENTS

 

 

To the Board of Directors and Stockholders of

Orchids Paper Products Company

 

We have audited the accompanying balance sheets of Orchids Paper Products Company as of December 31, 2007 and 2006, and the related statements of income, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2007. We also have audited Orchids Paper Products Company’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Orchids Paper Products Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Orchids Paper Products Company as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Orchids Paper Products Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

/s/ TULLIUS TAYLOR SARTAIN & SARTAIN, LLP

 

Tulsa, Oklahoma

March 17, 2008

ORCHIDS PAPER PRODUCTS COMPANY

 

BALANCE SHEETS

 

 

See notes to financial statements.

ORCHIDS PAPER PRODUCTS COMPANY

 

STATEMENTS OF INCOME

Years Ended December 31, 2007, 2006 and 2005

 

 

See notes to financial statements.

Years ended December 31, 2005, 2006 and 2007

 

 

See notes to financial statements.

ORCHIDS PAPER PRODUCTS COMPANY

 

STATEMENTS OF CASH FLOWS

Years ended December 31, 2007, 2006 and 2005

 

 

See notes to financial statements.

 

 

Basis of Presentation

 

Orchids Paper Products Company (“Orchids” or the “Company”) was formed in 1998 to acquire and operate the paper manufacturing facility, built in 1976, in Pryor, Oklahoma. Orchids Acquisition Group, Inc. (“Orchids Acquisition”) was established in November 2003, for the purpose of acquiring the common stock of Orchids. Orchids Acquisition closed the sale of its equity and debt securities on March 1, 2004, and immediately thereafter closed the acquisition of Orchids. On April 19, 2005, Orchids Acquisition merged with and into Orchids, with Orchids as the surviving entity.

 

Business

 

Orchids operates a paper mill and converting plant used to produce a full range of paper tissue products. The mill produces bulk rolls of paper from recycled paper stock. The bulk rolls are transferred to the converting plant for further processing. Tissue products produced in the converting plant include paper towels, bathroom tissue, and napkins, which the Company primarily markets to domestic value retailers.

 

Summary of Significant Accounting Policies

 

Fair value of financial instruments

 

The carrying amounts of the Company’s financial instruments, cash, accounts receivable, investments, accounts payable and accrued liabilities approximate fair value due to their short maturity. The fair value of the Company’s long-term debt is estimated by management to approximate fair value based on the obligations’ characteristics, including floating interest rate, credit ratings, maturity and collateral.

 

Accounts receivable

 

Accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts. A trade receivable is considered to be past due if it is outstanding for more than five days past terms. Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic conditions. Receivables are written-off when deemed uncollectible. Recoveries of receivables previously written-off are recorded when received. The Company does not typically charge interest on trade receivables.

 

Inventories

 

Inventories are stated at the lower of cost or market. The Company’s cost is based on standard cost, specific identification, or FIFO (first-in, first-out). Standard costs approximate actual costs on a first-in, first-out basis. Material, labor, and factory overhead necessary to produce the inventories are included in the standard cost.