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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

For the quarterly period ended June 30, 2011

OR

Commission File Number 001-32563

Orchids Paper Products Company

(Exact name of Registrant as Specified in its Charter)

4826 Hunt Street

Pryor, Oklahoma 74361

(Address of Principal Executive Offices and Zip Code)

(918) 825-0616

(Registrant’s Telephone Number, Including Area Code)

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

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

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 x

Number of shares outstanding of the issuer’s Common Stock, par value $.001 per share, as of July 31, 2011: 7,490,475 shares.

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ORCHIDS PAPER PRODUCTS COMPANY

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QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE AND SIX MONTHS ENDED June 30, 2011

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PART I. FINANCIAL INFORMATION

ITEM 1.  Financial Statements

ORCHIDS PAPER PRODUCTS COMPANY

BALANCE SHEETS

(Dollars in thousands, except share data)

See notes to unaudited interim financial statements.

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ORCHIDS PAPER PRODUCTS COMPANY

STATEMENTS OF INCOME

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

See notes to unaudited interim financial statements.

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ORCHIDS PAPER PRODUCTS COMPANY

STATEMENTS OF CASH FLOWS

(Dollars in thousands)

See notes to unaudited interim financial statements.

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ORCHIDS PAPER PRODUCTS COMPANY

NOTES TO UNAUDITED INTERIM FINANCIAL STATEMENTS

Note 1 — 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.  The sale of equity and debt securities closed in March 2004 and Orchids Acquisition Group, Inc. acquired Orchids for a price of $21.6 million.  Orchids Acquisition was subsequently merged into Orchids.  In July 2005, the Company completed its initial public offering of its common stock.  The Company’s stock trades on the NYSE Amex under the ticker symbol “TIS.”

The accompanying financial statements have been prepared without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States have been condensed or omitted pursuant to the rules and regulations.  However, the Company believes that the disclosures made are adequate to make the information presented not misleading when read in conjunction with the audited financial statements and the notes in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010, filed with the SEC on March 11, 2011.  Management believes that the financial statements contain all adjustments necessary for a fair presentation of the results for the interim periods presented.  All adjustments were of a normal, recurring nature.  The results of operations for the interim period are not necessarily indicative of the results for the entire fiscal year.

Note 2 — Fair Value Measurements

The Company has previously adopted fair value measurement accounting guidance.  The valuation hierarchy considers the transparency of inputs used to value assets and liabilities as of the measurement date. The less transparent or observable the inputs used to value assets and liabilities, the lower the classification of the assets and liabilities in the valuation hierarchy. A financial instrument’s classification within the valuation hierarchy is based on the lowest level of input that is significant to its fair value measurement. The three levels of the valuation hierarchy and the classification of the Company’s financial assets and liabilities within the hierarchy are as follows:

Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 - Observable inputs other than quoted prices included within Level 1 for the asset or liability, either directly or indirectly.  If an asset or liability has a specified term, a Level 2 input must be observable for substantially the full term of the asset or liability.

Level 3 - Unobservable inputs for the asset or liability.

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Set forth below are the assets that are measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010:

The Company has no liabilities measured at fair value at June 30, 2011 or December 31, 2010.  The carrying 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 rating, maturity and collateral.

There were no transfers between Level 1 and Level 2 assets during the first six months in 2011 or 2010.

Note 3 — Commitments and Contingencies

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

In the fourth quarter of 2008, the Company entered into a contract to purchase 334,000 MMBTU per year of natural gas at $7.50 per MMBTU plus a $0.07 per MMBTU management delivery fee for the period from April 2009 through March 2011.  The amounts represent approximately 60% of the Company’s natural gas requirements.  In November 2009, the agreement was extended for one year to March 2012 for 334,000 MMBTU per year at a price of $6.50 per MMBTU plus a $0.07 per MMBTU management delivery fee.  In August of 2010, the agreement was extended another year to March 2013 with a contract price of $5.50 per MMBTU plus a $0.07 per MMBU management fee.  Purchases under the gas contract were $0.5 million and $0.6 million for the three months ended June 30, 2011 and 2010, respectively, and $1.2 million and $1.3 million for the six months ended June 30, 2011 and 2010, respectively.  If the Company is unable to purchase the contracted amounts and the market price at that time is less than the contracted price, the Company would be obligated under the terms of the agreement to reimburse an amount equal to the volume purchased that was less than the contracted amount multiplied by the difference between the contract price and current spot price.

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Note 4 — Inventories

Inventories at June 30, 2011 and December 31, 2010 are as follows:

Note 5 — Long-Term Debt and Revolving Line of Credit

In April 2011, the Company paid off the remaining unmatured loans under our existing credit facility which totaled $17.5 million and entered into a new $36 million credit agreement (the “Credit Agreement”) with JPMorgan Chase consisting of the following:

·                  an $18.0 million revolving credit line due April 2014;

·                  a $10.8 million Real Estate Term Loan 1 with a 10-year term due April 2021 and amortized as if it had a 25-year life; and

·                  a $7.2 million Machinery and Equipment Term Loan 2 with a 7-year term due April 2018 and amortized as if it had a 10-year life.

The Credit Agreement has the effect of (i) extending and increasing the Company’s revolving line of credit from $8.0 million to $18.0 million, (ii) refinancing and extending the Company’s current $10.0 million term loan to a $10.8 million term loan and (iii) refinancing and extending the Company’s two construction loans of $10.7 million into a single $7.2 million term loan.

Under the terms of the Credit Agreement, amounts outstanding under the revolving credit line and the Real Estate Term Loan 1 will bear interest, at the Company’s election, at the prime rate (with a floor equal to the Adjusted One Month LIBOR rate, as defined in the credit facility agreement) or LIBOR, plus a margin, which is based on the Company’s quarterly Funded Debt-to-EBITDA ratio.  The margin ranges from negative 50 basis points to 25 basis points for prime rate loans and 185 basis points to 265 basis points for LIBOR rate loans.  Amounts outstanding under the Machinery and Equipment Term Loan 2 will bear interest at LIBOR plus 175 basis points.

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Long-term debt at June 30, 2011 and December 31, 2010 consists of:

The amount available under the revolving credit line may be reduced in the event that the Company’s borrowing base, which is based upon qualified receivables, qualified inventory, and equipment with a value up to a maximum of $3.0 million, is less than $18.0 million.  As of June 30, 2011, our qualified receivables were $5.3 million and our qualified inventory was $3.5 million, which, when added to the $3.0 million of equipment availability yielded a total borrowing base of $11.8 million.

Obligations under the Credit Agreement are secured by substantially all of the Company’s assets.  The Credit Agreement contains representations and warranties, and affirmative and negative covenants customary for financings of this type, including, but not limited to, limitations on additional borrowings, additional investments and asset sales, and maintaining certain financial ratios.

Note 6 — Earnings per Share

The computation of basic and diluted net income per share for the three-month and six-month periods ended June 30, 2011 and 2010 is as follows:

Note 7 — Stock Incentive Plan

In April 2005, the board of directors and the stockholders approved the 2005 Stock Incentive Plan (the “Plan”).  The Plan provides for the granting of incentive stock options to employees selected by the board’s compensation committee.   Prior to May 2011, the Plan was authorized to distribute up to 897,500 shares.  In May 2011, our stockholders approved an amendment to the Plan to increase the number of authorized shares under the Plan to 1,097,500.  Options typically have a 10-year life.

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The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable.  In addition, options valuation models require the input of highly subjective assumptions including the expected stock price volatility.

The following table details the options granted to certain members of the board of directors and management during the six months ended June 30, 2011 and 2010.

Estimated volatility is calculated based on actual historical volatility of the Company’s common stock from the Company’s initial public offering date to the grant date.  The Company’s dividend yield assumption is based on the expected dividend yield as of the grant date.  Expected life is calculated based on the simplified method for “plain vanilla” options, due to limited available exercise information.

The Company expenses the cost of options granted over the vesting period of the option based on the grant-date fair value of the award.  The Company recognized expense of $168,000 and $274,000 for the three months ended June 30, 2011 and 2010, respectively, and $230,000 and $383,000 for the six months ended June 30, 2011 and 2010, respectively, related to options granted under the Plan.

Note 8 — Major Customers and Concentration of Credit Risk

The Company sells its paper production in the form of converted products and bulk tissue paper, called parent rolls.  Revenues from converted product sales and parent roll sales in the three months and six months ended June 30, 2011 and 2010 were:

Credit risk for the Company in the three months and six months ended June 30, 2011 and 2010 was concentrated in the following customers who comprised more than 10% of the Company’s total net sales:

* Customer did not account for more than 10% of sales during the period indicated

At June 30, 2011 and 2010, respectively, approximately $5.5 million (75%) and $4.4 million (61%) of accounts receivable was due from the customers described above.  No other customer of the Company accounted for more than 10% of sales during these periods.  The Company generally does not require collateral from its customers and has not incurred any significant losses on uncollectible accounts receivable.

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Note 9 — 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 standard issued this quarter is applicable to the Company:

In May 2011, the FASB issued Accounting Standards Update 2011-04, “Fair Value Measurement — Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAAP and IFRSs” (“ASU 2011-04”).  ASU 2011-04 generally provides a uniform framework for fair value measurements and related disclosures between GAAP and International Financial Reporting Standards (“IFRS”).  Additional disclosure requirements in the update include: (1) for Level 3 fair value measurements, quantitative information about unobservable inputs used, a description of the valuation process used by the entity, and a qualitative discussion about the sensitivity of the measurements to changes in the unobservable inputs; (2) for an entity’s use of a nonfinancial asset that is different from the asset’s highest and best use, the reason for the difference; and (3) for financial instruments not measured at fair value but for which disclosure of fair value is required, the fair value hierarchy level in which the fair value measurements were determined.  ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011, or January 1, 2012 for the Company.  Other than requiring possible additional disclosures, adoption of this new guidance is not expected to have a material impact on the Company’s financial statements.

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

Forward-Looking Information

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

·                         our business strategy;

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

·                         our estimates regarding our capital requirements; and

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

These statements relate to future events or future financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements.  In some cases, you can identify forward-looking statements by terminology such as “may,” “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.

You should not place undue reliance on forward-looking statements because they involve known and unknown risks, uncertainties, and other factors that are, in some cases, beyond our control and that could materially affect actual results, levels of activity, performance or achievements.  Factors that could materially affect our actual results, levels of activity, performance or achievements include, without limitation, those detailed under the caption “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, as filed with the SEC on March 11, 2011, and include the following items:

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

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

·                  disruption in our supply or increase in the cost of waste paper;

·                  increased competition in our region;

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

·                  indebtedness limits our free cash flow and subjects us to restrictive covenants relating to the operation of our business;

·                  the availability of and prices for energy;

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

·                  our exposure to variable interest rates;

·                  the loss of key personnel;

·                  labor interruption;

·                  natural disaster or other disruption to our facility;

·                  ability to finance the capital requirements of our business;

·                  cost to comply with existing and new laws and regulations;

·                  failure to maintain an effective system of internal controls necessary to accurately report our financial results and prevent fraud;

·                  the parent roll market is a commodity market and subject to fluctuations in demand and pricing;

·                  excess supply in the market may reduce our prices;

·                  an inability to continue to implement our business strategies; and

·                  inability to sell the capacity generated from our new converting line.

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

Overview

We are an integrated manufacturer of private label tissue products, including paper towels, bathroom tissue and paper napkins for the consumer, or “at-home,” market. We produce bulk tissue paper, known as parent rolls and convert parent rolls into finished products. We have tailored our operations to serve our core customer base of dollar stores and other discount retailers. By dollar stores, we mean retailers that offer a limited

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selection across a broad range of products at everyday low prices in a smaller store format.  We focus on the dollar stores (which are also referred to as value retailers) and discount retail market because of their consistent order patterns and low number of stock keeping units (“SKUs”).  While we focus on the value retailers, we also service the grocery store channels as well.

While we have customers located throughout the United States, most of our products are distributed within an approximate 900-mile radius of our Oklahoma facility. However, our sales efforts are focused on an area within approximately 500 miles of our facility in northeast Oklahoma, which includes Texas, Oklahoma, Kansas, Missouri, Arkansas, Nebraska and Iowa. Because we are one of the few tissue paper manufacturers in this area, we typically have lower freight costs to our customers’ distribution centers located in our target region. At-home tissue market growth has historically been closely correlated to population growth and as such, performs well in a variety of economic conditions. Our target region has experienced strong population growth in the past five years relative to the national average and these trends are expected to continue.

Our converted products are sold primarily under our customers’ private labels and, to a lesser extent, under our brand names such as Colortex®, My Size®, Velvet®, Big Mopper®, Tackle® , Noble®, Soft and Fluffy® and care®.  All of our converted product revenue is derived pursuant to truck load purchase orders from our customers.  Parent roll revenue is derived from purchase orders that generally cover a one month time period. We do not have supply contracts with any of our customers.  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 converted products.

Our profitability depends on several key factors, including:

·                         the market price of our product;

·                         the cost of waste paper used in producing paper;

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

·                         the cost of energy.

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 affect price increases.  We expect these competitive conditions to continue.

Background

Since June 2006, when we began operations of a new paper machine, our paper-making capacity of approximately 56,000 tons per year has exceeded the demand requirements of our converting operations. We sell the excess supply into the market in the form of parent rolls.  We adjust our paper making production based on our internal converting needs for parent rolls and the open market demand for parent rolls.  Parent rolls are a commodity product and thus are subject to market pricing.  We plan to continue to sell any excess parent roll capacity on the open market as long as market pricing is profitable.

Our parent rolls are processed into paper towels, bathroom tissue and napkins in our adjacent converting facility. Our eleven converting lines have a total annual capacity of approximately 12.0 million cases of finished tissue products.  Our strategy is to sell all of our parent roll capacity as converted products which generally carry higher margins than parent rolls. To help achieve that goal, we continue to focus considerable efforts to improve our converting efficiencies.  In addition, we are placing significant focus on improving our sales efforts to sell this additional capacity.

Our strategy is to expand our position as a low cost provider of private label tissue products to the growing discount retail channel within our geographic area while leveraging our competitive advantages to increase our presence in other retail channels.  This will be accomplished through our continued high service levels, increased total manufacturing capacity and expansion of our product offering.

We intend to implement this strategy through our key initiatives set forth below:

·                  maintain and strengthen our core customer relationships;

·                  improve the product quality of our higher tier offerings to meet and or exceed the required attributes;

·                  increase our flexibility to meet a wider array of customer needs;

·                  utilize a third-party sales agency that specializes in premium grade tissue product sales and marketing along with our existing sales structure to develop business opportunities in the higher tier tissue market;

·                  further expand our customer base in other retail channels; and

·                  continue to improve operating efficiencies and reduce manufacturing costs.

Since our inception in 1998, we have strategically expanded capacity to meet demand.  In mid-2010, we completed an expansion project which added an eleventh converting line to our converting capacity and a 245,000 square foot warehouse.  The new line has a rated annual capacity of approximately four million cases of either kitchen towel or bathroom tissue products, bringing our total annual converting capacity to approximately twelve million cases from eleven lines.  The new line provides higher quality products and broadens our product offerings to

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supply the higher-quality, mid-tier market segment through increased packaging configurations, enhanced graphics and improved embossing.  In addition, we have made changes to our paper production process and pulp sourcing to improve the quality of our parent rolls designed for the higher tier product segments.  We expect to sell the majority of the output from this new line to new customers, particularly in the grocery segment.  Start-up of the new line began in July 2010.  The completion of the new warehouse has allowed us to consolidate all warehousing and shipping in our Pryor location, thereby eliminating third-party warehouse charges beginning in September of 2010.

Although we have an annual converting capacity of approximately 12 million cases, our in-house supply of parent rolls provides enough to convert approximately 10 million cases.  In order to convert at an annual capacity above approximately 10 million cases, we would have to supplement our supplies by purchasing parent rolls in the open market.

Comparative Three-Month Periods Ended June 30, 2011 and 2010

Net Sales

Net sales in the quarter ended June 30, 2011, decreased 5% to $23.4 million, compared to $24.7 million in the same period of 2010.  Net sales figures represent the gross selling price, including freight, less discounts and pricing allowances.  The decrease in net sales is due to a $1.4 million decrease in net sales of converted product which was partially offset by a $134,000 increase in parent roll net sales.  Net sales of converted product decreased in the quarter ended June 30, 2011, by $1.4 million, or 7%, to $18.8 million compared to $20.2 million in the same period last year. The decrease in net sales of converted product is primarily the result of a 10% decrease in the tonnage shipped being partially offset by a 3% increase in the net selling price per ton.  The decrease in converted product tonnage shipped is a result of the softer demand for our products from certain existing customers and to a lesser extent a shift in product mix.  The increase in net selling price per ton is primarily due to a shift in mix and did not materially affect gross margin.

Net sales of parent rolls increased $134,000, or 3%, to $4.6 million in the quarter ended June 30, 2011, compared to $4.5 million in the same period last year.  Net sales of parent rolls increased primarily as a result of a 4% increase in the net selling price per ton of parent rolls, offset by a 1% decrease in tonnage shipped. The decrease in parent roll tonnage shipments is due to higher requirements by our converting operation resulting in less excess paper available to sell in parent roll form.  The higher converting requirements in the quarter over quarter comparison is primarily due to reduction in converting production in the prior year quarter to facilitate the implementation of our converting expansion project compared to a build in inventory in the current year quarter.  The improvement in parent roll net selling prices is due to the stronger parent roll market and market reaction to higher waste paper prices.

Total shipments in the second quarter of 2011 decreased by 1,034 tons, or 7%, to 13,580 tons compared to 14,614 tons in the same period of 2010.  This decrease is primarily the result of lower converted product shipments.  The increase in selling price per ton of $33, or 2%, to $1,722 in the second quarter of 2011 compared to $1,689 in the second quarter of 2010 is due to a 3% increase in the net selling price per ton of converted products and a 4% increase in the net selling price per ton of parent rolls, as discussed above.

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Cost of Sales

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

Cost of sales remained flat in the quarter ended June 30, 2011, as compared to the same period of 2010.  Increased paper production costs and depreciation expense were offset by reduced non-paper costs.  As a percentage of net sales, cost of sales increased to 84.1% in the 2011 quarter from 79.4% in the 2010 quarter.  Cost of sales as a percentage of net sales for the second quarter of 2011 was unfavorable to the prior year quarter due to higher waste paper costs, a higher percentage of parent roll sales and higher depreciation expense.

Our overall cost of paper in the second quarter of 2011 was $818 per ton, an increase of $36 per ton compared to the same period in 2010.  Paper production costs increased primarily due to higher waste paper prices.  Waste paper prices increased approximately 8% in the second quarter of 2011 compared to the same quarter in 2010, thereby increasing our cost of sales by approximately $380,000 in the quarter-over-quarter comparison.

Excluding the effects of the higher depreciation, converting production costs on a per unit basis were lower in the 2011 quarter compared to the 2010 quarter by 13% as a result of a 7% increase in cases produced and the elimination of $362,000 in third-party warehouse costs that were incurred in the prior year quarter.  As previously discussed, the percentage of our parent roll production sold as parent rolls increased in the second quarter of 2011 compared to the same quarter last year, which had a negative effect on our gross margin percentage as parent roll sales generally generate a lower margin than the sale of converted product.  Depreciation expense increased $613,000 in the second quarter of 2011 compared to the same quarter last year primarily due to the completion of our converting and waste water treatment expansion projects in 2010.

Gross Profit

Gross profit in the quarter ended June 30, 2011, decreased $1.4 million, or 27%, to $3.7 million compared to $5.1 million in the same period last year.  Gross profit as a percentage of net sales in the 2011 quarter was 15.9% compared to 20.6% in the 2010 quarter.  The gross profit decrease as a percent of net sales was primarily the result of higher waste paper prices, lower converted product shipments, a higher percentage of parent roll sales and higher depreciation expense.

Selling, General and Administrative Expenses

Selling, general and administrative expenses include salaries, commissions to brokers and other miscellaneous expenses.  Selling, general and administrative expenses remained flat at $1.8 million in the quarters ended June 30, 2011 and 2010.  As a percentage of net sales, selling, general and administrative expenses increased to 7.8% in the second quarter of 2011 compared to 7.5% in the same period of 2010.

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Operating Income

As a result of the foregoing factors, operating income for the quarter ended June 30, 2011, was $1.9 million compared to operating income of $3.2 million for the same period of 2010.

Interest Expense and Other Income

Interest expense includes interest on all debt and amortization of deferred debt issuance costs.  Interest expense decreased $20,000 to $191,000 in the quarter ended June 30, 2011, compared to $211,000 in the quarter ended June 30, 2010.  The decrease in interest expense resulted from our debt refinancing in April 2011 at lower interest rates and lower average borrowing levels due to repayment of our Term Loan B upon maturity in April 2011.

Income Before Income Taxes

As a result of the foregoing factors, income before income taxes decreased $1.3 million to $1.7 million in the quarter ended June 30, 2011, compared to $3.0 million in the same period in 2010.

Income Tax Provision

For the quarter ended June 30, 2011, our effective income tax rate was 30.3%.  This rate is lower than the statutory rate because of manufacturing credits and Oklahoma Investment Tax Credits associated with our investments in a new paper machine in 2006, and new converting warehouse and new converting line that were completed in 2010.  For the quarter ended June 30, 2010, our annual effective income tax rate was 28.8%.  The effective tax rate is lower than the statutory rate because of the Oklahoma Investment Tax Credits cited above.

Comparative Six-Month Periods Ended June 30, 2011 and 2010

Net Sales

Net sales increased 1% to $46.1 million in the six months ended June 30, 2011, compared to $45.7 million in the same period of 2010.  Net sales figures represent gross selling price, including freight, less discounts and pricing allowances.  The increase in net sales is due to a a $1.4 million increase in the sales of parent rolls being partially offset by a $1.1 million decrease in the net sales of converted product.  Net sales of converted product decreased for the six months ended June 30, 2011, by $1.1 million, or 3% to $36.7 million compared to $37.8 million in the same period last year. The decrease in net sales of converted products is the result of an 8% decrease in the tons of product shipped offset by a 5% increase in net selling price.  The decrease in shipments of converted product was primarily due to shift in mix and to a lesser extent, softer demand from certain of our customers.  The increase in net selling prices is primarily the result of a shift in mix and, to a lesser extent, decreased promotional

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pricing.  Net sales of parent rolls increased $1.4 million, or 18%, to $9.3 million in the six months ended June 30, 2011, compared to $7.9 million in the same period last year.  Net sales of parent rolls increased due to a 9% increase in parent roll tonnage shipped and an 8% increase in net selling prices.  A higher level of parent roll production was the primary reason for the increased parent roll sales, while a strengthening parent roll market and market reaction to higher waste paper costs resulted in the higher net selling prices.

Total shipments in the six-month period of 2011 decreased by 585 tons, or 2%, to 27,208 tons compared to 27,793 tons in the same period of 2010, primarily due to an 8% decrease in shipments of converted products, partially offset by a 9% increase in parent roll shipments.  Our overall net selling price per ton increased by 3% in the first six months of 2011 compared to the comparable prior year period.  This increase was primarily attributable to higher prices for converted products and parent rolls being partially offset by an increased percentage of parent roll production shipped in parent roll form.

Cost of Sales

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

Cost of sales increased approximately $2.8 million, or 8%, to $39.6 million for the six months ended June 30, 2011, compared to $36.8 million in the same period of 2010.  As a percentage of net sales, cost of sales increased to 86.1% of net sales in the six-month period ended June 30, 2011, compared to 80.5% of net sales in the six-month period ended June 30, 2010.  The increase in cost of sales as a percentage of net sales in the six months ended June 30, 2011, was primarily attributed to higher waste paper costs, lower converted product sales, a higher percentage of parent roll sales and higher depreciation expense.

In the six months ended June 30, 2011, our overall cost of paper was $819 per ton, an increase of $30 per ton when compared to the same period in 2010.  Our cost per ton increased primarily due to increased waste paper prices.  Average waste paper prices increased 7% from the 2010 period to the 2011 period, which raised the cost of our waste paper by approximately $707,000 in the first six months of 2011 compared to the same period of 2010.

Converting production costs, excluding depreciation, decreased in the first six months of 2011 compared to the same period in 2010 by approximately 7% on a per unit basis primarily due to reduced overhead costs per case.  Reduced overhead resulted from a $900,000 reduction in outside warehousing costs and higher production levels.  The previously discussed increase in the percentage of our parent roll production sold as parent rolls negatively affected our gross margin percentage.  Depreciation expense increased $1.2 million in the first six months of 2011 compared to the same period last year primarily due to the completion of our converting and waste water treatment expansion projects in 2010.

Gross Profit

Gross profit in the six months ended June 30, 2011, decreased $2.5 million, or 28%, to $6.4 million compared to $8.9 million in the same period last year.  Gross profit as a percentage of net sales in the six-month period ended June 30, 2011, was 13.9% compared to 19.5% in the same period in 2010.  The decrease in gross profit as a percent of net sales was primarily due to higher waste paper costs, lower converted product shipments, a higher percentage of parent roll sales and higher depreciation expense.

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Selling, General and Administrative Expenses

Selling, general and administrative expenses include salaries, commissions to brokers and other miscellaneous expenses.  Selling, general and administrative expenses decreased $180,000, or 5%, to $3.4 million in the six months ended June 30, 2011 compared to $3.6 million in the comparable 2010 period, mainly as a result of decreased accruals under our incentive bonus plan and decreased stock option expense, primarily due to a decrease in the price of our stock.  As a percentage of net sales, selling, general and administrative expenses decreased to 7.4% in the six months ended June 30, 2010 compared to 7.8% in the same period of 2010.

Operating Income

As a result of the foregoing factors, operating income for the six months ended June 30, 2011 was $3.0 million compared to operating income of $5.4 million for the same period of 2010.

Interest Expense and Other Income