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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

For the quarterly period ended September 30, 2013

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 October 25, 2013: 8,036,309 shares.

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ORCHIDS PAPER PRODUCTS COMPANY

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QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2013

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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 MKT under the ticker symbol “TIS.”

The accompanying financial statements have been prepared without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States have been condensed or omitted pursuant to the rules and regulations.  However, the Company believes that the disclosures made are adequate to make the information presented not misleading when read in conjunction with the audited financial statements and the notes in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012, filed with the SEC on March 11, 2013.  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 does not report any assets or liabilities at fair value in the financial statements.  However, the estimated fair value of the Company’s short-term investments, which consist of commercial deposits in money market funds, was $5,033,000 and $5,027,000 at September 30, 2013 and December 31, 2012, respectively.  These short-term investments are considered Level 1 measurements in the fair value valuation hierarchy.  The fair value of the Company’s long-term debt is estimated by management to approximate the carrying value of $15,367,000 and $16,231,000 at September 30, 2013 and December 31, 2012, respectively.  Management’s estimates are based on periodic comparisons of the characteristics of the Company’s obligations, including floating interest rate, credit rating, maturity and collateral, to current market conditions as stated by an independent third-party financial institution.  Such valuation inputs are considered a Level 2 measurement in the fair value valuation hierarchy.

There were no transfers among Level 1, Level 2 or Level 3 assets or liabilities during the first nine months in 2013 or 2012.

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ORCHIDS PAPER PRODUCTS COMPANY

NOTES TO UNAUDITED INTERIM FINANCIAL STATEMENTS (continued)

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 October 2008, the Company entered into a contract to purchase 334,000 MMBTU per year of natural gas.  This contract has been extended through December 2016 and provides for approximately 60% to 70% of the Company’s natural gas requirements through December 31, 2016 as follows:

Purchases under the gas contract were $0.5 million for each of the three months ended September 30, 2013 and 2012.  Purchases under the gas contract were $1.4 million and $1.5 million for the nine-month periods ended September 30, 2013 and 2012, respectively. If the Company is unable to purchase the contracted amounts and the market price at that time is less than the contracted price, the Company would be obligated under the terms of the agreement to reimburse an amount equal to the difference between the contracted amount and the amount actually purchased, multiplied by the difference between the contract price and current spot price.

Note 4 — Inventories

Inventories at September 30, 2013 and December 31, 2012 were as follows:

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ORCHIDS PAPER PRODUCTS COMPANY

NOTES TO UNAUDITED INTERIM FINANCIAL STATEMENTS (continued)

Note 5 — Income Taxes

As of September 30, 2013, our annual estimated effective income tax rate is 27.5%.  For the quarter ended September 30, 2013, our actual effective income tax rate was 24.6%.  For the nine months ended September 30, 2013, our actual effective income tax rate was 26.2%. The actual effective tax rate differs from the annual estimated effective income tax rate due to recognition of $222,000 of an Indian employment tax credit (“IEC”) for 2012 during the first quarter of 2013.  Recognition of the IEC for 2012 was deferred until the first quarter of 2013 as the American Taxpayer Relief Act of 2012, which extended the IEC, was not signed into law by the President of the United States until 2013.  For the quarter and nine months ended September 30, 2012, our actual effective income tax rate was 28.8% and 29.7%, respectively.  The annual estimated effective tax rate for 2013 and 2012 is lower than the statutory rate due to: (i) manufacturing tax credits, (ii) IECs, (iii) Oklahoma Investment Tax Credits primarily associated with our investments in a new paper machine in 2006 and new converting warehouse and new converting line that were completed in 2010, and (iv) tax benefits realized on incentive stock options exercised during the period.

Note 6 — Earnings per Share

During the first quarter of 2013, the Company granted restricted stock to certain employees. These awards include a nonforfeitable right to receive dividends and therefore are considered to participate in undistributed earnings with common shareholders.  Therefore, the Company calculates basic and diluted earnings per common share using the two-class method, under which net earnings are allocated to each class of common stock and participating security.  We expect all the shares of restricted stock to ultimately vest, and therefore, we have not estimated any forfeitures of restricted stock.

The computation of basic and diluted net income per common share for the three-month and nine-month periods ended September 30, 2013 and 2012 is as shown in the following table. The presentation of 2012 net income per share has been conformed to presentation under the two-class method.

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 stock options and other stock based awards to employees and board members selected by the board’s compensation committee.  A total of 1,097,500 shares may be issued pursuant to the Plan.  As of September 30, 2013, there were 147,750 shares available for issuance under the Plan.

The Company uses the Black-Scholes option valuation model to estimate the grant date fair value of its options.  Option valuation models require the input of highly subjective assumptions including the expected stock price volatility.  The following table details the options granted to certain members of the board of directors and management during the nine months ended September 30, 2013 and 2012.

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ORCHIDS PAPER PRODUCTS COMPANY

NOTES TO UNAUDITED INTERIM FINANCIAL STATEMENTS (continued)

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 $18,000 and $27,000 for the three months ended September 30, 2013 and 2012, respectively, and $303,000 and $318,000 for the nine months ended September 30, 2013 and 2012, respectively, related to options granted under the Plan.

During the nine months ended September 30, 2013, the Company granted 16,000 shares of restricted stock to certain employees under the Plan.  These awards were valued at the arithmetic mean of the high and low market price of the Company’s stock on the grant date, which was $21.695 per share, and vest ratably over a three year period beginning on the first anniversary of the grant date.  The Company expenses the cost of restricted stock granted over the vesting period of the shares based on the grant-date fair value of the award.  The Company recognized expense of $29,000 and $77,000 for the three and nine month periods ended September 30, 2013, respectively, related to the shares granted under the Plan.

Note 8 — Major Customers and Concentration of Credit Risk

The Company sells its paper production in the form of parent rolls and converted products.  Revenues from converted product sales and parent roll sales in the three months and nine months ended September 30, 2013 and 2012 were:

Credit risk for the Company in the three months and nine months ended September 30, 2013 and 2012 was concentrated in the following customers who each 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 September 30, 2013 and December 31, 2012 the four significant customers accounted for the following amounts of the Company’s accounts receivable (in thousands):

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

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ORCHIDS PAPER PRODUCTS COMPANY

NOTES TO UNAUDITED INTERIM FINANCIAL STATEMENTS (continued)

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 there are no recently issued accounting pronouncements that the Company has yet to adopt that are expected to have a material effect on the Company’s financial position, results of operations or cash flows.

Note 10 — Subsequent Event

The Company’s Credit Agreement with JPMorgan Chase Bank, N.A. dated April 25, 2011 (the “Credit Agreement”) contains two debt covenants that effectively limit annual capital expenditures: the Unfunded Capital Expenditure Limit and the Fixed Charge Coverage Ratio.  While the Company was in compliance with all debt covenants included in the Credit Agreement as of September 30, 2013, due to the expected level of the Company’s 2013 annual capital expenditures, management requested a waiver of these covenants for the period ending December 31, 2013.  On October 30, 2013, the Company obtained an advanced waiver from compliance with these covenants from JPMorgan Chase.

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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, 2012, as filed with the SEC on March 11, 2013, and include the following items:

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

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

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

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

·                  increased competition in our region;

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

·                  excess supply in the market may reduce our prices;

·                  the availability of and prices for energy;

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

·                  our exposure to variable interest rates;

·                  the loss of key personnel;

·                  labor interruption;

·                  natural disaster or other disruption to our facilities;

·                  ability to 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;

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

·                  inability to sell the capacity generated from our converting lines.

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

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Overview

We are an integrated manufacturer of tissue products serving the private label segment of the “at-home” market.  We produce bulk tissue paper, known as parent rolls, and convert parent rolls into finished products, including paper towels, bathroom tissue and paper napkins. We sell any remaining parent rolls to other converters.  Our core customer base consists of dollar stores and other discount retailers. By dollar stores, we mean retailers that offer a limited selection across a broad range of products at everyday low prices in a smaller store format.  We have focused on the dollar stores (which are also referred to as discount retailers) and the broader discount retail market because of their overall market growth, consistent order patterns and low number of stock keeping units (“SKUs”).  The at-home tissue market consists of several quality levels, including a value tier, mid-tier and premium tier.  Our historical business strategy has focused on the value tier market, primarily due to the dollar stores’ concentration of product offerings in that market and, to some extent, limitations of certain manufacturing equipment.  As part of our growth strategy, we began to systematically invest in manufacturing assets to improve quality, expand our product offerings and strengthen our position as a low cost manufacturer.  This began with the investment in a new paper machine in 2006 which provided the opportunity to produce parent rolls for value tier, mid-tier and premium tier converted products and improved our cost structure.  Further, we undertook an expansion project that included the purchase and installation of a new converting line and the construction of a new converted product warehouse in mid-2010.  This project had three main objectives: increase the capacity of our converting operation, provide the capability to produce higher-quality mid-tier and premium tier converted products and reduce warehousing costs by centralizing all warehousing and shipping.  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, as we believe this radius maximizes our freight cost advantage over our competitors. 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 ten years relative to the national average, and these trends are expected to continue.

Our products are sold primarily under our customers’ private labels and, to a lesser extent, under our brand names such as Colortex®, My Size®, Velvet®, Big Mopper®, Soft & Fluffy®, Tackle®, Noble® and Linen Soft®.  All of our converted product revenue is derived through 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, which is normal practice within our industry.  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 products;

·        the cost of fiber used in producing paper;

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

·        the cost of energy.

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

Background

Since June 2006, when we began operations of a new paper machine, our paper-making capacity of approximately 57,000 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.  When converting production requirements exceed paper mill capacity, we will purchase bulk rolls in the open market to meet those converting requirements.

Our parent rolls are converted into paper towels, bathroom tissue and napkins in our adjacent converting facility. Our eleven converting lines currently have a total annual estimated capacity of approximately 11.5 million cases of finished tissue products, depending upon the mix of converted products produced, including the product configurations.  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 are placing significant focus on improving our sales efforts to sell all of our converting capacity.  In addition, we continue to focus considerable efforts to improve our converting efficiencies.

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Our strategy is to expand our position as a low cost provider of high-quality private label tissue products to the growing discount retail channel while leveraging our competitive advantages to increase our presence in the mid-tier and premium tier markets within the discount retail channel as well as other retail channels.  We expect to accomplish this strategy through the expansion of our product offerings through new product development, our continued high service levels and increased total manufacturing capacity.

We are implementing 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 customers’ required attributes;

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

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

·                  continue to improve operating efficiencies and reduce manufacturing costs.

We continue to focus our efforts on growth of our converted product sales and expansion of our product offerings through development of mid-tier and premium tier products.  The following graph shows shipments of our mid-tier and premium tier products as a percentage of total cases shipped:

Since our inception in 1998, we have strategically expanded capacity and capability in both paper manufacturing and finished product converting to meet market demand and customers’ quality requirements.  In 2010, we increased our annual converting capacity with the installation of a new converting line, which, along with other strategic investments, increased our annual converting capacity to approximately 11.5 million cases per year, depending upon the mix of converted products produced, including the product configurations.  This additional converting capacity has enabled us to both increase sales of existing products and to provide the flexibility to manufacture higher tier products for sales to our core customer base and into new retail channels.

Although we have an annual estimated converting capacity of approximately 11.5 million cases, our in-house supply of parent rolls provides enough to convert approximately 9.5 million cases.  In order to convert at an annual capacity above approximately 9.5 million cases, we would have to supplement our supplies by purchasing parent rolls in the open market, which we believe would have an unfavorable impact on our gross profit margin.

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Comparative Three-Month Periods Ended September 30, 2013 and 2012

Net Sales

Net sales in the quarter ended September 30, 2013, increased 15% to $29.8 million, compared to $25.8 million in the same period of 2012. Net sales figures represent the gross selling price, including freight, less discounts and pricing allowances.  The increase in net sales is due to a $5.4 million increase in net sales of converted product which was partially offset by a $1.4 million decrease in parent roll net sales.

Net sales of converted product increased in the quarter ended September 30, 2013, by $5.4 million, or 24%, to $28.2 million compared to $22.8 million in the same period last year. The increase in net sales of converted product is the result of a 24% increase in the tonnage shipped.  There was no significant change in the net selling price per ton.  The increase in converted product tonnage shipped is primarily due to increased sales of our mid and premium tier product lines to both existing and new customers.

Net sales of parent rolls decreased $1.4 million, or 48%, to $1.6 million in the quarter ended September 30, 2013, compared to $3.0 million in the same period last year.  Net sales of parent rolls decreased due to the higher requirements by our converting operation resulting in less excess paper available to sell in parent roll form.  The higher converting requirements are due to the increased sales of converted product.  Tonnage shipments decreased 47%, while there was no significant change in the net selling price per ton of parent rolls.

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 11% to $22.6 million, compared to $20.4 million in the same period of 2012, due to the previously discussed higher net sales amounts.  As a percentage of net sales, cost of sales decreased to 76.0% in the 2013 quarter from 79.1% in the 2012 quarter.  Cost of sales as a percentage of net sales for the third quarter of 2013 was favorable to the prior year quarter due to a higher percentage of converted product sales, lower paper production costs and lower fiber costs being partially offset by increased labor costs and the costs associated with the purchase of external parent rolls, which exceeds the cost of parent rolls produced internally, for consumption in our converting operation.

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Our overall cost of paper in the third quarter of 2013 was $753 per ton, a decrease of $33 per ton compared to the same period in 2012.  Paper production costs decreased primarily due to lower fiber costs, lower maintenance and repair costs, lower labor costs, lower production supply costs and lower utility costs, which were partially offset by the costs associated with a higher percentage of virgin fiber utilized to meet the quality characteristics of our mid and premium tier products.  Average fiber prices decreased approximately 17% in the third quarter of 2013 compared to the same quarter in 2012, thereby decreasing our cost of sales by approximately $570,000 in the quarter-over-quarter comparison.  As a result of strong cost controls, maintenance and repair costs in the paper mill were approximately $462,000 lower in the 2013 quarter than in the prior year quarter.

In anticipation of a short term spike in parent roll requirements of the converting plant, we purchased parent rolls to supplement our paper making capacity.  We consumed those purchased parent rolls during the third quarter, which negatively affected costs by approximately $254,000.  Excluding the effects of depreciation and external warehousing costs, converting production costs on a per unit basis were higher in the 2013 quarter compared to the 2012 quarter, primarily due to labor costs incurred in our converting operation, which increased $178,000 compared to the same quarter in 2012.  The Company also incurred $107,000 of outside warehousing expense during the 2013 quarter; costs that were not incurred during the 2012 quarter.  The percentage of our parent roll production sold as converted products increased in the third quarter of 2013 compared to the same quarter last year, which had a positive effect on our gross margin percentage as converted product sales generally generate a higher margin than the sale of parent rolls.

Gross Profit

Gross profit in the quarter ended September 30, 2013, increased $1.7 million, or 32%, to $7.1 million compared to $5.4 million in the same period last year.  Gross profit as a percentage of net sales in the 2013 quarter was 24.0% compared to 20.9% in the 2012 quarter.  The gross profit increase as a percent of net sales was primarily the result of a higher percentage of converted product sales, lower paper production costs, and lower fiber costs.

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 $93,000, or 5%, in the quarter ended September 30, 2013 as compared to the same period in 2012 primarily due to higher commission expense due to the improved level of converted product sales.  As a percentage of net sales, selling, general and administrative expenses decreased to 7.1% in the third quarter of 2013 compared to 7.9% in the same period of 2012.

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Operating Income

As a result of the foregoing factors, operating income for the quarter ended September 30, 2013, was $5.0 million compared to operating income of $3.4 million for the same period of 2012.

Interest Expense and Other Income

Interest expense includes interest on all debt and amortization of deferred debt issuance costs.  Interest expense decreased $7,000 to $92,000 in the quarter ended September 30, 2013, compared to $99,000 in the quarter ended September 30, 2012.  The decrease in interest expense resulted from lower average borrowing levels.

Income Before Income Taxes

As a result of the foregoing factors, income before income taxes increased $1.6 million to $4.9 million in the quarter ended September 30, 2013, compared to $3.3 million in the same period in 2012.

Income Tax Provision

As of September 30, 2013, our annual estimated effective income tax rate is 27.5%.  This compares to the 29.7% we estimated as of the end of the second quarter of 2013.  As a result, for the quarter ended September 30, 2013, our actual effective income tax rate was 24.6%, while our actual effective income tax rate was 28.8% for the quarter ended September 30, 2012.  The  annual estimated effective income tax rate is lower than the statutory rate due to: (i) manufacturing tax credits, (ii) Indian employment tax credits (“IECs”), (iii) Oklahoma Investment Tax Credits primarily associated with our investments in a new paper machine in 2006 and new converting warehouse and new converting line that were completed in 2010 and (iv) tax benefits realized on incentive stock options exercised during the period.

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Comparative Nine-Month Periods Ended September 30, 2013 and 2012

Net Sales 

Net sales increased 11% to $85.6 million in the nine months ended September 30, 2013, compared to $76.8 million in the same period of 2012. Net sales figures represent gross selling price, including freight, less discounts and pricing allowances.  The increase in net sales is due to an $11.9 million increase in the sales of converted products being partially offset by a $3.1 million decrease in the net sales of parent rolls.

Net sales of converted product increased for the nine months ended September 30, 2013, by $11.9 million, or 17%, to $80.6 million compared to $68.7 million in the same period last year. The increase in net sales of converted products is the result of a 17% increase in the tons of product shipped.  Net selling price did not change significantly when compared to the same period last year.  Sales of new mid and premium tier products to both existing and new customers were the primary reasons for the increased shipments.

Net sales of parent rolls decreased $3.1 million, or 38%, to $5.0 million in the nine months ended September 30, 2013, compared to $8.1 million in the same period last year.  Net sales of parent rolls decreased due to a 40% decrease in parent roll tonnage shipped offset by a 4% increase in net selling prices.  Higher converting requirements due to increased sales were the primary reason for the decreased parent roll sales, while net selling prices increased due to the stronger parent roll market and market reaction to higher virgin fiber prices.

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.

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Cost of sales increased approximately $5.3 million, or 9%, to $64.9 million for the nine months ended September 30, 2013, compared to $59.7 million in the same period of 2012, due to higher net sales levels.  As a percentage of net sales, cost of sales decreased to 75.9% of net sales in the nine-month period ended September 30, 2013, compared to 77.7% of net sales in the nine-month period ended September 30, 2012. The decrease in cost of sales as a percentage of net sales in the nine months ended September 30, 2013, was primarily attributed to a higher percentage of converted product shipments, lower recycled fiber prices and lower paper manufacturing costs, being partially offset by external warehousing costs.

In the nine months ended September 30, 2013, our overall cost of paper was $754 per ton, a decrease of $8 per ton when compared to the same period in 2012.  Our cost per ton decreased due to lower paper production costs, including labor, maintenance and repairs, production supplies and utility costs.  Average fiber prices decreased 13% from the 2012 period to the 2013 period, which reduced the cost of sales by approximately $1.2 million in the first nine months of 2013 compared to the same period of 2012.  Maintenance and repair costs decreased by approximately $825,000 in the 2013 period compared to the prior year period.

Converting production costs on a per unit basis, excluding depreciation and external warehousing costs, increased slightly during the first nine months of 2013 compared to the same period in 2012, primarily due to $310,000 of increased labor costs in our converting operation.  The Company also incurred $730,000 of outside warehousing expense during 2013, which was not incurred during the prior year period.  However, the previously discussed decrease in the percentage of our production sold as parent rolls positively affected our gross margin percentage.

Gross Profit

Gross profit in the nine months ended September 30, 2013, increased $3.5 million, or 21%, to $20.7 million compared to $17.1 million in the same period last year.  Gross profit as a percentage of net sales in the nine-month period ended September 30, 2013, was 24.1% compared to 22.3% in the same period in 2012.  The increase in gross profit as a percent of net sales was primarily due to a higher percentage of converted product sales, lower recycled fiber prices and lower paper production costs, which were partially offset by external warehousing costs.

Selling, General and Administrative Expenses