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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview. We produce film products for novelty, packaging and container applications. These products include metalized balloons, latex balloons and related latex toy products, films for packaging applications, and flexible containers for packaging and storage applications. We produce all of our film products for packaging and container applications at our plant in Barrington, Illinois. We produce all of our latex balloons and latex products at our facility in Guadalajara, Mexico. Substantially all of our film products for packaging applications and flexible containers for packaging and storage are sold to customers in the United States. We market and sell our novelty items - principally metalized balloons and latex balloons - in the United States, Mexico, the United Kingdom and a number of additional countries.

Recent Developments. On February 1, 2008, we entered into a License and Supply Agreement with S.C. Johnson & Son, Inc (“SC Johnson”). The agreement provides for the Company to manufacture and sell to SC Johnson (or its designee, Goodwill Commercial Services, Inc.) certain home food management products to be sold under the SC Johnson ZipLoc® brand. The agreement is for a term expiring on June 30, 2011 and provides for two renewal terms of two years each at the option of SC Johnson.

On or about July 11, 2008, the ZipLoc® Brand Vacuum Freezer System was launched in a number of retail outlets in the United States.

Results of Operations

Net Sales. For the three months ended September 30, 2008, net sales were $11,953,000 compared to net sales of $8,673,000 for the same period of 2007, an increase of 38%. For the quarters ended September 30, 2008 and 2007, net sales by product category were as follows:

 

		Three Months Ended
		September 30, 2008				September 30, 2007
		$		% of		$		% of
Product Category		(000) Omitted		Net Sales		(000) Omitted		Net Sales
Metalized Balloons		3,313		28%		2,899		34%
Films		2,418		20%		2,104		24%
Pouches		3,767		31%		1,581		18%
Latex Balloons		2,267		19%		1,900		22%
Helium/Other		188		2%		189		2%

 

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For the nine months ended September 30, 2008, net sales were $35,149,000 compared to net sales of $26,210,000 for the nine months ended September 30, 2007, an increase of 34%. For the nine months ended September 30, 2008 and 2007, net sales by product category were as follows:

 

		Nine Months Ended
		September 30, 2008				September 30, 2007
		$		% of		$		% of
Product Category		(000) Omitted		Net Sales		(000) Omitted		Net Sales
Metalized Balloons		12,829		37%		11,012		42%
Films		6,370		18%		5,891		22%
Pouches		9,656		27%		3,548		14%
Latex Balloons		5,737		16%		5,023		19%
Helium/Other		557		2%		745		3%

 

Metalized Balloons. During the three months ended September 30, 2008 revenues from the sale of metalized balloons increased by 14% compared to the prior year period from $2,899,000 to $3,313,000. During the nine months ended September 30, 2008 revenues from the sale of metalized balloons increased by 17% compared to the prior year period from $11,012,000 to $12,829,000. Most of this increase was the result of an increase in sales to a principal balloon customer.

Films. During the three months ended September 30, 2008 revenues from the sale of laminated films increased by 15% compared to the prior year period from $2,104,000 to $2,418,000. During the nine months ended September 30, 2008 revenues from the sale of laminated films increased by 8% compared to the prior year period from $5,891,000 to $6,370,000. The increase was the result of increased sales to a principal customer.

Pouches. During the three months ended September 30, 2008 revenues from the sale of pouches increased by 138% compared to the prior year period from $1,581,000 to $3,767,000. For the nine months ended September 30, 2008 revenues from the sale of pouches increased by 172% compared to the prior year period from $3,548,000 to $9,656,000. This significant increase was the result of sales of product under a new supply arrangement.

Latex Balloons. During the three months ended September 30, 2008 revenues from the sale of latex balloons increased by 19% compared to the prior year period from $1,900,000 to $2,267,000. For the nine months ended September 30, 2008 revenues from the sale of latex balloons increased by 14% compared to the prior year period from $5,023,000 to $5,737,000.

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Sales to a limited number of customers continue to represent a large percentage of our net sales. The table below illustrates the impact on sales of our top three and ten customers for the three and nine months ended September 30, 2008 and 2007.

		Three Months Ended						Nine Months Ended
		% of Net Sales						% of Net Sales
		September 30, 2008			September 30, 2007			September 30, 2008			September 30, 2007
Top 3 Customers			54.2%			47.3%			52.8%			47.1%
Top 10 Customers			76.1%			67.8%			72.5%			64.4%

 

During the nine months ended September 30, 2008, there were three customers whose purchases represented more than 10% of the Company’s consolidated net sales. The sales to each of these customers for the nine months ended September 30, 2008 were $6,307,000 or 18%, $6,267,000 or 18%, and $5,974,000 or 17% of consolidated net sales, respectively. The first customer is new to the Company in 2008. Sales of the other two customers in the same period of 2007 were $4,165,000 or 16%, and $5,300,000 or 20% of consolidated net sales, respectively. During the three months ended September 30, 2008, there were three customers whose purchases represented more than 10% of the Company’s consolidated net sales. The sales to each of these customers for the three months ended September 30, 2008 were $2,569,000 or 22%, $2,390,000 or 20%, and $1,520,000 or 13% of consolidated net sales, respectively. The first customer is new to the Company in 2008. Sales of the other two customers in the same period of 2007 were $1,960,000 or 23%, and $1,018,000 or 11% of consolidated net sales, respectively. As of September 30, 2008, the total amount owed to the Company by these customers was $1,381,000 or 21%, $1,173,000 or 17% and $470,000, or 7%, of the Company’s consolidated accounts receivables. The amounts owed at September 30, 2007 were $997,000, or 17%, and $667,000, or 12% of the Company’s consolidated net accounts receivables, respectively.

 

Cost of Sales. During the three months ended September 30, 2008, the cost of sales represented 77% of net sales compared to 81% for the three months ended September 30, 2007. For the nine months ended September 30, 2008, the cost of sales represented 77% of net sales compared to 76% for the same period of 2007. In the third quarter 2007, gross margins were negatively affected by certain production expenses not present in the third quarter 2008, including: (i) set-up, testing and initial production costs associated with the installation and initial production of pouch product lines and (ii) relatively low levels of production resulting in higher production overhead unit costs, which together account generally for the difference in margin levels between the third quarter 2008 compared to the same period of 2007. We have estimated the costs of set-up, testing and initial production expenses incurred during the third quarter 2007 were approximately $627,000 of which $549,000 was capitalized. For the third quarter 2008 and the nine month period ended September 30, 2008, gross margins were negatively affected by increases in the costs of raw materials in those periods compared to the same periods of 2007. We have determined that raw materials for United States production increased, on average, 14.4% over the nine months ended September 30, 2008, from the pricing levels in effect at December 31, 2007. Certain of our supply agreements include provisions for adjusting the selling price of finished goods based on certain raw materials costs, generally determined on a quarterly basis, so to some degree, we were able to adjust selling prices during the period based on increases in raw materials costs. However, there is a lag between the time of such cost increases and the time we can increase selling prices. Further, we do not have such agreements with respect to our novelty balloon products and we are not able, in all instances, to raise the selling price of such products to compensate for the increase in raw materials costs. Toward the end of the third quarter 2008 and extending into the fourth quarter 2008, the price of commodities which affect our raw materials costs (principally oil and latex) have declined significantly and we are beginning to experience reductions in certain of our raw materials costs. We do anticipate reductions in the cost of various raw materials over the next several months and believe that such reductions will result in improvement in our gross margins.

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General and Administrative. During the three months ended September 30, 2008, general and administrative expenses were $1,449,000 or 12% of net sales, compared to $1,413,000 or 16% of net sales for the same period in 2007. For the nine months ended September 30, 2008, general and administrative expenses were $4,064,000 or 12% of net sales, compared to $3,923,000 or 15% of net sales for the same period in 2007. During the three and nine months ended September 30, 2008, administrative expenses declined as a percentage of sales but increased on an absolute basis. The increase is attributable principally to the increase in total employee compensation annual increases and additional personnel in the accounting area.

Selling. During the three months ended September 30, 2008, selling expenses were $247,000 or 2% of net sales, compared to $162,000 or 2% of net sales for the same period in 2007. For the nine months ended September 30, 2008, selling expenses were $710,000 or 2% of net sales, compared to $592,000 or 2% of net sales for the same period in 2007. During the three and nine months ended September 30, 2008, selling expenses remained stable as a percentage of sales but increased on an absolute basis. This increase is attributable principally to salaries, $35,000 for the three months and $74,000 for the nine months ending September 30, 2008, and traveling expenses related to selling, $21,000 for the three months and $43,000 for the nine months ending September 30, 2008. 

Advertising and Marketing. During the three months ended September 30, 2008, advertising and marketing expenses were $493,000 or 4% of net sales for the period, compared to $326,000 or 4% of net sales for the same period of 2007. For the nine months ended September 30, 2008, advertising and marketing expenses were $1,265,000 or 4% of net sales for the period, compared to $1,013,000 or 4% of net sales for the same period of 2007. During the three and nine months ended September 30, 2008, advertising and marketing expenses remained stable as a percentage of sales but increased on an absolute basis. This increase is attributable principally to (i) marketing and promotional activities including allowances to balloon and pouch customers of $114,000 and $136,000 for the three and nine month period ending September 30, 2008, (ii) website enhancements relating to our ZipVac™ product line of $24,000 and $42,000 for the three and nine month period ending September 30, 2008, and (iii) trade show expense relating primarily to our ZipVac™ product line of $20,000 and $59,000 for the three and nine month period ending September 30, 2008.

Other Income (Expense). During the three months ended September 30, 2008, the Company incurred net interest expense of $243,000, compared to net interest expense during the same period of 2007 in the amount of $349,000. For the nine months ended September 30, 2008, the Company incurred net interest expense of $799,000, compared to net interest expense during the same period of 2007 in the amount of $976,000. The decrease in interest expense is due to lower applicable interest rates on outstanding loan principal amounts.

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During the three months ended September 30, 2008, the Company had other income of $25,000 compared to other income of $72,000 for the same period of 2007. For the nine months ended September 30, 2008, the Company had other income of $67,000 compared to other income of $165,000 for the same period of 2007. Both amounts consisted principally of foreign currency transaction gains.

Income Taxes. For the three months ended September 30, 2008, the Company reported a consolidated income tax expense of $66,000, compared to an income tax benefit of $146,000 during the same period in 2007. For the third quarter 2008, this income tax provision was composed principally of provisions for income tax on the income of CTI Balloons (our UK subsidiary) and Flexo Universal (our Mexico subsidiary). For the United States entity, there was no provision for income tax expense, by reason of the fact that the provision for income tax expense was offset by a reduction of the valuation allowance with respect to the deferred tax asset. For the third quarter of 2007, the income tax benefit related to losses incurred by our U.S. entity and Flexo Universal.

For the nine months ended September 30, 2008, we recorded an income tax expense of $182,000 compared to an income tax benefit of $31,000 for the nine months ended September 30, 2007. For both of these periods, the amount of the income tax expense or benefit recorded related to net income or loss of CTI Balloons and Flexo Universal. In these periods, there was no provision for income tax expense for the United States entity by reason of the fact that the income tax provision was offset by a reduction of the valuation allowance with respect to the deferred tax asset.

Net Income (Loss). For the three months ended September 30, 2008, the Company had net income of $269,000 or $0.10 per share (basic) and $0.09 (diluted), compared to net loss for the same period of 2007 of ($414,000) or ($0.18) per share (basic and diluted). For the nine months ended September 30, 2008, the Company had net income of $1,033,000 or $0.38 per share (basic) and $0.35 (diluted), compared to net loss from operations of ($43,000) or ($0.02) per share (basic and diluted) for the same period of 2007. The difference in net income for the third quarter of 2008 compared to the same period of 2007 is attributable principally to increased sales and gross profits.

 

Financial Condition, Liquidity and Capital Resources 

Cash Flow Items.

Operating Activities. During the nine months ended September 30, 2008, net cash provided by operations was $384,000, compared to net cash provided by operations during the nine months ended September 30, 2007 of $851,000.

Significant changes in working capital items during the nine months ended September 30, 2008 consisted of (i) an increase in accounts receivable of $1,012,000, (ii) an increase in inventory of $1,159,000 (iii) depreciation and amortization in the amount of $1,171,000, (iv) a decrease of $229,000 in prepaid expenses and other assets and (v) a decrease in accrued liabilities of $231,000.

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Investing Activity. During the nine months ended September 30, 2008, cash used in investing activity was $1,503,000, compared to $1,702,000 in the same period of 2007.

Financing Activities. During the nine months ended September 30, 2008, cash provided by financing activities was $1,532,000 compared to cash provided by financing activities for the same period of 2007 in the amount of $784,000. During the nine months ended September 30, 2008 financing activities included the receipt of $866,000 from the increase in the balances on our revolving line of credit, the receipt of $1,224,000 from the issuance of additional long term debt (proceeds under a capital lease line), and payment of long term debt obligations in the amount of $851,000.

Liquidity and Capital Resources. At September 30, 2008, the Company had cash balances of $860,000. At September 30, 2008, the Company had a working capital balance of $2,867,000 compared to a working capital balance of $1,318,000 at December 31, 2007.

The Company's current cash management strategy includes utilizing the Company's revolving line of credit for liquidity. Under our line of credit with RBS Citizens N.A. (formerly Charter One Bank), we are entitled to borrow an amount equal to 85% of eligible receivables and 60% of eligible inventory, up to a maximum of $9,000,000. Foreign receivables and inventory held by our foreign subsidiaries are not eligible. In addition, in order to be permitted to make advances under the line of credit, we are required to meet various financial covenants. As of September 30, 2008, we had complied with all applicable financial covenants in the loan agreement. Based on our results to date for the year and our projected results of operations for the balance of this year, we believe we will be in compliance with all applicable financial covenants of the loan agreement for the balance of 2008. Further, we believe that with our present cash and working capital and the amounts available to us under our line of credit and through sales of common stock, we will have sufficient funds to enable us to meet our obligations through the next twelve months.

The loan agreement provides for interest at varying rates in excess of the Bank’s prime rate, depending on the level of senior debt to EBITDA over time. As of September 30, 2008, the applicable premium being applied was 0.50%.

Also, under the loan agreement, we were required to purchase a swap agreement with respect to at least 60% of the mortgage and term loan portions of our loan. On April 5, 2006, we entered into a swap arrangement with RBS Citizens N.A. (formerly Charter One Bank) with respect to 60% of the principal amounts of the mortgage loan and the term loan, which had the effect of fixing the interest rate for such portions of the loans at 8.49% for the balance of the loan terms. On January 28, 2008 we entered into a swap arrangement with RBS Citizens for an additional $3,000,000 on our revolving line of credit, which had the effect of fixing the interest rate at 6.17%. These swap agreements are designated as a cash flow hedge and hedge the Company’s exposure to interest rate fluctuations on the Company’s floating rate loans. These swap arrangements are derivative financial instruments with respect to which we determine and record the fair market value each quarter. We record the fair market value of these contracts in the balance sheet, with an offset to other comprehensive loss. The fair market value of these swap agreements as of September 30, 2008 was a liability of $180,000. For the three months and nine months ended September 30, 2008, the other comprehensive loss included $62,000 and $57,000, respectively, of unrecognized losses representing the change in the mark-to-market value of the Company’s interest rate swap agreements for such periods. The swap agreements require monthly settlements of the difference between the amount to be received and paid under the agreements, the amount of which is recognized in current earnings as interest expense.

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The revolving loan line of credit matures on January 31, 2009. We are engaged in discussions with the Bank for the renewal or extension of the revolving loan line of credit. Our term loan and mortgage loan with the bank mature on January 31, 2011.

On June 6, 2006, we entered into a Standby Equity Distribution Agreement with Cornell Capital Partners LLC pursuant to which we may, at our discretion, periodically sell to Cornell Capital shares of common stock for a total purchase price of up to $5 million. For each share of common stock purchased under the Standby Equity Distribution Agreement, Cornell Capital will pay one hundred percent (100%) of the lowest volume weighted average price (as quoted by Bloomberg, LP) of our common stock on the NASDAQ Capital Market or other principal market on which our common stock is traded for the five (5) days immediately following the notice date. The number of shares purchased by Cornell Capital for each advance is determined by dividing the amount of each advance by the purchase price for the shares of common stock. Furthermore, Cornell Capital will receive five percent (5%) of each advance in cash under the Standby Equity Distribution Agreement as an underwriting discount. Cornell’s obligation to purchase shares of our common stock under the Agreement is subject to certain conditions, including: (i) we have obtained an effective registration statement for the shares of common stock sold to Cornell under the Agreement and (ii) the amount of each advance requested by us under the Agreement shall not be more than $100,000.

 

We are permitted to make draws on the Standby Equity Distribution Agreement only so long as Cornell Capital’s beneficial ownership of our common stock remains lower than 9.9% and a possibility exists that Cornell Capital may own more than 9.9% of CTI’s outstanding common stock at a time when we would otherwise plan to make an advance under the Standby Equity Distribution Agreement. We do not have any agreements with Cornell Capital regarding the distribution of such stock, although Cornell Capital has indicated that it intends promptly to sell any stock received under the Standby Equity Distribution Agreement.

 

We have registered 400,000 shares of common stock for the sale under the Standby Equity Distribution Agreement (SEDA). The Company and Cornell have agreed that the Company will not sell to Cornell Capital in excess of 400,000 shares unless and until the Company shall have obtained shareholder approval for such sales.

 

On December 28, 2006, we filed a Registration Statement for the registration of 403,500 shares of our common stock. On January 26, 2007, the Registration Statement was declared effective. Since that time, we have sold an aggregate of 341,864 shares of common stock to Cornell under the SEDA and have received net proceeds from the sale of those shares in the amount of $1,449,000. On July 24, 2008, we filed a Post Effective Amendment to the Registration Statement which became effective on August 1, 2008.

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Seasonality

In recent years, sales in the metalized balloon product line have historically been seasonal with approximately 45% occurring in the period from December through March and 21% being generated in the period from July through October. The sale of latex balloons and laminated film products have not historically been seasonal.

Critical Accounting Policies

Please see our Annual Report on Form 10-K for the year ended December 31, 2007 presented on pages 38-40, for a description of policies that are critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. No material changes to such information have occurred during the nine months ended September 30, 2008.

In September 2006, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, or SFAS No. 157. SFAS No. 157 clarifies the principle that fair value should be based on the assumptions that market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with early adoption permitted. Subsequently, the FASB provided for a one-year deferral of the provisions of SFAS No. 157 for non-financial assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a non-recurring basis. We adopted with no impact on our financial statements all requirements of SFAS No. 157 on January 1, 2008, except as they relate to nonfinancial assets and liabilities, which will be adopted on January 1, 2009, as allowed under SFAS No. 157. We have not yet determined the impact, if any, on our financial statements for nonfinancial assets and liabilities.