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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

x                QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

OR

o                   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 001-32563

Orchids Paper Products Company

(Exact name of Registrant as Specified in its Charter)

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 31, 2012: 7,582,975 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, 2012

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PART I. FINANCIAL INFORMATION

ITEM 1.  Financial Statements

ORCHIDS PAPER PRODUCTS COMPANY

BALANCE SHEETS

(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 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 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 common stock trades on the NYSE MKT under the ticker symbol “TIS.”

The accompanying financial statements have been prepared without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States have been condensed or omitted pursuant to the rules and regulations.  However, the Company believes that the disclosures made are adequate to make the information presented not misleading when read in conjunction with the audited financial statements and the notes in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed with the SEC on March 7, 2012.  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 had $5,024,000 and $2,019,000 invested in commercial deposits at September 30, 2012 and December 31, 2011, respectively.  These short-term investments are measured at fair value on a recurring basis and are considered Level 1 measurements in the fair value valuation hierarchy.  The Company had no liabilities measured at fair value at September 30, 2012 or December 31, 2011.  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 among Level 1, Level 2 or Level 3 assets during the first nine months in 2012 or 2011.

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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 at $7.50 per MMBTU plus a $0.07 per MMBTU management delivery fee.  This contract has been extended through December 2015 and provides for approximately 60% to 70% of the Company’s natural gas requirements through December 31, 2015 as follows:

Purchases under the gas contract were $0.5 million for the three months ended September 30, 2012 and 2011, respectively, and $1.5 million and $1.7 million for the nine months ended September 30, 2012 and 2011, 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, 2012 and December 31, 2011 were as follows:

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Note 5 — Income Taxes

As of September 30, 2012, our annual effective income tax rate is estimated to be 30.0%.  For the quarter and nine months ended September 30, 2012, our effective income tax rate was 28.8% and 29.7%, respectively. These rates differ from the annual effective income tax rate due to tax benefits recognized when employees exercised and sold incentive stock options during the periods described. For the quarter and nine months ended September 30, 2011, our effective income tax rate was 29.7% and 30.0%, respectively.  The rate for 2012 is lower than the statutory rate because of manufacturing tax credits, Indian Employment Credits and 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.  The 2011 rate is lower than the statutory rate due to the same reasons cited for the 2012 period.

Note 6 — Earnings per Share

The computation of basic and diluted net income per share for the three-month and nine-month periods ended September 30, 2012 and 2011 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 and board members selected by the board’s compensation committee.  A total of 1,097,500 shares of common stock are reserved 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, 2012 and 2011.

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 $27,000 and $38,000 for the three months ended September 30, 2012 and 2011, respectively, and $318,000 and $268,000 for the nine months ended September 30, 2012 and 2011, respectively, related to options granted under the Plan.

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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, 2012 and 2011 were: 

Credit risk for the Company in the three months and nine months ended September 30, 2012 and 2011 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

No other customer of the Company accounted for more than 10% of sales during these periods.

At September 30, 2012 and December 31, 2011, the four significant customers accounted for the following amounts of the Company’s accounts receivable (in thousands):

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.

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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:

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, 2011, as filed with the SEC on March 7, 2012, and include the following items:

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.

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Overview

We are an integrated manufacturer of tissue products serving the private label, or “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 value 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 start-up of a new paper machine in 2006 which provided the opportunity to produce parent rolls for the 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. 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®, Linen Soft®, Soft & Fluffy®, Tackle® , and Noble®.  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 private label market 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 converted into paper towels, bathroom tissue and napkins in our adjacent converting facility. Our eleven converting lines have a total annual capacity of approximately 12.5 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 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.

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 with the discount retail channel as well as other retail channels. This will be accomplished through the expansion of our product offerings through new product development, our continued high service levels and increased total manufacturing capacity.

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We are implementing this strategy through our key initiatives set forth below:

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 by approximately 4.0 million cases with the installation of a new converting line, which, along with other strategic investments, increased our annual converting capacity to 12.5 million cases per year.  This additional converting capacity will enable 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.  While our theoretical annual converting capacity is currently 12.5 million cases, in order to allow for production flexibility and provide a high level of customer service, our practical annual converting capacity is approximately 10.5 million cases.

Although we have an annual practical converting capacity of approximately 10.5 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.

Comparative Three-Month Periods Ended September 30, 2012 and 2011

Net Sales

Net sales in the quarter ended September 30, 2012, decreased 1% to $25.8 million, compared to $26.1 million in the same period of 2011.  Net sales figures represent the gross selling price, including freight, less discounts and pricing allowances.  The decrease in net sales is due to a $1.7 million decrease in parent roll net sales which was partially offset by a $1.4 million increase in net sales of converted product.

Net sales of converted product increased in the quarter ended September 30, 2012, by $1.4 million, or 6%, to $22.8 million compared to $21.4 million in the same period last year. The increase in net sales of converted product is primarily the result of an 8% increase in the tonnage shipped which was partially offset by a 2% decrease in the net selling price per ton.  The increase in converted product tonnage shipped is primarily due to expansion of our product lines to include mid-tier products.  The decrease in net selling price per ton is primarily due to a change in product mix.

Net sales of parent rolls decreased $1.7 million, or 36%, to $3.0 million in the quarter ended September 30, 2012, compared to $4.7 million in the same period last year.  Net sales of parent rolls decreased primarily as a result of a 37% decrease in tonnage shipped.  The net selling price per ton of parent rolls remained flat. 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 are due to the increased sales of converted product.

Total shipments in the third quarter of 2012 decreased by 866 tons, or 6%, to 14,015 tons compared to 14,881 tons in the same period of 2011.  This decrease is primarily the result of the higher levels of converted product sales and the normal yield loss that occurs when parent rolls are converted to products and, to a lesser extent, lower production of parent rolls.  The increase in selling price per ton of $84, or 5%, to $1,839 in the third quarter of 2012 compared to $1,755 in the third quarter of 2011 is primarily due to an increased percentage of converted product tons shipped, as converted products have a higher selling price per ton than parent rolls.

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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 in the quarter ended September 30, 2012, decreased 8% to $20.4 million, compared to $22.2 million in the same period of 2011.  As a percentage of net sales, cost of sales decreased to 79.1% in the 2012 quarter from 84.9% in the 2011 quarter.  Cost of sales as a percentage of net sales for the third quarter of 2012 was favorable to the prior year quarter due to lower paper production costs, which was primarily due to lower fiber costs, and the effects of increased converted product shipments as a percent of total sales, as converted product shipments generally earn a higher gross margin on a per ton basis than parent roll sales.

Our overall cost of paper in the third quarter of 2012 was $786 per ton, a decrease of $86 per ton compared to the same period in 2011.  Paper production costs decreased primarily due to lower fiber costs, which were partially offset by higher maintenance and repair costs.  Fiber prices decreased approximately 27% in the third quarter of 2012 compared to the same quarter in 2011, thereby decreasing our cost of sales by approximately $1.7 million in the quarter-over-quarter comparison.  Maintenance and repair costs increased approximately $0.5 million in the third quarter of 2012 compared to the same quarter in 2011.

Excluding depreciation, converting production costs on a per unit basis were lower in the 2012 quarter compared to the 2011 quarter by 9% primarily as a result of a 7% decrease in labor cost per case and a 5% decrease in overhead cost per case.  These improvements were primarily driven by higher production volumes.

Gross Profit

Gross profit in the quarter ended September 30, 2012, increased $1.5 million, or 37%, to $5.4 million compared to $3.9 million in the same period last year.  Gross profit as a percentage of net sales in the 2012 quarter was 20.9% compared to 15.1% in the 2011 quarter. The gross profit increase as a percent of net sales was primarily the result of lower fiber prices, increased converted product shipments as a percent of total sales and lower per case converting production costs, which were partially offset by higher maintenance and repair costs in the paper manufacturing operation, as discussed above.

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 $521,000 to $2.0 million in the 2012 quarter from $1.5 million in the 2011 quarter, primarily due to increased packaging related costs resulting from new product introductions, higher accruals under our incentive bonus plan due to our increased earnings and higher professional fees.  As a percentage of net sales, selling, general and administrative expenses increased to 7.9% in the third quarter of 2012 compared to 5.8% in the same period of 2011.

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Operating Income

As a result of the foregoing factors, operating income increased $933,000 to $3.4 million in the quarter ended September 30, 2012 compared to $2.4 million in the same period in 2011.

Interest Expense and Other Income

Interest expense includes interest on all debt and amortization of deferred debt issuance costs.

Income Before Income Taxes

As a result of the foregoing factors, income before income taxes increased $924,000 to $3.3 million in the quarter ended September 30, 2012, compared to $2.3 million in the same period in 2011.

Income Tax Provision

As of September 30, 2012, we estimate our annual effective income tax rate to be 30.0%.  This compares to the 30.3% we estimated as of the end of the second quarter of 2012.  As a result, for the quarter ended September 30, 2012, our effective income tax rate was 28.8%.  This rate is lower than the statutory rate because of manufacturing tax credits, Indian Employment Credits and 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.  For the quarter ended September 30, 2011, our annual effective income tax rate was 29.7%.  The effective tax rate is lower than the statutory rate because of the factors cited above.

Comparative Nine-Month Periods Ended September 30, 2012 and 2011

Net Sales

Net sales increased 6% to $76.8 million in the nine months ended September 30, 2012, compared to $72.2 million in the same period of 2011.  Net sales figures represent gross selling price, including freight, less discounts and pricing allowances.  The increase in net sales is due to a $10.6 million increase in the net sales of converted product and a $5.9 million decrease in the sales of parent rolls.

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Net sales of converted product increased for the nine months ended September 30, 2012, by $10.6 million, or 18%, to $68.7 million compared to $58.1 million in the same period last year. The increase in net sales of converted products is the result of a 21% increase in the tons of product shipped offset by a 2% decrease in net selling price.  The increase in converted product tonnage shipped is a result of increased demand for our products from current customers as well as sales of new mid-tier products to existing customers.  The decrease in net selling prices is primarily the result of a change in product mix.

Net sales of parent rolls decreased $5.9 million, or 42%, to $8.1 million in the nine months ended September 30, 2012, compared to $14.0 million in the same period last year.  Net sales of parent rolls decreased due to a 44% decrease in parent roll tonnage shipped which was partially offset by a 3% increase in net selling prices.  Higher converting requirements due to increased sales were the primary reason for the decreased parent roll sales.

Total shipments in the nine-month period of 2012 decreased by 690 tons, or 2%, to 41,399 tons compared to 42,089 tons in the same period of 2011, primarily due to a 44% decrease in parent roll shipments, partially offset by a 21% increase in shipments of converted products.  Our overall net selling price per ton increased by 8% in the first nine months of 2012 compared to the comparable prior year period.  This increase was primarily attributable to an increased percentage of converted product tons shipped, as converted products have a higher selling price per ton than 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 decreased approximately $2.1 million, or 3%, to $59.7 million for the nine months ended September 30, 2012, compared to $61.8 million in the same period of 2011.  As a percentage of net sales, cost of sales decreased to 77.7% of net sales in the nine-month period ended September 30, 2012, compared to 85.6% of net sales in the nine-month period ended September 30, 2011.  The decrease in cost of sales as a percentage of net sales in the nine months ended September 30, 2012 was primarily attributed to lower fiber costs, and the effects of increased converted product shipments as a percent of total sales, as converted product shipments generally earn a higher gross margin on a per ton basis than parent roll sales.

In the nine months ended September 30, 2012, our overall cost of paper was $762 per ton, a decrease of $75 per ton when compared to the same period in 2011.  Paper production costs decreased primarily due to lower fiber costs, which were partially offset by higher maintenance and repair costs.  Fiber prices decreased 24% from the 2011 period to the 2012 period, which reduced the cost of our fiber by approximately $4.1 million in the first nine months of 2012 compared to the same period of 2011.  Maintenance and repair costs increased approximately $1.0 million in the first nine months of 2012 compared to the same period of 2011.

Converting production costs, excluding depreciation, decreased in the first nine months of 2012 compared to the same period in 2011 by approximately 11% on a per unit basis primarily due to an 8% decrease in labor cost per case and an 11% decrease in overhead cost per case.  Additionally, the previously discussed decrease in the percentage of our total sales sold as parent rolls positively affected our gross margin percentage.

Gross Profit

Gross profit in the nine months ended September 30, 2012, increased $6.8 million, or 65%, to $17.1 million compared to $10.4 million in the same period last year.  Gross profit as a percentage of net sales in the nine-month period ended September 30, 2012, was 22.3% compared to 14.4% in the same period in 2011.  The increase in gross profit as a percent of net sales was primarily the result of lower fiber prices and increased converting production shipments as a percent of total sales.

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Selling, General and Administrative Expenses