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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 June 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 July 31, 2012: 7,568,975 shares.

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ORCHIDS PAPER PRODUCTS COMPANY

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QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2012

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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, 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 $5,022,000 and $2,019,000 invested in commercial deposits at June 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 June 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 six 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 at present, provides for approximately 60% of the Company’s natural gas requirements (increasing to 70%, or approximately 380,000 MMBTUs per year, as of April 2013) as follows:

Purchases under the gas contract were $0.4 million and $0.5 million for the three months ended June 30, 2012 and 2011, respectively, and $1.0 million and $1.2 million for the six months ended June 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 June 30, 2012 and December 31, 2011 were as follows:

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Note 5 — Income Taxes

As of June 30, 2012, our annual effective income tax rate is estimated to be 30.3%.  For the quarter and six months ended June 30, 2012, our effective income tax rate was 27.1% and 30.1%, respectively.  For the quarter and six months ended June 30, 2011, our effective income tax rate was 30.3%.  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 because of manufacturing tax credits and Oklahoma Investment Tax Credits primarily associated with our investments in a new paper machine, new converting warehouse and new converting line.

Note 6 — Earnings per Share

The computation of basic and diluted net income per share for the three-month and six-month periods ended June 30, 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.  The Plan is authorized to distribute up to 1,097,500 shares.

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 six months ended June 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 $215,000 and $168,000 for the three months ended June 30, 2012 and 2011, respectively, and $291,000 and $230,000 for the six months ended June 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 six months ended June 30, 2012 and 2011 were:

Credit risk for the Company in the three months and six months ended June 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 June 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.

Note 10 — Subsequent Event

On July 9, 2012, the Company’s shelf Registration Statement on Form S-3 (the “Registration Statement”) was declared effective by the Securities and Exchange Commission.  Pursuant to the Registration Statement, the Company, from time to time, may sell common stock, warrants or units comprised of the other securities described in the Registration Statement, in a single or multiple offerings up to a total dollar amount of $50,000,000, at prices and terms that will be determined at the time of the offering.

The Company’s willingness and ability to raise capital pursuant to the Registration Statement will depend upon a number of circumstances, including without limitation, the Company’s need for additional capital to fund operations, organic growth or acquisitions, the Company’s financial and operating performance and the receptiveness of the capital markets to potential offerings by the Company.  As of the date of this report, the Company does not have any agreements with respect to the issuance of securities pursuant to the Registration Statement.

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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, 2011, as filed with the SEC on March 7, 2012, 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;

·                  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;

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

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

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

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

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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®, 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.  Because our product is a daily consumable item, the order stream from our customer base is fairly consistent with no significant seasonal fluctuations. Changes in the national economy, in general, do not materially affect the market for our converted products.

Our profitability depends on several key factors, including:

·            the market price of our product;

·            the cost of 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 discount retail customers are extremely price sensitive.  As a result, it is difficult to effect 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.

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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 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.

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.

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.

Although we have an annual converting capacity of approximately 12.5 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 June 30, 2012 and 2011

Net Sales

Net sales in the quarter ended June 30, 2012, increased 8% to $25.3 million, compared to $23.4 million in the same period of 2011.  Net sales figures represent the gross selling price, including freight, less discounts and pricing allowances.  The increase in net sales is due to a $3.6 million increase in net sales of converted product which was partially offset by a $1.7 million decrease in parent roll net sales.

Net sales of converted product increased in the quarter ended June 30, 2012, by $3.6 million, or 19%, to $22.3 million compared to $18.8 million in the same period last year. The increase in net sales of converted product is primarily the result of a 24% increase in the tonnage shipped being partially offset by a 4% decrease in the net selling price per ton.  The increase in converted product tonnage shipped is due to increased sales to existing customers and 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 $2.9 million in the quarter ended June 30, 2012, compared to $4.6 million in the same period last year.  Net sales of parent rolls decreased primarily as a result of a 37% decrease in tonnage shipped, offset by a 1% increase in the net selling price per ton of parent rolls. 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.  The improvement in parent roll net selling prices is due to the stronger parent roll market.

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Total shipments in the second quarter of 2012 increased by 335 tons, or 2%, to 13,915 tons compared to 13,580 tons in the same period of 2011.  This increase is primarily the result of higher converted product shipments.  The increase in selling price per ton of $95, or 6%, to $1,817 in the second quarter of 2012 compared to $1,722 in the second quarter of 2011 is due to a 24% increase in the tonnage of converted products shipped and a 37% decrease in the tonnage of parent rolls 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 remained flat in the quarter ended June 30, 2012, as compared to the same period of 2011, despite the previously discussed higher net sales amounts.  Increased paper production costs and depreciation expense were offset by reduced fiber costs.  As a percentage of net sales, cost of sales decreased to 77.8% in the 2012 quarter from 84.1% in the 2011 quarter.  Cost of sales as a percentage of net sales for the second quarter of 2012 was favorable to the prior year quarter due to lower fiber costs and a higher percentage of converted product sales.

Our overall cost of paper in the second quarter of 2012 was $769 per ton, a decrease of $49 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 19% in the second quarter of 2012 compared to the same quarter in 2011, thereby decreasing our cost of sales by approximately $1.0 million in the quarter-over-quarter comparison.

Excluding the effects of the higher depreciation, converting production costs on a per unit basis were lower in the 2012 quarter compared to the 2011 quarter by 9% primarily as a result of a 15% increase in cases produced.  As previously discussed, the percentage of our parent roll production sold as parent rolls decreased in the second quarter of 2012 compared to the same quarter last year, which had a positive effect on our gross margin percentage as parent roll sales generally generate a lower margin than the sale of converted product.

Gross Profit

Gross profit in the quarter ended June 30, 2012, increased $1.9 million, or 51%, to $5.6 million compared to $3.7 million in the same period last year.  Gross profit as a percentage of net sales in the 2012 quarter was 22.2% compared to 15.9% in the 2011 quarter.  The gross profit increase as a percent of net sales was primarily the result of lower fiber prices, higher converted product shipments and a lower percentage of parent roll sales.

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Selling, General and Administrative Expenses

Selling, general and administrative expenses include salaries, commissions to brokers and other miscellaneous expenses.  Selling, general and administrative expenses increased $296,000, or 16%, in the quarter ended June 30, 2012 as compared to the same period in 2011 primarily due to higher accruals under our incentive bonus plan due to our increased earnings, higher professional fees and commission expense due to the improved level of converted product sales.  As a percentage of net sales, selling, general and administrative expenses increased to 8.4% in the second quarter of 2012 compared to 7.8% in the same period of 2011.

Operating Income

As a result of the foregoing factors, operating income for the quarter ended June 30, 2012, was $3.5 million compared to operating income of $1.9 million for the same period of 2011.

Interest Expense and Other Income

Interest expense includes interest on all debt and amortization of deferred debt issuance costs.  Interest expense decreased $89,000 to $102,000 in the quarter ended June 30, 2012, compared to $191,000 in the quarter ended June 30, 2011.  The decrease in interest expense resulted from our debt refinancing at the end of April 2011 at lower interest rates and lower average borrowing levels due to repayment of our Term Loan B.  Other expense includes a loss of approximately $336,000 due to the disposal of several pieces of converting equipment, including a wrapper and two case packers, following the completion of three capital expenditure projects totaling $2.1 million during the quarter.

Income Before Income Taxes

As a result of the foregoing factors, income before income taxes increased $1.4 million to $3.1 million in the quarter ended June 30, 2012, compared to $1.7 million in the same period in 2011.

Income Tax Provision

As of June 30, 2012, we estimate our annual effective income tax rate to be 30.3%.  This compares to the 32.7% we estimated as of the end of the first quarter of 2012.  As a result, for the quarter ended June 30, 2012, our effective income tax rate was 27.1%.  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.  For the quarter ended June 30, 2011, our annual effective income tax rate was 30.3%.  The 2011 rate is lower than the statutory rate because of manufacturing tax credits and Oklahoma Investment Tax Credits cited above.

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Comparative Six-Month Periods Ended June 30, 2012 and 2011

Net Sales

Net sales increased 11% to $51.0 million in the six months ended June 30, 2012, compared to $46.1 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 $9.2 million increase in the sales of converted products being partially offset by a $4.3 million decrease in the net sales of parent rolls.

Net sales of converted product increased for the six months ended June 30, 2012, by $9.2 million, or 25%, to $45.9 million compared to $36.7 million in the same period last year. The increase in net sales of converted products is the result of a 28% increase in the tons of product shipped offset by a 2% decrease in net selling price.  Increased demand for existing products from current customers as well as sales of new mid-tier products to existing customers were the primary reasons for the increased shipments.  The decrease in net selling prices is primarily the result of a change in product mix.

Net sales of parent rolls decreased $4.3 million, or 46%, to $5.1 million in the six months ended June 30, 2012, compared to $9.3 million in the same period last year.  Net sales of parent rolls decreased due to a 48% 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 a strengthening parent roll market and market reaction to higher fiber costs resulted in the higher net selling prices.

Total shipments in the six-month period of 2012 increased by 176 tons, or 1%, to 27,384 tons compared to 27,208 tons in the same period of 2011, primarily due to a 28% increase in shipments of converted products offset by a 48% decrease in parent roll shipments.  Our overall net selling price per ton increased by 10% in the first six months of 2012 compared to the comparable prior year period.  This increase was primarily attributable to a 28% increase in the tonnage of converted products shipped and a 48% decrease in the tonnage of parent rolls 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.

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Cost of sales decreased approximately $364,000, or 1%, to $39.3 million for the six months ended June 30, 2012, compared to $39.6 million in the same period of 2011, despite higher net sales levels.  As a percentage of net sales, cost of sales decreased to 77.0% of net sales in the six-month period ended June 30, 2012, compared to 86.1% of net sales in the six-month period ended June 30, 2011.  The decrease in cost of sales as a percentage of net sales in the six months ended June 30, 2012, was primarily attributed to lower fiber costs, higher converted product sales and a lower percentage of parent roll sales.

In the six months ended June 30, 2012, our overall cost of paper was $750 per ton, a decrease of $69 per ton when compared to the same period in 2011.  Our cost per ton decreased primarily due to decreased fiber prices, which were partially offset by higher maintenance and repair costs.  Average fiber prices decreased 22% from the 2011 period to the 2012 period, which reduced the cost of our fiber by approximately $2.4 million in the first six months of 2012 compared to the same period of 2011.

Converting production costs, excluding depreciation, decreased in the first six months of 2012 compared to the same period in 2011 by approximately 12% on a per unit basis primarily due to a 23% increase in cases produced.  Additionally, the previously discussed decrease in the percentage of our parent roll production sold as parent rolls positively affected our gross margin percentage.

Gross Profit

Gross profit in the six months ended June 30, 2012, increased $5.3 million, or 83%, to $11.7 million compared to $6.4 million in the same period last year.  Gross profit as a percentage of net sales in the six-month period ended June 30, 2012, was 23.0% compared to 13.9% in the same period in 2011.  The increase in gross profit as a percent of net sales was primarily due to lower fiber costs, higher converted product shipments and a lower percentage of parent roll sales.

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 $1.0 million, or 30%, to $4.4 million in the six months ended June 30, 2012 compared to $3.4 million in the comparable 2011 period, mainly as a result of increased professional fees, higher commission expense due to the higher level of converted product sales, increased accruals under an incentive bonus plan and higher artwork and packaging related expenditures.  As a percentage of net sales, selling, general and administrative expenses increased to 8.6% in the six months ended June 30, 2012 compared to 7.4% in the same period of 2011.

Operating Income

As a result of the foregoing factors, operating income for the six months ended June 30, 2012 was $7.3 million compared to operating income of $3.0 million for the same period of 2011.

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Interest Expense and Other Income

Interest expense decreased by $231,000 to $209,000 in the six months ended June 30, 2012, compared to $440,000 in the same period in the prior year.  The decrease was primarily attributable to higher balances of outstanding debt during 2011 related to the 2010 expansion of our waste water treatment facility and the construction of the new warehouse, prior to our debt refinancing in April 2011.  Other expense included the previously discussed $336,000 loss related to equipment disposals.