Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW In the 2009 second quarter, we made a strategic decision to rationalize our product lines and exit the commercial print market, choosing to focus our resources on our growing custom folding carton line. As a result of the rationalization, we expect to realize significant improvement in operating performance as we had not realized the results that we had anticipated in the commercial print market over the last four years. In addition, we expect that we can be more effective in sales and marketing in the custom folding carton market with a more focused approach. Our custom folding carton customers are generally in the healthcare, confectionary, food and food service, and automotive industries, including private label manufacturers. Our expertise in this market is our ability to run on-demand the specific quantities required by our customers as opposed to doing long runs and creating inventory and obsolescence challenges either for our customers or ourselves. As a result, we do not require minimum print orders and are more flexible than most printers in addressing our customers' needs. This capability has served extremely well for our private label customers who may have several of the same carton requirements with varying print requirements for their customers.
We also plan to continue developing our stock packaging and personalized print product lines. Our stock packaging line serves primarily private confectionaries and, therefore is seasonal in nature and driven by the economy. During this recession, sales in stock packages have declined measurably. Our personalized print product line is focused on its store, catalog and web sales. Because we provide products such as personalized dinner and cocktail napkins, small boxes for sundries at events, and other celebration type items both for the retail and corporate markets, this product line is also heavily impacted by economic downturns. Nonetheless, we believe that in the stock packaging market, we are a leader with over 4,000 customers that we serve around the world. Also, in personalized print where we compete with much larger companies, we have developed a strong brand as Krepe-Kraft among event planners and wedding coordinators. Our website, www.partybasics.com, has had some success, and we also provide our products to third-party webstores as well.
REVENUE For the third quarter of 2009, total revenue was $12.6 million, relatively unchanged from the third quarter of 2008. The custom folding carton product line sales were $9.4 million compared with $8.2 million in the third quarter of 2008. The 14.8% increase was mainly due to substantial growth with several large existing customers and sales to one large new customer, offset partially by decreased business with several existing customers and decreased waste sales due to a drop in the recycled paperboard market. Sales of the Company's stock packaging product line were $2.2 million compared with $2.3 million in the third quarter of 2008, down 1.7% primarily due to weakness in general business conditions. Personalized print sales for the third quarter of 2009 were $0.8 million compared with $1.0 million in 2008, a decrease of 17.5%, mainly due to weakness in general business conditions. There were no specialty print and direct mail sales in the third quarter of 2009 due to the product line rationalization that took place at the end of the second quarter of 2009. Specialty print and direct mail sales were $1.1 million in the third quarter of 2008.
For the first nine months of 2009, total revenue was $36.1 million compared with $35.3 million in 2008, an increase of 2.4%. The custom folding cartons product line sales were $25.9 million compared with $22.2 million in 2008. This was an increase of 16.7% due to increased business volumes from several customers including substantial growth from several large existing customers and sales to one large new customer, that was partially offset by decreased business from several existing customers and decreased waste sales due to a drop in the recycled paperboard market. Sales of the Company's stock packaging product line were $5.9 million, compared with $6.4 million in the prior year, a decrease of 7.9% mainly due to weakness in general business conditions. Personalized print sales for the first nine months of 2009 were $2.4 million compared with $3.1 million in the same period of 2008, a decrease of 22.5% primarily due to general soft market conditions. Specialty print and direct mail sales for the first nine months of 2009 were $1.5 million compared to $3.2 million in the first nine months of 2009. There were no specialty print and direct mail sales in the third quarter of 2009 due to the product line rationalization that took place at the end of the second quarter of 2009.

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EXPENSES AND MARGINS Gross margin was 20.0% for the third quarter of 2009, up from 15.6% in the third quarter of 2008. The improvement in gross margin was driven by the measurable savings realized from the product line rationalization. Savings were realized through lower depreciation expense and decreased labor and supply costs. Lower freight and utility costs also helped margin improvement. Partially offsetting those gains were generally weaker custom folding carton sales mix and decreased product waste sales due to a drop in the recycled paperboard market. Selling, general, and administrative costs ("SG&A") decreased slightly to $1.8 million in the third quarter of 2009 from $1.9 million during the same period in the prior year. Lower labor costs due to reduced headcount from the product line rationalization combined with decreased professional service fees more than offset increased commission expense.
Gross margin was 12.2% for the first nine months of 2009, down from 13.0% for the same period of 2008. The current year gross margin for the first nine months was negatively affected by a generally weaker sales mix, decreased waste sales due to a drop in the recycled paperboard market, and increased repairs expense, offset slightly by lower depreciation expense in the current year. Selling, general, and administrative costs decreased 3.2% to $5.8 million in the first nine months of 2009 from $6.0 million during the same period in the prior year. This slight decrease was driven primarily by lower professional service costs, offset partially by higher depreciation expense. Included in the first nine months of 2009 SG&A, was $65 thousand in workforce reduction costs that were the result of the Company's rationalization of the specialty print and direct mail product lines in the second quarter of 2009. Additionally, $2.2 million of expense was incurred that was associated with the write-down of impaired assets in the second quarter of 2009. This impairment resulted from the Company's rationalization of the specialty print and direct mail product line in the second quarter of 2009 and the write-down of its Blasdell, NY facility to fair market value based on expected selling prices net of costs to sell.
TAXES The Company's effective tax rate for the third quarter and first nine months of 2009 was 0% and 3.3%, respectively. This benefit was less than the statutory income tax rate, primarily as a result of the Company recording a full valuation allowance of $1.0 million related to its net deferred tax asset. The valuation allowance was recorded due to the uncertainty with respect to utilizing this net deferred tax asset in the future based on the trend of operating losses. The effective tax rate for the third quarter and first nine months of 2008 was 74.1% and 31.8%, respectively. The effective tax rate in the third quarter of 2008 was impacted by a revision in the expected effective annual tax rate and the low amount of income before income taxes in the quarter.
NET INCOME/LOSS AND INCOME/LOSS PER SHARE The net income for the third quarter of 2009 was $1.0 million, compared with a net income of $0.01 million in the third quarter of 2008. In addition to the fluctuations discussed above, other income was $0.4 million in the third quarter of 2009. Included in this balance is a $0.3 million fair value adjustment to increase the balance of assets held for sale associated with the rationalized product line based on bids received in a public auction held in September 2009. These assets had previously been written down in the second quarter of 2009. Also included in other income was a $0.1 million gain on the sale of assets associated with the rationalized product line. Diluted income per share was $0.29 in the third quarter of 2009 and $0.00 in the third quarter of 2008. The net loss for the first nine months of 2009 was $3.2 million, or $0.95 per diluted share, compared with a net loss of $1.0 million, or $0.30 per diluted share, in the first nine months of 2008. This increase in loss was due to the fluctuations discussed above.
LIQUIDITY Cash and cash equivalents at October 3, 2009, were increased slightly to $0.3 million from the $0.2 million balance at December 31, 2008. The Company has access to a $5.0 million committed line of credit with a commercial bank, which expires in March 2010. At October 3, 2009, $0.6 million was borrowed and an additional $0.2 million was in use through standby letters of credit. The borrowed amount is a decrease of $0.4 million from the balance at December 31, 2008. Interest on the line of credit is either LIBOR plus 150 basis points or the prime rate plus 50 basis points at the Company's option.

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The decrease in the amount outstanding under the line of credit in the first nine months of 2009 was primarily the result of proceeds from the cash surrender value of officer's life insurance policies, proceeds from the sale of specialty print and direct mail equipment, non-cash impairment charges, and depreciation and amortization expense, partially offset by net losses, capital expenditures, and working capital requirements.
Accounts payable declined $0.3 million during the first nine months of 2009 primarily due to timing of payments.
Accounts receivable increased $0.8 million during the first nine month of 2009, primarily due to the timing of sales and collections.
Capital expenditures driven primarily by productivity improvement and upgrade investments, for the first nine months of 2009, were $0.8 million compared with $1.6 million for the first nine months of 2008. Depreciation and amortization for the first nine months of 2009 was $2.5 million compared with $2.9 million in the same period last year.
The Company believes that cash, cash equivalents, and the line of credit are sufficient to meet cash requirements for operations, capital expenditures and debt service for the balance of 2009. The Company's management is in the process of negotiation to renew or replace the existing line of credit that is due to expire in the first quarter of 2010.
There were no shares repurchased by the Company during the first nine months of 2009. The Company has authorization to repurchase 75,885 shares at October 3, 2009. The closing price of the Company's stock at October 3, 2009 was $2.39. At this price, the repurchase of 75,885 shares would require $181,365.

CONTRACTUAL OBLIGATIONS The following table displays an update in the format of the information originally presented on the Company's 2008 Form 10-K related to its capital lease obligations. (in thousands, as of December 31, 2008) Payments Due by Period Total 2009 2010-2011 2012-2013 After 2013 Line of Credit $ 1,000 - $ 1,000 - - Equipment Loans 650 136 305 209 - Other Loans 111 20 44 47 - Capital Lease Obligation - Aggregate payments (1) 7,844 155 339 360 6,990 Capital Lease Obligations - Aggregate (Other) 21 13 8 - - Operating Leases 849 514 326 9 - Purchase Commitments 1,278 1,022 256 - - Total $ 11,753 $ 1,860 $ 2,278 $ 625 $ 6,990

(1) Represents a forty-nine year lease beginning November 2003 for 203,000 square feet of office and warehouse buildings adjacent to our corporate printing and manufacturing property. Beginning in
November 2022
and ending in
October 2027,
the Company
has an option
to purchase
the property
for
$1.8 million
and terminate
the lease. If
the purchase
option is not
exercised,
the Company
is obligated
to make
monthly
payments of
$15,000
through
October 2052.

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COMMITMENTS The Company has commitments for items that it purchases in the normal on-going affairs of the business. The Company is not aware of any obligations in excess of normal market conditions, or of any long-term commitments that would have a material adverse affect on its financial condition.
MARKET RISK There has been no significant change in market risks since December 31, 2008. As a result of short cycle times, the Company does not have any long-term commitments to purchase production raw materials or sell products that would present significant risks due to price fluctuations. Raw paper stock is available to us from multiple domestic sources; as a result, we believe the risk of supply interruptions due to such things as strikes at the source of supply or to failures in logistics systems are limited.
Risks due to fluctuation in interest rates are not material to the Company at October 3, 2009 because of our limited exposure to floating rate debt. Since May of 2003, over 90% of the Company's power needs are met through natural gas. The Company has investigated supply contracts of various lengths and currently it has supply arrangements for fixed prices on approximately 60% of its estimated usage through October 2010. Historically, the price of natural gas has fluctuated widely. Although the Company is concerned about cost, its main concern is availability. The Company monitors the availability of natural gas, considering such factors as amount in storage, gas production data and transportation data, so that it can take appropriate action if concerns about availability occur. The Company has investigated and tested a back-up power source in the form of a rented transportable diesel-powered generator. Although such generators are generally available, the Company cannot be assured that a generator adequate to meet the Company's needs would be available if and when such need should arise.
We have no foreign operations, nor do we transact any business in foreign currencies. Accordingly, we have no foreign currency market risks. The market risk that the Company was exposed to at December 31, 2008 was generally the same as described above.
CRITICAL ACCOUNTING POLICIES There have been no changes in critical accounting policies in the current year from those disclosed in our 2008 Form 10-K.
FORWARD-LOOKING STATEMENTS Certain statements contained in this report are "forward-looking statements" within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. All forward-looking statements involve risks and uncertainties. All statements contained herein that are not clearly historical in nature are forward-looking, and the word "anticipate," "believe," "expect," "estimate," "project," and similar expressions are generally intended to identify forward-looking statements. Any forward looking statement contained herein, in press releases, written statements or other documents filed with the Securities and Exchange Commission, or in MOD-PAC's communications and discussions with investors and analysts in the normal course of business through meetings, webcasts, phone calls and conference calls, regarding expectations with respect to sales, earnings, cash flows, operating efficiencies, product and market channel expansions, capacity utilization and expansion, and repurchase of capital stock, are subject to known and unknown risks, uncertainties and contingencies. Many of these risks, uncertainties, and contingencies are beyond our control, and may cause actual results, performance or achievements to differ materially from anticipated results, performance or achievements. Factors that might affect such forward-looking statements include, among other things:
• Overall economic and business conditions;

• The demand for MOD-PAC's goods and services;

• Customer acceptance of the products and services MOD-PAC provides;

• Competitive factors in print and print services and folding cartons industries;

• Changes in tax requirements (including tax rate changes, new tax laws and revised tax law interpretations);

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• The availability and costs of natural gas supplies in Western New York State;

• The internal and external costs of compliance with laws and regulations such as Section 404 of the Sarbanes-Oxley Act of 2002; and

• Litigation against the Company.