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

The following discussion may contain certain forward-looking statements that are subject to conditions that are beyond the control of the Company. Actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause actual results to differ include, but are not limited to, the Company's reliance on a small number of major clients; risks associated with the terms and pricing of our contracts; reliance on the telecommunications and direct marketing industries and the effect on the Company of the downturns, consolidation and changes in those industries in recent years; risks associated with the fluctuations in volumes from our clients; risks associated with upgrading, customizing, migrating or supporting existing technology; risks associated with competition; and other factors discussed in more detail in "Item 1A - Risk Factors" in our Annual Report on Form 10-K. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

Innotrac Corporation ("Innotrac" or the "Company"), founded in 1984 and headquartered in Atlanta, Georgia, is a full-service fulfillment and logistics provider serving enterprise clients and world-class brands. The Company employs sophisticated order processing and warehouse management technology and currently operates eight fulfillment centers and a call center in six cities spanning all time zones across the continental United States.

During the three months ended September 30, 2009, we completed the shutdown of one of our less automated facilities in Romeoville, Illinois. We recorded a charge in the quarter ended June 30, 2009 which included the cost of that facility's lease payments and carrying cost through the November 30, 2009 lease term on that building.

On July 5, 2009, the parent company of Smith and Hawken, Ltd. announced its decision to liquidate the operations of Smith and Hawken resulting in the Company ceasing to provide services to Smith and Hawken by a projected date of the end of 2009. One of our two facilities in Hebron, Kentucky is nearly exclusively used to provide fulfillment services for Smith and Hawken. By October 30th, we had substantially stopped providing fulfillment services to Smith and Hawken. We are evaluating existing and new customer opportunities to use that facility. Based on our current expectations regarding the terms of Smith and Hawken's liquidation plans and wind down of our services for Smith and Hawken, we do not currently project the shut down costs of our operations and the facility, net of recoverable costs from the client, to be material. At September 30, 2009, we had approximately $286,000 of undepreciated long lived assets in the facility which, if opportunities to restart operations are not formalized or the equipment is not moved to another facility, these long lived assets will be reviewed for possible impairment. As new business opportunities to be serviced from that facility are evaluated, we expect to be better able to assess whether any reserve for impairment of long lived asset or future costs related to this event is needed.

As presented in our prior quarterly report on Form 10-Q for the quarter ended June 30, 2009, the combined effect of the second quarter 2009 loss of the DSL fast access portion of AT&T fulfillment and the loss of the clients serviced from the Romeoville, Illinois facility and the loss of Smith and Hawken discussed immediately above is projected to result in a significant reduction in our revenue and operating profit in 2010 unless we identify new business services to replace these lost clients. The combined revenue generated from the AT&T DSL fast access account, the Romeoville, Illinois customers and Smith and Hawken represented approximately $27.1 million or 25.9% of our total service revenue of $104.5 million for the year ended December 31, 2008.

Additionally, we disclosed in our prior quarterly report on Form 10-Q for the quarter ended June 30, 2009, that the loss of the Romeoville clients business and partial loss of our AT&T business was expected to and, as reflected in this quarterly report on Form 10-Q for the quarter ended September 30, 2009, has caused a significant reduction in revenues and operating profit during the second half of 2009. In reaction to these events, we have already consolidated the call center operations and identified reductions in facility and general and administrative expenses which have partially offset the reduced profit contribution in future periods. Additionally, we have increased our marketing staffing and expect to increase our business development efforts going forward in an effort to replace these lost accounts. As we continue to review our prospects for new business, we will evaluate on an ongoing basis the carrying value of our long lived assets and goodwill for any possible impairment.

We receive most of our clients' orders either through inbound call center services, electronic data interchange ("EDI") or the Internet. On a same-day basis, depending on product availability, the Company picks, packs, verifies and ships the item, tracks inventory levels through an automated, integrated perpetual inventory system, warehouses data and handles customer support inquiries. Our fulfillment and customer support services interrelate and are sold as a package, however they are individually priced. Our clients may utilize our fulfillment services, our customer support services, or both, depending on their individual needs.

Our core service offerings include the following:

Fulfillment Services:
? sophisticated warehouse management technology ?? ? automated shipping solutions ? ??real-time inventory tracking and order status ? ??purchasing and inventory management ?? ? channel development ?? ? zone skipping for shipment cost reduction ? ??product sourcing and procurement ? ??packaging solutions ? ??back-order management; and ? ??returns management.

Customer Support Services:
? ??inbound call center services ? ??technical support and order status ? ??returns and refunds processing ? ??call centers integrated into fulfillment platform ? ??cross-sell/up-sell services ? ??collaborative chat; and ? intuitive e-mail response.

The Company is primarily focused on five diverse lines of business, or industry verticals. This is a result of a significant effort made by the Company to diversify both its industry concentration and client base over the past several years.

                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS

           Business Mix - Revenues


                                               Three Months Ended          Nine Months Ended
                                                  September 30,              September 30,
           Business Line/Vertical               2009          2008          2009         2008
           eCommerce / Direct to Consumer          47.3 %       34.9 %         40.7 %      35.2 %
           Direct Marketing                        30.1         34.8           30.0        35.9
           Modems                                  12.3         20.8           18.4        19.2
           Telecommunications                       7.2          3.9            5.2         3.7
           Business-to-Business ("B2B")             3.1          5.6            5.7         6.0
                                                  100.0 %      100.0 %        100.0 %     100.0 %

eCommerce/Direct-to-Consumer and Direct Marketing. The Company provides a variety of fulfillment and customer support services for a significant number of eCommerce, retail and direct marketing clients, including such companies as Target.com, a Division of Target Corporation, Ann Taylor Retail, Inc., The North Face, Microsoft, Inc., Product Partners and Thane International. We take orders for our retail, eCommerce and direct marketing clients via the Internet, through customer service representatives at our Pueblo call center or through direct electronic transmission from our clients. The orders are processed through one of our order management systems and then transmitted to one of our eight fulfillment centers located across the country and are shipped to the end consumer or retail store location, as applicable, typically within 24 hours of when the order is received. Inventory for our retail, eCommerce and direct marketing clients is held on a consignment basis, with minor exceptions, and includes items such as shoes, dresses, accessories, books, outdoor furniture, electronics, small appliances, home accessories, sporting goods and toys. Our revenues are sensitive to the number of orders and customer service calls received. Our client contracts do not guarantee volumes.

Telecommunications and Modems. The Company has historically been a major provider of fulfillment and customer support services to the telecommunications industry. In spite of a significant contraction and consolidation in this industry in the past several years, the Company continues to provide customer support services and fulfillment of consumer telephones and Digital Subscriber Line Modems ("Modems") for clients such as AT&T, Inc. and Qwest Communications International, Inc. and their customers. The consolidation in the telecommunications industry resulted in the acquisition of BellSouth by AT&T in December of 2006. On November 6, 2007, AT&T notified us that it intended to transition a portion of its fulfillment business in-house. That transition occurred at the end of the second quarter 2009. As a result, without new business in this vertical, our telecommunications and modems verticals are projected to represent a reduced percentage of our total revenues in the future.

Business-to-Business. The Company also provides fulfillment and customer support services for business-to-business ("B2B") clients, including NAPA and The Walt Disney Company. We have not concentrated efforts to grow our client base in this area, and due to the combination of the recent loss of a client and current economic conditions, we expect this vertical of our business to become a smaller percentage of our total revenues throughout the rest of 2009.

The following table sets forth unaudited summary operating data, expressed as a percentage of revenues, for the three and nine months ended September 30, 2009 and 2008. The data has been prepared on the same basis as the annual financial statements. In the opinion of management, it reflects normal and recurring adjustments necessary for a fair presentation of the information for the periods presented. Operating results for any period are not necessarily indicative of results for any future period.

                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS

    The financial information provided below has been rounded in order to
    simplify its presentation. However, the percentages below are calculated
    using the detailed information contained in the condensed financial
    statements.



                                                       Three Months Ended            Nine Months Ended
                                                         September 30,                 September 30,
                                                      2009            2008          2009           2008

    Service revenues                                     87.2 %         78.6 %         86.6 %        78.6 %
    Freight revenues                                     12.8           21.4           13.4          21.4
    Total Revenues                                      100.0 %        100.0 %        100.0 %       100.0 %

    Cost of service revenues                             38.7           36.0           37.7          36.3
    Cost of freight expense                              12.8           21.1           13.2          21.2
    Selling, general and administrative expenses         43.0           35.7           39.6          35.1
    Depreciation and amortization                         4.9            3.5            4.3           3.4
    Operating income                                      0.6            3.7            5.2           4.0
    Other expense, net                                   (0.2 )         (1.1 )         (0.3 )        (1.1 )
    Income before income taxes                            0.4            2.6            4.9           2.9
    Income taxes                                         (0.8 )            -           (0.2 )           -
    Net (loss) income                                    (0.4 )%         2.6 %          4.7 %         2.9 %

Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008

Service Revenues. Net service revenues decreased 22.8% to $19.4 million for the three months ended September 30, 2009 from $25.1 million for the three months ended September 30, 2008. This decrease was attributable to a $3.7 million decrease in revenue from our DSL-Modem clients due to the transition of a portion of the AT&T fulfillment business to AT&T's in-house fulfillment as previously discussed, a $1.1 million decrease in revenue from our direct marketing clients resulting from reduced volumes, a $1.0 million reduction in revenue from our B2B clients due to both the loss of clients that were being fulfilled from our Romeoville, Illinois facility and reduced volumes from existing clients and a $206,000 decrease in revenue from our eCommerce vertical resulting from a reduction in volumes. These decreases were offset by a $336,000 increase in revenue from our telecom vertical due to an increase in volumes.

Freight Revenues. The Company's freight revenues decreased 58.4% to $2.9 million for the three months ended September 30, 2009 from $6.9 million for the three months ended September 30, 2008. The $4.0 million decrease in freight revenues is primarily attributable to a combination of the transition of Company owned freight accounts to client owned freight accounts and the reduction in volumes from our direct marketing clients. Changes between reporting periods in freight revenue have no material impact on our operating profitability due to pricing practices for direct freight costs.

Cost of Service Revenues. Cost of service revenues decreased 25.2% to $8.6 million for the three months ended September 30, 2009, compared to $11.5 million for the three months ended September 30, 2008. The cost of service revenue decrease was primarily due to the reduction in service revenues explained above combined with a decrease in labor costs associated with the combined effect of a decreased use of higher cost temporary labor services and operating efficiencies resulting from adjusting labor shifts to correspond with client volumes. Cost of service revenues as a percent of service revenues decreased slightly by 1.4% to 44.5% from 45.9% for the three months ended September 30, 2009 and 2008 respectively.

Freight Expense. The Company's freight expense decreased 57.7% to $2.9 million for the three months ended September 30, 2009 compared to $6.9 million for the three months ended September 30, 2008 due to the decrease in freight revenue for the reasons discussed above.

Selling, General and Administrative Expenses. S,G&A expenses for the three months ended September 30, 2009 decreased to $9.6 million, or 43.0% of total revenues, compared to $11.4 million, or 35.7% of total revenues, for the same period in 2008. The increase in S,G&A expenses as a percentage of revenue in 2009 as compared to 2008 was primarily attributable to the decrease in revenues explained above. S,G&A expenses as a percentage of service revenue increased by 3.9% to 49.3% for the three months ended September 30, 2009 compared to 45.4% for the three months ended September 30, 2008. The decrease in S,G&A expenses primarily resulted from a $465,000 reduction in facility and equipment maintenance costs resulting from adjusting these costs to changes in client volumes combined with the offset of third quarter 2009 expenses totaling $295,000 related to the closing of the Romeoville facility against the reserve recorded at June 30, 2009, a $308,000 decrease in fulfillment and account management costs resulting from reductions in salaries due to the loss of clients discussed above, onetime legal costs of $296,000 incurred in 2008 related to a terminated merger agreement and a $215,000 reduction in worker's compensation insurance expense due to the adjustment of experience rates.

Interest Expense. Interest expense for the three months ended September 30, 2009 and 2008 was $42,000 and $358,000, respectively. The decrease was related to the September 26, 2008 repayment of the $5.0 million term loan which was outstanding in the third quarter of 2008 and a reduction in draws against the Credit Facility in 2009.

Income Taxes. The Company's effective tax rate for the three months ended September 30, 2009 and 2008 was 188% and 0% respectively. At December 31, 2003, a valuation allowance was recorded against the Company's net deferred tax assets as losses in recent years created uncertainty about the realization of tax benefits in future years. Income taxes associated with income for the three months ended September 30, 2009 and 2008 were offset by a corresponding decrease of the valuation allowance and tax expense of $167,000 for the three months ended September 30, 2009 related to the difference between financial and tax reporting of goodwill amortization was recorded, resulting in an effective tax rate of 188% and 0% for the three months ended September 30, 2009 and 2008 respectively.

Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008

Service revenues. Net service revenues decreased 8.0% to $68.1 million for the nine months ended September 30, 2009 from $74.0 million for the nine months ended September 30, 2008. This decrease was attributable to a $3.5 million decrease in revenue from our DSL-Modem clients primarily due to the transition of a portion of the AT&T fulfillment business to AT&T's in-house fulfillment as previously discussed, a $1.9 million decrease in revenue from our direct marketing clients resulting from decreased volume from existing clients and the loss of a client and a $1.6 million reduction in revenue from our B2B clients due to the loss of clients that were being fulfilled from our Romeoville, Illinois facility. These decreases were offset by a $513,000 increase in revenue from our eCommerce vertical resulting from increased volume from existing clients and a $554,000 increase in revenues from our telecom vertical resulting from an increase in volumes.

Freight Revenues. The Company's freight revenues decreased 48.0% to $10.5 million for the nine months ended September 30, 2009 from $20.2 million for the nine months ended September 30, 2008. The decrease in freight revenues of $9.7 million is primarily attributable to a combination of the transition of Company owned freight accounts to client owned freight accounts and the reduction in volumes from our direct marketing clients. Changes between reporting periods in freight revenue have no material impact on our operating profitability due to pricing practices for direct freight costs.

Cost of service revenues. Cost of service revenues decreased 13.4% to $29.6 million for the nine months ended September 30, 2009, compared to $34.2 million for the nine months ended September 30, 2008. The cost of service revenue decrease was due to a decrease in labor costs resulting from both reduced use of temporary labor services and operating efficiencies resulting from adjusting labor shifts to correspond with client volumes and fulfillment equipment installed during 2008 and the reduction in third quarter service revenues explained above. As a result of the improvement in labor costs, the cost of service revenues as a percent of service revenues decreased by 2.7% to 43.5% from 46.2% for the nine months ended September 30, 2009 and 2008 respectively.

Freight Expense. The Company's freight expense decreased 48.1% to $10.4 million for the nine months ended September 30, 2009 compared to $20.0 million for the nine months ended September 30, 2008 due to the decrease in freight revenue for the reason discussed above.

Selling, General and Administrative Expenses. S,G&A expenses for the nine months ended September 30, 2009 decreased to $31.1 million, or 39.6% of total revenues, compared to $33.1 million, or 35.1% of total revenues, for the same period in 2008. The increase in S,G&A expenses as a percentage of revenue in 2009 as compared to 2008 was primarily attributable to the decrease in freight revenue. S,G&A expenses as a percentage of service revenue increased slightly by 1.0% to 45.7% for the nine months ended September 30, 2009 compared to 44.7% for the nine months ended September 30, 2008. In June 2009, a $579,000 reserve was recorded for the costs associated with the Romeoville facility that will be closed at the termination of the Romeoville lease in November 2009 and employee severance costs associated with the transition of a portion of the AT&T fulfillment business to in-house fulfillment. Romeoville facility costs of approximately $295,000 incurred in the third quarter 2009 were offset against the reserve. The $2.0 million reduction in S,G&A expenses mainly resulted from a $759,000 reduction in facility management, equipment maintenance and account management costs made to respond to reductions in revenue discussed above, onetime legal costs of $406,000 incurred in 2008 related to a terminated merger agreement, reduced sales commission expense of $235,000 related to client accounts no longer eligible for sales commission and $197,000 in reduced travel costs.

Interest Expense. Interest expense for the nine months ended September 30, 2009 and September 30, 2008 was $207,000 and $1.1 million, respectively. The decrease was related to the interest and amortization of loan costs for the loans outstanding under the $5.0 million term loan which was outstanding during the nine months ended September 30, 2008 before being repaid on September 26, 2008 and a reduction in draws against the Credit Facility in 2009.

Income Taxes. The Company's effective tax rate for the nine months ended September 30, 2009 and 2008 was 4.3% and 0% respectively. At December 31, 2003, a valuation allowance was recorded against the Company's net deferred tax assets as losses in recent years created uncertainty about the realization of tax benefits in future years. Income taxes associated with income for the nine months ended September 30, 2009 and 2008 were offset by a corresponding decrease of the valuation allowance and tax expense of $167,000 related to the difference between financial and tax reporting of goodwill amortization was recorded resulting in an effective tax rate of 4.3% and 0% for the nine months ended September 30, 2009 and 2008 respectively.

The Company has a revolving credit facility (the "Credit Facility") with Wachovia Bank, National Association (the "Bank") which has a maximum borrowing limit of $15.0 million. The Credit Facility is used to fund the Company's capital expenditures, operational working capital and seasonal working capital needs. The Credit Facility was renewed on March 27, 2009 when the Company entered into a Fourth Amended and Restated Loan and Security Agreement (the "2009 Credit Agreement") with the Bank setting forth the new terms of the Credit Facility including a maturity date of June 30, 2012. There was no outstanding balance on September 30, 2009 under the Credit Facility.

The 2009 Credit Agreement continues the Bank's security interest in all of the Company's assets, but releases the Bank's previously granted security interest in certain personal assets of Scott Dorfman, the Company's Chairman, President and CEO, which were treated as additional collateral under the 2006 prior credit agreement.

Interest on borrowings pursuant to the 2009 Credit Agreement is payable monthly at specified rates of either, at the Company's option, the Base Rate (as defined in the 2009 Credit Agreement) plus between 2.00% and 2.50%, or the LIBOR Rate (as defined in the 2009 Credit Agreement) plus between 3.00% and 3.50%, in each case with the applicable margin depending on the Company's Average Excess Availability (as defined in the 2009 Credit Agreement). The Company will pay a specified fee on undrawn amounts under the Credit Facility. After an event of default, all loans will bear interest at the otherwise applicable rate plus 2.00% per annum.

The 2009 Credit Agreement contains financial, affirmative and negative covenants by the Company as are usual and customary for financings of this kind which can result in the acceleration of the maturity of amounts borrowed under the Credit Facility, including, without limitation, a change in ownership control covenant, a subjective material adverse change covenant and financial covenants establishing a minimum Fixed Charge Coverage Ratio of 1.35 to 1.00, maximum annual Capital Expenditures, and minimum Excess Availability (as each of these terms is defined in the 2009 Credit Agreement). The 2009 Credit Agreement also defines as an event of default any termination of the employment of the Chief Financial Officer of the Company, if the Company fails to fill such position with a replacement acceptable to the Bank within 90 days. The provisions of the 2009 Credit Agreement require that the Company maintain a lockbox arrangement with the Bank, and allows the Bank to declare any outstanding borrowings to be immediately due and payable as a result of noncompliance with any of the covenants. Accordingly, in the event of noncompliance, the Company's payment obligations with respect to such borrowings could be accelerated. Therefore, when the Company has a balance on its line of credit, it is classified as a current liability.

Under the terms of the Credit Facility, the maximum borrowing limit of $15.0 million is limited to borrowings at a specified percentage of eligible accounts receivable and inventory, which totaled $12.6 million at September 30, 2009. Additionally, the terms of the Credit Facility provide that the amount borrowed and outstanding at any time combined with certain reserves for rental payments, letters of credit outstanding and general reserves be subtracted from the Credit Facility limit or the value of the total collateral to arrive at an amount of unused availability to borrow. The total collateral under the Credit Facility at September 30, 2009 amounted to $12.6 million. At September 30, 2009, there were no borrowings outstanding under the Credit Facility, however, the value of reserves and letters of credit outstanding totaled $3.1 million. As a result, the Company had $9.5 . . .