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

OVERVIEW

In the third quarter of 2011, we continued to focus our resources on our growing custom folding carton line. We believe that we are beginning to gain some traction in our sales and marketing efforts in this product line with the more concentrated approach we have applied since rationalizing our product lines and exiting the commercial print market in the second quarter of 2009. As a result of that rationalization, we also have realized a significant improvement in our operating performance. Over the last two years, we lowered our cost structure, improved our operating efficiency and implemented sustainable improvements in every area of our business resulting in more than two full years of profitability.

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. 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 our private label customers, who may have several of the same carton requirements with varying print requirements for their customers, extremely well.

We also plan to continue developing our stock packaging and personalized print product lines. Our stock packaging line, which serves primarily private confectionaries, is seasonal in nature and driven by the economy. Nonetheless, we believe that we are a leader in this market with more than 3,000 customers that we serve primarily in the United States.

Our personalized print product line is focused on 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 for both the retail and corporate markets, this product line is heavily impacted by economic downturns. We compete in personalized print with much larger companies, yet 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 web stores as well.

REVENUE

For the third quarter of 2011, total revenue was $14.4 million compared with $12.4 million in 2010, an increase of 16.0%. The custom folding carton product line sales were $11.2 million compared with $9.3 million in the third quarter of 2010. The 21.1% increase was mainly due to increased business from several large existing customers, business from two new customers and increased waste sales due to improved market conditions, offset partially by decreased business with several existing customers. Sales of the Company's stock packaging product line were $2.3 million in the third quarter of 2011, up 2.7% from the third quarter of 2010, primarily due to improved market conditions. Personalized print sales for the second quarter of 2011 were $0.7 million compared with $0.8 million in 2010, a decrease of 4.2%, mainly due to continued weakness in this market.

For the first nine months of 2011, total revenue was $41.7 million, compared with $35.9 million in 2010, an increase of 16.0%. The custom folding cartons product line sales were $32.5 million compared with $27.0 million in 2010. The increase of 20.6% was mainly due to increased business from several large existing customers, business from three new customers and increased waste sales due to improved market conditions, offset partially by decreased business from several large customers. Sales of the Company's stock packaging product line were $6.6 million, compared with $6.3 million in the prior year, an increase of 5.3% mainly due to improved general business conditions. Personalized print sales for the first nine months of 2011 were $2.2 million, a decrease of 4.2% compared to the in the same period of 2010, primarily due to continued weakness in the market.

EXPENSES AND MARGINS

Gross margin was 19.7% for the third quarter of 2011, compared with 22.1% in the third quarter of 2010. Gross margin in 2011 was negatively affected by increased paperboard, repairs, supplies costs and sales mix, offset, partially, by decreased rental expense and operational leverage generated by increased product sales.

Selling, general, and administrative ("SG&A") costs were $1.8 million in the third quarter of 2011, an increase of 5.0% from the same period in the prior year. This increase was driven primarily by higher selling commissions.

Gross margin was 18.7% for the first nine months of 2011, compared to 18.1% for the same period of 2010. Operational leverage generated by increased product sales had a positive impact on gross margin. Gross margin was also positively affected by decreased rental expense, offset partially by increased repairs, supplies and paperboard costs, depreciation expense and sales mix.

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SG&A costs increased 3.7% to $5.6 million in the first nine months of 2011 from $5.4 million during the same period in the prior year. This increase was primarily the result of increased employee related costs and selling commissions offset partially by decreased professional services costs.

TAXES

The Company's effective tax rate for the third quarter and first nine months of 2011 was 36.9% and 34.0%, respectively. The Company's effective tax rate for the third quarter and first nine months of 2010 was 0.4% and 1.8%, respectively. The effective tax rate for the first nine months and third quarter of 2010 was recorded at a rate lower than customary mainly due to the utilization of available net operating loss carry-forward credits for which a full valuation allowance was previously recorded.

NET INCOME AND INCOME PER SHARE

The net income for the third quarter of 2011 was $625 thousand, compared with net income of $1.0 million in the third quarter of 2010. The net income was due to the fluctuations discussed above. Diluted income per share was $0.18 in the third quarter of 2011 and $0.28 in the third quarter of 2010.

The net income for the first nine months of 2011 was $1.5 million or $0.42 per diluted share, compared with $1.1 million, or $0.30 per diluted share, in the first nine months of 2010. This net income was due to the fluctuations discussed above.

LIQUIDITY

Cash and cash equivalents at October 1, 2011 was $2.2 million, which was down from the $3.4 million balance at December 31, 2010 for the reasons set forth below.

Accounts payable increased $0.9 million during the first nine months of 2011, primarily due to the timing of purchases and payments.

Accounts receivable increased by $1.0 million during the first nine months of 2011, primarily due to increased sales and the timing of payments from customers.

Inventory increased by $2.4 million mainly due to build-up of raw material and finished goods to satisfy customer needs.

Capital expenditures, driven primarily by productivity improvement and capacity investments, for the first nine months of 2011 and 2010 were $1.9 million and $1.2 million, respectively. Depreciation and amortization for the first nine months of 2011 and 2010 was $2.2 million and $2.1 million, respectively.

The Company made estimated tax payments of $0.6 million during the first nine months of 2011. This is less than the 2011 year to date tax expense of $0.8 million due to the utilization of available net operating loss carry-forwards for which a valuation allowance was previously recorded.

There were 182,539 shares repurchased by the Company during the first nine months of 2011. The Company has authorization to repurchase 200,000 shares at October 1, 2011. The closing price of the Company's stock at October 1, 2011 was $5.67. At this price, the repurchase of 200,000 shares would require $1.1 million.

The Company has access to a $3.0 million secured line of credit with a commercial bank which expires June 9, 2013. Interest on the line of credit is based on LIBOR plus 2.75%, with an interest floor of 3.35%. At October 1, 2011, $0.2 million was in use through a standby letter of credit and there was no balance drawn on the line. The Company was in compliance with all applicable covenants at October 1, 2011. The amount of the line of credit that was unused and available to the Company at October 1, 2011 was $2.8 million.

The Company believes that cash and cash equivalents, which totaled $2.2 million at October 1, 2011, in combination with cash expected to be generated from operations, will be adequate for the Company to meet its obligations, other working capital requirements and capital expenditure needs for the foreseeable future.

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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 effect on its financial condition.

MARKET RISK

There has been no significant change in market risks since December 31, 2010.

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 1, 2011 because of our limited exposure to floating rate debt.

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 80% of its estimated usage through October 2011 and 100% of its usage from November 2011 to October 2012. Historically, the price of natural gas has fluctuated widely. 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.

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, 2010 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 2010 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);

· Fluctuation in 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.

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