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

OVERVIEW

In the second quarter of 2009, we made a strategic decision to rationalize our product lines and exit the Specialty Print and Direct Mail market, choosing to focus our resources on our growing Custom Folding Carton line. As a result of the rationalization, we have begun to, and expect to continue to realize improvement in operating performance over the long-term. In addition, we believe we are more effective in sales and marketing in the custom folding carton market with a more focused approach and better utilization of our resources. 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 on-demand processing capability. We manufacture and print the specific quantities of custom folding cartons required by our customers as needed by them as opposed to printing 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 our private label customers who may have several of the same carton requirements, but with varying print requirements for their customers, extremely well.

We also continue to develop 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. We believe that we are a leader in the private confectionery industry with over 4,000 customers that we serve in North America. 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 for both the retail and corporate markets, this product line is also heavily impacted by economic downturns. We can compete with much larger companies in the personalized print industry and we have developed a strong brand in Krepe-Kraft among event planners and wedding coordinators. Our websites, www.partybasics.com and myweddingbasics.com, make our products available directly to the retail market. We also provide our products to third-party web-stores.

REVENUE

For the first quarter of 2012, total revenue was $13.8 million compared with $13.9 million in 2011, a slight decrease of 0.8%. The custom folding carton product line sales were $10.4 million compared with $10.5 million in the first quarter of 2011. The 1.0% decrease was mainly due to decreased business from several large existing customers and decreased graphic arts charges, offset partially by business from one new large customer and increased business with several large existing customers. Sales of the Company's stock packaging product line were $2.7 million in the first quarter of 2012, up 3.2% from the first quarter of 2011, primarily due to improved market conditions. Personalized print sales for the first quarter of 2012 were $0.6 million compared with $0.7 million in 2011, a decrease of 12.3%, mainly due to continued weakness in this market.

EXPENSES AND MARGINS

Gross margin was 12.9% for the first quarter of 2012, compared with 16.2% in the first quarter of 2011. Gross margin in 2012 was negatively affected by sales mix, increased paperboard costs, employee benefits and depreciation expense, offset, partially, by decreased repairs expense and utilities expense.

Selling, general, and administrative ("SG&A") costs were $1.9 million in the first quarter of 2012, compared with $1.8 million in the same period of the prior year. This increase was driven primarily by increased professional services costs.

TAXES

The Company's effective tax rate for the first quarter of 2012 was 29.7%. The effective tax rate for the first quarter of 2012 was recorded at a rate lower than customary mainly due to state income taxes. The Company's effective tax rate for the first quarter of 2011 was 26.2%. The effective tax rate for the first quarter of 2011 was recorded at a rate lower than customary mainly due to alternative minimum tax credits.

NET LOSS/INCOME AND LOSS/INCOME PER SHARE

The net loss for the first quarter of 2012 was $0.1 million, compared with net income of $0.4 million in the first quarter of 2011. The net loss/income was due to the fluctuations discussed above. Diluted loss per share was $0.04 in the first quarter of 2012 and income of $0.10 per share in the first quarter of 2011.

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LIQUIDITY

Cash and cash equivalents at March 31, 2012 was $0.9 million, which was down from the $3.9 million balance at December 31, 2011 for the reasons set forth below.

Inventory increased by $0.8 million mainly due to planned forward purchasing of raw material.

Capital expenditures, driven primarily by productivity improvement and capacity investments, for the first three months of 2012 and 2011 were $2.3 million and $0.3 million, respectively. The Company expects total capital expenditures to be approximately $4.8 to $5.2 million for the 2012 year compared to $2.3 million for the 2011 year. Depreciation and amortization for the first three months of 2012 and 2011 was $0.8 million and $0.7 million, respectively.

There were no shares repurchased by the Company during the first three months of 2012. The Company has authorization to repurchase 200,000 shares at March 31, 2012. The closing price of the Company's stock at March 31, 2012 was $7.00. At this price, the repurchase of 200,000 shares would require $1.4 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 March 31, 2012, $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 March 31, 2012. The amount of the line of credit that was unused and available to the Company at March 31, 2012 was $2.8 million.

The Company believes that cash and cash equivalents, which totaled $0.9 million at March 31, 2012, in combination with its secured line of credit and 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.

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, 2011.

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 March 31, 2012 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 100% of its estimated usage through 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.

In the first quarter of 2012, the Company began a project to convert the majority of its power needs from natural gas to electricity. This project is expected to be completed and operational in the fourth quarter of 2012.

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, 2011 was generally the same as described above.

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CRITICAL ACCOUNTING POLICIES

There have been no changes in critical accounting policies in the current year from those disclosed in our 2011 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.