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, provides order processing, fulfillment and customer support "contact" center services to large corporations that outsource these functions. In order to perform contact center and fulfillment functions in-house, a company may be required to develop expensive, labor-intensive infrastructures, which may divert its resources and management's focus from its principal or core business. By assuming responsibility for these tasks, Innotrac strives to improve the quality of the non-core operations of our clients and to reduce their overall operating costs.

We provide our services in the United States through an integrated network of eight fulfillment centers having a total footprint of 2.8 million square feet and one contact center which is expandable to over 400 workstations. Through Innotrac Europe, a joint venture created in 2011 and headquartered in Germany, we provide end to end fulfillment services in Europe through a network of operations with over 20 years of experience.

We receive most of our clients' orders either through inbound contact 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 competencies include:

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

Contact Center Services:
? inbound customer support services
? technical support and order status
? returns and refunds processing
? call center integrated into fulfillment platform ? cross-sell/up-sell services
? collaborative chat
? intuitive e-mail response

Business Mix - Revenues

                                            Three Months Ended March 31,
Business Line/Vertical                    2012                2011
  eCommerce/Direct-to-Consumer                     69.6 %              58.2 %
  Direct Marketing                                 19.0                25.6
  Modems & Telecommunications products              9.1                13.9
  Business-to-Business ("B2B")                      2.3                 2.3
                                                  100.0 %             100.0 %

Note: The above table is compiled by presenting the total of any individual client in a single Business Line/Vertical consistently in the years 2012 and 2011 based on the predominant category of the client's revenues for the year ended 2011.

eCommerce/Direct-to-Consumer and Direct Marketing. The Company is a major provider of fulfillment and customer support services to eCommerce/Direct to Consumer and Direct Marketing clients which include such companies as Target.com, a division of Target Corporation, Ann Taylor Retail, Inc., The North Face, Microsoft, Inc., Beachbody, LLC and Thane International. Our revenues are a result of the number of orders and customer service calls received. Our client contracts generally do not guarantee volumes. We anticipate that the percentage of our revenues attributable to our eCommerce and direct-to-consumer clients will increase during 2012 as we expect the growth in business from this group of clients to be higher than our other client categories.

Telecommunications and Modems. The Company has historically been a major provider of fulfillment and customer support services to the telecommunications industry. The consolidation in that industry over the last several years has resulted in a heavy concentration of volume in a few companies, and accordingly, concentration of the service providers to the telecommunication industry. We continue to provide fulfillment and technology services for several telecommunication companies however we project that the consolidation of service providers in this vertical will result in its percentage of our total revenue to continue to decline as the eCommerce/Direct-to-consumer vertical grows more quickly as a percentage of our total revenue.

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. Although we continue to provide services to business in this vertical, we expect future revenues in this category to remain a smaller portion of our total business mix.

Results of Operations

The following table sets forth unaudited summary operating data, expressed as a percentage of revenues, for the three months ended March 31, 2012 and 2011. 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.

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 consolidated financial statements.

                                                              Three Months Ended March 31,
                                                            2012                2011

Service revenues                                                     88.2 %              82.4 %
Freight revenues                                                     11.8                17.6
  Total Revenues                                                    100.0 %             100.0 %

Cost of service revenues                                             42.8                37.0
Freight expense                                                      11.5                17.3
Selling, general and administrative expenses                         40.3                43.9
Depreciation and amortization                                         3.4                 4.1
  Operating income (loss)                                             2.0                (2.3 )
Other expense, net                                                    0.2                 0.2
  Income (loss) before income taxes                                   1.8                (2.5 )
Income tax (provision) benefit                                          -                   -
Net income (loss) attributable to noncontrolling interest               -                   -
  Net income (loss)                                                   1.8 %              (2.5 )%

Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011

Service Revenues. Net service revenues increased 23.3% to $21.3 million for the three months ended March 31, 2012 from $17.3 million for the three months ended March 31, 2011. This increase was attributable to i) a $4.3 million increase in revenue from our eCommerce clients due to the addition of several new clients and increases in volumes from existing clients; ii) a $357,000 increase in revenue from our direct marketing clients resulting from increased volume from existing clients and the addition of several new clients, offset by a $739,000 decrease in revenue from our modems and telecommunications clients due to a decrease in volume.

Freight Revenues. The Company's freight revenues decreased 22.6% to $2.9 million for the three months ended March 31, 2012 from $3.7 million for the three months ended March 31, 2011. The $832,000 decrease in freight revenues is primarily attributable to one of our direct marketing clients transitioning the majority of their freight usage from Company owned freight accounts to their own freight accounts, offset by increased volumes from both existing and new direct marketing and eCommerce 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 increased 33.3% to $10.3 million for the three months ended March 31, 2012, compared to $7.8 million for the three months ended March 31, 2011. Cost of service revenues as a percent of service revenues increased to 48.5% from 44.8% mainly due to a higher usage of temporary labor in the first quarter of 2012 when compared to the first quarter of 2011 in response to a change in the mix of revenues by client.

Freight Expense. The Company's freight expense decreased 24.0% to $2.8 million for the three months ended March 31, 2012 compared to $3.6 million for the three months ended March 31, 2011 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 March 31, 2012 increased to $9.7 million, or 40.3% of total revenues, compared to $9.2 million, or 43.9% of total revenues, for the same period in 2011. The increase in S,G&A expenses primarily resulted from a $209,000 increase in information technology costs due to costs related to new client implementations, $151,000 increase in facility management costs due to the addition of several new clients and a $181,000 net increase in all other S,G & A costs. S,G&A expenses as a percentage of total revenue decreased due to the increased service revenue described above.

Depreciation and Amortization Expenses. Depreciation and amortization expense was relatively unchanged at $825,000 and $851,000 for the three months ended March 31, 2012 and 2011 respectively.

Interest Expense. Interest expense for the three months ended March 31, 2012 and 2011 was $53,000 and $46,000, respectively. The average daily amount of debt outstanding on the Credit Facility decreased to $317,000 during the three months ended March 31, 2012 from $764,000 during the same quarter in 2011 while interest expense related to capital leases increased to $10,000 during the three months ended March 31, 2012 compared to $5,000 during the same quarter in 2011.

Income Taxes. The Company's effective tax rate for the three months ended March 31, 2012 and 2011 was 0%. A valuation allowance continues to be recorded against the Company's net deferred tax assets as historical losses have created uncertainty about the realization of tax benefits in future years. Income taxes associated with the income from the three months ended March 31, 2012 and losses for the three months ended March 31, 2011 respectively were offset by a corresponding decrease or increase of the valuation allowance resulting in an effective tax rate of 0% for the three months ended in the respective periods.

Liquidity and Capital Resources

The Company has a revolving credit facility (the "Credit Facility") with Wells Fargo, N.A. (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. The Credit Facility has been further amended by the First, Second and Third Amendments on May 14, 2010, March 30, 2011 and March 29, 2012 respectively. The amended Credit Facility includes a maturity date of June 30, 2013 and continues the Bank's security interest in all of the Company's assets. There was no outstanding balance as of March 31, 2012 under the Credit Facility.

The Third Amendment, among other terms, provided for inclusion of a $1.8 million equipment loan within the $15.0 million borrowing limit and amended the definition of the assets of the Company included in the collateral supporting the Credit Facility to include up to $1.8 million in value as determined by an independent appraisal of the equipment being purchased with the proceeds of the equipment loan.

Interest on borrowings outstanding under the Credit Facility, other than amounts advanced under the $1.8 million equipment loan, is payable monthly at specified rates of either, at the Company's option, the Base Rate (as defined in the Credit Facility) plus between 2.00% and 2.50%, or the LIBOR Rate (as defined in the Credit Facility) 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 Credit Facility). Interest on amounts advanced and outstanding under the $1.8 million 5 year equipment term loan will be payable monthly at an annual interest rate of, at the Company's option, either the Base Rate (as defined in the Credit Facility) plus 3.00% or the LIBOR Rate (as defined in the Credit Facility) plus 4.0%. The Company pays a specified fee on undrawn amounts under the Credit Facility which fee was one-half of one percent, or 0.5% on and before March 30, 2011, the date of Second Amendment to the Credit Agreement, and is three quarters of one percent, or 0.75% thereafter. 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 restriction on cash dividends, a change in ownership control covenant, a subjective material adverse change covenant and financial covenants. As amended by the First, Second and Third Amendments, the Credit Facility includes the following financial covenants:
a. an annual capital expenditure limit of $6.0 million for the 12 months ended December 31, 2012 and $3.5 million for 2013,

b. an Availability Block (as defined by the Credit Facility) of $3.0 million from January 1, 2012 to March 29, 2012 when the Third Amendment was signed,

c. after March 29, 2012 an Availability Block of $4.0 million, which block will be reduced to $3.0 million when the twelve month trailing fixed charge ratio (as defined by the Credit Facility) exceeds 1.1, and further reduced to $2.5 million when both the trailing twelve month fixed charge ratio has a) exceeded 1.2 for three consecutive months and b) is projected to exceed 1.2 for the immediately upcoming three consecutive months.

The provisions of the Credit Facility 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, including any amounts borrowed under the $1.8 million equipment loan, all amounts borrowed and outstanding are classified as a current liability. As of March 31, 2012 the Company was in compliance with all terms of the Credit Facility.

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, plus the appraised value of equipment purchased under the $1.8 million equipment loan, which totaled $12.1 million at March 31, 2012. As of March 31, 2012, there were no amounts outstanding or collateral resulting from the $1.8 million equipment loan. 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 an availability block 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 March 31, 2012 amounted to $12.1 million. There were no amounts borrowed under the Credit Facility at March 31, 2012 however the value of the availability block and letters of credit outstanding at that date totaled $5.2 million. As a result, the Company had $6.9 million of borrowing availability under the Credit Facility at March 31, 2012.

For the three months ended March 31, 2012, we recorded interest expense of $3,000 on the Credit Facility at a weighted average interest rate of 3.35%. The rate of interest being charged on the Credit Facility at March 31, 2012 was 3.24%. For the three months ended March 31, 2011, we recorded interest expense of $6,000 on the Credit Facility at a weighted average interest rate of 3.15%. The rate of interest being charged on the Credit Facility at March 31, 2011 was 3.24%. The Company also incurred unused Credit Facility fees of approximately $26,000 and $16,000 for the three months ended March 31, 2012 and 2011 respectively, which unused Credit Facility fees are included in the total interest expense of $53,000 and $46,000 for the three months ended March 31, 2012 and 2011 respectively.

For the three months ended March 31, 2012, the Company used cash from operating activities of $388,000 compared to generating $957,000 positive cash flow from operations in the same period of 2011. The $1.3 million decrease for the three months ended March 31, 2012 from the same period in 2011 was due to the net change in all operating assets and liabilities using $1.7 million of cash during the three months ended March 31, 2012 compared to providing $683,000 during the same period in 2011, offset by the Company generating a net income of $445,000 for the three months ended March 31, 2012 compared to generating a net loss of $526,000 in the same period in 2011. The $2.4 million decrease in cash provided by operating assets and liabilities for the three months ended March 31, 2012 compared to 2011 resulted mainly from the combined effect of $2.8 million of cash provided from reducing inventory levels in 2011 compared to $54,000 in 2012 and $1.9 million of cash used in accounts payable in 2012 compared to $525,000 in 2011, offset by a $1.8 million increase in cash provided by accounts receivable for the three months ended March 31, 2012 compared to the same period in 2011. The inventory sale in 2011 was the result of the buyback of inventory by a client as discussed below. The $1.4 million increase in cash used for accounts payable was primarily due to an increase in vendor payables for temporary employees and other suppliers to support the increased volume in the fourth quarter of 2011. The $1.8 million increase in cash provided by accounts receivable was due to the collection of receivable balances in 2012 resulting from the higher volumes from the fourth quarter of 2011.

We only purchase inventory for two customers under contract terms that provide that the risk of inventory obsolescence remain with our customers. During 2010, one of our customers for whom we purchased inventory decided to discontinue a specific business program and liquidate the inventory supporting that program. The inventory buyback requirement is defined as the cost of that inventory, so upon buyback, there is no resulting revenue recorded in our operating results, consistent with past reporting by the Company. In the last week of March 2011, we shipped $2.9 million of inventory under normal payment terms and in mid May 2011, the resulting accounts receivable was collected from the customer.

During the three month periods ended March 31, 2012 and 2011, net cash used in investing activities consisted mainly of capital expenditures and were $1.7 million and $371,000 respectively. The $1.7 million of investing activities for the three months March 31, 2012 includes i) $1.1 million of purchased equipment for the build out of our new fulfillment center in Groveport, Ohio and ii) $611,000 for all other capital expenditures. The $371,000 of investing activities for the three months ended March 31, 2011 was mainly capital expenditures for all facilities which is comparable to the $611,000 spent in 2012 for capital expenditures excluding the Groveport facility. Some of the equipment already purchased as of March 31, 2012 for the build out of the Groveport facility will be included as collateral under the Credit Facility when the build out is further progressed. By June 30, 2012, we expect to have $1.8 million borrowed and outstanding under the equipment loan portion of the Credit Facility and a related $1.8 million of equipment included as collateral under the Credit Facility.

As of March 31, 2012 and March 31, 2011, there were no borrowings under the line of credit. The average daily borrowings outstanding on the Credit Facility for the three months ended March 31, 2012 and 2011 were $317,000 and $764,000, respectively. The maximum borrowing outstanding on the Credit Facility for any one day during the three months ended March 31, 2012 and 2011 were $2.1 million and $2.3 million, respectively. During the three months ended March 31, 2012 and 2011, the Company repaid $114,000 and $65,000 of principal outstanding on capital leases respectively. Additionally, during the three months ended March 31, 2012 and 2011, the Company incurred $15,000 and $30,000 of loan commitment fees as a result of the Third and Second Amendments to the Credit Agreement respectively.

The Company estimates that its cash and financing needs through at least the next twelve months will be met by cash flows from operations and availability under the Credit Facility.

Critical Accounting Policies

Critical accounting policies are those policies that can have a significant impact on the presentation of our financial position and results of operations and demand the most significant use of subjective estimates and management judgment. Because of the uncertainty inherent in such estimates, actual results may differ from these estimates. Specific risks inherent in our application of these critical policies are described below. For all of these policies, we caution that future events rarely develop exactly as forecasted, and the best estimates routinely require adjustment. These policies often require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. Additional information concerning our accounting policies can be found in Note 1 to the condensed financial statements in this Form 10-Q and Note 2 to the financial statements appearing in our Annual Report on Form 10-K for the year ended December 31, 2011. The policies that we believe are most critical to an investor's understanding of our financial results and condition and require complex management judgment are discussed below.

Accounting Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Accounting for Income Taxes. Innotrac utilizes the liability method of accounting for income taxes in accordance with ASC topic No. 740 - Income Taxes. Under the liability method, deferred taxes are determined based on the difference between the financial and tax basis of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. A valuation allowance is recorded against deferred tax assets if the Company considers it is more likely than not that deferred tax assets will not be realized. Innotrac's gross deferred tax asset as of March 31, 2012 and December 31, 2011 was approximately $22.8 million and $23.0 million, respectively. This deferred tax asset was generated primarily by net operating loss carryforwards created in prior years and the goodwill impairment charge of $25.2 million recorded in 2009. Innotrac has a net operating loss carryforward of $51.8 million at December 31, 2011 that expires between 2020 and 2031.

Innotrac's ability to generate taxable income from future operations is dependent upon general economic conditions, collection of existing outstanding accounts receivable, competitive pressures on sales and margins and other factors beyond management's control. These factors, combined with losses in recent years, create uncertainty about the ultimate realization of the gross deferred tax asset in future years. Therefore, a valuation allowance of approximately $21.7 million and $21.8 million has been recorded as of March 31, 2012 and December 31, 2011, respectively. Income taxes associated with future earnings may be offset by a reduction in the valuation allowance in that future year. For the three months ended March 31, 2012, a tax expense of $176,000 was . . .