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

Overview. We produce film products for novelty, packaging and container applications. These products include metalized balloons, latex balloons and related latex toy products, films for packaging applications, and flexible containers for packaging and storage applications. We produce all of our film products for packaging and container applications at our plant in Barrington, Illinois. We produce all of our latex balloons and latex products at our facility in Guadalajara, Mexico. Substantially all of our film products for packaging applications and flexible containers for packaging and storage are sold to customers in the United States. We market and sell our novelty items - principally metalized balloons and latex balloons - in the United States, Mexico, the United Kingdom and a number of additional countries.

 

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Results of Operations

Net Sales. For the three months ended March 31, 2007, net sales were $8,279,000 compared to net sales of $8,156,000 for the same period of 2006, an increase of 1.5%. For the quarters ended March 31, 2007 and 2006, net sales by product category were as follows: 

 

		Three Months Ended
		March 31, 2007						March 31, 2006
		$			% of			$			% of
Product Category		(000) Omitted			Net Sales			(000) Omitted			Net Sales
Metalized Balloons			3,999			48	%		3,674			45	%
Films			1,826			22	%		1,783			22	%
Pouches			665			8	%		983			12	%
Latex Balloons			1,516			19	%		1,519			19	%
Helium/Other			273			3	%		197			2	%

 

The increase in metalized balloon sales for three months ended March 31, 2007, compared to the same period of 2006 is attributable to the addition of two new customers in 2007. Sales to these customers totaled $390,000.

The decline in pouch sales is attributable principally to the reduction in sales to one customer by approximately $199,000. We anticipate continued sales of pouches to this customer under our supply agreement with this customer.

Sales to a limited number of customers continue to represent a large percentage of our net sales. The table below illustrates the impact on sales of our top two and ten customers for the three months ended March 31, 2007 and 2006.

 

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		Three Months Ended
		% of Net Sales
		March 31, 2007			March 31,2006
Top 2 customers			35.9	%		35.3	%
Top 10 Customers			64.1	%		58.4	%

 

During the three months ended March 31, 2007, there were two customers whose purchases represented more than 10% of the Company’s sales. The sales to each of these customers for the three months ended March 31, 2007 were $1,625,000 or 19.6% and $1,347,000 or 16.3% of net sales respectively. Sales to these customers in the same period of 2006 were $1,430,000 or 17.5% and $1,456,000 or 17.8%, of net sales, respectively. For the quarter ended March 31, 2007, the total amount due from these customers to the Company was $1,344,000 and $1,144,000 respectively. The balances owed at March 31, 2006 were $1,156,000 and $1,250,000 respectively.

Cost of Sales. Cost of sales in the first quarter of 2007 were $6,376,000 or 77% compared to cost of sales of $6,203,000 or 76% in the first quarter of 2006. In addition to the slightly higher rate of sales in the first quarter of 2007, the Company incurred production overhead expenses in that quarter related to the improvements to the facility in Barrington, Illinois and preparation for the production of a new line of pouch products.

 

General and Administrative. For the three months ended March 31, 2007, general and administrative expenses were $1,212,000 or 14.6% of net sales, compared to $1,017,000 or 12.5% of net sales for the same period in 2006. The increase included additions in administrative staff and compensation rates and increases in legal fees.

Selling. For the three months ended March 31, 2007, selling expenses were $206,000 or 2.5% of net sales for the quarter, compared to $177,000 or 2.2% of net sales for the same three months of 2006. The increase in selling expense is attributable to increased royalties and commissions paid on sales to new customers.

Advertising and Marketing. For the three months ended March 31, 2007, advertising and marketing expenses were $291,000 or 3.5% of net sales for the period, compared to $218,000 or 2.7% of net sales for the same period of 2006. The change in advertising and marketing was principally due to an increase in the amortization of artwork and printing plate costs that were expensed in the period as compared to the prior period.

Other Income (Expense). During the three months ended March 31, 2007, the Company incurred net interest expense of $335,000, compared to net interest expense during the same period of 2006 of $331,000.

 

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During the three months ended March 31, 2007, the Company had other income of $52,000 compared to other income of $48,000 during the first quarter of 2006. Both amounts consisted of foreign currency transaction gains.

Income Taxes. For the three months ended March 31, 2007, the income tax benefit of $36,000 related to the loss recorded in the U.S. This was offset by a provision for income taxes in the United Kingdom for CTI Balloons, Ltd, the Company’s subsidiary in the United Kingdom and in Mexico for Flexo Universal, S.A. de C.V., the Company’s subsidiary in Mexico. For the same period of 2006, the Company recorded an income tax expense of $38,000.

Net (Loss) Income. For the three months ended March 31, 2007, the Company had net loss of $52,000 or $0.02 per share (basic and diluted), compared to net income for the same period of 2006 of $220,000 or $0.11 per share basic and $0.10 diluted. For the three months ended March 31, 2007, the Company had net income from operations (before interest, taxes and non-operating items) of $194,000, compared to net income from operations of $541,000 during the same period of 2006. The difference in net income between the first quarter of 2007 and 2006 is attributable principally to increased administrative, selling and marketing costs incurred in the United States operations.

Financial Condition, Liquidity and Capital Resources 

Cash Flow Items.

Operating Activities. During the quarter ended March 31, 2007, net cash provided by operations was $529,000, compared to net cash used in operations during three months ended March 31, 2006 of $945,000.

Significant changes in working capital items during the three months ended March 31, 2007 consisted of (i) a decrease in accounts receivable of $372,000, (ii) an increase in inventory of $290,000, (iii) depreciation and amortization of $359,000, (iv) an increase in trade payable of $133,000 and (v) a decrease in accrued liabilities of $99,000. We do anticipate some increases in depreciation during the balance of 2007 due to additional equipment purchases relating to product line extension and building improvements.

Investing Activity. During the three months ended March 31, 2007, cash used in investing activity was $327,000, compared to $61,000 in same period of 2006. We do anticipate incurring additional capital expenditures during the balance of 2007 for improvements and for the acquisition of production equipment.

Financing Activities. For the three months ended March 31, 2007, cash used in financing activities was $122,000 compared to cash provided by financing activities for the same period of 2006 in the amount of $1,379,000. In the first quarter of 2007 financing activities included the receipt of $105,000 from the sale of common stock and payment of long term debt obligations of $268,000.

Liquidity and Capital Resources. At March 31, 2007, the Company had a cash balance of $466,000. At March 31, 2007, the Company had a working capital balance of $1,823,000 compared to a working capital balance of $1,848,000 at December 31, 2006.

 

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The Company's current cash management strategy includes utilizing the Company's revolving line of credit for liquidity. Under our line of credit with Charter One Bank, we are entitled to borrow an amount equal to 85% of eligible receivables and 60% of eligible inventory, up to a maximum of $7,000,000. Foreign receivables and inventory held by our foreign subsidiaries are not eligible. In addition, in order to be permitted to make advances under the line of credit, we are required to meet various financial covenants. As of March 31, 2007, we had complied with all applicable financial covenants in the loan agreement. Based on our results to date for the year and our projected results of operations for the balance of this year, we believe we will be in compliance with all applicable financial covenants of the loan agreement for the balance of 2007. Further, we believe that with our present cash and working capital and the amounts available to us under our line of credit and through sales of common stock, we will have sufficient funds to enable us to meet our obligations through the next twelve months.

The loan agreement provides for interest at varying rates in excess of the Bank’s prime rate, depending on the level of senior debt to EBITDA over time. As of March 31, 2007, the applicable premium being applied was 0.25%

Also, under the loan agreement, we were required to purchase a swap agreement with respect to at least 60% of the mortgage and term loan portions of our loan. On April 5, 2006, we entered into a swap arrangement with Charter One Bank with respect to 60% of the principal amounts of the mortgage loan and the term loan, which had the effect of fixing the interest rate for such portions of the loans at 8.49% for the balance of the loan terms. These swap arrangements are subject to some market variation due to market interest rate variability. Management believes that these variations will not materially affect the results of the Company. As of March 31, 2007, the net effect of these market adjustments were $61,000, which has been recorded in the Company’s consolidated financial statements. The net effect for the three months ending March 31, 2007 was additional interest expense of $6,000.

On June 6, 2006, we entered into a Standby Equity Distribution Agreement with Cornell Capital pursuant to which we may, at our discretion, periodically sell to Cornell Capital shares of common stock for a total purchase price of up to $5 million. For each share of common stock purchased under the Standby Equity Distribution Agreement, Cornell Capital will pay one hundred percent (100%) of the lowest volume weighted average price (as quoted by Bloomberg, LP) of our common stock on the NASDAQ Capital Market or other principal market on which our common stock is traded for the five (5) days immediately following the notice date. The number of shares purchased by Cornell Capital for each advance is determined by dividing the amount of each advance by the purchase price for the shares of common stock. Furthermore, Cornell Capital will receive five percent (5%) of each advance in cash under the Standby Equity Distribution Agreement as an underwriting discount. Cornell’s obligation to purchase shares of our common stock under the Agreement is subject to certain conditions, including: (i) we have obtained an effective registration statement for the shares of common stock sold to Cornell under the Agreement and (ii) the amount of each advance requested by us under the Agreement shall not be more than $100,000.

 

We are permitted to make draws on the Standby Equity Distribution Agreement only so long as Cornell Capital’s beneficial ownership of our common stock remains lower than 9.9% and a possibility exists that Cornell Capital may own more than 9.9% of CTI’s outstanding common stock at a time when we would otherwise plan to make an advance under the Standby Equity Distribution Agreement. We do not have any agreements with Cornell Capital regarding the distribution of such stock, although Cornell Capital has indicated that it intends promptly to sell any stock received under the Standby Equity Distribution Agreement.

 

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We cannot predict the actual number of shares of common stock that will be issued pursuant to the Standby Equity Distribution Agreement, in part, because the purchase price of the shares will fluctuate based on prevailing market conditions, and we have not determined the total amount of advances we intend to draw. We have registered 400,000 shares of common stock for the sale under the Standby Equity Distribution Agreement. The Company and Cornell have agreed that the Company will not sell to Cornell Capital in excess of 400,000 shares unless and until the Company shall have obtained shareholder approval for such sales.

 

On December 28, 2006, we filed a Registration Statement for the registration of 403,500 shares of our common stock. On January 26, 2007, the Registration Statement was declared effective. Since that time, to May 18, 2007, we have sold an aggregate of 116,603 shares of common stock to Cornell under the SEDA and have received net proceeds from the sale of those shares in the amount of $642,000. We intend to continue to sell shares to Cornell under the SEDA.

Seasonality

In recent years, sales in the metalized balloon product line have historically been seasonal with approximately 45% occurring in the period from December through March and 21% being generated in the period from July through October. The sale of latex balloons and laminated film products have not historically been seasonal.

Critical Accounting Policies

A summary of our critical accounting policies and estimates is presented on pages 42 and 43 of our 2006 Annual Report on Form 10-K, as filed with the Securities and Exchange Commission.

Item 3. Quantitative and Qualitative Disclosures Regarding Market Risk 

The Company is exposed to various market risks, primarily foreign currency risks and interest rate risks.

The Company’s earnings are affected by changes in interest rates as a result of variable rate indebtedness. If market interest rates for our variable rate indebtedness average 1% more than the interest rate actually paid for the first quarter ended March 31, 2007 and 2006, our interest rate expense would have increased, and income before income taxes would have decreased by $23,474 and $26,547 for these quarters, respectively. These amounts are determined by considering the impact of the hypothetical interest rates on our borrowings. This analysis does not consider the effects of the reduced level of overall economic activity that could exist in such an environment. Further, in the event of a change of such magnitude, management would likely take actions to reduce our exposure to such change. However, due to the uncertainty of the specific actions we would take and their possible effects, the sensitivity analysis assumes no change in our financial structure.

 

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The Company’s earnings and cash flows are subject to fluctuations due to changes in foreign currency rates, particularly the Mexican peso and the British pound, as the Company produces and sells products in Mexico for sale in the United States and other countries and the Company’s UK subsidiary purchases balloon products from the Company in dollars. Also, the Mexican subsidiary purchases goods from external sources in U.S. dollars and is affected by currency fluctuations in those transactions. Substantially all of the Company’s purchases and sales of goods for its operations in the United States are done in U.S. dollars. However, the Company’s level of sales in other countries may be affected by currency fluctuations. As a result, exchange rate fluctuations may have an effect on sales and gross margins. Accounting practices require that the Company’s results from operations be converted to U.S. dollars for reporting purposes. Consequently, the reported earnings of the Company in future periods may be affected by fluctuations in currency exchange rates, generally increasing with a weaker U.S. dollar and decreasing with a strengthening U.S. dollar. To date, we have not entered into any transactions to hedge against currency fluctuation results.

 

We have performed a sensitivity analysis as of March 31, 2007 that measures the change in the results of our foreign operations arising from a hypothetical 10% adverse movement in the exchange rate of all of the currencies the Company presently has operations in. Using the results of operations for the first quarter of 2007 and 2006 for the Company’s foreign operations as a basis for comparison, an adverse movement of 10% would create a potential reduction in the Company’s net income, or increase its net loss before taxes, in the amount of $45,221 and $44,860 for each of those quarters, respectively.

The Company is also exposed to market risk in changes in commodity prices in some of the raw materials it purchases for its manufacturing needs. However, this presents a risk that would not have a material effect on the Company’s results of operations or financial condition.