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## 

## Tembec Industries Inc.

## MD&A

## MANAGEMENT'S DISCUSSION AND ANALYSIS

## as at December 5, 2006



The Management's Discussion and Analysis (MD&A) section provides
a review of the significant developments and issues that influenced Tembec
Industries Inc.'s financial performance during the fiscal year ended September
30, 2006 as compared to the fiscal year ended September 24, 2005. The MD&A
should be read in conjunction with the audited consolidated financial statements
for the fiscal year ended
September 30, 2006. All references to quarterly or Corporation information
relate to Tembec Industries Inc.'s fiscal quarters.



The MD&A includes ''forward-looking statements'' within the meaning
of securities laws.  Such statements relate to the Corporation's or management's
objectives, projections, estimates, expectations or predictions of the future
and can be identified by words such as ''anticipate'', ''estimate'', ''expect'' and
''project'' or variations of such words. These statements are based on certain
assumptions and analyses made by the Corporation in light of its experience and
its perception of future developments. Such statements are subject to a number
of risks and uncertainties, including, but not limited to, changes in foreign
exchange rates, product selling prices, raw material and operating costs and
other factors identified in our periodic filings with securities regulatory
authorities in Canada and the United States. Many of these risks are beyond the
control of the Corporation and, therefore, may cause actual actions or results
to materially differ from those expressed or implied herein. The Corporation
disclaims any intention or obligation to update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.



Throughout the MD&A, ''Tembec'' or ''Corporation'' means Tembec
Industries Inc. and its consolidated subsidiaries and investments. ''AV Cell''
refers to the Corporation's 50% participation in AV Cell Inc. which operates a
dissolving pulp mill located in Atholville, New Brunswick. ''Marathon'' refers to
its 50% participation in Marathon Pulp Inc., which operates a northern bleached
softwood kraft (NBSK) pulp mill in Marathon, Ontario. ''Temlam'' refers to the
Corporation's 50% participation in Temlam Inc., which operates laminated veneer
lumber (LVL) plants in Ville Marie and Amos, Quebec and wood I-beam
manufacturing plants in Calgary, Alberta, Bolton, Ontario and Blainville,
Quebec. ''Temrex'' refers to the Corporation's 50% participation in Produits
Forestiers Temrex Limited Partnership, which operates two sawmills in the Gaspe
region of Quebec. These investments are accounted for by the proportionate
consolidation method.



Tembec's operations consists of four reportable business
segments: Forest Products, Pulp, Paper, and Chemicals. On September 30, 2006
Tembec had approximately 9,000 employees and operated manufacturing facilities
in New Brunswick, Quebec, Ontario, Manitoba, Alberta, British Columbia, the
states of Louisiana and Ohio as well as in Southern France. Principal facilities
are described in the subsequent sections of the MD&A.



On February 27, 2006, the Corporation completed the sale of its
oriented strandboard (OSB) business located in Saint-Georges-de-Champlain,
Quebec. The financial results of the OSB operation have been reclassified as
discontinued operations. Comparative figures have also been reclassified to
exclude the OSB mill's results from the continuing operations. For certain non-GAAP
financial measures, the amount presented still reflect the actual reported
results of prior periods. In those circumstances, a footnote indicates that they
include the results of the OSB operations.



1

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ACCOUNTING CHANGES



Effective January 2005, the Corporation adopted Canadian
Institute of Chartered Accountants (CICA) Accounting Guideline No. 15 (AcG-15),
''Consolidation of Variable Interest Entities''. AcG-15 addresses the
application of consolidation principles to entities that are subject to control
on a basis other than ownership voting interests. The implementation of this new
accounting guideline had no impact on the Corporation's consolidated financial
statements. The CICA Emerging Issues Committee issued Abstract 157 (EIC-157), ''Implicit Variable Interest under AcG-15''. The abstract clarifies that an
implicit variable interest is an implied pecuniary interest in an entity that
changes with the fair value of that entity's net assets exclusive of variable
interest. The CICA Emerging Issues Committee also issued Abstract 163 (EIC-163),
''Determining the Variability to be Considered in Applying AcG-15''.
EIC-163 provides guidance on the relevant risks and rewards that must be
identified and evaluated in order to apply AcG-15. The two abstracts had no
impact on the Corporation's consolidated financial statements.



The CICA Emerging Issues Committee issued Abstract 161 (EIC-161),
''Discontinued Operations''.
EIC-161 replaced EIC-45 ''Discontinued Operations'' and provides guidance
regarding the allocation of interest expense and of general corporate overhead.
The Corporation applied EIC-161 in fiscal 2006 as a result of the sale of its
OSB operation.



The CICA issued Section 3831 ''Non-Monetary Transactions''.
This section requires that all non-monetary transactions be measured at fair
value unless certain specified conditions where applicable. The Section became
effective January 1, 2006 and did not impact the Corporation's financial
statements.



Impact of accounting pronouncements on future reporting periods




The CICA issued three new Handbook Sections in relation with
financial instruments: Section 3855 ''Financial Instruments  Recognition and
Measurement'', Section 3865 ''Hedges'', and Section 1530 ''Comprehensive Income''. These Sections apply to the Corporation beginning
October 1, 2006. Section 3855 expands on Handbook Section 3860 ''Financial
Instruments  Disclosure and Presentation'', by prescribing when a financial
instrument is to be recognized on the balance sheet and at what amount. It also
specifies how financial instrument gains and losses are to be presented. Section
3865 provides alternative accounting treatments to Section 3855 for entities
which choose to designate qualifying transactions as hedges for accounting
purposes. It replaces and expands on AcG-13 ''Hedging Relationship'' and
the hedging guidance in Section 1650 ''Foreign Currency Translation'' by
specifying how hedge accounting is applied and what disclosures are necessary
when it is applied. Section 1530 introduces a new requirement to present certain
revenues, expenses, gains and losses, that otherwise would not be immediately
recorded in income, in a comprehensive income statement with the same prominence
as other statements that constitute a complete set of financial statements. The
application of these new Handbook Sections for financial instruments is not
expected to have a significant effect on the Corporation, but will require
Tembec to present a new statement entitled ''Comprehensive Income''.



The CICA subsequently amended Section 3865 "Hedges" by
deleting paragraph 54. This paragraph required the use of the same method to
assess the effectiveness of the hedge and to calculate the ineffective portion
of the gain or loss on the hedging item. The removal of this paragraph allows an
entity to use a different method to assess effectiveness and calculate
ineffectiveness. As the Corporation does not use hedge accounting, this
amendment did not impact its consolidated financial statements.



The CICA also subsequently amended Section 3855 ''Financial
Instruments  Recognition and Measurement''. The amendment provides guidance
on accounting for fees and costs incurred upon the exchange of debt instruments
or modification of a financial liability. Section 3855 applies to transactions
occurring after October 1, 2006.



2

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The CICA has released two new Handbook Sections in relation to
financial instruments: Section 3862 ''Financial Instruments  Disclosures''
and Section 3863 ''Financial Instruments  Presentation''. These standards
enhance existing disclosures in previously issued Section 3861 ''Financial
Instruments  Disclosures and Presentation''. Section 3862 places greater
emphasis on disclosures about risks related to recognized and unrecognized
financial instruments and how those risks are managed. Section 3863 carries
forward the same presentation standards as Section 3861. Both Sections will
become effective October 1, 2007 and will require the Corporation to increase
disclosure in the financial instruments note.



The CICA has released Section 1535 ''Capital Disclosures''.
The Section requires additional disclosure about capital management. The Section
will become effective October 1, 2007, and will require the Corporation to
expand its disclosure in that area.



The CICA issued a revised version of Section 1506 ''Accounting
Changes''. The revised Section provides additional guidance in determining
when it is impractible to give retrospective application to a change in
accounting policy. The Section will become effective on January 1, 2007.
Although the Corporation does not currently foresee the requirement to initiate
accounting changes, it will comply with Section 1506 should the need arise.



The CICA issued Section 3251 ''Equity''. The Section
replaces Section 3250 ''Surplus''. The Section incorporates consequential
amendments resulting from the issuance of Section 1530 ''Comprehensive
Income''.
The Section became effective on October 1, 2006. As noted previously, the
Corporation will be required to present a new statement entitled ''Comprehensive
Income'' beginning in October 2006.



CRITICAL ACCOUNTING POLICIES AND
  ESTIMATES




Fixed asset depreciation



The Corporation records its fixed assets, primarily production
buildings and equipment, at cost. Interest costs are capitalized for projects in
excess of $1 million that have a duration in excess of one year. Investment tax
credits or capital assistance received reduce the cost of the related assets.
Fixed assets acquired as a result of a business acquisition are recorded at
their estimated fair value. Depreciation of fixed assets is provided over their
estimated useful lives, generally on a straight-line basis. Forest access roads
are depreciated on the basis of harvested volumes and certain equipment is
depreciated using the unit of production method. The estimated useful lives of
fixed assets are based on judgement and the best currently available
information. Changes in circumstances can result in the actual useful lives
differing from our estimates. Revisions to the estimated useful lives of fixed
assets constitute a change in accounting estimate and are dealt with
prospectively by amending the amount of depreciation expense. There were no
significant adjustments to depreciation rates in fiscal 2005 and 2006. In fiscal
2005, the Corporation recorded an impairment charge of $4 million relating to a
specialty wood sawmill that was included in depreciation expense.



Impairment of goodwill



Accounting standards require that goodwill no longer be amortized
to earnings, but be periodically tested for impairment. The Corporation uses
certain operating and financial assumptions to conduct its impairment test,
principally those contained in its most recent multi-year operating plan. This
ensures that assumptions are supported, where available, by relevant independent
information. The fiscal 2005 impairment test did find impairment of goodwill in
relation to the hardwood flooring and newsprint operations. The carrying value
of goodwill was reduced by $26 million. The charge to income was included in
unusual items. There was no goodwill impairment in fiscal 2006.



3

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Impairment of long-lived assets



The Corporation must review the carrying value of long‐lived
assets when events or changes in circumstances indicate that the value may have
been impaired and is not recoverable through future operations and cash flows.
To estimate future cash flows, the Corporation uses operating and financial
assumptions, primarily those contained in its most recent multi-year operating
plan. This ensures that the assumptions are supported, where available, by
relevant independent information. The work conducted in fiscal 2005 indicated an
impairment of $4 million relating to a specialty wood sawmill. The charge to
income is included in depreciation and amortization expense.



Employee future benefits



Tembec contributes to several defined benefit pension plans,
primarily related to employees covered by collective bargaining agreements. The
Corporation also provides post-retirement benefits to certain retirees,
primarily health-care related. For post-retirement benefits, funding of
disbursements is done on a ''pay as you go'' basis. The Corporation uses
independent actuarial firms to quantify the amount of pension and
post-retirement obligations. The Corporation, based on its own experience and
recommendations from its actuarial firms, evaluates the underlying assumptions
on an annual basis. Changes in estimates or assumptions can have a substantial
impact on the amount of pension and post-retirement benefit expense, the
carrying values on the balance sheet, and, in the case of defined benefit plans,
the amount of plan surplus or deficit. At June 30, 2006, (''the measurement
date''), the fair value of defined benefit plan assets was $677 million, an
amount equal to 80% of the estimated accrued benefit obligation of $849 million,
generating a deficit of $172 million. The plan deficit was $274 million at the
prior measurement date,
June 30, 2005. The deficit decrease of $102 million that occurred over the 12
month period was caused primarily by two items. The deficit was reduced by $14
million as contributions of $36 million exceeded the current service cost of $22
million. An actuarial gain of $88 million decreased the accrued benefit
obligation at the measurement date. This item was caused primarily by an
increase from 4.98% to 5.59% of the weighted average discount rate applied to
the accrued benefit obligation. The discount rate is tied to the rates
applicable to high-quality corporate bonds (AA or higher) in effect as at the
measurement date. Pension expense in fiscal 2006 was $42 million, as compared to
$28 million in the prior year. Based on current assumptions, employer
contributions and pension expense in fiscal 2007 are expected to be
approximately $50 million and $21 million respectively. A description of the
Corporation's defined benefit pension plans and assumptions used in the
calculations are presented in note 19 of the audited consolidated financial
statements.



With regard to other employee future benefit plans, the accrued
benefit obligation at the measurement date was $59 million, a decrease from $75
million in the prior year. The decrease was also due to an increase in the
discount rate, from 4.99% to 5.80%. Employer contributions were $3 million,
unchanged from the prior year. The expense recognized for other employee benefit
plans was $9 million, up from $8 million in the prior year. Based on current
assumptions, the amount of employer contributions and the amount of expense to
be recognized in fiscal 2007 are expected to be approximately $3 million and
$5 million respectively. A description of the Corporation's other employee
future benefit plans and assumptions used in the calculations are presented in
note 20 of the audited consolidated financial statements.



Future income taxes



Future income tax is provided for using the asset and liability
method and recognizes temporary differences between the tax values and the
financial statement values of balance sheet items as well as certain
carry‐forward items. The Corporation only recognizes a future income tax asset
to the extent that, in its opinion, it is more likely than not that the future
income tax asset will be realized. This opinion is based on estimates and
assumptions as to the future financial performance of the various taxable legal
entities in the various tax jurisdictions. The Corporation periodically reviews
the carrying value of its future income tax assets. Additional details are
provided in note 18 of the audited consolidated financial statements.

4

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USE OF NON-GAAP FINANCIAL MEASURES




The following summarizes non-GAAP financial measures utilized in
the MD&A. As there is no generally accepted method of calculating these
financial measures, they may not be comparable to similar measures reported by
other companies.



EBITDA
refers to earnings before unusual items, interest, income taxes,
depreciation, amortization and other non-operating expenses and revenues. The
Corporation considers EBITDA to be a useful indicator of the financial
performance of the Corporation, the business segments and the individual
business units.



Free Cash Flow
refers to cash provided by operating activities before changes in
non-cash working capital balances less net fixed asset additions. Working
capital changes are excluded as they are often seasonal and temporary in nature.
The Corporation considers free cash flow to be a useful indicator of its ability
to generate discretionary cash flow, thereby improving its overall liquidity
position.



Net debt
refers to debt less cash and cash equivalents such as marketable
securities or temporary investments.



Total capitalization
refers to net debt plus future income taxes, other long-term
liabilities and shareholders' equity.



Net debt to total capitalization
is used by the Corporation to
measure its financial leverage.



Cash return on capital employed (CROCE)
refers to EBITDA for a given period divided by the average gross
capital employed for the period. Gross capital employed is the sum of working
capital (accounts receivable, inventories and prepaid expenses less accounts
payable), undepreciated fixed assets and other assets. The Corporation considers
this to be a useful indicator of financial returns being generated by the
Corporation.



Return on capital employed (ROCE)
refers to net earnings (or loss) for
a given period, adjusted for the after-tax impact of interest expense, divided
by the average of total assets less non-interest bearing current liabilities for
the period. The Corporation utilizes this measure to compare its performance to
other competitors in its industry. The long-term incentive plan for senior
management is based on ROCE performance.



Return on Equity (ROE)
refers to net earnings or loss for a given period divided by the
average shareholders' equity for the period.



5

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2006 vs 2005



|FINANCIAL SUMMARY
    $ millions, unless otherwise noted | 2002  | 2003  | 2004  | 2005  | 2006 
|-------------------------------------------------------- | ----- | ----- | ----- | ----- | -----
|Sales                                                    | 3,337 | 3,282 | 3,556 | 3,507 | 3,332
|                                                         |       |       |       |       |      
|Freight and sales deductions                             | 390   | 386   | 414   | 406   | 399  
|Lumber duties                                            | 18    | 81    | 112   | 89    | 35   
|Cost of sales                                            | 2,498 | 2,598 | 2,738 | 2,838 | 2,722
|SG& A                                                    | 165   | 162   | 175   | 168   | 151  
|EBITDA                                                   | 266   | 55    | 117   | 6     | 25   
|                                                         |       |       |       |       |      
|Depreciation & amortization                              | 223   | 225   | 228   | 236   | 206  
|Unusual items                                            | 24    | 18    | 10    | 255   | 188  
|Operating earnings (loss)                                | 19    | (188) | (121) | (485) | (369)
|Interest, foreign exchange & other                       | 214   | 124   | (94)  | 20    | 111  
|Gain on translation of foreign debt                      | (4)   | (264) | (94)  | (125) | (64) 
|Pre-tax earnings (loss)                                  | (191) | (48)  | 67    | (380) | (416)
|Income taxes (recovery)                                  | (70)  | (46)  | 25    | (60)  | (65) 
|Minority interests                                       | -     | (2)   | -     | -     | -    
|Net earnings (loss) from
    continuing operations       | (121) | -     | 42    | (320) | (351)
|Earnings from discontinued operations                    | 4     | 11    | 34    | 11    | 51   
|Net earnings (loss)                                      | (117) | 11    | 76    | (309) | (300)
|Total assets (at end of year)                            | 3,991 | 3,787 | 3,899 | 3,441 | 2,997
|Total long-term debt( 1)(at end of year)                 | 2,029 | 1,795 | 1,659 | 1,557 | 1,503

(1) Includes current portion





6

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SALES


|$ millions           | 2005  | 2006  | Total
    Variance | Price
    Variance | Volume & Mix
    Variance
|-------------------- | ----- | ----- | ------------------ | ------------------ | -------------------------
|Forest
    Products  | 1,267 | 1,088 | (179)              | (101)              | (78)                     
|Pulp                 | 1,373 | 1,451 | 78                 | (24)               | 102                      
|Paper                | 943   | 874   | (69)               | (16)               | (53)                     
|Chemical & other     | 209   | 199   | (10)               | (17)               | 7                        
|                     | 3,792 | 3,612 | (180)              | (158)              | (22)                     
|Less: internal sales | (285) | (280) | 5                  |                    |                          
|Sales                | 3,507 | 3,332 | (175)              |                    |                          



Sales declined by $175 million as compared to the prior year. The
Forest Products segment sales declined by $179 million as a results of lower
prices and volumes. Pricing was impacted by lower US $ reference prices and a
stronger Canadian $, which averaged 7% higher versus the US $. A portion of the
volume reduction was the result of the permanent shutdown of several
manufacturing facilities. The Pulp segment sales increased by $78 million with
higher volumes more than offsetting lower selling prices. The Paper segment
sales declined by $69 million, primarily as a result of lower volumes. The
decline in shipments was caused by the permanent closures of the Saint-Raymond,
Quebec paper mill and of an uncoated bleached board machine at the St.
Francisville, Louisiana paper mill. In terms of geographical distribution the US
remained the Corporation's principal market with 45% of sales in fiscal 2006, as
compared to 47% in the prior year. Canadian sales represented 20% of sales, the
same percentage as the prior year. Sales outside of the US and Canada
represented the remaining 35% in fiscal 2006, as compared to 33% a year ago.



EBITDA


|$ millions          | 2005 | 2006 | Total
    Variance | Price
    Variance | Cost & 
    Volume
    Variance
|------------------- | ---- | ---- | ------------------ | ------------------ | -------------------------------
|Forest
    Products | 32   | 22   | (10)               | (101)              | 91                             
|Pulp                | (25) | 6    | 31                 | (24)               | 55                             
|Paper               | (12) | (11) | 1                  | (16)               | 17                             
|Chemical & other    | 11   | 8    | (3)                | (17)               | 14                             
|                    | 6    | 25   | 19                 | (158)              | (177)                          



EBITDA increased by $19 million as compared to the prior year
period. The Forest Products segment EBITDA declined by $10 million with lower
prices being partially offset by lower costs. Lumber export duties on shipments
to the US declined by $54 million due to reduced deposit rates that came into
effect in December 2005. The Pulp segment EBITDA improved by $31 million as
lower manufacturing costs more than offset the decline in selling prices. The
cost improvement was driven by a more favourable exchange rate on the French
pulp mills' Euro costs. The Paper segment EBITDA was relatively unchanged with
lower manufacturing costs negating the impact of lower selling prices. Chemical
segment prices and costs decreased by similar amounts and profitability remained
relatively unchanged. This is to be expected for this segment as raw material
prices are linked to product selling prices.



7

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OPERATING EARNINGS (LOSS)


|$ millions          | 2005  | 2006  | Total
    Variance | EBITDA
    Variance | Depreciation & Amortization Variance | Unusual Items Variance
|------------------- | ----- | ----- | ------------------ | ------------------- | ------------------------------------ | ----------------------
|Forest
    Products | (81)  | (30)  | 51                 | (10)                | 2                                    | 59                    
|Pulp                | (143) | (269) | (126)              | 31                  | 22                                   | (179)                 
|Paper               | (267) | (72)  | 195                | 1                   | 7                                    | 187                   
|Chemical & other    | 6     | 2     | (4)                | (3)                 | (1)                                  | -                     
|                    | (485) | (369) | 116                | 19                  | 30                                   | 67                    



The operating loss decreased by $116 million as compared to the
prior year period. The Forest Products segment operating loss declined by $51
million due to a positive variance on unusual items. In the prior year period,
the Corporation recorded unusual charges totalling $57 million related to the
permanent closure of several facilities. The Pulp segment operating loss
increased by $126 million. The current year loss includes unusual charges of
$183 million relating primarily to asset impairment at the Smooth Rock Falls,
Ontario pulp mill. The impairment charge was the principal reason depreciation
and amortization expense declined by $22 million. The Paper segment operating
loss declined by $195 million. The prior year results included an unusual charge
of $101 million relating to the permanent closure of the Saint-Raymond, Quebec
paper mill as well as a charge of $93 million relating to three items; a charge
of $45 million for the closure of a pulp line and a paper machine; a charge of
$26 million to reduce the carrying value of a dismantled paper machine; and a
charge of $22 million to reduce the carrying value of previously recorded
goodwill in the newsprint operations.



A more detailed review of items having impacted sales, EBITDA and
operating results of each business segment is outlined in a subsequent section
of the MD&A. The following sections review the impact of non-operating items on
the financial performance of the Corporation.





8

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|INTEREST, FOREIGN EXCHANGE AND OTHER                       
|-----------------------------------------------------------
|$ millions                                                 
|Interest on indebtedness                                   
|Amortization of deferred gain on foreign exchange contracts
|Derivative financial instruments gain                      
|Other foreign exchange items                               
|Loss on consolidation of foreign integrated subsidiaries   
|Other items                                                
|                                                           



Interest on long-term debt declined by $9 million primarily as a
result of the stronger Canadian $. Approximately 89% of the Corporation's
long-term debt relates to US $ senior notes with fixed rates of interest. As
such, the only item affecting interest on long-term debt is a change in the
relative value of the Canadian $ versus the US $. Interest on short-term debt
increased by $10 million as the Corporation made greater use of its short-term
operating lines.



Effective September 28, 2003, the Corporation applied the
accounting treatment prescribed by EIC-128 of the CICA with respect to the
accounting treatment for derivative financial instruments that do not qualify
for hedge accounting. Prior to the implementation of this guideline, gains and
losses related to financial instruments, primarily foreign exchange contracts,
were recognized on the maturity dates of the instruments. If derivative
financial instruments were sold or traded prior to their stated maturity dates,
the gains or losses were deferred and recognized on the statement of operations
as per the original maturity dates. The old rules required disclosure of
outstanding derivative financial instruments and their mark to market value in
the notes to the financial statements, but the positions were not shown on the
Corporation's balance sheet. The Corporation applied EIC-128 and the accounting
guideline for discontinuing hedge accounting at the beginning of fiscal 2004.



The following table summarizes the change in the unamortized
deferred gain on foreign exchange contracts during the years ended September
2005 and 2006:



|                              | $ millions    
|----------------------------- | --------------
|                              | OpeningBalance
|Year
    ended September 2005 | 156           
|Year ended September 2006     | 38            



Since the beginning of fiscal 2004, the Corporation has shown the
market value of its derivative financial instruments on its balance sheet and
the resulting gain or loss for the period has been reflected in its statement of
operations. Derivative financial instruments relate primarily to foreign
exchange contracts but also include commodity related instruments such as lumber
futures and hedges for purchased waste fibre and energy.



9

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The
following tables summarize the change in the market value of derivative
financial instruments during fiscal 2005 and fiscal 2006:



|                                                                   | $ millions         
|------------------------------------------------------------------ | -------------------
|Year
    ended September 2005                                      | Opening
    Balance
|Market value of outstanding foreign exchange contracts             | 105                
|Market value of commodity related derivative financial instruments | 10                 
|                                                                   | 115                





|                                                                   | $ millions         
|------------------------------------------------------------------ | -------------------
|Year ended September 2006                                          | Opening
    Balance
|Market value of outstanding foreign exchange contracts             | -                  
|Market value of commodity related derivative financial instruments | 6                  
|                                                                   | 6                  



During fiscal 2005, the Corporation recorded a gain of $23
million on its outstanding foreign exchange contracts as the relative value of
the Canadian $ increased from US $0.784 to US $0.854.  The Corporation received
proceeds of $128 million relating to foreign exchange contracts during fiscal
2005. There was limited foreign exchange activity in fiscal 2006. The
Corporation had sold the bulk of its remaining positions in the prior year.



At
September 30, 2006, the Corporation did not hold any lumber futures. At the
September 24, 2005, the Corporation held lumber futures equal to approximately
0.5% of its annual SPF lumber capacity. The fair value of these instruments was
nil. At the end of fiscal 2006, the Corporation did not hold any ONP hedges. At
the end of the prior year, the Corporation held hedges relating to purchased old
newspapers (ONP) representing approximately 3% of its annual recycled fibre
purchases. The fair value of these instruments was nil. At September 30, 2006,
the Corporation did not hold any natural gas hedges. At September 24, 2005, the
Corporation held natural gas hedges covering approximately 7% of its anticipated
requirements for the next year. The fair value of these instruments was $6
million.



Gain on translation of foreign debt




During
fiscal 2006, the Corporation recorded a gain of $64 million on the translation
of its US $ denominated debt as the relative value of the Canadian $ increased
from US $0.854 to US $0.895. In the prior year, the Canadian $ had increased
from US $0.784 to US $0.854, and the Corporation had recorded a gain of $125
million. The after-tax impact of the gain on translation of foreign denominated
debt was $54 million as compared to the prior year after-tax gain of $104
million.



10

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INCOME
  TAXES




In fiscal 2005, the Corporation recorded an income tax recovery
of $60 million on a pre-tax loss of
$380 million. The income tax recovery was $66 million lower than the projected
recovery of $126 million based on the Corporation's combined Canadian federal
and provincial income tax rate of 33.3%. There was a favourable item which
increased the recovery by $20 million relating to the non-taxable portion of the
exchange gain on US $ denominated debt, which currently receives capital gains
treatment in Canada and is taxed at 50% of regular business income. Lower
corporate income tax rates in the Corporation's non-Canadian operations
increased the recovery by $9 million. The above favourable items were more than
offset by several items which reduced the income tax recovery by $95 million.
The non-recognition of period losses, primarily related to our US operations in
St. Francisville, Louisiana, reduced the recovery by $33 million. As well, the
reduction in carrying value of a previously recognized income tax asset relating
to the St. Francisville operations further reduced the income tax recovery by
$32 million. Non-deductible expenses, primarily related to goodwill impairment,
decreased the recovery by $23 million. The non-deductible loss on consolidation
of foreign subsidiaries decreased the recovery by $4 million. Finally, the
Canadian large corporation tax reduced the recovery by $3 million.



During fiscal 2006, the Corporation recorded an income tax
recovery of $65 million on a pre-tax loss from continuing operations of $416
million. The income tax recovery was $74 million lower than the projected
recovery of $139 million based on the Corporation's effective tax rate of 33.3%.
There were several favourable items which increased the recovery by $21 million.
Lower corporate income taxes in the Corporation's non-Canadian operations
increased the recovery by $9 million. There was a favourable item of $9 million
relating to the non-taxable portion of the exchange gain on US $ denominated
debt, which currently receives capital gains treatment in Canada and is taxed at
50% of regular business income. Other permanent differences increased the
recovery by $3 million. The aforementioned favourable items were more than
offset by several unfavourable items which reduced the income tax recovery by
$95 million. The non-recognition of period losses, primarily related to the
Corporation's Canadian and US operations, reduced the recovery by $88 million.
The change in valuation allowance at a joint venture reduced the recovery by $3
million. The income tax recovery was further reduced by $3 million due to the
net effect of announced future rate enactments, with favourable Canadian federal
corporate tax rate changes being more than offset by increased rates in the
province of Quebec. Finally, the non-deductible loss on consolidation of foreign
subsidiaries decreased the recovery by $1 million.



Details regarding the
Corporation's tax position are outlined in note 18 of the audited consolidated
financial statements.



EARNINGS FROM DISCONTINUED OPERATIONS




In February 2006, the Corporation sold its OSB mill located in
Saint-Georges-de Champlain, Quebec for total consideration of $98 million. The
sale generated an after-tax gain of $47 million. As well, the OSB mill generated
net earnings of $4 million during the five months it was owned by the
Corporation. This compares to net earnings of $11 million in the prior year.



11

---



NET
  LOSS




The Corporation generated a net loss of $300 million compared to
a net loss of $309 million in the same period a year ago. As noted previously,
the Corporation's financial results were impacted by certain specific items. The
following table summarizes the impact of these items on the reported financial
results. The Corporation believes it is useful supplemental information as it
provides an indication of results excluding the specific items. This
supplemental information is not intended as an alternative measure for net loss
as determined by Canadian GAAP. The table below contains one recurring item,
namely the gain or loss on translation of foreign debt. Because the Corporation
has a substantial amount of US $ denominated debt, relatively minor changes in
the value of the Canadian $ versus the US $ can lead to large unrealized
periodic gains or losses. As well, the item receives capital gains/loss tax
treatment and is not tax-affected at regular business income rates.



|                                                                    | Year ended 
    September 2005 | Year ended 
    September 2006
|------------------------------------------------------------------- | ------------------------------ | ------------------------------
|                                                                    | $ millions                     | $ millions                    
|Net loss as reported
     in accordance with GAAP                  | (309)                          | (300)                         
|Specific items
    (after-tax):                                     |                                |                               
|Gain on translation of foreign debt                                 | (104)                          | (53)                          
|Derivative financial instruments gain                               | (20)                           | -                             
|Amortization of deferred gain on foreign
    exchange contracts     | (80)                           | (26)                          
|Unusual item  Sawmills                                             | 38                             | -                             
|Unusual item  Saint-Raymond paper mill                             | 68                             | -                             
|Unusual item  Dismantled machines                                  | 20                             | -                             
|Unusual item  Asset impairment                                     | 3                              | -                             
|Unusual item  Goodwill impairment                                  | 23                             | -                             
|Unusual item  Smooth Rock Falls pulp mill                          | -                              | 121                           
|Unusual item  St. Francisville paper mill                          | 45                             | 7                             
|Unusual item  Gain on sale of metal and
    webs operations        | -                              | (3)                           
|Unusual item  International pine
    operations                    | -                              | 3                             
|Unusual item  Gain on sale of land and
    building                | -                              | (1)                           
|Earnings from discontinued operations 
    OSB mill                | (11)                           | (51)                          
|Net loss excluding specific items 
    not in accordance with GAAP | (329)                          | (303)                         





12

---



|QUARTERLY FINANCIAL  INFORMATION
    $ millions
|-----------------------------------------------
|                                               
|                                               
|Sales                                          
|EBITDA                                         
|Depreciation and amortization                  
|Unusual items                                  
|Operating loss                                 
|Net loss from continuing operations            
|Net loss                                       



FOURTH QUARTER ANALYSIS




The Corporation reported a net loss of $54 million in the fourth
quarter ended September 30, 2006 compared to net loss of $137 million in the
same quarter of fiscal 2005.



Sales increased by $46 million as compared to the same quarter a
year ago. The Forest Products segment sales declined by $28 million as a result
of lower prices US $ reference prices. Pricing also was impacted by a stronger
Canadian $, which averaged 7% higher versus the US $. The Pulp segment sales
increased by $71 million on the strength of improved prices and higher
shipments. The Paper segment sales increased by $5 million as lower selling
prices were more than offset by increased shipments for all grades of paper.



EBITDA
improved by $38 million over the prior year quarter. The Forest Products segment
negative EBITDA declined by $7 million with lower prices being more than offset
by lower costs. Lumber export duties on shipments to the US declined by $10
million due to reduced deposit rates that came into effect in December 2005. The
Pulp segment EBITDA improved by $23 million as prices improved substantially.
The Paper segment EBITDA improved by $9 million. This segment benefited from
lower manufacturing costs which more than offset weaker revenues. Energy costs
were lower and the segment also benefited from a more favourable exchange rate
on the St. Francisville paper mill's US $ costs.



13

---



The
operating loss decreased by $133 million as compared to the year ago quarter.
The Forest Products segment operating loss declined by $7 million. The
aforementioned improvement in EBITDA was the most significant contributor. The
Pulp segment operating loss of $10 million represented a $24 million improvement
over the prior year quarter. The gain was driven by the higher EBITDA and
reduced depreciation expense resulting from the asset impairment charge on the
Smooth Rock Falls pulp mill taken in the March 2006 quarter. The Paper segment
operating loss declined by $102 million as the year ago quarter included an
unusual charge of $93 million relating to three items; a charge of
$45 million for the closure of a pulp line and of a paper machine; a charge of
$26 million to reduce the carrying value of a dismantled paper machine; and a
charge of $22 million to reduce the carrying value of previously recorded
goodwill in the newsprint operations.



During
the September 2006 quarter, the Corporation recorded a gain of $7 million on the
translation of its
US $ denominated debt as the relative value of the Canadian $ increased from US
$0.890 to US $0.895. In the comparable period a year ago, the Canadian $ had
increased from US $0.811 to US $0.854, and the Corporation had recorded a gain
of $74 million. The after-tax impact of the gain on translation of foreign
denominated debt was $6 million as compared to the prior year after-tax gain of
$61 million.



SUMMARY OF QUARTERLY RESULTS




On a quarterly basis, sales have benefited from improvements in
US $ reference prices for lumber, pulp and paper over the last two years.
However, much of the benefit was offset by a strengthening Canadian $ compared
to the US $, increasing from an average of US $0.818 in the first quarter of
fiscal 2005 to US $0.892 in the fourth quarter of fiscal 2006, a 9% increase. As
a result, the Corporation has continued to generate low levels of EBITDA.



The Corporation's financial performance and that of its Forest
Products segment for the last eight quarters were negatively impacted by
substantial export duties on lumber shipped to the US. Total amount incurred
over the last two years was $124 million, an amount greater than the total
reported EBITDA of
$26 million.



The Corporation has generated losses from continuing operations
of $656 million in the last 8 quarters. In addition to marginal levels of EBITDA
previously noted, the Corporation has recorded unusual charges totalling $443
million over the last 8 quarters. The following summarizes major unusual items
recorded.



|$ millions                                                  | 2005 | 2006
|----------------------------------------------------------- | ---- | ----
|                                                            |      |     
|Ontario Sawmills  December 2004                            | 21   | -   
|Quebec/Specialty sawmills  March 2005                      | 35   | -   
|St. Raymond paper mill  March 2005                         | 101  | -   
|St. Francisville paper mill 
    September 2005/March 2006 | 45   | 7   
|Dismantled machines  September 2005                        | 30   | -   
|Goodwill impairment  September 2005                        | 23   | -   
|Smooth Rock Falls pulp mill  March
    2006/September 2006 | -    | 183 
|Sale of metal plates and webs  June
    2006               | -    | (5) 
|International pine operations 
    September 2006          | -    | 4   
|Sale of land and building  September
    2006              | -    | (1) 
|                                                            | 255  | 188 



Details are outlined in note 16 of the audited consolidated
financial statements.



14

---



While the stronger Canadian $ reduced EBITDA, the Corporation
realized significant gains on its derivative financial instruments, primarily US
$ foreign exchange contracts. During the four quarters of fiscal 2005 and the
first 2 quarters of fiscal 2006, the Corporation has recorded $186 million of
realized and amortized gains on derivative financial instruments. However, the
impact of foreign exchange derivatives on our financial results declined
considerably in March 2006. As a result, gains in the last 2 quarters of fiscal
2006 were negligible.



The Corporation also recorded a gain of $189 million on the
translation of its US $ denominated debt over the last 2 years. However, the
impact of the quarterly translation gains and losses added considerable
volatility to the results, with the impact ranging from a gain of $74 million in
the September 2005 quarter to a loss of $20 million in the June 2005 quarter.



15

---



SEGMENT REVIEW



|FOREST PRODUCTS
    $ millions          | 2002               | 2003               | 2004                 | 2005                 | 2006              
|--------------------------------------- | ------------------ | ------------------ | -------------------- | -------------------- | ------------------
|Total sales
    
    Consolidated sales | 1,079
    
    907 | 1,012
    
    838 | 1,308
    
    1,095 | 1,267
    
    1,072 | 1,088
    
    905
|Lumber duties                           | 18                 | 81                 | 111                  | 89                   | 35                
|EBITDA                                  | 61                 | (57)               | 75                   | 32                   | 22                
|EBITDA margin on consolidated sales     | 6.7%               | (6.8)%             | 6.8%                 | 3.0%                 | 2.4%              
|Depreciation and amortization           | 42                 | 43                 | 48                   | 56                   | 54                
|Unusual items                           | 6                  | 16                 | -                    | 57                   | (2)               
|Operating earnings (loss)               | 13                 | (116)              | 27                   | (81)                 | (30)              
|Identifiable assets (excluding cash)    | 752                | 717                | 846                  | 813                  | 744               



The Forest Products segment is divided into two main areas of
activity: forest resource management and manufacturing operations.



The Forest Resource Management group is responsible for managing
all of the Corporation's Canadian forestry operations. This includes the
harvesting of timber, either directly or by contractual agreements, and all silviculture and regeneration work required to ensure a sustainable supply for
the manufacturing units. The group is also responsible for third party timber
purchases, which are needed to supplement total requirements. The group's main
objective is the optimization of the flow of timber into various manufacturing
units. As the Corporation's forest activity in Canada is conducted primarily on
Crown Lands, the Forest Resource Management group works closely with provincial
governments to ensure harvesting plans and operations comply with established
regulations and that stumpage charged by the provinces is reasonable and
reflects the fair value of the timber being harvested. During fiscal 2006 the
Corporation's operations harvested and delivered 7.2 million cubic metres of
timber versus 8.0 million cubic metres in 2005. Additional supply of
approximately 1.2 million cubic metres was secured mainly through purchases and
exchanges with third parties, down from 1.3 million cubic metres in the prior
year.



The Forest Products group includes operations located in Quebec,
Ontario, Alberta, British Columbia and France. The group also has a minority
ownership position in a Chilean pine sawmill. As equity accounting is used for
this operation, its sales, margins and volumes are not included in the
Corporation's consolidated results. The group focuses on three main product
areas: SPF Lumber, Specialty Wood and Engineered Wood. The SPF Lumber operations
can produce approximately 1.7 billion board feet of lumber. The Specialty Wood
operations can annually produce 125 million board feet of pine lumber, hardwood
lumber and hardwood flooring, after allowing for the permanent shutdown of the
Davidson, Quebec pine and hardwood sawmills. The Engineered Wood operations
produce laminated veneer lumber (LVL), finger joint lumber, wood I‐Beams, rim
joists, metal plates and webs. On February 27, 2006, the Corporation completed
the sale of its oriented strandboard (OSB) business located in
Saint-Georges-de-Champlain, Quebec. The financial results of the OSB operation
have been reclassified as discontinued operations. Comparative figures have also
been reclassified to exclude the OSB mill's results from the continuing
operations.



16

---



The following summarizes the annual operating levels of each
facility by product group:



|SPF LUMBER                                        | MFBM               
|------------------------------------------------- | -------------------
|Stud
    Lumber  Taschereau / La Sarre, QC(1)    | 200,000            
|Stud
    Lumber  Senneterre, QC                  | 150,000            
|Stud Lumber  Cochrane, ON                        | 170,000            
|Stud Lumber  Kapuskasing, ON                     | 105,000            
|Random Lumber  Nouvelle / St-Alphonse, QC (2)    | 75,000             
|Random Lumber  Bearn, QC                         | 110,000            
|Random Lumber  Chapleau, ON                      | 135,000            
|Random Lumber  Timmins, ON                       | 100,000            
|Random Lumber  Hearst, ON                        | 160,000            
|Random Lumber  Canal Flats, BC(3)                | 180,000            
|Random Lumber  Elko, BC
    (3)                  | 270,000            
|                                                  |                    
|Finger Joint Lumber  Cranbrook,
    BC           | 25,000             
|                                                  |                    
|                                                  |                    
|SPECIALTY WOOD                                    | MFBM               
|Pine & Hardwood Lumber  Davidson, QC
    (4)     | 55,000             
|Pine & Hardwood Lumber  Mattawa, ON              | 30,000             
|Hardwood Lumber  Huntsville, ON                  | 30,000             
|Hardwood Flooring  Huntsville, ON                | 18,000             
|Pre-Finished Hardwood Flooring  Toronto, ON      | 10,000             
|Pine
    Lumber  Brassac, France                 | 15,000             
|Radiata Pine Lumber  Curanilahue, Chile
    (5)  | 22,000             
|                                                  |                    
|                                                  |                    
|ENGINEERED WOOD                                   | Thousand ft. 3     
|Laminated Veneer Lumber  Ville-Marie, QC
    (6) | 475                
|Laminated Veneer Lumber  Amos, QC
    (6)(7)     | 2,300              
|                                                  |                    
|                                                  |                    
|                                                  | MFBM               
|Engineered Finger Joint Lumber  La Sarre, QC     |                    
|                                                  |                    
|                                                  | Thousand linear ft.
|Wood I-Beams  Bolton, ON
    (6)                 | 40,000             
|Wood I-Beams  Calgary, AB
    (6)                | 18,000             
|Wood I-Beams  Blainville, QC
    (6)             | 5,000              
|                                                  |                    
|                                                  |                    
|                                                  | Millions lbs       
|Metal Plates and Webs  Bolton, ON
    (6)(7)     |                    



(1)Sites are operated as a combined entity.

(2)Volumes reflect 50% of the actual capacity as the units are part of the Temrex
joint venture.

(3)The Elko and Canal Flats sawmills rely on Cranbrook Planing Mill to dry and
dress 80,000 mfbm of lumber.

(4)The Davidson facility was temporarily shut down for an indefinite period in the
September 2005 quarter.

(5)Volume reflects 34.31% of the actual plant capacity as the unit is part of the
Foraction joint venture whose financial results are not consolidated with those
of the Corporation.

(6)Volumes reflect 50% of the actual plant capacity as the units are part of the
Temlam joint venture.

(7)The Temlam joint venture sold its metal plates and webs business in the June
2006 quarter.



17

---



The segment is dominated by SPF lumber, which represented 75% of
building material sales in fiscal 2006, the same as in the prior year. The
average selling price of SPF lumber was $62 per mfbm (thousand foot board
measure) lower than in the prior year. The lower prices were the result of lower
US $ reference prices for lumber and a Canadian $ that averaged 7% higher versus
the US $. Specialty and Engineered Wood prices and revenues were also negatively
impacted by the stronger Canadian $. Overall, Specialty Wood represented 14% of
building material sales in fiscal 2006, down from 16% in fiscal 2005. Engineered
Wood sales in the year were at 11%, up from 9% in the prior year.



In addition to the above, the Forest Products group produced and
shipped approximately 1.9 million tonnes of wood chips in fiscal 2006, 86% of
which were directed to the Corporation's pulp and paper operations. In 2005, the
group produced 2.0 million tonnes and shipped 85% of this volume to the pulp and
paper mills. The internal transfer price of woodchips is based on current and
expected market transaction prices.



Total sales for this segment reached $1,088 million, a decrease
of $179 million over the prior year.  Lower selling prices and volumes of SPF
lumber accounted for $96 million of the decrease. The shutdown of the Marks
Lumber reman operations, located in Brantford, Ontario, and the previously noted
Davidson hardwood and pine operations reduced sales by a further $42 million.
Wood chip sales declined by $25 million as a result of lower volumes and prices.
Overall, the Forest Products segment generated 27% of Corporation consolidated
sales, down from 31% in the prior year. The group's main market is North
America, which represented 95% of consolidated sales in fiscal 2006, as compared
to 94% in the prior year.

18

---



|                                        | Sales
    ($ millions) | Shipments
    (000 units) | Selling
    Prices       
    ($ / unit)
|--------------------------------------- | ---------------------- | ------------------------- | ----------------------------------------
|                                        | 2005                   | 2006                      | 2005                                    
|SPF Lumber                              |                        |                           |                                         
|SPF Lumber (mfbm)                       | 681                    | 585                       | 1,464.0                                 
|Remanufactured Lumber (mfbm)
    (1)    | 15                     | -                         | 36.6                                    
|                                        | 696                    | 585                       |                                         
|Specialty Wood                          |                        |                           |                                         
|Pine and Hardwood (mfbm)                | 86                     | 47                        | 107.3                                   
|Hardwood Flooring (mfbm)                | 68                     | 63                        | 15.3                                    
|                                        | 154                    | 110                       |                                         
|Engineered Wood                         |                        |                           |                                         
|LVL (cubic feet)                        | 17                     | 21                        | 633.8                                   
|Eng. Finger Joint Lumber (mfbm)         | 2                      | 12                        | 4.9                                     
|Wood I-Beams and Rim Joists (linear ft) | 50                     | 46                        | 31,274                                  
|Metal Plates & Webs ('000 lbs)(2)       | 10                     | 6                         | 10,062                                  
|                                        | 79                     | 85                        |                                         
|Total
    Building Materials            | 929                    | 780                       |                                         
|Wood chip & other sales                 | 338                    | 308                       |                                         
|                                        |                        |                           |                                         
|Total Sales                             | 1,267                  | 1,088                     |                                         
|Internal wood chip & other sales        | (195)                  | (183)                     |                                         
|                                        |                        |                           |                                         
|Consolidated Sales                      | 1,072                  | 905                       |                                         



(1)The lumber remanufacturing operations located in Brantford, Ontario were
permanently closed in the June 2005 quarter.

(2)The Corporation's proportionately consolidated joint venture, Temlam Inc., sold
all of its metal plates and web operations, located in Bolton, Ontario, in the
June 2006 quarter.



#### Markets



The benchmark random length Western SPF lumber net price averaged
US $311 per mfbm in 2006, a decrease from US $348 per mfbm in 2005. In the East,
the random length Eastern SPF average lumber price (delivered Great Lakes)
decreased from US $422 per mfbm to US $384 per mfbm in 2006. The Corporation
considers these to be relatively low levels, approximately US $20 to US $30
below normal trendline prices for random lumber. The reference price for stud
lumber decreased as well with the Eastern average lumber price (delivered Great
Lakes) down from US $421 per mfbm to US $363 per mfbm, a level approximately US
$20 to US $30 per mfbm below trendline prices. While US annual housing starts
were excess of 2 million units in fiscal 2006, a reduction in the latter part of
year, combined with uncertainty surrounding the then proposed lumber agreement
between Canada and the United States, led to excess shipments and significantly
lower selling prices.



It has now been approximately 51⁄2 years since the five-year Canada
/ US Softwood Lumber Agreement (SLA) expired on April 1, 2001. On April 2, 2001,
petitions for the imposition of antidumping and countervailing duties on
softwood lumber to the US were filed with the US Department of Commerce (USDOC)
and the US International Trade Commission (USITC) by certain US industry and
trade groups. In August 2001, the USDOC made a preliminary countervailing duty
determination, imposing a bonding rate of 19.31% on Canadian softwood lumber
shipped to the US after August 16, 2001.



19

---



The preliminary countervailing duty continued in fiscal 2002 as
the Corporation accrued $11 million on lumber shipments to the US from September
30 to December 15, 2001. Preliminary countervailing duty effectively expired on
the latter date. In addition, on October 31, 2001, the USDOC made a preliminary
antidumping determination imposing a bonding requirement at the rate of 10.76%
on the Corporation's shipments of Canadian softwood lumber to the US. The
aforementioned average rate was assigned specifically to the Corporation based
on the USDOC review of our actual historical shipments to the US. During the
first half of fiscal 2002, the Corporation accrued a total of $10 million
relating to shipments to the US between November 6, 2001 and March 30, 2002.



On May 16, 2002, the USITC announced it had found no current
injury, but a threat of injury, to the US lumber industry, effectively removing
the requirement to remit the $22 million of accrued preliminary countervailing
duty and the $10 million of accrued preliminary antidumping duty. The finding of
threat of injury by USITC resulted in the USDOC issuing an order to collect cash
deposits of estimated countervailing and antidumping duties on a going forward
basis. Effective May 22, 2002, the Corporation's softwood lumber exports to the
US were subject to a countervailing duty cash deposit rate of 18.79% and an
antidumping cash deposit rate of 10.21%. During fiscal 2003, the Corporation
incurred a charge of $50 million relating to countervailing duty and a charge of
$31 million for antidumping duty for lumber shipped to the US. During fiscal
2004, the Corporation incurred a charge of $68 million relating to
countervailing duty and a charge of $44 million for antidumping duty. On
December 20, 2004, the USDOC reduced the countervailing duty deposit rate to
17.18% and increased the antidumping rate to 10.59%. On February 17, 2005, the
countervailing duty rate was further corrected to 16.37% and the antidumping
rate to 9.1%. During fiscal 2005, the Corporation incurred a charge of $57
million relating to countervailing duty and a charge of $32 million for
antidumping duty. On December 12, 2005, the USDOC reduced the countervailing
duty rate to 8.7% and the antidumping rate to 4.02%. During fiscal 2006, the
Corporation incurred a charge of $30 million relating to countervailing duty and
a charge of
$5 million relating to antidumping duty.



Overall, the net impact of duties in fiscal 2006 was a charge of
$35 million, down from $89 million in the prior year. Lower prices combined with
the lower rates for the last 3 quarters of fiscal 2006 generated the decrease.
To the end of September 2006, the Corporation had expensed a total of $345
million in duties since May 22, 2002. The following table summarizes duty
expensed and remitted over that period. Additional details are outlined in note
14 of the audited consolidated financial statements.



|            | $ millions            
|----------- | ----------------------
|            | Duties Expensed
    C$
|Fiscal 2002 | 28                    
|Fiscal 2003 | 81                    
|Fiscal 2004 | 112                   
|Fiscal 2005 | 89                    
|Fiscal 2006 | 35                    
|            | 345                   



On October 30, 2006 the Corporation received a US $242 million
payment pertaining to the recovery of lumber export duties, including accrued
interest. The funds received represented approximately all of monies expected to
be recovered as part of the new softwood lumber agreement between Canada and the
United States.



20

---



# Operating Results



The volume of SPF lumber sold in fiscal 2006 was similar to the
shipments of the prior year. In fiscal 2005, there were significant changes to
the Corporation's Eastern Canadian SPF operations. In response to lower
allowable harvesting levels of timber on crown lands, the Corporation
permanently idled three stud lumber sawmills: Kirkland Lake, Ontario; Opasatika,
Ontario; and La Sarre, Quebec. The net impact was a reduction of production
capacity of approximately 100 million FBM. However, the remaining Eastern
Canadian sawmills became approximately 21% larger, in terms of normal production
capacity.



Overall, lower selling prices for SPF lumber were the primary
cause of the EBITDA decrease of
$10 million. The lower prices were substantially offset by lower manufacturing
costs, primarily timber consumed in the SPF lumber operations. SPF costs were
also favourably impacted by lower lumber export duties. As noted previously,
countervailing and antidumping duties totalled $35 million in fiscal 2006, down
from $89 million in the prior year. The decline is due to the reduced rates that
came into effect in December 2005. The EBITDA margin was 2.4%, compared to a
five-year average of 2.4%. In fiscal 2006, the Forest Products segment generated
as much EBITDA as the consolidated EBITDA of the Corporation, as the Paper
segment generated negative EBITDA. In fiscal 2005, the segment generated more
EBITDA than the consolidated EBITDA of the Corporation, as both the Pulp and
Paper segments generated negative EBITDA.



The Forest Product segment recorded several unusual items in
fiscal 2005 and 2006. During the prior year, the Corporation recorded unusual
charges totalling $57 million related to the permanent closure of several
facilities. These included an SPF lumber sawmill in Kirkland Lake, Ontario, an
SPF lumber sawmill in Opasatika, Ontario, an SPF lumber sawmill in La Sarre,
Quebec, hardwood and pine sawmills in Davidson, Quebec, a hardwood sawmill in
Temiscaming, Quebec and a lumber remanufacturing facility in Brantford, Ontario.
A charge relating to the impairment of goodwill for the hardwood flooring
business was also recorded in the prior year. During fiscal 2006, the
Corporation recorded a gain of $4 million on the disposal of the Temlam joint
venture's metal and webs operations as well as a gain of $1 million on the sale
of land and building of a lumber remanufacturing facility that had been
permanently idled in the prior year. The Corporation also recorded various
charges totalling $3 million to reduce the carrying value of the net assets of
pine lumber operations in France as well as two international sales offices to
fair value.



The Forest Products segment generated an operating loss of $30
million as compared to an operating loss of $81 million in the prior year. The
reduced loss was the result of the lower unusual charges in the current year.



21

---



|PULP
    $ millions                  | 2002  | 2003  | 2004  | 2005   | 2006 
|------------------------------------ | ----- | ----- | ----- | ------ | -----
|Total sales                          | 1,302 | 1,380 | 1,418 | 1,373  | 1,451
|Consolidated sales                   | 1,228 | 1,291 | 1,334 | 1,290  | 1,360
|EBITDA                               | 96    | 73    | 61    | (25)   | 6    
|EBITDA margin on consolidated sales  | 7.8%  | 5.7%  | 4.6%  | (1.9)% | 0.4% 
|Depreciation and amortization        | 104   | 107   | 108   | 114    | 92   
|Unusual items                        | 2     | -     | -     | 4      | 183  
|Operating loss                       | (10)  | (34)  | (47)  | (143)  | (269)
|Identifiable assets (excluding cash) | 1,601 | 1,490 | 1,523 | 1,486  | 1,207



The Pulp group consists of eleven market pulp manufacturing
facilities operating at ten sites. The facilities are divided into two main
types. Eight paper pulp mills produce softwood kraft, hardwood kraft and high
yield pulps. Three specialty pulp mills produce specialty cellulose, fluff and
dissolving pulps. Nine of the pulp mills are wholly owned and the Corporation
has a 50% joint venture position in the Marathon, Ontario softwood kraft pulp
mill and in the Atholville, New Brunswick dissolving pulp mill. All of the
Corporation's financial and statistical data include only its 50% proportionate
share of these two mills. The Corporation does however have responsibility for
marketing the entire output of the two joint ventures. The Corporation's partner
in the AV Cell joint venture is the Aditya Birla Group of India, which
effectively purchases the entire output of the mill at market prices. The paper
pulp mills can produce approximately 1,860,000 tonnes per year after adjusting
for proportionate joint ventures. The specialty pulp mills can produce
approximately 380,000 tonnes per year.



22

---



The following summarizes the annual operating levels of each
facility by product group:



|PAPER PULP                                 | TONNES   
|------------------------------------------ | ---------
|Softwood Kraft  Skookumchuck, BC          | 270,000  
|Softwood Kraft  Tarascon, France          | 260,000  
|Softwood Kraft  Smooth Rock Falls
    (1) | 200,000  
|Softwood Kraft  Marathon, ON
    (2)      | 95,000   
|                                           | 825,000  
|                                           |          
|Hardwood Kraft  Saint-Gaudens, France     | 305,000  
|                                           |          
|Hardwood High-Yield  Temiscaming, QC      | 300,000  
|Hardwood High-Yield  Matane, QC           | 230,000  
|Hardwood High-Yield  Chetwynd, BC         | 200,000  
|                                           | 730,000  
|                                           |          
|SPECIALTY PULP                             |          
|Specialty Cellulose  Temiscaming,
    QC  | 165,000  
|Fluff  Tartas, France                     | 155,000  
|Dissolving  Atholville, NB(2)             | 60,000   
|                                           | 380,000  
|                                           |          
|Total                                      | 2,240,000



(1)    The pulp mill was indefinitely idled at the end of July 2006. On December 5,
2006, the Corporation announced the permanent closure of the pulp mill. See
subsequent events note in the audited financial statements.

(2)    
50% of current annual capacity.



Total sales for the Pulp group reached a record $1,451 million,
an increase of $78 million from the prior year. Record shipment levels were
partially offset by lower selling prices. Strong market conditions allowed the
Corporation to sell 156,700 more tonnes in fiscal 2006, a 7.6% increase over the
prior year. Shipments outpaced production and the Corporation reduced its
inventories by 128,800 tonnes, the opposite of what had occurred in the prior
year when inventories had increased by 16,500 tonnes. While the segment
benefited from higher US $ reference prices on paper pulps, it was not
sufficient to offset the impact of a stronger Canadian $, which averaged 7%
higher versus the US $. The net price effect was a decrease in sales of $23
million or $10 per tonne. After eliminating internal sales, the Pulp group
generated 41% of consolidated sales, up from 37% in the prior year.



Markets



The Pulp segment is more ''global'' than the other business groups
within Tembec. In 2006, 81% of consolidated sales were generated outside of
Canada and the US, as compared to 80% in the prior year. The Corporation markets
its pulp on a world-wide basis, primarily through its own sales force. The Pulp
Group maintains sales or representative offices in Toronto, Canada, Signy/Nyon,
Switzerland, San Sebastian, Spain, Beijing, China. The Corporation's sales force
also periodically markets pulp and paperboard produced by third parties. In
fiscal 2006, agency pulp sales totalled 2,000 tonnes compared to 4,400 tonnes in
2005.



23

---



Year over year, average selling prices of pulp decreased by $10
per tonne. In fiscal 2005, the benchmark NBSK pulp price (delivered US) began
the year at US $610 per tonne. It dropped to US $585 per tonne in October 2004
before gradually increasing to US $680 per tonne by February 2005 and then
falling back to US $620 per tonne by September 2005. The average for fiscal 2005
was US $644 per tonne. In fiscal 2006, we experienced a continuous string of
price increases, eventually closing out the year at US $770 per tonne. The
average selling price for the year was US $688 per tonne, an increase of US $44
per tonne over the prior year. However, the Canadian $, which averaged 7% higher
versus the US $ effectively mitigated the effect of higher US $ paper pulp
prices. Specialty pulp markets were more difficult with little change to US $
prices, the business absorbed the full effect of the stronger Canadian $.
Average selling prices for specialty pulps declined by $58 per tonne.





|                        | Sales
    
    ($ millions) | Shipments
    (000
    tonnes) | Selling
    Prices
    ($ / tonne)
|----------------------- | --------------------------- | ------------------------------ | ----------------------------------
|                        | 2005                        | 2006                           | 2005                              
|Paper pulps             |                             |                                |                                   
|Softwood kraft          | 496                         | 521                            | 749.7                             
|Hardwood kraft          | 173                         | 172                            | 286.3                             
|Hardwood
    high yield | 373                         | 426                            | 683.5                             
|Specialty pulps         | 308                         | 308                            | 336.6                             
|Total pulp sales        | 1,350                       | 1,427                          | 2,056.1                           
|                        |                             |                                |                                   
|Other sales             | 23                          | 24                             |                                   
|                        |                             |                                |                                   
|Total sales             | 1,373                       | 1,451                          |                                   
|Internal
    sales      | (83)                        | (91)                           | (103.4)                           
|                        |                             |                                |                                   
|Consolidated sales      | 1,290                       | 1,360                          | 1,952.7                           



Operating Results



While total shipments in fiscal 2006 increased by 156,700 tonnes
over the prior year, establishing a new record, the total amount of pulp
produced increased by 11,600 tonnes. During fiscal 2006, the pulp group took
119,400 tonnes of total downtime, including 35,000 tonnes of lost production at
the Smooth Rock Falls NBSK pulp mill in August and September. There was no
market downtime taken in fiscal 2006. In the prior fiscal year, the Corporation
had taken 101,600 tonnes of downtime, which included 46,800 tonnes of market
related downtime, primarily in high-yield pulp. The Corporation defines ''market
downtime'' as temporary production curtailments designed to reduce or control
finished goods inventory levels.



Despite the increased production curtailments, year over year
mill level manufacturing costs remained relatively unchanged. A more favourable
exchange rate on the French pulp mill's Euro costs improved operating results by
$48 million.



As noted previously, the Corporation remains mindful of allowing
its inventories to increase beyond normal levels. Total consolidated pulp
inventories at September 30, 2006, represented approximately 21 days of
production. This was significantly lower than in 2005 when we ended the year
with 42 days of production in inventory. The Corporation considers 25 days to be
a normal level.



24

---



Total 2006 shipments of 2,212,800 tonnes include 58,600 tonnes of
high yield pulp and 47,200 tonnes of softwood kraft pulp consumed by the
Corporation's paperboard operations as compared to 56,500 tonnes and 34,900
tonnes respectively in the prior year. As well, 8,900 tonnes of pulp were
consumed internally by various other pulp and paper operations, as compared to
12,000 tonnes in 2005. In all, internal pulp consumption represented
approximately 5% of total shipments, unchanged from the prior year.



The eight North American pulp mills purchased approximately 2.3
million bone dry tonnes of woodchips in fiscal 2006, unchanged from the prior
year. Of this amount, approximately 47% were supplied by the Forest Products
Group, compared to 49% in the prior year. The remaining requirements were
purchased from third parties under contracts and agreements of various duration.
The three pulp mills located in Southern France purchased 1.5 million bone dry
tonnes of woodchips in fiscal 2006, as compared to
1.4 million bone dry tonnes in the prior year. The fibre is mainly sourced from
many private landowners.



Overall, lower manufacturing costs and higher US $ reference
prices more than offset the stronger Canadian $ and the EBITDA margin improved
from negative 1.9% to positive 0.4%. This compares with a five-year positive
average margin of 3.2%. The Pulp Group EBITDA represented 25% of total
Corporation EBITDA in 2006. As margins were negative in the prior year, the Pulp
Group did not contribute to total Corporation EBITDA in fiscal 2005.



Depreciation and amortization expense declined by $22 million,
primarily due to the absence of Smooth Rock Falls pulp mill depreciation expense
for the last six months of fiscal 2006. The carrying value of the mill's fixed
assets had been reduced in the March 2006 quarter.



The Pulp segment absorbed unusual item charges in fiscal 2005 and
2006. In the current year, the Corporation recorded a charge of $183 million
relating primarily to asset impairment at the Smooth Rock Falls pulp mill. In
the prior year, the Corporation recorded a charge of $4 million relating to the
reduction of the carrying value of a dismantled pulp machine.



The pulp segment generated an operating loss of $269 million as
compared to an operating loss of
$143 million in the prior year. The increased loss was the result of unusual
charges, with improved EBITDA and lower depreciation and amortization expense
providing a partial offset.

25

---



|PAPER
    $ millions                 | 2002  | 2003  | 2004   | 2005   | 2006  
|------------------------------------ | ----- | ----- | ------ | ------ | ------
|Consolidated sales                   | 1,078 | 1,010 | 953    | 943    | 874   
|EBITDA                               | 94    | 31    | (30)   | (12)   | (11)  
|EBITDA margin                        | 8.7%  | 3.1%  | (3.1)% | (1.3)% | (1.3)%
|Depreciation and amortization        | 73    | 70    | 67     | 61     | 54    
|Unusual items                        | -     | 2     | 10     | 194    | 7     
|Operating earnings (loss)            | 21    | (41)  | (107)  | (267)  | (72)  
|Identifiable assets (excluding cash) | 1,273 | 1,217 | 1,169  | 913    | 846   



The Paper segment includes four paper manufacturing facilities
with a total of 9 paper machines. The mills located in Kapuskasing, Ontario and
Pine Falls, Manitoba produce newsprint. The facility located in Témiscaming,
Quebec produces multi-ply bleached coated paperboard. The paperboard mill is
partially integrated with the high yield pulp mill and also consumes pulp
manufactured by the Corporation at other sites. The St. Francisville, Louisiana
mill produces coated and specialty papers. In May 2005, the Corporation
permanently shutdown a 68,000 tonnes per year specialty paper mill located in
Saint-Raymond, Quebec. The total capacity of the Paper Group is 1,085,000
tonnes.



The following summarizes the products and operating levels of
each facility by main type:



|NEWSPRINT                                              | TONNES(1)
|------------------------------------------------------ | ---------
|Kapuskasing, ON                                        | 330,000  
|Pine Falls, MB                                         | 185,000  
|                                                       | 515,000  
|                                                       |          
|COATED PAPER                                           |          
|St. Francisville, LA  Coated No 3 & 4                 | 280,000  
|                                                       |          
|SPECIALTY PAPER                                        |          
|Uncoated Bleached Board  St.
    Francisville, LA (2) | 80,000   
|Specialty Kraft Paper  St. Francisville, LA           | 30,000   
|Coated Paperboard  Temiscaming, QC                    | 180,000  
|                                                       | 290,000  
|                                                       |          
|Total                                                  | 1,085,000



(1)    
Although the above table shows all capacities in metric tonnes, coated paper and
certain specialty paper are sold primarily in short tonnes.

(2)   
This machine was shutdown in December 2005.



26

---



The $69 million decline in sales resulted primarily from lower
shipments and prices for specialty and coated papers. Higher shipments and
prices for newsprint provided a partial offset. The decline in specialty paper
shipments relates to the permanent closure of the 68,000 tonnes per year
Saint-Raymond, Quebec paper mill, which occurred in May 2005, and the closure of
the 80,000 tonnes per year uncoated bleached board machine at the St.
Francisville, Louisiana paper mill, which occurred in December 2005. Overall,
the Paper segment generated 26% of consolidated sales in fiscal 2006, as
compared to 27% in the prior year.



Markets



The focus of the Paper business is North America, which accounted
for 98% of sales in 2006, unchanged from the prior year. The US alone accounted
for 87% of sales. In fiscal 2005, the benchmark price for newsprint (48.8 gram)
increased from US $550 per tonne to US $615 per tonne, and averaged US $585 per
tonne. In fiscal 2006, price increases continued, ending the year at US $663 per
tonne. The average selling price for the year was US $648 per tonne, an increase
of US $63 per tonne over the prior year. After giving effect to the stronger
Canadian $, the Corporation's average selling price for newsprint increased by
$33 per tonne.



In fiscal 2005, the benchmark price for coated papers (No 5  40
lb) increased from US $740 per short ton to US $880 per short ton, and averaged
US $821 per short ton. The trend was reversed in fiscal 2006, as prices
gradually declined to US $805 per short ton. The average selling price for the
year was
US $856 per short ton, an increase of US $35 per short ton over the prior year.
After giving effect to the stronger Canadian $, the Corporation's average
selling price for coated papers decreased by $56 per short ton.



The benchmark for coated bleached boxboard (15 point) averaged US
$804 per short ton in fiscal 2006, a US $40 per short ton increase over the
prior year. Here again, the improved US $ reference prices were not enough to
offset the stronger Canadian $ and average prices for specialty papers remained
relatively unchanged. Average prices would have decreased if not for a higher
value sales mix of products resulting from the shutdown of the lower value
uncoated bleached board machine.



The 65,900 tonne decline in specialty paper shipments relates
primarily to the aforementioned closure of the Saint-Raymond paper mill and of
the uncoated bleached board machine in St. Francisville.



|                   | Total sales
    ($
    millions) | Shipments
    (000 tonnes) | Selling
    Price
    ($/tonne)
|------------------ | -------------------------------- | -------------------------- | -------------------------------
|                   | 2005                             | 2006                       | 2005                           
|Newsprint          | 335                              | 365                        | 489.2                          
|Coated paper       | 292                              | 266                        | 262.9                          
|Specialty paper    | 314                              | 241                        | 285.1                          
|Total paper sales  | 941                              | 872                        | 1,037.2                        
|Other
    sales    | 2                                | 2                          |                                
|Consolidated sales | 943                              | 874                        |                                



Although the above table shows all shipments in ''metric'' tonnes,
coated papers and certain specialty papers are sold primarily in short tons.



27

---



##### Operating Results



Lower average selling prices reduced EBITDA by $16 million or $16
per tonne. Lower manufacturing costs more than offset the decrease in revenues.
In the prior year, the Paper segment undertook 46,700 tonnes of downtime,
including 30,000 tonnes of market related downtime, primarily due to weak demand
for newsprint and coated paperboard. In fiscal 2006, markets were better and
downtime was reduced to 18,500 tonnes. In addition, the segment benefited from a
more favourable exchange rate on the
St. Francisville paper mill's US $ costs and the avoidance of EBITDA losses from
the idled
Saint-Raymond paper mill.



The Paper Group's mills are large users of virgin fibre,
primarily in the form of wood chips. During fiscal 2006, the operations
purchased 0.9 million bone dry tonnes of virgin fibre, of which approximately
40% was internally sourced. In the prior year, they had purchased 1.0 million
bone dry tonnes of virgin fibre, with 36% being sourced internally. The
operations in Kapuskasing and Pine Falls both produce newsprint that contains
recycled fibre. In 2006, these two facilities consumed 86,600 tonnes of
wastepaper, down from 92,800 tonnes in 2005.



Overall, fiscal 2006 was another difficult year. Improving US $
prices were largely negated by a stronger Canadian $. Although, the US $ cost
base of the St. Francisville mill provided a partial currency offset, the
segment's EBITDA margin remained negative 1.3% versus a five-year positive
average of 1.2%. The Paper segment reduced the total Corporation consolidated
EBITDA in fiscal 2006 and fiscal 2005.



The Paper segment absorbed several unusual charges in fiscal 2005
and fiscal 2006. The current year results include a charge of $7 million
relating to severance and related costs for the restructuring of the
St. Francisville paper mill. The prior year included several unusual item
charges. The largest item was a charge of $101 million relating to the permanent
closure of the Saint-Raymond paper mill. As a result of the permanent closure of
the pressurized groundwood pulping line and one of the four paper machines at
the St. Francisville, Louisiana paper mill, the Corporation recorded a non-cash
charge of $40 million relating to the reduction of the carrying value of the
fixed and other related assets. Employee severance and other closure costs
amounting to $5 million were also recorded. Also during the prior year, the
Corporation recorded a non-cash charge of $26 million relating to the reduction
of the carrying value of a dismantled paper machine. Finally, the Corporation
performed the required annual impairment test of goodwill and found that
impairment did exist in relation to its newsprint business. As a result, a
goodwill impairment charge of $22 million was recorded.



The Paper segment generated an operating loss of $72 million as
compared to an operating loss of
$267 million in the prior year. The reduced loss was the result of the lower
unusual charges in the current fiscal year.



28

---



|CHEMICALS
    $ millions             | 2002  | 2003 | 2004 | 2005 | 2006
|------------------------------------ | ----- | ---- | ---- | ---- | ----
|Consolidated sales                   | 124   | 143  | 174  | 202  | 193 
|EBITDA                               | 15    | 8    | 8    | 8    | 5   
|EBITDA margin                        | 12.1% | 5.6% | 4.6% | 4.0% | 2.6%
|Depreciation and amortization        | 4     | 3    | 4    | 3    | 3   
|Operating earnings                   | 11    | 5    | 4    | 5    | 2   
|Identifiable assets (excluding cash) | 69    | 70   | 77   | 80   | 80  



The Chemical segment operates in three main areas of activity:
resins, lignin and alcohol.



The resin business produces powder and liquid phenolic resins at
three operating sites in Quebec: Temiscaming; Longueuil and Trois-Pistoles. The
Corporation also operates a fourth manufacturing operation located in Toledo,
Ohio which manufactures powder and liquid amino based resins as well as
melamine. The Longueuil operation also produces formaldehyde, both for internal
resin production and external sales. In addition to its manufactured products
the resin business also markets third party resin binders to complement its
customer offering. Sales of third party products totalled $54 million in fiscal
2006, compared to $58 million in the prior year.



The lignin and alcohol businesses uses waste sulphite liquor
produced by the specialty pulp mills located in Temiscaming, Quebec and Tartas,
France. Lignin products are sold in liquid form and are also converted into
powder by utilizing two spray dryers. As well, the group operates an ethyl
alcohol plant located in Temiscaming, Quebec. The lignin and alcohol businesses
effectively convert pulp mill waste into value added products.



Beginning in fiscal 2006, the segment began purchasing and
selling pulp mill by-product chemicals from a related party, AV Nackawic Inc.



|                                    | Total Sales
    ($
    millions) | Shipments
    (000 units) | Selling
    Price
    ($ per
    unit)
|----------------------------------- | -------------------------------- | ------------------------- | --------------------------------------
|                                    | 2005                             | 2006                      | 2005                                  
|Resin and related products (tonnes) | 160                              | 152                       | 113.8                                 
|Lignin (tonnes)                     | 35                               | 35                        | 171.1                                 
|Alcohol (000 litres)                | 8                                | 6                         | 12.3                                  
|Other Chemicals                     | -                                | 2                         |                                       
|                                    |                                  |                           |                                       
|Total sales                         | 203                              | 195                       |                                       
|Internal sales                      | (1)                              | (2)                       |                                       
|                                    |                                  |                           |                                       
|Consolidated sales                  | 202                              | 193                       |                                       

###### 

###### 

###### 29

---



###### Markets



Chemical products are sold primarily in North America with sales
representing 88% of the total consolidated sales in 2006, compared to 87% in
2005. Resin products, which accounted for 79% of total chemical sales, are
designed for the OSB industry and other specialty applications. Lignin is sold
as a binder and surfactant for industrial markets such as animal feed, concrete
admixture and carbon black. Ethyl alcohol is sold into the Canadian vinegar and
cosmetics markets. Chemical Group sales represented 6% of consolidated sales in
2006, unchanged from the prior year.



Operating Results



The decrease in sales of $9 million is due primarily to lower
prices for resins and related products. Higher shipments of resin and lignin
mitigated the drop in revenues. The lower prices put downward pressure on EBITDA
margins, reaching their lowest level in 5 years. Manufacturing costs were lower,
primarily in the resin business where raw material prices are linked to selling
prices. As a result of the poor performance of the Pulp and Paper segments, the
Chemical Group generated 22% of total Corporation EBITDA in fiscal 2006. In
fiscal 2005, the Chemical segment EBITDA exceeded that of the total Corporation
due to negative performance of the Pulp and the Paper segments. Operating
earnings decreased from $5 million to
$2 million because of the aforementioned decline in EBITDA.



30

---



FINANCIAL
POSITION AND LIQUIDITY



|FREE CASH FLOW
    $ millions                           | 2002 | 2003  | 2004  | 2005  | 2006 
|------------------------------------------------------- | ---- | ----- | ----- | ----- | -----
|Cash flow from operationsbefore working capital changes | 52   | 38    | 234   | (18)  | (96) 
|Net fixed asset additions                               | (99) | (132) | (143) | (144) | (75) 
|                                                        | (47) | (94)  | 91    | (162) | (171)

Amounts
in the above table have not been restated to reflect the sale of the OSB
business and its reclassification to discontinued operations.



Cash flow from operations before working capital changes for
fiscal 2006 was negative $96 million, a
$78 million decline from the comparable period a year ago. The reduced cash flow
is due primarily to a $133 million decline in proceeds from derivative financial
instruments. The Corporation had disposed of substantially all of its foreign
exchange derivative instruments in the September 2005 quarter. After allowing
for net fixed asset addition of $75 million, free cash flow for fiscal 2006 was
negative
$171 million versus a negative amount of $162 million in the prior year. The
Corporation defines free cash flow as ''cash provided by operating activities
before changes in non-cash working capital balances less net fixed assets''.
Based on the approved fiscal 2006 budget, the Corporation had anticipated that
free cash flow for the year would be negative $65 million. A shortfall in
planned EBITDA of approximately $150 million led to the increase in negative
free cash flow. The budget had been prepared on the basis that the Canadian $
would average US $0.82, whereas the actual exchange rate for the year was US
$0.875. The sensitivity of the Corporation to foreign exchange is outlined in a
subsequent section of the MD&A. Based on the approved fiscal 2007 budget, the
Corporation's free cash flow is expected to be negative $55 million.



For the year ended September 2006, non-cash working capital items
generated $66 million, as compared to $25 million used by the same items in the
prior year. A significant portion of this change relates to inventories. During
fiscal 2006, the Corporation reduced inventories, primarily in the pulp
business, by $82 million. This is the opposite of what occurred in the prior
year when inventories increased by
$28 million.



|Capital Spending
    $ millions    | 2002 | 2003 | 2004 | 2005 | 2006
|---------------------------------- | ---- | ---- | ---- | ---- | ----
|Forest Products                    | 41   | 30   | 39   | 69   | 23  
|Pulp                               | 41   | 74   | 88   | 62   | 45  
|Paper                              | 10   | 19   | 13   | 11   | 7   
|Chemicals and other                | 7    | 9    | 3    | 2    | -   
|Net fixed asset additions          | 99   | 132  | 143  | 144  | 75  
|As a % of sales                    | 3%   | 4%   | 5%   | 4%   | 2%  
|As a % of fixed asset depreciation | 45%  | 59%  | 63%  | 61%  | 37% 

Amounts in the above table have not been restated to reflect the
sale of the OSB business and its reclassification to discontinued operations.



31

---



In response to relatively low EBITDA margins brought on by
challenging market conditions, the stronger Canadian $ and continuing export
duties on lumber shipped to the US, the Corporation continued to limit capital
expenditures to mandatory projects and those with high rates of return. In
fiscal 2006, net fixed asset additions totalled $75 million compared to $144
million a year ago. The amount spent was equal to 37% of fixed asset
depreciation and 2% of sales.



Significant capital expenditure items in 2006 include $11 million
representing the Corporation's 50% share of the amount spent to complete a
laminated veneer lumber (LVL) facility in Amos, Quebec. The plant, owned and
operated by the Temlam joint venture, has completed its start-up and is expected
to positively impact EBITDA in fiscal 2007. An investment of $11 million was
made to install a condensing turbine and 20-megawatt electrical generator at the
St-Gaudens pulp mill. A further amount of $4 million will be spent in the
December 2006 quarter, at which time the equipment will begin operations. An
amount of $11 million was spent to construct an alkaline liquor evaporator
system at the Tartas pulp mill. A further $2 million will be spent in the
December 2006 quarter, at which time the system will be activated. This will
greatly reduce the impact of the mill's waste effluent stream. Also at the Tartas pulp mill, an amount of $6 million was spent to begin the construction of
a new $50 million biomass/bark boiler. The remaining funds will be spent in
fiscal 2007 and 2008, at which time the new boiler is expected to begin
operations. Finally, an amount of $10 million was spent to complete the
construction of an anaerobic effluent treatment plant at the Temiscaming
Complex. The plant started up in the spring of 2006, reducing site energy and
effluent treatment costs.



Significant items in fiscal 2005 include $25 million representing
the Corporation's 50% share of capital expenditures relating to the laminated
veneer lumber (LVL) facility in Amos, Quebec. Capital expenditures of $15
million were incurred to modernize the Elko, British Columbia sawmill. Finally,
an amount of $12 million was spent on the anaerobic effluent treatment plant in
Témiscaming, Quebec.



ACQUISITIONS, INVESTMENTS AND DIVESTITURES




On February 27, 2006, the Corporation completed the sale of its
oriented strandboard (OSB) business located in Saint-Georges-de-Champlain,
Quebec to Jolina Capital Inc. (''Jolina'') for total consideration of
$98 million, including net working capital of $7 million. An amount of $88
million was paid on the closing and the balance is payable in the form of a $10
million interest-bearing note, repayable in equal annual instalments over a
five-year period. As a result of this transaction, the Corporation recorded a
gain of $63 million. The after-tax effect was $47 million. The financial results
of the OSB operation, as well as the gain on disposition have been reclassified
as discontinued operations.



FINANCING ACTIVITIES




The Corporation's total debt decreased from $1,557 million to
$1,503 million. The decrease was due primarily to the revaluation of the
Corporation's US $ denominated debt. The Canadian $ ended the 2006 fiscal year
at US $0.895, compared to US $0.854 a year ago. The Corporation's inability to
generate positive free cash flow under the current pricing environment and
lumber duties limited its ability to reduce net debt. The currency change
reduced the Corporation's US $ denominated debt by $64 million in fiscal 2006.



32

---



As part of its long-term strategy, the Corporation has resolved
to maintain its percentage of net debt to total capitalization to 40% or less.
The objective of the plan is to keep a strong balance sheet and maintain the
ability of the Corporation to access capital markets at favourable rates. The
Corporation remains committed to this program. As the Corporation's leverage at
September 2006 exceeds its stated goal, the emphasis in the near term will be to
maintain relatively high liquidity and limit capital expenditures. The receipt
of US $242 million in October 2006, has significantly increased the
Corporation's liquidity position. Continued improvement in the pricing levels
and EBITDA margins of the Corporation's main business segments will be required
before any significant reduction in financial leverage can be achieved.



Current credit ratings of various agencies on the Corporation and
its significant long term debt instruments are outlined in the table below.



|Dominion
    Bond Rating
    Service | Moody's
    Investors
    Service | Standard
    & Poor's  
|------------------------------------ | --------------------------------- | -----------------------
|CCC (negative trend)                 | Ca (stable outlook)               | CCC- (negative outlook)



The Corporation's ratings were reduced during 2006 as the
continued low selling prices combined with a stronger Canadian $ and lumber
export duties resulted in relatively low levels of EBITDA.



|Long-term debt
    $ millions                                     | 2005  |  | 2006 
|----------------------------------------------------------------- | ----- |  | -----
|Tembec Industries Inc.  advance from ultimate parent company     | 67    |  | 67   
|Tembec Industries  US $500 million 8.5% unsecured senior notes   | 586   |  | 559  
|Tembec Industries  US $350 million 7.75% unsecured senior notes  | 410   |  | 391  
|Tembec Industries  US $350 million 8.625% unsecured senior notes | 410   |  | 391  
|Tembec SAS debt                                                   | 23    |  | 31   
|Proportionate share of Marathon debt (50%)                        | 13    |  | 10   
|Proportionate share of Temlam debt (50%)                          | 32    |  | 40   
|Other debt                                                        | 16    |  | 14   
|                                                                  | 1,557 |  | 1,503
|Current portion included in above                                 | 21    |  | 21   



During the year, the Corporation's French operations increased
its non-interest bearings loans by $9 million (Euro 6 million) to assist with
the financing of certain capital expenditures being undertaken at the pulp
mills.



The Marathon joint venture does not currently meet certain
financial covenants on its operating line and its term loan with a syndicate of
banks. Discussions with lenders are ongoing and the Corporation believes it will
reach a satisfactory agreement to maintain and extend the credit agreement.
There is no recourse to the shareholders on either of these loan facilities. The
$10 million loan balance is included in current portion of long-term debt.



33

---



At the end of September 2006, Tembec had cash, temporary
investments and derivative financial instruments of $26 million plus unused
operating lines of $34 million. At the date of the previous audited financial
statements, the Corporation had cash, temporary investments and derivative
financial instruments of $57 million and unused operating lines of $211 million.
The Corporation defines ''operating lines'' to include loans of various duration
which are secured by charges on accounts receivable and/or inventories.
Operating lines are used primarily to fund short-term requirements associated
with both seasonal and cyclical inventory increases which can occur in the
Corporation's business segments. The Corporation would not normally draw on the
operating lines to fund capital expenditures or normal average working capital
requirements. The operating lines are established across multiple entities and
jurisdictions to ensure they meet the needs of the various operating units.



The following table summarizes the unused operating lines by
major area at the end of the last two fiscal years.



|OPERATING LINES - UNUSED             
|-------------------------------------
|$ millions                           
|Canadian operations                  
|US operations                        
|French operations                    
|Proportionate share of joint ventures
|                                     



The Canadian operations utilize two separate operating lines. The
Corporation has in place a committed facility of $150 million maturing in March
2009. At the end of September 2006, the amount available on this facility
(borrowing base) was $99 million and it was fully utilized. The facility is
secured by receivables and inventory. The Corporation also has in place a
committed facility of $136 million maturing in June 2008, secured by receivables
and inventory. At the end of September 2006, the facility was fully utilized.



During fiscal 2006, the St. Francisville operating line of US $20
million expired. The Corporation is currently in discussions with a potential
lender to put in place a similar facility for the operation. The Corporation
would expect to finalize the new loan in the December 2006 quarter.



The French operations are supported by several mill specific
''receivable factoring'' agreements. As such, the borrowing base fluctuates
periodically, depending on shipments and cash receipts. As at
September 30, 2006, the amount available was $55 million, of which $20 million
was unused.



The joint ventures maintain their own various operating lines,
without recourse to the Corporation, to meet working capital and liquidity
requirements.



The Corporation has a stated objective of maintaining at least
$400 million of liquidity, comprising cash on hand, temporary investments and
unused operating lines. As previously noted, liquidity at year-end was
$60 million, well below our stated objective. In response to this situation, the
Corporation had set an objective of generating between $100 million and $150
million of additional liquidity during fiscal 2006. The funds were to be raised
through several initiatives, including but not limited to, selective asset
divestitures and the monetization of a portion of the lumber duties previously
held on deposit.



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During the course of fiscal 2006, the Corporation did generate in
excess of $100 million of proceeds from various initiatives, with the sale of
the OSB mill generating nearly that amount in one single transaction. The
receipt of US $242 million relating to lumber export duty refunds in late
October 2006 has further enhanced the Corporation's liquidity position.



The consolidated financial statements are presented on the
assumption that the Corporation continues as a going concern in accordance with
GAAP. The going concern basis of presentation assumes that the Corporation will
continue its operations for the foreseeable future and will be able to realize
its assets and discharge its liabilities and commitments in the normal course of
business. In the March 2006 and
June 2006 quarterly financial statements, there was reasonable doubt about the
appropriateness of using the going concern assumption because of the
Corporation's relatively low liquidity position coupled with its expected
operating cash flow. On October 30, 2006, the Corporation received a US $242
million payment pertaining to the recovery of lumber export duties (see Note 22
Subsequent Events of the audited consolidated financial statements). Because of
the uncertainty of the recovery, these funds had not been included in prior
period forecasted operating cash flows. The receipt of these funds has resulted
in the withdrawal of the going concern issue.



|CONTRACTUAL OBLIGATIONS
    $ millions | Total | Within 1
    year | 2  3
    years | 4  5
    years | After
    5 
    years
|-------------------------------------- | ----- | ----------------- | --------------- | --------------- | ----------------------
|FISCAL 2006                            |       |                   |                 |                 |                       
|Long-term debt                         | 1,503 | 21                | 418             | 596             | 468                   
|Interest on long-term debt             | 484   | 117               | 223             | 129             | 15                    
|Operating leases                       | 25    | 8                 | 10              | 4               | 3                     
|Purchase obligations                   | 238   | 95                | 70              | 41              | 32                    
|Balance of price - acquisition         | 4     | 1                 | 3               | -               | -                     
|                                       | 2,254 | 242               | 724             | 770             | 518                   





|CONTRACTUAL OBLIGATIONS
    $ millions | Total | Within 1
    
    year | 2  3 
    years | 4  5
    
    years | After
    5 
    years
|-------------------------------------- | ----- | ---------------------- | ---------------- | -------------------- | ----------------------
|FISCAL 2005                            |       |                        |                  |                      |                       
|Long-term debt                         | 1,557 | 22                     | 14               | 456                  | 1,065                 
|Interest on long-term debt             | 636   | 121                    | 241              | 203                  | 71                    
|Operating leases                       | 27    | 9                      | 8                | 4                    | 6                     
|Purchase obligations                   | 292   | 114                    | 83               | 56                   | 39                    
|Balance of price - acquisition         | 8     | 1                      | 4                | 3                    | -                     
|                                       | 2,520 | 267                    | 350              | 722                  | 1,181                 



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The table shows the Corporation's contractual obligations as at
September 2005 and 2006. The Corporation has long-term debt with contractual
maturities and applicable interest as described in note 9 of the audited
consolidated financial statements. The operating lease obligations relate
primarily to property and equipment rentals entered into in the normal course of
business. Purchase obligations relate to ongoing normal commercial commitments
to purchase timber, wood chips, energy, chemicals and other operating inputs.
They also include outstanding obligations relating to capital expenditures.
Finally, the balance of price obligation represents the Corporation's
proportionate (50%) share of the balance payable by the Temlam joint venture to
the previous owners of Jager Building Systems pursuant to its acquisition by
Temlam in August 2001.





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2005 vs
2004



|FINANCIAL SUMMARY                                 
|--------------------------------------------------
|$
    million, unless otherwise noted             
|Sales                                             
|EBITDA                                            
|Depreciation and amortization                     
|Unusual items                                     
|Operating loss                                    
|Net
    earnings (loss) from continuing operations
|Net
    earnings (loss)                           
|Total
    assets (at end of year)                 
|Total
    long-term debt (1)(at end of year)      

(1)Includes current portion



Sales in fiscal 2005 decreased by $49 million as compared to
fiscal 2004. The Forest Products segment sales declined by $23 million as a
result of lower prices and volumes. Pricing was impacted by lower US $ reference
prices and a stronger Canadian $, which averaged 8% higher versus the US $. The
Pulp segment sales declined by $44 million as a result of lower selling prices,
partially offset by higher shipments. While US $ reference prices for various
grades of pulp increased, it was not sufficient to offset the impact of the
stronger Canadian $. The Paper segment sales declined by $10 million due to
lower shipments of newsprint and specialty papers, partially offset by higher
newsprint and coated paper prices. The decline in shipments was caused by the
permanent shutdown of approximately 138,000 tonnes of production capacity. US $
reference prices increased for all grades of paper, more than offsetting the
impact of the stronger Canadian $. The Chemical segment sales increased by $28
million as a result of higher selling prices for resin and related products.



EBITDA in fiscal 2005 decreased by $111 million as compared to
fiscal 2004. The Forest Products segment EBITDA declined by $43 million. In
addition to the lower selling prices, margins in SPF lumber were negatively
impacted by higher processing costs, partially offset by lower lumber export
duties. During fiscal 2005, countervailing and antidumping duties totalled $89
million, down from $111 million in fiscal 2004. Pulp segment EBITDA declined by
$86 million, primarily resulting from lower selling prices. Manufacturing costs
remained relatively unchanged with higher chemical, energy, freight and mill
supply costs offset by lower labour costs and a more favourable exchange rate on
the French pulp mill's Euro costs. The Paper segment EBITDA increased by $18
million as a result of the previously noted higher prices. The increase would
have been greater if not for increased manufacturing costs, primarily related to
chemicals, energy and freight. The higher costs were partially mitigated by a
more favourable exchange rate on the St. Francisville, Louisiana coated paper
mill's US $ costs.



Depreciation expense in fiscal 2005 was $8 million higher than in
fiscal 2004. In fiscal 2005, the Corporation recognized an impairment charge of
$4 million relating to the fixed assets of a specialty sawmill.



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Unusual items in fiscal 2005 were $245 million higher than in
fiscal 2004. During the latter year, the Corporation recorded unusual items
totalling $10 million to eliminate the book value of an idled newsprint machine,
including related spare parts. In fiscal 2005, the Corporation recorded unusual
items of $255 million. This included $56 million relating to the restructuring
and closure of several sawmills; a charge of $101 million for the permanent
closure of a paper mill; a charge of $45 million related to the closure of a
pulp line and one of the four paper machines at the St. Francisville paper mill;
a charge of $23 million relating to goodwill impairment; and a charge of
$30 million to reduce the carrying value of a dismantled pulp machine and a
dismantled paper machine.



Interest,
foreign exchange and other items totalled to a charge of $20 million in fiscal
2005 as compared to a credit amount of $94 million in fiscal 2004. In fiscal
2005, the Corporation had realized and amortized derivative financial instrument
gains of $148 million. In fiscal 2004, the amount recorded was
$234 million. In the prior year, the Corporation had also realized an investment
gain of $23 million on the sale of shares of a Canadian publicly-traded forest
products Corporation.



During
fiscal 2005, the Corporation recorded a gain of $125 million on the translation
of its US $ denominated debt as the relative value of the Canadian $ increased
from US $0.784 to US $0.854. In fiscal 2004, the Canadian $ had increased from
US $0.739 to US $0.784, and the Corporation had recorded a gain of $94 million.



In 2006,
the Corporation sold its OSB mill. As a result of the sale, the financial
results have been reclassified as discontinued operations. The earnings from
this operation amounted to $11 million in fiscal 2005 as compared to $34 million
in fiscal 2004. Lower OSB selling prices led to the reduction in earnings.



For the
year ended September 2005, the Corporation generated a net loss of $309 million
versus net earnings of $76 million in fiscal 2004.



RISKS AND
UNCERTAINTIES



PRODUCT PRICES




Our financial performance is dependent on the selling prices of
our products. The markets for most lumber, pulp and paper products are cyclical
and are influenced by a variety of factors. These factors include periods of
excess product supply due to industry capacity additions, periods of decreased
demand due to weak general economic activity, inventory de-stocking by
customers, and fluctuations in currency exchange rates. During periods of low
prices, the Corporation is subject to reduced revenues and margins, resulting in
substantial declines in profitability and possibly net losses.



Based on 2007 planned sales volumes, the following table
illustrates the approximate annual impact of changes to average Canadian dollar
selling prices on after-tax earnings.



|Selling price sensitivity | Impact on
    after-tax earnings
    ($ millions) | Average
    selling prices ($)
    4th Quarter  2006
|------------------------- | ------------------------------------------------- | -----------------------------------------------------
|                         
|Pulp - $25/tonne          | 31                                                | 685                                                  
|Papers - $25/tonne        | 17                                                | 887                                                  
|SPF lumber - $10/mfbm     | 10                                                | 367                                                  



38

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The Corporation's strategy is to mitigate price volatility by
maintaining operations in three core sectors, namely wood products, pulp and
paper; maintaining low cost, high quality flexible production facilities;
establishing and developing long-term relationships with its customers;
developing specialty niche products where possible. In addition, the Corporation
may periodically purchase lumber, pulp and newsprint price hedges to mitigate
the impact of price volatility. As at September 30, 2006, the Corporation did
not hold any product price hedges. At September 24, 2005 the Corporation held
lumber futures equal to approximately 0.5% of its annual SPF lumber capacity.
The fair value of the contracts was nil.



FOREIGN EXCHANGE




Our revenues for most of our products are affected by
fluctuations in the relative exchange rates of the Canadian $, the US $ and the
Euro. The prices for many of our products, including those we sell in Canada and
Europe are generally driven by US $ reference prices of similar products. We
generate approximately US $2.2 billion of US $ denominated sales annually from
our Canadian and European operations. As a result, any decrease in the value of
the US $ relative to the Canadian $ and the Euro reduces the amount of revenues
we realize on our sales in local currency. In addition, since business units
purchase the majority of their production inputs in local currency, fluctuations
in foreign exchange can significantly affect the unit's relative cost position
when compared to competing manufacturing sites in other currency jurisdictions.
This could result in the unit's inability to maintain its operations during
periods of low prices and/or demand.



Based on 2007, planned sales volumes and prices, the following
table illustrates the impact of a 1% change in the value of the US $ versus the
Canadian $ and the Euro. For illustrative purposes, we have assumed an increase
of 1% in the value of the US $. A decrease would have the opposite effects of
those shown below.



|Foreign exchange sensitivity  |     
|----------------------------- | ----
|$
    millions                |     
|Increase EBITDA               | 25  
|Increase interest expense     | (1) 
|Increase cash flow            | 24  
|Loss on US $ debt translation | (14)
|Pre-tax earnings              | 10  
|Tax provision                 | (5) 
|Net earnings                  | 5   



As can be seen, interest expense on the Corporation's US $
denominated debt provides only a small offset to its total US $ exposure. To
further reduce the impact of fluctuations in the value of the US $, the
Corporation has adopted a policy of hedging up to 50% of its anticipated US $
receipts for up to 36 months in duration. At September 30, 2006, the Corporation
held US $7 million of US $ foreign exchange contracts. The fair value of these
instruments was nil. At September 24, 2005, the Corporation held US $ foreign
exchange contracts totalling US $11 million with a fair value of $0.2 million.
The Corporation's derivative financial holdings at the end of fiscal 2006 are
disclosed in note 21 of the audited consolidated financial statements.



39

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OPERATIONAL RISKS




The manufacturing activities conducted by our operations are
subject to a number of risks including availability and price of fibre,
competitive prices for purchased energy, a productive and reliable workforce,
compliance with environmental regulations, maintenance and replacement/upgrade
of process equipment to manufacture competitive quality products and the
requirement to operate the manufacturing facilities at high rates of utilization
and efficiency to maintain a competitive cost structure.



Fibre represents the Corporation's major raw material in the
production of wood products, pulp and paper. In Canada, virgin fibre or timber
is sourced primarily by agreements with provincial governments. The agreements
are granted for various terms from 5 to 25 years and are generally subject to
regular renewals every 5 years. The agreements incorporate commitments with
respect to sustainable forest management, silvicultural work, forest and soil
renewal, as well as cooperation with other forest users. In addition, the
Corporation has undertaken, on a voluntary basis, to have its timber harvesting
certified by the Forest Stewardship Council (FSC). The Corporation expects the
agreements to be extended as they come up for renewal. Aboriginal groups have
claimed substantial portions of land in various provinces over which they claim
aboriginal title or in which they have a traditional interest and for which they
are seeking compensation from various levels of government. The Corporation has
taken a proactive approach to enhance the economic participation of the First
Nations in its operations wherever feasible. The Corporation's operations in the
United States and France source their fibre requirements from various private
sources, primarily through long-term supply arrangements. The Corporation also
purchases approximately 90,000 tonnes per year of recycled waste fibre. To
mitigate the impact of price fluctuations, the Corporation periodically
purchases ONP hedges. At September 30, 2006, the Corporation did not hold any
ONP hedges.  At September 24, 2005, the Corporation held hedges relating to ONP
representing approximately 3% of its annual recycled fibre purchases. The fair
value of these instruments was nil.



Energy is an important component of mill costs, especially for
high yield pulp mills, newsprint and paper mills. In 2006, we purchased
approximately $310 million of energy, 60% of which was electricity. Electrical
purchases are made primarily from large public utilities, at rates set by
regulating bodies. In certain jurisdictions, electricity is deregulated which
can lead to greater price volatility. To mitigate the effect of price
fluctuations on its financial performance, the Corporation employs several
tactics, including the securing of longer term supply agreements, the purchase
of derivative financial instruments and operational curtailments in periods of
high prices (load shedding). At September 2006 and September 2005, the
Corporation did not hold any derivative financial instruments relating to
purchased electricity. Fossil fuels, primarily natural gas, are purchased at
market rates. The Corporation periodically purchases derivative financial
instruments to hedge its exposure. At September 30, 2006, the Corporation did
not hold any natural gas hedges. At September 24, 2005 the Corporation had
natural gas hedges covering approximately 7% of its anticipated requirements for
the next year. The fair value of these instruments was $6 million.



Nearly all the Corporation's manufacturing units have a unionized
workforce. Over the past 30 years, the Corporation has successfully negotiated
new collective agreements in nearly all instances, with very few work stoppages.
At many of the Corporation's facilities, as well as those of the North American
industry as a whole, we have seen reductions in employment levels resulting from
technological and process improvements resulting in a workforce with more years
of service. This increases the relative costs of pensions and benefits. At
September 2006, the Corporation had approximately 6,050 hourly paid employees
covered by collective bargaining agreements. At September 30, 2006, there were
17 agreements covering 1,300 employees that had expired and were under active
negotiations. During fiscal 2007, a total of 4 agreements covering 450 employees
will expire. The remaining contracts expire at various dates to August 2011. The
Corporation anticipates it will reach satisfactory agreements on contracts
currently under active negotiations and those expiring in the future.



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The Corporation's operations are subject to industry specific
environmental regulations relating to air emissions, wastewater (effluent)
discharges, solid waste, landfill operations, forestry practices, and site
remediation. The Corporation has made significant progress in reducing the
environmental impact of its operations over the last 15 years. This has occurred
as a result of changes in manufacturing processes, the installation of
specialized equipment to treat/eliminate the materials being discharged and the
implementation of standardized practices such as ISO 14001.



The production of pulp and paper products is capital intensive.
The Corporation estimates it must spend approximately $90-$100 million per year
on capital expenditures to avoid degradation of its current operations.



Because of the relatively high fixed cost component of certain
manufacturing processes, especially in pulp and paper, the operations are 24/7
with target efficiency in the 80-85% range. Failure to operate at these levels
jeopardizes the continued existence of a mill. Producers are forced to operate
the facilities at ''full'' rate even when demand is not sufficient to absorb all
of the output. This can lead to over supply and lower prices, further increasing
the inherent cyclicality of the industry.



TRADE RESTRICTIONS / LUMBER EXPORT DUTIES




The Corporation's manufacturing operations are located primarily
in Canada. However sales into the Canadian market represented only 20% of
consolidated sales in 2006. As such, the Corporation's financial results are
highly dependant on its ability to sell its products into the ''export'' markets.
Tariffs and trade barriers that reduce or prohibit the movement of our products
across international borders constitute an ongoing risk. The dispute between
Canada and the United States over softwood lumber is a case in point. The United
States Department of Commerce initially assessed the Corporation with aggregate
countervailing and antidumping duties at an average rate of 29%. The combined
rate was subsequently reduced to 25.47% in February 2005 and to 12.72% in
December 2005. On October 12, 2006, Canada and the United States entered into an
agreement to govern the shipment of Canadian softwood lumber into the United
States. As part of the agreement, the Corporation received a US $242 million
payment on October 30, 2006 pertaining to the recovery of lumber duties on
deposit with the department of Commerce (DOC) that had accumulated since May
2002.



The amount received by the Corporation corresponds to
approximately 82% of the total amount on deposit at the DOC, including accrued
interest. The funds will be used by the Corporation to reduce its indebtedness
and increase overall liquidity levels. This item will be recorded in the
Corporation's December 2006 quarterly financial statements.



FINANCIAL RISKS / DEBT SERVICE




The Corporation currently has a non-investment grade rating of
CCC-/Ca/CCC. The ratings reflect the relatively high use of debt combined with
periods of reduced operating earning due to the cyclicality of its three
principal business segments. Of the total long-term debt of $1.5 billion, 89%
relates to US $ denominated high yield ''Senior Notes''. The annual interest
coupon on the high yield debt ranges between 7.75% and 8.625%, generating an
annual expense of US $100 million. The Senior Notes do not require periodic
payments for principal amortization. Since the entire principal amount becomes
due on the maturity dates of the Senior Notes, it is unlikely that the
Corporation will have the required funds to repay the principal due. The
Corporation will require access to the public or private debt markets to issue
new notes or debt instruments to replace or partially replace the Senior Notes
prior to their stated maturity dates. The nearest maturity relates to the 8.625%
US $350 million Senior Notes maturing in June 2009. The Corporation's objective
is to reduce its leverage and improve its credit ratings prior to the
refinancing of the aforementioned Senior Notes.



41

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GROWTH STRATEGY / ACQUISITION




The Corporation has a publicly stated objective of growing its
operations. Based on past experience, a significant portion of this growth will
likely occur through acquisitions and other forms of business combinations. The
ability to properly evaluate the fair value of acquisitions, to successfully
integrate them into our current business operations and to realize the projected
profits and returns are inherent risks related to acquisitions. The Corporation
has gained significant expertise in evaluating businesses, performing due
diligence and integrating new businesses. The Corporation believes the industry
consolidation of the recent years will continue and that ''size'' will be required
to effectively compete in the global forest products industry.



EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES



Disclosure controls and procedures have been established by the
Corporation to ensure that information disclosed by the Corporation in this MD&A
and the related financial statements was properly recorded, processed,
summarized and reported within the time periods specified in the U.S. Securities
and Exchange Commission rules and forms. Disclosure controls and procedures are
designed to ensure that the information required to be disclosed by the
Corporation in the reports that are filed or submitted is accumulated and
communicated to the management, including the Corporation's Executive
Vice-President, Finance & Chief Financial Officer, to allow timely decisions
regarding required disclosure.



The Corporation's President and Chief Executive Officer and the
Corporation's Executive Vice-President, Finance & Chief Financial Officer have
evaluated the disclosure controls and procedures and have determined that such
disclosure controls and procedures are effective.



CHANGES
IN INTERNAL CONTROLS



During the period covered by this report, there have been no
changes that have materially affected, or are reasonably likely to materially
affect the Corporation's internal control over financial reporting.



OVERSIGHT
ROLE OF AUDIT COMMITTEE AND BOARD OF DIRECTORS



The Audit Committee reviews the Corporation's annual MD&A and
related financial statements with management and the external auditors, and
recommends their approval to the Board. Management and the internal auditor of
the Corporation also present periodically to the committee a report of their
assessment of the Corporation's internal controls and procedures for financial
reporting. The external auditor periodically prepares for management a report on
internal control weaknesses identified during the course of the auditor's annual
audit, which is reviewed by the Audit Committee.



ADDITIONAL INFORMATION



Additional information relating to Tembec, including the Annual
Information Form, can be found on SEDAR at www.sedar.com.



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Management Responsibility



The consolidated financial statements and all information in the
Annual Report are the responsibility of the Corporation's management. The
consolidated financial statements have been prepared by management in accordance
with Canadian Generally Accepted Accounting Principles (GAAP) and, where
necessary, include amounts which are based on best estimates and judgment.
Financial information presented throughout the Annual Report is consistent with
the data presented in the consolidated financial statements.



A system of internal accounting and administrative controls is
maintained by management in order to provide reasonable assurance that
transactions are appropriately authorized, assets are safeguarded and financial
records are properly maintained to provide accurate and reliable financial
statements.



The Corporation's external auditors are responsible for auditing
the consolidated financial statements and giving an opinion thereon. The
external auditors also prepare for management a report on internal control
weaknesses identified during the course of the annual audit. In addition the
Corporation employs internal auditors to evaluate the effectiveness of its
systems, policies and procedures.



The Board of Directors has appointed an Audit Committee,
consisting solely of independent directors, which reviews the consolidated
financial statements and recommends their approval to the Board of Directors.
The Committee meets periodically with the external auditors, the internal
auditors and management to review their respective activities and the discharge
of each of their responsibilities. Both the external and internal auditors have
direct access to the Committee to discuss the scope of their audit work and the
adequacy of internal control systems and financial reporting procedures.



The accompanying consolidated financial statements have been
audited by the external auditors, KPMG LLP, whose report follows.







/s/
    James Lopez
    
    /s/ Michel J. DumasJAMES LOPEZ
    
    MICHEL J. DUMASPresident and Chief Executive Officer
    
    Executive Vice-President, Finance   
    
    & Chief Financial
    Officer




November 15, 2006, except as of note 22 (b) of the audited
consolidated financial statements, which is as of December 5, 2006.



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