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**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 

| x                                                                                                                                                                                     | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                  | ** ** | ** **                                                                                              |
| **For the Quarterly Period Ended August 28, 2008**                                                                                                                               |
| ** **                                                                                                                                                                            |
| **or**                                                                                                                                                                                |
| ** **                                                                                                                                                                            |
| o                                                                                                                                                                                     | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                  | ** ** | ** **                                                                                              |
| **For the transition period from            to            .** |

** **

**Commission file number 333-118829**

** **

**CelluTissue Holdings, Inc.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                  | ** ** | **06-1346495**                    |
|---------------------------------------------------------------|------------|-----------------------------------|
| (State of incorporation)                                      |       | (IRS Employer Identification No.) |
|                                                          |       |                              |
| **1855 Lockeway Drive, Suite 501, Alpharetta , Georgia** | ** ** | **30004**                         |
| (Address of principal executive offices)                      |       | (zip code)                        |

 

**(678) 393-2651**

(Registrant’s telephone number, includingarea code)

 

**Not Applicable**

(Former name, former address and former fiscal year, if changed sincelast report)

 

Indicate bycheck mark whether the registrant: (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports) and (2) has been subject tosuch filing requirements for the past 90 days.  Yes x No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company.  See definition of “large accelerated filer”, “acceleratedfiler”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer  o     Acceleratedfiler  o     Non-accelerated filer  x    Smallerreporting company  o

 

(Do not check if a smallerreporting company)

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).  YesoNox

 

The number of shares outstanding of each of the registrant’s classes ofcommon stock as of October 2, 2008:

 

| **Title of Class**           | ** ** | **Shares Outstanding** |
|------------------------------|------------|------------------------|
| Common Stock, $.01 par value |       | 100                    |

 

 

 

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CELLU TISSUE HOLDINGS, INC.

FORM 10-Q

QUARTER ENDED AUGUST 28, 2008

 

INDEX

 
| PART I –  FINANCIAL INFORMATION                                                                        |   |
|------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                             |   |
| Item 1.  Consolidated Financial Statements                                                                  |   |
|                                                                                                             |   |
| Item  2.  Management’s Discussion and  Analysis of Financial Condition and Results of  Operations |   |
|                                                                                                             |   |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                              |   |
|                                                                                                             |   |
| Item 4.   Controls and Procedures                                                                           |   |
|                                                                                                             |   |
| PART II  – OTHER INFORMATION                                                                           |   |
|                                                                                                             |   |
| Item  1A.  Risk Factors                                                                                     |   |
|                                                                                                             |   |
| Item  6.  Exhibits                                                                                          |   |
|                                                                                                             |   |
| SIGNATURES                                                                                                       |   |

 

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**PART I FINANCIAL INFORMATION**

 

**Item 1.  ConsolidatedFinancial Statements**

 

**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)**

 
| ** **                                        | ** ** | **Three Months Ended**   | ** **  | **Six Months Ended**     | ** ** |
|---------------------------------------------------|------------|-------------------------------|-------------|-------------------------------|------------|
| ** **                                        | ** ** | **August 28, 2008** | ** **  | **August 30, 2007** | ** ** | **August 28, 2008** | ** ** | **August 30, 2007** | ** ** |
|                                              |       |                          |        |                          |       |   |   |   |   |
| Net sales                                         |       | $                             | 128,956,594 |                          | $          | 109,000,321 |   | $ | 240,452,677 |   | $ | 212,201,107 |   |
| Cost of goods sold                                |       | 117,009,124                   |        | 97,233,784                    |       | 216,353,603 |   | 192,142,452 |   |
| Gross profit                                      |       | 11,947,470                    |        | 11,766,537                    |       | 24,099,074 |   | 20,058,655 |   |
|                                              |       |                          |        |                          |       |   |   |   |   |
| Selling, general and administrative  expenses     |       | 4,163,350                     |        | 4,519,992                     |       | 9,123,192 |   | 9,002,729 |   |
| Terminated acquisition-related transaction  costs |       | 65,044                        |        | —                        |       | 140,044 |   | — |   |
| Stock compensation expense                        |       | 226,987                       |        | 186,203                       |       | 445,493 |   | 419,322 |   |
| Income from operations                            |       | 7,492,089                     |        | 7,060,342                     |       | 14,390,345 |   | 10,636,604 |   |
|                                              |       |                          |        |                          |       |   |   |   |   |
| Interest expense, net                             |       | 6,061,057                     |        | 5,102,666                     |       | 11,040,745 |   | 10,121,760 |   |
| Amortization expense                              |       | 802,435                       |        | —                        |       | 802,435 |   | — |   |
| Foreign currency loss                             |       | 127,700                       |        | 196,110                       |       | 84,620 |   | 520,408 |   |
| Other expense (income)                            |       | 8,910                         |        | (40,261                       | )          | 38,418 |   | (82,500 | ) |
| Income before income tax expense                  |       | 491,987                       |        | 1,801,827                     |       | 2,424,127 |   | 76,936 |   |
|                                              |       |                          |        |                          |       |   |   |   |   |
| Income tax expense                                |       | 153,964                       |        | 731,997                       |       | 869,049 |   | 117,590 |   |
| Net income (loss)                                 |       | $                             | 338,023     |                          | $          | 1,069,830 |   | $ | 1,555,078 |   | $ | (40,654 | ) |
|                                                   |            |                               |             |                               |            |  |  |  |  |  |  |  |  |  |

 

Seeaccompanying notes to consolidated financial statements.

 

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**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                              | ** ** | **August 28** | ** **  | **February 29** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------|-------------|----------------------|------------|
| ** **                                                                                              | ** ** | **2008**           | ** **  | **2008**             | ** ** |
| ** **                                                                                              | ** ** | **(Unaudited)**    | ** **  | **(Note 1)**    | ** ** |
| **ASSETS**                                                                                              |       |               |        |                 |       |
| CURRENT ASSETS:                                                                                         |       |               |        |                 |       |
| Cash and cash equivalents                                                                               |       | $                  | 2,603,631   |                 | $          | 883,388 |   |
| Receivables, net                                                                                        |       | 62,634,374         |        | 44,542,337           |       |
| Inventories                                                                                             |       | 42,264,035         |        | 33,996,439           |       |
| Prepaid expenses and other current assets                                                               |       | 3,700,042          |        | 3,745,989            |       |
| Income tax receivable                                                                                   |       | 142,966            |        | 177,281              |       |
| Deferred income taxes                                                                                   |       | 5,429,241          |        | 7,157,191            |       |
| TOTAL CURRENT ASSETS                                                                                    |       | 116,774,289        |        | 90,502,625           |       |
| PROPERTY, PLANT AND EQUIPMENT, NET                                                                      |       | 293,582,902        |        | 296,597,888          |       |
| GOODWILL                                                                                                |       | 30,735,577         |        | 6,970,001            |       |
| OTHER INTANGIBLES, NET                                                                                  |       | 38,113,879         |        | 8,750,314            |       |
| OTHER ASSETS                                                                                            |       | 2,148,254          |        | 1,491,218            |       |
| TOTAL ASSETS                                                                                            |       | $                  | 481,354,901 |                 | $          | 404,312,046 |   |
|                                                                                                    |       |               |        |                 |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                           |       |               |        |                 |       |
| CURRENT LIABILITIES:                                                                                    |       |               |        |                 |       |
| Revolving line of credit                                                                                |       | $                  | 23,000,000  |                 | $          | 9,800,000 |   |
| Accounts payable                                                                                        |       | 26,603,319         |        | 24,055,782           |       |
| Accrued expenses                                                                                        |       | 22,791,970         |        | 18,860,526           |       |
| Accrued interest                                                                                        |       | 8,930,654          |        | 8,253,915            |       |
| Other current liabilities                                                                               |       | 15,592,442         |        | 15,000,000           |       |
| Current portion of long-term debt                                                                       |       | 760,000            |        | 760,000              |       |
| TOTAL CURRENT LIABILITIES                                                                               |       | 97,678,385         |        | 76,730,223           |       |
| LONG-TERM DEBT, LESS CURRENT PORTION                                                                    |       | 241,507,873        |        | 198,086,944          |       |
| DEFERRED INCOME TAXES                                                                                   |       | 60,660,034         |        | 62,008,004           |       |
| OTHER LIABILITIES                                                                                       |       | 20,127,373         |        | 20,148,590           |       |
| STOCKHOLDERS’ EQUITY:                                                                              |       |               |        |                 |       |
| Common stock, Class A, $.01 par value,  1,000 shares authorized, 100 shares issued and outstanding |       | 1                  |        | 1                    |       |
| Capital in excess of par value                                                                          |       | 62,482,173         |        | 47,035,214           |       |
| Accumulated deficit                                                                                     |       | (644,537           | )           | (2,199,615           | )          |
| Accumulated other comprehensive (loss)  income                                                          |       | (456,401           | )           | 2,502,685            |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                                         |       | 61,381,236         |        | 47,338,285           |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                         |       | $                  | 481,354,901 |                 | $          | 404,312,046 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS (Unaudited)**

 
| ** **                                                                                | ** ** | **Six Months Ended**     | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                | ** ** | **August 28, 2008** | ** ** | **August 30, 2007** | ** ** |
|                                                                                      |       |                          |       |   |   |
| **Cash flows from operating activities**                                                  |       |                          |       |   |   |
| Net income (loss)                                                                         |       | $                             | 1,555,078  |   | $ | (40,654 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                          |       |   |   |
| Stock-based compensation                                                                  |       | 445,493                       |       | 382,500 |   |
| Deferred income taxes                                                                     |       | 379,980                       |       | (1,473,753 | ) |
| Accretion of debt discount                                                                |       | 600,929                       |       | 304,776 |   |
| Amortization of bond costs                                                                |       | 70,197                        |       |   |   |
| Amortization of intangibles                                                               |       | 802,435                       |       | — |   |
| Depreciation                                                                              |       | 11,207,926                    |       | 12,194,748 |   |
| Changes in operating assets and  liabilities, net of effects of acquisitions:             |       |                          |       |   |   |
| Receivables                                                                               |       | (10,094,518                   | )          | (3,565,303 | ) |
| Inventories                                                                               |       | (611,272                      | )          | 406,347 |   |
| Prepaid expenses, other current assets and  income tax receivable                         |       | 254,655                       |       | (2,128,067 | ) |
| Other                                                                                     |       | (665,725                      | )          | 458,540 |   |
| Accounts payable, accrued expenses and  accrued interest                                  |       | 2,779,721                     |       | 6,685,112 |   |
| Total adjustments                                                                         |       | 5,169,821                     |       | 13,264,900 |   |
| *Net cash provided by operating activities*                                               |       | 6,724,899                     |       | 13,224,246 |   |
|                                                                                      |       |                          |       |   |   |
| **Cash flows from investing activities**                                                  |       |                          |       |   |   |
| Cash paid for acquisition, net of cash  acquired                                          |       | (63,829,401                   | )          | (43,617,819 | ) |
| Capital expenditures                                                                      |       | (4,820,549                    | )          | (6,940,787 | ) |
| *Net cash used in investing activities*                                                   |       | (68,649,950                   | )          | (50,558,606 | ) |
|                                                                                           |            |                               |            |  |  |  |  |

 

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| ** **                                              | ** ** | **Six Months Ended**     | ** ** |
|---------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                              | ** ** | **August 28, 2008** | ** ** | **August 30, 2007** | ** ** |
|                                                    |       |                          |       |   |   |
| **Cash flows from financing activities**                |       |                          |       |   |   |
| Borrowings on revolving line of credit,net              |       | 13,200,000                    |       | 2,600,000 |   |
| Payments of long-term debt                              |       | (380,000                      | )          | — |   |
| Equity investment by shareholders                       |       | 15,001,466                    |       | — |   |
| Debt issuance costs                                     |       | (847,813                      | )          | — |   |
| Net proceeds form bond offering                         |       | 36,900,000                    |       | 20,000,000 |   |
| *Net cash provided by financing activities*             |       | 63,873,653                    |       | 22,600,000 |   |
|                                                    |       |                          |       |   |   |
| Effect of foreign currency                              |       | (228,359                      | )          | 809,065 |   |
| *Net increase (decrease) in cash and cash  equivalents* |       | 1,720,243                     |       | (13,925,295 | ) |
| *Cash and cash equivalents at beginning of  period*     |       | 883,388                       |       | 16,260,601 |   |
| *Cash and cash equivalents at end of period*            |       | $                             | 2,603,631  |   | $ | 2,335,306 |   |
|                                                         |            |                               |            |  |  |  |  |

 

*See accompanying notes to consolidated financial statements.*

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited)**

**August 28, 2008**

 

**Note 1 Basis of Presentation and Significant Accounting Policies**

 

The accompanying unaudited interim consolidated financial statementsinclude the accounts of Cellu Tissue Holdings, Inc.  (“Cellu Tissue” or the “Company” ) and itswholly owned subsidiaries.  The Companyis a wholly owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”),which is a wholly owned subsidiary of Cellu Parent Corporation (“Cellu Parent”).

 

These statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included.  Operatingresults for the quarter and six months ended August 28, 2008 are not necessarilyindicative of the results that may be expected for the fiscal year ending February 28,2009.  For further information, refer tothe Company’s consolidated financial statements and footnotes thereto as of February 29,2008 and for the year then ended contained in the Company’s Annual Report on Form 10-K,from which the consolidated balance sheet at February 29, 2008 has beenderived and the Company’s latest Current Reports on Form 8-K, each asfiled with the Securities and Exchange Commission (“SEC”).

 

Stock-Based Compensation

 

The Company accounts for stock based compensation in accordance withStatement of Financial Accounting Standards No. 123R (“SFAS 123R”), *Share-Based Payments*, which requires the measurement of allshare-based payments to employees, including grants of employee stock options,using the fair-value-based method and the recording of compensation expense inthe Company’s consolidated statements of operations.  Cellu Parent has one share-based paymentarrangement under the 2006 Stock Option and Restricted Stock Plan (the “Plan”).  Under the Plan, the administrator of the Plan(the “Plan Administrator”) may make awards of options to purchase shares ofcommon stock of Cellu Parent and/or awards of restricted shares of common stockof Cellu Parent.  A maximum of 8,095shares of common stock of Cellu Parent may be delivered in satisfaction ofawards under the Plan, determined net of shares of common stock withheld byCellu Parent in payment of the exercise price of an award or in satisfaction oftax withholding requirements.  Keyemployees and directors of, and consultants and advisors to, Cellu Parent orits affiliates who, in the opinion of the Plan Administrator, are in a

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 1 Basis of Presentation and Significant Accounting Policies(continued)**

 

position to make a significant contribution to the success of CelluParent and its affiliates are eligible to participate in the Plan.   Stock options are granted with a strikeprice at the estimated fair value of the Cellu Parent’s stock on the date ofgrant and have a 10-year term. Generally, stock option grants vest ratably over four years from thedate of grant.  The following describeshow certain assumptions affecting the estimated fair value of stock options aredetermined.  The dividend yield is zero;the volatility is based on historical market value of the Cellu Parent’s stock;and the risk-free interest rate is based on U.S. Treasury securities.   The Company uses historical data in order toestimate exercise, termination and holding period behavior for valuationpurposes. The fair value of the stock option grant was estimated on the date ofgrant using the Black-Scholes option pricing model.  The weighted average assumptions used tovalue the grants were no dividend yield; 55% volatility; 1.4% risk freeinterest rate; and 10-year expected life. The weighted average fair value of stock options granted was $498.18 pershare and the unrecognized total compensation cost as of August 28, 2008related to nonvested awards is $543,256.

 

A summary of the outstanding options as of August 28, 2008 and theactivity during the six months then ended is as follows:

 
| ** **                          | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** |
|-------------------------------------|------------|-------------|------------|--------------------------------------------|------------|-------------------------------------------------------------|------------|
| Outstanding, February 29, 2008 |       | 1,125       |       | $                                          | 733.67     |                                                        | 8.59 Years |   |
| Forfeited                           |       | (125        | )          | 979.25                                     |       | 8.86 Years                                                  |       |
| Granted                             |       | 444         |       | 942.99                                     |       | 9.85 Years                                                  |       |
| Outstanding, August 28, 2008   |       | 1,444       |       | 776.77                                     |       | 8.95 Years                                                  |       |
| ** **                          | ** ** | ** **  | ** ** | ** **                                 | ** ** | ** **                                                  | ** ** |
| Exercisable, August 28, 2008   |       | 356         |       | 620.57                                     |       | 8.45 Years                                                  |       |
|                                     |            |             |            |                                            |            |                                                             |            |  |

 

On August 6, 2007, Cellu Parent entered into a Restricted StockAgreement with the Company’s newly appointed Chief Financial Officer, pursuantto which Cellu Parent granted 700 restricted shares of its common stock to thenamed individual pursuant to the Plan. The shares will vest and cease to be restricted in four equal annualinstallments commencing on August 6, 2008, as long as the named individualis continuously employed by the Company until such vesting date with respect tohis shares.  Any restricted stockoutstanding at the time of a Covered Transaction (as defined in the Plan) shallbecome vested and cease to be restricted stock at the time of a change incontrol.  Additionally, Cellu Parent hasagreed to pay an amount to the named individual equal to an amount that wouldbe included in such individual’s gross income and payable as income

 

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**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 1 Basis of Presentation and Significant Accounting Policies(continued)**

 

tax as a result of making a Section 83(b) election under theInternal Revenue Code of 1986, as amended. The named individual has made a timely Section 83(b) election.

 

On June 12, 2006, Cellu Parent entered into Restricted StockAgreements with each of the Company’s Chief Executive Officer, Chief OperatingOfficer and the then Chief Financial Officer, pursuant to which Cellu Parentgranted 3,778 restricted shares of its common stock to the Chief ExecutiveOfficer and 1,349 restricted shares of its common stock to each of the othertwo named individuals pursuant to the Plan. The shares will vest and cease to be restricted in four equal annualinstallments commencing on June 12, 2007, as long as the named individual,as the case may be, is continuously employed by the Company until each suchvesting date with respect to his or her shares. Any restricted stock outstanding at the time of a Covered Transaction(as defined in the Plan) shall become vested and cease to be restricted stockat the time of a change in control. Additionally, the Parent has agreed to pay an amount to the namedindividuals equal to an amount that would be included in such individuals’gross income and payable as income tax as a result of making a Section 83(b) electionunder the Internal Revenue Code of 1986, as amended.  All named individuals have made a timely Section 83(b) election.

 

Effective July 31, 2007, the then Chief Financial Officer resignedand forfeited three-fourths of the individual’s restricted stock grant, andaccordingly, the Company only recorded compensation expense associated withthis individual’s grant through June 12, 2007 as all other shares wereforfeited and no compensation expense is required to be recognized forforfeited shares.

 

For the three and six months ended August 28, 2008, the Companyhas recorded $179,078 and $356,188, respectively of compensation expenserelated to the above restricted stock grants.  For the three and six months ended August 30, 2007 the Company hasrecorded $152,822 and $326,944, respectively of compensation expense related tothe vesting of the grants at that time in accordance with SFAS 123R.

 

Derivatives and Hedging

 

The Company uses derivative financial instruments to offset asubstantial portion of its exposure to market risk arising from changes in theprice of natural gas. Hedging of this risk is accomplished by entering intoforward swap contracts, which are designated as hedges of specific quantitiesof natural gas expected to be purchased in future months.    These contracts are held for purposes otherthan trading and are designated as cash flow hedges.  The Company measures hedge effectiveness byformally assessing, at least quarterly, the correlation of the expected futurecash flows of the hedged item and the derivative hedging instrument.  The ineffective portions of the hedges, whichare not material for any period presented, are immediately recognized inearnings.  The Company

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 1 Basis of Presentation and Significant Accounting Policies(continued)**

 

measures fair value of its derivative financial instruments inaccordance with SFAS 157.  SFAS 157defined fair value as the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participants.SFAS 157 establishes a fair value hierarchy for valuation inputs that gives thehighest priority to quoted prices in active markets for identical assets orliabilities and the lowest priority to unobservable inputs.  The fair value hierarchy is as follows:

 

Level 1-Inputs utilize quoted prices(unadjusted) in active markets for identical assets or liabilities that theCompany has the ability to access.

 

Level 2-Inputs utilize data points that are observable such as quotedprices, interest rate and yield curves.

 

Level 3-Inputs are unobservable data pointsfor the asset or liability, and include situations where there is little, ifany, market activity for the asset or liability.

 

Derivatives are reported at fair value utilizing Level 2 inputs.  The fair value of these cash flow hedginginstruments was a liability of $.6 million and an asset of $.2 million as of August 28,2008 and February 29, 2008, respectively. During the next12 months, the entire $.6 million will be reclassified to earningsconsistent with the timing of the underlying hedged transactions.

 

Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standard Board (“FASB”)issued Statement of Financial Accounting Standards No. 157,”*Fair Value Measurements*” (“SFAS 157”).  The Company was required to adopt theprovisions of SFAS 157 effective March 1, 2008.  SFAS 157 provides a common fair valuehierarchy for companies to follow in determining fair value measurements in thepreparation of financial statements and expands disclosure requirementsrelating to how such fair value measurements were developed.  FAS157 clarifies the principle that fairvalue should be based on the assumptions that the marketplace would use whenpricing an asset or liability, rather than company specific data.  The adoption of FAS No. 157 did not havea material impact on the Company’s results of operations and financialposition.

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements (Unaudited)(continued)**

 

**Note 1 Basis of Presentation and Significant Accounting Policies(continued)**

 

In February 2007, the FASB issued Financial Accounting StandardsNo.159, “*The Fair Value Option for FinancialAssets and Liabilities, Including an amendment of FASB Statement No. 115*”(“SFAS 159”).  This Standard permitsentities to choose to measure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue.  SFAS 159 was effective as of thebeginning of fiscal 2009 and the Company chose not to adopt these fair valueprovisions.

 

In December 2007, the FASB issued Financial Accounting Standards No. 141(R), “*Business Combinations*” (“SFAS141 (R)”), and Financial Accounting Standards No. 160, *“Accounting and Reporting of Noncontrolling Interestsin Consolidated Financial Statements, an amendment of ARB No. 51”*(“SFAS160”).  These new standards willsignificantly change the financial accounting and reporting of businesscombination transactions and noncontrolling (or minority) interests inconsolidated financial statements.  SFAS141 (R) is required to be adopted concurrently with FAS 160 and iseffective for business combination transactions for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008.  Earlyadoption is prohibited.  The Company iscurrently assessing the impact that SFAS 141 (R) and SFAS 160 will have onits results of operations and financial position.

 

In March 2008, the FASB issued Financial Accounting Standards No. 161,“*Disclosures about Derivative Instruments andHedging Activities-an amendment of FASB Statement No. 133”*(“SFAS161”).  SFAS 161 requires entities toprovide enhanced disclosures about derivative instruments and hedgingactivities.  SFAS 161 is effective forfiscal years and interim periods beginning on or after November 15,2008.  The Company is currently assessingthe impact that SFAS 161 will have on its results of operations and financialposition.

 

**Note 2 Inventories**

 

Components of inventories are as follows:

 
| ** **                       | ** ** | **August 28, 2008** | ** ** | **February 29, 2008** | ** ** |
|----------------------------------|------------|-------------------------------|------------|---------------------------------|------------|
|                             |       |                          |       |                            |       |
| Finished goods                   |       | $                             | 24,836,058 |                            | $          | 17,961,802 |   |
| Raw materials                    |       | 5,120,073                     |       | 7,073,131                       |       |
| Packaging materials and supplies |       | 12,529,168                    |       | 9,082,592                       |       |
|                             |       | 42,485,299                    |       | 34,117,525                      |       |
| Inventory reserves               |       | (221,264                      | )          | (121,086                        | )          |
|                             |       | $                             | 42,264,035 |                            | $          | 33,996,439 |   |

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 3 Acquisitions**

 

On July 2, 2008, the Company, through two newlycreated, wholly-owned subsidiaries, Cellu Tissue – Hauppauge, LLC (“CelluHauppauge”) and Cellu Tissue – Thomaston, LLC (“Cellu Thomaston”) consummatedthe acquisition of certain assets, and assumption of certain liabilities, fromAtlantic Paper & Foil Corp. of N.Y., Atlantic Lakeside Properties,LLC, Atlantic Paper & Foil, LLC, Atlantic Paper & Foil ofGeorgia, LLC and Consumer Licensing Corporation (collectively, the “Sellers”)pursuant to a definitive asset purchase agreement (the “Purchase Agreement”)between Cellu Tissue and the Sellers.  The aggregate purchase price paidwas $68,000,000, including a cash payment at closing of $61,700,000 and theissuance of a promissory note by Cellu Tissue to Atlantic Paper & FoilCorp. of N.Y. in the principal amount of $6,300,000 (the “Seller Note”), plusthe assumption of certain liabilities. The Company also incurred $2.1 million of transaction relatedcosts.  The purchase price is subject tocertain post-closing working capital adjustments.  The acquisition of assets and assumption ofliabilities is referred to as the “APF Acquisition” and the acquired businessis referred to as “APF”.  The Companyfinanced the cash portion of the purchase price with cash on-hand, theborrowings described below (Note 4) and an equity contribution from the Parent,which was funded through the issuance of Cellu Parent stock to Weston Presidioand certain members of management.

 

The APF Acquisition has been accounted for as a purchase in accordancewith the provisions of SFAS 141 and, accordingly, the consolidated statement ofoperations includes the results of APF during the three and six months ended August 28,2008 from the date of acquisition.  Theacquisition has resulted in the recognition of goodwill, which is attributableto our Tissue segment and will be deductible for tax purposes.  Goodwill reflects the future earnings andcash flow potential of the acquired business in excess of fair values that areassigned to all other identifiable assets and liabilities.  Goodwill arises because the purchase pricepaid reflects factors including the strategic fit and expected synergies thisbusiness brings to existing operations. Purchase price allocations are subject to refinement until all pertinentinformation is obtained.    The Companyhas preliminarily allocated the purchase price over the net assets acquired inthe acquisition based on its estimates of the fair value of assets andliabilities as follows:

 

| ** **                                                     | ** ** | **Purchase price allocated to:** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Current assets, primarily accounts  receivable and inventories |       | $                                               | 15,860,042 |   |
| Property, plant and equipment                                  |       | 5,306,225                                       |       |
| Goodwill                                                       |       | 23,765,576                                      |       |
| Noncompete agreements                                          |       | 12,770,000                                      |       |
| Customer lists                                                 |       | 17,340,000                                      |       |
| Trademarks                                                     |       | 56,000                                          |       |
| Current liabilities                                            |       | (4,968,441                                      | )          |
| Total                                                          |       | $                                               | 70,129,402 |   |

 

12

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Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 3 Acquisition (continued)**

 

The Company has estimated the fair value ofthe assets and liabilities of the APF Acquisition, utilizing informationavailable at the time the Company’s unaudited interim financial statements wereprepared and these estimates are subject to refinement until all pertinentinformation has been obtained. The Company is in the process of finalizingoutside third-party appraisals of the tangible and intangible assets and hasrecorded the preliminary fair market values.  Furthermore, depreciation has been calculated on the fair value assignedto the tangible fixed assets based on an average remaining 10-year life.   Intangible assets are being amortized on astraight-line basis, assuming no significant residual value, over the followinglives:  noncompete agreements-5 years,customer lists-7 years and trademarks- 3 years. The fair value assigned and actual lives used in calculatingdepreciation and amortization will be finalized with the aforementionedappraisals.  Accordingly, the purchaseprice allocations are preliminary with respect to these items and also withrespect to finalizing the transferability of tax credits and other minor items.

 

The results of APF’s operations from the July 2,2008 date of acquisition are primarily included in the Company’s tissuesegment.  Part of the acquisitionrelated to the foam business, which the Company will show as a separate segment(see Note 6).  Unaudited pro formaresults of operations for the three and six months ended August 28, 2008and August 30, 2007, as if the Company and APF had been combined as of March 1,2007, are presented below.  The pro formaresults include estimates and assumptions, which the Company’s managementbelieves are reasonable.  However, thepro forma results do not include any cost savings or other effects of theplanned integration of APF and are not necessarily indicative of the resultswhich would have occurred if the business combination had been in effect on thedates indicated, or which may result in the future.

 
| ** **       | ** ** | **Three Months Ended August 28, 2008 (1)** | ** ** | **Three Months Ended August 30, 2007 (1)** | ** ** |
|------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **       | ** ** | **As Filed**                                                        | ** ** | **Pro Forma**                                                       | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | **(in thousands)**                                                  | ** ** | **(in thousands)**                                                  | ** ** |
| Net sales        |       | $                                                                        | 128,957    |                                                                     | $          | 141,009 |   | $ | 109,000 |   | $ | 129,132 |   |
| Operating income |       | $                                                                        | 7,492      |                                                                     | $          | 8,330 |   | $ | 7,060 |   | $ | 10,201 |   |
| Net income       |       | $                                                                        | 338        |                                                                     | $          | 721 |   | $ | 1,070 |   | $ | 3,727 |   |

 

----

(1) Pro forma operating results include theoperating results for APF for the three months ended June 30, 2008 and2007, as APF was previously a calendar year-end company.  The “as filed” operating results include theoperating results for APF for the period from the acquisition date (July 2,2008) to August 28, 2008.

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 3 Acquisition (continued)**

 
| ** **        | ** ** | **Six Months Ended August 28, 2008 (1)** | ** ** | **Six Months Ended August 30, 2007 (1)** | ** ** |
|-------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **        | ** ** | **As Filed**                                                      | ** ** | **Pro Forma**                                                     | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(in thousands)**                                                | ** ** | **(in thousands)**                                                | ** ** |
| Net sales         |       | $                                                                      | 240,453    |                                                                   | $          | 272,828 |   | $ | 212,201 |   | $ | 249,764 |   |
| Operating income  |       | $                                                                      | 14,390     |                                                                   | $          | 16,564 |   | $ | 10,637 |   | $ | 15,354 |   |
| Net income (loss) |       | $                                                                      | 1,555      |                                                                   | $          | 2,722 |   | $ | (41 | ) | $ | 3,779 |   |

 

----

(1) Pro forma operating results include theoperating results for APF for the six months ended June 30, 2008 and 2007,as APF was previously a calendar year-end company.  The “as filed” operating results include theoperating results for APF for the period from the acquisition date (July 2,2008) to August 28, 2008.

 

On March 21, 2007, the Company executed a definitive mergeragreement (the “Acquisition Agreement”) with CityForest Corporation (“CityForest”),Cellu City Acquisition Corporation (“Cellu City Merger Sub”) and Wayne Gullstadas the shareholders’ representative. Pursuant to the Acquisition Agreement, and subject to the terms andconditions therein, Cellu City Merger Sub, a wholly owned subsidiary of theCompany, merged with and into CityForest, with CityForest surviving andbecoming a wholly owned subsidiary of the Company (the “CityForest Acquisition”).  The aggregate merger consideration (includingassumption of $18.4 million in aggregate principal amount of industrial revenuebonds) was approximately $61.0 million subject to certain working capital andnet cash adjustments.  Total cash paidfor the acquisition of $46.8 million (purchase price of $61.0 million lessassumed indebtedness of $18.4 million plus restricted cash and othermiscellaneous adjustments of $1.6 million and acquisition costs of $2.6million) was financed in part by issuance of unregistered 9 3/4% Senior SecuredNotes due 2010 of approximately $20.0 million, borrowings on a revolving lineof credit ($17.4 million) and available cash on hand.

 

The CityForest Acquisition has been accountedfor as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statements of operations includes the results ofCityForest during the three months and six months ended August 28, 2008,during the three months ended August 30, 2007 and during the six monthsended August 30, 2007 from the date of acquisition.

 

The results of CityForest’s operations fromthe date of acquisition (March 21, 2007) are included in the Company’stissue segment. Unaudited pro forma results of operations for the six monthsended August 30, 2007, as if the Company and CityForest had been combinedas of March 1, 2007, are presented below. The pro forma results include estimates and assumptions, which theCompany’s management believes are reasonable. However, the pro forma results do not include any cost savings or othereffects of the planned integration of CityForest and are not necessarilyindicative of the results which

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 3 Acquisition (continued)**

 

would have occurred if the businesscombination had been in effect on the dates indicated, or which may result inthe future.

 
| ** **        | ** ** | **Six Months Ended August 30, 2007 (1)** | ** ** |
|-------------------|------------|------------------------------------------------------------------------|------------|
| ** **        | ** ** | **As Filed**                                                      | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(in thousands)**                                                | ** ** |
| Net sales         |       | $                                                                      | 212,201    |   | $ | 214,911 |   |
| Operating income  |       | $                                                                      | 10,637     |   | $ | 11,223 |   |
| Net (loss) income |       | $                                                                      | (41        | ) | $ | 520 |   |

 

----

(1) Pro forma operating results include theoperating results for CityForest for the six months ended August 30, 2007.The “as filed” operating results include the operating results for CityForestfor the period from the acquisition date (March 21, 2007) to August 30,2007.

 

**Note 4 Long-Term Debt**

 

Long-term debt consists of the following:

 
| ** **                                                                                                    | ** ** | **August 28, 2008** | ** **  | **February 29, 2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-------------------------------|-------------|---------------------------------|------------|
|                                                                                                          |       |                          |        |                            |       |
| 9 3⁄4% senior secured notes due 2010                                                                       |       | $                             | 222,255,572 |                            | $          | 182,255,572 |   |
| Less discount                                                                                                 |       | (3,782,699                    | )           | (1,283,628                      | )          |
|                                                                                                          |       | 218,472,873                   |        | 180,971,944                     |       |
| Industrial revenue bond payable, in  semi-annual installments, plus variable interest, due March 1, 2028 |       | 17,495,000                    |        | 17,875,000                      |       |
| Seller Note payable, quarterly interest  payments only at 12% annum, with principal due July 2, 2011     |       | 6,300,000                     |        | —                          |       |
|                                                                                                          |       | 242,267,873                   |        | 198,846,944                     |       |
| Less current portion of debt                                                                                  |       | 760,000                       |        | 760,000                         |       |
|                                                                                                          |       | $                             | 241,507,873 |                            | $          | 198,086,944 |   |

 

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Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 4 Long-Term Debt (continued)**

 

***9 3⁄4% Senior Secured Notes due 2010***

 

In March 2004, the Company completed a private offering of $162.0million aggregate principal amount of 9 3⁄4% senior secured notes due 2010 (the “OriginalNotes”) pursuant to and are governed by the Indenture, dated as of March 12,2004 (as amended and supplemented, the “Cellu Tissue Indenture”) among theCompany, the subsidiary guarantors party thereto and The Bank of New York TrustCompany, N.A., as successor trustee to the Bank of New York (the “Trustee”).  In connection with the CityForest Acquisition(see Note 3), the Company entered into a Note Purchase Agreement (the “NotePurchase Agreement”) with Wingate Capital Ltd. (“the Purchaser”), dated March 21, 2007, pursuant to which itissued and sold $20.3 million aggregate principal amount of 9 3⁄4% senior securednotes due 2010 (“First Additional Notes”) to the Purchaser for the purchaseprice of $20.0 million, which is equal to 98.7383% of the aggregate principalamount of the Additional Notes.  TheFirst Additional Notes were issued pursuant to and are governed by the CelluTissue Indenture.

 

In connection with the APF Acquisition (see Note 3) the Company enteredinto Note Purchase Agreements (the “Note Purchase Agreements”, or “SecondAdditional Notes”) with each of (i) GMAM Investment Funds Trust II, forthe account of the Promark Alternative High Yield Bond Fund (Account No. 7M2E),GMAM Investment Funds Trust, General Motors Welfare Benefit Trust (VEBA), GMAMInvestment Funds Trust II for the account of the Promark Alternative High YieldBond Fund (Account No. 7MWD), DDJ High Yield Fund, Multi-Style,Multi-Manager Funds PLC The Global Strategic Yield Fund (f/k/a Multi-Style,Multi-Manager Funds PLC The Global High Yield Fund), DDJ Capital ManagementGroup Trust, Stichting Pensioenfonds Hoogovens, Caterpillar Inc. MasterRetirement Trust, J.C. Penney Corporation, Inc. Pension Plan Trust,Stichting Bewaarder Interpolis Pensioenen Global High Yield Pool, DDJ/OntarioOS Investment Sub II, Ltd. and Stichting Pensioenfonds Metaal en Techniek, (ii) ClarenRoad Credit Master Fund, Ltd. and (iii) UBS High Yield Relationship Fund,a series of the UBS Relationship funds (the “Purchasers”), dated July 2,2008, pursuant to which the Company issued and sold $40,000,000 aggregateprincipal amount of unregistered 9 3/4% Senior Secured Notes due 2010 (“SecondAdditional Notes”) to the Purchasers for the purchase price of $36,900,000which is equal to 92.25% of the aggregate principal amount of the SecondAdditional Notes (together with the Original Notes and the First AdditionalNotes, the “Notes”).  The SecondAdditional Notes were issued pursuant to and are governed by the Cellu TissueIndenture.

 

The Notes mature on March 15, 2010 and require semi-annualinterest payments on March 15 and September 15.  The Notes are collateralized by a seniorsecured interest in substantially all of the Company’s assets.  The Cellu Tissue Indenture contains certaincovenants, including limitations on certain restricted payments, the incurrenceof

 

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Tableof Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 4 Long-Term Debt (continued)**

 

additional indebtedness and the sale of certain assets.  The Cellu Tissue Indenture has been amendedby two subsequent amendments pursuant to which CityForest, Cellu Happauge andCellu Thomaston became parties to the Cellu Tissue Indenture as subsidiary guarantors(collectively, the “Additional Guarantors”). As subsidiary guarantors, the Additional Guarantors, on a joint andseveral basis, with all the existing subsidiary guarantors, fully,unconditionally and irrevocably guarantee the obligations of Cellu Tissue underthe Cellu Tissue Indenture and Notes. The Notes are unconditionally guaranteed by all of the Company’ssubsidiaries.

 

***Seller Note Payable***

 

As part of the financing of the APF acquisition, the Company enteredinto the Seller Note in the principal amount of $6,300,000.  Interest only at 12% is payable on the notein quarterly installments with the principal due July 2, 2011.

 

***Credit Agreement***

 

The Company entered into a Credit Agreement, dated as of June 12,2006 (the “Credit Agreement”), among Cellu Tissue, as U.S. Borrower, InterlakeAcquisition Corporation Limited (“Interlake”), a subsidiary of Cellu Tissue, asCanadian Borrower, Parent, the other loan guarantors party thereto, JPMorganChase Bank, N.A., as U.S. Administrative Agent the “U.S. Administrative Agent”),JPMorgan Chase Bank, N.A., Toronto Branch, as Canadian Administrative Agent(the “Canadian Administrative Agent”) and the other lenders party thereto.  The Credit Agreement provides for a $35.0million working capital facility, which was subseqeuently increased to $60.0million (see discussion following), including a letter of credit sub-facilityand swing-line loan sub-facility. The Credit Agreement provides that amountsunder the facility may be borrowed, repaid and re-borrowed, subject to aborrowing base test, until the maturity date, which is June 12, 2011. Anamount equal to $32.0 million, which was subsequently increased to $57.0million (see discussion following), is available, in U.S. dollars, to the U.S.Borrower under the facility and an amount equal to $3.0 million is available,in U.S. or Canadian dollars, to the Canadian Borrower under the facility.  Borrowings of $17.4 million were made tofinance a portion of the CityForest Acquisition and borrowings of $12.1 millionwere made to finance a portion of the APF Acquisition. As of August 28,2008, there was $23.0 million of borrowings outstanding under the workingcapital facility and excess availability was $30.2 million.

 

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Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 4 Long-Term Debt (continued)**

 

Cellu Tissuehas entered into a First Amendment, dated March 21, 2007 (the “FirstAmendment”), to the Credit Agreement dated June 12, 2006 (as amended bythe First Amendment, the “Amended Credit Agreement”) among Cellu Tissue,Interlake, certain subsidiaries of Cellu Tissue, the Parent, the U.S.Administrative Agent and the Canadian Administrative Agent.

 

The FirstAmendment (1) increases the working capital facility from $35.0 million to$40.0 million, (2) permits the issuance and sale by the Company of theFirst Additional Notes, (3) provides for the consummation of theCityForest Acquisition and the conversion by CityForest from a Minnesotacorporation to a Minnesota limited liability company, (4) permits theassumption of approximately $18.4 million in aggregate principal amount ofindebtedness of CityForest in connection with the CityForest Acquisition inaccordance with the terms of the CityForest Bond Documents (as defined belowunder “CityForest Bond Documents”), and (5) permits the guarantee by CelluTissue of certain obligations of CityForest under the CityForest BondDocuments.  In connection with the FirstAmendment, CityForest became a guarantor of the obligations of the borrowersunder the Amended Credit Agreement.

 

The Company has entered into a Second Amendment, dated July 2,2008 (the “Second Amendment”), to the Credit Agreement dated June 12, 2006(as amended by the First Amendment, as Amended, and the Second Amendment, “CreditAgreement, as Amended”), among Cellu Tissue, Interlake, certain****subsidiaries of Cellu Tissue, the Parent, the U.S.Administrative Agent and the Canadian Administrative Agent.

 

The Second Amendment (1) increases the working capital facilityfrom $40.0 million to $60.0 million, (2) permits the issuance and sale byCellu Tissue of the Second Additional Notes, (3) provides for theconsummation of the APF Acquisition and (4) permits the issuance of theSeller Note.  In connection with theSecond Amendment, Cellu Hauppauge and Cellu Thomaston became guarantors of theobligations of the borrowers under the Credit Agreement, as Amended.

 

***CityForest Bond Documents***

 

CityForest isparty to a Loan Agreement, dated March 1, 1998 (the “Loan Agreement”),with the City of Ladysmith, Wisconsin (the “Issuer”).  Pursuant to the Loan Agreement, the Issuer loanedthe proceeds of the Issuer’s Variable Rate Demand Solid Waste Disposal FacilityRevenue Bonds, Series 1998 (CityForest Corporation Project) (the “Bonds”)to CityForest to finance the construction by CityForest of a solid wastedisposal facility.  Approximately $18.4million in aggregate principal amount of the Bonds was outstanding as of thedate of the CityForest Acquisition. CityForest is required, under the terms of the Indenture of Trustgoverning the Bonds (the “CityForest Indenture”), to

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 4 Long-Term Debt (continued)**

 

provide aletter of credit in favor of the trustee under the CityForest Indenture (the “BondsTrustee”).  CityForest has entered intoan Amended and Restated Reimbursement Agreement, dated March 21, 2007 (the“Reimbursement Agreement” and, together with the CityForest Indenture and theLoan Agreement, the “CityForest Bond Documents”), with Associated Bank,National Association (“Associated Bank”), pursuant to which Associated Bank hasextended the required letter of credit (the “Associated Bank Letter of Credit”)and has provided a revolving credit facility to CityForest in an aggregateprincipal amount of up to $3.5 million (the “Associated Bank Revolving CreditFacility”).

 

The Bonds Trustee is permittedto draw upon the Associated Bank Letter of Credit to pay principal and interestdue on the Bonds, and to provide liquidity to purchase Bonds put to CityForestby bondholders and not remarketed; and CityForest is obligated under theReimbursement Agreement to reimburse Associated Bank for any such draws.CityForest is also obligated to pay a fee in respect of the aggregate amountavailable to be drawn under the Associated Bank Letter of Credit at a rate perannum initially equal to 1.25%, subject to adjustment on a quarterly basisbased on CityForest’s leverage.  Theexpiration date of the Associated Bank Letter of Credit is February 15,2011.

 

Amounts borrowed by CityForestunder the Associated Bank Revolving Credit Facility bear interest at a rate perannum equal to the LIBOR Rate (as defined in the Reimbursement Agreement), plusan applicable margin. The applicable margin percentage initially is 1.75%,subject to adjustment on a quarterly basis based upon CityForest’sleverage.  During the continuance of anevent of default, the outstanding principal balance bears interest at a rateper annum equal to the then applicable interest rate plus 2.00%.  CityForest is also obligated to pay acommitment fee in respect of any unused commitment under the Associated BankRevolving Credit Facility in an amount equal to 0.50% per annum.  In addition, subject to certain exceptions,if CityForest terminates the Associated Bank Revolving Credit Facility prior toFebruary 15, 2009, CityForest is obligated to pay to Associated Bank a feeequal to 1.00% of the commitment then being terminated. The maturity date ofthe Associated Bank Revolving Credit Facility is February 15, 2011.

 

TheReimbursement Agreement requires scheduled semi-annual payments of principal ofthe Bonds equal to approximately 2.00% of the principal amount outstanding asof the date of the CityForest Acquisition, with the balance payable at maturityof the Bonds on March 1, 2028. The Reimbursement Agreement also contains anumber of other provisions regarding reserve funds and other mandatory andoptional repayments in connection with the Bonds.  In addition, the Reimbursement Agreementprovides that in certain circumstances where the Company incurs indebtedness,as defined, in excess of amounts currently permitted under the CityForestIndenture or refinances the

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 4 Long-Term Debt (continued)**

 

indebtedness issued under theCityForest Indenture, Associated Bank may require CityForest to repay all ofits obligations to Associated Bank under the Reimbursement Agreement and eitherto cause the Bonds to be redeemed or to replace the Associated Bank Letter ofCredit with a Substitute Credit Facility, as such term is defined in theCityForest Indenture.

 

TheReimbursement Agreement contains various affirmative and negative covenantscustomary for working capital and term credit facilities, as well as additionalcovenants relating to the Bonds.  Thenegative covenants include limitations on: indebtedness; liens; acquisitions,mergers and consolidations; investments; guarantees; asset sales; sale andleaseback transactions; dividends and distributions; transactions withaffiliates; capital expenditures; and changes to the status of the Bonds.CityForest is also required to comply on a quarterly basis with a maximumleverage covenant and a minimum fixed charge coverage covenant. TheReimbursement Agreement also contains customary events of default,including:  payment defaults; breaches ofrepresentations and warranties; covenant defaults; cross-defaults to certainother debt, including the First Additional Notes and indebtedness under theAmended Credit Agreement; certain events of bankruptcy and insolvency; judgmentdefaults; certain defaults related to the Employee Retirement Income SecurityAct of 1974, as amended; and a change of control of CityForest or the Company.

 

The Company has guaranteed all of the obligations of CityForest underthe Reimbursement Agreement, pursuant to a Guaranty, dated March 21, 2007(the “Cellu Tissue Guaranty”), executed by the Company in favor of AssociatedBank. In addition, the obligations of CityForest under the ReimbursementAgreement are secured by first-priority liens in favor of Associated Bank inall of CityForest’s assets.  The U.S.Administrative Agent, the Canadian Administrative Agent, Associated Bank andCityForest have entered into an Intercreditor Agreement, dated March 21,2007, which sets forth the respective rights and priorities of Associated Bank,on the one hand, and the U.S. Administrative Agent and the CanadianAdministrative Agent, on the other hand, as to the collateral of CityForestsecuring the Reimbursement Agreement and the Amended Credit Agreement.

 

**Note 5 Debt and Note Issuance Costs**

 

In connection with the financing related to the APF acquisition, theCompany incurred approximately $225,000 and $623,000 of costs related to theamendment to the credit agreement and note issuance, respectively.  These costs have been capitalized as of thedate of financing and are being amortized over the respective terms of thefinancing.  The debt issuance costs andrelated accumulated amortization balances as of August 28, 2008 are asfollows:

 

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Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 5 Debt and Note Issuance Costs (continued)**

 
| ** **                           | ** ** | **August 28, 2008** | ** ** |
|--------------------------------------|------------|-------------------------------|------------|
|                                 |       |                          |       |
| Debt issuance costs-credit agreement |       | $                             | 225,171    |   |
| Note issuance costs                  |       | 622,641                       |       |
|                                 |       | 847,812                       |       |
| Accumulated amortization             |       | (70,197                       | )          |
|                                 |       | $                             | 777,615    |   |

 

These costs, net of accumulated amortization, are included in otherassets on the balance sheet as of August 28, 2008.

 

**Note 6 Comprehensive (Loss) Income**

 

The components of comprehensive (loss) income for the three months andsix months ended August 28, 2008 and August 30, 2007 are as follows:

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **August 28, 2008**    | ** ** | **August 30, 2007**  | ** ** | **August 28, 2008** | ** ** | **August 30, 2007** | ** ** |
| Net income (loss)                        |       | $                                | 338,023    |                           | $          | 1,069,830 |   | $ | 1,555,078 |   | $ | (40,654 | ) |
| Foreign currency translation adjustments |       | (2,013,787                       | )          | 370,020                        |       | (2,162,195 | ) | 809,065 |   |
| Change in derivative (loss) gain         |       | (688,705                         | )          | (643,300                       | )          | (796,891 | ) | (633,170 | ) |
| Comprehensive (loss) income              |       | $                                | (2,364,469 | )                              | $          | 796,550 |   | $ | (1,404,008 | ) | $ | 135,241 |   |

 

**Note 7 Business Segments**

 

The Company operates in three business segments:  tissue, machine-glazed paper and foam.  The foam business segment was added inconnection with the APF Acquisition (see Note 3).  The Company assesses the performance of itsbusiness segments using income from operations. Income from operations excludes interest income, interest expense, otherincome (expense), income tax expense, amortization expense and the impact offoreign currency gains and losses. A portion of corporate and shared expensesis allocated to each segment.  Segmentinformation for the three months and six months ended August 28, 2008 and August 30,2007 follows:

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 7 Business Segments (continued)**

** **
| ** **                            | ** ** | **Three Months Ended** | ** **  | **Six Months Ended** | ** ** |
|---------------------------------------|------------|----------------------------------|-------------|--------------------------------|------------|
| ** **                            | ** ** | **August 28,  2008**        | ** **  | **August 30,  2007**      | ** ** | **August 28, 2008** | ** ** | **August 30,  2007** | ** ** |
| **Net Sales**                         |       |                             |        |                           |       |   |   |   |   |
| Tissue                                |       | $                                | 100,243,312 |                           | $          | 83,494,959 |   | $ | 183,902,571 |   | $ | 161,130,856 |   |
| Machine-glazed paper                  |       | 27,850,494                       |        | 25,505,362                     |       | 55,687,318 |   | 51,070,251 |   |
| Foam                                  |       | 862,788                          |        | —                         |       | 862,788 |   | — |   |
| Consolidated                          |       | $                                | 128,956,594 |                           | $          | 109,000,321 |   | $ | 240,452,677 |   | $ | 212,201,107 |   |
|                                  |       |                             |        |                           |       |   |   |   |   |
| **Income from operations**            |       |                             |        |                           |       |   |   |   |   |
| Tissue                                |       | $                                | 6,994,577   |                           | $          | 6,383,420 |   | 13,346,000 |   | $ | 10,466,397 |   |
| Machine-glazed paper                  |       | 318,855                          |        | 676,922                        |       | 865,688 |   | 170,207 |   |
| Foam                                  |       | 178,657                          |        | —                         |       | 178,657 |   | — |   |
| Consolidated                          |       | 7,492,089                        |        | 7,060,342                      |       | 14,390,345 |   | 10,636,604 |   |
| Interest expense, net                 |       | (6,061,057                       | )           | (5,102,666                     | )          | (11,040,745 | ) | (10,121,760 | ) |
| Amortization expense                  |       | (802,435                         | )           | —                         |       | (802,435 | ) | — |   |
| Net foreign currency transaction loss |       | (127,700                         | )           | (196,110                       | )          | (84,620 | ) | (520,408 | ) |
| Other (expense) income                |       | (8,910                           | )           | 40,261                         |       | (38,418 | ) | 82,500 |   |
| Income before income tax expense      |       | $                                | 491,987     |                           | $          | 1,801,827 |   | $ | 2,424,127 |   | $ | 76,936 |   |
|                                  |       |                             |        |                           |       |   |   |   |   |
| **Capital Expenditures**              |       |                             |        |                           |       |   |   |   |   |
| Tissue                                |       | $                                | 1,779,412   |                           | $          | 3,338,578 |   | $ | 3,808,941 |   | $ | 5,579,729 |   |
| Machine-glazed paper                  |       | 421,940                          |        | 718,584                        |       | 676,770 |   | 971,235 |   |
| Foam                                  |       | —                           |        | —                         |       | — |   | — |   |
| Corporate                             |       | 144,306                          |        | 237,279                        |       | 334,838 |   | 389,823 |   |
| Consolidated                          |       | $                                | 2,345,658   |                           | $          | 4,294,441 |   | $ | 4,820,549 |   | $ | 6,940,787 |   |
|                                  |       |                             |        |                           |       |   |   |   |   |
| **Depreciation**                      |       |                             |        |                           |       |   |   |   |   |
| Tissue                                |       | $                                | 4,142,518   |                           | $          | 4,154,703 |   | $ | 8,270,412 |   | $ | 9,156,870 |   |
| Machine-glazed paper                  |       | 1,453,464                        |        | 1,361,900                      |       | 2,923,908 |   | 3,037,878 |   |
| Foam                                  |       | 13,606                           |        | —                         |       | 13,606 |   | — |   |
|                                  |       | $                                | 5,609,588   |                           | $          | 5,516,603 |   | $ | 11,207,926 |   | $ | 12,194,748 |   |

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 7Business Segments (continued)**

 
| ** **           | ** ** | **August 28, 2008** | ** **  | **February 29, 2008** | ** ** |
|----------------------|------------|-------------------------------|-------------|---------------------------------|------------|
| **Segment assets**   |       |                          |        |                            |       |
| Tissue               |       | $                             | 387,236,374 |                            | $          | 312,969,171 |   |
| Machine-glazed paper |       | 87,097,391                    |        | 84,660,190                      |       |
| Foam                 |       | 1,902,089                     |        | —                          |       |
| Corporate assets     |       | 5,119,047                     |        | 6,682,685                       |       |
| Consolidated         |       | $                             | 481,354,901 |                            | $          | 404,312,046 |   |

 

**Note 8 Goodwill and Other Intangibles, Net**

 

Goodwill, trademarks and other intangibles and related accumulatedamortization as of August 28, 2008 and February 29, 2008 are asfollows:

 
| ** **               | ** ** | **August 28, 2008** | ** ** | **February 29, 2008** | ** ** |
|--------------------------|------------|-------------------------------|------------|---------------------------------|------------|
|                     |       |                          |       |                            |       |
| Goodwill                 |       | $                             | 30,735,577 |                            | $          | 6,970,001 |   |
|                     |       |                          |       |                            |       |
| Trademarks               |       | $                             | 8,806,314  |                            | $          | 8,750,314 |   |
| Noncompete agreements    |       | 12,770,000                    |       | —                          |       |
| Customer lists           |       | 17,340,000                    |       | —                          |       |
|                     |       | 38,916,314                    |       | 8,750,314                       |       |
| Accumulated amortization |       | (802,435                      | )          | —                          |       |
| Other Intangibles, Net   |       | $                             | 38,113,879 |                            | $          | 8,750,314 |   |

 

Intangible assets are being amortized on a straight-line basis,assuming no significant residual value, over the following lives:  noncompete agreements-5 years, customerlists-7 years and trademarks- 3 years. Annual aggregate amortization expense estimated for each of the 5succeeding years is approximately $5.0 million. Amortization expense for the three months and six months ended August 28,2008 was $802,435.

 

**Note 9 Income taxes**

 

The effective income tax rate for the three months and six months endedAugust 28, 2008 was 31.3% and 35.9%, respectively compared to 40.6% and152.8%, respectively for the three months and six months ended August 30,2007.  Included in the income tax expensefor the three months and six months ended August 30, 2007 is approximately$90,000 related to additional Canadian income taxes paid upon completion of theCompany’s fiscal year 2007 tax returns. The effective tax rate for the three months and

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated Financial Statements(Unaudited) (continued)**

 

**Note 9 Income Taxes (continued)**

 

six months ended August 30, 2007, without the effect of theadditional Canadian income tax expense, was 35.6% and 35.9%, respectively.

 

The Company recognizes interest and penalties related to uncertain taxpositions in income tax expense.  As of August 28,2008, the Company has accrued interest and penalties, if any, related touncertain tax positions.  At August 28,2008, the Company did not have any unrecognized tax benefits.

 

The fiscal tax years 2004 through 2008 remain open to examination bythe major taxing jurisdictions to which the Company is subject.  As of August 28, 2008, the Company doesnot expect any material changes to unrecognized tax positions within the next12 months.

 

**Note 10 Subsequent Events**

 

On August 29, 2008, $15.0 million in contingent consideration inconnection with the Agreement and Plan of Merger that the Parent consummated onJune 12, 2006 with Cellu Parent , a corporation organized and controlledby Weston Presidio V, L.P. (“Weston Presidio”), and Cellu AcquisitionCorporation (“Merger Sub”), a wholly owned subsidiary of Cellu Parent and anewly formed corporation indirectly controlled by Weston Presidio was paid outdue to the achievement of certain financial targets for fiscal year 2008.  Of the $15 million, $1.3 million was issuedin stock of Cellu Parent and $13.7 million was paid out in cash. The $13.7million was funded by an equity investment of $6.7 million by Weston Presidioto Cellu Parent and $7.0 by Cellu Tissue, which was funded through borrowingson the Company’s revolving line of credit.

 

On September 29, 2008 the Company entered into the Third Amendmentto the Credit  Agreement dated as of June 12,2006 (as amended by the First Amendment, as Amended and the Second Amendment,as Amended) and as further amended, supplemented or otherwise modified fromtime to time, by and among the Parent, Cellu Tissue,  Interlake, the Loan Guarantors party thereto,the lenders party thereto,  the USAdministrative Agent and the Canadian Administrative Agent.  This Amendment increases the amount of theCanadian Commitments by $2.0 million and reduces the amount of the USCommitments by the same amount.

 

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**Item2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

Certain statements contained in this Quarterly Report on Form 10-Qmay contain forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities and Exchange Act of 1934, as amended, and, as such, may involveknown or unknown risks, uncertainties and other factors which may cause ouractual results, performance or achievements to be materially different fromfuture results, performance or achievements expressed or implied by suchforward-looking statements. Forward-looking statements, which are based on certain assumptions anddescribe our future plans, strategies and expectations, are generally identifiableby use of the words “may,” “will,” “should,” “expect,” “anticipate,” “estimate,”“believe,” “intend,” “project,” or comparable terminology.  Factors which could have a material adverseeffect on our operations and future prospects include, but are not limited to,those set forth in Item 1. Business-Forward-Looking Statements and Item1A.  Risk Factors in our Annual Report onForm 10-K for our fiscal year ended February 29, 2008.  These risks and uncertainties should beconsidered in evaluating any forward-looking statements contained herein.

 

We manufacture and market a variety of specialty tissue hard rolls andmachine-glazed paper used in the manufacture of various end products, includingdiapers, facial and bath tissue, assorted paper towels and food wraps.  In addition, we produce a variety ofconverted tissue products.  Our customersinclude major North American producers of branded and unbranded disposableconsumer absorbent and tissue products for the personal and health caremarkets; consumer and away-from-home tissue products companies; national andregional tissue products distributors; and third-party converters who selltheir products to food, bakery and confections companies.  We service a diverse group of high-qualitycustomers, with three of our top 10 customers belonging to the Fortune 150group of companies.

 

We operate in three business segments: tissue, machine-glazed paper and foam. The foam business segment was added in connection with the APFAcquisition (see discussion below).  Weassess the performance of our business segments using income fromoperations.  Income from operationsexcludes interest income, interest expense, income tax expense, amortizationexpense, other income (expense) and the impact of foreign currency gains andlosses.

 

**Acquisitions**

 

On July 2, 2008, we, through two newly created,wholly-owned subsidiaries, Cellu Hauppauge and Cellu Thomaston consummated theacquisition of certain assets, and assumption of certain liabilities, fromAtlantic Paper & Foil Corp. of N.Y., Atlantic Lakeside Properties,LLC, Atlantic Paper & Foil, LLC, Atlantic Paper & Foil ofGeorgia, LLC and Consumer Licensing Corporation (collectively, the “Sellers”)pursuant to the Purchase Agreement between Cellu Tissue and the Sellers. The aggregate purchase price

 

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paid was $68,000,000, including a cash payment at closing of$61,700,000 and the issuance of a promissory note by Cellu Tissue to AtlanticPaper & Foil Corp. of N.Y. in the principal amount of $6,300,000 (the “SellerNote”), plus the assumption of certain liabilities.  We also incurred $2.1 million of transactionrelated costs.  The purchase price issubject to certain post-closing working capital adjustments.  The acquisition of assets and assumption ofliabilities is referred to as the “APF Acquisition” and the acquired businessis referred to as “APF”.  We financed thecash portion of the purchase price with cash on-hand, the borrowings describedbelow and an equity contribution from our Parent, which was funded through theissuance of Cellu Parent stock to Weston Presidio and certain members ofmanagement.

 

The APF Acquisition has been accounted for as a purchase in accordancewith the provisions of SFAS 141 and, accordingly, the consolidated statement ofoperations includes the results of APF during the three and six months ended August 28,2008 from the date of acquisition.  Theacquisition has resulted in the recognition of goodwill, which is attributableto our Tissue segment and will be deductible for tax purposes.  Goodwill reflects the future earnings andcash flow potential of the acquired business in excess of fair values that are assignedto all other identifiable assets and liabilities.  Goodwill arises because the purchase pricepaid reflects factors including the strategic fit and expected synergies thisbusiness brings to existing operations. Purchase price allocations are subject to refinement until all pertinentinformation is obtained.  We havepreliminarily allocated the purchase price over the net assets acquired in theacquisition based on an estimate of the fair value of assets and liabilities asfollows:

 
| ** **                                                     | ** ** | **Purchase price allocated to:** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Current assets, primarily accounts  receivable and inventories |       | $                                               | 15,860,042 |   |
| Property, plant and equipment                                  |       | 5,306,225                                       |       |
| Goodwill                                                       |       | 23,765,576                                      |       |
| Noncompete agreements                                          |       | 12,770,000                                      |       |
| Customer lists                                                 |       | 17,340,000                                      |       |
| Trademarks                                                     |       | 56,000                                          |       |
| Current liabilities                                            |       | (4,968,441                                      | )          |
| Total                                                          |       | $                                               | 70,129,402 |   |

 

We have estimated the fair value of theassets and liabilities of the APF Acquisition, utilizing information availableat the time our unaudited interim financial statements were prepared and these estimatesare subject to refinement until all pertinent information has beenobtained.  We are in the process offinalizing outside third-party appraisals of our tangible and intangible assetsand have recorded the preliminary fair market values.  Furthermore, depreciation has been calculatedon the fair value assigned to the tangible fixed assets based on an averageremaining 10-year life.  Intangibleassets are being amortized on a straight-line basis, assuming no significantresidual value, over the following lives: noncompete agreements-5 years, customer lists-7 years and trademarks- 3years.  The fair value assigned andactual lives used in calculating depreciation and 

 

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amortization will be finalized with theaforementioned appraisals.  Accordingly,the purchase price allocations are preliminary with respect to these items andalso with respect to finalizing the transferability of tax credits and otherminor items.

 

The results of APF’s operations from the July 2,2008 date of acquisition are primarily included in our tissue segment.  Part of the acquisition related to thefoam business, which we show as a separate segment as noted above.  Unaudited pro forma results of operations forthe three and six months ended August 28, 2008 and August 30, 2007,as if we and APF had been combined as of March 1, 2007, are presentedbelow.  The pro forma results includeestimates and assumptions, which our management believes are reasonable.  However, the pro forma results do not includeany cost savings or other effects of the planned integration of APF and are notnecessarily indicative of the results which would have occurred if the businesscombination had been in effect on the dates indicated, or which may result inthe future.

 
| ** **       | ** ** | **Three Months Ended August 28, 2008 (1)** | ** ** | **Three Months Ended August 30, 2007 (1)** | ** ** |
|------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **       | ** ** | **As Filed**                                                        | ** ** | **Pro Forma**                                                       | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | **(in thousands)**                                                  | ** ** | **(in thousands)**                                                  | ** ** |
| Net sales        |       | $                                                                        | 128,957    |                                                                     | $          | 141,009 |   | $ | 109,000 |   | $ | 129,132 |   |
| Operating income |       | $                                                                        | 7,492      |                                                                     | $          | 8,330 |   | $ | 7,060 |   | $ | 10,201 |   |
| Net income       |       | $                                                                        | 338        |                                                                     | $          | 721 |   | $ | 1,070 |   | $ | 3,727 |   |

 

----

(1) Pro forma operating results include theoperating results for APF for the three months ended June 30, 2008 and2007, as APF was previously a calendar year-end company.  The “as filed” operating results include theoperating results for APF for the period from the acquisition date (July 2,2008) to August 28, 2008.

 
| ** **        | ** ** | **Six Months Ended August 28, 2008 (1)** | ** ** | **Six Months Ended August 30, 2007 (1)** | ** ** |
|-------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **        | ** ** | **As Filed**                                                      | ** ** | **Pro Forma**                                                     | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(in thousands)**                                                | ** ** | **(in thousands)**                                                | ** ** |
| Net sales         |       | $                                                                      | 240,453    |                                                                   | $          | 272,828 |   | $ | 212,201 |   | $ | 249,764 |   |
| Operating income  |       | $                                                                      | 14,390     |                                                                   | $          | 16,564 |   | $ | 10,637 |   | $ | 15,354 |   |
| Net income (loss) |       | $                                                                      | 1,555      |                                                                   | $          | 2,722 |   | $ | (41 | ) | $ | 3,779 |   |

 

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(1) Pro forma operating results include theoperating results for APF for the six months ended June 30, 2008 and 2007,as APF was previously a calendar year-end company.  The “as filed” operating results include theoperating results for APF for the period from the acquisition date (July 2,2008) to August 28, 2008.

 

On March 21, 2007, we executed the Acquisition Agreement withCityForest, Cellu City Merger Sub and Wayne Gullstad as the shareholders’representative.  Pursuant to theAcquisition Agreement and subject to the terms and conditions therein, CelluCity Merger Sub, a wholly owned subsidiary of ours, merged with and intoCityForest, with CityForest surviving and becoming our wholly ownedsubsidiary.  The aggregate mergerconsideration (including assumption of $18.4 million in aggregate principalamount of industrial revenue bonds) was approximately $61.0 million subject tocertain working capital and net cash adjustments.  Total cash paid for the acquisition of $46.8million 

 

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(purchase price of $61.0 million less assumed indebtedness of $18.4million plus restricted cash and other miscellaneous adjustments of $1.6million and acquisition costs of $2.6 million), was financed in part by theFirst Additional Notes of approximately $20.0 million, borrowings on arevolving line of credit ($17.4 million) and available cash on hand.

 

The CityForest Acquisition has been accountedfor as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statements of operations includes the results ofCityForest during the three months and six months ended August 28, 2008,during the three months ended August 30, 2007 and during the six monthsended August 30, 2007 from the date of acquisition.  The results of CityForest’s operations areincluded in our tissue segment. Unaudited pro forma results of operations for the six months ended August 30,2007, as if we and CityForest had been combined as of March 1, 2007, arepresented below.  The pro forma resultsinclude estimates and assumptions, which our management believes arereasonable.  However, the pro formaresults do not include any cost savings or other effects of the plannedintegration of CityForest and are not necessarily indicative of the resultswhich would have occurred if the business combination had been in effect on thedate indicated, or which may result in the future.

 
| ** **        | ** ** | **Six Months Ended August 30, 2007 (1)** | ** ** |
|-------------------|------------|------------------------------------------------------------------------|------------|
| ** **        | ** ** | **As Filed**                                                      | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(in thousands)**                                                | ** ** |
| Net sales         |       | $                                                                      | 212,201    |   | $ | 214,911 |   |
| Operating income  |       | $                                                                      | 10,637     |   | $ | 11,223 |   |
| Net (loss) income |       | $                                                                      | (41        | ) | $ | 520 |   |

 

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(1) Pro forma operating results include theoperating results for CityForest for the six months ended August 30,2007.  The “as filed” operating resultsinclude the operating results for CityForest for the period from theacquisition date (March 21, 2007) to August 30, 2007.

 

**Subsequent Events**

 

On August 29, 2008, $15.0 million in contingent consideration inconnection with the Agreement and Plan of Merger that the Parent consummated onJune 12, 2006 with the Parent, Weston Presidio and Merger Sub, a whollyowned subsidiary of Cellu Parent and a newly formed corporation indirectlycontrolled by Weston Presidio was paid out due to the achievement of certainfinancial targets for fiscal year 2008.  Ofthe $15 million, $1.3 million was issued in stock of Cellu Parent and $13.7million was paid out in cash. The $13.7 million was funded by an equityinvestment of $6.7 million by Weston Presidio to Cellu Parent and $7.0 by CelluTissue, which was funded through borrowings on the Company’s revolving line ofcredit.

 

On September 29, 2008, the Company entered into the ThirdAmendment, to the Credit  Agreement datedas of June 12, 2006 (as amended by the First Amendment, as Amended and theSecond Amendment, as Amended, and as further amended, supplemented or 

 

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otherwise modified from time to time, by and among the Paper, CelluTissue,  Interlake, the Loan Guarantorsparty thereto, the lenders party thereto, the US Administrative Agent and the Canadian Administrative Agent.  ThisAmendment increases the amount of the Canadian Commitments by $2.0 million andreduces the amount of the US Commitments by the same amount.

 

**Results of Operations for the Three Months Ended August 28, 2008(the Fiscal 2009 Three-Month Period) compared to the Three Months Ended August 30,2007 (the Fiscal 2008 Three-Month Period) and the Six Months Ended August 28,2008 (the Fiscal 2009 Six-Month Period) compared to the Six Months ended August 30,2007 (the Fiscal 2008 Six-Month Period)**

 

**Net sales** for the fiscal 2009 three-monthperiod increased $20.0 million, or 18.3%, to****$129.0million from $109.0 million for the comparable period in the prior year. Netsales for the fiscal 2009 six-month period increased $28.3 million, or 13.3%,to $240.5 from $212.2 million for the comparable period in the prior year.  On a company-wide basis, tons sold increasedfor the fiscal 2009 three-month period and the fiscal 2009 six-month periodcompared to the comparable periods of fiscal 2008.  For the fiscal 2009 three-month period, wesold 87,036 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products, an increase of 6,887 tons, or 8.6%, compared to thefiscal 2008 three-month period.  For thefiscal 2008 six-month period, we sold 164,485 tons of tissue hard rolls,machine-glazed paper hard rolls and converted paper products, an increase of6,231 tons, or 3.9%, compared to the fiscal 2008 six-month period.  Of these increases, $14.0 million of netsales and 7,941 tons sold related to APF. Net selling price per ton increased from $1,360 and $1,341 for thefiscal 2008 three-month and six-month periods to $1,472 and $1,456 for thefiscal 2009 three-month and six-month periods.

 

Net sales for our tissue segment for the fiscal 2009 three-month periodwere $100.2 million, an increase of $16.7 million, or 20.1%, from thecomparable period in the****prioryear.  Net sales for our tissue segmentfor the fiscal 2009 six-month period were $183.9 million, an increase of $22.8million, or 14.1%, from the comparable period in the prior year.  These increases are the result of the APFAcquisition, an increase in tonnage sold, primarily in our converting business,and an increase in net selling price per ton over the comparable periods in theprior year.

 

Net sales for our machine-glazed segment for the 2009 three-monthperiod were****$27.9 million, an increase of$2.4 million, or 9.2%,****from the comparableperiod in the prior year.  Net sales forour machine-glazed segment for the 2009 six-month period were $55.7 million, anincrease of $4.6 million, or 9.0%, from the comparable period in the prioryear.  These increases are drivenprimarily by an increase in net selling price per ton over the comparableperiods in the prior year.

 

Net sales for our foam segment for the 2009 three-month and six-monthperiods were $.9 million.  We startedreporting with respect to the foam segment following the APF Acquisition.

 

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**Gross profit** for the fiscal 2009 three-monthperiod increased to $11.9 million from $11.8 million, an increase of $.1million, or 1.5%, from the comparable period in the prior****year. As a percentage of net sales, grossprofit decreased to 9.3% in the fiscal 2009 three-month period from 10.8% inthe fiscal 2008 three-month period. Gross profit for the fiscal 2009 six-month period increased to $24.1million from $20.1 million, an increase of $4.0 million, or 20.1%, from thecomparable period in the prior year. As a percentage of net sales, gross profitincreased to 10.0% in the fiscal 2009 six-month period from 9.5% in the fiscal2008 six-month period. ** **The decrease in gross profit as apercentage of net sales in the fiscal 2009 three-month period is the result ofincreased fiber and energy costs over the comparable period in the prioryear.  Furthermore, included in cost ofgoods sold for the fiscal 2009 three-month and six-month periods isapproximately $.3 million of a charge reflecting purchase price allocated toinventory in connection with the APF acquisition.

 

Gross profit for our tissue segment for the fiscal 2009 three-monthperiod was $10.4 million, an increase of $.6 million, or 6.1%, from thecomparable period in the prior year. Gross profit for our tissue segment for the fiscal 2009 six-month periodwas $20.8 million, an increase of $3.8 million, or 22.4%, from the comparableperiod in the prior year.

 

Gross profit for our machine-glazed segment for the fiscal 2009three-month period was $1.3 million, a decrease of $.7 million, or 34.6%, fromthe comparable period in the prior year. Gross profit for our machine-glazed segment for the fiscal 2009six-month period was $3.1 million consistent with the comparable period in theprior year.

 

Gross profit for our foam segment for the fiscal 2009 three-month andsix-month periods was $.2 million.

 

As a percentage of net sales, gross profit for the tissue segmentdecreased to 10.4% in the fiscal 2009 three-month period and increased to 11.3%in the fiscal 2009 six-month period from****11.6% in thefiscal 2008 three-month period and 10.5% in the fiscal 2008 six-month period**.**  As a percentage ofnet sales, gross profit for the machine-glazed segment decreased to 4.8% in thefiscal 2009 three-month period and 5.6% in the fiscal 2009 six-month periodfrom 8.0% in the fiscal 2008 three-month period and 6.1% in the fiscal 2008six-month period.  As a percentage of netsales, gross profit for the foam segment for the three-month and six-monthperiods was 21.2%.

 

**Selling, general and administrative expenses**inthe fiscal 2009 three-month period decreased $.3 million, or 7.9%, to $4.2million from $4.5 million in the fiscal 2008 three-month period.  Selling, general and administrative expensesin the fiscal 2009 six-month period increased $.1 million, or 1.3%, to $9.1million from $9.0 million in the fiscal 2008 six-month period.  As a percentage of net sales, selling,general and administrative expenses decreased to****3.2%in the fiscal 2009 three-month period and decreased to 3.8% in the fiscal 2009six-month period from 4.1% and 4.2%, respectively, for the comparable periodsin the prior year.  Included in thefiscal 2008 three-month and six-month periods

 

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are additional costs incurred in connection with being compliant withSarbanes Oxley as this was the first year we had to meet such requirements. 

 

**Terminated acquisition-related transaction costs**forthe fiscal 2009 three-month and six-month periods of less than $.1 million and$.1 million, respectively relate to costs incurred in connection withacquisitions that did not transpire.

 

**Stock compensation expense**in the fiscal 2009three-month and six-month periods of $.2 million and $.4 million, respectively,and fiscal 2008 three-month and six-month periods of $.2 and $.4 million,respectively relates to the accounting for restricted stock and stock optiongrants.

 

**Interest expense, net**in the fiscal 2009three-month period was $6.1 million compared to $5.1 million in the fiscal 2008three-month period.  Interest expense,net in the fiscal 2009 six-month period was $11.0 million compared to $10.1million in the fiscal 2008 six-month period. These increases are due to the additional debt incurred in connectionwith the APF Acquisition.

 

**Amortization expense**in the fiscal 2009three-month and six-month periods of $.8 million relates to amortization of theintangible assets recorded in connection with the APF Acquisition.

 

**Foreign currency loss**in the fiscal 2009three-month period was a loss of $.1 million and in the fiscal 2009 six-monthperiod was a loss of less than $.1 million compared to a loss of $.2 millionand a loss of $.5 million, respectively, for the comparable periods in theprior year.  The fluctuations relate tothe change in the Canadian currency period over period.

 

**Income tax expense**for the fiscal 2009three-month period was $.2 million or an effective tax rate of 31.3% comparedto income tax expense of $.7 million or an effective tax rate of 40.6% for thefiscal 2008 three-month period.  Theincome tax expense for the fiscal year 2009 six-month period was $.9 million oran effective tax rate of 35.9% compared to income tax expense of $.1 million oran effective tax rate of 152.8% for the fiscal year 2008 six-month period.  Included in the income tax expense for thefiscal 2008 three-month and six-month periods is approximately $90,000 relatedto additional Canadian income taxes paid upon completion of our fiscal year2007 tax returns.  The effective taxexpense for the 2008 three-month and six-month periods, without the effect ofthe additional Canadian income tax expense, was 35.6% and 35.9%, respectively.

 

**Net income**for the fiscal 2009 three-monthperiod was $.3 million, compared to net income of $1.1 million for the comparableperiod in the prior year. Net income for the fiscal 2009 six-month period was a$1.6 million compared to a net loss of less than $.1 million for the comparableperiod in the prior year.

 

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**FINANCIAL CONDITION**

 

**Liquidity and Capital Resources**

 

**Net cash provided by operations** was $6.7million for the fiscal 2009 six-month period compared to $13.2 million for thefiscal 2008 six-month period. ** **Non-cash items, consisting ofstock-based compensation, deferred income taxes, depreciation and amortizationfor the fiscal 2009 six-month period totaled $13.5 million compared to $11.4million for the 2008 fiscal six-month period.**   **Cash flows used by changes inworking capital totaled $8.3 million for the fiscal 2009 six-month periodcompared to cash flows provided by changes in working capital of $1.8 millionin the fiscal 2008 six-month period. ** **With respect to the changes inaccounts receivable and inventory, cash used by these items was $10.7 millionfor the fiscal 2009 six-month period compared to $3.2 million for thecomparable period in the prior fiscal year. This increase is reflective of a change in payment terms with a keycustomer, timing of customer payments and an increase in sales.  Cash****used bychanges in prepaid expenses and other current assets was $.4 million for thefiscal 2009 six-month period compared to $1.7 million for the comparable periodin the prior fiscal year.  Cash providedby changes in accounts payable, accrued expenses and accrued interest for thefiscal 2009 six-month period was $2.8 million compared to $6.7 million for thecomparable period in the prior year.

 

**Net cash used in investing activities** for thefiscal 2009 six-month period was $68.6****millioncompared to net cash used in investing activities of $50.6 million for thefiscal 2008 six-month period.  The fiscal2009 six-month period includes $63.8 million of cash paid for the APFAcquisition.  The fiscal 2008 six-monthperiod includes $43.7 million of cash paid for the CityForest Acquisition, netof cash received.  The remaining changerelates to the level of capital spending period over period.

 

**Net cash provided by financing activities**forthe fiscal 2009 six-month period was $63.9 million, primarily related tofinancing obtained in connection with the APF Acquisition.   Net cash provided by financing activitiesfor the fiscal 2008 six-month period was $22.6 million related to financingobtained in connection with the City Forest Acquisition.

 

**9****3/****4% Senior SecuredNotes due 2010**

 

In March 2004, we completed a private offering of the OriginalNotes pursuant to and are governed by the Cellu Tissue Indenture among us, thesubsidiary guarantors party thereto and the Trustee.   In connection with the CityForestAcquisition, we entered into the Note Purchase Agreement with the Purchaser,dated March 21, 2007, pursuant to which we issued and sold the FirstAdditional Notes to the Purchaser for the purchase price of $20.0 million,which is equal to 98.7383% of the aggregate principal amount of the AdditionalNotes.  The First Additional Notes wereissued pursuant to and are governed by the Cellu Tissue Indenture.

 

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In connection with the APF Acquisition, we entered into the NotePurchase Agreements with each of the Purchasers, dated July 2, 2008,pursuant to which we issued and sold the Second Additional Notes to thePurchasers for the purchase price of $36,900,000 which is equal to 92.25% ofthe aggregate principal amount of the Second Additional Notes.  The Second Additional Notes were issuedpursuant to and are governed by the Cellu Tissue Indenture.

 

The Notes mature on March 15, 2010 and require semi-annualinterest payments on March 15 and September 15.  The Notes are collateralized by a seniorsecured interest in substantially all of our assets.  The Cellu Tissue Indenture contains certaincovenants, including limitations on certain restricted payments, the incurrenceof additional indebtedness and the sale of certain assets.    The Cellu Tissue Indenture has been amendedby two subsequent amendments pursuant to which CityForest, Cellu Happauge andCellu Thomaston became parties to the Cellu Tissue Indenture as subsidiaryguarantors (collectively, the “Additional Guarantors”).  As subsidiary guarantors, the AdditionalGuarantors, on a joint and several basis, with all the existing subsidiaryguarantors, fully, unconditionally and irrevocably guarantee the obligations ofCellu Tissue under the Cellu Tissue Indenture and Notes.  The Notes are unconditionally guaranteed byall of the Company’s subsidiaries.

 

***Seller Note Payable***

 

As part of the financing of the APF Acquisition, the Company enteredinto the Seller Note in the principal amount of $6,300,000.  Interest only at 12% is payable on the notein quarterly installments with the principal due July 2, 2011.

 

***Credit Agreement***

 

We entered into the Credit Agreement, among Cellu Tissue, Interlake,our Parent, the other loan guarantors party thereto, the U.S. Administrative Agent,the Canadian Administrative Agent and the other lenders party thereto.  The Credit Agreement provides for a $35.0million working capital facility, which was subseqeuently increased to $60.0million (see discussion following), including a letter of credit sub-facilityand swing-line loan sub-facility. The Credit Agreement provides that amountsunder the facility may be borrowed, repaid and re-borrowed, subject to aborrowing base test, until the maturity date, which is June 12, 2011. Anamount equal to $32.0 million, which was subsequently increased to $57.0million (see discussion following), is available, in U.S. dollars, to the U.S.Borrower under the facility and an amount equal to $3.0 million is available,in U.S. or Canadian dollars, to the Canadian Borrower under the facility.  Borrowings of $17.4 million were made tofinance a portion of the CityForest Acquisition and borrowings of $12.1 millionwere made to finance a portion of the APF Acquisition.   As of August 28, 2008, there was $23.0million of borrowings outstanding under the working capital facility and excessavailability was $30.2 million.

 

Cellu Tissuehas into the First Amendment, to the Credit Agreement dated June 12, 2006(as amended by the First Amendment, the “Amended Credit Agreement”) among Cellu

 

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Tissue,Interlake, certain subsidiaries of Cellu Tissue, the Parent, the U.S.Administrative Agent and the Canadian Administrative Agent.

 

The FirstAmendment (1) increases the working capital facility from $35.0 million to$40.0 million, (2) permits the issuance and sale by us of the FirstAdditional Notes, (3) provides for the consummation of the CityForestAcquisition and the conversion by CityForest from a Minnesota corporation to aMinnesota limited liability company, (4) permits the assumption ofapproximately $18.4 million in aggregate principal amount of indebtedness ofCityForest in connection with the CityForest Acquisition in accordance with theterms of the CityForest Bond Documents (as defined below under “CityForest BondDocuments”), and (5) permits the guarantee by Cellu Tissue of certainobligations of CityForest under the CityForest Bond Documents.  In connection with the First Amendment,CityForest became a guarantor of the obligations of the borrowers under theAmended Credit Agreement.

 

The Company has entered into the Second Amendment, to the CreditAgreement dated June 12, 2006 (as amended by the First Amendment, asAmended, and the Second Amendment, “Credit Agreement, as Amended”), among CelluTissue, Interlake, certain****subsidiariesof Cellu Tissue, the Parent, the U.S. Administrative Agent and the CanadianAdministrative Agent.

 

The Second Amendment (1) increases the working capital facility from$40.0 million to $60.0 million, (2) permits the issuance and sale by CelluTissue of the Second Additional Notes, (3) provides for the consummationof the APF Acquisition and (4) permits the issuance of the SellerNote.  In connection with the Second Amendment,Cellu Hauppauge and Cellu Thomaston became guarantors of the obligations of theborrowers under the Credit Agreement, as Amended.

 

***CityForest Bond Documents***

 

CityForest isparty to a Loan Agreement with the City of Ladysmith, Wisconsin, as Issuer.  Pursuant to the Loan Agreement, the Issuerloaned the proceeds of the Issuer’s Bonds to CityForest to finance theconstruction by CityForest of a solid waste disposal facility.  Approximately $18.4 million in aggregateprincipal amount of the Bonds was outstanding as of the date of the CityForestAcquisition.  CityForest is required,under the terms of the CityForest Indenture, to provide a letter of credit infavor of the Bonds Trustee.  CityForesthas entered into the Reimbursement Agreement with Associated Bank, pursuant towhich Associated Bank has extended the Associated Bank Letter of Credit and hasprovided the Associated Bank Revolving Credit Facility to CityForest in anaggregate principal amount of up to $3.5 million.

 

The BondsTrustee is permitted to draw upon the Associated Bank Letter of Credit to payprincipal and interest due on the Bonds, and to provide liquidity to purchaseBonds put to CityForest by bondholders and not remarketed; and CityForest isobligated under the Reimbursement Agreement to reimburse Associated Bank forany such draws. CityForest is also obligated to pay a fee in respect of theaggregate amount available to be drawn under the Associated Bank Letter ofCredit at a rate per annum initially equal to 1.25%, 

 

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subject toadjustment on a quarterly basis based on CityForest’s leverage.  The expiration date of the Associated BankLetter of Credit is February 15, 2011.

 

Amounts borrowed by CityForest under the Associated Bank RevolvingCredit Facility bear interest at a rate per annum equal to the LIBOR Rate (asdefined in the Reimbursement Agreement), plus an applicable margin. The applicablemargin percentage initially is 1.75%, subject to adjustment on a quarterlybasis based upon CityForest’s leverage. During the continuance of an event of default, the outstanding principalbalance bears interest at a rate per annum equal to the then applicableinterest rate plus 2.00%.  CityForest isalso obligated to pay a commitment fee in respect of any unused commitmentunder the Associated Bank Revolving Credit Facility in an amount equal to 0.50%per annum.  In addition, subject tocertain exceptions, if CityForest terminates the Associated Bank RevolvingCredit Facility prior to February 15, 2009, CityForest is obligated to payto Associated Bank a fee equal to 1.00% of the commitment then beingterminated. The maturity date of the Associated Bank Revolving Credit Facilityis February 15, 2011.

 

The Reimbursement Agreement requires scheduled semi-annual payments ofprincipal of the Bonds equal to approximately 2.00% of the principal amountoutstanding as of the date of the Acquisition, with the balance payable atmaturity of the Bonds on March 1, 2028. The Reimbursement Agreement alsocontains a number of other provisions regarding reserve funds and othermandatory and optional repayments in connection with the Bonds.  In addition, the Reimbursement Agreementprovides that in certain circumstances where we incur indebtedness in excess ofamounts currently permitted under the indenture or refinances the indebtednessissued under the CityForest Indenture, Associated Bank may require CityForestto repay all of its obligations to Associated Bank under the ReimbursementAgreement and either to cause the Bonds to be redeemed or to replace theAssociated Bank Letter of Credit with a Substitute Credit Facility, as suchterm is defined in the CityForest Indenture.

 

TheReimbursement Agreement contains various affirmative and negative covenantscustomary for working capital and term credit facilities, as well as additionalcovenants relating to the Bonds.  Thenegative covenants include limitations on: indebtedness; liens; acquisitions,mergers and consolidations; investments; guarantees; asset sales; sale andleaseback transactions; dividends and distributions; transactions withaffiliates; capital expenditures; and changes to the status of the Bonds. CityForestis also required to comply on a quarterly basis with a maximum leveragecovenant and a minimum fixed charge coverage covenant.  The Reimbursement Agreement also containscustomary events of default, including: payment defaults; breaches of representations and warranties; covenantdefaults; cross-defaults to certain other debt, including the Additional Notesand indebtedness under the Amended Credit Agreement; certain events ofbankruptcy and insolvency; judgment defaults; certain defaults related to theEmployee Retirement Income Security Act of 1974, as amended; and a change ofcontrol of CityForest or us.

 

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We haveguaranteed all of the obligations of CityForest under the ReimbursementAgreement, pursuant to the Cellu Tissue Guaranty executed by us in favor ofAssociated Bank. In addition, the obligations of CityForest under theReimbursement Agreement are secured by first-priority liens in favor ofAssociated Bank in all of CityForest’s assets. The U.S. Administrative Agent, the Canadian Administrative Agent,Associated Bank and CityForest have entered into an Intercreditor Agreement,dated March 21, 2007, which sets forth the respective rights andpriorities of Associated Bank, on the one hand, and the U.S. AdministrativeAgent and the Canadian Administrative Agent, on the other hand, as to thecollateral of CityForest securing the Reimbursement Agreement and the AmendedCredit Agreement.

 

In addition, we have entered into a Third Amendment to the CreditAgreement which changes the borrowings under the Credit Agreement so that $55.0million is available, in U.S. dollars, to the U.S. Borrower and $5.0 million isavailable, in U.S. or Canadian dollars, to the Canadian Borrower.

 

**Cash**as of August 28, 2008 increased to$2.6 million from $.9 million as of the end of fiscal year 2008.

 

**Receivables, net**as of August 28, 2008increased to $62.6 million from $44.5 million as of the end of fiscal year2008.  Included in the $62.6 million is$10.0 million of receivables related to APF. Without the effect of the acquisition, receivables increased $8.1million from the end of fiscal year 2008 due primarily to a change in paymentterms for a significant customer, timing of customer payments and an increasein sales.

 

**Inventory**as of August 28, 2008 increasedto $42.3 million from $34.0 million as of the end of fiscal year 2008.   Included in the $42.3 million is $7.8million of inventories related to APF. Without the effect of the acquisition, inventories increased $.5 millionfrom the end of fiscal year 2008.

 

**Property, plant and equipment, net**as of August 28,2008 decreased to $293.6 million from $296.6 million as of the end of fiscalyear 2008.  Included in the $293.6million of property, plant and equipment, net is $5.3 million related toAPF.  Without the effect of theacquisition, property, plant and equipment decreased $8.3 million from the endof fiscal year 2008.  This decreaserelates to depreciation expense for the period offset partially by capitalexpenditures for the period.

 

**Goodwill**as of August 28, 2008 increasedto $30.7 million from $7.0 million as of the end of fiscal year 2008 due to theacquisition of APF.

 

**Other intangibles, net**as of August 28,2008 increased to $38.1 million from $8.8 million as of the end of fiscal year2008.  The additions to other intangiblesrelate to the acquisition of APF.

 

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**Other assets**as of August 28, 2008increased to $2.1 million from $1.5 million as of the end of fiscal year 2008due to debt and bond issuance costs capitalized and included in other assetsresulting from the financing in connection with the APF Acquisition.

 

**Revolving line of credit**as of August 28,2008 increased to $23.0 million from $9.8 million as of the end of fiscal year2008 primarily due to additional borrowings in connection with the financing ofthe APF Acquisition.

 

**Accounts payable**as of August 28, 2008increased to $26.6 million from $24.1 million as of the end of fiscal year2008.  Included in the $26.6 million ofaccounts payable is $3.9 million related to APF.  Without the effect of the acquisition,accounts payable decreased $1.4 million from the end of fiscal year 2008 due totiming of payments.

 

**Accrued expenses**as of August 28, 2008increased to $22.8 million from $18.9 million as of the end of fiscal year2008.  Included in the $22.8 million ofaccrued expenses is $2.6 million related to APF.  Without the effect of the acquisition,accrued expenses increased $1.3 million due to timing.

 

**Long-term debt**as of August 28, 2008increased to $242.3 million from $198.8 million as of the end of fiscal year2008 due to debt incurred to finance the APF Acquisition.

 

**Capital in excess of par value**as of August 28,2008 increased to $62.5 million from $47.0 million as of the end of fiscal year2008 due to an equity investment by Parent to fund a portion of the APFAcquisition.

 

Critical Accounting Policies

 

Our critical accounting policies are discussed in Management’sDiscussion and Analysis of Financial Condition and Results of Operations in ourAnnual Report on Form 10-K for fiscal year 2008.  The preparation of our financial statementsrequires us to make estimates that affect the reported amounts of assets,liabilities, revenue and expenses and related disclosures of contingent assetsand liabilities.  We base our accountingestimates on historical experience and other factors that we believe to bereasonable under the circumstances. However, actual results may vary from these estimates under differentassumptions or conditions.

 

Derivatives and Hedging

 

We use derivative financial instruments to offset a substantial portionof its exposure to market risk arising from changes in the price of naturalgas. Hedging of this risk is accomplished by entering into forward swapcontracts, which are designated as hedges of specific quantities of natural gasexpected to be purchased in future months.   These contracts are held for purposes other than trading and aredesignated as cash flow hedges.  Wemeasure hedge effectiveness by formally assessing, at least quarterly, thecorrelation of the expected future cash flows of the hedged item and thederivative hedging instrument.  Theineffective portions of the hedges, which are not material for any period 

 

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presented, are immediately recognized in earnings.  We measure fair value of our derivativefinancial instruments in accordance with SFAS 157.  SFAS 157 defined fair value as the price thatwould be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants. SFAS 157 establishes a fairvalue hierarchy for valuation inputs that gives the highest priority to quotedprices in active markets for identical assets or liabilities and the lowestpriority to unobservable inputs.  Thefair value hierarchy is as follows:

 

Level 1-Inputs utilize quoted prices(unadjusted) in active markets for identical assets or liabilities that theCompany has the ability to access.

 

Level 2-Inputs utilize data points that areobservable such as quoted prices, interest rate and yield curves.

 

Level 3-Inputs are unobservable data pointsfor the asset or liability, and include situations where there is little, ifany, market activity for the asset or liability.

 

Derivatives are reported at fair value utilizing Level 2 inputs.   The fair value of these cash flow hedginginstruments was a liability of $.6 million and an asset of $.2 million as of August 28,2008 and February 29, 2008, respectively. During the next12 months, the entire $.6 million will be reclassified to earningsconsistent with the timing of the underlying hedged transactions.

 

New Accounting Pronouncements

 

In September 2006, the FASB issued SFAS 157.  We were required to adopt the provisions ofSFAS 157 effective March 1, 2008. SFAS 157 provides a common fair value hierarchy for companies to followin determining fair value measurements in the preparation of financialstatements and expands disclosure requirements relating to how such fair valuemeasurements were developed.  FAS157clarifies the principle that fair value should be based on the assumptions thatthe marketplace would use when pricing an asset or liability, rather thancompany specific data.  The adoption ofFAS No. 157 did not have a material impact on our results of operationsand financial position.

 

In February 2007, the FASB issued SFAS 159.  This Standard permits entities to choose tomeasure many financial instruments and certain other items at fair value thatare not currently required to be measured at fair value.  SFAS 159 was effective as of the beginning offiscal 2009 and we chose not to adopt these fair value provisions.

 

In December 2007, the FASB issued SFAS 141 (R) and SFAS160.  These new standards willsignificantly change the financial accounting and reporting of businesscombination transactions and noncontrolling (or minority) interests inconsolidated financial statements.  SFAS141 (R) is required to be adopted concurrently with FAS 160 and iseffective for business combination transactions for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008.

 

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Early adoption is prohibited.  Weare currently assessing the impact that SFAS 141 (R) and SFAS 160 willhave on our results of operations and financial position.

 

In March 2008, the FASB issued SFAS 161.  SFAS 161 requires entities to provideenhanced disclosures about derivative instruments and hedging activities.  SFAS 161 is effective for fiscal years andinterim periods beginning on or after November 15, 2008. We are currentlyassessing the impact that SFAS 161 will have on our results of operations andfinancial position.

 

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**Item 3. Quantitative and Qualitative Disclosures about Market Risk**

 

In March 2004, we completed a private offering of the Notes.  In connection with the acquisition ofCityForest in March 2007, we issued and sold approximately $20.0 millionof First Additional Notes and assumed $18.4 million of additional debt.  In connection with the APF Acquisition, weissued and sold approximately $40.0 million of Second Additional Notes. OurNotes mature on March 15, 2010.  Wealso have the ability to borrow under our revolving line of credit, up to $60.0million, of which as of August 28, 2008 we have outstanding borrowings of$23.0 million.  Borrowings of $12.1million were made to finance a portion of the APF Acquisition.  As a result, we are highly leveraged.    The interest on our revolving line ofcredit fluctuates based on prime plus .50% or LIBOR plus 1.75% depending onwhether our borrowing is based on prime or LIBOR rates.

 

We have minimal foreign currency translation risk.  All international sales, other than salesoriginating from our Canadian subsidiary, are denominated in U. S.dollars.  Due to our Canadian operations,however, we could be adversely affected by unfavorable fluctuations in foreigncurrency exchange rates.

 

We are also subject to commodity price risk associated withfluctuations in energy and pulp costs. We currently use derivative financial instruments to offset a portion ofour exposure to market risk arising from changes in the price of naturalgas.  We also continue to take advantageof spot prices on pulps to minimize market risk arising from changes in pulpcosts.

 

**Item 4. Controls and Procedures**

 

(a)           Disclosure Controls andProcedures.  The Company’s management,with the participation of the Company’s Chief Executive Officer and ChiefFinancial Officer, has evaluated the effectiveness of the Company’s disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of the end of the period covered by this report.  The Company’s Chief Executive Officer andChief Financial Officer have concluded that, as of the end of such period, theCompany’s disclosure controls and procedures are effective in ensuring themthat all material information required to be disclosed by the Company in thisQuarterly Report on Form 10-Q was recorded, processed, summarized,reported and properly disclosed in the time period specified in the rules andregulations of the Securities and Exchange Commission, and that suchinformation was accumulated and communicated to the Company’s management(including its Chief Executive Officer and Chief Financial Officer) to allow timelydecisions regarding required disclosure. Based on such evaluation, the Company’s Chief Executive Officer andChief Financial Officer have concluded that the Company is in compliance with Rule13a-15(e) of the Exchange Act.

 

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(b)         Changes in Internal Control Over FinancialReporting.  There have not been anychanges in the Company’s internal control over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) during the fiscal quarter to which this report relates that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

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PART II– OTHER INFORMATION

 

Item1A.  Risk Factors

 

The risk factors included in our Annual Report on Form 10-K forthe fiscal year ended February 29, 2008 have not materially changed.

 
| Item 6. | Exhibits                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|---------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| (a)     | Exhibits                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1    | Asset Purchase Agreement, dated July 2, 2008,  between Cellu Tissue Holdings, Inc. and Atlantic Paper & Foil  Corp. of N.Y., Atlantic Lakeside Properties, LLC, Atlantic Paper &  Foil, LLC, Atlantic Paper & Foil of Georgia, LLC and Consumer  Licensing Corporation, as Sellers (incorporated by reference to  Exhibit 10.1 to the Current Report on Form 8-K filed on July 8,  2008).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.2    | Note Purchase Agreement, dated July 2, 2008  between Cellu Tissue Holdings, Inc. and GMAM Investment Funds Trust II,  for the account of the Promark Alternative High Yield Bond Fund (Account  No. 7M2E), GMAM Investment Funds Trust, General Motors Welfare Benefit  Trust (VEBA), GMAM Investment Funds Trust II for the account of the Promark  Alternative High Yield Bond Fund (Account No. 7MWD), DDJ High Yield  Fund, Multi-Style, Multi-Manager Funds PLC The Global Strategic Yield Fund (f/k/a  Multi-Style, Multi-Manager Funds PLC The Global High Yield Fund), DDJ Capital  Management Group Trust, Stichting Pensioenfonds Hoogovens, Caterpillar Inc.  Master Retirement Trust, J.C. Penney Corporation, Inc. Pension Plan  Trust, Stichting Bewaarder Interpolis Pensioenen Global High Yield Pool,  DDJ/Ontario OS Investment Sub II, Ltd. and Stichting Pensioenfonds Metaal en  Techniek (incorporated by reference to Exhibit 10.3 to the Current  Report on Form 8-K filed on July 8, 2008). |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.3    | Note Purchase Agreement, dated July 2, 2008  between Cellu Tissue Holdings, Inc. and Claren Road Credit Master Fund,  Ltd (incorporated by reference to Exhibit 10.4 to the Current Report on  Form 8-K filed on July 8, 2008).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.4    | Note Purchase Agreement, dated July 2, 2008  between Cellu Tissue Holdings, Inc. and UBS High Yield Relationship  Fund, a series of the UBS Relationship funds (incorporated by reference to  Exhibit 10.5 to the Current Report on Form 8-K filed on  July 8, 2008).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.5    | Third Supplemental Indenture, dated July 2,  2008, by and among Cellu Tissue Holdings, Inc., the subsidiary  guarantors, and The Bank of New York Trust Company, N.A., as successor  trustee to The Bank of New York (incorporated by reference to  Exhibit 10.6 to the Current Report on Form 8-K filed on  July 8, 2008).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

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| 10.6   | Second Amendment, dated July 2, 2008 to the  Credit Agreement dated June 12, 2006 among Cellu Tissue, as U.S.  Borrower, Interlake Acquisition Corporation Limited, a subsidiary of Cellu  Tissue, as Canadian Borrower, certain subsidiaries of Cellu Tissue, Cellu  Paper Holdings, Inc., JPMorgan Chase Bank, N.A. and JPMorgan Chase Bank,  N.A., Toronto Branch (incorporated by reference to Exhibit 10.7 to the  Current Report on Form 8-K filed on July 8, 2008). |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.7   | Third Amendment, dated September 26, 2008 to  the Credit Agreement dated June 12, 2006 among Cellu Tissue, as U.S.  Borrower, Interlake Acquisition Corporation Limited, a subsidiary of Cellu  Tissue, as Canadian Borrower, certain subsidiaries of Cellu Tissue, Cellu  Paper Holdings, Inc., JPMorgan Chase Bank, N.A. and JPMorgan Chase Bank,  N.A., Toronto Branch                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 31.1   | Certification by President and Chief Executive  Officer pursuant to Rule 13a-14(a)                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 31.2   | Certification by Senior Vice President, Finance and  Chief Financial Officer pursuant to Rule 13a-14(a)                                                                                                                                                                                                                                                                                                                                                                                             |

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, asamended, the Registrant has duly caused this report to be signed on its behalfby the undersigned thereunto duly authorized.

 
|   | Cellu Tissue Holdings, Inc.         |
|--------|------------------------------------------|
|   |                                     |
|   |                                     |
| Date:  | October 10, 2008                    |   | /s/ Russell C. Taylor |
|   | Mr. Russell C. Taylor               |
|   | President and Chief Executive Officer    |
|   |                                     |
| Date:  | October 10, 2008                    |   | /s/ David J. Morris |
|   | Mr. David J. Morris                 |
|   | Senior Vice President, Finance and Chief |
|   | Financial Officer                        |
|        |                                          |  |  |  |

 

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