**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                         |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       | ** **                                                                                                                                                                                                     |
|       |       | **For the Quarterly Period Ended  November 24, 2005**                                                                                                                                                     |
|       |       | ** **                                                                                                                                                                                                     |
|       |       | **or**                                                                                                                                                                                                         |
|       |       | ** **                                                                                                                                                                                                     |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                        |
|       |       | ** **                                                                                                                                                                                                     |
|       |       | **For the  transition period from              to              .** |

 

**Commissionfile number 333-118829**

 

**Cellu Tissue Holdings, Inc.**

(Exact name of registrant asspecified in its charter)

 
| **Delaware**                                                | ** ** | **06-1346495**                    |
|-------------------------------------------------------------|------------|-----------------------------------|
| (State of incorporation)                                    |       | (IRS Employer Identification No.) |
|                                                        |       |                              |
| **3442 Francis Road Suite 220,  Alpharetta , Georgia** | ** ** | **30004**                         |
| (Address of principal executive offices)                    |       | (zip code)                        |
|                                                        |       |                              |
| **(678) 393-2651**                                          |
| (Registrant’s telephone number, including  area code)  |
|                                                        |       |                              |

**Not Applicable** (Former name,former address and former fiscal year, if changed since last 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 ý No o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). YesoNoý

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).   YesoNoý

 

The number of shares outstanding of each of theregistrant’s classes of common stock as of January 6, 2006:

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

 

 

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CELLU TISSUE HOLDINGS, INC.FORM 10-QQUARTER ENDED NOVEMBER 24, 2005

 

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 6. Exhibits                                                                                     |   |   |
|                                                                                                 |   |   |
| SIGNATURES                                                                                           |   |   |

 

2

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**PART I FINANCIAL INFORMATION**

 

**Item 1.  ConsolidatedFinancial Statements**

 

**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)**

 
| ** **                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **November 24**   | ** ** | **November 25**  | ** ** | **November 24** | ** ** | **November 25** | ** ** |
| ** **                                                 | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                       |       |                   |       |                  |       |   |   |   |   |
| Net sales                                                  |       | $                      | 81,512,440 |                  | $          | 85,689,504 |   | $ | 245,173,940 |   | $ | 250,749,125 |   |
| Cost of  goods sold                                        |       | 74,783,816             |       | 74,470,985            |       | 223,828,740 |   | 219,459,065 |   |
| Gross profit                                               |       | 6,728,624              |       | 11,218,519            |       | 21,345,200 |   | 31,290,060 |   |
|                                                       |       |                   |       |                  |       |   |   |   |   |
| Selling,  general and administrative expenses              |       | 3,317,418              |       | 3,670,287             |       | 9,475,114 |   | 11,455,770 |   |
| Restructuring  costs                                       |       | 1,031,593              |       | —                |       | 1,031,593 |   | — |   |
| Merger  related transaction costs                          |       | 1,477,300              |       | —                |       | 2,366,427 |   | — |   |
| Compensation  from redemption of stock options             |       | —                 |       | —                |       | — |   | 3,414,441 |   |
| Accelerated  vesting of stock options - noncash            |       | 64,248                 |       | —                |       | 64,248 |   | 533,551 |   |
| Income from  operations                                    |       | 838,065                |       | 7,548,232             |       | 8,407,818 |   | 15,886,298 |   |
|                                                       |       |                   |       |                  |       |   |   |   |   |
| Write-off of  debt issuance costs and prepayment penalties |       | —                 |       | —                |       | — |   | 3,318,495 |   |
| Interest  expense, net                                     |       | 4,300,112              |       | 4,429,706             |       | 12,748,606 |   | 13,069,662 |   |
| Foreign  currency loss                                     |       | 93,528                 |       | 658,371               |       | 377,713 |   | 854,759 |   |
| (Gain) loss  on sale of equipment, net                     |       | 12,566                 |       | 7,195                 |       | (12,261 | ) | (2,374,121 | ) |
| Other  (income) expense, net                               |       | (34,009                | )          | (7,906                | )          | (41,359 | ) | 17,252 |   |
| (Loss)  income before income tax expense (benefit)         |       | (3,534,132             | )          | 2,460,866             |       | (4,664,881 | ) | 1,000,251 |   |
|                                                       |       |                   |       |                  |       |   |   |   |   |
| Income tax  expense (benefit)                              |       | (2,303,667             | )          | 2,952,404             |       | (2,468,465 | ) | (1,045,970 | ) |
| Net (loss)  income                                         |       | $                      | (1,230,465 | )                     | $          | (491,538 | ) | $ | (2,196,416 | ) | $ | 2,046,221 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

 

3

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**CELLU TISSUE HOLDINGS, INC, AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                    | ** ** | **November 24** | ** **  | **February 28** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|-------------|----------------------|------------|
| ** **                                                                                                                                                    | ** ** | **2005**             | ** **  | **2005**             | ** ** |
| ** **                                                                                                                                                    | ** ** | **(Unaudited)**      | ** **  | ** **           | ** ** |
| **ASSETS**                                                                                                                                                    |       |                 |        |                 |       |
| CURRENT  ASSETS:                                                                                                                                              |       |                 |        |                 |       |
| Cash and cash equivalents                                                                                                                                     |       | $                    | 16,342,569  |                 | $          | 26,959,029 |   |
| Receivables, net                                                                                                                                              |       | 34,055,222           |        | 35,786,666           |       |
| Inventories                                                                                                                                                   |       | 29,466,032           |        | 24,601,068           |       |
| Prepaid expenses and other current assets                                                                                                                     |       | 4,266,391            |        | 3,499,414            |       |
| Income tax receivable                                                                                                                                         |       | 2,128,822            |        | —               |       |
| Deferred income taxes                                                                                                                                         |       | 1,251,295            |        | 1,294,851            |       |
| TOTAL CURRENT ASSETS                                                                                                                                          |       | 87,510,331           |        | 92,141,028           |       |
| PROPERTY,  PLANT AND EQUIPMENT, NET                                                                                                                           |       | 97,665,314           |        | 97,314,590           |       |
| DEBT  ISSUANCE COSTS                                                                                                                                          |       | 6,120,356            |        | 7,167,718            |       |
| GOODWILL                                                                                                                                                      |       | 13,723,935           |        | 13,723,935           |       |
| OTHER ASSETS                                                                                                                                                  |       | 185,936              |        | 190,220              |       |
| TOTAL ASSETS                                                                                                                                                  |       | $                    | 205,205,872 |                 | $          | 210,537,491 |   |
|                                                                                                                                                          |       |                 |        |                 |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIENCY)**                                                                                                   |       |                 |        |                 |       |
| CURRENT  LIABILITIES:                                                                                                                                         |       |                 |        |                 |       |
| Accounts payable                                                                                                                                              |       | $                    | 19,268,726  |                 | $          | 18,974,022 |   |
| Accrued expenses                                                                                                                                              |       | 14,825,438           |        | 15,156,693           |       |
| Accrued interest                                                                                                                                              |       | 3,261,162            |        | 7,416,122            |       |
| Current portion of long-term debt                                                                                                                             |       | 290,000              |        | 270,000              |       |
| TOTAL CURRENT LIABILITIES                                                                                                                                     |       | 37,645,326           |        | 41,816,837           |       |
| LONG-TERM  DEBT, LESS CURRENT PORTION                                                                                                                         |       | 160,711,362          |        | 160,790,288          |       |
| DEFERRED  INCOME TAXES                                                                                                                                        |       | 13,725,860           |        | 15,280,376           |       |
| OTHER  LIABILITIES                                                                                                                                            |       | 216,946              |        | 235,780              |       |
| STOCKHOLDERS’  EQUITY (DEFICIENCY):                                                                                                                      |       |                 |        |                 |       |
| Common stock, Class A, $.01 par value,  1,000 shares authorized, 100 shares issued and outstanding at November 24,  2005 and February 28, 2005 |       | 1                    |        | 1                    |       |
| Capital in excess of par value                                                                                                                                |       | 597,799              |        | 533,551              |       |
| Accumulated deficit                                                                                                                                           |       | (11,252,821          | )           | (9,056,405           | )          |
| Accumulated other comprehensive income                                                                                                                        |       | 3,561,399            |        | 937,063              |       |
| TOTAL STOCKHOLDERS’ EQUITY(DEFICIENCY)                                                                                                                   |       | (7,093,622           | )           | (7,585,790           | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIENCY)                                                                                                 |       | $                    | 205,205,872 |                 | $          | 210,537,491 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

4

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**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)**

 
| ** **                                                                                          | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                          | ** ** | **November 24**  | ** ** | **November 25** | ** ** |
| ** **                                                                                          | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities**                                                           |       |                  |       |   |   |
| Net (loss) income                                                                                   |       | $                     | (2,196,416 | ) | $ | 2,046,221 |   |
| Adjustments to reconcile net (loss) income  to net cash (used in) provided by operating activities: |       |                  |       |   |   |
| Write-off of debt issuance costs-noncash                                                            |       | —                |       | 2,894,868 |   |
| Accelerated vesting of stock  options-noncash                                                       |       | 64,248                |       | 533,551 |   |
| Deferred income taxes                                                                               |       | (1,510,960            | )          | 2,193,327 |   |
| Accretion of debt discount                                                                          |       | 221,074               |       | 221,896 |   |
| Amortization of intangibles                                                                         |       | 1,049,015             |       | 1,038,855 |   |
| Depreciation                                                                                        |       | 11,672,501            |       | 11,140,187 |   |
| Gain on sale of property, plant and  equipment                                                      |       | (12,261               | )          | (2,374,121 | ) |
| Stock based compensation                                                                            |       | —                |       | 388,888 |   |
| Changes in operating assets and  liabilities:                                                       |       |                  |       |   |   |
| Receivables                                                                                         |       | 1,731,444             |       | 2,813,843 |   |
| Inventories                                                                                         |       | (4,864,964            | )          | 2,246,836 |   |
| Prepaid expenses and other current assets                                                           |       | (766,977              | )          | (39,225 | ) |
| Income tax receivable                                                                               |       | (2,128,822            | )          | (4,534,158 | ) |
| Other assets                                                                                        |       | (14,550               | )          | 123,299 |   |
| Accounts payable, accrued expenses, accrued  interest and income taxes                              |       | (4,191,511            | )          | 3,322,104 |   |
| Total adjustments                                                                                   |       | 1,248,237             |       | 19,970,150 |   |
| *Net cash (used in) provided by operating  activities*                                              |       | (948,179              | )          | 22,016,371 |   |
|                                                                                                |       |                  |       |   |   |
| **Cash  flows from investing activities**                                                           |       |                  |       |   |   |
| Proceeds from sale of property, plant and  equipment, net                                           |       | —                |       | 4,003,727 |   |
| Capital expenditures                                                                                |       | (9,750,430            | )          | (7,676,415 | ) |
| *Net cash used in investing activities*                                                             |       | (9,750,430            | )          | (3,672,688 | ) |
|                                                                                                |       |                  |       |   |   |
| **Cash  flows from financing activities**                                                           |       |                  |       |   |   |
| Payments of long-term debt                                                                          |       | (280,000              | )          | (43,863,541 | ) |
| Proceeds from note offering                                                                         |       | —                |       | 160,200,180 |   |
| Payments on revolving line of credit, net                                                           |       | —                |       | (10,953,999 | ) |
| Cash dividends                                                                                      |       | —                |       | (96,788,801 | ) |
| Prepayment penalties                                                                                |       | —                |       | (423,627 | ) |
| Debt issuance costs                                                                                 |       | (1,653                | )          | (6,659,104 | ) |
| *Net cash (used in) provided by financing  activities*                                              |       | (281,653              | )          | 1,511,108 |   |
|                                                                                                |       |                  |       |   |   |
| Effect of  foreign currency                                                                         |       | 363,802               |       | 675,861 |   |
|                                                                                                |       |                  |       |   |   |
| *Net  (decrease) increase in cash and cash equivalents*                                             |       | (10,616,460           | )          | 20,530,652 |   |
| *Cash and  cash equivalents at beginning of period*                                                 |       | 26,959,029            |       | — |   |
| *Cash and  cash equivalents at end of period*                                                       |       | $                     | 16,342,569 |   | $ | 20,530,652 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

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**CelluTissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited)November 24, 2005**

 

**Note 1 Basis of Presentation and SignificantAccounting Policies**

 

The accompanying unaudited interim consolidated financial statementsinclude the accounts of Cellu Tissue Holdings, Inc.  (the “Company” ) and its wholly-ownedsubsidiaries.  The Company is awholly-owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”).  These statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States forcomplete financial statements.  In theopinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation have been included.  Operating results for the three- andnine-month periods ended November 24, 2005 are not necessarily indicativeof the results that may be expected for the fiscal year ending February 28,2006.  For further information, refer tothe Company’s consolidated financial statements and footnotes thereto as of February 28,2005 and for the year then ended, from which the consolidated balance sheet at February 28,2005 has been derived.

 

Reclassification

 

Certain prior year amounts have been reclassified to conform to thecurrent fiscal year 2006 presentation.

 

Stock Based Compensation

 

The Company accounts for stock options using the intrinsic value methodunder Accounting Principles Board (APB) Opinion No. 25, “*Accounting for Stock Issued to Employees”*(“APB No. 25”).  As such, it does not recognize compensationexpense associated with stock options to purchase the Parent’s common stockgranted under the Parent’s stock option plan, if the exercise price is at leastequal to the fair market value of the Parent’s common stock, as determined bythe Board of Directors, at the date granted. If applicable, stock-based compensation costs for stock awards arereflected in operating results over the awards’ vesting period.  If compensation expense for the Parent’sstock options had been determined using the fair value methodology consistentwith the method prescribed by Statement of Financial Standards (SFAS) No. 123,“*Accounting for Stock-Based Compensation”*(“FAS No. 123”), the Company’snet (loss) income would have been adjusted to the pro forma amounts indicatedbelow.

 

6

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| ** **                                                                                                         | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                         | ** ** | **November 24**           | ** ** | **November 25**          | ** ** | **November 24** | ** ** | **November 25** | ** ** |
| ** **                                                                                                         | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net (loss) income, as reported                                                                                     |       | $                              | (1,230,465 | )                             | $          | (491,538 | ) | $ | (2,196,416 | ) | $ | 2,046,221 |   |
| Add: stock-based employee compensation  expense included in reported net (loss) income, net of related tax effects |       | 22,358                         |       | —                        |       | 30,250 |   | (180,453 | ) |
| Less: stock-based employee compensation  expense determined under fair value method, net of related tax            |       | (13,829                        | )          | —                        |       | (65,686 | ) | (29,983 | ) |
| Pro forma net (loss) income, fair value  method                                                                    |       | $                              | (1,221,936 | )                             | $          | (491,538 | ) | $ | (2,231,852 | ) | $ | 1,895,751 |   |

 

Pro forma compensation expense related to the stock options isgenerally recognized over the vesting period. The vesting period used for all periods presented is three years.  The fair value of each option grant wasestimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted average assumptions:  risk-free interest rate of 4.16%, expectedoption lives of 4 years, zero dividend payments and no volatility.

 

In connection with the Company’s debt transaction (Note 4), the Parentaccelerated vesting of all unvested employee stock options.  As a result thereof, the APB 25 expense forthe nine-months ended November 25, 2004 recognized in the table above islarger than the expense calculated under FAS 123 as a portion of the expenseassociated with the accelerated vesting and cash paid for redemption of stockoptions would have been previously recognized if FAS 123 had been applied fromthe date of grant.

 

The Company may need to recognize additional expense should management’sestimate of the number of employees that will actually benefit from theaccelerated vesting of the options need to be adjusted.  The Company estimated and recognized $.5million of

 

7

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expense, prior to related tax effects, in the nine-month period ended November 25,2004, associated with employees that will actually benefit from the acceleratedvesting of the stock options.  TheCompany recognized expense of $64,248 in the three-month and nine-month periodsended November 24, 2005.  TheCompany updates its estimate each reporting period and adjusts the totalexpense recognized until the original vesting period associated with the stockoptions has expired.

 

Recent Accounting Pronouncements

 

In June 2005,the Financial Accounting Standards Board (“FASB”) issued Statement No. 154,“*Accounting Changes and Error Corrections-a replacementof APB Opinion No. 20 and FASB Statement No. 3*” (“SFAS 154”).This standard replaces APB Opinion No. 20, “*Accounting Changes”,* and FASB Statement No. 3, “*Reporting Accounting Changes in Interim FinancialStatements”,* and changes the requirements for the accounting andreporting of a change in accounting principle. SFAS 154 applies to allvoluntary changes in accounting principle and to changes required by anaccounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. SFAS 154 also requires that achange in depreciation, amortization, or depletion method for long-lived,nonfinancial assets be accounted for as a change in accounting estimateeffected by a change in accounting principle. SFAS 154 requires that the changein accounting principle be applied to the balances of assets and liabilities asof the beginning of the earliest period for which retrospective application ispracticable and that a corresponding adjustment be made to the opening balanceof retained earnings for that period rather than being reported in an incomestatement. Such a change would require the Company to restate its previouslyissued financial statements to reflect the change in accounting principle toprior periods presented. SFAS 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. The adoption of SFAS 154 will not have a material impact on the Company’sresults of operations and financial position.

 

In March 2005,FASB Interpretation No. 47, “*Accounting for ConditionalAsset Retirement Obligations (an interpretation of FASB Statement No. 143)*”(“FIN 47”) was issued. FIN 47 provides clarification with respect to the timingof liability recognition for legal obligations associated with the retirementof tangible long-lived assets when the timing and/or method of settlement ofthe obligation are conditional on a future event. The Company is currentlyevaluating the potential impact of FIN 47.

 

8

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In December 2004, the FASB issued SFAS No. 153, “*Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29*”(“SFAS 153”).  SFAS 153 amends theguidance in APB Opinion No. 29, “*Accounting for NonmonetaryTransactions*” by replacing the exception from fair value measurementfor nonmonetary exchanges of similar productive assets with an exception forexchanges that do not have commercial substance.  SFAS 153 specifies that a nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange.  The provisions of SFAS 153 are effective fornonmonetary asset exchanges occurring in fiscal years beginning after June 15,2005.  The Company does not expect theadoption of SFAS 153 to have a material impact on its results of operations andfinancial position.

 

In December 2004, the FASB issued Statement No. 123(revised), “*Share-Based Payment*”, which is arevision of FASB Statement No. 123, “*Accounting for Stock-BasedCompensation*”(“SFAS 123R”). SFAS 123R supersedes Accounting Principles Board Opinion No. 25, “*Accounting for Stock Issued to Employees*” (“APB 25”) andamends FASB Statement No. 95, “*Statement of Cash Flows*.”  Although the approach to quantifyingstock-based compensation expense in SFAS 123R is similar to SFAS 123, therevised statement requires all share-based payments to employees, includinggrants of employee stock options, to be recognized as an expense in the consolidatedstatements of operations based on their fair values as they are earned by theemployees under the vesting terms.  Proforma disclosure of stock-based compensation expense, as is the Company’spractice under SFAS 123, will not be permitted commencing with fiscal year2007, since SFAS 123R must be adopted by the Company at the beginning of thefirst annual period beginning after December 15, 2005.  Given the Company has applied a minimum-valueapproach, due to its lack of sufficient trading history to estimate expectedstock volatility, to estimating compensation expense associated with employeestock options under SFAS 123, it is required to use the prospective method ofSFAS 123R, whereby nonvested awards outstanding at the date of adoption of SFAS123R will continue to be accounted for in the same manner as they had beenprevious to the adoption.  All awardsgranted, modified or settled after adoption will be accounted for using themeasurement, recognition and attribute provisions of FAS 123R.

 

As permitted by SFAS 123, the Company currently accounts forstock-based compensation to employees under the APB 25 intrinsic value methodand generally recognizes no compensation cost for employee stock options.  Accordingly, the adoption of the SFAS 123Rfair value method will impact the Company’s results of operations.  The impact of adoption of SFAS 123R willdepend on levels of share-based

 

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compensation granted in the future and the fair value assigned thereto.   As permitted by SFAS 123, the Company usesthe actual forfeitures method, whereby pro forma compensation expense isreduced only when options are forfeited. Under SFAS 123R, the estimated forfeiture method is required, such thatexpected future forfeitures will be reflected as a reduction of stock-basedcompensation expense.  However, underSFAS 123R, reduction of compensation expense is not permitted if a vestedshare-based payment is later forfeited, as would occur when an out-of-the moneystock option is surrendered by a resigning employee.

 

In December 2004, the FASB issued FASB Staff Position No. FAS109-1, “*Application of FASB Statement No. 109,**Accounting for Income Taxes, to the Tax Deductionon Qualified Production Activities provided by the American Jobs Creation Actof 2004*” (“FAS 109-1”).  TheAmerican Jobs Creation Act of 2004 (the “AJCA”), introduces a special 9% taxdeduction when fully phased in on qualified production activities.   FAS 109-1 clarifies that this tax deductionshould be accounted for as a special tax deduction in accordance with Statement109.  The Company has determined that theamount of the special deduction for fiscal year 2006 will not have asignificant impact on the effective tax rate for the fiscal year.

 

In November 2004, the FASB issued SFAS No. 151, “*Inventory Costs, an amendment of ARB No. 43, Chapter 4*“(“SFAS151”).  SFAS 151 clarifies the accountingfor abnormal amounts of idle facility expense, freight, handling costs andspoilage.  In addition, SFAS 151 requiresthat allocation of fixed production overhead to the costs of conversion bebased on normal capacity of the production facilities.  The provisions of SFAS 151 are effective forinventory costs incurred during fiscal years beginning after June 15,2005.  The Company does not expect theadoption of SFAS 151 to have a material impact on its results of operations andfinancial position.

 

**Note 2 Inventories**

 

Components of inventories are as follows:

 
| ** **                        | ** ** | **November 24, 2005** | ** ** | **February 28, 2005** | ** ** |
|-----------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                              |       |                       |       |                       |       |
| Finished  goods                   |       | $                          | 17,790,076 |                       | $          | 14,028,875 |   |
| Raw  materials                    |       | 3,961,632                  |       | 3,910,698                  |       |
| Packaging  materials and supplies |       | 7,790,846                  |       | 6,740,649                  |       |
|                              |       | 29,542,554                 |       | 24,680,222                 |       |
| Inventory  reserves               |       | (76,522                    | )          | (79,154                    | )          |
|                              |       | $                          | 29,466,032 |                       | $          | 24,601,068 |   |

 

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**Note 3 Debt Issuance Costs**

 

Debt issuance costs consist of the following:

 
| ** **                     | ** ** | **November 24, 2005** | ** ** | **February 28, 2005** | ** ** |
|--------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                           |       |                       |       |                       |       |
| Debt  issuance costs           |       | $                          | 8,541,986  |                       | $          | 8,540,333 |   |
| Less  accumulated amortization |       | (2,421,630                 | )          | (1,372,615                 | )          |
|                           |       | $                          | 6,120,356  |                       | $          | 7,167,718 |   |

 

Amortization expense for the three months and nine months ended November 24,2005 and November 25, 2004 of $354,871 and $1,049,015, and $346,128 and$1,038,855, respectively, has been included in interest expense on thestatement of operations for all periods presented.

 

**Note 4 Long-Term Debt**

 

Long-term debt consists of the following:

 
| ** **                                                                                                      | ** ** | **November 24, 2005** | ** **  | **February 28, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------|-------------|----------------------------|------------|
| 9 3⁄4% senior  secured notes due 2010                                                                        |       | $                          | 162,000,000 |                       | $          | 162,000,000 |   |
| Less discount                                                                                                   |       | (1,288,638                 | )           | (1,509,712                 | )          |
|                                                                                                            |       | 160,711,362                |        | 160,490,288                |       |
| Industrial revenue bond payable, in annual  installments, plus interest ranging from 4.8% to 6.65%, due in 2006 |       | 290,000                    |        | 570,000                    |       |
|                                                                                                            |       | 161,001,362                |        | 161,060,288                |       |
| Less current  portion of debt                                                                                   |       | 290,000                    |        | 270,000                    |       |
|                                                                                                            |       | $                          | 160,711,362 |                       | $          | 160,790,288 |   |

 

In March 2004, the Company completed a Rule 144A offering of$162.0 million principal amount of 9 3⁄4% senior secured notes due 2010 (the “Notes”).  The Company raised $152.2 million, net ofdebt issuance costs of $8.0 million and original issuance discount of $1.8million.  At the same time, the Companyentered into a new $30.0 million revolving working capital facility with CITGroup/Business Credit Inc.  A portion ofthe proceeds, along with a drawdown from the new working capital facility, wereused to pay-off existing debt of approximately $56.0 million.  Furthermore, the Company used approximately$100.2 million of the proceeds to fund a stockholder dividend to its Parent torepurchase a portion of its common stock and warrants and fund compensationfrom the redemption of employee stock options ($3.4 million).  As a result of the

 

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extinguishment of debt, approximately $2.9 million of debt issuancecosts previously capitalized were written off and the Company incurredapproximately $.4 million in prepayment penalties.  The total amount of $3.3 million is reflectedas a write-off of debt issuance costs and prepayment penalties in the fiscalyear 2005 statement of operations.

 

The Notes mature on March 15, 2010 and require semi-annualinterest payments on March 15 and September 15, which commenced on September 15,2004.   The Notes are collateralized by asenior secured interest in substantially all of the Company’s assets.  Terms of the indenture under which the Noteshave been issued contain certain covenants, including limitations on certainrestricted payments and the incurrence of additional indebtedness.  The Notes are unconditionally guaranteed byall of the Company’s subsidiaries.

 

As of November 24, 2005 and February 28, 2005, there were nooutstanding borrowings under the working capital facility.

 

**Note 5 Stockholders’ Equity (Deficiency)**

 

The Company used approximately $96.8 million of the proceeds from theNotes to fund a stockholder dividend to the Parent to repurchase a portion ofits common stock and warrants. Approximately $66.2 million was charged to capital in excess of parvalue, reducing this balance to zero and the remaining $30.6 million was chargedto accumulated earnings, resulting in a deficiency.

 

**Note 6 Comprehensive Income**

 

The components of comprehensive income for the three months and ninemonths ended November 24, 2005 and November 25, 2004 are as follows:

 
| ** **                                | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended**      | ** ** |
|-------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | **November 24, 2005** | ** ** | **November 25, 2004** | ** ** | **November 24,2005** | ** ** | **November 25,2004** | ** ** |
| Net (loss)  income                        |       | $                          | (1,230,465 | )                          | $          | (491,538 | ) | $ | (2,196,416 | ) | $ | 2,046,221 |   |
| Foreign  currency translation adjustments |       | 2,391,620                  |       | 568,746                    |       | 2,624,336 |   | 675,861 |   |
| Comprehensive  income                     |       | $                          | 1,161,155  |                       | $          | 77,208 |   | $ | 427,920 |   | $ | 2,722,082 |   |

 

Included in foreign currency translation adjustments for the threemonths and nine months ended November 24, 2005 is a one-time adjustment of$2.3 million to correct the cumulative effect of improperly translatingthe  value of property, plant andequipment.  Historically, the translationof these assets from Canadian dollars to U.S dollars had been occurring athistorical rates, as opposed to actual month-end rates, as

 

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required under FAS 52,”*Foreign CurrencyTranslation”*.

 

**Note 7 Gain on Sale of Equipment**

 

In July 2004, the Company sold a previously idled paper machine atits Menominee mill and recorded a gain on the sale of $2.4 million.  The net proceeds from the sale were $4.0million (gross proceeds of $5.2 million less brokerage fees and other directcosts of $1.2 million).

 

**Note 8 Business Segments**

 

The Company operates in two reportable business segments:  tissue and machine-glazed paper.  The Company assesses the performance of itsreportable business segments using income from operations.  Income from operations excludes interestincome, interest expense, income tax expense, write-off of debt issuance costsand prepayment penalties, the impact of foreign currency gains and losses, andgain on sale of equipment.   A portion ofcorporate and shared expenses is allocated to each segment.   Included in the three-months and nine-monthsended November 24, 2005 income from operations is $1.0 million related torestructuring activities.  Of thisamount, $.8 million impacts the machine-glazed paper segment and $.2 millionimpacts the tissue segment.  Also includedin the three-months and nine-months ended November 24, 2005 income fromoperations is $1.5 million and $2.4 million, respectively of merger relatedtransaction costs.  Of these amounts, $.5million and $.8 million, respectively impacts the machine-glazed paper segmentand $1.0 million and $1.6 million, respectively impacts the tissue segment.

 
| ** **                                                 | ** ** | **Three Months Ended**      | ** ** | **Nine Months Ended**       | ** ** |
|------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                 | ** ** | **November 24,  2005** | ** ** | **November 25,  2004** | ** ** | **November 24,  2005** | ** ** | **November 25,  2004** | ** ** |
| **Net  Sales**                                             |       |                        |       |                        |       |   |   |   |   |
| Tissue                                                     |       | $                           | 56,845,036 |                        | $          | 56,606,229 |   | $ | 173,774,486 |   | $ | 172,119,692 |   |
| Machine-glazed  paper                                      |       | 24,667,404                  |       | 29,083,275                  |       | 71,399,454 |   | 78,629,433 |   |
| Consolidated                                               |       | $                           | 81,512,440 |                        | $          | 85,689,504 |   | $ | 245,173,940 |   | $ | 250,749,125 |   |
| **Income  (loss) from operations**                         |       |                        |       |                        |       |   |   |   |   |
| Tissue                                                     |       | $                           | 1,096,191  |                        | $          | 4,391,221 |   | $ | 6,440,834 |   | $ | 10,407,766 |   |
| Machine-glazed  paper                                      |       | (258,126                    | )          | 3,157,011                   |       | 1,966,984 |   | 5,478,532 |   |
| Consolidated                                               |       | 838,065                     |       | 7,548,232                   |       | 8,407,818 |   | 15,886,298 |   |
| Write-off of debt issuance costs and  prepayment penalties |       |                        |       |                        |       |   |   | (3,318,495 | ) |
| Interest  expense                                          |       | (4,376,268                  | )          | (4,453,072                  | )          | (12,938,577 | ) | (13,102,400 | ) |
| Net foreign  currency transaction loss                     |       | (93,528                     | )          | (658,371                    | )          | (377,713 | ) | (854,759 | ) |
| Interest  income                                           |       | 76,156                      |       | 23,366                      |       | 189,971 |   | 32,738 |   |
| Other income                                               |       | 21,443                      |       | 711                         |       | 53,620 |   | 2,356,869 |   |
| Pretax  (loss) income                                      |       | $                           | (3,534,132 | )                           | $          | 2,460,866 |   | $ | (4,664,881 | ) | $ | 1,000,251 |   |

 

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| ** **                | ** ** | **Three Months Ended**      | ** ** | **Nine Months Ended**       | ** ** |
|---------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                | ** ** | **November 24,  2005** | ** ** | **November 25,  2004** | ** ** | **November 24,  2005** | ** ** | **November 25,  2004** | ** ** |
|                      |       |                        |       |                        |       |   |   |   |   |
| **Capital  Expenditures** |       |                        |       |                        |       |   |   |   |   |
| Tissue                    |       | $                           | (1,939,387 | )                           | $          | (3,963,961 | ) | $ | (8,380,928 | ) | $ | (6,792,685 | ) |
| Machine-glazed  paper     |       | (271,760                    | )          | (441,226                    | )          | (658,502 | ) | (708,287 | ) |
| Corporate                 |       | (127,544                    | )          | (87,934                     | )          | (711,000 | ) | (175,443 | ) |
| Consolidated              |       | $                           | (2,338,691 | )                           | $          | (4,493,121 | ) | $ | (9,750,430 | ) | $ | (7,676,415 | ) |
|                      |       |                        |       |                        |       |   |   |   |   |
| **Depreciation**          |       |                        |       |                        |       |   |   |   |   |
| Tissue                    |       | $                           | 2,630,153  |                        | $          | 2,373,774 |   | $ | 7,845,595 |   | $ | 6,942,742 |   |
| Machine-glazed  paper     |       | 971,036                     |       | 1,457,060                   |       | 3,826,906 |   | 4,197,445 |   |
| Consolidated              |       | $                           | 3,601,189  |                        | $          | 3,830,834 |   | $ | 11,672,501 |   | $ | 11,140,187 |   |

 

**Note 9 Income Taxes**

 

Income tax benefit for the three months ended November 24, 2005was 65.2% compared to income tax expense for the three months ended November 25,2004 of 120%.  Income tax benefit for thenine months ended November 24, 2005 was 52.9% compared to income taxbenefit for the nine months ended November 25, 2004 of 105%.  Included in the 52.9% effective tax rate forthe nine months ended November 24, 2005 is approximately $1.2 million ofbenefit related to the different book and tax treatment of deductions relatedto stock compensation matters.  Thisbenefit has been recorded in the current quarter upon completion of the Company’s2005 tax return as the impact is considered discrete to this quarter.  Also, included in this effective rate is $.1million of tax expense related to Canadian withholding tax.  Without these items, the effective tax ratefor the nine-month period ended November 24, 2005 is 29.8% (benefit of$1.4 million) on the cumulative loss recognized for this period.  The effective tax rate is calculated based onthe Company’s projected fiscal 2006 pretax operating results and expectedbook-to-tax permanent differences. The significant benefit recorded in theprior year (105% for the nine months ended November 25, 2004) wasprimarily related to the book-to-tax permanent differences generated due to theoffering of the Notes, which occurred in the first quarter of the prior year.

 

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**Note 10 Agreement and Plan of Merger**

 

On June 14, 2005, the Parent entered into an Agreement and Plan ofMerger with an affiliate of Kohlberg & Company, a Mt. Kisco, NewYork-based private equity firm (“Kohlberg”), pursuant to which Kohlberg wouldacquire the Parent for total consideration (including assumption of debt) ofapproximately $276 million, subject to certain adjustments.

 

The merger agreement was terminated as of the close of business on October 6,2005 by the mutual consent of the parties.

 

As of November 24, 2005, the Company had expensed approximately$2.4 million in costs associated with the proposed transaction.  These costs are shown separately on theCompany’s 2006 statement of operations for the nine-months ended November 24,2005.

 

**Note 11 Restructuring Activities**

 

On September 26, 2005, the Company announced to its employees itsintention to indefinitely idle one of its paper machines at its Interlakefacility in Ontario, Canada effective November 21, 2005.  The Company is currently evaluating businessalternatives with respect to the idle machine. This decision was due to significant increases in manufacturing coststhat the Company was unable to pass on to the machine-glazed segmentmarket.  As a result of this action, 48employees were terminated on that date.  In connection therewith, the Company has estimated severance costs ofapproximately $.7 million (“Interlake restructuring”).   The Company has also recorded approximately$.3 million related to severance costs associated with a change in thecorporate organizational structure of the Company (“Corporate restructuring”).  The total restructuring costs of $1.0 millionhave been recorded as a separate line item in the Company’s statement ofoperations for the three-months ended November 24, 2005.  As of November 24, 2005, the restructuringaccrual on the balance sheet is approximately $.6 million related to theInterlake restructuring and approximately $.2 million related to the corporaterestructuring.

 

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**Note 12 Hurricane Katrina**

 

On August 29, 2005, the Company’s facility in Wiggins, Mississippiwas in the direct path of Hurricane Katrina. As a result of the storm, the mill was shut down for a week, duringwhich time the Company worked with its customers to source their needs from itsother five facilities.  The Companymaintains property and business interruption insurance and has determined thetotal cost of the hurricane damage and business interruption to beapproximately $.9 million.  The Companyhas submitted an insurance claim and will collect approximately $.2 million,after deductibles.  This amount has beenrecorded as a receivable on the Company’s November 24, 2005 balance sheet.

 

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**Item 2.  MANAGEMENT’S DISCUSSIONAND ANALYSIS OF 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 involve knownor unknown risks, uncertainties and other factors which may cause our actualresults, performance or achievements to be materially different from futureresults, 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 generallyidentifiable by 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 Forward-Looking Statements in our Annual Report on Form 10-Kfor our fiscal year ended February 28, 2005.  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.

 

We operate in two reportable business segments:  tissue and machine-glazed paper.  We assess the performance of our reportablebusiness segments using income from operations. Income from operations excludes interest income, interest expense,income tax expense (benefit), write-off of debt issuance costs and prepaymentpenalties, gain on sale of equipment, other income, other expense, and theimpact of foreign currency gains and losses.

 

**RESULTS OF OPERATIONS**

 

**Results of Operations for the Three Months EndedNovember 24, 2005 (the fiscal 2006 three-month period) compared to theThree Months Ended November 25, 2004 (the fiscal 2005 three-month period)and the Nine Months Ended November 24, 2005 (the fiscal 2006 nine-monthperiod) compared to the Nine Months ended November 25, 2004 (the fiscal2005 nine-month period)**

 

**Net sales** for thefiscal 2006 three-month period decreased $4.2 million, or 4.9%, to****$81.5****million from$85.7 million for the comparable period in the prior year. Net sales for thefiscal 2006 nine-month period decreased $5.5 million, or 2.2%, to $245.2 from$250.7 million for the comparable period in the prior year.  On a Company-wide basis, tons sold hasdecreased for the fiscal 2006 three-month period and the fiscal 2006 nine-monthperiod from the comparable period in the prior year.  For the fiscal 2006 three-month period, wesold 63,988****tons of tissue hard rolls,machine-glazed paper hard rolls

 

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and converted paper products, a decrease of 3,229****tons,or 4.8%.  For the fiscal 2006 nine-monthperiod, we sold****194,154 tons of tissue hardrolls, machine-glazed paper hard rolls and converted paper products, a decreaseof****9,068 tons, or 4.5%.  Contributing to the decrease in volume soldfor the fiscal 2006 three-month period was the reduced operating schedule andultimate shutdown of one of the machines at our Interlake facility, aspreviously announced.  Additionally,volume sold in September 2005 was less than the same month in the prioryear due to the shutdown of our Mississippi mill resulting from HurricaneKatrina.  The decrease in tons sold inthe nine-month period was attributable to the items discussed above and ashortfall in our machine-glazed segment volume experienced in the first quarterof fiscal year 2006.  Partiallyoffsetting the decrease in volume sold for the fiscal 2006 nine-month periodover the prior year was an increase in net selling price per ton from $1,234 to$1,263 for the fiscal 2006 nine-month period.

 

Net sales for our tissue segment for the fiscal 2006 three-month periodwere $56.8 million, an increase of $.2 million, or .4%, from $56.6 million forthe comparable period in the****prioryear.  Net sales for our tissue segmentfor the fiscal 2006 nine-month period were $173.8 million, an increase of $1.7million, or .9%, from $172.1 million for the comparable period in the prioryear.  In both periods, growth in tissueconverted product sales is being offset by unfavorable tissue hard rollmix.  The unfavorable tissue hard rollmix includes the loss of two premium specialty hard roll accounts that moved tonon-woven****substitutes.****Netsales for our machine-glazed segment for the 2006 three-month period were****$24.7 million, a decrease of $4.4 million, or 15.2%,****from $29.1 million for the comparable period in the prioryear.  Net sales for our machine-glazedsegment for the 2006 nine-month period were $71.4 million, a decrease of $7.2million, or 9.2% from $78.6 million for the comparable period in the prioryear.   This decrease is driven by lowervolume experienced in the 2006 nine-month period and by unfavorable price/mix.

 

**Gross profit** for thefiscal 2006 three-month period decreased to $6.7 million from $11.2 million, adecrease of $4.5 million, or 40.0%, from the comparable period in the prior****year. **  **Gross profit for the fiscal 2006nine-month period decreased to $21.3 million from $31.3 million, a decrease of$10.0 million, or 31.8%, from the comparable period in the prior year.  As a percentage of net sales, gross profitdecreased to 8.3% in the fiscal 2006 three-month period and 8.7% in the fiscal2006 nine-month period from 13.1% in the fiscal 2005 three-month period and12.5% in the fiscal 2005 nine-month period. ** **The decrease in gross profit in thefiscal 2006 three-month period and fiscal 2006 nine-month period is primarilydue to significant market price increases for both natural gas andelectricity.  The effect of the increasein energy prices for the fiscal 2006 three-month period was $4.1 million.  Absent these energy price increases, grossmargin for the fiscal 2006 three-month period would have been 13.2% compared to13.1 % for the comparable period in the prior year.  The effect of the increase in energy pricesfor the fiscal 2006 nine-month period was $7.8 million.  Absent these energy price increases, grossmargin for the fiscal 2006 nine-month period would have been 11.9% compared to12.5% for the comparable period in the prior year.  We anticipate that the current trends inmarket energy prices for natural gas will continue at least through the wintermonths.  Additionally, the state ofMississippi has announced electrical rate increases of 15%-22% for calendaryear 2006.  We anticipate that otherstates will also be implementing sizable

 

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increases.  Other factors whichnegatively impacted gross profit in the fiscal 2006 three-month period andfiscal 2006 nine-month period were unfavorable machined-glazed segment volumeand machine-glazed and tissue hard roll price/mix as described above.  These negative factors were partially offsetby the growth in gross profit of the tissue converting business.

 

Gross profit for our tissue segment for the fiscal 2006 three-monthperiod was $4.5 million, a decrease of $2.3 million, or 34.1%, from $6.8million for the comparable period in the prior year.  Gross profit for our tissue segment for thefiscal 2006 nine-month period was $14.5 million, a decrease of $6.1 million, or29.3%, from $20.6 million  for thecomparable period in the prior year. Gross profit for our machine-glazed segment for the fiscal 2006three-month period was $2.2 million, a decrease of $2.2 million, or 49.2%, from$4.4 million for the comparable period in the prior year.  Gross profit for our machine-glazed segmentfor the fiscal 2006 nine-month period was $6.8 million, a decrease of $3.9million, or 36.5%, from $10.7 million for the comparable period in the prioryear.  As a percentage of net sales,gross profit for the tissue segment decreased to 7.9% in the fiscal 2006three-month period and 8.3% in the fiscal 2006 nine-month period from 12.0% inthe fiscal 2005 three-month period and 11.9% in the fiscal 2005 nine-monthperiod.  As a percentage of net sales,gross profit for the machine-glazed segment decreased to 9.1% in the fiscal2006 three-month period and 9.6% in the fiscal 2006 nine-month period from15.2% in the fiscal 2005 three-month period and 13.7% in the fiscal 2005nine-month period. The decrease in the tissue segment is primarily driven by theincrease in market energy prices as described above and unfavorable hard rollmix, both of which more than offset the improved gross profit in tissueconverting.  The decrease in themachine-glazed segment is attributable to the increase in market energy prices,the decrease in tons sold and unfavorable price/mix.

 

**Selling, general and administrative expenses**inthe fiscal 2006 three-month period decreased $.4 million, or 9.6 % to $3.3million from $3.7 million in the fiscal 2005 three-month period.  Selling, general and administrative expensesin the fiscal 2006 nine-month period decreased $2.0 million, or 17.3%, to $9.5million from $11.5 million in the fiscal 2005 nine-month period.  As a percentage of net sales, selling,general and administrative expenses decreased to****4.1%in the fiscal 2006 three-month period and 3.9% in the fiscal 2006 nine-monthperiod from 4.3% in the fiscal 2005 three-month period and 4.6% in the fiscal2005 nine-month period.  Included in thefiscal 2005 three-month and nine-month periods is the accrual of businessperformance bonuses and non-cash compensation expense related to the vesting ofa restricted common stock award to our chief executive officer.   There was no accrual of business performancebonuses in the fiscal 2006 three-month and nine-month periods and nocompensation expense related to the restricted common stock award as it wasfully vested at the end of fiscal year 2005.

 

**Restructuring costs**inthe fiscal 2006 three-month and nine-month period were $1.0 million, of which$.7 million related to our fiscal 2006 decision to indefinitely idle one of ourpaper machines at our Interlake facility and the resulting severance coststhereof.  Furthermore,****we have also recorded approximately $.3 million related toseverance costs associated with the corporate organizational restructuring.

 

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**Merger related transaction costs**inthe fiscal 2006 three-month period were $1.5 million and in the fiscal 2006nine-month period were $2.4 million associated with the June 14, 2005proposed transaction with an affiliate of Kohlberg & Company, whichwas subsequently terminated on October 6, 2005, by mutual consent of theparties.

 

**Compensation from the redemption of stockoptions and accelerated vesting of stock options**includedin the fiscal 2005 nine-month period income from operations is $3.9 million;$3.4 million related to compensation from the redemption of stock options and$.5 million related to accelerated vesting of certain stock options, bothtriggered by the offering of the Notes completed in March 2004.  With respect to the $.5 million related toaccelerated vesting of certain stock options, $.3 million was recorded in thesecond quarter of fiscal 2005 and $.2 million was recorded in the first quarterof fiscal 2005.  Furthermore, we haverecorded $.1 million in the fiscal 2006 three-month period related toaccelerated vesting of certain stock options. We may need to recognize additional expense should management’s estimateof the number of employees that will actually benefit from the acceleratedvesting of the options need to be adjusted. Management will update its estimate each reporting period and adjust thetotal expense recognized until the original vesting period associated with theoptions has expired.

 

**Write-off of debt issuance costs andprepayment penalties**of $3.3 million included in thefiscal  2005 nine-month period incomefrom operations was an expense incurred primarily related to the write-off ofdebt issuance costs (non-cash) previously capitalized and associated with debtthat was extinguished in March 2004 with proceeds from the offering of theNotes.  No such expense was recognized inthe fiscal 2006 nine-month period.

 

**Gain on sale of equipment**of$2.4 million included in the fiscal 2005 nine-month period relates to the saleof a paper machine at our Menominee mill. Net proceeds from the sale were $4.0 million (gross proceeds of $5.2million less brokerage fees and other direct costs of $1.2 million).

 

**Income tax expense (benefit)**for the fiscal 2006 three-month period was a benefit of 65.2%****compared to income tax expense for the fiscal 2005three-month period of 120%**. **Income tax benefit for the fiscal2006 nine-month period was 52.9%****compared toincome tax benefit for the fiscal 2005 nine-month period of 105%.****  Included in the52.9% effective tax rate for the nine months ended November 24, 2005 isapproximately $1.2 million of benefit related to the different book and taxtreatment of deductions related to stock compensation matters.  This benefit has been recorded in the currentquarter upon completion of our 2005 tax return as the impact is considereddiscrete to this quarter.  Also, includedin this effective rate is $.1 million of tax expense related to Canadianwithholding tax.  Without these items,the effective tax rate for the nine-month period ended November 24, 2005is 29.8% (benefit of $1.4 million) on the cumulative loss recognized for thisperiod.  The effective tax rate iscalculated based on our projected fiscal 2006 pretax operating results andexpected book-to-tax permanent differences. The significant benefit recorded inthe prior year (105% for the nine months ended November

 

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25, 2004) was primarily related to the book-to-tax permanentdifferences generated due to the offering of the Notes, which occurred in thefirst quarter of the prior year.

 

**Net (loss) income**for the fiscal 2006 three-month period was a net loss of $1.2 million, comparedto net loss of $.5 million for the comparable period in the prior year.****Net loss for the fiscal 2006 nine-month period was a netloss of $2.2 million,****compared tonet income of $2.0 million for the comparable period in the prior year.

 

**FINANCIAL CONDITION**

 

**Liquidity and Capital Resources**

 

**Net cash used in operations**was $.9 million for the fiscal 2006 nine-month period, compared to net cashprovided by operations of $22.0 million for the fiscal 2005 nine-month period. ** **Significant non-cashitems included in the comparable period in the prior fiscal year were $2.9million for the write-off of debt issuance costs and $.5 million related toaccelerated vesting of stock options, which are related to the $162.0 millionNotes offering completed in the fiscal 2005 nine-month period.   These charges are offset by a gain on saleof equipment of $2.4 million.  Net ofthese items, non-cash items for the fiscal 2005 nine-month period totaled $15.1million compared to $11.5 million for the 2006 fiscal nine-month period.**   **Cash flows used bychanges in working capital totaled $10.2 million for the fiscal 2006 nine-monthperiod, compared to cash flows provided of $3.9 million in the fiscal 2005nine-month period. ** **With respect to the changes inaccounts receivable and inventory, cash used by these items was $3.1 millionfor the fiscal 2006 nine-month period compared to cash provided by these itemsof $5.0 million for the comparable period in the prior fiscal year.  Cash****used bychanges in prepaid expenses and other current assets was $.8 million for thefiscal 2006 nine-month period compared to cash provided of $.1 million for thecomparable period in the prior fiscal year. Cash used by changes in income tax receivable was $2.1 million for thefiscal 2006 nine-month period compared to cash used of $4.5 million for thecomparable period in the prior year. Cash used by changes in accounts payable, accrued expenses, accruedinterest and income taxes for the fiscal 2006 nine-month period was $4.2million compared to cash provided of $3.3 million for the comparable period inthe prior year.

 

**Net cash used in investing activities**for the fiscal 2006 nine-month period was $9.8****millioncompared to net cash used in investing activities of $3.7 million for thefiscal 2005 nine-month period.  Thechange relates to the level of capital spending period over period, offset inthe prior year by the machine sale proceeds.

 

**Net cash used in financing activities**for the fiscal 2006 nine-month period was $.3****millioncompared to net cash provided by financing activities of $1.5 million for thefiscal 2005 nine-month period.  Net cashused in the fiscal 2006 nine-month period relates primarily to payments on ourindustrial revenue bond. In the comparable period in the prior fiscal year,proceeds, net of $1.8 million of original issue discount, from the Noteoffering (see discussion below) of $160.2 million were offset by net paymentson

 

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long-term debt and the revolving line of credit of $43.9 million and$11.0 million, respectively, $96.8 million to fund dividends to our Parent torepurchase shares of our parent’s common stock and warrants, prepaymentpenalties of $.4 million and debt issuance costs of $6.7 million.

 

In March 2004, we completed a Rule 144A offering of $162.0million aggregate principle amount of Notes due 2010.  We raised $152.2 million, net of debtissuance costs of $8.0 million and original issuance discount of $1.8 million.   At the same time, we entered into a new$30.0 million revolving working capital facility with CIT Group/Business CreditInc. A portion of the proceeds, along with a drawdown from the new workingcapital facility, were used to pay-off existing debt of approximately $56.0million.  As a result of the extinguishmentof debt, approximately $2.9 million of debt issuance costs previouslycapitalized were written-off and we incurred approximately $.4 million inprepayment penalties.  The total amountof $3.3 million is reflected as write-off of debt issuance costs and prepaymentpenalties on the fiscal year 2005 statement of operations.

 

The Notes mature on March 15, 2010 and require semi-annualinterest payments on March 15 and September 15, which commenced on September 15,2004.

 

As of November 24, 2005, there were no outstanding borrowingsunder the working capital facility.

 

As a result of the Notes offering described above, the vesting ofcertain stock options was accelerated and certain stock options wereredeemed.  Accordingly, we incurredapproximately $3.9 million of compensation expense.  Furthermore, we used approximately $100.2million of the proceeds of the Rule 144A offering of the Notes to fund astockholder dividend to our Parent to purchase shares of our Parent’s commonstock and warrants and fund compensation from the redemption of employee stockoptions.

 

**Cash**as of November 24,2005 decreased to $16.3 million from $27.0 million as of the end of the fiscalyear ended February 28, 2005, or fiscal year 2005.  The decrease in our cash position wasprimarily due to the semi-annual interest payments on the Notes and capitalexpenditures partially offset by cash provided by operations, net of the effectof the interest payments, in the fiscal 2006 nine-month period.

 

**Receivables, net**asof November 24, 2005 decreased to $34.1 million from $35.8 million as ofthe end of fiscal year 2005.   Thisdecrease is the result of an improvement in our days sales outstanding to 36days from 38 days at the end of fiscal year 2005.

 

**Inventories**as of November 24,2005 increased to $29.5 million from $24.6 million as of the end of fiscal year2005. ** **Thisincrease is primarily attributable to the decrease in machine-glazed segmentsales experienced in the fiscal 2006 nine-month period resulting in a build ininventory levels and the need to replenish some tissue inventories that werecritically low at the end of fiscal year 2005.

 

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**Prepaid expense and other current assets**asof November 24, 2005 increased to $4.3 million from $3.5 million as of theend of fiscal year 2005. ** **This increase is primarilyattributable to an increase in prepaid coal due to our normal build-up in coalsupplies at our Menominee mill prior to the winter months.

 

**Income tax receivable**asof November 24, 2005 was $2.1 million due to the recording of a receivablein the fiscal 2006 three-month period. See income tax discussion above.

 

**Property, plant and equipment, net**asof November 24, 2005 increased to $97.7 million from $97.3 million as ofthe end of fiscal year 2005.  The netincrease consists of a one-time adjustment of $2.3 million to correct thecumulative effective of improperly translating the value of our Canadiansubsidiary’s property, plant equipment (as discussed above), capitalexpenditures of $9.8 million, offset by depreciation expense of $11.7 million.

 

**Accrued expenses**asof November 24, 2005 decreased to $14.8 million from $15.2 million as ofthe end of fiscal year 2005.  Thedecrease is attributable to the payment of business performance bonuses in thefiscal 2006 nine-month period that were earned in fiscal year 2005. No suchbonuses were earned in the fiscal 2006 nine-month period.  The impact of the decrease in bonuses ispartially offset by higher energy costs in the fiscal 2006 nine-month periodresulting in higher accrual balances as of November 24, 2005.

 

**Accrued interest**asof November 24, 2005 decreased to $3.3 million from $7.4 million as of theend of fiscal year 2005 due primarily to semi-annual interest payment in September 2005.

 

**Stockholders’ deficiency**asof November 24, 2005 decreased to $7.1 million compared to $7.6 million asof the end of fiscal year 2005.   Thedecrease was a result of the increase in accumulated other comprehensive incomedue to a one-time adjustment of $2.3 million to reflect the translation ofproperty, plant and equipment at month-end rates as opposed to historical rates(as described above), offset partially by the net loss generated for the fiscal2006 nine-month period.

 

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 the fiscal year ended February 28,2005.  The preparation of our financialstatements requires us to make estimates that affect the reported amounts ofassets, liabilities, revenue and expenses and related disclosures of contingentassets and liabilities.  We base ouraccounting estimates on historical experience and other factors that we believeto be reasonable under the circumstances. However, actual results may vary from these estimates under differentassumptions or conditions.

 

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New Accounting Pronouncements

 

In June 2005,the Financial Accounting Standards Board (“FASB”) issued Statement No. 154,“*Accounting Changes and Error Corrections-areplacement of APB Opinion No. 20 and FASB Statement No.3*” (“SFAS154”). This standard replaces APB Opinion No. 20, “*Accounting Changes”,* and FASB Statement No. 3,“*Reporting Accounting Changes in InterimFinancial Statements”,* and changes the requirements for theaccounting and reporting of a change in accounting principle. SFAS 154 appliesto all voluntary changes in accounting principle and to changes required by anaccounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. SFAS 154 also requires that achange in depreciation, amortization, or depletion method for long-lived, nonfinancialassets be accounted for as a change in accounting estimate effected by a changein accounting principle. SFAS 154 requires that the change in accountingprinciple be applied to the balances of assets and liabilities as of thebeginning of the earliest period for which retrospective application ispracticable and that a corresponding adjustment be made to the opening balanceof retained earnings for that period rather than being reported in an incomestatement. Such a change would require us to restate our previously issuedfinancial statements to reflect the change in accounting principle to priorperiods presented. SFAS 154 is effective for accounting changes and correctionsof errors made in fiscal years beginning after December 15, 2005. Theadoption of SFAS 154 will not have a material impact on our results ofoperations and financial position.

 

In March 2005,FASB Interpretation No. 47, “*Accounting for ConditionalAsset Retirement Obligations (an interpretation of FASB Statement No. 143)*”(“FIN 47”) was issued. FIN 47 provides clarification with respect to the timingof liability recognition for legal obligations associated with the retirementof tangible long-lived assets when the timing and/or method of settlement ofthe obligation are conditional on a future event. We are currently evaluatingthe potential impact of FIN 47.

 

In December 2004, the FASB issued SFAS No. 153, “*Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29*”(“SFAS 153”).  SFAS 153 amends theguidance in APB Opinion No. 29, “*Accounting for NonmonetaryTransactions*” by replacing the exception from fair value measurementfor nonmonetary exchanges of similar productive assets with an exception forexchanges that do not have commercial substance.  SFAS 153 specifies that a nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange.  The provisions of SFAS 153 are effective fornonmonetary asset exchanges occurring in fiscal years beginning after June 15,2005.  We expect the adoption of SFAS 153will not have a material impact on our results of operations and financialposition.

 

In December 2004, the FASB issued Statement No. 123(revised), “*Share-Based Payment*”, which is a revisionof FASB Statement No. 123, “*Accounting for Stock-BasedCompensation*” (“SFAS 123R”). SFAS 123R supersedes AccountingPrinciples Board Opinion No. 25, “*Accounting for StockIssued to Employees*” (“APB 25”), and amends FASB Statement No. 95,“*Statement of Cash Flows.*”  The approach to quantifying stock-based compensation expense in SFAS 123R issimilar to SFAS 123.  However, therevised

 

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statementrequires all share-based payments to employees, including grants of employeestock options, to be recognized as an expense in the consolidated statements ofoperations based on their fair values as they are earned by the employees underthe vesting terms.  Pro forma disclosureof stock-based compensation expense, as is our practice under SFAS 123, willnot be permitted commencing with fiscal year 2007, since SFAS 123R must beadopted by us at the beginning of the first annual period beginning after December 15,2005.   Given we have applied aminimum-value approach, due to our lack of sufficient trading history toestimate expected stock volatility, to estimating compensation expenseassociated with employee stock options under SFAS 123, we are required to usethe prospective method of SFAS 123R, whereby nonvested awards outstanding atthe date of adoption of SFAS 123R will continue to be accounted for in the samemanner as they had been previous to the adoption.  All awards granted, modified or settled afteradoption will be accounted for using the measurement, recognition and attributeprovisions of FAS 123R.

 

Aspermitted by SFAS 123, we currently account for stock-based compensation toemployees under the APB 25 intrinsic value method and generally recognize nocompensation cost for employee stock options. Accordingly, the adoption of the SFAS 123R fair value method will impactour results of operations.  The impact ofadoption of SFAS 123R will depend on levels of share-based compensation grantedin the future and the fair value assigned thereto.   As permitted by SFAS 123, we use the actualforfeitures method whereby pro forma compensation expense is reduced only whenoptions are forfeited.  Under SFAS 123R,the estimated forfeiture method is required such that expected futureforfeitures will be reflected as a reduction of stock-based compensationexpense.  However, under SFAS 123R,reduction of compensation expense is not permitted if a vested share-basedpayment is later forfeited, as would occur when an out-of-the money stockoption is surrendered by a resigning employee.

 

InDecember 2004, the FASB issued FASB Staff Position No. FAS 109-1, “*Application of FASB Statement No. 109, “Accounting for IncomeTaxes, to the Tax Deduction on Qualified Production Activities provided by theAmerican Jobs Creation Act of 2004*” (“FAS 109-1”).  The American Jobs Creation Act of 2004 (the “AJCA”),introduces a special 9% tax deduction when fully phased in on qualifiedproduction activities. FAS 109-1 clarifies that this tax deduction should beaccounted for as a special tax deduction in accordance with Statement 109.  We have determined that the amount of thespecial deduction for fiscal year 2006 will not have a significant impact onthe effective tax rate for the fiscal year.

 

InNovember 2004, the FASB issued SFAS No. 151, “*InventoryCosts, an amendment of ARB No. 43, Chapter 4*“(“SFAS 151”).  SFAS 151 clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs andspoilage.  In addition, SFAS 151 requiresthat allocation of fixed production overhead to the costs of conversion bebased on normal capacity of the production facilities.  The provisions of SFAS 151 are effective forinventory costs incurred during fiscal years beginning after June 15,2005. We expect the adoption of SFAS 151 will not have a material impact on ourresults of operations and financial position.

 

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

 

In March 2004, we completed a Rule 144A offering of $162million aggregate principle amount of Notes. At the same time, we entered into a new $30 million revolving workingcapital facility.  We raisedapproximately $152.2 million, net of debt issuance costs and original discounton the notes.  The proceeds, along with adrawdown from the new revolver, were used to pay off existing debt ofapproximately $56 million and to fund a stockholder dividend to the Parent torepurchase shares of its common stock and warrants and fund compensation fromthe redemption of employee stock options of $100.2 million.  As a result of these transactions, we arehighly leveraged.  As of November 24,2005, there were no borrowings on the new working capital facility, but we havethe ability to borrow funds under this facility up to an aggregate of $30million and could be adversely affected by a significant increase in interestrates.  We also have obligations under anindustrial revenue bond (balance as of November 24, 2005 of $.3 million)that is payable in annual installments with interest ranging from 4.8% to6.65%.

 

Market risk is the potential economic loss that may result from adversechanges in the fair value of financial instruments. We are exposed to marketrisk from changes in foreign currency exchange rates, primarily in Canada. All international sales, otherthan sales originating from our Canadian subsidiary, are denominated in U. S.dollars.  Due to our Canadian operationshowever, we could be adversely affected by unfavorable fluctuations in foreigncurrency exchange rates.

 

**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.  Based on such evaluation, the Company’s ChiefExecutive Officer and Chief Financial Officer have concluded that, as of theend of such period, the Company’s disclosure controls and procedures areeffective in recording, processing, summarizing and reporting, on a timelybasis, information required to be disclosed by the Company in the reports thatit files or submits under the Securities and Exchange Commission’s rules andforms.

 

(b)         Changes in InternalControl Over Financial Reporting.  Therehave not been any changes in the Company’s internal control over financialreporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during the fiscal quarter to which this report relates thathave materially affected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

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PART II – OTHER INFORMATION

 

Item 6. Exhibits

 

(a)       Exhibits

 
| 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)                                                                                          |
|   |   |                                                                                                                                                                                                  |
| 32.1   |   | Certification by President and Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                           |
|   |   |                                                                                                                                                                                                  |
| 32.2   |   | Certification by Senior Vice President,  Finance and Chief Financial Officer pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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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:  | January 6, 2006             |   |   | /s/ Russell C. Taylor |   |
|   |                             | Mr. Russell C. Taylor |
|   |                             | President and Chief Executive Officer |
|   |                             |   |
| Date:  | January 6, 2006             |   |   | /s/ Dianne M. Scheu |   |
|   |                             | Ms. Dianne M. Scheu |
|   |                             | Senior Vice President, Finance and Chief |
|   |                             | Financial Officer |

 

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