**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  August 25, 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 fiscalyear, 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 by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct).   YesoNoý

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b02of the Exchange Act).  YesoNoý

 

The number of shares outstanding of each of theregistrant’s classes of common stock as of September 30, 2005:

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

 

 

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CELLU TISSUE HOLDINGS, INC.FORM 10-QQUARTER ENDED AUGUST 25, 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 5. Other Information                                                                           |   |
|                                                                                                |   |
| Item 6. Exhibits                                                                                    |   |
|                                                                                                |   |
| SIGNATURES                                                                                          |   |

 

2

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**PART I FINANCIAL INFORMATION**

 

**Item 1. Consolidated Financial Statements**

 

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

 
| ** **                                                | ** ** | **Three Months Ended**   | ** ** | **Six Months Ended**     | ** ** |
|-----------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                                                | ** ** | **August 25  2005** | ** ** | **August 26  2004** | ** ** | **August 25  2005** | ** ** | **August 26  2004** | ** ** |
|                                                      |       |                     |       |                     |       |   |   |   |   |
| Net sales                                                 |       | $                        | 86,017,502 |                     | $          | 86,275,437 |   | $ | 163,661,500 |   | $ | 165,059,621 |   |
| Cost of goods sold                                        |       | 78,494,044               |       | 75,353,411               |       | 149,243,482 |   | 145,183,926 |   |
| Gross profit                                              |       | 7,523,458                |       | 10,922,026               |       | 14,418,018 |   | 19,875,695 |   |
|                                                      |       |                     |       |                     |       |   |   |   |   |
| Selling, general and administrative expenses              |       | 3,059,757                |       | 3,966,639                |       | 5,959,138 |   | 7,589,637 |   |
| Merger related transaction costs                          |       | 762,306                  |       |                     |       | 889,127 |   |   |   |
| Compensation from redemption of stock options             |       |                     |       |                     |       |   |   | 3,414,441 |   |
| Accelerated vesting of stock options - non cash           |       |                     |       | 292,776                  |       |   |   | 533,551 |   |
| Amortization of intangibles                               |       | 354,871                  |       | 336,240                  |       | 694,144 |   | 692,727 |   |
| Income from operations                                    |       | 3,346,524                |       | 6,326,371                |       | 6,875,609 |   | 7,645,339 |   |
|                                                      |       |                     |       |                     |       |   |   |   |   |
| Write-off of debt issuance costs and prepayment penalties |       |                     |       |                     |       |   |   | 3,318,495 |   |
| Interest expense, net                                     |       | 3,960,510                |       | 4,057,476                |       | 7,754,350 |   | 7,947,229 |   |
| Foreign currency loss                                     |       | 383,804                  |       | 212,445                  |       | 284,185 |   | 196,388 |   |
| Gain on sale of equipment                                 |       | (31,339                  | )          | (2,381,316               | )          | (24,827 | ) | (2,381,316 | ) |
| Other (income) expense                                    |       | (5,224                   | )          | 25,758                   |       | (7,350 | ) | 25,158 |   |
| Income (loss) before income tax expense (benefit)         |       | (961,227                 | )          | 4,412,008                |       | (1,130,749 | ) | (1,460,615 | ) |
|                                                      |       |                     |       |                     |       |   |   |   |   |
| Income tax expense (benefit)                              |       | (105,448                 | )          | 875,903                  |       | (164,798 | ) | (3,998,374 | ) |
| Net (loss) income                                         |       | $                        | (855,779   | )                        | $          | 3,536,105 |   | $ | (965,951 | ) | $ | 2,537,759 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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**CELLUTISSUE HOLDINGS, INC, AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                                                  | ** ** | **August 25  2005** | ** **  | **February 28  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|-------------|----------------------------|------------|
| ** **                                                                                                                                                  | ** ** | **(Unaudited)**          | ** **  | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                  |       |                     |        |                       |       |
| CURRENT ASSETS:                                                                                                                                             |       |                     |        |                       |       |
| Cash and cash equivalents                                                                                                                                   |       | $                        | 22,242,475  |                       | $          | 26,959,029 |   |
| Receivables, net                                                                                                                                            |       | 35,176,955               |        | 35,786,666                 |       |
| Inventories                                                                                                                                                 |       | 27,666,046               |        | 24,601,068                 |       |
| Prepaid expenses and other current assets                                                                                                                   |       | 4,267,688                |        | 3,499,414                  |       |
| Deferred income taxes                                                                                                                                       |       | 973,978                  |        | 1,294,851                  |       |
| TOTAL CURRENT ASSETS                                                                                                                                        |       | 90,327,142               |        | 92,141,028                 |       |
| PROPERTY, PLANT AND EQUIPMENT, NET                                                                                                                          |       | 96,679,844               |        | 97,314,590                 |       |
| DEBT ISSUANCE COSTS                                                                                                                                         |       | 6,475,227                |        | 7,167,718                  |       |
| GOODWILL                                                                                                                                                    |       | 13,723,935               |        | 13,723,935                 |       |
| OTHER ASSETS                                                                                                                                                |       | 186,850                  |        | 190,220                    |       |
| TOTAL ASSETS                                                                                                                                                |       | $                        | 207,392,998 |                       | $          | 210,537,491 |   |
|                                                                                                                                                        |       |                     |        |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY(DEFICIENCY)**                                                                                                   |       |                     |        |                       |       |
| CURRENT LIABILITIES:                                                                                                                                        |       |                     |        |                       |       |
| Accounts payable                                                                                                                                            |       | $                        | 19,282,375  |                       | $          | 18,974,022 |   |
| Accrued expenses                                                                                                                                            |       | 13,693,011               |        | 15,156,693                 |       |
| Accrued interest                                                                                                                                            |       | 7,221,175                |        | 7,416,122                  |       |
| Current portion of long-term debt                                                                                                                           |       | 290,000                  |        | 270,000                    |       |
| TOTAL CURRENT LIABILITIES                                                                                                                                   |       | 40,486,561               |        | 41,816,837                 |       |
| LONG-TERM DEBT, LESS CURRENT PORTION                                                                                                                        |       | 160,636,575              |        | 160,790,288                |       |
| DEFERRED INCOME TAXES                                                                                                                                       |       | 14,365,505               |        | 15,280,376                 |       |
| OTHER LIABILITIES                                                                                                                                           |       | 223,381                  |        | 235,780                    |       |
| STOCKHOLDERS’ EQUITY (DEFICIENCY):                                                                                                                     |       |                     |        |                       |       |
| Common stock, Class A, $.01 par value,  1,000 shares authorized, 100 shares issued and outstanding at August 25,  2005 and February 28, 2005 |       | 1                        |        | 1                          |       |
| Capital in excess of par value                                                                                                                              |       | 533,551                  |        | 533,551                    |       |
| Accumulated deficit                                                                                                                                         |       | (10,022,356              | )           | (9,056,405                 | )          |
| Accumulated other comprehensive income                                                                                                                      |       | 1,169,780                |        | 937,063                    |       |
| TOTAL STOCKHOLDERS’ EQUITY(DEFICIENCY)                                                                                                                 |       | (8,319,024               | )           | (7,585,790                 | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’  EQUITY(DEFICIENCY)                                                                                                |       | $                        | 207,392,998 |                       | $          | 210,537,491 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

4

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

 
| ** **                                                                                | ** ** | **Six Months Ended**     | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                | ** ** | **August 25  2005** | ** ** | **August 26  2004** | ** ** |
| **Cash flows from operating activities**                                                  |       |                     |       |   |   |
| Net (loss) income                                                                         |       | $                        | (965,951   | ) | $ | 2,537,759 |   |
| Adjustments to reconcile net (loss) income  to net cash provided by operating activities: |       |                     |       |   |   |
| Write-off of debt issuance costs-noncash                                                  |       |                     |       | 2,894,868 |   |
| Accelerated vesting of stock  options-noncash                                             |       |                     |       | 533,551 |   |
| Deferred income taxes                                                                     |       | (593,998                 | )          |   |   |
| Accretion of debt discount                                                                |       | 146,287                  |       | 147,109 |   |
| Amortization of intangibles                                                               |       | 694,144                  |       | 692,727 |   |
| Depreciation                                                                              |       | 8,071,312                |       | 7,309,353 |   |
| Gain on sale of property, plant and  equipment                                            |       | (24,827                  | )          | (2,381,316 | ) |
| Stock based compensation                                                                  |       |                     |       | 297,482 |   |
| Changes in operating assets and  liabilities:                                             |       |                     |       |   |   |
| Receivables                                                                               |       | 609,711                  |       | (4,279,989 | ) |
| Receivables, other                                                                        |       |                     |       | (3,900,000 | ) |
| Inventories                                                                               |       | (3,064,978               | )          | 1,941,441 |   |
| Prepaid expenses and other current assets                                                 |       | (768,274                 | )          | (4,994,198 | ) |
| Other assets and liabilities                                                              |       | (9,029                   | )          | 77,241 |   |
| Accounts payable, accrued expenses, accrued  interest and income taxes                    |       | (1,350,276               | )          | 8,511,287 |   |
| Total adjustments                                                                         |       | 3,710,072                |       | 6,849,556 |   |
| *Net cash  provided by operating activities*                                              |       | 2,744,121                |       | 9,387,315 |   |
|                                                                                      |       |                     |       |   |   |
| **Cash flows from investing activities**                                                  |       |                     |       |   |   |
| Proceeds from sale of property, plant and  equipment, net                                 |       |                     |       | 4,003,727 |   |
| Capital expenditures,net                                                                  |       | (7,411,739               | )          | (3,183,294 | ) |
| *Net cash  (used in) provided by investing activities*                                    |       | (7,411,739               | )          | 820,433 |   |
|                                                                                      |       |                     |       |   |   |
| **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                   | )          | (6,319,479 | ) |
| *Net cash  (used in) provided by financing activities*                                    |       | (281,653                 | )          | 1,850,733 |   |
|                                                                                      |       |                     |       |   |   |
| Effect of foreign currency                                                                |       | 232,717                  |       | 107,115 |   |
| *Net (decrease) increase in cash and cash equivalents*                                    |       | (4,716,554               | )          | 12,165,596 |   |
| *Cash and cash equivalents at beginning of period*                                        |       | 26,959,029               |       | — |   |
| *Cash and cash equivalents at end of period*                                              |       | $                        | 22,242,475 |   | $ | 12,165,596 |   |

 

*See accompanying notes to consolidated financial statements.*

 

5

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**Cellu Tissue Holdings, Inc. andSubsidiariesNotes to Consolidated Financial Statements (Unaudited)August 25, 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 recurring accruals)considered necessary for a fair presentation have been included.  Operating results for the three and six monthperiods ended August 25, 2005 are not necessarily indicative of theresults that may be expected for the fiscal year ending February 28, 2006.  For further information, refer to the Company’sconsolidated 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 income would have been adjusted to the pro forma amounts indicated below.

 

6

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| ** **                                                                                                                | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                | ** ** | **August 25,  2005**      | ** ** | **August 26,  2004**    | ** ** | **August 25,  2005** | ** ** | **August 26,  2004** | ** ** |
| Net (loss) income, as reported                                                                                            |       | $                              | (855,779   | )                            | $          | 3,536,105 |   | $ | (965,951 | ) | $ | 2,537,759 |   |
| Add:   stock-based employee compensation expense included in reported net  (loss) income, net of related tax effects |       |                           |       | (74,219                      | )          |   |   | (988,024 | ) |
| Less: stock-based employee compensation  expense determined under fair value method, net of related tax                   |       | (26,028                        | )          |                         |       | (51,857 | ) | (113,775 | ) |
| Pro forma net (loss) income, fair value method                                                                            |       | $                              | (881,807   | )                            | $          | 3,461,886 |   | $ | (1,017,808 | ) | $ | 1,435,960 |   |

 

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 six-months ended August 26, 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 six-month period ended August 26,2004, associated with employees that will actually benefit from the acceleratedvesting of the stock options.  No suchexpense was recognized in the three-month and six-month periods ended August 25,2005.  The Company updates its estimateeach reporting period and adjusts the total expense recognized until theoriginal vesting period associated with the stock options has expired.

 

Recent Accounting Pronouncements

 

In June 2005,the Financial Accounting Standards Board (“FASB”) issued Statement No. 154,“Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20and FASB Statement No.3” (“SFAS 154”). This standard replaces APB Opinion No. 20,*Accounting Changes,* and FASBStatement No. 3, *Reporting AccountingChanges in Interim Financial Statements,* and changes therequirements for the accounting and reporting of a change in accountingprinciple. SFAS 154 applies to all voluntary changes in accounting principleand to changes required by an accounting pronouncement in the unusual instancethat the pronouncement does not include specific transition provisions. SFAS154 also requires that a change in depreciation, amortization, or depletionmethod for long-lived, nonfinancial assets be accounted for as a change inaccounting estimate effected by a change in accounting principle. SFAS 154requires that the change in accounting principle be applied to the balances ofassets and liabilities as of the beginning of the earliest period for which retrospectiveapplication is practicable and that a corresponding adjustment be made to theopening balance of retained earnings for that period rather than being reportedin an income statement. Such a change would require the Company to restate itspreviously issued financial statements to reflect the change in accountingprinciple to prior periods presented. SFAS 154 is effective for accountingchanges and corrections 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 Conditional Asset RetirementObligations (an interpretation of FASB Statement No. 143)” (“FIN 47”) wasissued. FIN 47 provides clarification with respect to the timing of liabilityrecognition for legal obligations associated with the retirement of tangiblelong-lived assets when the timing and/or method of settlement of the obligationare conditional on a future event. The Company is currently evaluating thepotential impact of FIN 47.

 

8

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In December 2004, the FASB issued SFAS No. 153, “Exchanges ofNonmonetary Assets, an amendment of APB Opinion No. 29” (SFAS 153).  SFAS 153 amends the guidance in APB Opinion No. 29,“Accounting for Nonmonetary Transactions” by replacing the exception from fairvalue measurement for nonmonetary exchanges of similar productive assets withan exception for exchanges 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” (SFAS 123R), which is a revision of FASBStatement No. 123, “Accounting for Stock-Based Compensation.”  SFAS 123R supersedes Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25)and amends 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 theconsolidated statements of operations based on their fair values as they areearned by the employees under the vesting terms.  Pro forma disclosure of stock-basedcompensation expense, as is the Company’s practice under SFAS 123, will not bepermitted commencing with fiscal year 2007, since SFAS 123R must be adopted bythe Company at the beginning of the first annual period beginning after December 15,2005.  Given the Company has applied aminimum-value approach, due to its lack of sufficient trading history toestimate expected stock volatility, to estimating compensation expenseassociated with employee stock options under SFAS 123, it is 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.

 

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

 

9

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compensation granted in the future and the fair value assignedthereto.   As permitted by SFAS 123, theCompany uses the actual forfeitures method, whereby pro forma compensationexpense is reduced only when options are forfeited.  Under SFAS 123R, the estimated forfeituremethod is required, such that expected future forfeitures will be reflected asa reduction of stock-based compensation expense.  However, under SFAS 123R, reduction ofcompensation expense is not permitted if a vested share-based payment is laterforfeited, as would occur when an out-of-the money stock option is surrenderedby a resigning employee.

 

In December 2004, the FASB issued FASB Staff Position No. FAS109-1 (“FAS 109-1”), “Application of FASB Statement No. 109, “Accountingfor Income Taxes, to the Tax Deduction on Qualified Production Activitiesprovided by the American Jobs Creation Act of 2004.”  The American Jobs Creation Act of 2004 (the“AJCA”), introduces a special 9% tax deduction when fully phased in on qualifiedproduction activities.   FAS 109-1clarifies that this tax deduction should be accounted for as a special taxdeduction in accordance with Statement 109. The Company has determined that the amount of the special deduction forfiscal year 2006 will not have a significant impact on the effective tax ratefor the fiscal year.

 

In November 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.  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:

 
| ** **                       | ** ** | **August 25, 2005** | ** ** | **February 28, 2005** | ** ** |
|----------------------------------|------------|--------------------------|------------|----------------------------|------------|
|                             |       |                     |       |                       |       |
| Finished goods                   |       | $                        | 16,617,743 |                       | $          | 14,028,875 |   |
| Raw materials                    |       | 3,165,238                |       | 3,910,698                  |       |
| Packaging materials and supplies |       | 7,993,401                |       | 6,740,649                  |       |
|                             |       | 27,776,382               |       | 24,680,222                 |       |
| Inventory reserves               |       | (110,336                 | )          | (79,154                    | )          |
|                             |       | $                        | 27,666,046 |                       | $          | 24,601,068 |   |

 

10

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**Note 3 Debt Issuance Costs**

 

Debt issuance costs consist of the following:

 
| ** **                    | ** ** | **August 25, 2005** | ** ** | **February 28, 2005** | ** ** |
|-------------------------------|------------|--------------------------|------------|----------------------------|------------|
|                          |       |                     |       |                       |       |
| Debt issuance costs           |       | $                        | 8,541,986  |                       | $          | 8,540,333 |   |
| Less accumulated amortization |       | (2,066,759               | )          | (1,372,615                 | )          |
|                          |       | $                        | 6,475,227  |                       | $          | 7,167,718 |   |

 

**Note 4 Long-Term Debt**

 

Long-term debt consists of the following:

 
| ** **                                                                                                      | ** ** | **August 25, 2005** | ** **  | **February 28, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------|-------------|----------------------------|------------|
| 9 3⁄4 % senior secured notes due 2010                                                                        |       | $                        | 162,000,000 |                       | $          | 162,000,000 |   |
| Less discount                                                                                                   |       | (1,363,425               | )           | (1,509,712                 | )          |
|                                                                                                            |       | 160,636,575              |        | 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                    |       |
|                                                                                                            |       | 160,926,575              |        | 161,060,288                |       |
| Less current portion of debt                                                                                    |       | 290,000                  |        | 270,000                    |       |
|                                                                                                            |       | $                        | 160,636,575 |                       | $          | 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 $152.2million, net of debt issuance costs of $8.0 million and original issuancediscount of $1.8 million.  At the sametime, the Company entered into a new $30.0 million revolving working capitalfacility with CIT Group/Business Credit Inc. 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.  Furthermore, the Company usedapproximately $100.2 million of the proceeds to fund a stockholder dividend toits Parent to repurchase a portion of its common stock and warrants and fundcompensation from the redemption of employee stock options ($3.4 million).  As a result of the extinguishment of debt,approximately $2.9 million of debt issuance costs previously capitalized werewritten-off and the Company incurred approximately $.4 million in prepaymentpenalties.  The total amount of $3.3million is reflected as write-off of

 

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debt issuance costs and prepayment penalties in the fiscal year 2004statement 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 August 25, 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 thenote offering to fund a stockholder dividend to the Parent to purchase sharesof common stock, warrants and options. Approximately $66.2 million was charged to capital in excess of parvalue, reducing this balance to zero and the remaining $30.6 million wascharged to accumulated earnings, resulting in a deficiency.

 

**Note 6 Comprehensive (Loss) Income**

 

The components of comprehensive (loss) income for the three months andsix months ended August 25, 2005 and August 26, 2004 are as follows:

 
| ** **                               | ** ** | **Three Months Ended**   | ** ** | **Six Months Ended**     | ** ** |
|------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                               | ** ** | **August 25, 2005** | ** ** | **August 26, 2004** | ** ** | **August 25, 2005** | ** ** | **August 26,2004** | ** ** |
| Net (loss) income                        |       | $                        | (855,779   | )                        | $          | 3,536,105 |   | $ | (965,951 | ) | $ | 2,537,759 |   |
| Foreign currency translation adjustments |       | 394,826                  |       | 189,673                  |       | 232,717 |   | 107,115 |   |
| Comprehensive income (loss)              |       | $                        | (460,953   | )                        | $          | 3,725,778 |   | $ | (733,234 | ) | $ | 2,644,874 |   |

 

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**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.  There are no sales between segments.

 

 
| ** **                                                | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended**      | ** ** |
|-----------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                                                | ** ** | **August 25,  2005** | ** ** | **August 26,  2004** | ** ** | **August 25,  2005** | ** ** | **August 26,  2004** | ** ** |
| **Net Sales**                                             |       |                      |       |                      |       |   |   |   |   |
| Tissue                                                    |       | $                         | 60,857,758 |                      | $          | 60,500,858 |   | $ | 116,929,450 |   | $ | 115,513,463 |   |
| Machine-glazed paper                                      |       | 25,159,744                |       | 25,774,579                |       | 46,732,050 |   | 49,546,158 |   |
| Consolidated                                              |       | $                         | 86,017,502 |                      | $          | 86,275,437 |   | $ | 163,661,500 |   | $ | 165,059,621 |   |
|                                                      |       |                      |       |                      |       |   |   |   |   |
| **Income from operations**                                |       |                      |       |                      |       |   |   |   |   |
| Tissue                                                    |       | $                         | 2,765,930  |                      | $          | 4,644,144 |   | $ | 5,344,643 |   | $ | 6,016,545 |   |
| Machine-glazed paper                                      |       | 935,465                   |       | 2,018,467                 |       | 2,225,110 |   | 2,321,521 |   |
| Corporate amortization of intangibles                     |       | (354,871                  | )          | (336,240                  | )          | (694,144 | ) | (692,727 | ) |
| Consolidated                                              |       | 3,346,524                 |       | 6,326,371                 |       | 6,875,609 |   | 7,645,339 |   |
| Write-off of debt issuance costs and prepayment penalties |       |                      |       |                      |       |   |   | (3,318,495 | ) |
| Interest expense                                          |       | (4,021,578                | )          | (4,064,200                | )          | (7,868,165 | ) | (7,956,601 | ) |
| Net foreign currency transaction loss                     |       | (383,804                  | )          | (212,445                  | )          | (284,185 | ) | (196,388 | ) |
| Interest income                                           |       | 61,068                    |       | 6,724                     |       | 113,815 |   | 9,372 |   |
| Other income                                              |       | 36,563                    |       | 2,355,558                 |       | 32,177 |   | 2,356,158 |   |
| Pretax (loss) income                                      |       | $                         | (961,277   | )                         | $          | 4,412,008 |   | $ | (1,130,749 | ) | $ | (1,460,615 | ) |

 

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| ** **               | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended**      | ** ** |
|--------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **               | ** ** | **August 25,  2005** | ** ** | **August 26,  2004** | ** ** | **August 25,  2005** | ** ** | **August 26  2004** | ** ** |
|                     |       |                      |       |                      |       |   |   |   |   |
| **Capital Expenditures** |       |                      |       |                      |       |   |   |   |   |
| Tissue                   |       | $                         | (3,029,291 | )                         | $          | (1,889,793 | ) | $ | (6,441,541 | ) | $ | (2,828,724 | ) |
| Machine-glazed paper     |       | (195,136                  | )          | (213,273                  | )          | (386,742 | ) | (267,061 | ) |
| Corporate                |       | (183,945                  | )          | (20,000                   | )          | (583,456 | ) | (87,509 | ) |
| Consolidated             |       | $                         | (3,408,372 | )                         | $          | (2,123,066 | ) | $ | (7,411,739 | ) | $ | (3,183,294 | ) |
|                     |       |                      |       |                      |       |   |   |   |   |
| **Depreciation**         |       |                      |       |                      |       |   |   |   |   |
| Tissue                   |       | $                         | 2,631,133  |                      | $          | 2,318,374 |   | $ | 5,215,442 |   | $ | 4,568,968 |   |
| Machine-glazed paper     |       | 1,430,755                 |       | 1,371,309                 |       | 2,855,870 |   | 2,740,385 |   |
|                     |       | $                         | 4,061,888  |                      | $          | 3,689,683 |   | $ | 8,071,312 |   | $ | 7,309,353 |   |

 

**Note 9 Income Taxes**

 

Income tax benefit for the three months ended August 25, 2005 was11.0% compared to income tax expense for the three months ended August 26,2004 of 19.9%.  Income tax benefit forthe six months ended August 25, 2005 was 14.6% compared to income taxbenefit for the six months ended August 26, 2004 of 274%.  The effective tax rate differs from thefederal statutory rate primarily due to the accounting for certain mergerrelated transaction costs.  On October 6,2005, the Company announced that the merger agreement was terminated by mutualconsent of the parties effective as of the close of business thereon.  Accordingly, previous non-deductible transactioncosts will be deducted in the third quarter 2006.  The significant benefit recorded in the prioryear was primarily related to the book to tax permanent differences generateddue to the offering of the Notes, which occurred in the first quarter of theprior year.

 

In October 2004, the AJCA was signed into law.  The Act creates a temporary incentive forU.S. corporations to repatriate foreign earnings by providing an 85 percentdividends received deduction for certain dividends from controlled foreigncorporations.  The deduction is subjectto a number of limitations and, at present, significant uncertainty remainswith respect to interpretation of numerous provisions in the Act.    As such, the Company is awaiting theissuance of further regulatory guidance and passage of statutory technicalcorrections with respect to certain provisions in the Act prior to determiningthe amounts, if any, it will repatriate and expects to be in a position tofinalize its assessment during fiscal year 2006.

 

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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.  Kohlberg planned to effect the acquisition bycombining the operations of the Company with Thilmany, LLC (“Thilmany”), thenewly named business which Kohlberg recently purchased from International PaperCompany.  Thilmany manufactures andconverts lightweight packaging, pressure-sensitive and industrial papers, suchas laminations, grease-resistant packaging, interleaving applications,pressure-sensitive and medical products.  As part of the financing of the acquisition, Kohlberg intended to leavethe Company’s existing $162 million of Notes outstanding, subject to the rightof noteholders to put the Notes to the Company at a price of 101%.  In addition, Kohlberg and other investorswould contribute approximately $120 million of equity to support thetransactions.  As of August 25,2005, the Company had expensed approximately $.9 million in costs associatedwith the proposed transaction.  Thesecosts are shown separately on the 2006 statement of operations.

 

In September 2005, the Company’s majority shareholder received arequest for additional information from the U.S. Department of Justice relatingto its filing under the Hart-Scott-Rodino Antitrust Improvements Act of 1976(HSR Act) in connection with its proposed merger with an affiliate of Kohlberg &Company.  This request extended thewaiting period during which the proposed transaction could not be consummatedfor 30 days from the date after which both the Company’s majority shareholderand the affiliate of Kohlberg & Company have substantially compliedwith the request.

 

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

 

**Note 11 Union Negotiations**

 

Effective July 18, 2005 the United Steelworkers’ InternationalUnion was certified as the exclusive bargaining representative for theemployees in the bargaining unit at the Company’s Wiggins, Mississippifacility.  The Company anticipates thefirst round of union contract negotiations will occur in fiscal year 2006.

 

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**Note 12 Subsequent Events**

 

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 is currently in theprocess of determining the total cost of the hurricane damage and businessinterruption.  However, the impact on theCompany’s operating results will not be determined until an insurancesettlement is reached.

 

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.  As a result of this action, 48 employees havebeen notified that they will be terminated on that date.   The Company is estimating severance costs ofapproximately $1.0 million, which will be recorded in the third quarter offiscal 2006.  The Company is also currentlyevaluating business alternatives with respect to the idle machine.

 

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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-lookingstatements, which are based on certain assumptions and describe our futureplans, strategies and expectations are generally identifiable by use of thewords “may,” “will,” “should,” “expect,” “anticipate,” “estimate”, “believe”,“intend”, “project”, or comparable terminology. Factors which could have a material adverse effect on our operations andfuture prospects include, but are not limited to, those set forth inForward-Looking Statements in our Annual Report on Form 10-K for ourfiscal year ended February 28, 2005. These risks and uncertainties should be considered in evaluating anyforward-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 MonthsEnded August 25, 2005 (the fiscal 2006 three-month period) compared to theThree Months Ended August 26, 2004 (the fiscal 2005 three-month period)and the Six Months Ended August 25, 2005 (the fiscal 2006 six-monthperiod) compared to the Six Months ended August 26, 2004 (the fiscal 2005three-month period)**

 

**Net sales** for thefiscal 2006 three-month period decreased $.3 million, or .3%, to****$86.0****million from$86.3 million for the comparable period in the prior year. Net sales for thefiscal 2006 six-month period decreased $1.4 million, or .8%, to $163.7 from$165.1 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 six-monthperiod.  For the fiscal 2006 three-monthperiod, we sold 68,363 tons of tissue hard rolls, machine-glazed paper hardrolls and converted paper products, a decrease of 804 tons, or

 

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1.2%.  For the fiscal 2006six-month period, we sold 130,165 tons of tissue hard rolls, machine-glazedpaper hard rolls and converted paper products, a decrease of 5,840 tons, or4.3%.  Partially offsetting the decreasein volume sold for the fiscal 2006 three-month period and fiscal 2006 six-monthperiod over the prior year, was an increase in net selling price per ton from$1,247 and $1,214 for the fiscal 2005 three-month period and six-month period,respectively to $1,258 and $1,257 for the fiscal 2006 three-month period andsix-month period, respectively.

 

Net sales for our tissue segment for the fiscal 2006 three-month periodwere $60.8 million, an increase of $.3 million, or .6%, from the comparableperiod in the****prior year.  Net sales for our tissue segment for thefiscal 2006 six-month period were $116.9 million, an increase of $1.4 million,or 1.2%, from the comparable period in the prior year.  In both periods, growth in tissue convertedproduct sales is being muted by unfavorable tissue hard roll mix.  The unfavorable tissue hard roll mix includesthe loss of two premium specialty hard roll accounts that moved to non-wovensubstitutes. Net sales for our machine-glazed segment for the 2006 three-monthperiod were****$25.2 million, a decrease of $.6million, or 2.4%,****from the comparable period in theprior year.  Net sales for ourmachine-glazed segment for the 2006 six-month period were $46.8 million, adecrease of $2.8 million, or 5.7% from the comparable period in the prioryear.   This decrease is driven by lowervolume experienced primarily in the first quarter 2006 and unfavorable price/mix.

 

**Gross profit** for thefiscal 2006 three-month period decreased to $7.5 million from $10.9 million, adecrease of $3.4 million, or 31.1%, from the comparable period in the prior****year. **  **Gross profit for the fiscal 2006six-month period decreased to $14.4 million from $19.9 million, a decrease of$5.5 million, or 27.5%, from the comparable period in the prior year.  As a percentage of net sales, gross profitdecreased to 8.7% in the fiscal 2006 three-month period and 8.8% in the fiscal2006 six-month period from 12.7% in the fiscal 2005 three-month period and12.0% in the fiscal 2005 six-month period. ** **The decrease in gross profit in thefiscal 2006 three-month period and fiscal 2006 six-month period was primarilyattributable to unfavorable machined-glazed segment volume and machine-glazedand tissue hard roll price/mix as described above.  Furthermore, for the fiscal 2006 six-monthperiod energy costs per ton increased 25% over the comparable period in theprior year.  The Company anticipatesnatural gas prices across the Company and electrical prices in the unregulatedstates to be significantly higher in the later six months of fiscal 2006.

 

Gross profit for our tissue segment for the fiscal 2006 three-monthperiod was $5.3 million, a decrease of $2.1 million, or 28.8%, from thecomparable period in the prior year. Gross profit for our tissue segment for the fiscal 2006 six-month periodwas $9.9 million, a decrease of $3.7 million, or 27.2%, from the comparableperiod in the prior year.  Gross profitfor our machine-glazed segment for the fiscal 2006 three-month period was $2.2million, a decrease of $1.3 million, or 36.0%, from the comparable period inthe prior year.  Gross profit for ourmachine-glazed segment for the fiscal 2006 six-month period was $4.5 million, adecrease of $1.8 million, or 28.0%, from the comparable period in the prioryear.  As a percentage of net sales,gross profit for the tissue segment

 

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decreased to 8.7% in the fiscal 2006 three-month period and 8.5% in thefiscal 2006 six-month period from 12.3 % in the fiscal 2005 three-month periodand 11.8% in the fiscal 2005 six-month period.. As a percentage of net sales, gross profit for the machine-glazedsegment decreased to 8.9% in the fiscal 2006 three-month period and 9.7% in thefiscal 2006 six-month period from 13.5% in the fiscal 2005 three-month periodand 12.7% in the fiscal 2005 six-month period. The decrease in gross profit forthe tissue segment was due to the unfavorable hard roll mix, partially offsetby improved gross profit in tissue converting, in addition to an increase inutilities costs from the prior year.  Thedecrease in gross profit for the machine-glazed segment was due to the decreasein tons sold and unfavorable price/mix, in addition to an increase in utilitiescosts from the prior year.

 

**Selling, general and administrative expenses**inthe fiscal 2006 three-month period decreased $.9 million, or 22.9%, to $3.1million from $4.0 million in the fiscal 2005 three-month period.  Selling, general and administrative expensesin the fiscal 2006 six-month period decreased $1.6 million, or 21.5%, to $6.0million from $7.6 million in the fiscal 2005 six-month period.  As a percentage of net sales, selling,general and administrative expenses decreased to****3.6%in the fiscal 2006 three-month period and in the fiscal 2006 six-month periodfrom 4.6% in both the fiscal 2005 three-month period and six-month period.  Included in the fiscal 2005 three-month andsix-month periods is the accrual of team bonuses and non-cash compensationexpense related to the vesting of a restricted common stock award to our chiefexecutive officer.   There was no accrualof bonuses in the fiscal 2006 three-month and six-month periods and no compensationexpense related to the restricted common stock award as it was fully vested atthe end of fiscal year 2005.

 

**Merger related transaction costs**inthe fiscal 2006 three-month period were $.8 million and in the fiscal 2006six-month period were $.9 million associated with the June 14, 2005 proposedtransaction with an affiliate of Kohlberg & Company.

 

**Compensation from the redemption of stockoptions and accelerated vesting of stock options**includedin the fiscal 2005 six-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 thefiscal 2005 three-month period ended August 26, 2004 and $.2 million wasrecorded in the first quarter of fiscal 2005. 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. No such expense was recognized in the fiscal 2006six-month period.

 

**Write-off of debt issuance costs andprepayment penalties**of $3.3 million included in thefiscal 2005 six-month period income from operations was an expense incurredprimarily related to the write-off of debt issuance costs (non-cash) previouslycapitalized

 

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and associated with debt that was extinguished in March 2004 withproceeds from the note offering.  No suchexpense was recognized in the fiscal 2006 six-month period.

 

**Gain on sale of equipment**of$2.4 million included in the fiscal 2005 three-month and six-month periods relatesto the sale of a paper machine at our Menominee mill.  Net proceeds from the sale were $4.0 million(gross proceeds of $5.2 million 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 11.0% compared toincome tax expense for the fiscal 2005 three month period of 19.9%.  Income tax benefit for the fiscal 2006 sixmonth period was 14.6% compared to income tax benefit for the fiscal 2006 sixmonth period of 274%.  The effective taxrate differs from the federal statutory rate primarily due to the accountingfor certain merger related transaction costs. On October 6, 2005, the Company announced that the merger agreement wasterminated by mutual consent of the parties effective as of the close ofbusiness thereon.  Accordingly, previous non-deductibletransaction costs will be deducted in the third quarter 2006.  The significant benefit recorded in the prioryear was primarily related to the book to tax permanent differences generateddue to the offering of the Notes, which occurred in the first quarter of theprior year.

 

**Net (loss) income**forthe fiscal 2006 three-month period was a net loss of $.9 million, compared tonet income of $3.5 million for the comparable period in the prior year. Netloss for the fiscal 2006 six-month period was a net loss of $1.0 million,compared to net income of $2.5 million for the comparable period in the prioryear.

 

**FINANCIAL CONDITION**

 

**Liquidity and Capital Resources**

 

**Net cash provided by operations**was $2.7 million for the fiscal 2006 six-month period, compared to net cashprovided by operations of $9.4 million for the fiscal 2005 six-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 six-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 six-month period totaled $8.5million compared to $8.3 million for the 2006 fiscal six-month period.**   **Cash flows used bychanges in working capital totaled $4.6 million for the fiscal 2006 six-monthperiod, compared to $2.6 million in the fiscal 2005 six-month period. ** **With respect to thechanges in accounts receivable and inventory, cash used by these items was $2.5million for the fiscal 2006 six-month period compared to cash used by theseitems of $2.3 million for the comparable period in the prior fiscal year.  Cash****used bychanges in prepaid expenses and other current assets was $.7 million for thefiscal 2006 six-month period compared to cash used of $4.9 million for thecomparable period in the prior fiscal year. The fluctuation is primarily the result of the significant tax benefitgenerated in the fiscal 2005 six-month period. ** **Cash used by other receivables inthe prior year relates to the cash received in the third quarter fiscal 2005related to the

 

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machine sale that occurred in the second quarter fiscal 2005.  Cash used by changes in accounts payable,accrued expenses and accrued interest for the fiscal 2006 six-month period was$1.4 million compared to cash provided of $8.5 million for the comparableperiod in the prior year.  Thesignificant fluctuation for the prior year is primarily due to the increase inaccrued interest based on the timing of interest payments relative to the newnotes and an increase in accounts payable due to the timing of vendor payments.No such fluctuations were experienced for the fiscal 2006 six-month period.

 

**Net cash used in investing activities**for the fiscal 2006 six-month period was $7.4****millioncompared to net cash provided by investing activities of $.8 million for thefiscal 2005 six-month period.  The changerelates to the level of capital spending period over period, offset in theprior year by the machine sale proceeds.

 

**Net cash used in financing activities**for the fiscal 2006 six-month period was $.3****millioncompared to net cash provided by financing activities of $1.9 million for thefiscal 2005 six-month period.  Net cashused in the fiscal 2006 six-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 long-term debt and the revolving line of credit of $43.9 million and $11.0million, respectively, $96.8 million to fund dividends to our parent topurchase shares of our parent’s common stock and warrants, prepayment penaltiesof $.4 million and debt issuance costs of $6.3 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 August 25, 2005, there were no outstanding borrowings underthe working capital facility.

 

As a result of the Notes offering described above, the vesting ofcertain stock options was accelerated and certain stock options were redeemed.  Accordingly, we incurred approximately $3.9million of compensation expense. Furthermore, we used approximately $100.2 million of the proceeds of theRule 144A offering of the Notes to fund a stockholder dividend to ourParent to purchase shares of our Parent’s common

 

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stock and warrants and fund compensation from the redemption ofemployee stock options.

 

**Cash**as of August 25,2005 decreased to $22.2 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 payment on the Notes, offset by thecash provided by operations, net of capital expenditures, in the fiscal 2006six-month period.

 

**Inventory**as of August 25,2005 increased to $27.7 million from $24.6 million as of the end of fiscal year2005.  This increase is primarilyattributable to an increase in inventory levels in the first three months offiscal 2006 to support a major customer’s request for greater sales in thesecond and third quarter of fiscal 2006. In the fiscal 2006 three-month period inventory decreased from $30.2million to the current level of $27.7 million.

 

**Accrued expenses**asof August 25, 2005 decreased to $13.7 million from $15.2 million as of theend of fiscal year 2005 due primarily to the payment of bonuses in the fiscal2006 six-month period that were earned in fiscal year 2005.  No such bonuses were earned in the fiscal2006 six-month period.

 

**Stockholders’ deficiency**asof August 25, 2005 increased to $8.3 million compared to $7.6 million asof the end of fiscal year 2005.   Theincrease was a result of the net loss generated for the fiscal 2006 six-monthperiod, offset partially by the increase in accumulated other comprehensiveincome due to the increase in exchange rates that occurred in the fiscal 2006three-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.

 

New Accounting Pronouncements

 

In June 2005,the Financial Accounting Standards Board (“FASB”) issued Statement No. 154,“Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20and FASB Statement No.3” (“SFAS 154”). This standard replaces APB Opinion No. 20,*Accounting Changes,* and FASBStatement No. 3, *Reporting AccountingChanges in Interim Financial Statements,* and changes therequirements for the accounting and reporting of a change in accountingprinciple. SFAS 154 applies to all voluntary changes in accounting principleand to changes required by an accounting pronouncement in the

 

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unusualinstance that the pronouncement does not include specific transition provisions.SFAS 154 also requires that a change in depreciation, amortization, ordepletion method for long-lived, nonfinancial assets be accounted for as achange in accounting estimate effected by a change in accounting principle.SFAS 154 requires that the change in accounting principle be applied to thebalances of assets and liabilities as of the beginning of the earliest periodfor which retrospective application is practicable and that a correspondingadjustment be made to the opening balance of retained earnings for that periodrather than being reported in an income statement. Such a change would requirethe Company to restate its previously issued financial statements to reflectthe change in accounting principle to prior periods presented. SFAS 154 is effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. The adoption of SFAS 154 will not have a materialimpact on the Company’s results of operations and financial position.

 

In March 2005,FASB Interpretation No. 47, “Accounting for Conditional Asset RetirementObligations (an interpretation of FASB Statement No. 143)” (“FIN 47”) wasissued. FIN 47 provides clarification with respect to the timing of liabilityrecognition for legal obligations associated with the retirement of tangiblelong-lived assets when the timing and/or method of settlement of the obligationare conditional on a future event. The Company is currently evaluating thepotential impact of FIN 47.

 

In December 2004, the FASB issued SFAS No. 153, “Exchanges ofNonmonetary Assets, an amendment of APB Opinion No. 29” (SFAS 153).  SFAS 153 amends the guidance in APB Opinion No. 29,“Accounting for Nonmonetary Transactions” by replacing the exception from fairvalue measurement for nonmonetary exchanges of similar productive assets withan exception for exchanges 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” (SFAS 123R), which is a revision of FASBStatement No. 123, “Accounting for Stock-Based Compensation.”  SFAS 123R supersedes Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25),and amends FASB Statement No. 95, “Statement of Cash Flows.” The approachto quantifying stock-based compensation expense in SFAS 123R is similar to SFAS123.  However, the revised 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 the Company has applied aminimum-value approach, due to its lack of sufficient trading history toestimate expected stock volatility, to

 

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estimating compensation expense associated with employee stock optionsunder SFAS 123, it is required to use the prospective method of SFAS 123R,whereby nonvested awards outstanding at the date of adoption of SFAS 123R willcontinue to be accounted for in the same manner as they had been previous tothe adoption.  All awards granted,modified or settled after adoption will be accounted for using the measurement,recognition and attribute provisions of FAS 123R.

 

As permitted by SFAS 123, we currently account for stock-based compensationto employees 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.

 

In December 2004, the FASB issued FASB Staff Position No. FAS109-1 (“FAS 109-1”), “Application of FASB Statement No. 109, “Accountingfor Income Taxes, to the Tax Deduction on Qualified Production Activitiesprovided by the American Jobs Creation Act of 2004.”  The American Jobs Creation Act of 2004 (the“AJCA”), introduces a special 9% tax deduction when fully phased in onqualified production activities. FAS 109-1 clarifies that this tax deductionshould be accounted for as a special tax deduction in accordance with Statement109.  We have determined that the amountof the special deduction for fiscal year 2006 will not have a significantimpact on the effective tax rate for the fiscal year.

 

In November 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, the Company completed a Rule 144A offering of$162 million aggregate principle amount of 9 3⁄4% senior secured notes due2010.  At the same time, the Companyentered into a new $30 million revolving working capital facility.  The Company raised approximately $152million, net of debt issuance costs and original discount on the notes.  The proceeds, along with a drawdown from thenew revolver, were used to pay off existing debt of approximately $56 millionand to fund a stockholder dividend to the Parent to purchase shares of itscommon stock and warrants and fund compensation from the redemption of employeestock options of $100.2 million.  As aresult of these transactions, the Company is highly leveraged.  As of August 25, 2005, there were noborrowings on the new working capital facility, but the Company has the abilityto borrow funds under this facility up to an aggregate of $30 million and couldbe adversely affected by a significant increase in interest rates.  The Company also has obligations under anindustrial revenue bond (balance as of August 25, 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. The Company is exposed tomarket risk from changes in foreign currency exchange rates, primarily inCanada.   All internationalsales, other than sales originating from its Canadian subsidiary, aredenominated in U. S. dollars.  Due to theCompany’s Canadian operations however, the Company could be adversely affectedby unfavorable fluctuations in foreign currency exchange rates.

 

**Item 4.  Controls and Procedures**

 

(a)  DisclosureControls and Procedures.  The Company’smanagement, with the participation of the Company’s Chief Executive Officer andChief Financial Officer, has evaluated the effectiveness of the Company’sdisclosure controls 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“Exchange Act”)) 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)  Changesin Internal Control Over Financial Reporting. There have 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, theCompany’s internal control over financial reporting.

 

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PART II– OTHER INFORMATION

Item5.  Other Information

 

**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.  Kohlberg planned to effect the acquisition bycombining the operations of the Company with Thilmany, LLC (“Thilmany”), thenewly named business which Kohlberg recently purchased from International PaperCompany.   Thilmany manufactures andconverts lightweight packaging, pressure-sensitive and industrial papers, suchas laminations, grease-resistant packaging, interleaving applications,pressure-sensitive and medical products.  As part of the financing of the acquisition, Kohlberg intended to leavethe Company’s existing $162 million of Notes outstanding, subject to the rightof noteholders to put the Notes to the Company at a price of 101%.  In addition, Kohlberg and other investorswould contribute approximately $120 million of equity to support thetransactions.  As of August 25,2005, the Company had expensed approximately $.9 million in costs associatedwith the proposed transaction.  Thesecosts are shown separately on the 2006 statement of operations.

 

In September 2005, the Company’s majority shareholder received arequest for additional information from the U.S. Department of Justice relatingto its filing under the Hart-Scott-Rodino Antitrust Improvements Act of 1976(HSR Act) in connection with its proposed merger with an affiliate of Kohlberg &Company.  This request extended thewaiting period during which the proposed transaction could not be consummatedfor 30 days from the date after which both the Company’s majority shareholderand the affiliate of Kohlberg & Company have substantially compliedwith the request.

 

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

 

**Election of New Director**

 

Effective October 5, 2005 William Landuyt was elected to the Board of Directors.  Bill has been named as a member of the Audit Committee.   Mr. Landuyt, is a Senior Partner at Charterhouse Group, Inc. (an affiliate of the majority stockholder of the Parent), having joined the New York City-based private equity firm in December 2003.  He served as Chairman of the Board and Chief Executive Officer of Millennium Chemicals Inc. from its demerger from Hanson Plc (“Hanson”) in October 1996 until July 2003. He had served as the President of that company from June 1997 until that date. Mr. Landuyt was Director, President and Chief Executive Officer of Hanson Industries (which managed the United States operations of Hanson until the demerger) from June 1995 until the demerger, a Director of Hanson from 1992 until September 29, 1996, Finance Director of Hanson from 1992 to May 1995, and Vice President and Chief Financial Officer of Hanson Industries from 1988 to 1992. He joined Hanson Industries in 1983. He was a director of Bethlehem Steel Corporation from April 1997 until October 2003.

 

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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:  | October 11, 2005                    |   | /s/ Russell C. Taylor |   |
|   | Mr. Russell C. Taylor               |
|   | President and Chief Executive Officer    |
|   |                                     |
|   |                                     |
| Date:  | October 11, 2005                    |   | /s/ Dianne M. Scheu |   |
|   | Ms. Dianne M. Scheu                 |
|   | Senior Vice President, Finance and Chief |
|   | Financial Officer                        |
|        |                                          |  |  |  |  |  |

 

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