** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington,D.C. 20549**

----

**FORM 10-Q**

**(Mark One)**

| x      | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                    |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | ** **                                                                                                                                                                                                                                                                                      |
|   | **For the Quarterly Period Ended  November 29, 2007**                                                                                                                                                                                                                                           |
|   | **or**                                                                                                                                                                                                                                                                                          |
| o      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                   |
|   | ** **                                                                                                                                                                                                                                                                                      |
|   | **For  the transition period from               to                             .** |
|   | ** **                                                                                                                                                                                                                                                                                      |
|   | **Commission  file number 333-118829**                                                                                                                                                                                                                                                          |

**Cellu Tissue Holdings, Inc.****** (Exact name of registrant as specified in itscharter)

| **Delaware**                                               | ** ** | **06-1346495**                    |
|------------------------------------------------------------|------------|-----------------------------------|
| (State of incorporation)                                   |       | (IRS Employer Identification No.) |
| ** **                                                 | ** ** | ** **                        |
| **1855 Lockeway Drive, Suite 501,  Alpharetta, Georgia**   | ** ** | **30004**                         |
| (Address of principal executive  offices)                  |       | (zip code)                        |
|                                                       |
|  **(678) 393-2651**                                   |
| (Registrant’s telephone number,  including area code) |

**NotApplicable** (Former name, former address and former fiscalyear, if changed since last report)

Indicate by check mark whether theregistrant: (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports)and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer”inRule 12b-2 of the Exchange Act.

| Large  accelerated filer o |   | Accelerated  filer o |   | Non-accelerated  filer  x |
|----------------------------|--------|----------------------|--------|--------------------------------|

Indicate by check mark whether theregistrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct).  Yes o No x

The number ofshares outstanding of each of the registrant’s classes of common stock as of January4, 2008:

 

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

 

 

CELLUTISSUE HOLDINGS, INC.

FORM10-Q

QUARTERENDED NOVEMBER 29, 2007

 

INDEX

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

 

 

2

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**Part 1 FINANCIAL INFORMATION**

**Item 1.Consolidated Financial Statements**
|   | ** ** | **CELLU TISSUE HOLDINGS, INC. AND  SUBSIDIARIES**      |
|--------|------------|--------------------------------------------------------|
|   | ** ** | **CONSOLIDATED STATEMENTS OF  OPERATIONS (Unaudited)** |

 
| ** **                                    | ** ** | **Three Months Ended** | ** **  |
|-----------------------------------------------|------------|------------------------|-------------|
| ** **                                    | ** ** | **November 29, 2007**  | ** **  | **November 23, 2006** | ** ** |
| ** **                                    | ** ** | **(Post-Merger)**      | ** **  | **(Post-Merger)** | ** ** |
| ** **                                    | ** ** | ** **             | ** **  | ** ** | ** ** |
| Net sales                                     |       | $                      | 109,161,988 |   | $ | 83,281,206 |   |
| Cost of  goods sold                           |       | 97,646,110             |        | 77,390,427 |   |
| Gross  profit                                 |       | 11,515,878             |        | 5,890,779 |   |
|                                          |       |                   |        |   |   |
| Selling,  general and administrative expenses |       | 4,835,215              |        | 3,240,571 |   |
| Stock and  related compensation expense       |       | 714,812                |        | 169,806 |   |
| Merger-related  transaction costs             |       | —                 |        | 53,474 |   |
| Income  from operations                       |       | 5,965,851              |        | 2,426,928 |   |
|                                          |       |                   |        |   |   |
| Interest  expense, net                        |       | 4,843,976              |        | 4,066,402 |   |
| Foreign  currency loss (gain)                 |       | 220,348                |        | (79,440 | ) |
| Other  income                                 |       | (104,573               | )           | (3,501 | ) |
| Income  (loss) before income tax benefit      |       | 1,006,100              |        | (1,556,533 | ) |
|                                          |       |                   |        |   |   |
| Income  tax benefit                           |       | (369,572               | )           | (481,798 | ) |
| Net  income (loss)                            |       | $                      | 1,375,672   |   | $ | (1,074,735 | ) |

 

See accompanying notes to consolidated financialstatements.

 

3

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|   | ** ** | **CELLU TISSUE HOLDINGS, INC. AND  SUBSIDIARIES**                  |
|--------|------------|--------------------------------------------------------------------|
|   | ** ** | **CONSOLIDATED STATEMENTS OF  OPERATIONS (Unaudited) (continued)** |

 
| ** **                                    | ** ** | **For the Periods**   | ** **  |
|-----------------------------------------------|------------|-----------------------|-------------|
| ** **                                    | ** ** | **(Post - Merger)**   | ** **  | **(Pre-Merger)** | ** ** |
| ** **                                    | ** ** | **March 1, 2007-**    | ** **  | **June 13, 2006-** | ** ** | **March 1, 2006-** | ** ** |
| ** **                                    | ** ** | **November 29, 2007** | ** **  | **November 23, 2006** | ** ** | **June 12, 2006** | ** ** |
| Net sales                                     |       | $                     | 321,363,095 |   | $ | 151,843,592 |   | $ | 94,241,932 |   |
| Cost of  goods sold                           |       | 289,788,562           |        | 142,608,186 |   | 86,053,812 |   |
| Gross  profit                                 |       | 31,574,533            |        | 9,235,406 |   | 8,188,120 |   |
|                                          |       |                  |        |   |   |   |   |
| Selling,  general and administrative expenses |       | 13,874,266            |        | 7,018,962 |   | 5,584,865 |   |
| Stock and  related compensation expense       |       | 1,097,812             |        | 306,076 |   | — |   |
| Restructuring  costs                          |       | —                |        | 240,218 |   | — |   |
| Merger-related  transaction costs             |       | —                |        | 155,849 |   | 5,933,265 |   |
| Income  (loss) from operations                |       | 16,602,455            |        | 1,514,301 |   | (3,330,010 | ) |
|                                          |       |                  |        |   |   |   |   |
| Interest  expense, net                        |       | 14,965,736            |        | 7,218,938 |   | 4,896,355 |   |
| Foreign  currency loss (gain)                 |       | 740,756               |        | (146,116 | ) | 289,010 |   |
| Other  income                                 |       | (187,073              | )           | (20,954 | ) | (27,049 | ) |
| Income  (loss) before income tax benefit      |       | 1,083,036             |        | (5,537,567 | ) | (8,488,326 | ) |
| Income  tax benefit                           |       | (251,982              | )           | (1,843,447 | ) | (1,953,362 | ) |
| Net  income (loss)                            |       | $                     | 1,335,018   |   | $ | (3,694,120 | ) | $ | (6,534,964 | ) |

 

Seeaccompanying notes to consolidated financial statements.

 

4

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| **CELLU TISSUE HOLDINGS, INC. AND SUBSIDIARIES** |
|--------------------------------------------------|
| **CONSOLIDATED BALANCE SHEETS**                  |

 
| ** **                                                                                                                                       | ** ** | **November 29** | ** **  | **February 28** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|-------------|-----------------|------------|
|                                                                                                                                             | ** ** | **2007**        | ** **  | **2007**        | ** ** |
|                                                                                                                                             | ** ** | **(Unaudited)** | ** **  | ** **      | ** ** |
| **ASSETS**                                                                                                                                       | ** ** | ** **      | ** **  | ** **      | ** ** |
| CURRENT  ASSETS:                                                                                                                                 |       |            |        |            |       |
| Cash and  cash equivalents                                                                                                                       |       | $               | 1,681,072   |            | $          | 16,260,601 |   |
| Receivables,  net                                                                                                                                |       | 43,523,811      |        | 34,140,844      |       |
| Inventories                                                                                                                                      |       | 30,898,908      |        | 29,603,809      |       |
| Prepaid  expenses and other current assets                                                                                                       |       | 6,574,081       |        | 2,809,014       |       |
| Income  tax receivable                                                                                                                           |       | 327,183         |        | 329,861         |       |
| Deferred  income taxes                                                                                                                           |       | 6,262,777       |        | 6,498,098       |       |
| TOTAL  CURRENT ASSETS                                                                                                                            |       | 89,267,832      |        | 89,642,227      |       |
| PROPERTY,  PLANT AND EQUIPMENT, NET                                                                                                              |       | 292,178,158     |        | 228,851,765     |       |
| GOODWILL                                                                                                                                         |       | 6,944,317       |        | —          |       |
| TRADEMARKS                                                                                                                                       |       | 8,750,314       |        | 6,550,314       |       |
| OTHER  ASSETS                                                                                                                                    |       | 1,531,631       |        | 224,438         |       |
| TOTAL  ASSETS                                                                                                                                    |       | $               | 398,672,252 |            | $          | 325,268,744 |   |
|                                                                                                                                             |       |            |        |            |       |
| **LIABILITIES AND STOCKHOLDERS' EQUITY**                                                                                                         | ** ** | ** **      | ** **  | ** **      | ** ** |
| CURRENT  LIABILITIES:                                                                                                                            |       |            |        |            |       |
| Bank  overdrafts                                                                                                                                 |       | $               | 2,213,043   |            | $          | — |   |
| Revolving  line of credit                                                                                                                        |       | 3,500,000       |        | —          |       |
| Accounts  payable                                                                                                                                |       | 23,094,400      |        | 16,523,755      |       |
| Accrued  expenses                                                                                                                                |       | 23,271,781      |        | 16,315,163      |       |
| Accrued  interest                                                                                                                                |       | 3,746,490       |        | 7,226,753       |       |
| Current  portion of long-term debt                                                                                                               |       | 760,000         |        | —          |       |
| TOTAL  CURRENT LIABILITIES                                                                                                                       |       | 56,585,714      |        | 40,065,671      |       |
| LONG-TERM  DEBT, LESS CURRENT PORTION                                                                                                            |       | 197,929,287     |        | 160,355,507     |       |
| DEFERRED  INCOME TAXES                                                                                                                           |       | 64,592,517      |        | 50,677,332      |       |
| OTHER  LIABILITIES                                                                                                                               |       | 35,154,438      |        | 35,179,252      |       |
| STOCKHOLDERS'  EQUITY :                                                                                                                          |       |            |        |            |       |
| Common  stock, Class A, $.01 par value, 1,000 shares  authorized, 100 shares issued and outstanding at   November 29, 2007 and February 28, 2007 |       |            |        |            |       |
|                                                                                                                                             |       |            |        |            |
|                                                                                                                                             | 1          |            | 1           |            |
| Capital  in excess of par value                                                                                                                  |       | 46,854,562      |        | 46,259,101      |       |
| Accumulated  deficit                                                                                                                             |       | (4,857,348      | )           | (6,192,366      | )          |
| Accumulated  other comprehensive (loss) income                                                                                                   |       | 2,413,081       |        | (1,075,754      | )          |
| TOTAL  STOCKHOLDERS' EQUITY                                                                                                                      |       | 44,410,296      |        | 38,990,982      |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                      |       | $               | 398,672,252 |            | $          | 325,268,744 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

5

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| **CELLU TISSUE HOLDINGS, INC. AND  SUBSIDIARIES   CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)** |   |
|-------------------------------------------------------------------------------------------------------|--------|
| ** **                                                                                            |

 
| ** **                                                                                           | ** ** | **For the Periods**   | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                           | ** ** | **Post**              | **-**      | **Merger** | ** ** | **Pre-Merger** | ** ** |
| ** **                                                                                           | ** ** | **March 1, 2007-**    | ** ** | **June 13, 2006-** | ** ** | **March 1, 2006-** | ** ** |
| ** **                                                                                           | ** ** | **November 29, 2007** | ** ** | **November 23, 2006** | ** ** | **June 12, 2006** | ** ** |
|                                                                                                 |       |                  |       |   |   |   |   |
| **Cash flows from operating activities**                                                             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  income (loss)                                                                                   |       | $                     | 1,335,018  |   | $ | (3,694,120 | ) | $ | (6,534,964 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                  |       |   |   |   |   |
|                                                                                                 |       |                  |       |   |   |   |
| Noncash  inventory charge                                                                            |       | —                |       | 909,264 |   | — |   |
| Stock-based  compensation                                                                            |       | 595,461               |       | 306,096 |   | 923,580 |   |
| Deferred  income taxes                                                                               |       | (3,088,003            | )          | (1,760,180 | ) | (396,024 | ) |
| Accretion  of debt discount                                                                          |       | 458,780               |       | 239,092 |   | 85,471 |   |
| Amortization  of intangibles                                                                         |       | —                |       | — |   | 405,568 |   |
| Depreciation                                                                                         |       | 17,568,304            |       | 10,041,824 |   | 4,226,643 |   |
| Changes  in operating assets and liabilities:                                                        |       |                  |       |   |   |   |   |
| Receivables                                                                                          |       | (3,811,469            | )          | 2,956,053 |   | (1,994,674 | ) |
| Inventories                                                                                          |       | 250,334               |       | (1,601,320 | ) | (2,208,757 | ) |
| Prepaid  expenses, other current assets and income tax receivable                                    |       |                  |       |   |   |   |   |
|                                                                                                 | (2,604,297 | )                     | 96,906     |   | (683,329 | ) |
| Other                                                                                                |       | 357,991               |       | (35,240 | ) | (5,328 | ) |
| Accounts  payable, accrued expenses, accrued interest and income taxes                               |       |                  |       |   |   |   |   |
|                                                                                                 | 2,795,383  |                  | (5,138,065 | ) | (358,006 | ) |
| Total  adjustments                                                                                   |       | 12,522,484            |       | 6,014,430 |   | (4,856 | ) |
| *Net cash provided by (used in) operating  activities*                                               |       | 13,857,502            |       | 2,320,310 |   | (6,539,820 | ) |
|                                                                                                 |       |                  |       |   |   |   |   |
| **Cash flows from investing activities**                                                             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid  for acquisition, net of cash received                                                     |       | (43,637,578           | )          | — |   | — |   |
| Equity  investment by Weston Presidio                                                                |       | —                |       | 45,761,997 |   | — |   |
| Capital  expenditures, net                                                                           |       | (10,965,313           | )          | (3,995,243 | ) | (1,937,610 | ) |
| *Net cash (used in) provided by investing  activities*                                               |       | (54,602,891           | )          | 41,766,754 |   | (1,937,610 | ) |
|                                                                                                      |            |                       |            |  |  |  |  |  |  |  |

 

6

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| **CELLU TISSUE HOLDINGS, INC. AND  SUBSIDIARIES   CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (continued)** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                        |

 
| ** **                                             | ** ** | **For the Periods**   | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **Post**              | **-**      | **Merger** | ** ** | **Pre-Merger** | ** ** |
| ** **                                             | ** ** | **March 1, 2007-**    | ** ** | **June 13, 2006-** | ** ** | **March 1, 2006-** | ** ** |
| ** **                                             | ** ** | **November 29, 2007** | ** ** | **November 23, 2006** | ** ** | **June 12, 2006** | ** ** |
|                                                   |       |                  |       |   |   |   |   |
| **Cash flows from financing activities**               | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Bank overdrafts                                        |       | 2,213,043             |       | — |   | — |   |
| Merger  consideration paid to former shareholders      |       | —                |       | (45,761,997 | ) | — |   |
| Payments  of long-term debt                            |       | (575,000              | )          | — |   | (290,000 | ) |
| Borrowings  on revolving line of credit, net           |       | 3,500,000             |       | — |   | — |   |
| Proceeds  from bond offering                           |       | 20,000,000            |       | — |   | — |   |
| *Net cash provided by (used in) financing  activities* |       | 25,138,043            |       | (45,761,997 | ) | (290,000 | ) |
| * *                                               | * *   | * *              | * *   | * * | * * | * * | * * |
| Effect of  foreign currency                            |       | 1,027,817             |       | (406,629 | ) | 362,212 |   |
| *Net decrease in cash and cash equivalents*            |       | (14,579,529           | )          | (2,081,562 | ) | (8,405,218 | ) |
| *Cash and cash equivalents at beginning of period*     |       | 16,260,601            |       | 14,418,844 |   | 22,824,062 |   |
| *Cash and cash equivalents at end of period*           |       | $                     | 1,681,072  |   | $ | 12,337,282 |   | $ | 14,418,844 |   |
|                                                        |            |                       |            |  |  |  |  |  |  |  |

 

*See accompanying notes to consolidated financial statements.*

 

7

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited)November 29, 2007**

**Note 1 Basis ofPresentation and Significant Accounting Policies**

The accompanying unauditedinterim consolidated financial statements include the accounts of Cellu TissueHoldings, Inc.  (the “Company” ) andits wholly owned subsidiaries.  TheCompany is a wholly owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”).

On June 12, 2006 theParent consummated an Agreement and Plan of Merger with Cellu ParentCorporation (“Cellu Parent”), a corporation organized and controlled by WestonPresidio V, L.P. (“Weston Presidio”), and Cellu Acquisition Corporation, awholly owned subsidiary of Cellu Parent and a newly formed corporation indirectlycontrolled by Weston Presidio (“Merger Sub”). Pursuant to the agreement, on June 12, 2006, Merger Sub was mergedwith and into Parent, with Parent surviving (the “Merger”).  Accordingly, the operating results and cashflows for the prior year are presented in the accompanying financial statementson a pre-merger (period from March 1, 2006 to June 12, 2006) andpost-merger (three months ended November 23, 2006 and the period June 13,2006 to November 23, 2006) basis. The current year operating results and cash flows are post-merger.

These statements have beenprepared in accordance with U.S. generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q and Article 10of Regulation S-X.  Accordingly, they donot include all of the information and footnotes required by U.S. generallyaccepted accounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the quarter and nine months ended November 29,2007 are not necessarily indicative of the results that may be expected for thefiscal year ending February 29, 2008. For further information, refer to the Company’s consolidated financialstatements and footnotes thereto as of February 28, 2007 and for the yearthen ended contained in the Company’s Annual Report on Form 10-K, fromwhich the consolidated balance sheet at February 28, 2007 has been derivedand the Company’s latest Current Reports on Form 8-K as filed with theSecurities and Exchange Commission (“SEC”).

The Company accounted forthe Merger as a purchase in accordance with the provisions of Statement ofFinancial Accounting Standards No. 141 (“SFAS 141”), *BusinessCombinations*, which resulted in a new valuation for the assets andliabilities of the Company based upon fair values as of the date of theMerger.  As allowed under SEC StaffAccounting Bulletin No. 54, *Push Down Basis ofAccounting Required in Certain Limited Circumstances*, the Companyhas reflected all applicable purchase accounting

 

8

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited) (continued)**

**Note 1 Basis ofPresentation and Significant Accounting Policies (continued)**

 

adjustments in the Company’sconsolidated financial statements for all periods subsequent to the Merger date(“Push Down Accounting”).  Push Down Accountingrequires the Company to establish a new basis for its assets and liabilitiesbased on the amount paid for its equity at close of business on June 12,2006.  Accordingly, Cellu Parent’sownership basis is reflected in the Company’s consolidated financial statementsbeginning upon completion of the Merger. In order to apply Push Down Accounting, Cellu Parent’s purchase price of$207.8 million, including assumption of $162.0 million in aggregate principalamount of the Company’s outstanding 9.75% senior secured notes (the “Notes”),was allocated to the assets and liabilities based on their relative fairvalues.  The total consideration issubject to adjustment for up to an additional $35.0 million in contingentearnout consideration based upon the achievement of certain financialtargets.  If any portion of the earnedcontingent payments is unable to be made, then Weston Presidio has agreed toprovide the necessary funds to former holders of the Parent’s capital stock,options and warrants through an equity investment in Parent or otherwise.  In accordance with SFAS 141, the $35.0million has been recognized as a liability in the Company’s balance sheet andis recorded in other liabilities as of November 29, 2007.

The Company has allocatedthe excess purchase price over the net assets acquired in the Merger based onits estimates of the fair value of assets and liabilities as follows:

| ** **                     | ** ** | **Excess purchase price allocated  to:** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|
| Inventories                    |       | $                                        | 909,264    |   |
| Property,  plant and equipment |       | 142,292,525                              |       |
| Trademarks                     |       | 6,550,314                                |       |
| Long-term  debt                |       | (900,729                                 | )          |
| Contingent  consideration      |       | (35,000,000                              | )          |
| Deferred  income taxes         |       | (50,830,323                              | )          |
| Total                          |       | $                                        | 63,021,051 |   |

 

In conjunction with thevaluation of the Company’s fixed assets, the lives over which the assets aredepreciated were re-evaluated and the resulting estimated useful lives of theprincipal classifications of depreciable assets are as follows:

|                       | ** ** | **Life in Years** |
|----------------------------|------------|-------------------|
| Buildings and improvements |       | 20-30             |
| Machinery and equipment    |       | 15-30             |
| Furniture and fixtures     |       | 10                |
| Land improvements          |       | 5                 |
| Computer software          |       | 5                 |

 

9

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited) (continued)**

**Note 1 Basis ofPresentation and Significant Accounting Policies (continued)**

Reclassification

Certain prior year amountshave been reclassified to conform to the current fiscal year 2008 presentation.

Stock-Based Compensation

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS 123R”), *Share-Based Payment*,which requires the measurement of all employee share-based payments toemployees, including grants of employee stock options, using fair-value-basedmethod and the recording of such expense in the Company’s consolidatedstatement of operations.  The Companyadopted the provisions of SFAS 123R using the prospective method effective March 1,2006.  As such, there was no accountingeffect on any outstanding awards.  Uponadoption of SFAS 123R, the Company had only one share-based payment arrangementunder which the Parent granted stock options to certain members of the Company’smanagement under the Cellu Paper Holdings, Inc. 2001 Stock Incentive Plan(the “old Plan”).  In accordance with theold Plan, each option outstanding at the time of a change in controlimmediately vested and became exercisable. Furthermore, in accordance with the terms of the Merger, all outstandingoptions were cancelled and automatically converted into the right to receive theper share merger consideration for in-the-money options.

On June 12, 2006, theBoard of Directors of Cellu Parent adopted the 2006 Stock Option and RestrictedStock Plan (the “Plan”).  Under the Plan,the Plan Administrator may make awards of options to purchase shares of commonstock of Cellu Parent and/or awards of restricted shares of common stock ofCellu Parent.  A maximum of 8,095 sharesof common stock of Cellu Parent may be delivered in satisfaction of awardsunder the Plan, determined net of shares of common stock withheld by CelluParent in payment of the exercise price of an award or in satisfaction of taxwithholding requirements.  Key employeesand directors of, and consultants and advisors to, Cellu Parent or itsaffiliates who, in the opinion of the Plan Administrator, are in a position tomake a significant contribution to the success of Cellu Parent and itsaffiliates are eligible to participate in the Plan.   Stock options are granted at the marketprice of the Company’s stock on the date of grant and have a 10-year term.  Generally, stock option grants vest ratablyover four years from the date of grant. The following describes how certain assumptions affecting the estimatedfair value of stock options are determined. The dividend yield is zero; the volatility is based on historical marketvalue of the Company’s stock; and the risk-free interest rate is based on U.S.Treasury securities with

 

10

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited) (continued)**

**Note 1 Basis ofPresentation and Significant Accounting Policies (continued)**

maturities equal to theexpected life of the option.  The Companyuses historical data in order to estimate exercise, termination and holdingperiod behavior for valuation purposes. A summary of the outstanding options as of November 29, 2007 is asfollows:  There was no activity duringthe three months then ended.

| ** **                                | ** ** | **Options** | ** ** | ** ** | **Weighted Average Exercise Price** | ** ** | **Weighted Average  Remaining Contractual Life** | ** **           |
|-------------------------------------------|------------|-------------|------------|------------|-------------------------------------|------------|--------------------------------------------------|----------------------|
| Outstanding,  August 31, 2007   | ** ** |        | ** ** | ** ** | ** **                          | ** ** | ** **                                       | ** **           | ** ** |
| and  November 29, 2007               |       | 1,150       |       |       | $                                   | 726.99     |                                             | 9.28 and 9.10 years, |   |
|                                      |       |        |       |       |                                |       |  respectively                               |                 |
| Exercisable,  November 29, 2007      |       | —      |       |       | —                              |       | —                                           |                 |
|                                           |            |             |            |            |                                     |            |                                                  |                      |  |  |

 

 

 

The fair value of the stockoption grant was estimated on the date of grant using the Black-Scholes optionpricing model.  The weighted averageassumptions used to value the grants were no dividend yield; 57% volatility;4.9% risk free interest rate; and 10-year expected life.  The weighted average fair value of stockoptions granted was $472.69 per share and the unrecognized total compensationcost as of November 29, 2007 related to nonvested awards is $439,471.

On August 6, 2007,Cellu Parent entered into a Restricted Stock Agreement with the Company’s newlyappointed Chief Financial Officer, pursuant to which Cellu Parent granted 700restricted shares of its common stock to the named individual pursuant to thePlan.  The shares will vest and cease tobe restricted in four equal annual installments commencing on August 6,2007, as long as the named individual is continuously employed by the Companyuntil such vesting date with respect to his shares.  Any restricted stock outstanding at the timeof a Covered Transaction (as defined in the Plan) shall become vested and ceaseto be restricted stock at the time of a change in control.  Additionally, the Parent has agreed to pay anamount to the named individual equal to an amount that would be included insuch individual’s gross income and payable as income tax as a result of makinga Section 83(b) election under the Internal Revenue Code of 1986, asamended.  The named individual has made atimely Section 83(b) election. In connection with this election, the Company has recorded compensationexpense of $501,853 for the three months ended November 29, 2007.

On June 12, 2006, CelluParent entered into Restricted Stock Agreements with the Company’s ChiefExecutive Officer, Chief Operating Officer and the then Chief FinancialOfficer, pursuant to which Cellu Parent granted 3,778 restricted shares of itscommon stock to the Chief Executive Officer and 1,349 restricted shares of itscommon stock to each of the other two named individuals pursuant to thePlan.  The shares will vest and cease tobe restricted in four equal annual installments commencing on June 12,

 

11

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited) (continued)**

**Note 1 Basis ofPresentation and Significant Accounting Policies (continued)**

2007, as long as the namedindividual, as the case may be, is continuously employed by the Company untileach such vesting date with respect to his or her shares.  Any restricted stock outstanding at the timeof a Covered Transaction (as defined in the Plan) shall become vested and ceaseto be restricted stock at the time of a change in control.  Additionally, the Parent has agreed to pay anamount to the named individuals equal to an amount that would be included insuch individuals’ gross income and payable as income tax as a result of makinga Section 83(b) election under the Internal Revenue Code of 1986, asamended.  All named individuals have madea timely Section 83(b) election.

Effective July 31,2007, the then Chief Financial Officer resigned and forfeited two-thirds of theindividual’s restricted stock grant and, accordingly, the Company only recordedcompensation expense associated with this individual’s grant through June 12,2007 as all other shares were forfeited and no compensation expense is requiredto be recognized for forfeited shares.

For the three months andnine months ended November 29, 2007, the Company has recorded $179,078****and $506,022, respectively, of compensation expense relatedto the above restricted stock grants.  For the three months ended November 23, 2006 and for the period June 13,2006 to November 23, 2006, the Company has recorded $169,806 and $306,076,respectively of compensation expense related to the vesting of the grants at thattime in accordance with SFAS 123R.

Immediately prior toconsummation of the Merger, there were 341.3 restricted shares of the Parent’scommon stock.  In accordance with theterms of the old Plan, the restricted stock immediately vested.  Accordingly, for the period from May 26,2006 to June 12, 2006, the Company has recorded $870,922 of compensationexpense related to the vesting of the above restricted stock in accordance withSFAS 123R.  The Company had previouslyrecorded $52,658 related to the normal vesting in the three-month period ended May 25,2006.

Derivatives and Hedging

The Company uses derivativefinancial instruments to offset a substantial portion of its exposure to marketrisk arising from changes in the price of natural gas.  Hedging of this risk is accomplished byentering into forward swap contracts, which are designated as hedges ofspecific quantities of natural gas expected to be purchased in futuremonths.    These contracts are held forpurposes other than trading and are designated as cash flow hedges.  The Company measures hedge effectiveness byformally assessing, at least quarterly, the correlation of the expected futurecash flows of the hedged item and the derivative hedging instrument.  The ineffective portions of the hedges, whichare not material for any period presented, are immediately recognized inearnings.  The fair value of these cashflow hedging instruments was a liability of $.1 million and an asset of lessthan $.1 million as of November 29, 2007 and February 28, 2007,respectively.  During the next 12months, the entire $.1 million will be reclassified to earnings consistent withthe timing of the underlying hedged transactions.

 

12

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited) (continued)**

**Note 2 Inventories**

 

Components of inventories are as follows:

 

| ** **                        | ** ** | **November 29, 2007** | ** ** | **February 28, 2007** | ** ** |
|-----------------------------------|------------|----------------------------|------------|----------------------------|------------|
|                              |       |                       |       |                       |       |
| Finished  goods                   |       | $                          | 15,738,863 |                       | $          | 18,896,790 |   |
| Raw  materials                    |       | 5,397,337                  |       | 2,742,025                  |       |
| Packaging  materials and supplies |       | 9,948,053                  |       | 8,098,582                  |       |
|                              |       | 31,084,253                 |       | 29,737,397                 |       |
| Inventory  reserves               |       | (185,345                   | )          | (133,588                   | )          |
|                              |       | $                          | 30,898,908 |                       | $          | 29,603,809 |   |

 

**Note 3 Acquisitions**

On March 21, 2007, theCompany executed a definitive merger agreement (the “Acquisition Agreement”)with CityForest Corporation (“CityForest”), Cellu City Acquisition Corporation(“Cellu City Merger Sub”) and Wayne Gullstad as the shareholders’representative.  Pursuant to theAcquisition Agreement, and subject to the terms and conditions therein, CelluCity Merger Sub, a wholly owned subsidiary of the Company, merged with and intoCityForest, with CityForest surviving and becoming a wholly owned subsidiary ofthe Company (the “Acquisition”).  Theaggregate merger consideration (including assumption of $18.4 million inaggregate principal amount of industrial revenue bonds) was approximately $61.0million subject to certain working capital and net cash adjustments.  Total cash paid for the acquisition of $46.8million (purchase price of $61.0 million less assumed indebtedness of $18.4million plus restricted cash and other miscellaneous adjustments of $1.6million and acquisition costs of $2.6 million) was financed in part by issuanceof unregistered 9 3/4% Senior Secured Notes due 2010 (the “Additional Notes”)of approximately $20.0 million, borrowings on a revolving line of credit ($17.4million) and available cash on hand.

The Acquisition has beenaccounted for as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statements of operations includes the results ofCityForest during the three months and nine months ended November 29, 2007from the date of acquisition.  Purchaseprice allocations are subject to refinement until all pertinent information isobtained.  The Company has allocated theexcess of purchase price over the net assets acquired in the acquisition basedon its estimates of the fair value of assets and liabilities as follows:

 

13

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited) (continued)**

**Note 3 Acquisitions(continued)**

** **

| ** **                     | ** ** | **Excess purchase price allocated  to:** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|
| Property,  plant and equipment |       | $                                        | 32,854,514 |   |
| Trademarks                     |       | 2,200,000                                |       |
| Goodwill                       |       | 6,944,317                                |       |
| Long-term  debt                |       | (1,724,684                               | )          |
| Deferred  income taxes         |       | (17,238,509                              | )          |
| Total                          |       | $                                        | 23,035,638 |   |

 

The Company has estimatedthe fair value of the assets and liabilities of the Acquisition, utilizinginformation available at the time the Company’s unaudited interim financialstatements subsequent to the Acquisition were prepared, and these estimates aresubject to refinement until all pertinent information has been obtained. Atthat time, the Company was in the process of obtaining outside third-partyappraisals of its tangible and intangible assets and had assumed no intangibleassets or goodwill arising from the acquisition.  In the second quarter of the fiscal yearending February 29, 2008 (“fiscal year 2008”), the Company obtained athird-party appraisal of CityForest’s tangible and intangible assets andfinalized its calculation of deferred income taxes resulting from the book totax differences arising from the application of purchase accounting.  As a result thereof, trademarks of $2.2million and goodwill of $6.9 million have been recorded.  Furthermore, the net deferred income taxliability has increased $4.2 million from the Company’s original estimate.

The results of CityForest’soperations from the date of acquisition (March 21, 2007) are included inthe Company’s tissue segment and accordingly, are included for the three monthsended November 29, 2007.  Unauditedpro forma results of operations for the three months ended November 23,2006, for the nine months ended November 29, 2007, for the period June 13,2006-November 23, 2006 and for the period March 1, 2006-June 12,2006, as if the Company and CityForest had been combined as of March 1,2006, are presented below.  The pro formaresults include estimates and assumptions, which the Company’s managementbelieves are reasonable.  However, thepro forma results do not include any cost savings or other effects of theplanned integration of CityForest and are not necessarily indicative of theresults which would have occurred if the business combination had been ineffect on the dates indicated, or which may result in the future.

 

14

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited) (continued)**

**Note 3 Acquisitions(continued)**
| ** **         | ** ** | **Three Months Ended November 23, 2006(1)** | ** ** |
|--------------------|------------|--------------------------------------------------|------------|
| ** **         | ** ** | **As Filed**                                     | ** ** | **Pro Forma** | ** ** |
| ** **         | ** ** | **(in thousands)**                               | ** ** |
| Net  sales         |       | $                                                | 83,281     |   | $ | 95,422 |   |
| Operating  income  |       | $                                                | 2,427      |   | $ | 5,336 |   |
| Net  (loss) income |       | $                                                | (1,075     | ) | $ | 1,461 |   |

 

----

| (1) | Pro forma operating results include the operating  results for CityForest for the three months ended September 30, 2006 as  CityForest was previously a calendar year-end company. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
| ** **               | ** ** | **Nine Months Ended November  29,   2007(1)** | ** ** | **June 13, 2006-November 23,  2006(2)** | ** ** | **March 1, 2006-June 12,  2006(2)** | ** ** |
|--------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **As Filed**                                       | ** ** | **Pro Forma**                                     | ** ** | **As Filed**                                  | ** ** | **Pro Forma** | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **               | ** ** | **(in thousands)**                                 | ** ** | **(in thousands)**                                | ** ** | **(in thousands)**                            | ** ** |
| Net  sales               |       | $                                                  | 321,363    |                                              | $          | 324,073                                       |       | $ | 151,844 |   | $ | 173,272 |   | $ | 94,242 |   | $ | 107,942 |   |
| Operating  income (loss) |       | $                                                  | 16,602     |                                              | $          | 17,188                                        |       | $ | 1,514 |   | $ | 6,761 |   | $ | (3,330 | ) | $ | 25 |   |
| Net  income (loss)       |       | $                                                  | 1,335      |                                              | $          | 1,896                                         |       | $ | (3,694 | ) | $ | 384 |   | $ | (6,535 | ) | $ | (3,928 | ) |

 

----

| (1)    | Pro forma operating results include the operating  results for CityForest for the nine months ended November 29, 2007. The  “as filed” operating results include the operating results for CityForest for  the period from the acquisition date (March 21, 2007) to  November 29, 2007. |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                             |
| (2)    | Pro forma operating results include the operating  results for CityForest for the nine months ended September 30, 2006,  prorated between the two reporting periods presented for the Company, as  CityForest was previously a calendar year-end company.                                                   |

 

 

15

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

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

 

**Note 4Long-Term Debt**

 

Long-termdebt consists of the following:

 
| ** **                                                                                                      | ** ** | **November 29, 2007** | ** **  | **February 28, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------|-------------|----------------------------|------------|
|  9 3⁄4% senior secured notes due 2010                                                                   |       | $                          | 182,255,572 |                       | $          | 162,000,000 |   |
|  Less discount                                                                                             |       | (1,441,285                 | )           | (1,644,493                 | )          |
|                                                                                                            |       | 180,814,287                |        | 160,355,507                |       |
| Industrial revenue bond  payable, in semi-annual installments,   plus variable interest, due March 1, 2028 |       | 17,875,000                 |        | —                     |       |
|                                                                                                            |       | 198,689,287                |        | 160,355,507                |       |
| Less current portion of  debt                                                                                   |       | 760,000                    |        | —                     |       |
|                                                                                                            |       | $                          | 197,929,287 |                       | $          | 160,355,507 |   |

 

Inconnection with the Acquisition (see Note 3), the Company entered into a NotePurchase Agreement (the “Note Purchase Agreement”) with Wingate Capital Ltd. (“Wingate”),dated March 21, 2007, pursuant to which it issued and sold $20.3 million aggregateprincipal amount of Additional Notes to Wingate for the purchase price of $20.0million, which is equal to 98.7383% of the aggregate principal amount of theAdditional Notes.  The Additional Noteswere issued pursuant to and will be governed by the Indenture, dated as of March 12,2004 (as amended and supplemented, the “Cellu Tissue Indenture”) among theCompany, the subsidiary guarantors party thereto and The Bank of New York TrustCompany, N.A., as successor trustee to the Bank of New York (the “Trustee”).

 

TheNotes and Additional Notes mature on March 15, 2010 and requiresemi-annual interest payments on March 15 and September 15, whichcommenced on September 15, 2004.  The Notes and Additional Notes are collateralized by a senior securedinterest in substantially all of the Company’s assets.  Terms of the indenture under which the Notesand Additional Notes have been issued contain certain covenants, includinglimitations on certain restricted payments and the incurrence of additionalindebtedness.  The Notes and AdditionalNotes are unconditionally guaranteed by all of the Company’s subsidiaries.

 

Inconnection with the Merger (see Note 1), the Company solicited consents withrespect to the Notes.   Consents werereceived with respect to 100% of the aggregate outstanding principal amount ofthe Notes. The Company accepted all of the consents delivered in the consentsolicitation and paid to the consenting noteholders a consent fee of $40 per$1,000 principal amount of Notes for which they delivered consents.  These payments were made in the Company’ssecond quarter of the fiscal year ended February 28, 2007

 

 

16

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

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

 

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

 

(“fiscalyear 2007”).  These payments along withother transaction costs totaling $5.9 million are reflected as merger-relatedtransaction costs on the statement of operations for the prior year.  The Company had previously incurred $.1million in the first quarter of fiscal year 2007.  As a result of the acceptance by the Companyof the consents delivered by noteholders and the completion of the consentsolicitation, the amendments to the Cellu Tissue Indenture described in theConsent Solicitation Statement dated May 9, 2006 and related Supplementdated May 24, 2006 became operative and the Company was not required tomake a change of control offer to purchase any Notes in connection with theMerger.

 

TheCompany entered into a Credit Agreement, dated as of June 12, 2006 (the “CreditAgreement”), among the Company, as U.S. Borrower, Interlake AcquisitionCorporation Limited, a subsidiary of the Company, as Canadian Borrower, Parent,the other loan guarantors party thereto, JPMorgan Chase Bank, N.A., as U.S.Administrative Agent, JPMorgan Chase Bank, N.A., Toronto Branch, as CanadianAdministrative Agent, and the other lenders party thereto.  The Credit Agreement provides for a $35.0million working capital facility, including a letter of credit sub-facility andswing-line loan sub-facility. The Credit Agreement provides that amounts underthe facility may be borrowed, repaid and re-borrowed, subject to a borrowingbase test, until the maturity date, which is June 12, 2011. An amountequal to $32.0 million is available, in U.S. dollars, to the U.S. Borrowerunder the facility, and an amount equal to $3.0 million is available, in U.S.or Canadian dollars, to the Canadian Borrower under the facility.  Borrowings of $17.4 million were made tofinance a portion of the Acquisition.  Asof November 29, 2007, $3.5 million of borrowings remained outstandingunder the working capital facility and excess availability was $33.3million.  In addition to the NotePurchase Agreement, the following agreements were entered into in connectionwith the Acquisition:

 

***Second SupplementalIndenture***

 

The Company, certain of itssubsidiaries, the Trustee and CityForest have executed the Second SupplementalIndenture, dated March 21, 2007 (the “Second Supplemental Indenture”),pursuant to which CityForest became a party to the Cellu Tissue Indenture as asubsidiary guarantor.  As a subsidiaryguarantor, CityForest, on a joint and several basis with all the existingsubsidiary guarantors, fully, unconditionally and irrevocably guarantees toeach holder of the Notes and the Trustee the obligations of Company under itsIndenture and the Notes.

 

***Amendment to CreditAgreement***

 

The Company has entered intoa First Amendment, dated March 21, 2007 (the “Amendment”), to the CreditAgreement dated June 12, 2006 (as amended by the

 

 

17

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

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

 

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

 

Amendment, the “AmendedCredit Agreement”) among Cellu Tissue, as U.S. Borrower, Interlake AcquisitionCorporation Limited, a subsidiary of Cellu Tissue, as Canadian Borrower,certain subsidiaries of Cellu Tissue, Cellu Paper Holdings, Inc., theparent corporation of Cellu Tissue, JPMorgan Chase Bank, N.A. (the “U.S.Administrative Agent”) and JPMorgan Chase Bank, N.A., Toronto Branch (the “CanadianAdministrative Agent”).

 

The Amendment (1) increasesthe working capital facility from $35.0 million to $40.0 million, (2) permitsthe issuance and sale by the Company of the Additional Notes, (3) providesfor the consummation of the Acquisition and the conversion by CityForest from aMinnesota corporation to a Minnesota limited liability company, (4) permitsthe assumption of approximately $18.4 million in aggregate principal amount ofindebtedness of CityForest in connection with the Acquisition in accordancewith the terms of the CityForest Bond Documents (as defined below under “CityForestBond Documents”) and (5) permits the guarantee by Cellu Tissue of certainobligations of CityForest under the CityForest Bond Documents.  In connection with the Amendment, CityForestbecame a guarantor of the obligations of the borrowers under the Amended CreditAgreement.

 

***CityForest Bond Documents***

 

CityForest is party to aLoan Agreement, dated March 1, 1998 (the “Loan Agreement”), with the Cityof Ladysmith, Wisconsin (the “Issuer”). Pursuant to the Loan Agreement, the Issuer loaned the proceeds of theIssuer’s Variable Rate Demand Solid Waste Disposal Facility Revenue Bonds, Series 1998(CityForest Corporation Project) (the “Bonds”) to CityForest to finance the constructionby CityForest of a solid waste disposal facility.  Approximately $18.4 million in aggregateprincipal amount of the Bonds was outstanding as of the date of theAcquisition.  CityForest is required,under the terms of the Indenture of Trust governing the Bonds (the “CityForestIndenture”), to provide a letter of credit in favor of the trustee under theCityForest Indenture (the “Bonds Trustee”). CityForest has entered into an Amended and Restated ReimbursementAgreement, dated March 21, 2007 (the “Reimbursement Agreement” and,together with the CityForest Indenture and the Loan Agreement, the “CityForestBond Documents”), with Associated Bank, National Association (“Associated Bank”),pursuant to which Associated Bank has extended the required letter of credit(the “Associated Bank Letter of Credit”) and has provided a revolving creditfacility to CityForest in an aggregate principal amount of up to $3.5 million(the “Associated Bank Revolving Credit Facility”).

 

The Bonds Trustee ispermitted to draw upon the Associated Bank Letter of Credit to pay principaland interest due on the Bonds, and to provide liquidity to purchase Bonds putto

 

 

18

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

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

 

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

 

CityForest by bondholdersand not remarketed; and CityForest is obligated under the ReimbursementAgreement to reimburse Associated Bank for any such draws. CityForest is alsoobligated to pay a fee in respect of the aggregate amount available to be drawnunder the Associated Bank Letter of Credit at a rate per annum initially equalto 1.25%, subject to adjustment on a quarterly basis based on CityForest’sleverage.  The expiration date of theAssociated Bank Letter of Credit is February 15, 2011.

 

Amounts borrowed byCityForest under the Associated Bank Revolving Credit Facility bear interest ata rate per annum equal to the LIBOR Rate (as defined in the ReimbursementAgreement), plus an applicable margin. The applicable margin percentageinitially is 1.75%, subject to adjustment on a quarterly basis based uponCityForest’s leverage.  During thecontinuance of an event of default, the outstanding principal balance bearsinterest at a rate per annum equal to the then applicable interest rate plus2.00%.  CityForest is also obligated topay a commitment fee in respect of any unused commitment under the AssociatedBank Revolving Credit Facility in an amount equal to 0.50% per annum.  In addition, subject to certain exceptions,if CityForest terminates the Associated Bank Revolving Credit Facility prior toFebruary 15, 2009, CityForest is obligated to pay to Associated Bank a feeequal to 1.00% of the commitment then being terminated. The maturity date ofthe Associated Bank Revolving Credit Facility is February 15, 2011.

 

The Reimbursement Agreementrequires scheduled semi-annual payments of principal of the Bonds equal toapproximately 2.00% of the principal amount outstanding as of the date of theAcquisition, with the balance payable at maturity of the Bonds on March 1,2028. The Reimbursement Agreement also contains a number of other provisionsregarding reserve funds and other mandatory and optional repayments in connectionwith the Bonds.  In addition, theReimbursement Agreement provides that in certain circumstances where theCompany incurs indebtedness, as defined, in excess of amounts currentlypermitted under the CityForest Indenture or refinances the indebtedness issuedunder the Indenture, Associated Bank may require CityForest to repay all of itsobligations to Associated Bank under the Reimbursement Agreement and either tocause the Bonds to be redeemed or to replace the Associated Bank Letter ofCredit with a Substitute Credit Facility, as such term is defined in theCityForest Indenture.

 

The Reimbursement Agreementcontains various affirmative and negative covenants customary for workingcapital and term credit facilities, as well as additional covenants relating tothe Bonds.  The negative covenantsinclude limitations on: indebtedness; liens; acquisitions, mergers andconsolidations; investments; guarantees; asset sales; sale and leasebacktransactions; dividends and distributions; transactions with affiliates;capital expenditures; and changes to the status of the Bonds. CityForest isalso required to

 

 

19

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

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

 

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

 

comply on a quarterly basiswith a maximum leverage covenant and a minimum fixed charge coverage covenant.

 

The Reimbursement Agreementalso contains customary events of default, including:  payment defaults; breaches of representationsand warranties; covenant defaults; cross-defaults to certain other debt,including the Additional Notes and indebtedness under the Amended CreditAgreement; certain events of bankruptcy and insolvency; judgment defaults;certain defaults related to the Employee Retirement Income Security Act of1974, as amended; and a change of control of CityForest or the Company.

 

The Company has guaranteedall of the obligations of CityForest under the Reimbursement Agreement,pursuant to a Guaranty, dated March 21, 2007 (the “Cellu Tissue Guaranty”),executed by the Company in favor of Associated Bank. In addition, theobligations of CityForest under the Reimbursement Agreement are secured byfirst-priority liens in favor of Associated Bank in all of CityForest’sassets.  The U.S. Administrative Agent,the Canadian Administrative Agent, Associated Bank and CityForest have enteredinto an Intercreditor Agreement, dated March 21, 2007, which sets forththe respective rights and priorities of Associated Bank, on the one hand, andthe U.S. Administrative Agent and the Canadian Administrative Agent, on theother hand, as to the collateral of CityForest securing the ReimbursementAgreement and the Amended Credit Agreement.

 

**Note 5Comprehensive Income (Loss)**

 

Thecomponents of comprehensive income (loss) for the three months ended November 29,2007 and November 23, 2006 are as follows:

 
| ** **                                | ** ** | **For the Three Months Ended**            | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **November 29, 2007  (Post-Merger)** | ** ** | **November 23, 2006  (Post-Merger)** | ** ** |
| Net income (loss)                         |       | $                                         | 1,375,672  |   | $ | (1,074,735 | ) |
| Foreign currency  translation adjustments |       | 218,752                                   |       | (358,094 | ) |
| Derivative gain                           |       | 459,296                                   |       | — |   |
| Comprehensive income  (loss)              |       | $                                         | 2,053,720  |   | $ | (1,432,829 | ) |

 

 

20

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

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

 

**Note 5Comprehensive Income (Loss) (continued)**

 

Thecomponents of comprehensive income (loss) for the nine months ended November 29,2007 and for the periods from June 13, 2006 to November 23, 2006 and March 1,2006 to June 12, 2006 are as follows:

 
| ** **                                | ** ** | **Nine Months Ended  November 29, 2007** | ** ** | **June 13, 2006-  November 23, 2006** | ** ** | **March 1, 2006-  June 12, 2006** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                | ** ** | **(Post-Merger)**                             | ** ** | **(Pre-Merger)**                                | ** ** |
| Net income (loss)                         |       | $                                             | 1,335,018  |                                            | $          | (3,694,120                                  | )          | $ | (6,534,964 | ) |
| Foreign currency  translation adjustments |       | 1,027,817                                     |       | (406,629                                        | )          | 362,212                                     |       |
| Derivative loss                           |       | (173,874                                      | )          | (154,672                                        | )          | —                                      |       |
| Comprehensive income  (loss)              |       | $                                             | 2,188,961  |                                            | $          | (4,255,421                                  | )          | $ | (6,172,752 | ) |

 

**Note 6Business Segments**

 

TheCompany 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, other income (expense), income tax expense (benefit)and the impact of foreign currency gains and losses.   A portion of corporate and shared expensesis allocated to each segment**. **Included in income from operationsfor the three months ended November 23, 2006 is $53,474 of restructuringcosts and $1,892,770 of additional depreciation expense related to excesspurchase price allocated to property, plant and equipment.  Of these amounts, $34,758 and $1,230,301,respectively, impacts the tissue segment and $18,716 and $662,469, respectivelyimpacts the machine-glazed paper segment. Included in loss from operations for the period March 1, 2006 to June 12,2006 is $5,933,265 of merger-related transaction costs.  Of this amount, $3,856,622 impacts the tissuesegment and $2,076,643 impacts the machine-glazed paper segment.**** Included in lossfrom operations for the period June 13, 2006 to November 23, 2006 is$155,849 of merger-related transaction costs, $240,218 of restructuring costs,$909,264 for a non-cash charge to cost of goods sold related to excess purchaseprice allocated to inventory and $3,411,200 of additional depreciation expenserelated to excess purchase price allocated to property, plant and equipment.**** Of these amounts,$101,302, $156,142, $591,022 and $2,217,280, respectively, impact the tissuesegment and $54,547, $84,076, $318,242 and $1,193,920, respectively, impact themachine-glazed paper segment. Also, included in loss from operations for thethree months ended November 23, 2006 are compensation charges of $370,320million related to the vesting of restricted stock awards granted after theMerger and other compensation expense related to the Merger. Of this amount,$240,708 and $129,522, respectively, impacts the tissue segment andmachine-glazed

 

 

21

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

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

 

**Note 6Business Segments (continued)**

 

segment,respectively.  Also, included in lossfrom operations for the periods June 13, 2006 to November 23, 2006and March 1, 2006 to June 12, 2006 are compensation charges of$2,205,384****and $1,301,945, respectively, relatedto non-cash compensation expense related to the vesting of restricted stockawards, payments of taxes associated with such awards and other compensationexpense related to the Merger.**** Of these amounts, $1,433,500 and $846,264,respectively, impact the tissue segment and $771,884****and$455,681, respectively, impact the machine-glazed segment.  Segment information for the three monthsended November 29, 2007 and November 23, 2006 follows:

 
| ** **                                   | ** ** | **(Post-Merger)**                             | ** **  |
|----------------------------------------------|------------|-----------------------------------------------|-------------|
| ** **                                   | ** ** | **Three Months Ended November 29, 2007** | ** **  | **Three Months Ended November 23, 2006** | ** ** |
| **Net Sales**                                | ** ** | ** **                                    | ** **  | ** ** | ** ** |
| Tissue                                       |       | $                                             | 81,998,560  |   | $ | 58,059,690 |   |
| Machine-glazed paper                         |       | 27,163,428                                    |        | 25,221,516 |   |
| Consolidated                                 |       | $                                             | 109,161,988 |   | $ | 83,281,206 |   |
| ** **                                   | ** ** | ** **                                    | ** **  | ** ** | ** ** |
| **Income (loss) from operations**            | ** ** | ** **                                    | ** **  | ** ** | ** ** |
| Tissue                                       |       | $                                             | 5,777,310   |   | $ | 1,962,656 |   |
| Machine-glazed paper                         |       | 188,541                                       |        | 464,272 |   |
| Consolidated                                 |       | 5,965,851                                     |        | 2,426,928 |   |
| Interest expense                             |       | (4,856,452                                    | )           | (4,122,043 | ) |
| Net foreign  currencytransaction (loss) gain |       | (220,348                                      | )           | 79,440 |   |
| Interest income                              |       | 12,476                                        |        | 55,641 |   |
| Other income                                 |       | 104,573                                       |        | 3,501 |   |
| Pretax income (loss)                         |       | $                                             | 1,006,100   |   | $ | (1,556,533 | ) |
|                                         |       |                                          |        |   |   |   |   |
| **Capital Expenditures**                     | ** ** | ** **                                    | ** **  | ** ** | ** ** |
| Tissue                                       |       | $                                             | 3,392,489   |   | $ | 1,730,828 |   |
| Machine-glazed paper                         |       | 258,712                                       |        | 391,777 |   |
| Corporate                                    |       | 373,325                                       |        | (11,819 | ) |
| Consolidated                                 |       | $                                             | 4,024,526   |   | $ | 2,110,786 |   |
| ** **                                   | ** ** | ** **                                    | ** **  | ** ** | ** ** |
| **Depreciation**                             | ** ** | ** **                                    | ** **  | ** ** | ** ** |
| Tissue                                       |       | $                                             | 3,954,469   |   | $ | 3,897,453 |   |
| Machine-glazed paper                         |       | 1,419,088                                     |        | 1,628,608 |   |
|                                         |       | $                                             | 5,373,557   |   | $ | 5,526,061 |   |

 

 

22

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

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

 

**Note 6Business Segments (continued)**

 

Segmentinformation for the nine months ended November 29, 2007 and for theperiods June 13, 2006 to November 23, 2006 and March 1, 2006 to June 12,2006 follows:

 
| ** **                                    | ** ** | **(Post-Merger)**                            | ** **  | **(Pre-Merger)**                               | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|-------------|------------------------------------------------|------------|
| ** **                                    | ** ** | **Nine Months Ended November 29, 2007** | ** **  | **June 13, 2006-  November 23,2006** | ** ** | **March 1, 2006-  June 12, 2006** | ** ** |
| **Net Sales**                                 | ** ** | ** **                                   | ** **  | ** **                                     | ** ** | ** ** | ** ** |
| Tissue                                        |       | $                                            | 243,129,416 |                                           | $          | 107,084,355 |   | $ | 67,199,611 |   |
| Machine-glazed paper                          |       | 78,233,679                                   |        | 44,759,237                                     |       | 27,042,321 |   |
| Consolidated                                  |       | $                                            | 321,363,095 |                                           | $          | 151,843,592 |   | $ | 94,241,932 |   |
|                                          |       |                                         |        |                                           |       |   |   |
| **Income (loss) from operations**             | ** ** | ** **                                   | ** **  | ** **                                     | ** ** | ** ** | ** ** |
| Tissue                                        |       | $                                            | 16,243,707  |                                           | $          | 1,843,141 |   | $ | (1,210,487 | ) |
| Machine-glazed paper                          |       | 358,748                                      |        | (328,840                                       | )          | (2,119,523 | ) |
| Consolidated                                  |       | 16,602,455                                   |        | 1,514,301                                      |       | (3,330,110 | ) |
| Interest expense                              |       | (15,041,350                                  | )           | (7,346,364                                     | )          | (5,000,732 | ) |
| Net foreign currency  transaction gain (loss) |       | (740,756                                     | )           | 146,116                                        |       | (289,010 | ) |
| Interest income                               |       | 75,614                                       |        | 127,426                                        |       | 104,377 |   |
| Other income                                  |       | 187,073                                      |        | 20,954                                         |       | 27,049 |   |
| Pretax income (loss)                          |       | $                                            | 1,083,036   |                                           | $          | (5,537,567 | ) | $ | (8,488,326 | ) |

 

 

23

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

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

 

**Note 6Business Segments (continued)**

 
| **Capital Expenditures** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------|------------|------------|------------|------------|------------|------------|------------|
| Tissue                   |       | $          | 8,972,218  |       | $          | 2,929,390  |       | $ | 711,857 |   |
| Machine-glazed paper     |       | 1,229,947  |       | 696,359    |       | 236,288    |       |
| Corporate                |       | 763,148    |       | 369,494    |       | 989,465    |       |
| Consolidated             |       | $          | 10,965,313 |       | $          | 3,995,243  |       | $ | 1,937,610 |   |
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Depreciation**         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Tissue                   |       | $          | 13,111,338 |       | $          | 7,088,006  |       | $ | 3,056,653 |   |
| Machine-glazed paper     |       | 4,456,966  |       | 2,953,818  |       | 1,169,990  |       |
|                     |       | $          | 17,568,304 |       | $          | 10,041,824 |       | $ | 4,226,643 |   |

 
| ** **           | ** ** | **November 29,  2007** | ** **  | **February 28,  2007** | ** ** |
|----------------------|------------|-----------------------------|-------------|-----------------------------|------------|
| **Segment assets**   | ** ** | ** **                  | ** **  | ** **                  | ** ** |
| Tissue               |       | $                           | 308,527,012 |                        | $          | 214,039,270 |   |
| Machine-glazed paper |       | 82,574,836                  |        | 79,277,799                  |       |
| Corporate assets     |       | 7,570,404                   |        | 31,951,675                  |       |
| Consolidated         |       | $                           | 398,672,252 |                        | $          | 325,268,744 |   |

 

**Note 7Income taxes**

 

Theeffective income tax benefit for the three months ended November 29, 2007was 36.7% compared to effective income tax benefit of 31.0% for the threemonths ended November 23, 2006.  Theeffective income tax benefit for the nine months ended November 29, 2007was 23.3% compared to an effective income tax benefit of 33.3% and 23.0%,respectively, for the periods June 13, 2006 to November 23, 2006 and March 1,2006 to June 12, 2006.   Included inthe income tax benefit for the three months and nine months ended November 29,2007 is $.7 million of benefit primarily related to the different book and taxtreatment of deductions related to transaction costs.  This benefit has been recorded in the currentquarter upon completion of the Company’s 2007 tax return as the impact isconsidered discrete to this quarter. Also, included in the effective benefit for the nine months ended November 29,2007 is approximately $90,000 related to additional Canadian income taxes paidupon completion of the Company’s fiscal year 2007 tax returns, which wasrecorded in the second quarter upon completion of those returns.  The effective income tax rate for the threemonths and nine months ended November 29, 2007 without the effect of theabove items was 29.2% and 29.6%, respectively. The effective income tax ratefor the period March 1, 2006 to June 12, 2006 differs from thefederal statutory rate primarily due to non-deductible transactions costsexpensed for book purposes.

 

 

24

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

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

 

**Note 7Income Taxes (continued)**

 

TheCompany adopted Financial Accounting Standards Board (“FASB”) Interpretation48, “*Accounting for Uncertainty in Income Taxes*”(“FIN 48”), at the beginning of the fiscal year ending February 29, 2008 (‘fiscalyear 2008”).  The implementation of FIN48 did not have a material impact on the Company’s results of operations andfinancial position.  At November 29,2007, the Company did not have any unrecognized tax benefits.

 

TheCompany recognizes interest and penalties related to uncertain tax positions inincome tax expense.  As of November 29,2007, the Company has accrued interest and penalties, if any, related touncertain tax positions.

 

Thefiscal tax years 2003 through 2007 remain open to examination by the majortaxing jurisdictions to which the Company is subject.  As of November 29, 2007, the Companydoes not expect any material changes to unrecognized tax positions within thenext 12 months.

 

**Note 8Union Contract**

 

In July 2005, the United Steelworkers of America, referred to asUSW, (formerly the Paper, Allied —Industrial, Chemical & EnergyWorkers International Union, referred to as PACE prior to PACE’s merger withand into USW)was elected to represent 84 hourly employees at our Mississippi facility, andwas certified by the National Labor Relations Board as the exclusive collectivebargaining representative of such employees. On June 29, 2007, a collective bargaining agreement with USW wasratified.

 

**Note 9 Subsequent Event**

* *

In December 2007,the Company purchased machinery and equipment for $5.4 million that it had beenleasing under a 10-year operating lease. The lease had a remaining term of two years and lease payments wereapproximately $1.5 million a year.

 

 

25

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| **Item 2.** | **MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-------------|-------------------------------------------------------------------------------------------------|

 

**OVERVIEW**

Certain statements containedin this Quarterly Report on Form 10-Q may contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities and Exchange Act of1934, as amended, and, as such, may involve known or unknown risks,uncertainties and other factors which may cause our actual results, performanceor achievements to be materially different from future results, performance orachievements expressed or implied by such forward-looking statements.  Forward-looking statements, which are basedon certain assumptions and describe our future plans, strategies andexpectations, are generally identifiable by use of the words “may,” “will,” “should,”“expect,” “anticipate,” “estimate,” “believe,” “intend,” “project,” orcomparable terminology.  Factors whichcould have a material adverse effect on our operations and future prospectsinclude, but are not limited to, those set forth in Item 1.Business-Forward-Looking Statements and Item 1A.  Risk Factors in our Annual Report on Form 10-Kfor our fiscal year ended February 28, 2007.  These risks and uncertainties should beconsidered in evaluating any forward-looking statements contained herein.

We manufacture and market avariety of specialty tissue hard rolls and machine-glazed paper used in themanufacture of various end products, including diapers, facial and bath tissue,assorted paper towels and food wraps.  Inaddition, we produce a variety of converted tissue products.  Our customers include major North Americanproducers of branded and unbranded disposable consumer absorbent and tissueproducts for the personal and health care markets; consumer and away-from-hometissue products companies; national and regional tissue products distributors;and third-party converters who sell their products to food, bakery andconfections companies.  We service adiverse group of high-quality customers, with three of our top 10 customersbelonging to the Fortune 150 group of companies.

We operate in two reportablebusiness segments:  tissue andmachine-glazed paper.  We assess theperformance of our reportable business segments using income from operations.  Income from operations excludes interestincome, interest expense, income tax expense (benefit), other income andexpense and the impact of foreign currency gains and losses.

**Merger**

On June 12, 2006 CelluPaper Holdings, Inc., our parent, consummated an Agreement and Plan ofMerger with Cellu Parent, a corporation organized and controlled by WestonPresidio, and Cellu Acquisition Corporation, a wholly owned subsidiary of CelluParent and a newly formed corporation indirectly controlled by Weston Presidio,or Merger Sub.  Pursuant to theagreement, on June 12, 2006, Merger Sub was merged with and into ourparent, with our parent surviving (referred to herein as the Merger).  Accordingly, the operating results and cashflows for the prior year are presented in the accompanying 

 

26

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financial statements on apre-merger (period from March 1, 2006 to June 12, 2006) andpost-merger (period from June 13, 2006-November 23, 2006) basis.  The current year operating results and cashflows are post-merger.

We accounted for the Mergeras a purchase in accordance with the provisions of Statement of FinancialAccounting Standards No. 141, or SFAS 141, *BusinessCombinations*, which resulted in a new valuation for our assets andliabilities based upon fair values as of the date of the Merger.  As allowed under SEC Staff AccountingBulletin No. 54, *Push Down Basis ofAccounting Required in Certain Limited Circumstances*, we havereflected all applicable purchase accounting adjustments in our consolidatedfinancial statements for all periods subsequent to the Merger date (referred toherein as push down accounting).  Pushdown accounting requires us to establish a new basis for our assets andliabilities based on the amount paid for our equity at close of business on June 12,2006.  Accordingly, Cellu Parent’s equitybasis is reflected in our consolidated financial statements beginning uponcompletion of the Merger.

In order to apply push downaccounting, Cellu Parent’s purchase price of $207.8 million (includingassumption of $162.0 million in aggregate principal amount of our outstanding9.75% senior secured notes), or the Notes, was allocated to the assets andliabilities based on their relative fair values.  The total consideration is subject toadjustment for up to an additional $35.0 million in contingent earnoutconsideration based upon the achievement of certain financial targets.  If any portion of the contingent payments areunable to be made, then Weston Presidio has agreed to provide the necessaryfunds to former holders of our parent’s capital stock, options and warrantsthrough an equity investment in our parent or otherwise.  In accordance with SFAS 141, the $35.0million has been recognized as a liability and is recorded in other liabilitiesas of November 29, 2007.

We have allocated the excesspurchase price over the net assets acquired in the Merger based on ourestimates of the fair value of assets and liabilities as follows:

| ** **                     | ** ** | **Excess purchase  price allocated to:** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|
| Inventories                    |       | $                                        | 909,264    |   |
| Property,  plant and equipment |       | 142,292,525                              |       |
| Trademarks                     |       | 6,550,314                                |       |
| Long-term  debt                |       | (900,729                                 | )          |
| Contingent  consideration      |       | (35,000,000                              | )          |
| Deferred  income taxes         |       | (50,830,323                              | )          |
| Total                          |       | $                                        | 63,021,051 |   |

 

 

**Acquisition**

 

On March 21, 2007, we executed the Acquisition Agreement withCityForest, Cellu City Merger Sub and Wayne Gullstad as the shareholders’representative.  Pursuant to theAcquisition Agreement, and subject to the terms and conditions therein, CelluCity Merger Sub, a wholly owned subsidiary of ours, merged with and intoCityForest, with

 

27

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CityForest surviving andbecoming our wholly owned subsidiary. The aggregate merger consideration (including assumption of $18.4million in aggregate principal amount of industrial revenue bonds) wasapproximately $61.0 million subject to certain working capital and net cashadjustments.  Total cash paid for theacquisition of $46.8 million (purchase price of $61.0 million less assumedindebtedness of $18.4 million plus restricted cash and other miscellaneousadjustments of $1.6 million and acquisition costs of $2.6 million), wasfinanced in part by issuance of unregistered 9 3/4% Senior Secured Notes due2010 (the “Additional Notes”) of approximately $20.0 million, borrowings on arevolving line of credit ($17.4 million) and available cash on hand.

The Acquisition has beenaccounted for as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statements of operations includes the results ofCityForest during the three months and nine months ended November 29, 2007from the date of Acquisition.  Purchaseprice allocations are subject to refinement until all pertinent information isobtained.  We have allocated the excessof purchase price over the net assets acquired in the acquisition based on ourestimates of the fair value of assets and liabilities as follows:

| ** **                     | ** ** | **Excess purchase price allocated  to:** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|
| Property,  plant and equipment |       | $                                        | 32,854,514 |   |
| Trademarks                     |       | 2,200,000                                |       |
| Goodwill                       |       | 6,944,317                                |       |
| Long-term  debt                |       | (1,724,684                               | )          |
| Deferred  income taxes         |       | (17,238,509                              | )          |
| Total                          |       | $                                        | 23,035,638 |   |

 

 

We have estimated the fairvalue of the assets and liabilities of the Acquisition, utilizing informationavailable at the time our unaudited interim financial statements subsequent tothe Acquisition were prepared, and these estimates are subject to refinementuntil all pertinent information has been obtained. At that time, we were in theprocess of obtaining outside third-party appraisals of our tangible andintangible assets and had assumed no intangible assets or goodwill arising fromthe acquisition.  In the second quarterof fiscal year 2008, we obtained a third-party appraisal of CityForest’stangible and intangible assets and finalized the calculation of deferred incometaxes resulting from the book to tax differences arising from the applicationof purchase accounting.  As a resultthereof, trademarks of $2.2 million and goodwill of $6.9 million have beenrecorded.  Furthermore, the net deferredincome tax liability has increased $4.2 million from our original estimate.

The results of CityForest’soperations from the date of acquisition (March 21, 2007) are included inour tissue segment and accordingly, are included for the three months ended November 29,2007.  Unaudited pro forma results ofoperations for the three months ended November 23, 2006, for the ninemonths ended November 29, 2007, for the periods June 13, 2006-November 23,2006 and March 1, 2006-June 12, 2006, as if we and CityForest hadbeen combined as of March 1, 2006, are presented below.  The pro forma results include estimates andassumptions, which our management believes are

 

28

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reasonable.  However, the pro forma results do not includeany cost savings or other effects of the planned integration of CityForest andare not necessarily indicative of the results which would have occurred if thebusiness combination had been in effect on the dates indicated, or which mayresult in the future.

 

| ** **         | ** ** | **Three Months Ended November 23, 2006(1)** | ** ** |
|--------------------|------------|--------------------------------------------------|------------|
| ** **         | ** ** | **As Filed**                                     | ** ** | **Pro Forma** | ** ** |
| ** **         | ** ** | **(in thousands)**                               | ** ** |
| Net  sales         |       | $                                                | 83,281     |   | $ | 95,422 |   |
| Operating  income  |       | $                                                | 2,427      |   | $ | 5,336 |   |
| Net  income (loss) |       | ($1,075                                          | )          | $ | 1,461 |   |

 

----

| (1) | Pro forma operating results include the operating  results for CityForest for the three months ended September 30, 2006 as  CityForest was previously a calendar year-end company. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
| ** **               | ** ** | **Nine Months Ended  November 29, 2007(1)** | ** ** | **June 13,  2006-November 23, 2006(2)** | ** ** | **March 1, 2006-June 12,  2006(2)** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **As Filed**                                     | ** ** | **Pro Forma**                                     | ** ** | **As Filed**                                  | ** ** | **Pro Forma** | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **               | ** ** | **(in thousands)**                               | ** ** | **(in thousands)**                                | ** ** | **(in thousands)**                            | ** ** |
| Net  sales               |       | $                                                | 321,363    |                                              | $          | 324,073                                       |       | $ | 151,844 |   | $ | 173,272 |   | $ | 94,242 |   | $ | 107,942 |   |
| Operating  income (loss) |       | $                                                | 16,602     |                                              | $          | 17,188                                        |       | $ | 1,514 |   | $ | 6,761 |   | ($3,330 | ) | $ | 25 |   |
| Net  income (loss)       |       | $                                                | 1,335      |                                              | $          | 1,896                                         |       | ($3,694 | ) | $ | 384 |   | ($6,535 | ) | ($3,928 | ) |
|                          |            |                                                  |            |                                                   |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

| (1)    |   | Pro forma operating results include the operating  results for CityForest for the nine months ended November 29, 2007. The  “as filed” operating results include the operating results for CityForest for  the period from the acquisition date (March 21, 2007) to  November 29, 2007. |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                             |   |   |
| (2)    |   | Pro forma operating results include the operating  results for CityForest for the nine months ended September 30, 2006,  prorated between the two reporting periods presented for us, as CityForest  was previously a calendar year-end company.                                                            |

 

**Union Contract**

In July 2005, the United Steelworkers of America,referred to as USW, (formerly represented by the Paper, Allied —Industrial,Chemical & Energy Workers International Union, referred to as PACEprior to PACE’s merger with and into USW) was elected to represent 84 hourly employees at ourMississippi facility, and was certified by the National Labor Relations Boardas the exclusive collective bargaining representative of such employees.  On June 29, 2007, a collectivebargaining agreement with USW was ratified.

 

29

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**Subsequent Event**

In December 2007, wepurchased machinery and equipment for $5.4 million that we had been leasingunder a 10-year operating lease.  Thelease had a remaining term of 2 years and lease payments were approximately$1.5 million a year.

**RESULTS OF OPERATIONS**

The three months ended November 29,2007 (post-merger) has been compared to the three months ended November 23,2006 (post-merger).  The nine monthsended November 29, 2007(post-merger) have been compared to the combinednine months ended November 23, 2006 pre- and post-Merger for purposes ofmanagement’s discussion and analysis of the results of operations.  Any references below to the nine months endedNovember 23, 2006 shall refer to the combined periods.
| ** **                                    | ** ** | **Three Months Ended**     | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|
| ** **                                    | ** ** | **November 23, 2006** | ** ** | **November 29, 2007** | ** ** |
|                                          | ** ** | **(Post-Merger)**          | ** ** |
|                                          |       |                       |       |   |   |
| Net  sales                                    |       | $                          | 83,281,206 |   | $ | 109,161,988 |   |
| Cost  of goods sold                           |       | 77,390,427                 |       | 97,646,110 |   |
| Gross  profit                                 |       | 5,890,779                  |       | 11,515,878 |   |
|                                          |       |                       |       |   |   |
| Selling,  general and administrative expenses |       | 3,240,571                  |       | 4,835,215 |   |
| Stock  and related compensation expense       |       | 169,806                    |       | 714,812 |   |
| Merger-related  transaction costs             |       | 53,474                     |       | — |   |
| Income  from operations                       |       | 2,426,928                  |       | 5,965,851 |   |
|                                          |       |                       |       |   |   |
| Interest  expense, net                        |       | 4,066,402                  |       | 4,843,976 |   |
| Foreign  currency (gain) loss                 |       | (79,440                    | )          | 220,348 |   |
| Other  income                                 |       | (3,501                     | )          | (104,573 | ) |
| Income  (loss) before income tax benefit      |       | (1,556,533                 | )          | 1,006,100 |   |
| Income  tax benefit                           |       | (481,798                   | )          | (369,572 | ) |
| Net  income (loss)                            |       | $                          | (1,074,735 | ) | $ | 1,375,672 |   |

 

30

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| ** **                                    | ** ** | **Pre-Merger**          | ** ** | **Post-Merger**            | ** ** | **Combined**               | ** ** | **Post-Merger**            | ** **  |
|-----------------------------------------------|------------|-------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|-------------|
| ** **                                    | ** ** | **March 1, 2006-** | ** ** | **June 13, 2006-**    | ** ** | **Nine Months  Ended**     | ** ** | **Nine Months  Ended**     | ** **  |
|                                          | ** ** | **June 12, 2006**  | ** ** | **November 23, 2006** | ** ** | **November 23, 2006** | ** ** | **November 29, 2007** | ** **  |
|                                          |       |                    |       |                       |       |                       |       |                       |        |
| Net  sales                                    |       | $                       | 94,241,932 |                       | $          | 151,843,592                |       | $                          | 246,085,524 |   | $ | 321,363,095 |   |
| Cost  of goods sold                           |       | 86,053,812              |       | 142,608,186                |       | 228,661,998                |       | 289,788,562                |        |
| Gross  profit                                 |       | 8,188,120               |       | 9,235,406                  |       | 17,423,526                 |       | 31,574,533                 |        |
|                                          |       |                    |       |                       |       |                       |       |                       |        |
| Selling,  general and administrative expenses |       | 5,584,865               |       | 7,018,962                  |       | 12,603,827                 |       | 13,874,266                 |        |
| Stock  and related compensation expense       |       | —                  |       | 306,076                    |       | 306,076                    |       | 1,097,812                  |        |
| Restructuring  costs                          |       | —                  |       | 240,218                    |       | 240,218                    |       | —                     |        |
| Merger-related  transaction costs             |       | 5,933,265               |       | 155,849                    |       | 6,089,114                  |       | —                     |        |
| Income  (loss) from  operations               |       | (3,330,010              | )          | 1,514,301                  |       | (1,815,709                 | )          | 16,602,455                 |        |
|                                          |       |                    |       |                       |       |                       |       |                       |        |
| Interest  expense, net                        |       | 4,896,355               |       | 7,218,938                  |       | 12,115,293                 |       | 14,965,736                 |        |
| Foreign  currency loss  (gain)                |       | 289,010                 |       | (146,116                   | )          | 142,894                    |       | 740,756                    |        |
| Other  income                                 |       | (27,049                 | )          | (20,954                    | )          | (48,003                    | )          | (187,073                   | )           |
| Income  (loss) before income tax benefit      |       | (8,488,326              | )          | (5,537,567                 | )          | (14,025,893                | )          | 1,083,036                  |        |
| Income  tax benefit                           |       | (1,953,362              | )          | (1,843,447                 | )          | (3,796,809                 | )          | (251,982                   | )           |
| Net  income (loss)                            |       | $                       | (6,534,964 | )                          | $          | (3,694,120                 | )          | $                          | (10,229,084 | ) | $ | 1,335,018 |   |

 

The tables that followpresent unaudited net sales and gross profit for our principal segments for thethree months ended November 29, 2007 and November 23, 2006, ninemonths ended November 29, 2007 and the combined nine months ended November 23,2006.

| ** **            | ** ** | **Three Months Ended**     | ** ** |
|-----------------------|------------|----------------------------|------------|
| ** **            | ** ** | **November 23, 2006** | ** ** | **November 29, 2007** | ** ** |
|                  | ** ** | **(Post-Merger)**          | ** ** | **(Post-Merger)** | ** ** |
| **Net Sales**         | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Tissue                |       | $                          | 58,059,690 |   | $ | 81,998,560 |   |
| Machine-glazed  paper |       | 25,221,516                 |       | 27,163,428 |   |
| Consolidated          |       | $                          | 83,281,206 |   | $ | 109,161,988 |   |
|                  |       |                       |       |   |   |
| **Gross Profit**      | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Tissue                |       | $                          | 4,332,155  |   | $ | 9,662,245 |   |
| Machine-glazed  paper |       | 1,558,624                  |       | 1,853,633 |   |
| Consolidated          |       | $                          | 5,890,779  |   | $ | 11,515,878 |   |

 

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| ** **            | ** ** | **Pre-Merger**          | ** ** | **Post-Merger**            | ** ** | **Combined**               | ** ** | ** **                 | ** **  |
|-----------------------|------------|-------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|-------------|
| ** **            | ** ** | **March 1, 2006-** | ** ** | **June 13, 2006-**    | ** ** | **Nine Months  Ended**     | ** ** | **Nine Months  Ended**     | ** **  |
|                  | ** ** | **June 12, 2006**  | ** ** | **November 23, 2006** | ** ** | **November 23, 2006** | ** ** | **November 29, 2007** | ** **  |
| **Net Sales**         | ** ** | ** **              | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** **  |
| Tissue                |       | $                       | 67,199,611 |                       | $          | 107,084,355                |       | $                          | 174,283,966 |   | $ | 243,129,416 |   |
| Machine-glazed  paper |       | 27,042,321              |       | 44,759,237                 |       | 71,801,558                 |       | 78,233,679                 |        |
| Consolidated          |       | $                       | 94,241,932 |                       | $          | 151,843,592                |       | $                          | 246,085,524 |   | $ | 321,363,095 |   |
|                  |       |                    |       |                       |       |                       |       |                       |        |
| **Gross Profit**      | ** ** | ** **              | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** **  |
| Tissue                |       | $                       | 6,423,465  |                       | $          | 7,085,890                  |       | $                          | 13,509,355  |   | $ | 26,616,813 |   |
| Machine-glazed  paper |       | 1,764,655               |       | 2,149,516                  |       | 3,914,171                  |       | 4,957,720                  |        |
| Consolidated          |       | $                       | 8,188,120  |                       | $          | 9,235,406                  |       | $                          | 17,423,526  |   | 31,574,533 |   |

** **

**Results of Operations forthe Three Months Ended November 29, 2007 (the Fiscal 2008 Three-MonthPeriod) compared to the Three Months Ended November 23, 2006 (the Fiscal2007 Three-Month Period) and the Nine Months Ended November 29, 2007 (theFiscal 2008 Nine-Month Period) compared to the Nine Months ended November 23,2006 (the Fiscal 2007 Nine-Month Period)**

**Net sales** for the fiscal2008 three-month period increased $25.9 million, or 31.1%, to****$109.2 million from $83.3 million for the comparable periodin the prior year. Net sales for the fiscal 2008 nine-month period increased$75.3 million, or 30.6%, to $321.4 from $246.1 million for the comparableperiod in the prior year.  On acompany-wide basis, tons sold increased for the fiscal 2008 three-month periodand the fiscal 2008 nine-month period compared to the comparable periods offiscal 2007.  For the fiscal 2008three-month period, we sold 79,541 tons of tissue hard rolls, machine-glazedpaper hard rolls and converted paper products, an increase of 17,705 tons, or28.6%, compared to the fiscal 2007 three-month period.  For the fiscal 2008 nine-month period, wesold 237,950 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products, an increase of 49,919 tons, or 26.5%, compared to thefiscal 2007 nine-month period.  Netselling price per ton increased from $1,347 and $1,309 for the fiscal 2007three-month and nine-month periods to $1,372 and $1,351 for the fiscal 2008three-month and nine-month periods.

Net sales for our tissuesegment for the fiscal 2008 three-month period were $82.0 million, an increaseof $24.0 million, or 41.2%, from the comparable period in the****prior year.  Netsales for our tissue segment for the fiscal 2008 nine-month period were $243.1million, an increase of $68.8 million, or 39.5%, from the comparable period inthe prior year.  These increases areattributable to the acquisition of CityForest and an increase in tonnage sold,primarily in our converting business, over the comparable periods in the prioryear.

Net sales for ourmachine-glazed segment for the 2008 three-month period were****$27.2million, an increase of $1.9 million, or 7.7%,****fromthe comparable period in the prior year. Net sales for our machine-glazed segment for the 2008 nine-month periodwere

 

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$78.3 million, an increaseof $6.5 million, or 9.0%, from the comparable period in the prior year.   These increases are driven primarily by anincrease in net selling price per ton over the comparable periods in the prioryear.

**Gross profit** for the fiscal2008 three-month period increased to $11.5 million from $5.9 million, anincrease of $5.6 million, or 95.5%, from the comparable period in the prior****year. **  **As a percentage of net sales,gross profit increased to 10.5% in the fiscal 2008 three-month period from 7.1%in the fiscal 2007 three-month period. Gross profit for the fiscal 2008 nine-month period increased to $31.6million from $17.4 million, an increase of $14.2 million, or 81.2%, from thecomparable period in the prior year.

As a percentage of netsales, gross profit increased to 9.8% in the fiscal 2008 nine-month period from7.1% in the fiscal 2007 nine-month period. ** **The increases in gross profit areattributable to continued improvement in product mix, lower manufacturing costand the strong market for tissue hard rolls, compared to the comparable periodin the prior year.

Gross profit for our tissuesegment for the fiscal 2008 three-month period was $9.7 million, an increase of$5.3 million, or 123.0%, from the comparable period in the prior year.  Gross profit for our tissue segment for thefiscal 2008 nine-month period was $26.6 million, an increase of $13.1 million,or 97.0%, from the comparable period in the prior year.

Gross profit for ourmachine-glazed segment for the fiscal 2008 three-month period was $1.8 million,an increase of $.3 million, or 18.9%, from the comparable period in the prioryear.  Gross profit for ourmachine-glazed segment for the fiscal 2008 nine-month period was $5.0 million,an increase of $1.1 million, or 26.7%, from the comparable period in the prioryear.

As a percentage of netsales, gross profit for the tissue segment increased to 11.8% in the fiscal2008 three-month period and 10.9% in the fiscal 2008 nine-month period from****7.5% in the fiscal 2007 three-month period and 7.8% in thefiscal 2007 nine-month period**.**  As a percentage of net sales, gross profitfor the machine-glazed segment increased to 6.8% in the fiscal 2008 three-monthperiod and 6.3% in the fiscal 2008 nine-month period from 6.2% in the fiscal2007 three-month period and 5.5% in the fiscal 2007 nine-month period.

**Selling, general andadministrative expenses**in the fiscal 2008 three-month periodincreased $1.6 million, or 49.2%, to $4.8 million from $3.2 million in thefiscal 2007 three-month period.  Selling,general and administrative expenses in the fiscal 2008 nine-month periodincreased $1.3 million, or 10.1%, to $13.9 million from $12.6 million in thefiscal 2007 nine-month period.  As apercentage of net sales, selling, general and administrative expenses increasedto****4.4% in the fiscal 2008 three-monthperiod and decreased to 4.3% in the fiscal 2008 nine-month period from 3.9% and5.1%, respectively, for the comparable periods in the prior year.  Included in the fiscal 2008 three-month andnine-month periods are $.4 million and $1.2 million, respectively, of ongoingCityForest administrative expenses. Also, included in the fiscal 2008 three-month and nine-month periods areadditional costs incurred in connection with being compliant withSarbanes-Oxley and increases in incentive compensation expense associated withstrong business performance.  Included inthe fiscal 2007 nine-month period****is $.9 millionof non-cash compensation expense related to merger related vesting of restrictedstock awards, $1.4 million of 

 

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other compensation expenserelated to tax payments associated with such awards and $.8 million of othercompensation expense related to the merger.

**Stock and relatedcompensation expense**in the fiscal 2008 three-month and nine-monthperiods of $.7 million and $1.1 million, respectively, and in the fiscal 2007three-month and nine-month periods of $.2 million and $.3 million,respectively, relates to the accounting for restricted stock and stock optiongrants.

**Restructuring costs**in the fiscal2007 three-month and nine-month periods were $.2 million related to severancecosts associated with the elimination of a corporate position.

**Merger-related transactioncosts**in the fiscal 2007 three-month period were less than $.1 million and inthe fiscal 2007 nine-month period were $6.1 million associated with the Merger.

**Interest expense, net**in the fiscal2008 three-month period was $4.8 million compared to $4.1 million in the fiscal2007 three-month period.  Interestexpense, net in the fiscal 2008 nine-month period was $15.0 million compared to$12.1 million in the fiscal 2007 nine-month period.  These increases are due to the assumption ofCityForest debt and additional debt incurred in connection with the acquisitionthereof.

**Foreign currency loss(gain)**in the fiscal 2008 three-month period was a loss of $.2 million and inthe fiscal 2008 nine-month period was a loss of $.7 million compared to a gainof less than $.1 million and a loss of $.2 million, respectively, for thecomparable periods in the prior year.  Thefluctuations relate to the change in the Canadian currency period over period.

**Income tax benefit**for the fiscal2008 three-month period was $.4 million or an effective tax rate of 36.7%compared to income tax benefit of $.5 million or an effective tax rate of 31.0%for the fiscal 2007 three-month period. The income tax benefit for the fiscal year 2008 nine-month period was$.3 million or an effective tax rate of 23.3% compared to income tax benefit of$3.8 million or an effective tax rate of 27.1% for the fiscal year 2007nine-month period.  Included in theincome tax benefit for the three months and nine months ended November 29,2007 is $.7 million of benefit primarily related to the different book and taxtreatment of deductions related to transaction costs.  This benefit has been recorded in the currentquarter upon completion of the Company’s 2007 tax return as the impact isconsidered discrete to this quarter. Also, included in the effective benefit for the nine months ended November 29,2007 is approximately $90,000 related to additional Canadian income taxes paidupon completion of the Company’s fiscal year 2007 tax returns, which wasrecorded in the second quarter upon completion of those returns.  The effective income tax rate for the threemonths and nine months ended November 29, 2007 without the effect of theabove items was 29.2% and 29.6%, respectively. The effective income tax ratefor the period March 1, 2006 to June 12, 2006 differs from thefederal statutory rate primarily due to non-deductible transactions costsexpensed for book purposes.

**Net income**for the fiscal2008 three-month period was $1.4 million, compared to a net loss of $1.1 millionfor the comparable period in the prior year. For the fiscal 2008 nine-

 

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month period, net income was$1.3 million compared to a net loss of $10.2 million for the comparable periodin the prior year.

**FINANCIAL CONDITION**

**Liquidity and CapitalResources**

The table that followspresents cash flows information for the nine months ended November 29,2007 compared to the combined nine months ended November 23, 2006.
| ** **                                               | ** ** | **Pre-Merger**          | ** ** | **Post-Merger**            | ** ** | **Combined**               | ** ** | **Post-Merger**            | ** **  |
|----------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|-------------|
| ** **                                               | ** ** | **March 1, 2006-** | ** ** | **June 13, 2006-**    | ** ** | **Nine Months  Ended**     | ** ** | **Nine Months  Ended**     | ** **  |
|                                                     | ** ** | **June 12, 2006**  | ** ** | **November 23, 2006** | ** ** | **November 23, 2006** | ** ** | **November 29, 2007** | ** **  |
| **Net Provided by (Used in) Operating Activities**       | ** ** | ** **              | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** **  |
| Net  income (loss)                                       |       | $                       | (6,534,964 | )                          | $          | (3,694,120                 | )          | $                          | (10,229,084 | ) | $ | 1,335,018 |   |
| Non-cash  items                                          |       | 5,245,238               |       | 9,736,096                  |       | 14,981,334                 |       | 15,534,542                 |        |
| Changes  in working capital                              |       | (5,250,094              | )          | (3,721,666                 | )          | (8,971,760                 | )          | (3,012,058                 | )           |
| Net  cash provided by (used in) operating activities     |       | $                       | (6,539,820 | )                          | $          | 2,320,310                  |       | $                          | (4,219,510  | ) | $ | 13,857,502 |   |
|                                                     |       |                    |       |                       |       |                       |       |                       |        |
| **Net Cash Provided by (Used in) Investing  Activities** |       | $                       | (1,937,610 | )                          | $          | 41,766,754                 |       | $                          | 39,829,144  |   | $ | (54,602,891 | ) |
|                                                     |       |                    |       |                       |       |                       |       |                       |        |
| **Net Cash Provided by (Used in) Financing  Activities** |       | $                       | (290,000   | )                          | $          | (45,761,997                | )          | $                          | (46,051,997 | ) | $ | 25,138,043 |   |

 

**Net cash provided byoperations** was $13.9 million for the fiscal 2008 nine-monthperiod, compared to net cash used in operations of $4.2 million for the fiscal2007 nine-month period. ** **Non-cash items, consisting ofinventory charge, stock-based compensation, deferred income taxes, depreciationand amortization for the fiscal 2008 nine-month period totaled $15.5 millioncompared to $15.0 million for the 2007 fiscal nine-month period.**   **Cash flows used bychanges in working capital totaled $3.0 million for the fiscal 2008 nine-monthperiod, compared to cash flows used by changes in working capital of $9.0million in the fiscal 2007 nine-month period. With respect to the changes inaccounts receivable and inventory, cash used by these items was $3.5 millionfor the fiscal 2008 nine-month period compared to cash used by these items of$2.9 million for the comparable period in the prior fiscal year.  Cash****used bychanges in prepaid expenses and other current assets was $2.2 million for thefiscal 2008 nine-month period compared to cash used of $.6 million for thecomparable period in the prior fiscal year. Cash provided by changes in accounts payable, accrued expenses andaccrued interest for the fiscal 2008 nine-month period was $2.7 millioncompared to cash used of $5.5 million for the comparable period in the prioryear.

 

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**Netcash used by investing activities** for the fiscal 2008nine-month period was $54.6****millioncompared to net cash provided by investing activities of $39.8 million for thefiscal 2007 nine-month period.  Thefiscal 2008 nine-month period includes $43.6 million of cash paid for theacquisition, net of cash received.  Thefiscal 2007 nine-month period includes $45.8 million related to the equityinvestment by Weston Presidio.  The remainingchange relates to the level of capital spending period over period.

 

**Netcash provided by financing activities** for the fiscal 2008nine-month period was $25.1 million related primarily to financing obtained inconnection with the Acquisition.  The netcash used by financing activities for the fiscal 2007 nine-month period includes$45.8 million related to merger consideration paid to former shareholders.  The remaining $.3 million for the fiscal 2007nine-month period relates to payments on our industrial revenue bond. Our lastpayment on our industrial revenue bond was made in the first quarter of fiscalyear 2007.

 

Inconnection with the acquisition of CityForest, we entered into the NotePurchase Agreement, pursuant to which we issued and sold $20.3 millionaggregate principal amount of Additional Notes to the Wingate for the purchaseprice of $20.0 million, which is equal to 98.7383% of the aggregate principalamount of the Additional Notes.  TheAdditional Notes were issued pursuant to and will be governed by Cellu TissueIndenture among us, our subsidiary guarantors party thereto and the Trustee.

 

OurNotes and Additional Notes mature on March 15, 2010 and requiresemi-annual interest payments on March 15 and September 15, whichcommenced on September 15, 2004.

 

Inconnection with the Merger, we solicited consents with respect to theNotes.   Consents were received withrespect to 100% of the aggregate outstanding principal amount of theNotes.  We accepted all of the consentsdelivered in the consent solicitation and paid to the consenting noteholders aconsent fee of $40 per $1,000 principal amount of Notes for which theydelivered consents.  As a result of theacceptance by us of the consents delivered by noteholders and the completion ofthe consent solicitation, the amendments to the Cellu Tissue Indenturedescribed in the Consent Solicitation Statement dated May 9, 2006 andrelated Supplement dated May 24, 2006 became operative and we were notrequired to make a change of control offer to purchase any Notes in connectionwith the Merger.

 

Furthermore,in connection with the Merger, we entered into the Credit Agreement, among us,as U.S. Borrower, Interlake Acquisition Corporation Limited, one of oursubsidiaries, as Canadian Borrower, our Parent, the other loan guarantors partythereto, JPMorgan Chase Bank, N.A., as U.S. Administrative Agent, JPMorganChase Bank, N.A., Toronto Branch, as Canadian Administrative Agent, and theother lenders party thereto.

 

TheCredit Agreement provides for a $35.0 million working capital facility, whichhas subsequently been increased to $40.0 million (see below), including aletter of credit sub-

 

 

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facilityand swing-line loan sub-facility. The Credit Agreement provides that amountsunder the facility may be borrowed, repaid and re-borrowed, subject to aborrowing base test, until the maturity date, which is June 12, 2011. Anamount equal to $32.0 million is available, in U.S. dollars, to the U.S.Borrower under the facility, and an amount equal to $3.0 million is available,in U.S. or Canadian dollars, to the Canadian Borrower under the facility.  Borrowings of $17.4 million were made tofinance a portion of the acquisition of CityForest.    As of November 29, 2007, there was$3.5 million of borrowings outstanding under the working capital facility andexcess availability of $33.3 million.

 

Inaddition to the Note Purchase Agreement, the following agreements were enteredinto in connection with the acquisition of CityForest:

 

***Second SupplementalIndenture***

 

We, certain of our subsidiaries, the Trusteeand CityForest have executed the Second Supplemental Indenture, pursuant towhich CityForest became a party to the Cellu Tissue Indenture as a subsidiaryguarantor.  As a subsidiary guarantor,CityForest, on a joint and several basis with all the existing subsidiaryguarantors, fully, unconditionally and irrevocably guarantees to each holder ofthe Notes and the Trustee our obligations under its Indenture and the Notes.

 

***Amendment to CreditAgreement***

 

We have entered into theAmendment to the Credit Agreement dated June 12, 2006 among us, as U.S.Borrower, Interlake Acquisition Corporation Limited, one of our subsidiaries,as Canadian Borrower, certain other of our subsidiaries and our Parent,JPMorgan Chase Bank, N.A. (the “U.S. Administrative Agent”) and JPMorgan ChaseBank, N.A., Toronto Branch (the “Canadian Administrative Agent”).

 

The Amendment (1) increasesthe working capital facility from $35.0 million to $40.0 million, (2) permitsthe issuance and sale by us of the Additional Notes, (3) provides for theconsummation of the acquisition of CityForest and the conversion by CityForestfrom a Minnesota corporation to a Minnesota limited liability company, (4) permitsthe assumption of approximately $18.4 million in aggregate principal amount ofindebtedness of CityForest in connection with the acquisition of CityForest inaccordance with the terms of the CityForest Bond Documents and (5) permitsthe guarantee by us of certain obligations of CityForest under the CityForestBond Documents.  In connection with theAmendment, CityForest became a guarantor of the obligations of the borrowersunder the Amended Credit Agreement.

 

***CityForest Bond Documents***

 

CityForest is party to aLoan Agreement with the City of Ladysmith, Wisconsin, as Issuer.  Pursuant to the Loan Agreement, the Issuerloaned the proceeds of the Issuer’s 

 

 

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Bonds to CityForest tofinance the construction by CityForest of a solid waste disposal facility.  Approximately $18.4 million in aggregateprincipal amount of the Bonds was outstanding as of the date of the CityForestacquisition.  CityForest is required,under the terms of the CityForest Indenture, to provide a letter of credit infavor of the Bonds Trustee.  CityForesthas entered into the Reimbursement Agreement with Associated Bank, pursuant towhich Associated Bank has extended the Associated Bank Letter of Credit and hasprovided the Associated Bank Revolving Credit Facility to CityForest in anaggregate principal amount of up to $3.5 million.

 

The Bonds Trustee ispermitted to draw upon the Associated Bank Letter of Credit to pay principaland interest due on the Bonds, and to provide liquidity to purchase Bonds putto CityForest by bondholders and not remarketed; and CityForest is obligatedunder the Reimbursement Agreement to reimburse Associated Bank for any suchdraws. CityForest is also obligated to pay a fee in respect of the aggregateamount available to be drawn under the Associated Bank Letter of Credit at arate per annum initially equal to 1.25%, subject to adjustment on a quarterlybasis based on CityForest’s leverage. The expiration date of the Associated Bank Letter of Credit is February 15,2011.

 

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

 

The Reimbursement Agreement requires scheduledsemi-annual payments of principal of the Bonds equal to approximately 2.00% ofthe principal amount outstanding as of the date of the Acquisition, with thebalance payable at maturity of the Bonds on March 1, 2028. TheReimbursement Agreement also contains a number of other provisions regardingreserve funds and other mandatory and optional repayments in connection withthe Bonds.  In addition, theReimbursement Agreement provides that in certain circumstances where we incurindebtedness in excess of amounts currently permitted under the indenture orrefinances the indebtedness issued under the CityForest Indenture, AssociatedBank may require CityForest to repay all of its obligations to Associated Bankunder the Reimbursement Agreement and either to cause the Bonds to be redeemedor to replace the Associated Bank Letter of Credit with a Substitute CreditFacility, as such term is defined in the CityForest Indenture.

 

 

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The Reimbursement Agreementcontains various affirmative and negative covenants customary for workingcapital and term credit facilities, as well as additional covenants relating tothe Bonds.  The negative covenantsinclude limitations on: indebtedness; liens; acquisitions, mergers and consolidations;investments; guarantees; asset sales; sale and leaseback transactions;dividends and distributions; transactions with affiliates; capitalexpenditures; and changes to the status of the Bonds. CityForest is alsorequired to comply on a quarterly basis with a maximum leverage covenant and aminimum fixed charge coverage covenant.

 

The Reimbursement Agreementalso contains customary events of default, including:  payment defaults; breaches of representationsand warranties; covenant defaults; cross-defaults to certain other debt,including the Additional Notes and indebtedness under the Amended CreditAgreement; certain events of bankruptcy and insolvency; judgment defaults;certain defaults related to the Employee Retirement Income Security Act of1974, as amended; and a change of control of CityForest or us.

 

We have guaranteed all ofthe obligations of CityForest under the Reimbursement Agreement, pursuant tothe Cellu Tissue Guaranty executed by us in favor of Associated Bank. Inaddition, the obligations of CityForest under the Reimbursement Agreement aresecured by first-priority liens in favor of Associated Bank in all ofCityForest’s assets.  The U.S.Administrative Agent, the Canadian Administrative Agent, Associated Bank andCityForest have entered into an Intercreditor Agreement, dated March 21,2007, which sets forth the respective rights and priorities of Associated Bank,on the one hand, and the U.S. Administrative Agent and the CanadianAdministrative Agent, on the other hand, as to the collateral of CityForestsecuring the Reimbursement Agreement and the Amended Credit Agreement.

 

**Cash**as of November 29,2007 decreased to $1.7 million from $16.3 million as of the end of fiscal year2007.  The decrease in our cash positionwas primarily due to using cash on hand to finance a portion of the acquisitionof CityForest, payment of our semi-annual interest in March 2007 andpaydown on the revolving line of credit.

 

**Receivables,net**as of November 29, 2007 increased to $43.5 million from $34.1million as of the end of fiscal year 2007. Included in the $43.5 million is $5.8 million of receivables related toCityForest.  Without the effect of theacquisition, receivables increased $3.6 million from the end of fiscal year2007, primarily due to increased net sales and timing of customer payments.

 

**Inventory**as of November 29, 2007 increased to $30.9 million from $29.6million as of the end of fiscal year 2007.  Included in the $30.9 million is $1.3 million of inventories related toCityForest.  Without the effect of theacquisition, inventory levels remained consistent period to period.

 

**Prepaidexpenses and other current assets**as of November 29, 2007increased to $6.6 million from $2.8 million as of the end of fiscal year2007.  Included in the $6.6 million is$1.2 of prepaid expenses and other current assets related to CityForest.  Without the effect of the acquisition,prepaid expense and other current assets increased $2.6 million 

 

 

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fromthe end of fiscal year 2007.  Also,included in the $6.6 million is approximately $2.6 millioof costs incurred withrespect to potential acquisitions.

 

**Property,plant and equipment, net**as of November 29, 2007 increased to$292.2 million from $228.9 million as of the end of fiscal year 2007.  Included in the $292.2 million of property,plant and equipment, net is $67.1 million related to CityForest.  Without the effect of the acquisition,property, plant and equipment decreased $3.8 million from the end of fiscalyear 2007.  This decrease relates todepreciation expense for the period offset partially by capital expendituresfor the period.

 

**Goodwill**as of November 29, 2007 of $6.9 million arose due to theacquisition of CityForest.

 

**Trademarks**as of November 29, 2007 increased to $8.8 million from $6.6million as of the end of fiscal year 2007. The additions to trademarks relate to the acquisition of CityForest.

 

**Otherassets**as of November 29, 2007 increased to $1.5 million from $.2 millionas of the end of fiscal year 2007. Included in the $1.5 million of other assets is $1.2 million related toCityForest.  Without the effect of theacquisition, other assets are consistent with the end of fiscal year 2007.

 

**Bankoverdrafts**as of November 29, 2007 were $2.2 millioncompared to zero as of the end of fiscal year 2007.  As of the end of the current quarter checksoutstanding exceeded cash balances in our lockbox account by this amount,reflecting a shift in cash management practices to use all excess cash on a dailybasis to pay down our revolving line of credit.

 

**Revolvingline of credit**as of November 29, 2007 represents $17.4million of borrowings to finance a portion of the acquisition of CityForest,offset by payments of $13.9 million since the date of the acquisition.

 

**Accountspayable**as of November 29, 2007 increased to $23.1million from $16.5 million as of the end of fiscal year 2007.  Included in the $23.1 million of accountspayable is $4.0 million related to CityForest. Without the effect of the acquisition, accounts payable increased $2.6million from the end of fiscal year 2007 due to increased pulp purchases andthe timing of payments.

 

**Accruedexpenses**as of November 29, 2007 increased to $23.3million from $16.3 million as of the end of fiscal year 2007.  Included in the $23.3 million of accruedexpenses is $.9 million related to CityForest. Without the effect of the acquisition, accrued expenses increased $6.1million due to accrued legal expense and other costs associated with potentialacquisitions and accrual of bonuses during the second and third quarters offiscal year 2008.

 

 

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**Accruedinterest**as of November 29, 2007 decreased to $3.7million from $7.2 million as of the end of fiscal year 2007.  The decrease is due to the timing of oursemi-annual interest payments.

 

**Long-termdebt**as of November 29, 2007 increased to $198.7 million from $160.4million as of the end of fiscal year 2007 due to the assumption of CityForestdebt and debt incurred to finance the acquisition.

 

**Deferredincome taxes**as of November 29, 2007 increased to $64.6million from $50.7 million as of the end of fiscal year 2007 primarily due tothe deferred taxes recorded in purchase accounting for CityForest.

 

CriticalAccounting Policies

 

Ourcritical accounting policies are discussed in Management’s Discussion andAnalysis of Financial Condition and Results of Operations in our Annual Reporton Form 10-K for fiscal year 2007. The preparation of our financial statements requires us to makeestimates that affect the reported amounts of assets, liabilities, revenue andexpenses and related disclosures of contingent assets and liabilities.  We base our accounting estimates onhistorical experience and other factors that we believe to be reasonable underthe circumstances.  However, actualresults may vary from these estimates under different assumptions orconditions.

 

NewAccounting Pronouncements

 

Weadopted FIN 48 at the beginning of fiscal year 2008.  The implementation did not have a materialimpact on our results of operations and financial position. At November 29,2007, we did not have any unrecognized tax benefits.

 

Werecognize interest and penalties related to uncertain tax positions in incometax expense.  As of November 29,2007, we have accrued interest and penalties, if any, related to uncertain taxpositions.

 

Thefiscal tax years 2003 through 2007 remain open to examination by the majortaxing jurisdictions to which we are subject. As of November 29, 2007, we do not expect any material changes tounrecognized tax positions within the next 12 months.

 

 

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** **

**Item 3.  Quantitative andQualitative Disclosures about Market Risk**

 

InMarch 2004, we completed a private offering of the Notes.  In connection with the acquisition ofCityForest in March 2007, we issued and sold approximately $20 million ofAdditional Notes and assumed $18.4 million of additional debt.  We also have the ability to borrow under arevolving line of credit, up to $40.0 million, of which as of November 29,2007 we have outstanding borrowings of $3.5 million.  As a result, we are highly leveraged.

 

Wehave minimal foreign currency translation risk. All international sales, other than sales originating from our Canadiansubsidiary, are denominated in U.S. dollars. Due to our Canadian operations, however, we could be adversely affectedby unfavorable fluctuations in foreign currency exchange rates.

 

**Item 4.  Controls and Procedures**

 

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

 

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

 

 

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PART II- OTHER INFORMATION

 

Item1A.  Risk Factors

 

Therisk factors included in our Annual Report on Form 10-K for fiscal year2007 have not materially changed.

 

Item6.  Exhibits

 

(a)           Exhibits

 

                         31.1     Certification by President and Chief Executive Officer pursuantto Rule 13a-14(a)

 

                         31.2     Certification by Senior Vice President, Finance and ChiefFinancial Officer pursuant to Rule 13a-14(a)

 

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theRegistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|   |                   |   | Cellu  Tissue Holdings, Inc.         |
|--------|------------------------|--------|-------------------------------------------|
|   |                   |   |                                      |
|   |                   |   |                                      |
|   |                   |   |                                      |
| Date:  | January 11,  2008 |   | /s/  Russell C. Taylor                    |
|   |                   |   | Mr. Russell  C. Taylor               |
|   |                   |   | President  and Chief Executive Officer    |
|   |                   |   |                                      |
| Date:  | January 11,  2008 |   | /s/  David J. Morris                      |
|   |                   |   | Mr. David  J. Morris                 |
|   |                   |   | Senior  Vice President, Finance and Chief |
|   |                   |   | Financial  Officer                        |

 

 

 

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