**UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549**

** **

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**FORM 10-Q**

 

**(Mark One)**

 

| **x**                                                                                                                                              | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                               | ** **                                                                                              |
| **For the  Quarterly Period Ended May 29, 2008**                                                                                              |
| ** **                                                                                                                                         |
| **or**                                                                                                                                             |
| ** **                                                                                                                                         |
| **o**                                                                                                                                              | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                               | ** **                                                                                              |
| **For the  transition period from         to         .** |

 

**Commissionfile number 333-118829**

 

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

** **

| **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)    |

 

**Not Applicable** (Former name,former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports) and (2) has beensubject to such filing requirements for the past 90 days.  Yes xNo o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

| Large accelerated filer o                     |   | Accelerated filer o         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer x                       |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yeso Nox

 

The number of shares outstanding of each of the registrant’s classes ofcommon stock as of July 3, 2008:

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

 

 

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CELLU TISSUE HOLDINGS, INC.

FORM 10-Q

QUARTER ENDED MAY 29,2008

 

INDEX

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

 

2

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PART 1FINANCIAL INFORMATION

 

**Item1.  Consolidated Financial Statements**

 

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

** **
| ** **                                        | ** ** | **Three Months Ended** | ** **  |
|---------------------------------------------------|------------|----------------------------------|-------------|
| ** **                                        | ** ** | **May 29**                  | ** **  | **May 31** | ** ** |
| ** **                                        | ** ** | **2008**                         | ** **  | **2007** | ** ** |
| ** **                                        | ** ** | ** **                       | ** **  | ** ** | ** ** |
| Net sales                                         |       | $                                | 111,496,083 |   | $ | 103,200,786 |   |
| Cost of goods sold                                |       | 99,344,479                       |        | 94,908,668 |   |
| Gross profit                                      |       | 12,151,604                       |        | 8,292,118 |   |
|                                              |       |                             |        |   |   |
| Selling, general and administrative  expenses     |       | 4,959,842                        |        | 4,482,737 |   |
| Terminated acquisition-related transaction  costs |       | 75,000                           |        | — |   |
| Stock and related compensation expense            |       | 218,506                          |        | 233,119 |   |
| Income from operations                            |       | 6,898,256                        |        | 3,576,262 |   |
|                                              |       |                             |        |   |   |
| Interest expense, net                             |       | 4,979,688                        |        | 5,019,094 |   |
| Foreign currency (gain) loss                      |       | (43,080                          | )           | 324,298 |   |
| Other expense (income)                            |       | 29,508                           |        | (42,239 | ) |
| Income (loss) before income tax                   |       | 1,932,140                        |        | (1,724,891 | ) |
|                                              |       |                             |        |   |   |
| Income tax expense (benefit)                      |       | 715,085                          |        | (614,407 | ) |
| Net income (loss)                                 |       | $                                | 1,217,055   |   | $ | (1,110,484 | ) |

 

See accompanying notes to consolidatedfinancial statements.

 

3

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**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                | ** ** | **May 29** | ** **  | **February 29** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------|-------------|----------------------|------------|
| ** **                                                                                | ** ** | **2008**        | ** **  | **2008**             | ** ** |
| ** **                                                                                | ** ** | **(Unaudited)** | ** **  | ** **           | ** ** |
| **ASSETS**                                                                                |       |            |        |                 |       |
| CURRENT ASSETS:                                                                           |       |            |        |                 |       |
| Cash and cash equivalents                                                                 |       | $               | 1,625,424   |                 | $          | 883,388 |   |
| Receivables, net                                                                          |       | 52,197,208      |        | 44,542,337           |       |
| Inventories                                                                               |       | 34,900,313      |        | 33,996,439           |       |
| Prepaid expenses and other current assets                                                 |       | 3,006,025       |        | 3,745,989            |       |
| Income tax receivable                                                                     |       | 142,966         |        | 177,281              |       |
| Deferred income taxes                                                                     |       | 6,216,017       |        | 7,157,191            |       |
| TOTAL CURRENT ASSETS                                                                      |       | 98,087,953      |        | 90,502,625           |       |
| PROPERTY, PLANT AND EQUIPMENT, NET                                                        |       | 293,302,474     |        | 296,597,888          |       |
| GOODWILL                                                                                  |       | 6,970,001       |        | 6,970,001            |       |
| TRADEMARKS                                                                                |       | 8,750,314       |        | 8,750,314            |       |
| OTHER ASSETS                                                                              |       | 1,515,762       |        | 1,491,218            |       |
| TOTAL ASSETS                                                                              |       | $               | 408,626,504 |                 | $          | 404,312,046 |   |
|                                                                                      |       |            |        |                 |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                             |       |            |        |                 |       |
| CURRENT LIABILITIES:                                                                      |       |            |        |                 |       |
| Revolving line of credit                                                                  |       | $               | 18,000,000  |                 | $          | 9,800,000 |   |
| Accounts payable                                                                          |       | 22,002,057      |        | 24,055,782           |       |
| Accrued expenses                                                                          |       | 21,352,023      |        | 18,860,526           |       |
| Accrued interest                                                                          |       | 3,765,379       |        | 8,253,915            |       |
| Other current liabilities                                                                 |       | 15,000,000      |        | 15,000,000           |       |
| Current portion of long-term debt                                                         |       | 760,000         |        | 760,000              |       |
| TOTAL CURRENT LIABILITIES                                                                 |       | 80,879,459      |        | 76,730,223           |       |
| LONG-TERM DEBT, LESS CURRENT PORTION                                                      |       | 197,862,013     |        | 198,086,944          |       |
| DEFERRED INCOME TAXES                                                                     |       | 61,231,712      |        | 62,008,004           |       |
| OTHER LIABILITIES                                                                         |       | 20,136,068      |        | 20,148,590           |       |
| STOCKHOLDERS’ EQUITY:                                                                |       |            |        |                 |       |
| Common stock, $.01 par value, 1,000 shares authorized,  100 shares issued and outstanding |       | 1               |        | 1                    |       |
| Capital in excess of par value                                                            |       | 47,253,720      |        | 47,035,214           |       |
| Accumulated deficit                                                                       |       | (982,560        | )           | (2,199,615           | )          |
| Accumulated other comprehensive income                                                    |       | 2,246,091       |        | 2,502,685            |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                           |       | 48,517,252      |        | 47,338,285           |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                           |       | $               | 408,626,504 |                 | $          | 404,312,046 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

4

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

 
| ** **                                                                                          | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                          | ** ** | **May 29**                  | ** ** | **May 31** | ** ** |
| ** **                                                                                          | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| ** **                                                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Cash flows from operating activities**                                                            |       |                             |       |   |   |
| Net income (loss)                                                                                   |       | $                                | 1,217,055  |   | $ | (1,110,484 | ) |
| Adjustments to reconcile net income (loss)  to net cash (used in) provided by operating activities: |       |                             |       |   |   |
| Stock-based compensation                                                                            |       | 218,506                          |       | 196,297 |   |
| Deferred income taxes                                                                               |       | 164,882                          |       | (1,217,891 | ) |
| Accretion of debt discount                                                                          |       | 155,069                          |       | 150,772 |   |
| Depreciation                                                                                        |       | 5,598,338                        |       | 6,678,145 |   |
| Changes in operating assets and  liabilities, net of the effects of acquisition:                    |       |                             |       |   |   |
| Receivables                                                                                         |       | (7,654,871                       | )          | 194,152 |   |
| Inventories                                                                                         |       | (903,874                         | )          | 867,490 |   |
| Prepaid expenses and other current assets  and income tax receivable                                |       | 774,279                          |       | 464,351 |   |
| Other                                                                                               |       | —                           |       | (1,521 | ) |
| Accounts payable, accrued expenses and  accrued interest                                            |       | (4,050,764                       | )          | (3,727,701 | ) |
| Total adjustments                                                                                   |       | (5,698,435                       | )          | 3,604,094 |   |
| *Net cash (used in) provided by operating  activities*                                              |       | (4,481,380                       | )          | 2,493,610 |   |
|                                                                                                |       |                             |       |   |   |
| **Cash flows from investing activities**                                                            |       |                             |       |   |   |
| Cash paid for acquisition, net of cash  received                                                    |       | —                           |       | (43,343,798 | ) |
| Capital expenditures                                                                                |       | (2,474,891                       | )          | (2,646,346 | ) |
| Other                                                                                               |       | (145,252                         | )          | 383,835 |   |
| *Net cash used in investing activities*                                                             |       | (2,620,143                       | )          | (45,606,309 | ) |
|                                                                                                |       |                             |       |   |   |
| **Cash flows from financing activities**                                                            |       |                             |       |   |   |
| Payments of long-term debt                                                                          |       | (380,000                         | )          | — |   |
| Borrowings on revolving line of credit, net                                                         |       | 8,200,000                        |       | 14,400,000 |   |
| Proceeds from bond offering                                                                         |       | —                           |       | 20,000,000 |   |
| *Net cash provided by financing activities*                                                         |       | 7,820,000                        |       | 34,400,000 |   |
|                                                                                                |       |                             |       |   |   |
| Effect of foreign currency                                                                          |       | 23,559                           |       | 439,045 |   |
|                                                                                                |       |                             |       |   |   |
| *Net increase (decrease) in cash and cash  equivalents*                                             |       | 742,036                          |       | (8,273,654 | ) |
| *Cash and cash equivalents at beginning of  period*                                                 |       | 883,388                          |       | 16,260,601 |   |
| *Cash and cash equivalents at end of period*                                                        |       | $                                | 1,625,424  |   | $ | 7,986,947 |   |

 

*See accompanying notes to consolidatedfinancial statements.*

 

5

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

**May 29, 2008**

 

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

 

The accompanying unaudited interim consolidated financial statementsinclude the accounts of Cellu Tissue Holdings, Inc.  (the “Company” ) and its wholly-ownedsubsidiaries.  The Company is awholly-owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”), whois a wholly-owned subsidiary of Cellu Parent Corporation (“Cellu Parent”).

 

These statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the quarter ended May 29, 2008 are notnecessarily indicative of the results that may be expected for the fiscal yearending February 28, 2009.  Forfurther information, refer to the Company’s consolidated financial statementsand footnotes thereto as of February 29, 2008 and for the year then endedincluded in the Company’s Annual Report on Form 10-K, from which theconsolidated balance sheet at February 29, 2008 has been derived, and theCompany’s latest current reports on Form 8-K, each as filed with theSecurities and Exchange Commission (“SEC”).

 

Stock-Based Compensation

 

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

 

6

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

award or in satisfaction of tax withholding requirements.  Key employees and directors of, andconsultants and advisors to, Cellu Parent or its affiliates who, in the opinionof the Plan Administrator, are in a position to make a significant contributionto the success of Cellu Parent and its affiliates are eligible to participatein the Plan.  Stock options are granted atthe market price of Cellu Parent’s stock on the date of grant and have a10-year term.  Generally, stock optiongrants vest ratably over four years from the date of grant.  The following describes how certain assumptionsaffecting the estimated fair value of stock options are determined.  The dividend yield is zero; the volatility isbased on historical market value of Cellu Parent’s stock; and the risk-freeinterest rate is based on U.S. Treasury securities.  The Company includes historical data to estimateexercise, termination and holding period behavior for valuation purposes.  A summary of the outstanding options as of May 29,2008 and the activity during the three months then ended is as follows:

 
| ** **                          | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** |
|-------------------------------------|------------|-------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|
| Outstanding, February 29, 2008 |       | 1,125       |       | $                                          | 733.67     |                                                    | 8.59 Years |   |
| Forfeited                           |       | (125        | )          | $                                          | 979.25     |                                                    | 8.86 Years |   |
| Granted                             |       | 444         |       | $                                          | 942.99     |                                                    | 9.85 Years |   |
| Outstanding, May 29, 2008      |       | 1,444       |       | $                                          | 776.77     |                                                    | 8.95 Years |   |
| Exercisable, May 29, 2008      |       | 250         |       | $                                          | 702.97     |                                                    | 8.56 Years |   |

 

The fair value of the stock option grants was estimated on the date ofgrant using the Black-Scholes option pricing model.  The assumptions used to value the grantswere: no dividend yield; 55% volatility; 1.4% risk free interest rate; and10-year expected life.  The weightedaverage fair value of stock options granted was $498.18 per share and theunrecognized total compensation cost as of May 29, 2008 related tononvested awards is $591,166.

 

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

 

7

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

tax as a result of making a Section 83(b) election under theInternal Revenue Code of 1986, as amended. The named individual has made a timely Section 83(b) election.  In connection with this election, the Companyhas recorded compensation expense of $42,255 for the three months ended May 29,2008.

 

On June 12, 2006, Cellu Parent entered into Restricted StockAgreements with the Company’s Chief Executive Officer, Chief Operating Officerand Chief Financial Officer, pursuant to which Cellu Parent granted 3,778restricted shares of its common stock to the Chief Executive Officer and 1,349restricted shares of its common stock to each of the other two namedindividuals pursuant to the Plan.  The shareswill vest and cease to be restricted in four equal annual installmentscommencing on June 12, 2007, as long as the named individual, as the casemay be, is continuously employed by the Company until each such vesting datewith respect to his or her shares.  Anyrestricted stock outstanding at the time of a Covered Transaction (as definedin the Plan) shall become vested and cease to be restricted stock at thattime.  Additionally, the Parent hasagreed to pay an amount to the named individual equal to an amount that wouldbe included in gross income and payable as income tax as a result of making a Section 83(b) electionunder the Internal Revenue Code of 1986, as amended.  All named individuals have made a timely Section 83(b) election.  Effective July 31, 2007, the then ChiefFinancial Officer resigned and forfeited two-thirds of the individual’srestricted stock grant and, accordingly, the Company only recorded compensationexpense associated with this individual’s grant through June 12, 2007 asall other shares were forfeited and no compensation expense is required to berecognized for forfeited shares.

 

For the three months ended May 29, 2008 and May 31, 2007, theCompany has recorded $134,853 and $196,297 of compensation expense related tothe vesting of the above grants in accordance with SFAS 123R.

 

Derivatives and Hedging

 

The Company uses derivative financial instruments to offset asubstantial portion of its exposure to market risk arising from changes in theprice of natural gas.  Hedging of thisrisk is accomplished by entering into forward swap contracts, which aredesignated as hedges of specific quantities of natural gas expected to bepurchased in future months.  Thesecontracts are held for purposes other than trading and are designated as cashflow hedges.  The Company measures hedgeeffectiveness by formally assessing, at least quarterly, the correlation of theexpected future cash flows of the hedged item and the derivative hedginginstrument.  The ineffective portions ofthe hedges, which are not material for any period presented, are immediatelyrecognized in earnings.  The fair value

 

8

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

of these cash flow hedging instruments was an asset of $.1 million and$.2 million as of May 29, 2008 and February 29, 2008,respectively.  During the next 12 months,the entire $.1 million will be reclassified to earnings consistent with thetiming of the underlying hedged transactions.

 

Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standard Board (“FASB”)issued Financial Accounting Standards No. 157, “*Fair ValueMeasurements*” (“FAS 157”). The Company was required to adopt the provisions of FAS 157 effective March 1,2008.  FAS 157 provides a common fairvalue hierarchy for companies to follow in determining fair value measurementsin the preparation of financial statements and expands disclosure requirementsrelating to how such fair value measurements were developed.  FAS

157 clarifies the principle that fair value should be based on theassumptions that the marketplace would use when pricing an asset or liability,rather than company specific data.  Theadoption of FAS No. 157 did not have a material impact on the Company’sresults of operations and financial position.

 

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

 

In December 2007, the FASB issued Financial Accounting Standards No. 141(R), “*Business Combinations*” (“FAS141 (R)”), and Financial Accounting Standards No. 160, *“Accounting and Reporting of Noncontrolling Interestsin Consolidated Financial Statements, an amendment of ARB No. 51”*(“FAS160”).  These new standards willsignificantly change the financial accounting and reporting of businesscombination transactions and noncontrolling (or minority) interests inconsolidated financial statements.  FAS141 (R) is required to be adopted concurrently with FAS 160 and is effectivefor business combination transactions for which the acquisition date is on orafter the beginning of the first annual reporting period beginning on or after December 15,2008.  Early adoption is prohibited.  The Company is currently assessing the impactthat FAS 141 (R) and FAS 160 will have on our results of operations andfinancial position.

 

9

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 2 Inventories**

 

Components of inventories are as follows:

 
| ** **                       | ** ** | **May 29, 2008** | ** ** | **February 29, 2008** | ** ** |
|----------------------------------|------------|----------------------------|------------|---------------------------------|------------|
| Finished goods                   |       | $                          | 19,048,274 |                            | $          | 17,961,802 |   |
| Raw materials                    |       | 5,852,935                  |       | 7,073,131                       |       |
| Packaging materials and supplies |       | 10,088,420                 |       | 9,082,592                       |       |
|                             |       | 34,989,629                 |       | 34,117,525                      |       |
| Inventory reserves               |       | (89,316                    | )          | (121,086                        | )          |
|                             |       | $                          | 34,900,313 |                            | $          | 33,996,439 |   |

 

**Note 3 Acquisition**

 

On March 21, 2007, the Company executed a definitive mergeragreement (the “Acquisition Agreement”) with CityForest Corporation (“CityForest”),Cellu City Acquisition Corporation (“Cellu City Merger Sub”) and Wayne Gullstadas the shareholders’ representative. Pursuant to the Acquisition Agreement and, subject to the terms andconditions therein, Cellu City Merger Sub, a wholly-owned subsidiary of theCompany, merged with and into CityForest, with CityForest surviving andbecoming a wholly-owned subsidiary of the Company (the “Acquisition”).  The aggregate merger consideration (includingassumption of $18.4 million in aggregate principal amount of industrial revenuebonds) was approximately $61.0 million subject to certain working capital andnet cash adjustments.  Total cash paid forthe acquisition 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 been accounted for as a purchase in accordance withthe provisions of SFAS 141 and, accordingly, the consolidated statement ofoperations includes the results of CityForest during the three-months ended May 29,2008 and during the three-months ended May 31, 2007 from the date ofacquisition.

 

The results of CityForest’s operations fromthe March 21, 2007 date of acquisition are included in the Company’stissue segment.  Unaudited pro formaresults of operations for the three months ended May 31, 2007, as if theCompany and CityForest had been combined as of March 1, 2007, arepresented below.  The pro forma resultsinclude estimates and assumptions, which the Company’s management believes arereasonable.  However, the pro formaresults do not include any cost savings or other effects of the plannedintegration of CityForest, and are not necessarily indicative of the resultswhich

 

10

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 3 Acquisition (continued)**

 

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

 
| ** **       | ** ** | **Three Months Ended May 31, 2007 (1)** | ** ** |
|------------------|------------|-----------------------------------------------------------------------|------------|
| ** **       | ** ** | **As Filed**                                                     | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | **(in thousands)**                                               | ** ** |
| Net sales        |       | $                                                                     | 103,201    |   | $ | 105,911 |   |
| Operating income |       | $                                                                     | 3,576      |   | $ | 4,162 |   |
| Net loss         |       | $                                                                     | (1,110     | ) | $ | (549 | ) |

 

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(1)          Pro forma operating results include theoperating results for CityForest for the three months ended May 31,2007.  The “as filed” operating resultsinclude the operating results for CityForest for the period from theacquisition date (March 21, 2007) to May 31, 2007.

 

**Note 4 Long-Term Debt**

 

Long-term debt consists of the following:

 
| ** **                                                                                                   | ** ** | **May 29, 2008** | ** **  | **February 29, 2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|----------------------------|-------------|---------------------------------|------------|
| 9 3⁄4% senior secured notes due 2010                                                                      |       | $                          | 182,255,572 |                            | $          | 182,255,572 |   |
| Less discount                                                                                                |       | (1,128,559                 | )           | (1,283,628                      | )          |
|                                                                                                         |       | 181,127,013                |        | 180,971,944                     |       |
| Industrial revenue bond payable in  semi-annual installments, plus variable interest, due March 1, 2028 |       | 17,495,000                 |        | 17,875,000                      |       |
|                                                                                                         |       | 198,622,013                |        | 198,846,944                     |       |
| Less current portion of debt                                                                                 |       | 760,000                    |        | 760,000                         |       |
|                                                                                                         |       | $                          | 197,862,013 |                            | $          | 198,086,944 |   |

 

In March 2004, the Company completed a private offering of $162.0million aggregate principal amount of 9 3⁄4% senior secured notes due 2010 (the “OriginalNotes”).  In connection with theAcquisition (see Note 3), the Company entered into a Note Purchase Agreement(the “Note Purchase Agreement”) with Wingate Capital Ltd. (the “Purchaser”),dated March 21, 2007, pursuant to which it issued and sold $20.3 million

 

11

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

aggregate principal amount of Additional Notes (together with theOriginal Notes, the “Notes”) to the Purchaser 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”).

 

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

 

The Company entered into a Credit Agreement, dated as of June 12,2006 (the “Credit Agreement”), among the Company, as U.S. Borrower, InterlakeAcquisition Corporation Limited, a subsidiary of the Company, as CanadianBorrower, 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 Canadian Administrative Agent, and the other lenders party thereto.  The Credit Agreement provides for a $35.0million working capital facility, which was subsequently increased to $60.0million (see discussion following and footnote 8), including a letter of creditsub-facility and swing-line loan sub-facility. The Credit Agreement providesthat amounts under the facility may be borrowed, repaid and re-borrowed,subject to a borrowing base test, until the maturity date, which is June 12,2011. An amount equal to $32.0 million, which was subsequently increased to$57.0 million (see discussion following and footnote 8) is available, in U.S.dollars, to the U.S.  Borrower under thefacility, and an amount equal to $3.0 million is available, in U.S. or Canadiandollars, to the Canadian Borrower under the facility.  Borrowings of $17.4 million were made tofinance a portion of the Acquisition.  Asof May 29, 2008, there was $18.0 million of borrowings outstanding underthe working capital facility and excess availability was $18.1 million.

 

In addition to the Note Purchase Agreement, the following agreementswere entered into in connection with the Acquisition:

 

***Second Supplemental Indenture***

 

The Company,certain of its subsidiaries, the Trustee and CityForest have executed theSecond Supplemental Indenture, dated March 21, 2007 (the “SecondSupplemental Indenture”), pursuant to which CityForest became a party to theCellu Tissue Indenture as

 

12

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

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 the obligations of Company under its Indenture and theNotes.

 

***Amendment to Credit Agreement***

 

The Companyhas entered into a First Amendment, dated March 21, 2007 (the “Amendment”),to the Credit Agreement dated June 12, 2006 (as amended by the Amendment,the “Amended Credit Agreement”) among Cellu Tissue, as U.S. Borrower, InterlakeAcquisition Corporation Limited, a subsidiary of Cellu Tissue, as CanadianBorrower, certain subsidiaries of Cellu Tissue, Cellu Paper Holdings, Inc.,the parent

 

corporation ofCellu Tissue, JPMorgan Chase Bank, N.A. (the “U.S. Administrative Agent”) andJPMorgan Chase Bank, 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 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 the Company 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 isparty to a Loan Agreement, dated March 1, 1998 (the “Loan Agreement”),with the City of Ladysmith, Wisconsin (the “Issuer”).  Pursuant to the Loan Agreement, the Issuerloaned the proceeds of the Issuer’s Variable Rate Demand Solid Waste DisposalFacility Revenue Bonds, Series 1998 (CityForest Corporation Project) (the “Bonds”)to CityForest to finance the construction by CityForest of a solid wastedisposal facility.  Approximately $18.4million in aggregate principal amount of the Bonds was outstanding as of thedate of the Acquisition.  CityForest isrequired, 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

 

13

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

the CityForestIndenture and the Loan Agreement, the “CityForest Bond Documents”), withAssociated Bank, National Association (“Associated Bank”), pursuant to which AssociatedBank has extended the required letter of credit (the “Associated Bank Letter ofCredit”) and has provided a revolving credit facility to CityForest in anaggregate principal amount of up to $3.5 million (the “Associated BankRevolving Credit Facility”).

 

The BondsTrustee is permitted to draw upon the Associated Bank Letter of Credit to payprincipal and interest due on the Bonds, and to provide liquidity to purchaseBonds put to CityForest by bondholders and not remarketed; and CityForest isobligated under the Reimbursement Agreement to reimburse Associated Bank forany such draws. CityForest is also obligated to pay a fee in respect of theaggregate amount available to be drawn under the Associated Bank Letter ofCredit at a rate per annum initially equal to 1.25%, subject to adjustment on aquarterly basis 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 requiresscheduled semi-annual payments of principal of the Bonds equal to approximately2.00% of the principal amount outstanding as of the date of the Acquisition,with the balance 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 theCompany incurs indebtedness, as defined, in excess of amounts currentlypermitted under its Indenture or refinances the indebtedness issued under itsIndenture, 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.

 

14

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

TheReimbursement Agreement contains various affirmative and negative covenantscustomary for working capital and term credit facilities, as well as additionalcovenants relating to the Bonds.  Thenegative covenants include limitations on: indebtedness; liens; acquisitions,mergers and consolidations; investments; guarantees; asset sales; sale andleaseback transactions; dividends and distributions; transactions withaffiliates; capital expenditures; and changes to the status of the Bonds.CityForest is also required to comply on a quarterly basis with a maximumleverage covenant and a minimum fixed charge coverage covenant.

 

TheReimbursement Agreement also contains customary events of default,including:  payment defaults; breaches ofrepresentations and warranties; covenant defaults; cross-defaults to certainother debt, including the Additional Notes and indebtedness under the AmendedCredit Agreement; certain events of bankruptcy and insolvency; judgmentdefaults; certain defaults related to the Employee Retirement Income SecurityAct of 1974, as amended; and a change of control of CityForest or the Company.

 

The Companyhas guaranteed all of the obligations of CityForest under the ReimbursementAgreement, pursuant to a Guaranty, dated March 21, 2007 (the “Cellu TissueGuaranty”), executed by the Company in favor of Associated Bank. In addition,the obligations 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 5 Comprehensive Income**

 

The components of comprehensive income for the three months ended May 29,2008 and May 31, 2007 are as follows:

 
| ** **                                                                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **May 29, 2008**       | ** ** | **May 31, 2007** | ** ** |
| Net income (loss)                                                                     |       | $                                | 1,217,055  |   | $ | (1,110,484 | ) |
| Foreign currency translation adjustments  and change in unrealized gain on derivative |       | (256,594                         | )          | 1,319,142 |   |
| Comprehensive income                                                                  |       | $                                | 960,461    |   | $ | 208,658 |   |

 

15

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 6 Business Segments**

 

The Company operates in two business segments:  tissue and machine-glazed paper.  The Company assesses the performance of itsbusiness segments using income from operations. Income from operations for thethree months ended May 29, 2008 includes $.3 million of bad debt expenseassociated with a customer bankruptcy and $.3 million related to additionalsales tax incurred at one of our facilities. Of this $.6 million, $.2 million impacts the machine-glazed papersegment and $.4 million impacts the tissue segment.  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 expenses isallocated to each segment.  Segmentinformation for the three months ended May 29, 2008 and May 31, 2007follows:

 
| ** **                                    | ** ** | **Three Months Ended** | ** **  |
|-----------------------------------------------|------------|----------------------------------|-------------|
| ** **                                    | ** ** | **May 29, 2008**       | ** **  | **May 31, 2007** | ** ** |
| **Net Sales**                                 |       |                             |        |   |   |
| Tissue                                        |       | $                                | 83,659,259  |   | $ | 77,635,897 |   |
| Machine-glazed paper                          |       | 27,836,824                       |        | 25,564,889 |   |
| Consolidated                                  |       | $                                | 111,496,083 |   | $ | 103,200,786 |   |
|                                          |       |                             |        |   |   |
| **Income (loss) from operations**             |       |                             |        |   |   |
| Tissue                                        |       | $                                | 6,351,423   |   | $ | 4,082,978 |   |
| Machine-glazed paper                          |       | 546,833                          |        | (506,716 | ) |
| Consolidated                                  |       | 6,898,256                        |        | 3,576,262 |   |
|                                          |       |                             |        |   |   |
| Interest expense, net                         |       | (4,979,688                       | )           | (5,019,094 | ) |
| Net foreign currency transaction gain  (loss) |       | 43,080                           |        | (324,298 | ) |
| Other (expense) income                        |       | (29,508                          | )           | 42,239 |   |
| Pretax income (loss)                          |       | $                                | 1,932,140   |   | $ | (1,724,891 | ) |
|                                          |       |                             |        |   |   |
| **Capital Expenditures**                      |       |                             |        |   |   |
| Tissue                                        |       | $                                | 2,029,529   |   | $ | 2,241,151 |   |
| Machine-glazed paper                          |       | 254,830                          |        | 252,651 |   |
| Corporate                                     |       | 190,532                          |        | 152,544 |   |
| Consolidated                                  |       | $                                | 2,474,891   |   | $ | 2,646,346 |   |
|                                          |       |                             |        |   |   |
| **Depreciation**                              |       |                             |        |   |   |
| Tissue                                        |       | $                                | 4,127,894   |   | $ | 5,002,167 |   |
| Machine-glazed paper                          |       | 1,470,444                        |        | 1,675,978 |   |
|                                          |       | $                                | 5,598,338   |   | $ | 6,678,145 |   |

 

16

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 7 Income taxes**

 

The effective income tax rate for the three months ended May 29,2008 was 37.0% compared to a 35.6% benefit for the three months ended May 31,2007.

 

The Company recognizes interest and penalties related to uncertain taxpositions in income tax expense.  As of May 29,2008, the Company had accrued $1.6 million related to uncertain tax positions.

 

The tax years 2004 through 2008 remain open to examination by the majortaxing jurisdictions to which the Company is subject.  As of May 29, 2008, the Company does notexpect any material changes to unrecognized tax positions within the nexttwelve months.

 

**Note 8 Subsequent Event**

 

On July 2, 2008, the Company, through two newly created,wholly-owned subsidiaries, Cellu Tissue-Hauppauge, LLC (“Cellu Tissue-Hauppauge”)and Cellu Tissue-Thomaston, LLC (“Cellu Tissue-Thomaston”) consummated theacquisition of certain assets, and assumption of certain liabilities, fromAtlantic Paper & Foil Corp. of N.Y., Atlantic Lakeside Properties,LLC, Atlantic Paper & Foil, LLC, Atlantic Paper & Foil ofGeorgia, LLC and Consumer Licensing Corporation (collectively, the “Sellers”)pursuant to a definitive asset purchase agreement between the Company and theSellers.  The aggregate purchase price paid was $68,000,000, including acash payment at closing of $61,700,000 and the issuance of a promissory note bythe Company to Atlantic Paper & Foil Corp. of N.Y. in the aggregateprincipal amount equal of $6,300,000 plus the assumption of certain liabilities.  The Company financed the cash portion of thepurchase price with cash on-hand, the borrowings described below and an equitycontribution from Parent.  The purchaseprice is subject to certain post-closing working capital adjustments.

 

In connection with the Acquisition, the following agreements wereentered into:

 

**Note Purchase Agreement**

 

The Company has entered into Note Purchase Agreements (the “NotePurchase Agreements”) with each of (i) GMAM Investment Funds Trust II, forthe account of the Promark Alternative High Yield Bond Fund (Account No. 7M2E),GMAM Investment Funds Trust, General Motors Welfare Benefit Trust (VEBA), GMAMInvestment Funds Trust II for the account of the Promark Alternative High YieldBond Fund (Account No. 7MWD), DDJ High Yield Fund, Multi-Style,Multi-Manager Funds PLC The Global Strategic Yield Fund (f/k/a Multi-Style,Multi-Manager Funds PLC The Global High

 

17

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 8 Subsequent Event (continued)**

 

Yield Fund), DDJ Capital Management Group Trust, StichtingPensioenfonds Hoogovens, Caterpillar Inc. Master Retirement Trust, J.C. PenneyCorporation, Inc. Pension Plan Trust, Stichting Bewaarder InterpolisPensioenen Global High Yield Pool, DDJ/Ontario OS Investment Sub II, Ltd. and Stichting PensioenfondsMetaal en Techniek, (ii) Claren Road Credit Master Fund, Ltd. and (iii) UBSHigh Yield Relationship Fund, a series of the UBS Relationship funds (the “Purchaser”),dated July 2, 2008, pursuant to which the Company issued and sold$40,000,000 aggregate principal amount of unregistered 9 3/4% Senior SecuredNotes due 2010 (the “New Notes”) to the Purchasers for the purchase price of$36,900,000 which is equal to 92.25% of the aggregate principal amount of theNew Notes. The New Notes were issued pursuant to and will be governed by theIndenture, dated as of March 12, 2004 (as amended and supplemented, the “CelluTissue Indenture”) among the Company, the subsidiary guarantors party theretoand The Bank of New York Mellon Trust Company, N.A., as successor trustee tothe Bank of New York (the “Trustee”). The proceeds of the sale were used tofinance a portion of the Acquisition.

 

**Third Supplemental Indenture**

 

The Company, certain subsidiaries of the Company and the Trustee haveexecuted the Third Supplemental Indenture, dated July 2, 2008 (the “ThirdSupplemental Indenture”), pursuant to which Cellu Hauppauge and Cellu Thomastonbecame parties to the Cellu Tissue Indenture as subsidiary guarantors.  As subsidiary guarantors, Cellu Hauppauge andCellu Thomaston, on a joint and several basis, with all the existing subsidiaryguarantors, fully, unconditionally and irrevocably guarantees to each holder ofthe New Notes and the Trustee the obligations of the Company under the CompanyIndenture and the New Notes.

 

**Amendment to Credit Agreement**

 

The Company has entered into a Second Amendment, dated July 2,2008 (the “Amendment”), to the Credit Agreement dated June 12, 2006 (asamended by the First Amendment, dated as of March 21, 2007, and theAmendment, the “Amended Credit Agreement”) among the Company, as U.S. Borrower,Interlake Acquisition Corporation Limited, a subsidiary of the Company, asCanadian Borrower, certain subsidiaries of the Company,  Parent, JPMorgan Chase Bank, N.A. (the “U.S.Administrative Agent”) and JPMorgan Chase Bank, N.A., Toronto Branch (the “CanadianAdministrative Agent”).

 

The Amendment (1) increases the working capital facility from$40.0 million to $60.0 million, (2) permits the issuance by the Company ofthe Notes, (3) provides for the consummation of the Acquisition and (4) permitsthe issuance of the Seller Note.  Inconnection with Amendment, Cellu Hauppauge and Cellu Thomaston becameguarantors of the obligations of the borrowers under the Amended CreditAgreement.

 

18

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**Item 2.****         MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

**OVERVIEW**

 

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

** **

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

** **

We operate in two business segments: tissue and machine-glazed paper. We assess the performance of our business segments using income fromoperations.  Income from operationsexcludes interest income, interest expense, income tax expense (benefit), otherincome and expense and the impact of foreign currency gains and losses.

 

***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 CityForest surviving and becoming our wholly-ownedsubsidiary.  The aggregate mergerconsideration (including assumption of $18.4 million in aggregate principalamount of industrial revenue bonds) was approximately $61.0 million subject tocertain working capital and net cash adjustments.  Total cash paid for the acquisition of $46.8million 

 

19

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

 

The Acquisition has been accounted for as apurchase in accordance with the provisions of SFAS 141 and, accordingly, theconsolidated statement of operations includes the results of CityForest duringthe three-months ended May 29, 2008 and during the three-months ended May 31.,2007 from the date of acquisition.  Theresults of CityForest’s operations from the March 21, 2007 date ofacquisition are included in our tissue segment. Unaudited pro forma results of operations for the three months ended May 31,2007 as if we and CityForest had been combined as of March 1, 2007, arepresented below.  The pro forma resultsinclude estimates and assumptions, which our management believes arereasonable.  However, the pro formaresults do not include any cost savings or other effects of the plannedintegration of CityForest, and are not necessarily indicative of the resultswhich would have occurred if the business combination had been in effect on thedates indicated, or which may result in the future.

 
| ** **       | ** ** | **Three Months Ended May 31, 2007 (1)** | ** ** |
|------------------|------------|-----------------------------------------------------------------------|------------|
| ** **       | ** ** | **As Filed**                                                     | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | **(in thousands)**                                               | ** ** |
| Net sales        |       | $                                                                     | 103,201    |   | $ | 105,911 |   |
| Operating income |       | $                                                                     | 3,576      |   | $ | 4,162 |   |
| Net loss         |       | $                                                                     | (1,110     | ) | $ | (549 | ) |

 

----

(1)          Pro forma operating results include theoperating results for CityForest for the three months ended May 31,2007.  The “as filed” operating resultsinclude the operating results for CityForest for the period from theacquisition date (March 21, 2007) to May 31, 2007.

 

***Subsequent Event***

*** ***

On July 2, 2008, we, through two newly created, wholly-ownedsubsidiaries, Cellu Tissue-Hauppauge, LLC (“Cellu Tissue-Hauppauge”) and CelluTissue-Thomaston, LLC (“Cellu Tissue-Thomaston”) consummated the acquisition ofcertain assets, and assumption of certain liabilities, from Atlantic Paper &Foil Corp. of N.Y., Atlantic Lakeside Properties, LLC, Atlantic Paper &Foil, LLC, Atlantic Paper & Foil of Georgia, LLC and ConsumerLicensing Corporation (collectively, the “Sellers”) pursuant to a definitiveasset purchase agreement between us and the Sellers.  The aggregatepurchase price paid was $68,000,000, including a cash payment at closing of$61,700,000 and the issuance of a promissory notes by us to the Atlantic Paper &Foil Corp. of N.Y. in the aggregate principal amount equal of $6,300,000 plusassumption of certain liabilities.  TheCompany financed the cash portion of the purchase price with cash on-hand, theborrowings described below and an equity contribution from Parent.  The purchase price is subject to certainpost-closing working capital adjustments.

 

20

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In connection with the Acquisition, the following agreements wereentered into:

 

**Note Purchase Agreement**

 

We have entered into Note Purchase Agreements (the “Note PurchaseAgreements”) with each of (i) GMAM Investment Funds Trust II, for theaccount of the Promark Alternative High Yield Bond Fund (Account No. 7M2E),GMAM Investment Funds Trust, General Motors Welfare Benefit Trust (VEBA), GMAMInvestment Funds Trust II for the account of the Promark Alternative High YieldBond Fund (Account No. 7MWD), DDJ High Yield Fund, Multi-Style,Multi-Manager Funds PLC The Global Strategic Yield Fund (f/k/a Multi-Style,Multi-Manager Funds PLC The Global High Yield Fund), DDJ Capital ManagementGroup Trust, Stichting Pensioenfonds Hoogovens, Caterpillar Inc. MasterRetirement Trust, J.C. Penney Corporation, Inc. Pension Plan Trust,Stichting Bewaarder Interpolis Pensioenen Global High Yield Pool, DDJ/OntarioOS Investment Sub II, Ltd. and Stichting Pensioenfonds Metaal en Techniek, (ii) ClarenRoad Credit Master Fund, Ltd. and (iii) UBS High Yield Relationship Fund,a series of the UBS Relationship funds (the “Purchaser”), dated July 2,2008, pursuant to which we issued and sold $40,000,000 aggregate principalamount of unregistered 9 3/4% Senior Secured Notes due 2010 (the “New Notes”)to the Purchasers for the purchase price of $36,900,000 which is equal to92.25% of the aggregate principal amount of the New Notes. The New Notes wereissued pursuant to and will be governed by the Indenture, dated as of March 12,2004 (as amended and supplemented, the “Cellu Tissue Indenture”) among us, thesubsidiary guarantors party thereto and The Bank of New York Mellon TrustCompany, N.A., as successor trustee to the Bank of New York (the “Trustee”).The proceeds of the sale were used to finance a portion of the Acquisition.

 

**Third Supplemental Indenture**

 

We, certain subsidiaries of us and the Trustee have executed the ThirdSupplemental Indenture, dated July 2, 2008 (the “Third SupplementalIndenture”), pursuant to which Cellu Hauppauge and Cellu Thomaston becameparties to the Cellu Tissue Indenture as subsidiary guarantors.  As subsidiary guarantors, Cellu Hauppauge andCellu Thomaston, on a joint and several basis, with all the existing subsidiaryguarantors, fully, unconditionally and irrevocably guarantees to each holder ofthe New Notes and the Trustee the obligations of us under the Company Indentureand the New Notes.

 

**Amendment to Credit Agreement**

 

We have entered into a Second Amendment, dated July 2, 2008 (the “Amendment”),to the Credit Agreement dated June 12, 2006 (as amended by the FirstAmendment, dated as of March 21, 2007, and the Amendment, the “AmendedCredit Agreement”) among us, as U.S. Borrower, Interlake AcquisitionCorporation Limited, a subsidiary of us, as Canadian Borrower, certainsubsidiaries of the Company,  Parent,JPMorgan Chase Bank, N.A. (the “U.S. Administrative Agent”) and JPMorgan ChaseBank, N.A., Toronto Branch (the “Canadian Administrative Agent”).

 

21

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The Amendment (1) increases the working capital facility from$40.0 million to $60.0 million, (2) permits the issuance by us of theNotes, (3) provides for the consummation of the Acquisition and (4) permitsthe issuance of the Seller Note.  Inconnection with Amendment, Cellu Hauppauge and Cellu Thomaston becameguarantors of the obligations of the borrowers under the Amended CreditAgreement.

*** ***

**RESULTS OF OPERATIONS**

** **

**Results of Operations for the Three Months Ended May 29, 2008 (thefiscal 2009 three-month period) compared to the Three Months Ended May 31,2007 (the fiscal 2008 three-month period)**

** **

**Net sales** for the fiscal 2009 three-monthperiod increased $8.3 million, or 8.0%, to****$111.5****million from $103.2 million for the comparable period inthe prior year.  For the fiscal 2009three-month period, we sold 77,449 tons of tissue hard rolls, machine-glazedpaper hard rolls and converted paper products. This is a decrease of 656 tons, or less than 1%, from the comparable periodin the prior year.  Net selling price perton increased from $1,321 for the fiscal 2008 three-month period to $1,440 forthe fiscal 2009 three-month period.

 

Net sales for our tissue segment for the fiscal 2009 three-month periodwere $83.7 million, an increase of $6.0 million, or 7.8%, from the comparableperiod in the****prior year.  Net sales for our machine-glazed segment forthe 2009 three-month period were****$27.8 million,an increase of $2.3 million, or 8.9%,****from thecomparable period in the prior year. These increases are primarily attributable to increases in net sellingprice per ton

** **

**Gross profit** for the fiscal 2009 three-monthperiod increased to $12.2 million from $8.3 million, an increase of $3.9million, or 46.5%, from the comparable period in the prior****year.  As a percentage of net sales, gross profitincreased to 10.9% in the fiscal 2009 three-month period from 8.0% in thefiscal 2008 three-month period. ** **The increase in gross profit in thefiscal 2008 three-month period is primarily attributable to the increase in netselling price per ton, despite an increase in net pulp cost and net energy costper ton.

 

Gross profit for our tissue segment for the fiscal 2009 three-monthperiod increased to $10.4 million from $7.2 million, an increase of $3.2 million,or 43.0%, from the comparable period in the prior year.  Gross profit for our machine-glazed segmentfor the fiscal 2009 three-month period increased to $1.8 million, an increaseof $.7 million, or 70.7%, from the comparable period in the prior year.  As a percentage of net sales, gross profitfor the tissue segment increased to 12.4% in the fiscal 2009 three-month periodfrom 9.3% in the fiscal 2008 three-month period.  As a percentage of net sales, gross profit forthe machine-glazed segment increased to 6.5% in the fiscal 2009 three-monthperiod from 4.1% in the fiscal 2008 three-month period.  These increases are reflective of increasesin net selling price per ton, which more than offset increases in net pulp andenergy cost per ton, over the comparable period in the prior year.

 

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**Selling, general and administrative expenses**inthe fiscal 2009 three-month period increased $.5 million, or 10.6%, to $5.0million from $4.5 million in the fiscal 2008 three-month period.  This increase reflects $.3 million of baddebt expense associated with a customer bankruptcy and $.3 million related toadditional sales tax incurred at one of our facilities.

 

**Terminated acquisition-related transactioncosts** in thefiscal 2009 three-month period of less than $.1 million related to costsincurred related to an acquisition that did not transpire.

 

**Stock and related compensation expense**in thefiscal 2009 and 2008 three-month periods of $.2 million relates primarily tothe accounting for restricted stock and stock option grants.

* *

**Foreign currency gain**in the fiscal 2009three-month period was less than $.1 million compared to a loss of $.3 millionin the fiscal 2008 three-month period. The fluctuation relates to the change in the Canadian currency periodover period.

 

**Income tax expense** for the fiscal 2009three-month period was $.7 million or an effective tax rate of 37.0% comparedto income tax benefit of $.6 million or an effective tax rate 35.6% benefit forthe fiscal 2008 three-month period.

 

**Net income**for the fiscal 2009 three-monthperiod was $1.2 million compared to net loss of $1.1 million for the comparableperiod in the prior year.

 

**FINANCIAL CONDITION**

 

**Liquidity and Capital Resources**

 

**Net cash used in operations** was $4.5 millionfor the fiscal 2009 three-month period, compared to cash provided by operationsof $2.5 million for the fiscal 2008 three-month period. ** **Non-cash items, consistingprimarily of depreciation, stock-based compensation and deferred income taxes,for the fiscal 2009 three-month period totaled $6.1 million compared to $5.8million for the 2008 fiscal three-month period. Cash flows used by changes in working capital totaled $11.9 million forthe fiscal 2009 three-month period compared to $2.2 million in the fiscal 2008three-month period. ** **With respect to the changes inaccounts receivable and inventory, cash used by these items was $8.6 millionfor the fiscal 2009 three-month period, compared to cash provided of $1.0million for the comparable period in the prior fiscal year.  This increase is reflective of changes insales terms with a key customer and timing of customer payments. Cash****provided by changes in prepaid expenses and other currentassets was $.8 million for the 2009 fiscal three-month period compared to cashprovided by changes in prepaid expenses and other current assets of $.5 millionfor the comparable period in the prior fiscal year.  Cash used in changes in accounts payable,accrued expenses and accrued interest for the fiscal 2009 

 

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three-month period was $4.1 million, compared to cash used of $3.7million for the comparable period in the prior year.

 

**Net cash used in investing activities** for thefiscal 2009 three-month period was $2.6****millioncompared to $45.6 million used in the fiscal 2008 three-month period.  Included in the prior year is $43.3attributable to the cash paid for the acquisition of CityForest.  The remaining change relates to the level ofcapital spending period over period.

 

**Net cash provided by financing activities** forthe fiscal 2009 three-month period was $7.8****millioncompared to $34.4 million for the fiscal 2008 three-month period.  Net cash provided for the fiscal 2009three-month period relates to net borrowings on our revolving line of creditoffset by payment on CityForest’s industrial revenue bond.  Net cash provided for the fiscal 2008three-month period relates to financing obtained in connection with theacquisition of CityForest.

 

In connection with the acquisition of CityForest, we entered into theNote Purchase Agreement, pursuant to which we issued and sold $20.3 millionaggregate principal amount of Additional Notes to the Purchaser for thepurchase price of $20.0 million, which is equal to 98.7383% of the aggregateprincipal amount of the Additional Notes. The Additional Notes were issued pursuant to and will be governed byCellu Tissue Indenture among us, our subsidiary guarantors party thereto andthe Trustee.

 

Our Notes mature on March 15, 2010 and require semi-annualinterest payments on March 15 and September 15.

 

We entered into the Credit Agreement, dated as of June 12, 2006,among us, as U.S. Borrower, Interlake Acquisition Corporation Limited, one ofour subsidiaries, as Canadian Borrower, our Parent, the other loan guarantorsparty thereto, JPMorgan Chase Bank, N.A., as U.S. Administrative Agent,JPMorgan Chase Bank, N.A., Toronto Branch, as Canadian Administrative Agent,and the other lenders party thereto.

 

The Credit Agreement providesfor a $35.0 million working capital facility, which has subsequently beenincreased to $60.0 million (see below and preceding discussion), including aletter of credit sub-facility and swing-line loan sub-facility. The CreditAgreement provides that amounts under the facility may be borrowed, repaid andre-borrowed, subject to a borrowing base test, until the maturity date, whichis June 12, 2011. An amount equal to $32.0 million, which was subsequentlyincreased to $57.0 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 to financea portion of the acquisition of CityForest. As of May 29, 2008, there was $18.0 million of borrowingsoutstanding under the working capital facility and excess availability was$18.1 million.

* *

In addition to the Note Purchase Agreement, the following agreementswere entered into in connection with the acquisition of CityForest:

 

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***Second Supplemental Indenture***

 

We, certain ofour subsidiaries, the Trustee and CityForest have executed the SecondSupplemental Indenture, pursuant to which CityForest became a party to theCellu Tissue Indenture as a subsidiary guarantor.  As a subsidiary guarantor, CityForest, on ajoint and several basis with all the existing subsidiary guarantors, fully,unconditionally and irrevocably guarantees to each holder of the Notes and theTrustee our obligations under its Indenture and the Notes.

** **

***Amendment to Credit Agreement***

* *

We haveentered into the Amendment to the Credit Agreement dated June 12, 2006among us, as U.S. Borrower, Interlake Acquisition Corporation Limited, one ofour subsidiaries, as Canadian Borrower, certain other of our subsidiaries andour Parent, JPMorgan Chase Bank, N.A. (the “U.S. Administrative Agent”) andJPMorgan Chase Bank, 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 isparty to a Loan Agreement with the City of Ladysmith, Wisconsin, asIssuer.  Pursuant to the Loan Agreement,the Issuer loaned the proceeds of the Issuer’s Bonds to CityForest to financethe 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 BondsTrustee is permitted to draw upon the Associated Bank Letter of Credit to payprincipal and interest due on the Bonds, and to provide liquidity to purchaseBonds put to 

 

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CityForest bybondholders and not remarketed; and CityForest is obligated under theReimbursement Agreement to reimburse Associated Bank for any such draws. CityForestis also obligated to pay a fee in respect of the aggregate amount available tobe drawn under the Associated Bank Letter of Credit at a rate per annuminitially equal to 1.25%, subject to adjustment on a quarterly basis based onCityForest’s leverage.  The expirationdate of the Associated Bank Letter of Credit is February 15, 2011.

 

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

 

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 we incurindebtedness in excess of amounts currently permitted under the indenture orrefinances the indebtedness issued under the indenture, Associated Bank mayrequire CityForest to repay all of its obligations to Associated Bank under theReimbursement Agreement and either to cause the Bonds to be redeemed or toreplace the Associated Bank Letter of Credit with a Substitute Credit Facility,as such term is defined in the CityForest Indenture.

 

TheReimbursement Agreement contains various affirmative and negative covenantscustomary for working capital and term credit facilities, as well as additionalcovenants relating to the Bonds.  Thenegative covenants include limitations on: indebtedness; liens; acquisitions,mergers and consolidations; investments; guarantees; asset sales; sale andleaseback transactions; dividends and distributions; transactions withaffiliates; capital expenditures; and changes to the status of the Bonds.CityForest is also required to comply on a quarterly basis with a maximumleverage covenant and a minimum fixed charge coverage covenant.

 

TheReimbursement Agreement also contains customary events of default, including:  payment defaults; breaches of representationsand warranties; covenant defaults; cross-defaults to certain other debt,including the Additional Notes and indebtedness under the 

 

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

 

**Cash**as of May 29, 2008 increased to $1.6million from $.9 million as of the end of fiscal year 2008.

 

**Receivables, net**as of May 29, 2008increased to $52.2 million from $44.5 million as of the end of fiscal year2008.  The increase is attributable to achange in payments terms for a significant customer and timing of customerpayments.

 

**Property, plant and equipment, net**as of May 29,2008 decreased to $293.3 million from $296.6 million as of the end of fiscalyear 2008.  This decrease relates to depreciationexpense for the period offset partially by capital expenditures for the period.

 

**Revolving line of credit**amount outstanding asof May 29, 2008 increased to $18.0 million from $9.8 million as of the endof fiscal year 2008 primarily due to increased borrowing to pay the semi-annualinterest payments due on the Notes and funding of increases in accountsreceivable.

 

**Accrued interest**as of May 29, 2008decreased to $3.8 million from $8.3 million as of the end of fiscal year 2008due primarily to the timing of semi-annual interest payments on the Notes.

 

**Stockholders’ equity**as of May 29, 2008was $48.5 million compared to $47.3 as of the end of fiscal year 2008.  The increase is primarily attributable to thenet income generated for the three-month period.

 

Critical Accounting Policies

 

Our critical accounting policies are discussed in Management’sDiscussion and Analysis of Financial Condition and Results of Operations in ourAnnual Report on Form 10-K for the fiscal year ended February 29,2008.  The preparation of our financialstatements requires us to make estimates that affect the reported amounts ofassets, liabilities,

 

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revenue and expenses and related disclosures of contingent assets andliabilities.  We base our accountingestimates on historical experience and other factors that we believe to bereasonable under the circumstances. However, actual results may vary from these estimates under differentassumptions or conditions.

 

New Accounting Pronouncements

 

In September 2006, the FASB issued FAS 157.  We were required to adopt the provisions ofFAS 157 effective March 1, 2008. FAS 157 provides a common fair value hierarchy for companies to followin determining fair value measurements in the preparation of financialstatements and expands disclosure requirements relating to how such fair valuemeasurements were developed.  FAS 157clarifies the principle that fair value should be based on the assumptions thatthe marketplace would use when pricing an asset or liability, rather thancompany specific data.  The adoption ofFAS 157 did not have a material impact our results of operations and financialposition.

 

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

 

In December 2007,the FASB issued FAS 141 (R) and FAS 160. These new standards will significantly change the financial accountingand reporting of business combination transactions and noncontrolling (orminority) interests in consolidated financial statements.  FAS 141 (R) is required to be adoptedconcurrently with FAS 160 and is effective for business combinationtransactions for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15,2008.  Early adoption is prohibited.  We are currently assessing the impact thatFAS 141 (R) and FAS 160 will have on our results of operations andfinancial position.

 

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

 

In March 2004, we completed a private offering of the Notes.  In connection with the acquisition ofCityForest in March 2007, we issued and sold approximately $20.0 millionof Additional Notes and assumed $18.4 million of additional debt.  In connection with our recent acquisition byCellu Tissue-Hauppauge and Cellu Tissue-Thomaston, we issued and soldapproximately $40.0 million of New Notes. We also have the ability to borrowunder our revolving line of credit, up to $60.0 million, of which as of May 29,2008 we have outstanding borrowings of $18.0 million.  Furthermore, we borrowed an additional $12.1million under the revolving line of credit to finance a portion of our recentacquisition.  As a result, we are highlyleveraged.  The interest on our revolvingline of credit fluctuates based on prime plus .50% or LIBOR plus 1.75%depending on whether our borrowing is based on prime or LIBOR rates.

 

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

 

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

 

**Item 4. Controls and Procedures**

 

(a)   Disclosure Controls and Procedures.  The Company’s management, with theparticipation of the Company’s Chief Executive Officer and Chief FinancialOfficer, has evaluated the effectiveness of the Company’s disclosure controlsand procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of theend of the period covered by this report. The Company’s Chief Executive Officer and Chief Financial Officer haveconcluded that, as of the end of such period, the Company’s disclosure controlsand procedures are effective in ensuring them that all material informationrequired to be disclosed by the Company in this Quarterly Report on Form 10-Qwas 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 ChiefFinancial Officer) to allow timely decisions regarding requireddisclosure.  Based on such evaluation,the Company’s Chief Executive Officer and Chief Financial Officer haveconcluded that the Company is in compliance with Rule 13a-15(e) ofthe Exchange Act.

 

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

 

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PART II– OTHER INFORMATION

 

Item1A.  Risk Factors

 

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

 

Item6.  Exhibits

 

(a)     Exhibits

 

31.1       Certification by President and ChiefExecutive Officer pursuant to Rule 13a-14(a)

 

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

 

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SIGNATURES

 

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

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

 

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