**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

**(Mark One)**
|            | **x**      | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                         |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       | ** ** | ** **                                                                                                                                                                                                           |
|       |       | **For the Quarterly Period Ended November 23, 2006**                                                                                                                                                                 |
|       |       | ** **                                                                                                                                                                                                           |
|       |       | **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 ofregistrant 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 telephonenumber, including area code)

**Not Applicable**

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

Indicate by check mark whether the registrant: (1) hasfiled all reports 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 been subjectto such filing requirements for the past 90 days.  Yes x No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer”in Rule 12b-2of the Exchange Act.

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

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).  Yes o No x

The number of shares outstanding of each of the registrant’sclasses of common stock as of January 5, 2007:
| Title of Class      | ** ** | **Shares Outstanding** | ** ** |
|-------------------------------|------------|-----------------------------|------------|
| Common Stock,  $.01 par value |       | 100                         |       |

 

 

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CELLUTISSUE HOLDINGS, INC.

FORM10-Q

QUARTER ENDED NOVEMBER 23, 2006

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

2

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**PART 1 FINANCIAL INFORMATION**

 

**Item1.  Consolidated Financial Statements**

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

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **November 23, 2006**  | ** ** | **November 24, 2005** | ** ** |
| ** **                                    | ** ** | **(Post-Acquisition)**           | ** ** | **(Pre-Acquisition)** | ** ** |
|                                          |       |                             |       |   |   |
| Net sales                                     |       | $                                | 83,281,206 |   | $ | 81,512,440 |   |
| Cost of goods sold                            |       | 77,390,427                       |       | 74,783,816 |   |
| Gross profit                                  |       | 5,890,779                        |       | 6,728,624 |   |
|                                          |       |                             |       |   |   |
| Selling, general and administrative  expenses |       | 3,410,377                        |       | 3,317,418 |   |
| Restructuring costs                           |       | —                           |       | 1,031,593 |   |
| Merger-related  transaction costs             |       | 53,474                           |       | 1,477,300 |   |
| Accelerated vesting of  stock options-noncash |       | —                           |       | 64,248 |   |
| Income from operations                        |       | 2,426,928                        |       | 838,065 |   |
|                                          |       |                             |       |   |   |
| Interest expense, net                         |       | 4,066,402                        |       | 4,300,112 |   |
| Foreign currency (gain)  loss                 |       | (79,440                          | )          | 93,528 |   |
| Other income                                  |       | (3,501                           | )          | (21,443 | ) |
| Loss before income tax  benefit               |       | (1,556,533                       | )          | (3,534,132 | ) |
|                                          |       |                             |       |   |   |
| Income tax benefit                            |       | (481,798                         | )          | (2,303,667 | ) |
| Net loss                                      |       | $                                | (1,074,735 | ) | $ | (1,230,465 | ) |

 

See accompanyingnotes to consolidated financial statements.

3

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| ** **                                    | ** ** | **For the Periods**   | ** **  |
|-----------------------------------------------|------------|---------------------------------|-------------|
| ** **                                    | ** ** | **Post-Acquisition**            | ** **  | **Pre- Acquisition** | ** ** |
| ** **                                    | ** ** | **June 13, 2006-**    | ** **  | **March 1, 2006-** | ** ** | **March 1, 2005-** | ** ** |
| ** **                                    | ** ** | **November 23, 2006** | ** **  | **June 12, 2006** | ** ** | **November 24, 2005** | ** ** |
| Net sales                                     |       | $                               | 151,843,592 |   | $ | 94,241,932 |   | $ | 245,173,940 |   |
| Cost of goods sold                            |       | 142,608,186                     |        | 86,053,812 |   | 223,828,740 |   |
| Gross profit                                  |       | 9,235,406                       |        | 8,188,120 |   | 21,345,200 |   |
|                                          |       |                            |        |   |   |   |   |
| Selling, general and  administrative expenses |       | 7,325,038                       |        | 5,584,865 |   | 9,475,114 |   |
| Restructuring costs                           |       | 240,218                         |        | — |   | 1,031,593 |   |
| Merger-related  transaction costs             |       | 155,849                         |        | 5,933,265 |   | 2,366,427 |   |
| Accelerated vesting of  stock options-noncash |       | —                          |        | — |   | 64,248 |   |
| Income (loss) from  operations                |       | 1,514,301                       |        | (3,330,010 | ) | 8,407,818 |   |
|                                          |       |                            |        |   |   |   |   |
| Interest expense, net                         |       | 7,218,938                       |        | 4,896,355 |   | 12,748,606 |   |
| Foreign currency (gain)  loss                 |       | (146,116                        | )           | 289,010 |   | 377,713 |   |
| Other income                                  |       | (20,954                         | )           | (27,049 | ) | (53,620 | ) |
| Loss before income tax  benefit               |       | (5,537,567                      | )           | (8,488,326 | ) | (4,664,881 | ) |
| Income tax benefit                            |       | (1,843,447                      | )           | (1,953,362 | ) | (2,468,465 | ) |
| Net loss                                      |       | $                               | (3,694,120  | ) | $ | (6,534,964 | ) | $ | (2,196,416 | ) |

 

See accompanyingnotes to consolidated financial statements.

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**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**
| ** **                                                                                                                                     | ** ** | **November 23** | ** **  | **February 28** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|-------------|----------------------|------------|
| ** **                                                                                                                                     | ** ** | **2006**             | ** **  | **2006**             | ** ** |
| ** **                                                                                                                                     | ** ** | **(Unaudited)**      | ** **  | ** **           | ** ** |
| **ASSETS**                                                                                                                                     |       |                 |        |                 |       |
| CURRENT ASSETS:                                                                                                                                |       |                 |        |                 |       |
| Cash and cash  equivalents                                                                                                                     |       | $                    | 12,337,282  |                 | $          | 22,824,062 |   |
| Receivables, net                                                                                                                               |       | 34,092,993           |        | 35,054,372           |       |
| Inventories                                                                                                                                    |       | 31,730,025           |        | 27,919,948           |       |
| Prepaid expenses  and other current assets                                                                                                     |       | 4,462,441            |        | 3,377,952            |       |
| Income tax  receivable                                                                                                                         |       | 1,164,531            |        | 362,122              |       |
| Deferred income  taxes                                                                                                                         |       | 3,027,235            |        | 2,931,599            |       |
| TOTAL CURRENT  ASSETS                                                                                                                          |       | 86,814,507           |        | 92,470,055           |       |
| PROPERTY, PLANT AND  EQUIPMENT, NET                                                                                                            |       | 238,563,788          |        | 98,090,451           |       |
| DEBT ISSUANCE COSTS                                                                                                                            |       | —               |        | 5,745,983            |       |
| GOODWILL                                                                                                                                       |       | —               |        | 13,723,935           |       |
| OTHER ASSETS                                                                                                                                   |       | 223,564              |        | 201,690              |       |
| TOTAL ASSETS                                                                                                                                   |       | $                    | 325,601,859 |                 | $          | 210,232,114 |   |
|                                                                                                                                           |       |                 |        |                 |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY (DEFICIENCY)**                                                                                    |       |                 |        |                 |       |
| CURRENT LIABILITIES:                                                                                                                           |       |                 |        |                 |       |
| Accounts payable                                                                                                                               |       | $                    | 19,203,993  |                 | $          | 18,648,281 |   |
| Accrued expenses                                                                                                                               |       | 14,310,750           |        | 16,005,155           |       |
| Accrued interest                                                                                                                               |       | 3,029,178            |        | 7,231,888            |       |
| Current portion  of long-term debt                                                                                                             |       | —               |        | 290,000              |       |
| TOTAL CURRENT  LIABILITIES                                                                                                                     |       | 36,543,921           |        | 42,175,324           |       |
| LONG-TERM DEBT, LESS  CURRENT PORTION                                                                                                          |       | 160,214,093          |        | 160,790,258          |       |
| DEFERRED INCOME TAXES                                                                                                                          |       | 52,097,378           |        | 13,961,743           |       |
| OTHER LIABILITIES                                                                                                                              |       | 35,191,655           |        | 210,349              |       |
| STOCKHOLDERS’ EQUITY  (DEFICIENCY):                                                                                                       |       |                 |        |                 |       |
| Common stock,  Class A, $.01 par value, 1,000 shares authorized, 100 shares issued and  outstanding at November 23, 2006 and February 28, 2006 |       | 1                    |        | 1                    |       |
| Capital in  excess of par value                                                                                                                |       | 46,068,092           |        | 615,338              |       |
| Accumulated  deficit                                                                                                                           |       | (3,694,120           | )           | (11,625,759          | )          |
| Accumulated  other comprehensive (loss) income                                                                                                 |       | (819,161             | )           | 4,104,860            |       |
| TOTAL  STOCKHOLDERS’ EQUITY(DEFICIENCY)                                                                                                   |       | 41,554,812           |        | (6,905,560           | )          |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY(DEFICIENCY)                                                                                   |       | $                    | 325,601,859 |                 | $          | 210,232,114 |   |

 

See accompanying notes toconsolidated financial statements.

5

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**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS****(Unaudited)**
| ** **                                                                                 | ** ** | **For the Periods**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **Post-Acquisition**            | ** ** | **Pre- Acquisition** | ** ** |
| ** **                                                                                 | ** ** | **June 13, 2006-**    | ** ** | **March 1, 2006-** | ** ** | **March 1, 2005-** | ** ** |
| ** **                                                                                 | ** ** | **November 23, 2006** | ** ** | **June 12, 2006** | ** ** | **November 24, 2005** | ** ** |
|                                                                                       |       |                            |       |   |   |   |   |
| **Cash flows from operating  activities**                                                  |       |                            |       |   |   |   |   |
| Net loss                                                                                   |       | $                               | (3,694,120 | ) | $ | (6,534,964 | ) | $ | (2,196,416 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                            |       |   |   |   |   |
| Noncash  inventory charge                                                                  |       | 909,264                         |       | — |   | — |   |
| Stock-based  compensation                                                                  |       | 306,096                         |       | 923,580 |   | 64,248 |   |
| Deferred income  taxes                                                                     |       | (1,760,180                      | )          | (396,024 | ) | (1,510,960 | ) |
| Accretion of  debt discount                                                                |       | 239,092                         |       | 85,471 |   | 221,074 |   |
| Amortization of  intangibles                                                               |       | —                          |       | 405,568 |   | 1,049,015 |   |
| Depreciation                                                                               |       | 10,041,824                      |       | 4,226,643 |   | 11,672,501 |   |
| Gain on sale of  property, plant and equipment                                             |       | —                          |       | — |   | (12,261 | ) |
| Changes in  operating assets and liabilities:                                              |       |                            |       |   |   |   |   |
| Receivables                                                                                |       | 2,956,053                       |       | (1,994,674 | ) | 1,731,444 |   |
| Inventories                                                                                |       | (1,601,320                      | )          | (2,208,757 | ) | (4,864,964 | ) |
| Prepaid  expenses, other current assets and income tax receivable                          |       | 96,906                          |       | (683,329 | ) | (2,895,799 | ) |
| Other                                                                                      |       | (35,240                         | )          | (5,328 | ) | (14,550 | ) |
| Accounts  payable, accrued expenses, accrued interest and income taxes                     |       | (5,138,065                      | )          | (358,006 | ) | (4,191,511 | ) |
| Total  adjustments                                                                         |       | 6,014,430                       |       | (4,856 | ) | 1,248,237 |   |
| *Net  cash provided by (used in) operating activities*                                     |       | 2,320,310                       |       | (6,539,820 | ) | (948,179 | ) |
|                                                                                       |       |                            |       |   |   |   |   |
| **Cash flows from investing activities**                                                   |       |                            |       |   |   |   |   |
| Equity  investment by Weston Presidio                                                      |       | 45,761,997                      |       | — |   | — |   |
| Capital  expenditures, net                                                                 |       | (3,995,243                      | )          | (1,937,610 | ) | (9,750,430 | ) |
| *Net cash provided by (used in)  investing activities*                                     |       | 41,766,754                      |       | (1,937,610 | ) | (9,750,430 | ) |
|                                                                                            |            |                                 |            |  |  |  |  |  |  |  |

 

6

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** **
| ** **                                          | ** ** | **For the Periods**   | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **Post-Acquisition**            | ** ** | **Pre- Acquisition** | ** ** |
| ** **                                          | ** ** | **June 13, 2006-**    | ** ** | **March 1, 2006-** | ** ** | **March 1, 2005-** | ** ** |
| ** **                                          | ** ** | **November 23, 2006** | ** ** | **June 12, 2006** | ** ** | **November 24, 2005** | ** ** |
|                                                |       |                            |       |   |   |   |   |
| **Cash flows from financing  activities**           |       |                            |       |   |   |   |   |
| Merger  consideration paid to former shareholders   |       | (45,761,997                     | )          | — |   | — |   |
| Payments of  long-term debt                         |       | —                          |       | (290,000 | ) | (280,000 | ) |
| Debt issuance  costs                                |       | —                          |       | — |   | (1,653 | ) |
| *Net  cash used in financing activities*            |       | (45,761,997                     | )          | (290,000 | ) | (281,653 | ) |
|                                                |       |                            |       |   |   |   |   |
| Effect of foreign  currency                         |       | (406,629                        | )          | 362,212 |   | 363,802 |   |
| *Net decrease in cash and cash  equivalents*        |       | (2,081,562                      | )          | (8,405,218 | ) | (10,616,460 | ) |
| *Cash and cash equivalents at  beginning of period* |       | 14,418,844                      |       | 22,824,062 |   | 26,959,029 |   |
| *Cash and cash equivalents at end of period*        |       | $                               | 12,337,282 |   | $ | 14,418,844 |   | $ | 16,342,569 |   |
|                                                     |            |                                 |            |  |  |  |  |  |  |  |

 

*Seeaccompanying notes to consolidated financial statements.*

7

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated FinancialStatements (Unaudited)**

**November23, 2006**

**Note 1 Basis of Presentation andSignificant Accounting Policies**

The accompanyingunaudited interim consolidated financial statements include the accounts ofCellu Tissue Holdings, Inc.  (the “Company”) and its wholly-owned subsidiaries.  TheCompany is a wholly-owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”).

On June 12, 2006, theParent consummated an Agreement and Plan of Merger with Cellu ParentCorporation (“Cellu Parent”), a corporation organized and controlled by WestonPresidio V, L.P. (“Weston Presidio”), and Cellu Acquisition Corporation (“MergerSub”), a wholly-owned subsidiary of Cellu Parent and a newly-formed corporationindirectly controlled by Weston Presidio. Pursuant to the agreement, on June 12, 2006, Merger Sub was merged withand into Parent, with the Parent surviving (the “Merger”).  Accordingly, the operating results and cashflows are presented in the accompanying financial statements on apre-acquisition (period from March 1, 2006 to June 12, 2006) andpost-acquisition (period from June 13, 2006 to November 23, 2006) basis.

These statements have beenprepared in accordance with accounting principles generally accepted in theUnited States for interim financial information and with the instructions toForm 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States forcomplete financial statements.  In theopinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation have been included.  Operating results for the post-acquisitionperiod from June 13, 2006 to November 23, 2006 are not necessarily indicativeof the results that may be expected for the post-acquisition period endingFebruary 28, 2007.  For further information,refer to the Company’s consolidated financial statements and footnotes theretoas of February 28, 2006 and for the year then ended included in the Company’sForm 10-K, from which the consolidated balance sheet at February 28, 2006 hasbeen derived, and the Company’s latest current reports on Form 8-K, each asfiled with the Securities and Exchange Commission (“SEC”).

Beginning on June 13,2006, the Company accounted for the Merger as a purchase in accordance with theprovisions of Statement of Financial Accounting Standards No. 141 (“SFAS 141”),*Business Combinations*, which resulted ina new valuation for the assets and liabilities of the Company based upon fairvalues as of the date of the Merger.  Asallowed under SEC Staff Accounting Bulletin No. 54, *Push DownBasis of Accounting Required in Certain Limited Circumstances*, theCompany has reflected all applicable purchase accounting adjustments in theCompany’s consolidated financial statements for all periods subsequent to theMerger date (“Push Down Accounting”). Push Down

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Accounting requires theCompany to establish a new basis for its assets and liabilities based on theamount paid for its equity at the close of business on June 12, 2006.  Accordingly, Cellu Parent’s ownership basisis reflected in the Company’s consolidated financial statements beginning uponcompletion of the Merger.  In order toapply Push Down Accounting, Cellu Parent’s purchase price of $207.8 million,including assumption of $162.0 million in aggregate principal amount of theCompany’s outstanding 9.75% senior secured notes (the “Notes”), was allocatedto the assets and liabilities based on their relative fair values.  The purchase price is subject to adjustmentfor certain tax benefits that the Company may realize.  In addition, total consideration is subjectto adjustment for up to an additional $35.0 million in contingent earnoutconsideration based upon the achievement of certain financial targets.  If any portion of the earned contingentpayments is unable to be made, then Weston Presidio has agreed to provide thenecessary funds to former holders of the Parent’s capital stock, options andwarrants through an equity investment in Parent or otherwise.  In accordance with SFAS 141, the $35.0million has been recognized as a liability and is recorded in other liabilitiesas of November 23, 2006.

Purchase priceallocations are subject to refinement until all pertinent information isobtained.  As of June 13, 2006, theCompany preliminarily allocated the excess purchase price over the net assetsacquired in the Merger based on its estimates of the fair value of assets andliabilities as follows:
|                                | ** ** | **Excess purchase  price allocated to:** | ** ** |
|--------------------------------|------------|---------------------------------------------------------|------------|
| Inventories                    |       | $                                                       | 909,264    |   |
| Property, plant  and equipment |       | 148,842,839                                             |       |
| Long-term debt                 |       | (900,729                                                | )          |
| Contingent  consideration      |       | (35,000,000                                             | )          |
| Deferred income  taxes         |       | (50,830,323                                             | )          |
| Total                          |       | $                                                       | 63,021,051 |   |

 

During the period fromJune 13, 2006 to November 23, 2006, the Company reflected $909,264 of excesspurchase price allocated to inventory as a non-cash charge to cost of goodssold and $3,411,200 of additional depreciation expense in cost of goods sold ascompared to the Company’s historical basis of accounting prior to the Merger.

The Company has estimatedthe fair value of its assets and liabilities as of the Merger, utilizinginformation available at the time the Company’s unaudited financial statementswere prepared and these estimates are subject to refinement until all pertinentinformation has been obtained.  TheCompany is in the process of obtaining outside third party appraisals of itsintangible assets and finalizing the allocation within property, plant and equipmentcategories.  The impact of these fairvalue estimates has been reflected in the

9

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Company’s statement ofoperations for the period June 13, 2006 through November 23, 2006.  Should the intangible assets appraisal orallocations within the property, plant and equipment categories result indifferences in amortizable intangible assets or depreciable lives of property,plant and equipment, changes in annual operating results would occur.

Reclassification

Certain prior yearamounts have been reclassified to conform to the current fiscal year 2007presentation.

Stock-Based Compensation

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123R (“SFAS 123R”), *Share-BasedPayment*, which requires the measurement of all employee share-basedpayments to employees, including grants of employee stock options, using thefair-value-based method and the recording of such expense in the Company’sconsolidated statement of operations. The Company adopted the provisions of SFAS 123R using the prospectivemethod effective March 1, 2006.  As such,there was no accounting effect on any awards outstanding at the date ofadoption.  At the time of adoption ofSFAS 123R, the Company had only one share-based payment arrangement, the CelluPaper Holdings, Inc. 2001 Stock Incentive Plan (the “Old Plan”), under whichthe Parent granted stock options to certain members of the Company’smanagement.  In accordance with the OldPlan, each option outstanding at the time of a change in control immediatelyvested and became exercisable. Furthermore, in accordance with the terms of the Merger, all outstandingoptions were cancelled and automatically converted into the right to receivethe per share merger consideration for any in-the-money options.

On June 12, 2006, the Board of Directors of Cellu Parent adopted the2006 Stock Option and Restricted Stock Plan (the “Plan”).  Under the Plan, the Plan Administrator maymake awards of options to purchase shares of common stock of Cellu Parentand/or awards of restricted shares of common stock of Cellu Parent.  A maximum of 8,095 shares of common stock ofCellu Parent may be delivered in satisfaction of awards under the Plan,determined net of shares of common stock withheld by Cellu Parent in payment ofthe exercise price of an award or in satisfaction of tax withholdingrequirements.  Key employees anddirectors of, and consultants and advisors to, Cellu Parent or its affiliateswho, in the opinion of the Plan Administrator, are in a position to make asignificant contribution to the success of Cellu Parent and its affiliates areeligible

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to participate in thePlan.   Stock options are granted at themarket price of the 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 certainassumptions affecting the estimated fair value of stock options aredetermined.  The dividend yield is zero;the volatility is based on historical market value of the Company’s stock; andthe risk-free interest rate is based on U.S. Treasury securities withmaturities equal to the expected life of the option.  The Company uses historical value to estimateexercise, termination and holding period behavior for valuation purposes.  A summary of the option activity as ofNovember 23, 2006 and changes during the period from June 13, 2006 to November23, 2006 is as follows:
|                                 | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** |
|---------------------------------|------------|-------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|
| Outstanding,  June 13, 2006     |       | —      |       | $                                          | —     |                                                    | —     |   |
| Granted                         |       | 500         |       | $                                          | 426.69     |                                                    | 9.20 Years |   |
| Outstanding,  November 23, 2006 |       | 500         |       | $                                          | 426.69     |                                                    | 9.20 Years |   |
| Exercisable, November  23, 2006 |       | —      |       | $                                          | —     |                                                    | —     |   |

 

The fair value of thestock option grant was estimated on the date of grant using the Black-Scholesoption pricing model.  The weightedaverage assumptions used to value the grants were: no dividend yield; 22.5%volatility; 4.9% risk free interest rate; and 10-year expected life.  The weighted average fair value of stockoptions granted was $196.77 per share and the unrecognized total compensationcost as of November 23, 2006 related to nonvested awards is $91,647.

On June 12, 2006, CelluParent entered into Restricted Stock Agreements with the Company’s ChiefExecutive Officer, Chief Operating Officer and Chief Financial Officer, pursuantto which Cellu Parent granted 3,778 restricted shares of its common stock tothe Chief Executive Officer and 1,349 restricted shares of its common stock toeach of the other two named individuals pursuant to the Plan.  The shares will vest and cease to berestricted in four equal annual installments commencing on June 12, 2007, aslong as the named individual, as the case may be, is continuously employed bythe Company until each such vesting date with respect to his or her shares.  Any restricted stock outstanding at the timeof a Covered Transaction (as defined in the Plan) shall become vested and ceaseto be restricted stock at that time. Additionally, the Parent has agreed to pay an additional amount to thenamed individuals,

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as the case may be, to fully gross up him or her as applicable, for theamount included in gross income for income tax purposes as a result of making aSection 83(b) election under the Internal Revenue Code of 1986, as amended, orthe payment of any gross-up amount payment. All named individuals have made a timely Section 83(b) election.

 

For the period from June13, 2006 to November 23, 2006, the Company has recorded $306,076 ofcompensation expense related to the vesting of the above grants in accordancewith SFAS 123R.  Immediately prior toconsummation of the Merger, there were 341.3 restricted shares of Parent’scommon stock.  In accordance with theterms of the old Plan, the restricted stock immediately vested.  Accordingly, for the period from May 26, 2006to June 12, 2006, the Company recorded $870,922 of compensation expense relatedto the vesting of the above restricted stock in accordance with SFAS 123R.  The Company had previously recorded $52,658related to the normal vesting in the three-month period ended May 25, 2006.

Derivatives and Hedging

The Company usesderivative financial instruments to offset a substantial portion of itsexposure to market risk arising from changes in the price of natural gas.  Hedging of this risk is accomplished byentering into forward swap contracts, which are designated as hedges ofspecific quantities of natural gas expected to be purchased in futuremonths.    These contracts are held forpurposes other than trading and are designated as cash flow hedges.  The Company measures hedge effectiveness byformally assessing, at least quarterly, the correlation of the expected futurecash flows of the hedged item and the derivative hedging instrument.  The ineffective portions of the hedges arerecorded in the statement of operations in the current period.  As the hedges were highly effective for theperiods from March 1, 2006 to June 12, 2006, for the three months endedNovember 23, 2006 and from June 13, 2006 to November 23, 2006, the Companyexperienced minimal impact to operating results.

Recent AccountingPronouncements

In June 2006, the FASBissued FASB Interpretation No. 48 (“FIN 48”), *Accountingfor Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)*.The provisions of FIN 48 are effective for fiscal years beginning afterDecember 15, 2006. This statement was issued to clarify the accounting for theuncertainty related to income taxes. FIN 48 requires the evaluation of whethera tax position is more likely than not to be sustained upon examination withthe assumption that the position will be examined by the relevant taxauthorities.  FIN 48 also requires suchtax positions to be measured at the largest amount of the respective benefitthat is greater than 50% likely of being realized

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upon ultimate settlement.The Company is currently assessing the impact that the adoption of FIN 48 willhave on its results of operations and financial position.

In September 2006, theFASB issued FAS No. 157,”Fair Value Measurements” (“SFAS 157”).  SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 as well asinterim periods within such fiscal years. SFAS 157 provides a common fair value hierarchy for companies to followin determining fair value measurements in the preparation of financialstatements and expands disclosure requirements relating to how such fair valuemeasurements were developed.  SFAS 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 Company iscurrently assessing the impact that SFAS will have on its results of operationsand financial position.

**Note 2 Inventories**

Components of inventoriesare as follows:
|                                   | ** ** | **November 23, 2006** | ** **  | **February 28, 2006** | ** ** |
|-----------------------------------|------------|---------------------------------|-------------|---------------------------------|------------|
| Finished goods                    |       | $                               | 19, 469,863 |                            | $          | 18,072,976 |   |
| Raw materials                     |       | 4,469,029                       |        | 2,624,006                       |       |
| Packaging  materials and supplies |       | 7,907,020                       |        | 7,446,184                       |       |
|                              |       | 31,845,912                      |        | 28,143,166                      |       |
| Inventory  reserves               |       | (115,887                        | )           | (223,218                        | )          |
|                              |       | $                               | 31,730,025  |                            | $          | 27,919,948 |   |

 

**Note 3 Debt Issuance Costs**

Debt issuance costsconsist of the following:
|                                | ** ** | **February 28, 2006** | ** ** |
|--------------------------------|------------|---------------------------------|------------|
| Debt issuance  costs           |       | $                               | 8,541,986  |   |
| Less accumulated  amortization |       | (2,796,003                      | )          |
|                           |       | $                               | 5,745,983  |   |

 

Amortization expense forthe period from March 1, 2006 to June 12, 2006 and for the nine months endedNovember 23, 2005 of $405,568 and $1,049,015, respectively, has been includedin interest expense on the respective statements of operations.  The unamortized debt issuance costs as ofJune 12, 2006 of $5,340,415 have been adjusted through the purchase priceallocation and the fair value assigned to the Company’s debt.

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**Note 4 Long-Term Debt**

Long-term debt consistsof the following:
|                                                                                                                  | ** ** | **November 23, 2006** | ** **  | **February 28, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|-------------|---------------------------------|------------|
| 9 3⁄4% senior  secured notes due 2010                                                                         |       | $                               | 162,000,000 |                            | $          | 162,000,000 |   |
| Less discount                                                                                                    |       | (1,785,907                      | )           | (1,209,742                      | )          |
|                                                                                                             |       | 160,214,093                     |        | 160,790,258                     |       |
| Industrial  revenue bond payable, in annual installments, plus interest ranging from 4.8%  to 6.65%, due in 2006 |       | —                          |        | 290,000                         |       |
|                                                                                                             |       | 160,214,093                     |        | 161,080,258                     |       |
| Less current  portion of debt                                                                                    |       | —                          |        | 290,000                         |       |
|                                                                                                             |       | $                               | 160,214,093 |                            | $          | 160,790,258 |   |

 

The Notes mature on March15, 2010 and require semi-annual interest payments on March 15 and September15, which commenced on September 15, 2004.  The Notes are collateralized by a senior secured interest insubstantially all of the Company’s assets. Terms of the indenture under which the Notes have been issued containcertain covenants, including limitations on certain restricted payments and theincurrence of additional indebtedness. The Notes are unconditionally guaranteed by all of the Company’ssubsidiaries.

In connection with theMerger, the Company solicited consents with respect to the Notes.   Consents were received with respect to 100%of the aggregate outstanding principal amount of the Notes. The Companyaccepted all of the consents delivered in the consent solicitation and paid tothe consenting noteholders a consent fee of $40 per $1,000 principal amount ofNotes for which they delivered consents. These payments were made in the Company’s second quarter of the fiscalyear ending February 28, 2007.  Thesepayments, along with other transaction costs totaling $6.0 million, arereflected as merger-related transaction costs on the statement of operationsfor the period March 1, 2006 through November 23, 2006.  The Company had previously incurred $.1million in the first quarter of the fiscal year ending February 28, 2007.  As a result of the acceptance by the Companyof the consents delivered by noteholders and the completion of the consentsolicitation, the amendments to the indenture governing the Notes described inthe Consent Solicitation Statement dated May 9, 2006 and related Supplementdated May 24, 2006 have become operative and the Company will not be requiredto make a change of control offer to purchase any Notes in connection with theMerger.

The Company entered intoa Credit Agreement, dated as of June 12, 2006 (the “Credit Agreement”), amongthe Company, as U.S. Borrower, Interlake Acquisition Corporation

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Limited, a subsidiary ofthe Company, as Canadian Borrower, Parent, the other loan guarantors partythereto, JPMorgan Chase Bank, N.A., as U.S. Administrative Agent, JPMorganChase Bank, N.A., Toronto Branch, as Canadian Administrative Agent, and theother lenders party thereto.  The CreditAgreement provides for a $35.0 million working capital facility, 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 is available, in U.S. dollars,to the U.S. Borrower under the facility, and an amount equal to $3.0 million isavailable, in U.S. or Canadian dollars, to the Canadian Borrower under thefacility.  As of November 23, 2006, therewere no outstanding borrowings under the working capital facility.

**Note 5 Comprehensive Loss**

The components ofcomprehensive loss for the three months ended November 23, 2006 and November24, 2005 are as follows:
|                                           | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **November 23, 2006**  | ** ** | **November 24, 2005** | ** ** |
| Net loss                                  |       | $                                | (1,074,735 | ) | $ | (1,230,465 | ) |
| Foreign currency  translation adjustments |       | (358,094                         | )          | 2,391,620 |   |
| Comprehensive (loss)  income              |       | $                                | (1,432,829 | ) | $ | 1,161,155 |   |

 

The components ofcomprehensive loss for the period from June 13, 2006 to November 23, 2006,March 1, 2006 to June 12, 2006 and for the nine months ended November 24, 2005are as follows:
|                                           | ** ** | **For the Periods**                             | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                | ** ** | **Post-Acquisition**                                      | ** ** | **Pre-Acquisition** | ** ** |
| ** **                                | ** ** | **June 13, 2006-  November 23, 2006** | ** ** | **March 1, 2006-  June 12, 2006** | ** ** | **March 1, 2005-   November 24, 2005** | ** ** |
| Net loss                                  |       | $                                                         | (3,694,120 | ) | $ | (6,534,964 | ) | $ | (2,196,416 | ) |
| Foreign currency  translation adjustments |       | (664,489                                                  | )          | 586,186 |   | 2,624,336 |   |
| Derivative loss                           |       | (154,672                                                  | )          | — |   | — |   |
| Comprehensive (loss)  income              |       | $                                                         | (4,513,281 | ) | $ | (5,948,778 | ) | $ | 427,920 |   |

 

Included in foreigncurrency translation adjustments for the three months and nine months endedNovember 24, 2005 is a one-time adjustment of $2.3 million to correct thecumulative effect of improperly translating the value of property, plant andequipment.  Historically, the translationof these assets from Canadian dollars to U.S dollars had been occurring athistorical rates, as opposed to actual month-end rates, as required under FAS52,”*Foreign Currency Translation”*.

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**Note 6 Management Agreement**

On June 12, 2006, theCompany, Cellu Parent, and Merger Sub entered into a Management Agreement withWeston Presidio Service Company, LLC (“Weston Presidio Service Company”),pursuant to which Weston Presidio Service Company has agreed to provide theCompany with certain management, consulting and financial and other advisoryservices.  Weston Presidio ServiceCompany is an affiliate of Weston Presidio, which is the controllingshareholder of Cellu Parent, which is the sole shareholder of Parent.   In consideration for such services, theCompany and Cellu Parent have jointly and severally agreed to pay WestonPresidio Service Company an annual fee of $450,000, to be paid in equalquarterly installments, and to reimburse out-of-pocket expenses of WestonPresidio Service Company and its affiliates. In addition, in connection with the consummation of the Merger and asrequired by the Management Agreement, the Company paid Weston Presidio ServiceCompany a fee in the amount of $2,000,000. This amount has been capitalized through purchase accounting as part oftotal merger consideration.  TheManagement Agreement expires on June 12, 2016, but will be automaticallyextended on each anniversary of such date for an additional year, unless one ofthe parties provides written notice of its desire not to automatically extendthe term at least 90 days prior to such anniversary.

Management fees paid of$187,500 for the period June 13, 2006 to November 23, 2006 are reflected inselling, general and administrative expenses.

**Note 7 Business Segments**

The Company operates intwo reportable business segments:  tissueand machine-glazed paper.  The Companyassesses the performance of its reportable business segments using income fromoperations.  Income from operationsexcludes interest income, interest expense, other income (expense), income taxexpense (benefit) and the impact of foreign currency gains and losses.   A portion of corporate and shared expensesis allocated to each segment. Included in income from operations for the three monthsended November 23, 2006 is $53,474 of restructuring costs and $1,892,770 ofadditional depreciation expense related to excess purchase price allocated toproperty, plant and equipment.  Of theseamounts, $34,758 and $1,230,301, respectively, impacts the tissue segment and$18,716 and $662,469, respectively impacts the machine-glazed papersegment.  Included in loss fromoperations for the period March 1, 2006 to June 12, 2006 is $5,933,265 ofmerger-related transaction costs.  Ofthis amount, $3,856,622 impacts the tissue segment and $2,076,643 impacts themachine-glazed paper segment.**** Included in loss from operations for theperiod June 13, 2006 to November 23, 2006 is $155,849 of merger-relatedtransaction costs, $240,218 of restructuring costs, $909,264 for a non-cashcharge to cost of goods sold related to excess purchase price allocated toinventory and

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$3,411,200 of additionaldepreciation expense related to excess purchase price allocated to property,plant and equipment.**** Of these amounts, $101,302, $156,142, $591,022and $2,217,280, respectively, impact the tissue segment and $54,547, $84,076,$318,242 and $1,193,920, respectively, impact the machine-glazed paper segment.Also, included in loss from operations for the three months ended November 23,2006 are compensation charges of $370,320 million related to the vesting ofrestricted stock awards granted after the merger and other compensation expenserelated to the merger. Of this amount, $240,708 and $129,522, respectively,impacts the tissue segment and machine-glazed segment, respectively.  Also, included in loss from operations forthe periods June 13, 2006 to November 23, 2006 and March 1, 2006 to June 12,2006 are compensation charges of $2,205,384****and$1,301,945, respectively, related to non-cash compensation expense related tothe vesting of restricted stock awards, payments of taxes associated with suchawards and other compensation expense related to the Merger.**** Of these amounts,$1,433,500 and $846,264, respectively, impact the tissue segment and $771,884****and $455,681, respectively, impact the machine-glazedsegment.  Included in the three monthsended and nine months ended November 24, 2005 income from operations is$1,031,593 related to restructuring activities. Of this amount, $843,308impacts the machine-glazed paper segment and $188,285 impacts the tissuesegment.  Also included in the threemonths ended and nine months ended November 24, 2005 income from operations is$1,477,300 and $2,366,427, respectively, of merger related transactionscosts.  Of these amounts, $517,055 and$828,250, respectively, impact the machine-glazed paper segment and $960,245and $1,538,177 impact the tissue segment. Segment information for the three months ended November 23, 2006 andNovember 24, 2005 follows:
|                                               | ** ** | **Three Months Ended**                    | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                    | ** ** | **November 23, 2006  (Post-Acquisition)** | ** ** | **November 24, 2005   (Pre-Acquisition)** | ** ** |
| **Net  Sales**                                |       |                                                |       |   |   |
| Tissue                                        |       | $                                                   | 58,059,690 |   | $ | 56,845,036 |   |
| Machine-glazed  paper                         |       | 25,221,516                                          |       | 24,667,404 |   |
| Consolidated                                  |       | $                                                   | 83,281,206 |   | $ | 81,512,440 |   |
| ** **                                    |       |                                                |       |   |   |
| **Income  (loss) from operations**            |       |                                                |       |   |   |
| Tissue                                        |       | $                                                   | 1,962,656  |   | $ | 1,096,191 |   |
| Machine-glazed  paper                         |       | 464,272                                             |       | (258,126 | ) |
| Consolidated                                  |       | 2,426,928                                           |       | 838,065 |   |
| Interest expense                              |       | (4,122,043                                          | )          | (4,376,268 | ) |
| Net foreign  currency transaction gain (loss) |       | 79,440                                              |       | (93,528 | ) |
| Interest income                               |       | 55,641                                              |       | 76,156 |   |
| Other income                                  |       | 3,501                                               |       | 21,443 |   |
| Pretax loss                                   |       | $                                                   | (1,556,533 | ) | $ | (3,534,132 | ) |

 

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| **Capital Expenditures** |   |      |      |    |   |
|--------------------------|--------|-----------|-----------|---------|--------|
| Tissue                   |   | $         | 1,730,828 |    | $      | 1,939,387 |   |
| Machine-glazed  paper    |   | 391,777   |      | 271,760 |   |
| Corporate                |   | (11,819   | )         | 127,544 |   |
| Consolidated             |   | $         | 2,110,786 |    | $      | 2,338,691 |   |
| ** **               |   |      |      |    |   |
| **Depreciation**         |   |      |      |    |   |
| Tissue                   |   | $         | 3,897,453 |    | $      | 2,630,153 |   |
| Machine-glazed  paper    |   | 1,628,608 |      | 971,036 |   |
|                     |   | $         | 5,526,061 |    | $      | 3,601,189 |   |

 

Segment information forthe periods June 13, 2006 to November 23, 2006, March 1, 2006 to June 12, 2006and March 1, 2005 to November 24, 2005 follows:
|                                               | ** ** | **Post-Acquisition**                                      | ** **  | **Pre-Acquisition**                                   | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------|-------------|-------------------------------------------------------|------------|
| ** **                                    | ** ** | **June 13, 2006-  November 23, 2006** | ** **  | **March 1, 2006-  June 12, 2006** | ** ** | **March 1, 2005-  November 24, 2005** | ** ** |
| **Net  Sales**                                |       |                                                      |        |                                                  |       |   |   |
| Tissue                                        |       | $                                                         | 107,084,355 |                                                  | $          | 67,199,611 |   | $ | 173,774,486 |   |
| Machine-glazed  paper                         |       | 44,759,237                                                |        | 27,042,321                                            |       | 71,399,454 |   |
| Consolidated                                  |       | $                                                         | 151,843,592 |                                                  | $          | 94,241,932 |   | $ | 245,173,940 |   |
|                                          |       |                                                      |        |                                                  |       |   |   |
| **Income  (loss) from operations**            |       |                                                      |        |                                                  |       |   |   |
| Tissue                                        |       | $                                                         | 1,843,141   |                                                  | $          | (1,210,487 | ) | $ | 6,440,834 |   |
| Machine-glazed  paper                         |       | (328,840                                                  | )           | (2,119,523                                            | )          | 1,966,984 |   |
| Consolidated                                  |       | 1,514,301                                                 |        | (3,330,010                                            | )          | 8,407,818 |   |
| Interest expense                              |       | (7,346,364                                                | )           | (5,000,732                                            | )          | (12,938,577 | ) |
| Net foreign  currency transaction gain (loss) |       | 146,116                                                   |        | (289,010                                              | )          | (377,713 | ) |
| Interest income                               |       | 127,426                                                   |        | 104,377                                               |       | 189,971 |   |
| Other income                                  |       | 20,954                                                    |        | 27,049                                                |       | 53,620 |   |
| Pretax loss                                   |       | $                                                         | (5,537,567  | )                                                     | $          | (8,488,326 | ) | $ | (4,664,881 | ) |

 

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| **Capital Expenditures** |   |      |       |      |   |      |   |
|--------------------------|--------|-----------|------------|-----------|--------|-----------|--------|
| Tissue                   |   | $         | 2,929,390  |      | $      | 711,857   |   | $ | 8,380,928 |   |
| Machine-glazed  paper    |   | 696,359   |       | 236,288   |   | 658,502   |   |
| Corporate                |   | 369,494   |       | 989,465   |   | 711,000   |   |
| Consolidated             |   | $         | 3,995,243  |      | $      | 1,937,610 |   | $ | 9,750,430 |   |
| ** **               |   |      |       |      |   |      |   |
| **Depreciation**         |   |      |       |      |   |      |   |
| Tissue                   |   | $         | 7,088,006  |      | $      | 3,056,653 |   | $ | 7,845,595 |   |
| Machine-glazed  paper    |   | 2,953,818 |       | 1,169,990 |   | 3,826,906 |   |
|                     |   | $         | 10,041,824 |      | $      | 4,226,643 |   | $ | 11,672,501 |   |

 

**Note 8 Income taxes**

The effective income taxbenefit for the three months ended November 23, 2006 was 31.0% compared to a65.2% benefit for the three months ended November 24, 2005.  The effective income tax benefit for theperiods March 1, 2006 to June 12, 2006 and June 13, 2006 to November 23, 2006were 23.0 % and 33.3%, respectively, compared to a 52.9% benefit for the periodMarch 1, 2005 to November 24, 2005.  Theeffective income tax rate for the period March 1, 2006 to June 12, 2006 differsfrom the federal statutory rate primarily due to non-deductible transactioncosts expensed for book purposes. Included in the 52.9% effective tax rate for the period March 1, 2005 toNovember 24, 2005 is approximately $1.2 million of benefit related to thedifferent book and tax treatment of deductions related to stock compensationmatters.  This benefit was recorded inthe third quarter of the prior fiscal year upon completion of the Company’s2005 tax returns as the impact was discrete to that quarter.  Also, included in the 52.9% effective taxrate was $.1 million of tax expense related to Canadian withholding tax.  Without these items, the effective tax ratefor the period March 1, 2005 to November 24, 2005 was 29.8%.

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

 

**OVERVIEW**

Certain statementscontained in this Quarterly Report on Form 10-Q may contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, as amended,and as such, may involve known or unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from future results, performance or achievements expressedor implied by such forward-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 Item 1. Business-Forward-Looking Statements and Item1A.  Risk Factors in our Annual Report onForm 10-K for our fiscal year ended February 28, 2006.  These risks and uncertainties should beconsidered in evaluating any forward-looking statements contained herein.

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

We operate in tworeportable business segments:  tissue andmachine-glazed paper.  We assess theperformance of our reportable 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.

On June 12, 2006 CelluPaper Holdings, Inc., our parent, consummated an Agreement and Plan of Mergerwith Cellu Parent Corporation (referred to herein as Cellu Parent), acorporation organized and controlled by Weston Presidio V, L.P. (referred toherein as Weston Presidio), and Cellu Acquisition Corporation, a wholly-ownedsubsidiary of Cellu Parent and a newly-formed corporation indirectly controlledby Weston Presidio (referred to herein as Merger Sub).  Pursuant to the agreement, on June 12, 2006,Merger Sub was merged with and into our parent, with our parent surviving(referred to herein as the merger).

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Beginning on June 13,2006, we accounted for the merger as a purchase in accordance with theprovisions of Statement of Financial Accounting Standards No. 141, or SFAS 141,*Business Combinations*, which resulted ina new valuation for our assets and liabilities based upon fair values as of thedate of the merger.  As allowed under SECStaff Accounting Bulletin No. 54, *Push Down Basis of AccountingRequired in Certain Limited Circumstances*, we have reflected allapplicable purchase accounting adjustments in our consolidated financialstatements for all periods subsequent to the merger date (referred to herein aspush down accounting).  Push downaccounting requires us to establish a new basis for our assets and liabilitiesbased on the amount paid for our equity at close of business on June 12,2006.  Accordingly, Cellu Parent’s equitybasis is reflected in our consolidated financial statements beginning uponcompletion of the merger.  In order toapply push down accounting, Cellu Parent’s purchase price of $207.8 million(including assumption of $162.0 million in aggregate principal amount of ouroutstanding 9.75% senior secured notes, or the Notes), was allocated to theassets and liabilities based on their relative fair values.  The purchase price is subject to adjustmentfor certain tax benefits that we may realize. In addition, total consideration is subject to adjustment for up to anadditional $35.0 million in contingent earnout consideration based upon theachievement of certain financial targets. If any portion of the contingent payments are unable to be made, thenWeston Presidio has agreed to provide the necessary funds to former holders ofour parent’s capital stock, options and warrants through an equity investmentin our parent or otherwise.  Inaccordance with SFAS 141, the $35.0 million has been recognized as a liabilityand is recorded in other liabilities as of November 23, 2006.

Purchase priceallocations are subject to refinement until all pertinent information isobtained.  As of June 13, 2006, wepreliminarily allocated the excess purchase price over the net assets acquiredin the merger based on our estimates of the fair value of assets andliabilities as follows:
|                                | ** ** | **Excess purchase   price allocated to:** | ** ** |
|--------------------------------|------------|---------------------------------------------------------------|------------|
| Inventories                    |       | $                                                             | 909,264    |   |
| Property, plant  and equipment |       | 148,842,839                                                   |       |
| Long-term debt                 |       | (900,729                                                      | )          |
| Contingent  consideration      |       | (35,000,000                                                   | )          |
| Deferred income  taxes         |       | (50,830,323                                                   | )          |
| Total                          |       | $                                                             | 63,021,051 |   |

 

During the period fromJune 13, 2006 to November 23, 2006, we reflected $909,264 of excess purchaseprice allocated to inventory as a non-cash charge to cost of goods sold and$3,411,200 of additional depreciation expense in cost of goods sold as comparedto our historical basis of accounting prior to the merger.

We have estimated thefair value of our assets and liabilities as of the merger utilizing informationavailable at the time our unaudited financial statements were prepared andthese estimates are subject to refinement until all pertinent information hasbeen obtained.

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We are in the process ofobtaining outside third party appraisals of our intangible assets andfinalizing the allocation within property, plant and equipment categories.  The impact of these fair value estimates hasbeen reflected in our statement of operations for the period June 13, 2006through November 23, 2006.  Should theintangible assets appraisal or allocations within the property, plant andequipment categories result in differences in amortizable intangible assets ordepreciable lives of property, plant and equipment, changes in annual operatingresults would occur.

 **RESULTS OF OPERATIONS**

The three months endedNovember 23, 2006 (post-acquisition) period has been compared to the threemonths ended November 24, 2005 (pre-acquisition).  The combined nine months ended November 23,2006 pre- and post- acquisition periods have been compared to the nine monthsended November 24, 2005 for purposes of management’s discussion and analysis ofthe results of operations.  Anyreferences below to the nine months ended November 23, 2006 shall refer to thecombined periods.  Material fluctuationsin operations resulting from the effect of purchase accounting have beenhighlighted.
| ** **                                    | ** ** | **Pre-Acquisition**          | ** ** | **Post-Acquisition**            | ** ** | **Combined**                    | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **March 1, 2006-** | ** ** | **June 13, 2006-**    | ** ** | **Nine Months Ended** | ** ** |
| ** **                                    | ** ** | **June 12, 2006**  | ** ** | **November 23, 2006** | ** ** | **November 23, 2006** | ** ** |
|                                          |       |                         |       |                            |       |                            |       |
| Net sales                                     |       | $                            | 94,241,932 |                            | $          | 151,843,592                     |       | $ | 246,085,524 |   |
| Cost of goods sold                            |       | 86,053,812                   |       | 142,608,186                     |       | 228,661,998                     |       |
| Gross profit                                  |       | 8,188,120                    |       | 9,235,406                       |       | 17,423,526                      |       |
|                                          |       |                         |       |                            |       |                            |       |
| Selling, general and  administrative expenses |       | 5,584,865                    |       | 7,325,038                       |       | 12,909,903                      |       |
| Restructuring costs                           |       | —                       |       | 240,218                         |       | 240,218                         |       |
| Merger-related  transaction costs             |       | 5,933,265                    |       | 155,849                         |       | 6,089,114                       |       |
| (Loss) income from  operations                |       | (3,330,010                   | )          | 1,514,301                       |       | (1,815,709                      | )          |
|                                          |       |                         |       |                            |       |                            |       |
| Interest expense, net                         |       | 4,896,355                    |       | 7,218,938                       |       | 12,115,293                      |       |
| Foreign currency loss  (gain)                 |       | 289,010                      |       | (146,116                        | )          | 142,894                         |       |
| Other income                                  |       | (27,049                      | )          | (20,954                         | )          | (48,003                         | )          |
| Loss before income tax  benefit               |       | (8,488,326                   | )          | (5,537,567                      | )          | (14,025,893                     | )          |
| Income tax benefit                            |       | (1,953,362                   | )          | (1,843,447                      | )          | (3,796,809                      | )          |
| Net loss                                      |       | $                            | (6,534,964 | )                               | $          | (3,694,120                      | )          | $ | (10,229,084 | ) |

 

The tables that follow presentunaudited net sales and gross profit for our principal segments for thecombined nine months ended November 23, 2006.

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| ** **           | ** ** | **Pre-Acquisition**          | ** ** | **Post-Acquisition**            | ** ** | **Combined**                    | ** ** |
|----------------------|------------|------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **           | ** ** | **March 1, 2006-** | ** ** | **June 13, 2006-**    | ** ** | **Nine Months Ended** | ** ** |
| ** **           | ** ** | **June 12, 2006**  | ** ** | **November 23, 2006** | ** ** | **November 23, 2006** | ** ** |
| **Net Sales**        |       |                         | ** ** | ** **                      | ** ** | ** **                      | ** ** |
| Tissue               |       | $                            | 67,199,611 |                            | $          | 107,084,355                     |       | $ | 174,283,966 |   |
| Machine-glazed paper |       | 27,042,321                   |       | 44,759,237                      |       | 71,801,558                      |       |
| Consolidated         |       | $                            | 94,241,932 |                            | $          | 151,843,592                     |       | $ | 246,085,524 |   |
|                 |       |                         |       |                            |       |                            |       |
| **Gross Profit**     |       |                         |       |                            |       |                            |       |
| Tissue               |       | $                            | 6,423,465  |                            | $          | 7,085,890                       |       | $ | 13,509,355 |   |
| Machine-glazed paper |       | 1,764,655                    |       | 2,149,516                       |       | 3,914,171                       |       |
| Consolidated         |       | $                            | 8,188,120  |                            | $          | 9,235,406                       |       | $ | 17,423,526 |   |

 

**Results of Operations for theThree Months Ended November 23, 2006 (the Fiscal 2007 Three-Month Period)compared to the Three Months Ended November 24, 2005 (the Fiscal 2006Three-Month Period) and the Nine Months Ended November 23, 2006 (the Fiscal2007 Nine-Month Period) compared to the Nine Months ended November 24, 2005(the Fiscal 2006 Six-Month Period)**

**Net sales** forthe fiscal 2007 three-month period increased $1.8 million, or 2.2%, to****$83.3 million from $81.5 million for the comparable periodin the prior year. Net sales for the fiscal 2007 nine-month period increased$.9 million, or .4%, to $246.1 from $245.2 million for the comparable period inthe prior year.  On a Company-wide basis,tons sold decreased for the fiscal 2007 three-month period and the fiscal 2007nine-month period compared to the comparable periods of fiscal 2006.  For the fiscal 2007 three-month period, wesold 61,835 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products, a decrease of 2,153 tons, or 3.4% compared to thefiscal 2006 three-month period.  For thefiscal 2007 nine-month period, we sold 188,033 tons of tissue hard rolls,machine-glazed paper hard rolls and converted paper products, a decrease of6,119 tons, or 3.2% compared to the fiscal 2006 nine-month period.  Included in these decreases is the effect ofthe shutdown of our machine-glazed machine at our Ontario facility, whichtranspired in the third quarter of fiscal 2006 and represented a decrease of1,345 tons in the fiscal 2007 three-month period and 5,148 in the fiscal 2007nine-month period from the comparable periods in the prior fiscal year.  Net of the effect of this, tons solddecreased 808, or 1.3%, for the fiscal 2007 three-month period over thecomparable period in the prior year and tons sold decreased 971, or .5%, forthe fiscal 2007 nine-month period over the comparable period in the prioryear.  Offsetting the decrease in volumesold for the fiscal 2007 three-month period and fiscal 2007 nine-month periodover the comparable periods in the prior fiscal year, was an increase in net sellingprice per ton from $1,274 and $1,263 for the fiscal 2006 three-month period andnine-month period, respectively, to $1,347 and $1,309 for the fiscal 2007three-month period and nine-month period, respectively.

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Net sales for our tissuesegment for the fiscal 2007 three-month period were $58.1 million, an increaseof $1.2 million, or 2.1%, from the comparable period in the prior fiscalyear.  Net sales for our tissue segmentfor the fiscal 2007 nine-month period were $174.3 million, an increase of $.5million, or .3%, from the comparable period in the prior fiscal year. Theincrease is attributable to an increase in net selling price per ton, which waspartially offset by a decrease in tonnage sold. Net sales for our machine-glazed segment for the 2007 three-month periodwere****$25.2 million, an increase of $.6million, or 2.2%,****from the comparable period in theprior fiscal year.  Net sales for ourmachine-glazed segment for the 2007 nine-month period were $71.8 million, anincrease of $.4 million, or .6%, from the comparable period in the prior fiscalyear.   This increase is driven by anincrease in net selling price per ton partially offset by the decrease intonnage sold as noted above.

**Gross profit**for the fiscal 2007 three-month period decreased to $5.9 million from $6.7million, a decrease of $.8 million, or 12.5%, from the comparable period in theprior****fiscal year. ** **Gross profit for the fiscal 2007nine-month period decreased to $17.4 million from $21.3 million, a decrease of$3.9 million, or 18.4%, from the comparable period in the prior fiscalyear.  Included in the fiscal 2007three-month and nine-month periods are $1.9 million and $3.4 million,respectively, of additional depreciation expense in cost of goods sold ascompared to our historical basis of accounting prior to the merger.  Also, included in the fiscal 2007 nine-monthperiod is a non-cash charge to cost of goods sold reflecting $.9 million ofexcess purchase price allocated to inventory.

As a percentage of netsales, gross profit decreased to 7.1% in the fiscal 2007 three-month andnine-month periods from 8.3% and 8.7%, respectively, in the comparable fiscal2006 three-month and nine-month periods.

Gross profit for ourtissue segment for the fiscal 2007 three-month period was****$4.3million, a decrease of****$.2 million,or 3.4%, from the comparable period in the prior fiscal year.  Gross profit for our tissue segment for thefiscal 2007 nine-month period was $13.5 million, a decrease of $1.0 million, or6.8%, from the comparable period in the prior fiscal year.  Included in the fiscal 2007 three-month andnine-month periods is the impact of the additional charges noted above on thetissue segment of $1.2 million and $2.8 million, respectively.

Gross profit for ourmachine-glazed segment for the fiscal 2007 three-month period was $1.6 million,a decrease of $.6****million, or 30.5%, from thecomparable period in the prior fiscal year. Gross profit for our machine-glazed segment for the fiscal 2007nine-month period was $3.9 million, a decrease of $2.9 million, or 42.8%, fromthe comparable period in the prior fiscal year. Included in the fiscal 2007 three-month and nine-month periods is theimpact of the additional charges noted above on the machine-glazed segment of$.7 million and $1.5 million, respectively.

As a percentage of netsales, gross profit for the tissue segment decreased to 7.5% in the fiscal 2007three-month period and 7.8% in the fiscal 2007 nine-month period from 7.9 %

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in the fiscal 2006 three-monthperiod and 8.3% in the fiscal 2006 nine-month period.  As a percentage of net sales, gross profitfor the machine-glazed segment decreased to 6.2% in the fiscal 2007 three-monthperiod and 5.5% in the fiscal 2007 nine-month period from 9.1% in the fiscal2006 three-month period and 9.6% in the fiscal 2006 nine-month period.

**Selling, general andadministrative expenses**in the fiscal 2007 three-month periodincreased $.1 million, or 2.8%, to $3.4 million from $3.3 million in the fiscal2006 three-month period.  Selling,general and administrative expenses in the fiscal 2007 nine-month periodincreased $3.4 million, or 36.3%, to $12.9 million from $9.5 million in thefiscal 2006 nine-month period.  As apercentage of net sales, selling, general and administrative expenses remainedconstant at****4.1% in the fiscal 2007three-month period and increased to 5.2% in the fiscal 2007 nine-month periodcompared to 4.1% and 3.9%, respectively, for the comparable periods in theprior fiscal year.  Included in the fiscal2007 three-month period is $.2 million of non-cash compensation expense relatedto the vesting of restricted stock awards granted after the merger and $.2million of other compensation expense related to the merger.  Included in the fiscal 2007 nine-month period****is $.9 million of non-cash compensation expense related tomerger related vesting of restricted stock awards, $1.4 million of othercompensation expense related to tax payments associated with such awards, $.8million of other compensation expense related to the merger and $.3 million ofnon-cash compensation expense related to the vesting of restricted stock awardsgranted after the merger.

**Restructuring costs**inthe fiscal 2007 nine-month period were $.2 million related to severances costsassociated with the elimination of a corporate position.  Restructuring costs in the fiscal 2006three-month and nine-month periods were $1.0 million, of which $.7 millionrelated to our fiscal 2006 decision to indefinitely idle one of our papermachines at our Interlake facility and the resulting severances costs thereofand $.3 million related to severance costs associated with a corporateorganizational restructuring.

**Merger-related transaction costs**inthe fiscal 2007 three-month period were less than $.1 million and in the fiscal2007 nine-month period were $6.1 million. The merger-related transaction costs in the fiscal 2006 three-month andnine-month periods relate to a previously announced terminated transaction.

**Income tax benefit**for the fiscal 2007 three-month period was a benefit of 31.0% compared toincome tax benefit for the fiscal 2006 three-month period of 65.2%.  Income tax benefit for the fiscal 2007nine-month period was 27.1% compared to income tax benefit for the fiscal 2006nine-month period of 52.9%.   Theeffective income tax rate for the fiscal 2007 three-month and nine-monthperiods differ from the federal statutory rate primarily due to non-deductibletransaction costs expensed for book purposes. Included in the 52.9% effective tax rate for the fiscal 2006 nine-monthperiod is approximately $1.2 million of benefit related to the different bookand tax treatment of deductions related to stock compensation matters.  This benefit was recorded in the thirdquarter of the prior fiscal year upon completion of the Company’s 2005 taxreturns as the

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impact was discrete tothat quarter.  Also, included in 52.9%effective tax rate was $.1 million of tax expense related to Canadianwithholding tax.  Without these items,the effective tax rate for the fiscal 2006 nine-month period was 29.8%.

**Net loss**forthe fiscal 2007 three-month period was a net loss of $1.1 million, compared toa net loss of $1.2 million for the comparable period in the prior fiscal year.Net loss for the fiscal 2007 nine-month period was $10.2 million, compared tonet loss of $2.2 million for the comparable period in the prior fiscal year.

**FINANCIAL CONDITION**

**Liquidity and Capital Resources**

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

 

**Net cash used in operations**was $4.2 million for the fiscal 2007 nine-month period, compared to net cashused in operations of $.9 million for the fiscal 2006 nine-month period. ** **Non-cash items,consisting of an inventory charge, stock-based compensation, deferred incometaxes, accretion of debt discount, depreciation, amortization and gain on saleof property, plant and equipment, for the fiscal 2007 nine-month period totaled$15.0 million compared to $11.5 million for the 2006 fiscal nine-month period.**   **Cash flows used bychanges in working capital totaled $9.0 million for the fiscal 2007 nine-monthperiod, compared to $10.2 million in the fiscal 2006 nine-month period. ** **With respect to thechanges in accounts receivable and inventory, cash used by these items was $2.9million for the fiscal 2007 nine-month period compared to cash used by theseitems of $3.1 million for the comparable period in the prior fiscal year.  Cash****used bychanges in prepaid expenses and other current assets was $.6 million for thefiscal 2007 nine-month period compared to cash used of $2.9 million for thecomparable period in the prior fiscal year. Cash used by changes in accounts payable, accrued expenses and accruedinterest

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for the fiscal 2007nine-month period was $5.5 million compared to cash used of $4.2 million forthe comparable period in the prior fiscal year.

**Net cash provided by investingactivities** for the fiscal 2007 nine-month period was $39.8million compared to net cash used in investing activities of $9.8 million forthe fiscal 2006 nine-month period.  Thefiscal 2007 nine-month period included $45.8 million related to the equityinvestment by Weston Presidio.  Theremaining change related to the level of capital spending period over period.

**Net cash used in financingactivities** for the fiscal 2007 nine-month period was $46.1million, which includes $45.8 million related to merger consideration paid toformer shareholders of our Parent.  Theremaining $.3 million for the fiscal 2007 nine-month period is consistent withnet cash used in financing activities for the fiscal 2006 nine-monthperiod.  These amounts in both periodsrelate to payments on our industrial revenue bond. Our last payment on ourindustrial revenue bond was made in the first quarter of the fiscal year endingFebruary 28, 2007.

The Notes mature on March15, 2010 and require semi-annual interest payments on March 15 and September15, which commenced on September 15, 2004.  The Notes are collateralized by a senior secured interest insubstantially all of our assets.  Termsof the indenture under which the Notes have been issued contain certaincovenants, including limitations on certain restricted payments and theincurrence of additional indebtedness. The Notes are unconditionally guaranteed by all of our subsidiaries.

In connection with themerger, we solicited consents with respect to the Notes.   Consents were received with respect to 100%of the aggregate outstanding principal amount of the Notes.  We accepted all of the consents delivered inthe consent solicitation and paid to the consenting noteholders a consent feeof $40 per $1,000 principal amount of Notes for which they deliveredconsents.  These payments were made inthe second quarter of our fiscal 2007. As a result of our acceptance of the consents delivered by noteholdersand the completion of the consent solicitation, the amendments to the indenturegoverning the Notes described in the Consent Solicitation Statement dated May9, 2006 and related Supplement dated May 24, 2006 have become operative and wewill not be required to make a change of control offer to purchase any Notes inconnection with the merger.

We entered into a Credit Agreement, dated as of June 12, 2006 (referredto herein as Credit Agreement), among us, as U.S. Borrower, InterlakeAcquisition Corporation Limited, one of our subsidiaries, as Canadian Borrower,our parent, the other loan guarantors party thereto, JPMorgan Chase Bank, N.A.,as U.S. Administrative Agent, JPMorgan Chase Bank, N.A., Toronto Branch, asCanadian Administrative Agent, and the other lenders party thereto.

 

*TheCredit Agreement provides for a $35.0 million working capital facility,including a letter of credit sub-facility and swing-line loan sub-facility. TheCredit Agreement provides that amounts under the facility may be borrowed,repaid and re-borrowed, subject to a borrowing base test, until the maturitydate, which is June 12, 2011. An amount equal to $32.0 million is available, inU.S. dollars, to the U.S. Borrower under the*

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*facility,and an amount equal to $3.0 million is available, in U.S. or Canadian dollars,to the Canadian Borrower under the facility. As of November 23, 2006, there were no outstanding borrowings under theworking capital facility.*

**Cash**as ofNovember 23, 2006 decreased to $12.3 million from $22.8 million as of the endof the fiscal year ended February 28, 2006, or fiscal year 2006.  The decrease in our cash position wasprimarily due to the payments with respect to the merger-related costs incurredduring this period and our semi-annual interest payment on the Notes.

**Receivables, net**asof November 23, 2006 decreased to $34.1 million from $35.1 million as of theend of fiscal year 2006 primarily due to the timing of customer payments in thefirst quarter 2007.  The balance as ofthe end of the third quarter of our fiscal 2007 is consistent with the balanceas of the end of the second quarter 2007.

**Inventories**asof November 23, 2006 increased to $31.7 million from $27.9 million as of theend of fiscal year 2006.  This increaseis reflective of an increase in both raw materials and finished goods due to anincrease in our costs.

**Prepaid expenses and othercurrent assets**increased to $4.5 million from $3.4 million asof the end of fiscal year 2006.  Theincrease is primarily due to an increase in prepaid coal due to our normal build-upin coal supplies at our Menominee mill prior to the winter months and thetiming of renewal on our insurance policies.

**Income tax receivable**asof November 23, 2006 increased to $1.1 million from $.4 million as of the endof fiscal year 2006.  This increase isprimarily attributable to the tax benefit recorded in the fiscal 2007nine-month period.

**Property, plant and equipment**asof November 23, 2006 increased to $238.6 million from $98.1 million as of theend of fiscal year 2006 primarily due to the excess purchase price associatedwith the merger allocated to property, plant and equipment.

**Debt issuance costs**havebeen reduced to zero as of November 23, 2006 from $5.7 million as of the end offiscal year 2006 due to purchase accounting adjustments resulting from themerger.

**Goodwill**hasbeen reduced to zero as of November 23, 2006 from $13.7 million as of the endof fiscal year 2006 due to purchase accounting adjustments resulting from themerger.

**Accrued expenses**asof November 23, 2006 decreased to $14.3 million from $16.0 million as of theend of fiscal year 2006 due to the timing of payment with respect to certain ofour service providers resulting from delayed billings.

**Accrued interest**as of November 23, 2006 decreased to $3.0 million from $7.2 million as of theend of fiscal year 2006 due to our semi-annual interest payment on the Notes.

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**Deferred income taxes**asof November 23, 2006 increased to $52.1 million from $14.0 million as of theend of fiscal year 2006 primarily due to purchase accounting adjustmentsresulting from the merger consisting mainly of differences between book and taxtreatment of property, plant and equipment.

**Other liabilities**asof November 23, 2006 increased to $35.2 million from $.2 million as of the endof fiscal year 2006 due to the recording of $35.0 million related to contingentearnout consideration in connection with the merger.

**Stockholders’ equity (deficiency)**as of November 23, 2006 increased to equity of $41.6 millioncompared to a deficit of $6.9 million as of the end of fiscal year 2006.   The equity as of November 23, 2006 isreflective of the equity invested in us relative to the merger, the net lossgenerated for the period June 13, 2006 to November 23, 2006 and other equityactivity for this period.

Critical AccountingPolicies

Our critical accountingpolicies are discussed in Management’s Discussion and Analysis of FinancialCondition and Results of Operations in our Annual Report on Form 10-K for thefiscal year ended February 28, 2006.  Thepreparation of our financial statements requires us to make estimates thataffect the reported amounts of assets, liabilities, revenue and expenses andrelated disclosures of contingent assets and liabilities.  We base our accounting estimates onhistorical experience and other factors that we believe to be reasonable underthe circumstances.  However, actualresults may vary from these estimates under different assumptions orconditions.

New AccountingPronouncements

In June 2006, the FASBissued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes(an interpretation of FASB Statement No. 109)” (“FIN 48”). The provisions ofFIN 48 are effective for fiscal years beginning after December 15, 2006. Thisstatement was issued to clarify the accounting for the uncertainty related toincome taxes. FIN 48 requires the evaluation of whether a tax position is morelikely than not to be sustained upon examination with the assumption that theposition will be examined by the relevant tax authorities.  FIN 48 also requires such tax positions to bemeasured at the largest amount of the respective benefit that is greater than50% likely of being realized upon ultimate settlement. We are currentlyassessing the impact that the adoption of FIN 48 will have on our results ofoperations and financial position.

In September 2006, theFASB issued FAS No. 157, “Fair Value Measurements” (“SFAS 157”).  SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 as well asinterim periods within such fiscal years. SFAS 157 provides a common fair value hierarchy for companies to followin determining fair value measurements in the preparation of financialstatements and expands disclosure requirements relating to how such fair valuemeasurements were developed.  SFAS 157clarifies the principle that fair value should be based on the assumptions thatthe

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marketplace would usewhen pricing an asset or liability, rather than company specific data.  The Company is currently assessing the impactthat SFAS will have on its results of operations and financial position.

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**Item 3.  Quantitativeand Qualitative Disclosures about Market Risk**

In March 2004, wecompleted a Rule 144A offering of $162 million aggregate principle amount of 93⁄4% senior secured notes due 2010.  As aresult, we are highly leveraged.  On June12, 2006, we entered into the Credit Agreement in connection with the mergerand we have the ability to borrow funds under this facility up to an aggregateof $35 million and could be adversely affected by a significant increase ininterest rates.

Market risk is thepotential economic loss that may result from adverse changes in the fair valueof financial instruments. We are exposed to market risk from changes in foreigncurrency exchange rates, primarily in Canada. All international sales, other than sales originating from our Canadiansubsidiary, are denominated in U. S. dollars. Due to our Canadian operations however, we could be adversely affectedby unfavorable fluctuations in foreign currency exchange rates.

**Item 4.  Controlsand Procedures**

(a)           Disclosure Controls andProcedures.  The Company’s management,with the participation of the Company’s Chief Executive Officer and ChiefFinancial Officer, has evaluated the effectiveness of the Company’s disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of the end of the period covered by this report.  Based on such evaluation, the Company’s ChiefExecutive Officer and Chief Financial Officer have concluded that, as of theend of such period, the Company’s disclosure controls and procedures areeffective in recording, processing, summarizing and reporting, on a timely basis,information required to be disclosed by the Company in the reports that itfiles or submits under the Securities and Exchange Commission’s rules andforms.

(b)  Changes inInternal Control Over Financial Reporting. There have not been any changes in the Company’s internal control overfinancial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f)under the Exchange Act) during the fiscal quarter to which this report relatesthat have materially affected, or are reasonably likely to materially affect,the Company’s internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1A.  Risk Factors

Therisk factors included in our Annual Report on Form 10-K for the fiscal yearended February 28, 2006 have not materially changed.

Item 6.  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 requirementsof the Securities Exchange Act of 1934, as amended, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|        | Cellu Tissue Holdings, Inc. |
|--------|-----------------------------|
|   |                        |   |
|   |                        |   |
| Date:  | January 8, 2007             |   |   | /s/ Russell C. Taylor |   |
|   |                        | Mr. Russell C.  Taylor |
|   |                        | President and  Chief Executive Officer |
|   |                        |   |
| Date:  | January 8, 2007             |   |   | /s/ Dianne M. Scheu |   |
|   |                        | Ms. Dianne M.  Scheu |
|   |                        | Senior Vice  President, Finance and Chief |
|   |                        | Financial  Officer |

 

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