** **

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

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**FORM 10-Q**

**(Mark One)**
|            | x          | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------|------------|------------|---------------------------------------------------------------------------------------------------------|
|       | ** ** |       | **For the Quarterly Period Ended May 25, 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  __________.**                                            |
| ** ** | ** ** |       | **Commission file number 333-118829**                                                                   |

 

**CelluTissue Holdings, Inc.**(Exact name of registrant as specified in its charter)
| **Delaware**(State of incorporation)                                                                   | ** ** | **06-1346495**(IRS Employer Identification No.) |
|--------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|
| **1855 Lockeway Drive, Suite 501, Alpharetta  , Georgia**(Address of principal executive offices) | ** ** | **30004**(zip code)                             |
| **(678) 393-2651**(Registrant’s telephone number, including area code)                            |
| **Not Applicable**(Former name, former address and former fiscal year, if  changed since last report)  |

 

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports) and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes x No o

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

The number of sharesoutstanding of each of the registrant’s classes of common stock as of July 7,2006:
| **Title of Class**           | ** ** | **Shares  Outstanding** |
|------------------------------|------------|-------------------------|
| Common Stock, $.01 par value |       | 100                     |

 

 

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

 

SIGNATURES

 

2

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**PART I FINANCIALINFORMATION**

**Item 1.Consolidated Financial Statements**

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

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **May 25  2006**            | ** ** | **May 26  2005** | ** ** |
|                                          |       |                             |       |   |   |
| Net sales                                     |       | $                                | 78,641,977 |   | $ | 77,643,998 |   |
| Cost of goods  sold                           |       | 71,791,158                       |       | 70,650,159 |   |
| Gross profit                                  |       | 6,850,819                        |       | 6,993,839 |   |
|                                          |       |                             |       |   |   |
| Selling, general  and administrative expenses |       | 3,147,304                        |       | 2,998,659 |   |
| Merger-related  transaction costs             |       | 127,207                          |       | 126,822 |   |
| Income from  operations                       |       | 3,576,308                        |       | 3,868,358 |   |
|                                          |       |                             |       |   |   |
| Interest  expense, net                        |       | 4,052,725                        |       | 4,133,113 |   |
| Foreign currency  loss (gain)                 |       | 205,500                          |       | (99,619 | ) |
| Other (income)  expense                       |       | (25,392                          | )          | 4,386 |   |
| Loss before  income tax benefit               |       | (656,525                         | )          | (169,522 | ) |
|                                          |       |                             |       |   |   |
| Income tax  benefit                           |       | (180,873                         | )          | (59,350 | ) |
| Net loss                                      |       | $                                | (475,652   | ) | $ | (110,172 | ) |

 

See accompanying notes to consolidated financial statements.

3

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**CELLU TISSUEHOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                              | ** ** | **May 25  2006** | ** **  | **February 28  2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|----------------------------|------------|
| ** **                                                                                                              | ** ** | **(Unaudited)**       | ** **  | ** **                 | ** ** |
| **ASSETS**                                                                                                              | ** ** | ** **            | ** **  | ** **                 | ** ** |
| CURRENT ASSETS:                                                                                                         |       |                  |        |                       |       |
| Cash and cash equivalents                                                                                               |       | $                     | 15,708,054  |                       | $          | 22,824,062 |   |
| Receivables, net                                                                                                        |       | 37,669,025            |        | 35,054,372                 |       |
| Inventories                                                                                                             |       | 29,652,197            |        | 27,919,948                 |       |
| Prepaid expenses and other current assets                                                                               |       | 3,456,189             |        | 3,377,952                  |       |
| Income tax receivable                                                                                                   |       | 363,027               |        | 362,122                    |       |
| Deferred income taxes                                                                                                   |       | 3,018,607             |        | 2,931,599                  |       |
| TOTAL CURRENT ASSETS                                                                                                    |       | 89,867,099            |        | 92,470,055                 |       |
| PROPERTY, PLANT  AND EQUIPMENT, NET                                                                                     |       | 96,394,167            |        | 98,090,451                 |       |
| DEBT ISSUANCE  COSTS                                                                                                    |       | 5,410,609             |        | 5,745,983                  |       |
| GOODWILL                                                                                                                |       | 13,723,935            |        | 13,723,935                 |       |
| OTHER ASSETS                                                                                                            |       | 202,070               |        | 201,690                    |       |
| TOTAL ASSETS                                                                                                            |       | $                     | 205,597,880 |                       | $          | 210,232,114 |   |
|                                                                                                                    |       |                  |        |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY(DEFICIENCY)**                                                              | ** ** | ** **            | ** **  | ** **                 | ** ** |
| CURRENT LIABILITIES:                                                                                                    |       |                  |        |                       |       |
| Accounts payable                                                                                                        |       | $                     | 18,066,909  |                       | $          | 18,648,281 |   |
| Accrued expenses                                                                                                        |       | 16,612,543            |        | 16,005,155                 |       |
| Accrued interest                                                                                                        |       | 3,050,815             |        | 7,231,888                  |       |
| Current portion of long-term debt                                                                                       |       | —                |        | 290,000                    |       |
| TOTAL CURRENT LIABILITIES                                                                                               |       | 37,730,267            |        | 42,175,324                 |       |
| LONG-TERM DEBT,  LESS CURRENT PORTION                                                                                   |       | 160,860,936           |        | 160,790,258                |       |
| DEFERRED INCOME  TAXES                                                                                                  |       | 13,652,727            |        | 13,961,743                 |       |
| OTHER  LIABILITIES                                                                                                      |       | 205,805               |        | 210,349                    |       |
| STOCKHOLDERS’ EQUITY  (DEFICIENCY):                                                                                |       |                  |        |                       |       |
| Common stock, $.01 par value, 1,000 shares authorized,  100 shares issued and outstanding      |       | 1                     |        | 1                          |       |
| Capital in excess of par value                                                                                          |       | 667,996               |        | 615,338                    |       |
| Accumulated deficit                                                                                                     |       | (12,101,411           | )           | (11,625,759                | )          |
| Accumulated other comprehensive income                                                                                  |       | 4,581,559             |        | 4,104,860                  |       |
| TOTAL STOCKHOLDERS’ EQUITY(DEFICIENCY)                                                                             |       | (6,851,855            | )           | (6,905,560                 | )          |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY(DEFICIENCY)                                                            |       | $                     | 205,597,880 |                       | $          | 210,232,114 |   |

 

See accompanying notes toconsolidated financial statements.

4

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**CELLU TISSUEHOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **May 25  2006**            | ** ** | **May 26  2005** | ** ** |
| **Cash flows from operating  activities**                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | (475,652                         | )          | ($110,172 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                             |       |   |   |
| Stock-based compensation                                                     |       | 52,658                           |       | — |   |
| Deferred income taxes                                                        |       | (396,024                         | )          | (191,010 | ) |
| Accretion of debt discount                                                   |       | 70,678                           |       | 71,500 |   |
| Amortization of intangibles                                                  |       | 335,374                          |       | 339,273 |   |
| Depreciation                                                                 |       | 3,534,475                        |       | 4,009,424 |   |
| Changes in  operating assets and liabilities:                                |       |                             |       |   |   |
| Receivables                                                                  |       | (2,614,653                       | )          | (284,023 | ) |
| Inventories                                                                  |       | (1,732,249                       | )          | (5,624,890 | ) |
| Prepaid expenses and other current assets and income  tax receivable         |       | (79,142                          | )          | 319,244 |   |
| Other                                                                        |       | (4,924                           | )          | (12,464 | ) |
| Accounts payable, accrued expenses and accrued  interest                     |       | (4,155,057                       | )          | (4,142,396 | ) |
| Total adjustments                                                            |       | (4,988,864                       | )          | (5,515,342 | ) |
| *Net cash used in operating activities*                                      |       | (5,464,516                       | )          | (5,625,514 | ) |
|                                                                         |       |                             |       |   |   |
| **Cash flows from investing  activities**                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Capital expenditures,net                                                     |       | (1,682,565                       | )          | (4,003,367 | ) |
| *Net cash used in investing activities*                                      |       | (1,682,565                       | )          | (4,003,367 | ) |
|                                                                         |       |                             |       |   |   |
| **Cash flows from financing  activities**                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Payments of long-term debt                                                   |       | (290,000                         | )          | (280,000 | ) |
| Debt issuance costs                                                          |       | —                           |       | (1,653 | ) |
| *Net cash used in financing activities*                                      |       | (290,000                         | )          | (281,653 | ) |
| * *                                                                     | * *   | * *                         | * *   | * * | * * |
| Effect of  foreign currency                                                  |       | 321,073                          |       | (162,109 | ) |
|                                                                         |       |                             |       |   |   |
| *Net  decrease in cash and cash equivalents*                                 |       | (7,116,008                       | )          | (10,072,643 | ) |
| *Cash and  cash equivalents at beginning of period*                          |       | 22,824,062                       |       | 26,959,029 |   |
| *Cash  and cash equivalents at end of period*                                |       | $                                | 15,708,054 |   | $ | 16,886,386 |   |
|                                                                              |            |                                  |            |  |  |  |  |

 

See accompanying notes to consolidated financialstatements.

5

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**Cellu TissueHoldings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited)May 25, 2006**

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

The accompanyingunaudited interim consolidated financial statements include the accounts ofCellu Tissue Holdings, Inc. and its wholly-owned subsidiaries (the “Company”).The Company is a wholly-owned subsidiary of Cellu Paper Holdings, Inc.(the “Parent”). These statements have been prepared in accordance with U. S.generally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Article 10 of RegulationS-X. Accordingly, they do not include all of the information and footnotesrequired by U. S. generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals) considered necessary for a fair presentation havebeen included. Operating results for the three-month period ended May 25,2006 are not necessarily indicative of the results that may be expected for thefiscal year ending February 28, 2007. For further information, refer tothe Company’s Annual Report on Form 10-K for the fiscal year ended February 28,2006 and the consolidated financial statements and footnotes thereto as of February 28,2006 and for the year then ended, from which the consolidated balance sheet at February 28,2006 has been derived.

Reclassification

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

Stock Based Compensation

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS 123R”), “Share-Based Payment,” which requires themeasurement of all employee share-based payments to employees, including grantsof employee stock options, using fair-value-based method and the recording ofsuch expense in the Company’s consolidated statement of operations. The Companyadopted the provisions of SFAS 123R using the prospective method effective March 1,2006. As such, there was no accounting effect on any outstanding awards. Uponadoption of SFAS 123R, the Company had only one share-based payment arrangement.The Parent grants stock options to certain members of the Company’s managementunder the Cellu Paper Holdings, Inc. 2001 Stock Incentive Plan (the “Plan”).As of the date of adoption of SFAS 123R, there were 743 options outstandingwith a weighted average exercise price of $7,313 and a weighted averageremaining contractual life of 7.84 years.

6

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**Cellu TissueHoldings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

**Note 1 Basis of Presentation andSignificant Accounting Policies (continued)**

For the three-monthperiod ended May 25, 2006 there were no options granted and 184 optionswere cancelled in connection with a restricted stock grant as discussed below.

On March 27, 2006, the Parent entered intoRestricted Stock Agreements with the Company’s Chief Financial Officer andChief Operating Officer, pursuant to which the Parent granted 170.65 restrictedshares of its common stock to each pursuant to the Plan. The shares will vestand cease to be restricted in three equal annual installments commencing on March 27,2007, as long as the named individual, as the case may be, is continuouslyemployed by the Company until each such vesting date with respect to her or hisshares. Any restricted stock outstanding at the time of a Change of Control (asdefined in the Plan) shall become vested and cease to be restricted stock. Additionally,our Parent has agreed to pay an additional amount to the named individual, asthe case may be, to fully gross up her or him, as applicable, for the amountincluded in gross income for income tax purposes as a result of making a Section 83(b) electionunder the Internal Revenue Code of 1986, as amended, or the payment of anygross-up amount payment. Both named individuals have made a timely Section 83(b) election.For the three-month period ended May 25, 2006, the Company has recorded$52,658 of compensation expense related to the vesting of the above grants inaccordance with SFAS 123R.

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. Hedgingof this risk is accomplished by entering into forward swap contracts, which aredesignated as hedges of specific quantities of natural gas expected to bepurchased in future months.   Thesecontracts are held for purposes other than trading and are designated as cashflow hedges. The Company measures hedge effectiveness by formally assessing, atleast quarterly, the correlation of the expected future cash flows of thehedged item and the derivative hedging instrument. The ineffective portions ofthe hedges are recorded in the statement of operations in the current period. TheCompany had minimal derivative activity in the three-month period ended May 25,2006 and therefore, minimal impact to operating results.

Recent AccountingPronouncements

In November 2004,the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43,Chapter 4 “(SFAS 151). SFAS 151 clarifies the accounting for abnormal amountsof idle facility expense, freight, handling costs and spoilage. In addition,SFAS 151 requires that allocation of fixed production overhead to the costs ofconversion be based on normal capacity of the production facilities. TheCompany adopted the

7

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**Cellu TissueHoldings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

**Note 1 Basis of Presentation andSignificant Accounting Policies (continued)**

provisions of SFAS 151 asof March 1, 2006 and the adoption thereof, did not have a material impacton the Company’s results of operations and financial position.

**Note 2 Inventories**

Components of inventoriesare as follows:
| ** **                        | ** ** | **May 25, 2006** | ** ** | **February 28, 2006** | ** ** |
|-----------------------------------|------------|----------------------------|------------|---------------------------------|------------|
|                              |       |                       |       |                            |       |
| Finished goods                    |       | $                          | 18,313,605 |                            | $          | 18,072,976 |   |
| Raw materials                     |       | 3,383,536                  |       | 2,624,006                       |       |
| Packaging  materials and supplies |       | 8,148,760                  |       | 7,446,184                       |       |
|                              |       | 29,845,901                 |       | 28,143,166                      |       |
| Inventory  reserves               |       | (193,704                   | )          | (223,218                        | )          |
|                              |       | $                          | 29,652,197 |                            | $          | 27,919,948 |   |

 

**Note 3 Debt Issuance Costs**

Debt issuance costsconsist of the following:

 
| ** **                     | ** ** | **May 25, 2006** | ** ** | **February 28, 2006** | ** ** |
|--------------------------------|------------|----------------------------|------------|---------------------------------|------------|
|                           |       |                       |       |                            |       |
| Debt issuance  costs           |       | $                          | 8,541,986  |                            | $          | 8,541,986 |   |
| Less accumulated  amortization |       | (3,131,377                 | )          | (2,796,003                      | )          |
|                           |       | $                          | 5,410,609  |                            | $          | 5,745,983 |   |

 

Amortization expense forthe three months ended May 25, 2006 and May 26, 2005 of $335,374 and$339,273, respectively, has been included in interest expense on the statementof operations for all periods presented.

8

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**Cellu TissueHoldings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

**Note 4 Long-Term Debt**

Long-term debt consistsof the following:

 
| ** **                                                                                                       | ** ** | **May 25, 2006** | ** **  | **February 28, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------|-------------|---------------------------------|------------|
| 9 3⁄4% senior  secured notes due 2010                                                                         |       | $                          | 162,000,000 |                            | $          | 162,000,000 |   |
| Less discount                                                                                                    |       | (1,139,064                 | )           | (1,209,742                      | )          |
|                                                                                                             |       | 160,860,936                |        | 160,790,258                     |       |
| Industrial  revenue bond payable, in annual installments, plus interest ranging from 4.8%  to 6.65%, due in 2006 |       | —                     |        | 290,000                         |       |
|                                                                                                             |       | 160,860,936                |        | 161,080,258                     |       |
| Less current  portion of debt                                                                                    |       | —                     |        | (290,000                        | )          |
|                                                                                                             |       | $                          | 160,860,936 |                            | $          | 160,790,258 |   |

 

The Company’s 93⁄4% seniorsecured notes (the “Notes”) mature on March 15, 2010 and requiresemi-annual interest payments on March 15 and September 15, whichcommenced on September 15, 2004.  The Notes are collateralized by a seniorsecured interest in substantially all of the Company’s assets. Terms of theindenture under which the Notes have been issued contain certain covenants,including limitations on certain restricted payments and the incurrence ofadditional indebtedness. The Notes are unconditionally guaranteed by all of theCompany’s subsidiaries.

In connection with theMerger as defined and discussed in Note 9, the Company solicited consents withrespect to the Notes.  Consents werereceived with respect to 100% of the aggregate outstanding principal amount ofthe Notes, the Company accepted all of the consents delivered in the consentsolicitation and paid to the consenting Note holders a consent fee of $40 per$1,000 principal amount of Notes for which they delivered consents. Thesepayments were made in the Company’s second quarter 2007. As a result of theacceptance by the Company of the consents delivered by Note holders and thecompletion of the consent solicitation, the amendments to the indenturegoverning the Notes described in the Consent Solicitation Statement dated May 9,2006 and related Supplement dated May 24, 2006 have become operative andthe Company will not be required to make a change of control offer to purchaseany Notes in connection with the Merger.

As of May 25, 2006,there were no outstanding borrowings under the Company’s working capitalfacility.

 

9

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**Cellu TissueHoldings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

**Note 5 Comprehensive Loss**

The components ofcomprehensive loss for the three months ended May 25, 2006 and May 26,2005 are as follows:

 
| ** **                                | ** ** | **Three months ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **May 25, 2006**       | ** ** | **May 26, 2005** | ** ** |
| Net loss                                  |       | $                                | (475,652   | ) | $ | (110,172 | ) |
| Foreign currency  translation adjustments |       | 321,073                          |       | (162,109 | ) |
| Comprehensive loss                        |       | $                                | (154,579   | ) | $ | (272,281 | ) |

 

**Note 6 Business Segments**

The Company operates intwo reportable business segments:  tissueand machine-glazed paper. The Company assesses the performance of itsreportable business segments using income from operations. Income fromoperations excludes interest income, interest expense, other income (expense),income tax expense (benefit) and the impact of foreign currency gains andlosses.  A portion of corporate andshared expenses is allocated to each segment.

 
| ** **                                    | ** ** | **Three months ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **May 25, 2006**       | ** ** | **May 26, 2005** | ** ** |
| **Net Sales**                                 | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Tissue                                        |       | $                                | 55,328,622 |   | $ | 56,071,692 |   |
| Machine-glazed  paper                         |       | 23,313,355                       |       | 21,572,306 |   |
| Consolidated                                  |       | $                                | 78,641,977 |   | $ | 77,643,998 |   |
| ** **                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Income from operations**                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Tissue                                        |       | $                                | 2,939,493  |   | $ | 2,578,713 |   |
| Machine-glazed  paper                         |       | 636,815                          |       | 1,289,645 |   |
| Consolidated                                  |       | 3,576,308                        |       | 3,868,358 |   |
| Interest expense                              |       | (4,135,637                       | )          | (4,185,860 | ) |
| Net foreign  currency transaction (loss) gain |       | (205,500                         | )          | 99,619 |   |
| Interest income                               |       | 82,912                           |       | 52,747 |   |
| Other (expense)  income                       |       | 25,392                           |       | (4,386 | ) |
| Pretax loss                                   |       | $                                | (656,525   | ) | $ | (169,522 | ) |

 

10

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**Cellu TissueHoldings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

**Note 6 Business Segments(continued)**

** **
| **Capital Expenditures** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------|------------|------------|------------|------------|------------|
| Tissue                   |       | $          | 669,789    |       | $          | 3,412,250 |   |
| Machine-glazed  paper    |       | 141,670    |       | 191,606    |       |
| Corporate                |       | 871,106    |       | 399,511    |       |
| Consolidated             |       | $          | 1,682,565  |       | $          | 4,003,367 |   |
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Depreciation**         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Tissue                   |       | $          | 2,563,895  |       | $          | 2,584,309 |   |
| Machine-glazed  Paper    |       | 970,580    |       | 1,425,115  |       |
|                     |       | $          | 3,534,475  |       | $          | 4,009,424 |   |

 

**Note 7 Income Taxes**

The effective income taxbenefit for the three months ended May 25, 2006 was 27.6% compared to a35% effective tax benefit for the three months ended May 26, 2005. Thereduction in the effective tax rate for the three months ended May 25,2006 is due to the difference between book and tax treatment relative tocompensation matters.

**Note 8 Bonus Agreements**

On March 27, 2006, the Company entered intoagreements with Russell Taylor, its President and Chief Executive Officer;Dianne Scheu, its Senior Vice President, Finance and Chief Financial Officer;and Steven Ziessler, its President, Tissue & Machine-Glazed and ChiefOperating Officer, pursuant to which each received a lump sum cash paymentequal to one year’s current base salary thereof. As of that date, Mr. Taylor’scurrent base salary was $425,000, Ms. Scheu’s current base salary was$230,000 and Mr. Ziessler’s current base salary was $250,000. The paymentdoes not affect any other terms of such executive’s employment arrangementswith the Company and will not be taken into account in computing any future compensation.

Pursuant to the terms ofhis agreement, if Mr. Taylor’s employment with the Company is terminatedon or prior to September 27, 2006, for any reason, other than due to hisdeath or disability, he is required to repay the bonus to the Company. Pursuantto the terms of her agreement, if Ms. Scheu’s employment with the Companyis terminated on or prior to March 27, 2007, for any reason, other thandue to her death or disability, she is required to repay the bonus to theCompany. Pursuant to the terms of his agreement, if Mr. Ziessler’semployment with the Company is terminated on or prior to March 27, 2007,for any reason, other than due to his death or disability, he is required torepay the bonus to the Company. These payments were made during the quarterended May 25, 2006 and

11

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**Cellu TissueHoldings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

**Note 8 Bonus Agreements(continued)**

have been included inprepaid expenses and other current assets as of May 25, 2006 as they werereimbursed as part of the merger consideration as further discussed in Note 9.

**Note 9Merger Agreement**

On May 8,2006, Parent entered into an Agreement and Plan of Merger with Cellu ParentCorporation (“Cellu Parent”), a corporation organized and controlled by WestonPresidio V, L.P. (“Weston Presidio”), and Cellu Acquisition Corporation, awholly owned subsidiary of Cellu Parent and a newly-formed corporationindirectly controlled by Weston Presidio (“Merger Sub”). Pursuant to the agreement,on June 13, 2006, Merger Sub was merged with and into Parent, with Parentsurviving. The aggregate merger consideration (including assumption of $162.0million in aggregate principal amount of the Company’s****outstanding9.75% senior secured notes)  paid toParent was $205 million, subject to adjustments for working capital and actualnet cash at closing versus agreed upon targets, and for certain tax benefitsthat the Company may realize.

In addition, totalconsideration is subject to adjustment for up to an additional $35 million incontingent earnout consideration based upon the achievement of certainfinancial targets. If any portion of the contingent payments are unable to bemade, then Weston Presidio has agreed to provide the necessary funds to formerholders of the Parent’s capital stock, options and warrants through an equityinvestment in Parent or otherwise.

**Note 10Subsequent Events**

On June 12,2006, the abovementioned merger was completed. Accordingly, the followingagreements were entered into or adopted in connection with the consummation ofthe merger:

Option Plan

On June 12, 2006,the Board of Directors of Cellu Parent adopted a 2006 Stock Option andRestricted Stock Plan (the “Plan”). The Plan provides the ability for the PlanAdministrator to make awards of options to purchase shares of common stock ofCellu Parent and/or awards of restricted shares of common stock of Cellu Parent.A maximum of 8,095 shares of common stock of Cellu Parent may be delivered insatisfaction of awards under the Plan, determined net of shares of common stockwithheld by Cellu Parent in payment of the exercise price of an award or insatisfaction of tax withholding requirements. Key employees and directors of,and consultants and advisors to, Cellu Parent or its affiliates who, in theopinion of the Plan Administrator, are in a position to make a significantcontribution to the success of Cellu Parent and its affiliates are eligible toparticipate in the Plan.

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**Cellu TissueHoldings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

**Note 10Subsequent Events (continued)**

Management Agreement

On June 12, 2006,the Company, Cellu Parent, and Cellu Acquisition Corporation entered into aManagement Agreement with Weston Presidio Service Company, LLC (“WestonPresidio Service Company”), pursuant to which Weston Presidio Service Companyhas agreed to provide the Company with certain management, consulting andfinancial and other advisory services. Weston Presidio Service Company is anaffiliate of Weston Presidio, which is the controlling shareholder of CelluParent, which is the sole shareholder of Parent.  In consideration for such services, theCompany, Cellu Parent and Cellu Acquisition Corporation have jointly andseverally agreed to pay Weston Presidio Service Company an annual fee of$450,000, to be paid in equal quarterly installments, and to reimburseout-of-pocket expenses of Weston Presidio Service Company and its affiliates. Inaddition, in connection with the consummation of the Merger and as required bythe Management Agreement, the Company paid Weston Presidio Service Company afee in the amount of $2,000,000. The Management Agreement expires on June 12,2016, but will be automatically extended on each anniversary of such date foran additional year, unless one of the parties provides written notice of itsdesire not to automatically extend the term at least 90 days prior to suchanniversary.

Credit Agreement

The Company entered into a Credit Agreement, dated asof June 12, 2006 (the “Credit Agreement”), among the Company, as U.S.Borrower, Interlake Acquisition Corporation Limited, a subsidiary of theCompany, as Canadian Borrower, Parent, the other loan guarantors party thereto,JPMorgan Chase Bank, N.A., as U.S. Administrative Agent, JPMorgan Chase Bank,N.A., Toronto Branch, as Canadian Administrative Agent, and the other lendersparty thereto.

The Credit Agreement provides for a $35.0 millionworking capital facility, including a letter of credit sub-facility and swing-lineloan sub-facility. The Credit Agreement provides that amounts under thefacility may be borrowed, repaid and re-borrowed, subject to a borrowing basetest, until the maturity date, which is June 12, 2011. An amount equal to$32.0 million is available, in U.S. dollars, to the U.S. Borrower under thefacility, and an amount equal to $3.0 million is available, in U.S. or Canadiandollars, to the Canadian Borrower under the facility.

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

**OVERVIEW**

Certain statementscontained in this Quarterly Report on Form 10-Q may containforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities and ExchangeAct of 1934, as amended, and as such, may involve known or unknown risks,uncertainties and other factors which may cause our actual results, performanceor achievements to be materially different from future results, performance orachievements expressed or implied by such forward-looking statements. Forward-lookingstatements, which are based on certain assumptions and describe our futureplans, strategies and expectations are generally identifiable by use of thewords “may,” “will,” “should,” “expect,” “anticipate,” “estimate”, “believe”, “intend”,“project”, or comparable terminology. Factors which could have a materialadverse effect on our operations and future prospects include, but are notlimited to, those set forth in Forward-Looking Statements in our Annual Reporton Form 10-K for our fiscal year ended February 28, 2006. Theserisks and uncertainties should be considered in evaluating any forward-lookingstatements 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. In addition, we produce a variety ofconverted tissue products. Our customers include major North American producersof branded and unbranded disposable consumer absorbent and tissue products forthe personal and health care markets; consumer and away-from-home tissueproducts companies; national and regional tissue products distributors; andthird-party converters who sell their products to food, bakery and confectionscompanies. We service a diverse group of high-quality customers, with three ofour top 10 customers belonging to the Fortune 150 group of companies.

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

On June 12, 2006,Weston Presidio completed the acquisition of our Parent through a merger of acompany controlled by Weston Presidio with and into our Parent, with our Parentsurviving.

**RESULTS OF OPERATIONS**

**Results of Operations for theThree Months Ended May 25, 2006 (the fiscal 2007 three-month period)compared to the Three Months Ended May 26, 2005 (the fiscal 2006 three-monthperiod)**

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**Net sales** forthe fiscal 2007 three-month period increased $1.0 million, or 1.3%, to****$78.6****million from$77.6 million for the comparable period in the prior year.  For the fiscal 2007 three-month period, wesold 61,359 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products. This is a decrease of 443 tons, or .7%, from thecomparable period in the prior year. Included in this decrease is the effect ofthe shut down of our machine-glazed machine at our Ontario facility, whichtranspired in the third quarter of fiscal 2006 and represented a decrease of1,804 tons. Net of the effect of this, tons sold increased 1,361 or 2.3% forthe fiscal 2007 three-month period over the comparable period in the prior year.More than offsetting the effect of the decrease, inclusive of the effect of themachine shutdown, in tonnage sold is an increase in net sales per ton in thefiscal 2007 three-month period to $1,282 from $1,256 in the fiscal 2006three-month period.

Net sales for our tissuesegment for the fiscal 2007 three-month period were $55.3 million, a decreaseof $.7 million, or 1.3%, from the comparable period in the****prioryear.  The decrease is attributable to adecrease in tonnage sold which was partially offset by an increase in netselling price per ton.  Net sales for ourmachine-glazed segment for the 2007 three-month period were****$23.3million, an increase of $1.7 million, or 8.1%,****fromthe comparable period in the prior year. Despite the effect of the machineshutdown, as discussed above, this increase is attributable to an increase intonnage sold. The increase in tonnage sold is the result of the net sales forthe fiscal 2006 three-month period being unusually low due to one of our topmachine-glazed customers buying fewer tons during this period.

**Gross profit**for the fiscal 2007 three-month period decreased to $6.9 million from $7.0million, a decrease of $.1 million, or 2.0%, from the comparable period in theprior****year. ** **As a percentage of net sales, grossprofit decreased to 8.7% in the fiscal 2007 three-month period from 9.0% in thefiscal 2006 three-month period. The decrease in gross profit in the fiscal 2007three-month period was primarily attributable to an increase in energy costsper ton over the comparable period in the prior year.  The effect of the increase in energy pricesfor the fiscal 2007 three-month period was $1.2****million.Absent these energy price increases, gross profit for the fiscal 2007three-month period would have been 10.2% compared to 9.0% for the comparableperiod in the prior year. The increase in the fiscal 2007 three-month period,after adjusting for the effect of the increase in energy prices, isattributable to an increase in selling price per ton over the comparable periodin the prior year as discussed above.

Gross profit for ourtissue segment for the fiscal 2007 three-month period was $5.2 million, anincrease of $.5 million, or 11.4%, from the comparable period in the prior year.Gross profit for our machine-glazed segment for the fiscal 2007 three-monthperiod was $1.7 million, a decrease of $.6 million, or 28.8%, from thecomparable period in the prior year. As a percentage of net sales, gross profitfor the tissue segment increased to 9.4% in the fiscal 2007 three-month periodfrom 8.3% in the fiscal 2006 three-month period. As a percentage of net sales,gross profit for the machine-glazed segment decreased to 7.1% in the fiscal2007 three-month period from 10.8% in the fiscal 2006 

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three-month period. Theincreases experienced by our tissue segment are attributable to an increase inselling price per ton in the fiscal 2007 three-month period which more thanoffset the increase in energy costs over the comparable period in the prioryear. The decreases experienced by our machine-glazed segment are attributableto a decrease in selling price per ton and an increase in energy costs per tonin the fiscal 2007 three-month period over the comparable period in the prioryear, which more than offset the increase in tons sold.

**Selling, general andadministrative expenses**in the fiscal 2007 three-month periodincreased $.1 million, or 5.0%, to $3.1 million from $3.0 million in the fiscal2006 three-month period. As a percentage of net sales, selling, general andadministrative expenses increased to****4.0% in thefiscal 2007 three-month period from 3.9% in the fiscal 2006 three-month period.

**Merger-related transaction costs**inthe fiscal 2007 three-month period were $.1 million associated with therecently completed merger. Merger-related transaction costs in the fiscal 2006three-month period were $.1 million associated with a proposed transactionwhich was subsequently terminated.

**Foreign currency loss (gain)**inthe fiscal 2007 three-month period was a loss of $.2 million compared to a gainof $.1 million in the fiscal 2006 three-month period. The fluctuation relatesto the change in the Canadian currency period over period.

**Income tax benefit**for the fiscal 2007 three-month period was a 27.6% benefit compared to a 35%benefit for the fiscal 2006 three-month period. The reduction in the effectivetax rate for the fiscal 2007 three-month period is due to the differencebetween book and tax treatment relative to compensation matters.

**Net loss**forthe fiscal 2007 three-month period was a net loss of $.5 million compared to anet loss of $.1 million for the comparable period in the prior year.

**FINANCIAL CONDITION**

**Liquidity and Capital Resources**

**Net cash used in operations**was $5.5 million for the fiscal 2007 three-month period, compared to $5.6million for the fiscal 2006 three-month period. Non-cash items, consisting ofstock-based compensation, depreciation, amortization and deferred income taxes,for the fiscal 2007 three-month period totaled $3.6 million compared to $4.2million for the 2006 fiscal three-month period. **  **Cash flows used by changes inworking capital totaled $8.6 million for the fiscal 2007 three-month periodcompared to $9.7 million in the fiscal 2006 three-month period. With respect tothe changes in accounts receivable and inventory, cash used by these items was$4.3 million for the current fiscal three-month period compared to $5.9 millionfor the comparable period in the prior fiscal year. This shift is primarilyattributable to increased inventory levels in the fiscal 2006 

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three-month period. ** ** Cash****used bychanges in prepaid expenses and other current assets was less than $.1 millioncompared to cash provided by changes in prepaid expenses and other currentassets of $.3 million for the comparable period in the prior fiscal year. ** **Cash used by changesin account payable, accrued expenses and accrued interest for the fiscal 2007three-month period was $4.2 million compared to cash used of $4.1 million forthe comparable period in the prior year.

**Net cash used in investingactivities** for the fiscal 2007 three-month period was $1.7****million compared to $4.0 million for the fiscal 2006three-month period. The change relates to the level of capital spending periodover period.

**Net cash used in financingactivities** for the fiscal 2007 three-month period was $.3****million consistent with the net cash provided by financingactivities for the fiscal 2006 three-month period. Net cash used in bothperiods relates primarily to payments on our industrial revenue bond. Our lastpayment on our industrial revenue bond was made in the fiscal 2007 three-monthperiod.

Our Notes mature on March 15,2010 and require semi-annual interest payments on March 15 and September 15,which commenced on September 15, 2004. As of May 25, 2006, there wereno outstanding borrowings under our working capital facility.

In connection with theMerger, we solicited consents with respect to the Notes.  Consents were received with respect to 100% ofthe aggregate outstanding principal amount of the Notes, we accepted all of theconsents delivered in the consent solicitation and paid to the consenting Noteholders a consent fee of $40 per $1,000 principal amount of Notes for whichthey delivered consents. These payments were made in our second quarter 2007. Asa result of the acceptance by us of the consents delivered by Note holders andthe completion of the consent solicitation, the amendments to the indenturegoverning the Notes described in the Consent Solicitation Statement dated May 9,2006 and related Supplement dated May 24, 2006 have become operative andwe will not be required to make a change of control offer to purchase any Notesin connection with the Merger.

Furthermore, inconnection with the Merger, we entered into the Credit Agreement among us, asU.S. Borrower, Interlake Acquisition Corporation Limited, a subsidiary of theCompany, as Canadian Borrower, Cellu Paper, 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 Credit Agreementprovides for a $35.0 million working capital facility, including a letter ofcredit sub-facility and swing-line loan sub-facility. The Credit Agreementprovides 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 $3.0million is available, in U.S. or Canadian dollars, to 

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the Canadian Borrowerunder the facility.

Lastly, in connectionwith the merger,**we, Cellu Parent, and CelluAcquisition Corporation entered into a Management Agreement with WestonPresidio Service Company, pursuant to which Weston Presidio Service Company hasagreed to provide us with certain management, consulting and financial andother advisory services. Weston Presidio Service Company is an affiliate ofWeston Presidio, which is the controlling shareholder of Cellu Parent, which isthe sole shareholder of our Parent. In consideration for such services, we, ourParent and Cellu Acquisition Corporation have jointly and severally agreed topay Weston Presidio Service Company an annual fee of $450,000, to be paid inequal quarterly installments, and to reimburse expenses of Weston PresidioService Company and its affiliates. In addition, in connection with theconsummation of the Merger and as required by the Management Agreement, we paidWeston Presidio Service Company a fee in the amount of $2,000,000. 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.

**Cash**as of May 25,2006 decreased to $15.7 million from $22.8 million as of the end of the fiscalyear ended February 28, 2006, or fiscal year 2006. The decrease in ourcash position was primarily due to the cash used by operations, including oursemi-annual interest payment of $8.0 million, in the fiscal 2007 three-monthperiod. See below for details.

**Receivables, net**asof May 25, 2006 increased to $37.7 million from $35.1 million as of theend of fiscal year 2006 due to the increase in net sales per selling day in thefiscal 2007 three-month period.

**Inventory**as ofMay 25, 2006 increased to $29.7 million from $27.9 million as of the endof fiscal year 2006 primarily due to increased costs for raw materials,packaging materials and supplies.

**Accounts payable**asof May 25, 2006 decreased to $18.1 million from $18.6 million as of theend of fiscal year 2006. The decrease was attributable to the timing of payments.

**Accrued interest**asof May 25, 2006 decreased to $3.1 million from $7.2 million as of the endof fiscal year 2006 due to the timing (semi-annual) of interest payments on theNotes.

**Stockholders’ deficiency**asof May 25, 2006 was $6.9 million consistent with the end of fiscal year2006.  The net loss generated for thefiscal 2007 three-month period was offset by the increase in accumulated othercomprehensive income due to the increase in Canadian exchange rates for thefiscal 2007 three-month period.

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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-Kfor the fiscal year ended February 28, 2006. The preparation of ourfinancial statements requires us to make estimates that affect the reportedamounts of assets, liabilities, revenue and expenses and related disclosures ofcontingent assets and liabilities. We base our accounting estimates onhistorical experience and other factors that we believe to be reasonable underthe circumstances. However, actual results may vary from these estimates underdifferent assumptions or conditions.

New AccountingPronouncements

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS 123R”), “Share-Based Payment,” which requiresthe measurement of all employee share-based payments to employees, includinggrants of employee stock options, using fair-value-based method and therecording of such expense in our consolidated statement of operations. Weadopted the provisions of SFAS 123R using the prospective method effective March 1,2006. As such, there was no accounting effect on any outstanding awards. Upon adoptionof SFAS 123R, we had only one share-based payment arrangement. Our Parentgrants stock options to certain members of our management under the Cellu PaperHoldings, Inc. 2001 Stock Incentive Plan (the “Plan”). As of the date ofadoption of SFAS 123R, there were 743 options outstanding with a weightedaverage exercise price of $7,313 and a weighted average remaining contractuallife of 7.84 years.

On March 27, 2006,the Parent entered into Restricted Stock Agreements with the Company’s ChiefFinancial Officer and Chief Operating Officer, pursuant to which the Parentgranted 170.65 restricted shares of its common stock to each pursuant to thePlan. The shares will vest and cease to be restricted in three equal annualinstallments commencing on March 27, 2007, as long as the namedindividual, as the case may be, is continuously employed by the Company untileach such vesting date with respect to her or his shares. Any restricted stockoutstanding at the time of a Change of Control (as defined in the Plan) shallbecome vested and cease to be restricted stock. Additionally, our Parent hasagreed to pay an additional amount to the named individual, as the case may be,to fully gross up her or him, as applicable, for the amount included in grossincome for income tax purposes as a result of making a Section 83(b) electionunder the Internal Revenue Code of 1986, as amended, or the payment of anygross-up amount payment. Both named individuals have made a timely Section 83(b) election.For the three-month period ended May 25, 2006, the Company has recorded$52,658 of compensation expense related to the vesting of the above grants inaccordance with SFAS 123R.

On June 12, 2006,the Board of Directors of Cellu Parent adopted a 2006 Stock Option andRestricted Stock Plan and accordingly, all awards under this plan will beaccounted for in accordance with SFAS 123R.

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In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43, Chapter 4 “(SFAS 151). SFAS151 clarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs and spoilage. In addition, SFAS 151 requires thatallocation of fixed production overhead to the costs of conversion be based onnormal capacity of the production facilities. We adopted the provisions of SFAS151 as of March 1, 2006 and the adoption thereof did not have a materialimpact on our results of operations and financial position.

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**Item 3. Quantitative and Qualitative Disclosuresabout Market Risk**

In March 2004, wecompleted a Rule 144A offering of $162 million aggregate principle amountof Notes. At the same time, we entered into a new $30 million revolving workingcapital facility. We raised approximately $152.2 million, net of debt issuancecosts and original discount on the notes. The proceeds, along with a drawdownfrom the new revolver, were used to pay off existing debt of approximately $56million and to fund a stockholder dividend to the Parent to repurchase sharesof its common stock and warrants and fund compensation from the redemption ofemployee stock options of $100.2 million. As a result of these transactions, weare highly leveraged. As of May 25, 2006, there were no borrowings on theworking capital facility.  On June 12,2006 the Company entered into the Credit Agreement in connection with theMerger and we have the ability to borrow funds under this facility up to anaggregate of $35 million and could be adversely affected by a significantincrease in interest 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, otherthan sales originating from our Canadian subsidiary, are denominated in U. S.dollars. Due to our Canadian operations however, we could be adversely affectedby unfavorable fluctuations in foreign currency exchange rates.

**Item 4. Controls and Procedures**

(a)           Disclosure Controls andProcedures. The Company’s management, with the participation of the Company’sChief Executive Officer and Chief Financial Officer, has evaluated theeffectiveness of the Company’s disclosure controls and procedures (as such termis defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of theend of the period covered by this report. Based on such evaluation, the Company’sChief Executive Officer and Chief Financial Officer have concluded that, as ofthe end of such period, the Company’s disclosure controls and procedures areeffective in recording, processing, summarizing and reporting, on a timelybasis, information required to be disclosed by the Company in the reports thatit files or submits under the Securities and Exchange Commission’s rules andforms.

(b)         Changesin Internal Control Over Financial Reporting. There have not been any changesin the Company’s internal control over financial reporting (as such term isdefined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) during the fiscal quarter to which this report relates that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

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**PART II —OTHER INFORMATION**

**Item 5. OtherInformation**

Severance Agreement

On July 5, 2006 theCompany entered into a severance agreement with Hugo Vivero, Secretary of theCompany. The agreement is effective July 14, 2006 upon separation from theCompany and entitles the above named individual to a severance package equal toa year and 2 weeks pay at the individual’s current rate of pay plus accruedvacation along with certain other benefits, which approximates $.2 million.

The foregoing descriptionis qualified in its entirety by reference to the actual Severance Agreement, acopy of which is filed as Exhibit 10.4 to this Form 10-Q.

**Item 6. Exhibits**

(a)                Exhibits

10.1               EmploymentAgreement, dated June 12, 2006, between Russell Taylor and the Company.

10.2               EmploymentAgreement, dated June 12, 2006, between Dianne Scheu and the Company.

10.3               EmploymentAgreement, dated June 12, 2006, between Steven Ziessler and the Company.

10.4               SeveranceAgreement, dated July 14, 2006, between Hugo Vivero and the Company.

31.1               Certification byPresident and Chief Executive Officer pursuant to Rule 13a-14(a)

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

32.1               Certification byPresident and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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

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SIGNATURES

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the Registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.
|                           |   | Cellu Tissue Holdings, Inc.                            |
|---------------------------|--------|-------------------------------------------------------------|
|                      |   |                                                        |
|                      |   |                                                        |
| Date: July 10,  2006 |   | /s/ Russell C. Taylor                                       |
|                      |   |                                                        | Mr. Russell  C. Taylor |
|                      |   |                                                        | President and  Chief Executive Officer |
|                      |   |                                                        |
| Date: July 10,  2006 |   | /s/ Dianne M. Scheu                                         |
|                      |   | Ms. Dianne M. Scheu                                    |
|                      |   | Senior Vice President, Finance and Chief Financial  Officer |

 

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