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

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**FORM 10-Q**

 

| **(Mark One)**                                                 |                                                                                                         |
|----------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------|
| ** **                                                     |                                                                                                         |
| **ý**                                                     | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                     | ** **                                                                                                   |
| **For the  Quarterly Period Ended  August 24, 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 of registrant as specified in its charter)

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

 

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

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer”in Rule 12b-2 of theExchange Act.

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

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

The number of shares outstanding of each of theregistrant’s classes of common stock as of October 6, 2006:

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

 

 

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**CELLU TISSUEHOLDINGS, INC.FROM 10-QQUARTER ENDED AUGUST 24, 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                        |   |                                                                                        |

 

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**PART IFINANCIAL INFORMATION**

** **

**Item 1.****                                                                        ConsolidatedFinancial Statements**

 

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

 
| ** **                                    | ** ** | **For the Periods**     | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **Post-Acquisition**              | ** ** | **Pre-Acquisition** | ** ** |
| ** **                                    | ** ** | **June 13, 2006–** | ** ** | **May 26, 2006–** | ** ** | **May 27, 2005–** | ** ** |
| ** **                                    | ** ** | **August 24, 2006**     | ** ** | **June 12, 2006** | ** ** | **August 25, 2005** | ** ** |
|                                          | ** ** | ** **                        |       |   |   |   |   |
| Net sales                                     |       | $                                 | 68,562,386 |   | $ | 15,599,955 |   | $ | 86,017,502 |   |
| Cost of goods  sold                           |       | 65,217,759                        |       | 14,262,654 |   | 78,394,765 |   |
| Gross profit                                  |       | 3,344,627                         |       | 1,337,301 |   | 7,622,737 |   |
|                                          |       |                              |       |   |   |   |   |
| Selling, general  and administrative expenses |       | 3,914,664                         |       | 2,437,561 |   | 3,159,036 |   |
| Restructuring  costs                          |       | 240,218                           |       | — |   | — |   |
| Merger-related  transaction costs             |       | 102,375                           |       | 5,806,058 |   | 762,306 |   |
| (Loss) income  from operations                |       | (912,630                          | )          | (6,906,318 | ) | 3,701,395 |   |
|                                          |       |                              |       |   |   |   |   |
| Interest  expense, net                        |       | 3,152,536                         |       | 843,630 |   | 4,315,381 |   |
| Foreign currency  (gain) loss                 |       | (66,676                           | )          | 83,510 |   | 383,804 |   |
| Other income                                  |       | (17,453                           | )          | (1,657 | ) | (36,563 | ) |
| Loss before  income tax benefit               |       | (3,981,037                        | )          | (7,831,801 | ) | (961,227 | ) |
|                                          |       |                              |       |   |   |   |   |
| Income tax  benefit                           |       | (1,361,649                        | )          | (1,772,489 | ) | (105,448 | ) |
| Net loss                                      |       | $                                 | (2,619,388 | ) | $ | (6,059,312 | ) | $ | (855,779 | ) |

 

See accompanying notes toconsolidated financial statements.

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| ** **                                    | ** ** | **For the Periods** | ** ** |
|-----------------------------------------------|------------|-------------------------------|------------|
| ** **                                    | ** ** | **Post-Acquisition**          | ** ** | **Pre-Acquisition** | ** ** |
| ** **                                    | ** ** | **June 13, 2006-**  | ** ** | **March 1, 2006-** | ** ** | **March 1, 2005-** | ** ** |
| ** **                                    | ** ** | **August 24, 2006** | ** ** | **June 12, 2006** | ** ** | **August 25, 2005** | ** ** |
| Net sales                                     |       | $                             | 68,562,386 |   | $ | 94,241,932 |   | $ | 163,661,500 |   |
| Cost of goods  sold                           |       | 65,217,759                    |       | 86,053,812 |   | 149,044,924 |   |
| Gross profit                                  |       | 3,344,627                     |       | 8,188,120 |   | 14,616,576 |   |
|                                          |       |                          |       |   |   |   |   |
| Selling, general  and administrative expenses |       | 3,914,664                     |       | 5,584,865 |   | 6,157,696 |   |
| Restructuring  costs                          |       | 240,218                       |       | — |   | — |   |
| Merger-related  transaction costs             |       | 102,375                       |       | 5,933,265 |   | 889,127 |   |
| (Loss) income  from operations                |       | (912,630                      | )          | (3,330,010 | ) | 7,569,753 |   |
|                                          |       |                          |       |   |   |   |   |
| Interest  expense, net                        |       | 3,152,536                     |       | 4,896,355 |   | 8,448,494 |   |
| Foreign currency  (gain) loss                 |       | (66,676                       | )          | 289,010 |   | 284,185 |   |
| Other income                                  |       | (17,453                       | )          | (27,049 | ) | (32,177 | ) |
| Loss before  income tax benefit               |       | (3,981,037                    | )          | (8,488,326 | ) | (1,130,749 | ) |
| Income tax  benefit                           |       | (1,361,649                    | )          | (1,953,362 | ) | (164,798 | ) |
| Net loss                                      |       | ($2,619,388                   | )          | ($6,534,964 | ) | ($965,951 | ) |
|                                               |            |                               |            |  |  |  |  |  |  |  |

 

See accompanying notes toconsolidated financial statements.

 

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**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                    | ** ** | **August 24** | ** **  | **February 28** | ** ** |
|---------------------------------------------------------------|------------|--------------------|-------------|----------------------|------------|
| ** **                                                    | ** ** | **2006**           | ** **  | **2006**             | ** ** |
| ** **                                                    | ** ** | **(Unaudited)**    | ** **  | ** **           | ** ** |
| **ASSETS**                                                    | ** ** | ** **         | ** **  | ** **           | ** ** |
| CURRENT ASSETS:                                               |       |               |        |                 |       |
| Cash and cash  equivalents                                    |       | $                  | 18,136,438  |                 | $          | 22,824,062 |   |
| Receivables, net                                              |       | 34,050,221         |        | 35,054,372           |       |
| Inventories                                                   |       | 27,943,139         |        | 27,919,948           |       |
| Prepaid expenses  and other current assets                    |       | 3,660,851          |        | 3,377,952            |       |
| Income tax  receivable                                        |       | 1,885,541          |        | 362,122              |       |
| Deferred income  taxes                                        |       | 2,893,439          |        | 2,931,599            |       |
| TOTAL CURRENT  ASSETS                                         |       | 88,569,629         |        | 92,470,055           |       |
| PROPERTY, PLANT AND  EQUIPMENT, NET                           |       | 242,121,540        |        | 98,090,451           |       |
| DEBT ISSUANCE COSTS                                           |       | —             |        | 5,745,983            |       |
| GOODWILL                                                      |       | —             |        | 13,723,935           |       |
| OTHER ASSETS                                                  |       | 210,899            |        | 201,690              |       |
| TOTAL ASSETS                                                  |       | $                  | 330,902,068 |                 | $          | 210,232,114 |   |
|                                                          |       |               |        |                 |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY (DEFICIENCY)**   | ** ** | ** **         | ** **  | ** **           | ** ** |
| CURRENT LIABILITIES:                                          |       |               |        |                 |       |
| Accounts payable                                              |       | $                  | 18,990,347  |                 | $          | 18,648,281 |   |
| Accrued expenses                                              |       | 13,563,295         |        | 16,005,155           |       |
| Accrued interest                                              |       | 6,988,746          |        | 7,231,888            |       |
| Current portion  of long-term debt                            |       | —             |        | 290,000              |       |
| TOTAL CURRENT  LIABILITIES                                    |       | 39,542,388         |        | 42,175,324           |       |
| LONG-TERM DEBT, LESS  CURRENT PORTION                         |       | 160,034,995        |        | 160,790,258          |       |
| DEFERRED INCOME TAXES                                         |       | 53,165,556         |        | 13,961,743           |       |
| OTHER LIABILITIES                                             |       | 35,198,820         |        | 210,349              |       |
| STOCKHOLDERS’ EQUITY  (DEFICIENCY):                      |       |               |        |                 |       |
| Common stock,  Class A, $.01 par value, 1,000 shares          |       |               |        |                 |       |
| authorized, 100  shares issued and outstanding at             |       |               |        |                 |       |
| August 24, 2006  and February 28, 2006                        |       | 1                  |        | 1                    |       |
| Capital in  excess of par value                               |       | 45,898,286         |        | 615,338              |       |
| Accumulated  deficit                                          |       | (2,619,388         | )           | (11,625,759          | )          |
| Accumulated  other comprehensive (loss) income                |       | (318,590           | )           | 4,104,860            |       |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIENCY)                 |       | 42,960,309         |        | (6,905,560           | )          |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIENCY) |       | $                  | 330,902,068 |                 | $          | 210,232,114 |   |

 

See accompanying notes toconsolidated financial statements.

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

 
| ** **                                                                                 | ** ** | **For the Periods** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                 | ** ** | **Post-Acquisition**          | ** ** | **Pre-Acquisition** | ** ** |
| ** **                                                                                 | ** ** | **June 13, 2006-**  | ** ** | **March 1, 2006-** | ** ** | **March 1, 2005-** | ** ** |
| ** **                                                                                 | ** ** | **August 24, 2006** | ** ** | **June 12, 2006** | ** ** | **August 25, 2005** | ** ** |
|                                                                                       | ** ** | ** **                    |       |   |   |   |   |
| **Cash flows from operating  activities**                                                  |       |                          |       |   |   |   |   |
| Net loss                                                                                   |       | $                             | (2,619,388 | ) | $ | (6,534,964 | ) | $ | (965,951 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                          |       |   |   |   |   |
| Noncash  inventory charge                                                                  |       | 909,264                       |       | —   |   | — |   |
| Stock-based  compensation                                                                  |       | 136,290                       |       | 923,580 |   | — |   |
| Deferred income  taxes                                                                     |       | (558,206                      | )          | (396,024 | ) | (593,998 | ) |
| Accretion of  debt discount                                                                |       | 59,994                        |       | 85,471 |   | 146,287 |   |
| Amortization of  intangibles                                                               |       | —                        |       | 405,568 |   | 694,144 |   |
| Depreciation                                                                               |       | 4,515,763                     |       | 4,226,643 |   | 8,071,312 |   |
| Gain on sale of  property, plant and equipment                                             |       | —                        |       | — |   | (24,827 | ) |
| Changes in  operating assets and liabilities:                                              |       |                          |       |   |   |   |   |
| Receivables                                                                                |       | 2,998,825                     |       | (1,994,674 | ) | 609,711 |   |
| Inventories                                                                                |       | 2,185,566                     |       | (2,208,757 | ) | (3,064,978 | ) |
| Prepaid  expenses, other current assets and income tax receivable                          |       | 177,486                       |       | (683,329 | ) | (768,274 | ) |
| Other                                                                                      |       | (15,410                       | )          | (5,328 | ) | (9,029 | ) |
| Accounts  payable, accrued                                                                 |       |                          |       |   |   |   |   |
| expenses and  accrued interest                                                             |       | (2,139,598                    | )          | (358,006 | ) | (1,350,276 | ) |
| Total  adjustments                                                                         |       | 8,269,974                     |       | (4,856 | ) | 3,710,072 |   |
| *Net  cash provided by (used in) operating activities*                                     |       | 5,650,586                     |       | (6,539,820 | ) | 2,744,121 |   |
|                                                                                       |       |                          |       |   |   |   |   |
| **Cash flows from investing  activities**                                                  |       |                          |       |   |   |   |   |
| Equity  investment by Weston Presidio                                                      |       | 45,761,997                    |       | — |   | — |   |
| Capital  expenditures, net                                                                 |       | (1,884,457                    | )          | (1,937,610 | ) | (7,411,739 | ) |
| *Net cash provided by (used) in  investing activities*                                     |       | 43,877,540                    |       | (1,937,610 | ) | (7,411,739 | ) |
|                                                                                            |            |                               |            |  |  |  |  |  |  |  |

 

6

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| ** **                                                   | ** ** | **For the Periods** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                   | ** ** | **Post-Acquisition**          | ** ** | **Pre-Acquisition** | ** ** |
| ** **                                                   | ** ** | **June 13, 2006-**  | ** ** | **March 1, 2006-** | ** ** | **March 1, 2005-** | ** ** |
| ** **                                                   | ** ** | **August 24, 2006** | ** ** | **June 12, 2006** | ** ** | **August 25, 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                                  |       | (48,535                       | )          | 362,212 |   | 232,717 |   |
| *Net  increase (decrease) in cash and cash equivalents*      |       | 3,717,594                     |       | (8,405,218 | ) | (4,716,554 | ) |
| *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*                |       | $                             | 18,136,438 |   | $ | 14,418,844 |   | $ | 22,242,475 |   |
|                                                              |            |                               |            |  |  |  |  |  |  |  |

 

See accompanying notes toconsolidated financial statements.

 

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**CelluTissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited)August 24, 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, awholly owned subsidiary of Cellu Parent and a newly-formed corporationindirectly controlled by Weston Presidio (“Merger Sub”).  Pursuant to the agreement, on June 12, 2006,Merger Sub was merged with and into Parent, with 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 August 24, 2006) basis.

These statements havebeen prepared in accordance with accounting principles generally accepted inthe United States for interim financial information and with the instructionsto Form 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 August 24, 2006 are not necessarily indicative ofthe results that may be expected for the post-acquisition period endingFebruary 28, 2007.  For furtherinformation, refer to the Company’s consolidated financial statements andfootnotes thereto as of February 28, 2006 and for the year then ended, fromwhich the consolidated balance sheet at February 28, 2006 has been derived andthe Company’s latest Current Reports on Form 8-K as filed with the Securitiesand 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 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 earnout considerationbased 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 August 24, 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 August 24, 2006, the Company reflected $909,264 of excesspurchase price allocated to inventory as a non-cash charge to cost of goodssold and $1,518,430 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

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Company’s statement ofoperations for the period June 13, 2006 through August 24, 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 (“SFAS 123R”), *Share-Based Payment*,which requires the measurement of all employee share-based payments toemployees, including grants of employee stock options, using fair-value-basedmethod and the recording of such expense in the Company’s consolidatedstatement of operations.  The Companyadopted the provisions of SFAS 123R using the prospective method effectiveMarch 1, 2006.  As such, there was noaccounting effect on any outstanding awards. Upon adoption of SFAS 123R, the Company had only one share-based paymentarrangement under which the Parent granted stock options to certain members ofthe Company’s management under the Cellu Paper Holdings, Inc. 2001 StockIncentive Plan (the “old Plan”).  Inaccordance with the old Plan, each option outstanding at the time of a changein control immediately vested and became exercisable.  Furthermore, in accordance with the terms ofthe Merger, all outstanding options were cancelled and automatically convertedinto the right to receive the per share merger consideration for in-the-moneyoptions.

On June 12, 2006, theBoard of Directors of Cellu Parent adopted the 2006 Stock Option and RestrictedStock Plan (the “Plan”).  Under the Plan,the Plan Administrator may make awards of options to purchase shares of commonstock of Cellu Parent and/or awards of restricted shares of common stock ofCellu Parent.  A maximum of 8,095 sharesof common stock of Cellu Parent may be delivered in satisfaction of awardsunder the Plan, determined net of shares of common stock withheld by CelluParent in payment of the exercise price of an award or in satisfaction of taxwithholding requirements.  Key employeesand directors of, and consultants and advisors to, Cellu Parent or itsaffiliates who, in the opinion of the Plan Administrator, are in a position tomake a significant contribution to the success of Cellu Parent and itsaffiliates are eligible

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to participate in thePlan.   Stock options are granted at themarket price of the Company’s stock on the date of grant and have a 10-yearterm.  Generally, stock option grantsvest 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;  and the risk-free interest rate is based onU.S. Treasury securities with maturities equal to the expected life of theoption.  The Company uses historical datain order to estimate exercise, termination and holding period behavior forvaluation purposes.  A summary of theoption activity as of August 24, 2006 and changes during the period from June13, 2006 to August 24, 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,  August 24, 2006 |       | 500         |       | 426.69                                         |       | 9.20 Years                                                      |       |
| Exercisable, August 24,  2006 |       | —      |       | —                                         |       | —                                                          |       |

 

The fair value of thestock option grant was estimated on the date of grant using the Black-Scholes optionpricing model.  The weighted averageassumptions used to value the grants were no dividend yield; 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 August 24, 2006 related to nonvested awards is $98,385.

On June 12, 2006, CelluParent entered into Restricted Stock Agreements with the Company’s ChiefExecutive Officer, Chief Operating Officer and Chief Financial Officer,pursuant to which Cellu Parent granted 3,778 restricted shares of its commonstock to the Chief Executive Officer and 1,349 restricted shares of its commonstock to each 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 the time of a change in control.  Additionally, our Parent has agreed to pay anadditional amount to the named individuals, as the case may be, to fully grossup him or her as applicable, for the amount included in gross income for incometax purposes as a result of making a Section 83(b) election

11

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under the InternalRevenue Code of 1986, as amended, or the payment of any gross-up amountpayment.  All named individuals have madea timely Section 83(b) election.   Forthe period from June 13, 2006 to August 24, 2006, the Company has recorded$136,290 of compensation expense related to the vesting of the above grants inaccordance with 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 has recorded $870,922 of compensation expenserelated to the vesting of the above restricted stock in accordance with SFAS123R.  The Company had previouslyrecorded $52,658 related to the normal vesting in the three-month period endedMay 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 May 26, 2006 to June 12, 2006 and from June 13, 2006 to August 24,2006, the Company experienced 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 upon ultimate settlement. TheCompany is currently assessing the impact that the adoption of FIN 48 will haveon its results of operations and financial position.

 

12

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**Note 2 Inventories**

Components of inventoriesare as follows:
| ** **                       | ** ** | **August 24, 2006** | ** ** | **February 28, 2006** | ** ** |
|----------------------------------|------------|-------------------------------|------------|---------------------------------|------------|
|                             |       |                          |       |                            |       |
| Finished goods                   |       | $                             | 17,870,136 |                            | $          | 18,072,976 |   |
| Raw materials                    |       | 3,411,113                     |       | 2,624,006                       |       |
| Packaging  materials andsupplies |       | 6,828,588                     |       | 7,446,184                       |       |
|                             |       | 28,109,837                    |       | 28,143,166                      |       |
| Inventory  reserves              |       | (166,698                      | )          | (223,218                        | )          |
|                             |       | $                             | 27,943,139 |                            | $          | 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 six months endedAugust 25, 2005 of $405,568 and $694,144, respectively, has been included ininterest expense on the statement of operations for all periods presented.  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.

 

13

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**Note 4 Long-Term Debt**

Long-term debt consistsof the following:
| ** **                                                                                                       | ** ** | **August 24, 2006** | ** **  | **February 28, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|-------------|---------------------------------|------------|
| 9 3⁄4% senior  secured notes due 2010                                                                         |       | $                             | 162,000,000 |                            | $          | 162,000,000 |   |
| Less discount                                                                                                    |       | (1,965,005                    | )           | (1,209,742                      | )          |
|                                                                                                             |       | 160,034,995                   |        | 160,790,258                     |       |
| Industrial  revenue bond payable, in annual installments, plus interest ranging from 4.8%  to 6.65%, due in 2006 |       | —                        |        | 290,000                         |       |
|                                                                                                             |       | 160,034,995                   |        | 161,080,258                     |       |
| Less current  portion of debt                                                                                    |       | —                        |        | 290,000                         |       |
|                                                                                                             |       | $                             | 160,034,995 |                            | $          | 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 $5.9 million are reflectedas merger-related transaction costs on the statement of operations.  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 Limited, asubsidiary of the Company, as Canadian Borrower, Parent, the other loanguarantors party thereto, JPMorgan Chase Bank, N.A., as U.S. AdministrativeAgent,

 

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JPMorgan Chase Bank,N.A., Toronto Branch, as Canadian Administrative Agent, and the other lendersparty 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 the Canadian Borrowerunder the facility.  As of August 24,2006, there were no outstanding borrowings under the working capital facility.

**Note 5 Comprehensive Loss**

The components ofcomprehensive loss for the periods from June 13, 2006 to August 24, 2006, May26, 2006 to June 12, 2006 and for the three months ended August 25, 2005 are asfollows:
| ** **                                | ** ** | **For the Periods**                                | ** **  |
|-------------------------------------------|------------|--------------------------------------------------------------|-------------|
| ** **                                | ** ** | **Post-Acquisition**                                         | ** **  | **Pre-Acquisition** | ** ** |
| ** **                                | ** ** | **June 13, 2006–  August 24, 2006** | ** **  | **May 26, 2006–  June 12, 2006** | ** ** | **Three Months Ended  August 25, 2005** | ** ** |
| Net loss                             |       | $                                                            | (2,619,388) |   | ($6,059,312) |   | $ | (855,779) |   |
| Foreign currency  translation adjustments |       | (48,535                                                      | )           | 41,139 |   | 394,826 |   |
| Derivative loss                           |       | (154,672                                                     | )           | — |   | — |   |
| Comprehensive loss                        |       | $                                                            | (2,822,595  | ) | $ | (6,018,173 | ) | $ | (460,953 | ) |
|                                           |            |                                                              |             |  |  |  |  |  |  |  |

 

The components ofcomprehensive loss for the period from June 13, 2006 to August 24, 2006, March1, 2006 to June 12, 2006 and for the six months ended August 25, 2005 are asfollows:
| ** **                                | ** ** | **For the Periods**                                | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                | ** ** | **Post-Acquisition**                                         | ** ** | **Pre-Acquisition** | ** ** |
| ** **                                | ** ** | **June 13, 2006–  August 24, 2006** | ** ** | **March 1, 2006–  June 12, 2006** | ** ** | **Six Months Ended  August 25, 2005** | ** ** |
| Net loss                                  |       | $                                                            | (2,619,388 | ) | ($6,534,964 | ) | $ | (965,951 | ) |
| Foreign currency  translation adjustments |       | (48,535                                                      | )          | 362,212 |   | 232,717 |   |
| Derivative loss                           |       | (154,672                                                     | )          | — |   | — |   |
| Comprehensive loss                        |       | $                                                            | (2,822,595 | ) | $ | (6,172,752 | ) | $ | (733,234 | ) |
|                                           |            |                                                              |            |  |  |  |  |  |  |  |

 

15

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** **

**Note 6 ManagementAgreement**

On June 12, 2006, theCompany, Cellu Parent, and Merger Sub consummated 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. The Management Agreement expires on June 12, 2016, but will beautomatically extended on each anniversary of such date for an additional year,unless one of the parties provides written notice of its desire not toautomatically extend the term at least 90 days prior to such anniversary.

Management fees paid of$75,000 for the period June 13, 2006 to August 24, 2006 are reflected inselling, general and administrative expenses.

**Note 7 BusinessSegments**

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.  Includedin loss from operations for the period May 26, 2006 to June 12, 2006 is$5,806,058 of merger-related transaction costs. Of this amount, $3,773,938 impacts the tissue segment and $2,032,120impacts the machine-glazed paper segment. Included in loss from operations for the period June 13, 2006 to August24, 2006 is $102,375 of merger-related transaction costs, $240,218 ofrestructuring costs, $909,264 for a non-cash charge to cost of goods soldrelated to excess purchase price allocated to inventory and $1,518,430 ofadditional depreciation expense related to excess purchase price allocated toproperty, plant and equipment.  Of theseamounts, $66,544, $156,142, $591,022 and $986,980, respectively, impacts thetissue segment and $35,831, $84,076, $318,242 and $531,450, respectively,impacts the machine-glazed paper segment. Also, included in loss fromoperations for the periods June 13, 2006 to August 24, 2006 and May 26, 2006 toJune 12, 2006 is compensation charges of $2,687,092 and $397,279, respectively,related to non-cash compensation expense related to the vesting of restrictedstock awards, payments of taxes associated with such awards and othercompensation

16

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expense related to theMerger.  Of theses amounts, $1,746,610and $258,231, respectively, impacts the tissue segment and $940,482 and$139,048, respectively, impacts the machine-glazed segment.  Segment information for the period June 13,2006 to August 24, 2006, May 26, 2006 to June 12, 2006 and for the three monthsended August 25, 2005 follows:

 
| ** **            | ** ** | **Post-Acquisition**                                    | ** ** | **Pre-Acquisition**                                  | ** ** |
|-----------------------|------------|---------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **            | ** ** | **June 13, 2006-  August 24, 2006** | ** ** | **May 26, 2006-  June 12, 2006** | ** ** | **Three Months Ended  August 25, 2005** | ** ** |
| **Net  Sales**        |       |                                                    |       |                                                 |       |   |   |
| Tissue                |       | $                                                       | 49,024,665 |                                                 | $          | 11,870,989 |   | $ | 60,857,758 |   |
| Machine-glazed  paper |       | 19,537,721                                              |       | 3,728,966                                            |       | 25,159,744 |   |
| Consolidated          |       | $                                                       | 68,562,386 |                                                 | $          | 15,599,955 |   | $ | 86,017,502 |   |

 
| ** **                                    | ** ** | **Post-Acquisition**                                    | ** ** | **Pre-Acquisition**                                  | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                    | ** ** | **June 13, 2006-  August 24, 2006** | ** ** | **May 26, 2006-  June 12, 2006** | ** ** | **Three Months Ended  August 25, 2005** | ** ** |
| **Income  (loss) from operations**            |       |                                                    |       |                                                 |       |   |   |
| Tissue                                        |       | $                                                       | (119,515   | )                                                    | $          | (4,149,980 | ) | $ | 2,765,930 |   |
| Machine-glazed  paper                         |       | (793,115                                                | )          | (2,756,338                                           | )          | 935,465 |   |
| Consolidated                                  |       | (912,630                                                | )          | (6,906,318                                           | )          | 3,701,395 |   |
| Interest expense                              |       | (3,224,321                                              | )          | (865,095                                             | )          | (4,376,449 | ) |
| Net foreign  currency transaction gain (loss) |       | 66,676                                                  |       | (83,510                                              | )          | (383,804 | ) |
| Interest income                               |       | 71,785                                                  |       | 21,465                                               |       | 61,068 |   |
| Other income                                  |       | 17,453                                                  |       | 1,657                                                |       | 36,563 |   |
| Pretax loss                                   |       | $                                                       | (3,981,037 | )                                                    | $          | (7,831,801 | ) | $ | (961,227 | ) |
|                                          |       |                                                    |       |                                                 |       |   |   |
| **Capital  Expenditures**                     |       |                                                    |       |                                                 |       |   |   |
| Tissue                                        |       | $                                                       | 1,198,562  |                                                 | $          | 42,068 |   | $ | 3,029,291 |   |
| Machine-glazed  paper                         |       | 304,582                                                 |       | 94,618                                               |       | 195,136 |   |
| Corporate                                     |       | 381,313                                                 |       | 118,359                                              |       | 183,945 |   |
| Consolidated                                  |       | $                                                       | 1,884,457  |                                                 | $          | 255,045 |   | $ | 3,408,372 |   |
| ** **                                    |       |                                                    |       |                                                 |       |   |   |
| **Depreciation**                              |       |                                                    |       |                                                 |       |   |   |
| Tissue                                        |       | $                                                       | 3,190,553  |                                                 | $          | 492,758 |   | $ | 2,631,133 |   |
| Machine-glazed  paper                         |       | 1,325,210                                               |       | 199,410                                              |       | 1,430,755 |   |
|                                          |       | $                                                       | 4,515,763  |                                                 | $          | 692,168 |   | $ | 4,061,888 |   |

 

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Segment information forthe period June 13, 2006 to August 24, 2006, March 1, 2006 to June 12, 2006 andfor the six months ended August 25, 2005 follows:

 
| ** **            | ** ** | **Post-Acquisition**                                    | ** ** | **Pre-Acquisition**                                   | ** ** |
|-----------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **            | ** ** | **June 13, 2006-  August 24, 2006** | ** ** | **March 1, 2006-  June 12, 2006** | ** ** | **Six Months Ended  August 25, 2005** | ** ** |
| **Net  Sales**        |       |                                                    |       |                                                  |       |   |   |
| Tissue                |       | $                                                       | 49,024,665 |                                                  | $          | 67,199,611 |   | $ | 116,929,450 |   |
| Machine-glazed  paper |       | 19,537,721                                              |       | 27,042,321                                            |       | 46,732,050 |   |
| Consolidated          |       | $                                                       | 68,562,386 |                                                  | $          | 94,241,932 |   | $ | 163,661,500 |   |

 
| ** **                                    | ** ** | **Post-Acquisition**                                    | ** ** | **Pre-Acquisition**                                   | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                    | ** ** | **June 13, 2006-  August 24, 2006** | ** ** | **March 1, 2006-  June 12, 2006** | ** ** | **Six Months Ended  August 25, 2005** | ** ** |
| **Income  (loss) from operations**            |       |                                                    |       |                                                  |       |   |   |
| Tissue                                        |       | $                                                       | (119,515   | )                                                     | $          | (1,210,487 | ) | $ | 5,344,643 |   |
| Machine-glazed  paper                         |       | (793,115                                                | )          | (2,119,523                                            | )          | 2,225,110 |   |
| Consolidated                                  |       | (912,630                                                | )          | (3,330,010                                            | )          | 7,569,753 |   |
| Interest expense                              |       | (3,224,321                                              | )          | (5,000,732                                            | )          | (8,562,309 | ) |
| Net foreign  currency transaction gain (loss) |       | 66,676                                                  |       | (289,010                                              | )          | (284,185 | ) |
| Interest income                               |       | 71,785                                                  |       | 104,377                                               |       | 113,815 |   |
| Other income                                  |       | 17,453                                                  |       | 27,049                                                |       | 32,177 |   |
| Pretax loss                                   |       | $                                                       | (3,981,037 | )                                                     | $          | (8,488,326 | ) | $ | (1,130,749 | ) |
| ** **                                    |       |                                                    |       |                                                  |       |   |   |
| **Capital  Expenditures**                     |       |                                                    |       |                                                  |       |   |   |
| Tissue                                        |       | $                                                       | 1,198,562  |                                                  | $          | 711,857 |   | $ | 6,441,541 |   |
| Machine-glazed  paper                         |       | 304,582                                                 |       | 236,288                                               |       | 386,742 |   |
| Corporate                                     |       | 381,313                                                 |       | 989,465                                               |       | 583,456 |   |
| Consolidated                                  |       | $                                                       | 1,884,457  |                                                  | $          | 1,937,610 |   | $ | 7,411,739 |   |
| ** **                                    |       |                                                    |       |                                                  |       |   |   |
| **Depreciation**                              |       |                                                    |       |                                                  |       |   |   |
| Tissue                                        |       | $                                                       | 3,190,553  |                                                  | $          | 3,056,653 |   | $ | 5,215,442 |   |
| Machine-glazed  paper                         |       | 1,325,210                                               |       | 1,169,990                                             |       | 2,855,870 |   |
|                                          |       | $                                                       | 4,515,763  |                                                  | $          | 4,226,643 |   | $ | 8,071,312 |   |

 

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**Note 9 Income Taxes**

The effective income taxbenefit for the period May 26, 2006 to June 12, 2006 and June 13, 2006 toAugust 24, 2006 was 22.63% and 34.20%, respectively, compared to an 10.97%benefit for the three months ended August 25, 2005.  The effective income tax benefit for theperiod March 1, 2006 to June 12, 2006 and June 13, 2006 to August 24, 2006 was23.00 % and 34.20%, respectively, compared to a 14.57% benefit for the sixmonths ended August 25, 2005.  Theeffective tax rate for the period May 26, 2006 to June 12, 2006 and the periodMarch 1, 2006 to June 12, 2006 differs from the federal statutory rateprimarily due to non-deductible transaction costs expensed for bookpurposes.  The effective tax rate in theprior year differs from the federal statutory rate primarily due to theaccounting for certain merger-related transaction costs.

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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 contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities and Exchange Act of 1934, asamended, and as such, may involve known or unknown risks, uncertainties andother factors which may cause our actual results, performance or achievementsto be materially different from future results, performance or achievementsexpressed or implied by such forward-looking statements.  Forward-looking statements, which are basedon certain assumptions and describe our future plans, strategies andexpectations, are generally identifiable by use of the words “may,” “will,” “should,”“expect,” “anticipate,” “estimate,” “believe,” “intend,” “project,” orcomparable terminology.  Factors whichcould have a material adverse effect on our operations and future prospects include,but are not limited to, those set forth in Item 1. Business-Forward-LookingStatements and Item 1A.  Risk Factors inour Annual Report on Form 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 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 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 owned subsidiaryof Cellu Parent and a newly-formed corporation indirectly controlled by WestonPresidio (referred to herein as Merger Sub). Pursuant to the agreement, on June 12, 2006, Merger Sub was merged withand into our parent, with our parent surviving (referred to herein as themerger).

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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 ofAccounting Required in Certain Limited Circumstances*, we havereflected all applicable purchase accounting adjustments in our consolidatedfinancial statements for all periods subsequent to the merger date (referred toherein as push down accounting).  Pushdown accounting requires us to establish a new basis for our assets andliabilities based on the amount paid for our equity at close of business onJune 12, 2006.  Accordingly, Cellu Parent’sequity basis is reflected in our consolidated financial statements beginningupon completion of the merger.  In orderto apply 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 August 24, 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 August 24, 2006, we reflected $909,264 of excess purchaseprice allocated to inventory as a non-cash charge to cost of goods sold and$1,518,430 of additional depreciation expense in cost of goods sold as comparedto our historical basis of accounting prior to the merger.

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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. We are in the process of obtaining outside third partyappraisals of our intangible assets and finalizing the allocation withinproperty, plant and equipment categories. The impact of these fair value estimates has been reflected in ourstatement of operations for the period June 13, 2006 through August 24,2006.  Should the intangible assetsappraisal or allocations within the property, plant and equipment categoriesresult in differences in amortizable intangible assets or depreciable lives ofproperty, plant and equipment, changes in annual operating results would occur.

**RESULTS OFOPERATIONS**

The combined three monthsand six months ended August 24, 2006 pre- and post-acquisition periods havebeen compared to the three months and six months ended August 25, 2005 forpurposes of management’s discussion and analysis of the results ofoperations.  Any references below to thethree months and six months ended August 24, 2006 shall refer to the combinedperiods.  Material fluctuations inoperations resulting from the effect of purchase accounting have beenhighlighted.

 
| ** **                                    | ** ** | **Pre-Acquisition**         | ** ** | **Post-Acquisition**          | ** ** | **Combined**                     | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **May 26, 2006-** | ** ** | **June 13, 2006-**  | ** ** | **Three Months Ended** | ** ** |
| ** **                                    | ** ** | **June 12, 2006** | ** ** | **August 24, 2006** | ** ** | **August 24, 2006**    | ** ** |
|                                          |       |                        | ** ** | ** **                    | ** ** | ** **                       | ** ** |
| Net sales                                     |       | $                           | 15,599,955 |                          | $          | 68,562,386                       |       | $ | 84,162,341 |   |
| Cost of goods  sold                           |       | 14,262,654                  |       | 65,217,759                    |       | 79,480,413                       |       |
| Gross profit                                  |       | 1,337,301                   |       | 3,344,627                     |       | 4,681,928                        |       |
|                                          |       |                        |       |                          |       |                             |       |
| Selling, general  and administrative expenses |       | 2,437,561                   |       | 3,914,664                     |       | 6,352,225                        |       |
| Restructuring  costs                          |       | —                      |       | 240,218                       |       | 240,218                          |       |
| Merger-related  transaction costs             |       | 5,806,058                   |       | 102,375                       |       | 5,908,433                        |       |
| Loss from  operations                         |       | (6,906,318                  | )          | (912,630                      | )          | (7,818,948                       | )          |
|                                          |       |                        |       |                          |       |                             |       |
| Interest  expense, net                        |       | 843,630                     |       | 3,152,536                     |       | 3,996,166                        |       |
| Foreign currency  (gain) loss                 |       | 83,510                      |       | (66,676                       | )          | 16,834                           |       |
| Other income                                  |       | (1,657                      | )          | (17,453                       | )          | (19,110                          | )          |
| Loss before  income tax benefit               |       | (7,831,801                  | )          | (3,981,037                    | )          | (11,812,838                      | )          |
|                                          |       |                        |       |                          |       |                             |       |
| Income tax  benefit                           |       | (1,772,489                  | )          | (1,361,649                    | )          | (3,134,138                       | )          |
| Net loss                                      |       | $                           | (6,059,312 | )                             | $          | (2,619,388                       | )          | $ | (8,678,700 | ) |

 
| ** **          | ** ** | **Pre-Acquisition**          | ** ** | **Post-Acquisition**          | ** ** | **Combined**                   | ** ** |
|---------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **          | ** ** | **March 1, 2006-** | ** ** | **June 13, 2006-**  | ** ** | **Six Months Ended** | ** ** |
| ** **          | ** ** | **June 12, 2006**  | ** ** | **August 24, 2006** | ** ** | **August 24, 2006**  | ** ** |
|                |       |                         | ** ** | ** **                    | ** ** | ** **                     | ** ** |
| Net sales           |       | $                            | 94,241,932 |                          | $          | 68,562,386                     |       | $ | 162,804,318 |   |
| Cost of goods  sold |       | 86,053,812                   |       | 65,217,759                    |       | 151,271,571                    |       |
| Gross profit        |       | 8,188,120                    |       | 3,344,627                     |       | 11,532,747                     |       |
|                |       |                         |       |                          |       |                           |       |
|                     |            |                              |            |                               |            |                                |            |  |  |  |

 

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| Selling, general  and administrative expenses |   | 5,584,865  |       | 3,914,664  |   | 9,499,529   |   |
|-----------------------------------------------|--------|------------|------------|------------|--------|-------------|--------|
| Restructuring  costs                          |   | —     |       | 240,218    |   | 240,218     |   |
| Merger-related  transaction costs             |   | 5,933,265  |       | 102,375    |   | 6,035,640   |   |
| Loss from  operations                         |   | (3,330,010 | )          | (912,630   | )      | (4,242,640  | )      |
|                                          |   |       |       |       |   |        |   |
| Interest  expense, net                        |   | 4,896,355  |       | 3,152,536  |   | 8,048,891   |   |
| Foreign currency  (gain) loss                 |   | 289,010    |       | (66,676    | )      | 222,334     |   |
| Other income                                  |   | (27,049    | )          | (17,453    | )      | (44,502     | )      |
| Loss before  income tax benefit               |   | (8,488,326 | )          | (3,981,037 | )      | (12,469,363 | )      |
|                                          |   |       |       |       |   |        |   |
| Income tax  benefit                           |   | (1,953,362 | )          | (1,361,649 | )      | (3,315,011  | )      |
| Net loss                                      |   | $          | (6,534,964 | )          | $      | (2,619,388  | )      | $ | (9,154,352 | ) |
|                                               |        |            |            |            |        |             |        |  |  |  |

 

The tables that followpresent unaudited net sales and gross profit for our principal segments for thecombined three months and six months ended August 24, 2006.

** **
| ** **            | ** ** | **Pre-Acquisition**         | ** ** | **Post-Acquisition**          | ** ** | **Combined**                     | ** ** |
|-----------------------|------------|-----------------------------|------------|-------------------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **May 26, 2006-** | ** ** | **June 13, 2006-**  | ** ** | **Three Months Ended** | ** ** |
| ** **            | ** ** | **June 12, 2006** | ** ** | **August 24, 2006** | ** ** | **August 24, 2006**    | ** ** |
| **Net Sales**         |       |                        | ** ** | ** **                    | ** ** | ** **                       | ** ** |
| Tissue                |       | $                           | 11,870,989 |                          | $          | 49,024,665                       |       | $ | 60,895,654 |   |
| Machine-glazed  paper |       | 3,728,966                   |       | 19,537,721                    |       | 23,266,687                       |       |
| Consolidated          |       | $                           | 15,599,955 |                          | $          | 68,562,386                       |       | $ | 84,162,341 |   |
|                  |       |                        |       |                          |       |                             |       |
| **Gross Profit**      |       |                        |       |                          |       |                             |       |
| Tissue                |       | $                           | 1,234,589  |                          | $          | 2,753,737                        |       | $ | 3,988,326 |   |
| Machine-glazed  paper |       | 102,712                     |       | 590,890                       |       | 693,602                          |       |
| Consolidated          |       | $                           | 1,337,301  |                          | $          | 3,344,627                        |       | $ | 4,681,928 |   |
|                  |       |                        |       |                          |       |                             |       |

** **
| ** **            | ** ** | **Pre-Acquisition**          | ** ** | **Post-Acquisition**          | ** ** | **Combined**                   | ** ** |
|-----------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **            | ** ** | **March 1, 2006-** | ** ** | **June 13, 2006-**  | ** ** | **Six Months Ended** | ** ** |
| ** **            | ** ** | **June 12, 2006**  | ** ** | **August 24, 2006** | ** ** | **August 24, 2006**  | ** ** |
| **Net  Sales**        |       |                         | ** ** | ** **                    | ** ** | ** **                     | ** ** |
| Tissue                |       | $                            | 67,199,611 |                          | $          | 49,024,665                     |       | $ | 116,224,276 |   |
| Machine-glazed  paper |       | 27,042,321                   |       | 19,537,721                    |       | 46,580,042                     |       |
| Consolidated          |       | $                            | 94,241,932 |                          | $          | 68,562,386                     |       | $ | 162,804,318 |   |
|                  |       |                         |       |                          |       |                           |       |
| **Gross  Profit**     |       |                         |       |                          |       |                           |       |
| Tissue                |       | $                            | 6,423,465  |                          | $          | 2,753,737                      |       | $ | 9,177,202 |   |
| Machine-glazed  paper |       | 1,764,655                    |       | 590,890                       |       | 2,355,545                      |       |
| Consolidated          |       | $                            | 8,188,120  |                          | $          | 3,344,627                      |       | $ | 11,532,747 |   |
|                  |       |                         |       |                          |       |                           |       |

** **

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**Results of Operations for theThree Months Ended August 24, 2006 (the Fiscal 2007 Three-Month Period)compared to the Three Months Ended August 25, 2005 (the Fiscal 2006 Three-MonthPeriod) and the Six Months Ended August 24, 2006 (the Fiscal 2007 Six-MonthPeriod) compared to the Six Months ended August 25, 2005 (the Fiscal 2006Six-Month Period)**

**Net sales** forthe fiscal 2007 three-month period decreased $1.8 million, or 2.2%, to****$84.2****million from$86.0 million for the comparable period in the prior year. Net sales for thefiscal 2007 six-month period decreased $.9 million, or .5%, to $162.8 from$163.7 million for the comparable period in the prior year.  On a Company-wide basis, tons sold decreasedfor the fiscal 2007 three-month period and the fiscal 2007 six-month periodcompared to the comparable period of fiscal 2006.  For the fiscal 2007 three-month period, wesold 64,840 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products, a decrease of 3,523 tons, or 5.2% compared to thefiscal 2006 three-month period.  For thefiscal 2007 six-month period, we sold 126,199 tons of tissue hard rolls,machine-glazed paper hard rolls and converted paper products, a decrease of3,966 tons, or 3.0% compared to the fiscal 2006 six-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 of1,999 tons in the above three-month period and 3,803 in the above six-monthperiod.  Net of the effect of this, tonssold decreased 1,524, or 2.2%, for the fiscal 2007 three-month period over thecomparable period in the prior year and tons sold decreased 163, or .1%, forthe fiscal 2007 six-month period over the comparable period in the prior year.  Partially offsetting the decrease in volumesold for the fiscal 2007 three-month period and fiscal 2007 six-month periodover the prior year, was an increase in net selling price per ton from $1,258and $1,257 for the fiscal 2006 three-month period and six-month period,respectively, to $1,298 and $1,290 for the fiscal 2007 three-month period andsix-month period, respectively.

Net sales for our tissuesegment for the fiscal 2007 three-month period were $60.9 million, which wasconsistent with the comparable period in the****prioryear.  Net sales for our tissue segmentfor the fiscal 2007 six-month period were $116.2 million, a decrease of $.7million, or .6%, from the comparable period in the prior year. The decrease isattributable to a decrease in tonnage sold which was partially offset by anincrease in net selling price per ton. Net sales for our machine-glazed segment for the 2007 three-month periodwere****$23.3 million, a decrease of $1.8million, or 7.5%,****from the comparable period in theprior year.  Net sales for ourmachine-glazed segment for the 2007 six-month period were $46.6 million, adecrease of $.2 million, or .3%, from the comparable period in the prioryear.   This decrease is driven by thedecrease in tonnage sold as noted above, partially offset by an increase in netselling price per ton.

**Gross profit**for the fiscal 2007 three-month period decreased to $4.7 million from $7.6million, a decrease of $2.9 million, or 38.6%, from the comparable period inthe prior****year. **  **Gross profit for the fiscal 2007 six-monthperiod decreased to $11.5 million from $14.6 million, a decrease of $3.1million, or 21.1%, from the comparable period in the prior year.  Included in the fiscal 2007 three-month andsix-month periods is a non-cash

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charge to cost of goodssold reflecting $.9 million of excess purchase price allocated to inventory and$1.5 million of additional depreciation expense in cost of goods sold ascompared to our historical basis of accounting prior to the merger.

As a percentage of netsales, gross profit decreased to 5.6% in the fiscal 2007 three-month period and7.1% in the fiscal 2007 six-month period from 8.9% in each of the fiscal 2006three-month and six-month periods.

Gross profit for ourtissue segment for the fiscal 2007 three-month period was $4.0 million, adecrease of $1.3 million, or 25.6%, from the comparable period in the prioryear.  Gross profit for our tissuesegment for the fiscal 2007 six-month period was $9.2 million, a decrease of$.8 million, or 8.4%, from the comparable period in the prior year.  Included in the fiscal 2007 three-month andsix-month periods is the impact of the additional charges noted above on thetissue segment of $1.6 million.

Gross profit for ourmachine-glazed segment for the fiscal 2007 three-month period was $.7 million,a decrease of $1.6 million, or 69.4%, from the comparable period in the prioryear.  Gross profit for ourmachine-glazed segment for the fiscal 2006 six-month period was $2.3 million, adecrease of $2.3 million, or 48.8%, from the comparable period in the prioryear.  Included in the fiscal 2007three-month and six-month periods is the impact of the additional charges notedabove on the machine-glazed segment of $.8 million.

As a percentage of netsales, gross profit for the tissue segment decreased to 6.5% in the fiscal 2007three-month period and 7.9% in the fiscal 2007 six-month period from 8.8 % inthe fiscal 2006 three-month period and 8.6% in the fiscal 2006 six-monthperiod.  As a percentage of net sales,gross profit for the machine-glazed segment decreased to 3.0% in the fiscal2007 three-month period and 5.1% in the fiscal 2007 six-month period from 9.0%in the fiscal 2006 three-month period and 9.8% in the fiscal 2006 six-monthperiod.

**Selling, general andadministrative expenses**in the fiscal 2007 three-month periodincreased $3.2 million, or 101.1%, to $6.4 million from $3.2 million in thefiscal 2006 three-month period.  Selling,general and administrative expenses in the fiscal 2007 six-month periodincreased $3.3 million, or 54.3%, to $9.5 million from $6.2 million in thefiscal 2006 six-month period.  As apercentage of net sales, selling, general and administrative expenses increasedto****7.5% in the fiscal 2007 three-monthperiod and increased to 5.8% in the fiscal 2006 six-month period from 3.7% and3.8%, respectively, for the comparable periods in the prior year.  Included in the fiscal 2007 three-month andsix-month periods****is $1.0 million of non-cashcompensation expense related to the vesting of restricted stock awards, $1.5million of other compensation expense related to tax payments associated withsuch awards and $.6 million of other compensation expense related to theMerger.

**Restructuring costs**inthe fiscal 2007 three-month and six-month periods were $.2 million related to severancescosts associated with the elimination of a corporate position.

25

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**Merger-related transaction costs**inthe fiscal 2007 three-month period were $5.9 million and in the fiscal 2007six-month period were $6.0 million associated with the Merger.  The merger-related transaction costs in thefiscal 2006 three-month and six-month periods relate to a previously announcedterminated transaction.

**Foreign currency (gain) loss**inthe fiscal 2007 three-month period was a loss of less than $.1 million and inthe fiscal 2007 six-month period was a loss of $.2 million compared to a lossof $.4 million and $.3 million, respectively, for the comparable periods in theprior year.  The fluctuations relate tothe change in the Canadian currency period over period.

**Income tax benefit**for the fiscal 2007 three-month period was a benefit of 26.5% compared toincome tax benefit for the fiscal 2006 three-month period of 11.0%.  Income tax benefit for the fiscal 2007six-month period was 26.6% compared to income tax benefit for the fiscal 2006six-month period of 14.6%.   Theeffective tax rate for the fiscal 2007 three-month and the six-month periodsdiffer from the federal statutory rate primarily due to non-deductibletransaction costs expensed for book purposes. The effective tax rate in the prior year differs from the federalstatutory rate primarily due to the accounting for certain merger-relatedtransaction costs.

**Net loss**forthe fiscal 2007 three-month period was a net loss of $8.7 million, compared toa net loss of $.9 million for the comparable period in the prior year. Net lossfor the fiscal 2007 six-month period was a net loss of $9.2 million, comparedto net loss of $1.0 million for the comparable period in the prior year.

**FINANCIAL CONDITION**

**Liquidity and Capital Resources**

The table that followspresents cash flows information for the combined six months ended August 24,2006.

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** **
| ** **                                               | ** ** | **Pre-Acquisition**          | ** ** | **Post-Acquisition**          | ** ** | **Combined**                   | ** ** |
|----------------------------------------------------------|------------|------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                                               | ** ** | **March 1, 2006-** | ** ** | **June 13, 2006-**  | ** ** | **Six Months Ended** | ** ** |
| ** **                                               | ** ** | **June 12, 2006**  | ** ** | **August 24, 2006** | ** ** | **August 24, 2006**  | ** ** |
| **Net  Provided by (Used in) Operating Activities**      |       |                         | ** ** | ** **                    | ** ** | ** **                     | ** ** |
| Net loss                                                 |       | $                            | (6,534,964 | )                             | $          | (2,619,388                     | )          | $ | (9,154,352 | ) |
| Non-cash items                                           |       | 5,245,238                    |       | 5,063,105                     |       | 10,308,343                     |       |
| Changes in  working capital                              |       | (5,250,094                   | )          | 3,206,869                     |       | (2,043,225                     | )          |
| Net cash  provided by (used in) operating activities     |       | $                            | (6,539,820 | )                             | $          | 5,650,586                      |       | $ | (889,234 | ) |
|                                                     |       |                         |       |                          |       |                           |       |
| **Net  Cash Provided by (Used in) Investing Activities** |       | $                            | (1,937,610 | )                             | $          | 43,877,540                     |       | $ | 41,939,930 |   |
|                                                     |       |                         |       |                          |       |                           |       |
| **Net Cash Used in Financing  Activities**               |       | $                            | (290,000   | )                             | $          | (45,761,997                    | )          | $ | (46,051,997 | ) |

 

**Net cash used in operations**was $.9 million for the fiscal 2007 six-month period, compared to net cashprovided by operations of $2.7 million for the fiscal 2006 six-month period. ** **Non-cash items,consisting of inventory charge, stock-based compensation, deferred incometaxes, depreciation, amortization and gain on sale of property, plant andequipment, for the fiscal 2007 six-month period totaled $10.3 million comparedto $8.3 million for the 2006 fiscal six-month period.**   **Cash flows used by changes inworking capital totaled $2.0 million for the fiscal 2007 six-month period,compared to $4.6 million in the fiscal 2006 six-month period. ** **With respect to thechanges in accounts receivable and inventory, cash provided by these items was$1.0 million for the fiscal 2007 six-month period compared to cash used bythese items of $2.5 million for the comparable period in the prior fiscalyear.  Cash****usedby changes in prepaid expenses and other current assets was $.5 million for thefiscal 2007 six-month period compared to cash used of $.8 million for thecomparable period in the prior fiscal year. Cash used by changes in accounts payable, accrued expenses and accruedinterest for the fiscal 2007 six-month period was $2.5 million compared to cashused of $1.3 million for the comparable period in the prior year.

**Net cash provided by investingactivities** for the fiscal 2007 six-month period was $41.9****million compared to net cash used in investing activitiesof $7.4 million for the fiscal 2006 six-month period.  The fiscal 2007 six-month period includes$45.8 million related to the equity investment by Weston Presidio.  The remaining change relates to the level ofcapital spending period over period.

**Net cash used in financing activities**for the fiscal 2007 six-month period was $46.1 million, which includes $45.8million related to merger consideration paid to former shareholders.  The remaining $.3 million for the fiscal 2007six-month period is consistent with net cash used in financing activities forthe fiscal 2006 six-month period.  Theseamounts in both periods relate to payments on our industrial revenue bond. Ourlast payment on our industrial revenue bond was made in the first quarter ofthe fiscal year ending February 28, 2007, or fiscal 2007.

27

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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 in substantiallyall of our 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 areunconditionally 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 inour second quarter of fiscal 2007.  As aresult of our acceptance of the consents delivered by noteholders and thecompletion 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 CreditAgreement, dated as of June 12, 2006 (referred to herein as Credit Agreement),among us, as U.S. Borrower, Interlake Acquisition Corporation Limited, one ofour subsidiaries, as Canadian Borrower, our Parent, the other loan guarantorsparty thereto, JPMorgan Chase Bank, N.A., as U.S. Administrative Agent, JPMorganChase Bank, N.A., Toronto Branch, as Canadian Administrative Agent, and theother lenders party thereto.

*TheCredit Agreement provides for a $35.0 million working capital facility,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 facility, and an amount equal to$3.0 million is available, in U.S. or Canadian dollars, to the CanadianBorrower under the facility.  As ofAugust 24, 2006, there were no outstanding borrowings under the working capitalfacility.*

**Cash**as ofAugust 24, 2006 decreased to $18.1 million from $22.8 million as of the end ofthe 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.

**Receivables, net**asof August 24, 2006 decreased to $34.1 million from $35.1 million as of the endof fiscal year 2006 primarily due to the timing of customer payments.

**Income tax receivable**asof August 24, 2006 increased to $1.9 million from $.4 million as of the end offiscal year 2006.  This increase isprimarily attributable to the tax benefit recorded in the fiscal 2007 six-monthperiod.

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**Property, plant and equipment**asof August 24, 2006 increased to $242.0 million from $98.1 million as of the endof fiscal year 2006 primarily due to the excess purchase price allocated toproperty, plant and equipment.

**Debt issuance costs**havebeen reduced to zero as of August 24, 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 August 24, 2006 from $13.7 million as of the end offiscal year 2006 due to purchase accounting adjustments resulting from themerger.

**Accrued expenses**asof August 24, 2006 decreased to $13.6 million from $16.0 million as of the endof fiscal year 2006 due to the timing of payment with respect to certain of ourservice providers resulting from delayed billings.

**Deferred income taxes**asof August 24, 2006 increased to $53.2 million from $14.0 million as of the endof fiscal year 2006 primarily due to purchase accounting adjustments resultingfrom the merger.

**Other liabilities**asof August 24, 2006 increased to $35.2 million from $.2 million as of the end offiscal year 2006 due to the recording of $35.0 million related to contingentearnout consideration in connection with the merger.

**Stockholders’ equity (deficiency)**as of August 24, 2006 increased to equity of $43.0 millioncompared to a deficit of $6.9 million as of the end of fiscal year 2006.   The equity as of August 24, 2006 isreflective of the equity invested in us relative to the merger, the net lossgenerated for the period June 13, 2006 to August 24, 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

29

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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.

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

In March 2004, we completed a Rule 144A offering of $162 millionaggregate principle amount of 9 3⁄4% senior secured notes due 2010.  At the same time, we entered into a new $30million revolving working capital facility.  As a result of these transactions, we are highly leveraged.  On June 12, 2006, we entered into the CreditAgreement in connection with the merger and we have the ability to borrow fundsunder this facility up to an aggregate of $35 million and could be adverselyaffected by a significant increase in interest rates.   

 

Market risk is the potential economic lossthat may result from adverse changes in the fair value of financialinstruments. We are exposed to market risk from changes in foreign currencyexchange rates, primarily in Canada.  All international sales, other than salesoriginating from our Canadian subsidiary, are denominated in U. S.dollars.  Due to our Canadian operationshowever, we could be adversely affected by unfavorable fluctuations in foreigncurrency exchange rates.

 

**Item 4.  Controls and Procedures**

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

 

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

 

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PART II—OTHERINFORMATION

Item 1A.                                                   RiskFactors

The risk factors includedin our Annual Report on Form 10-K for the fiscal year ended February 28,2006 have not materially changed.

Item 6.                                                             Exhibits

(a)   Exhibits
|   | 31.1   |   | Certification by President and Chief Executive  Officer pursuant to Rule 13a-14(a)                      |
|--------|--------|--------|--------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                         |
|   | 31.2   |   | Certification by Senior Vice President, Finance and  Chief Financial Officer pursuant to Rule 13a-14(a) |

 

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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:  | October 10, 2006 |   |                        | /s/ Russell C. Taylor |
|   |             |   |                        | Mr. Russell C. Taylor |
|   |             |   |                        | President and Chief Executive Officer |
|   |             |   |                        |   |
| Date:  | October 10, 2006 |   |                        | /s/ Dianne M. Scheu |
|   |             |   |                        | Ms. Dianne M. Scheu |
|   |             |   |                        | Senior Vice President, Finance and Chief |
|   |             |   |                        | Financial Officer |

 

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