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

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**FORM 10-Q**

**(Mark One)**
| **x**                                                                                                                                                                                                                                              | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                               | ** ** | ** **                                                                                    |
| **For the  Quarterly Period Ended August 30, 2007**                                                                                                                                                                                                |
| ** **                                                                                                                                                                                                                                         |
| **or**                                                                                                                                                                                                                                             |
| ** **                                                                                                                                                                                                                                         |
| **o**                                                                                                                                                                                                                                              | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                               | ** ** | ** **                                                                                    |
| **For the  transition period from                 to                 .** |
| ** **                                                                                                                                                                                                                                         |
| **Commission  file number 333-118829**                                                                                                                                                                                                             |

 

**CelluTissue 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) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports) and (2) has been subjectto such filing requirements for the past 90 days.   Yes ýNo 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 the ExchangeAct.

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

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).  YesoNox

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

 

 

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CELLUTISSUE HOLDINGS, INC.

FORM10-Q

QUARTER ENDED AUGUST 30, 2007

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

 

2

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**PART I – FINANCIAL INFORMATION**

**Item1.  Consolidated Financial Statements**

**CELLU TISSUE HOLDINGS, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFOPERATIONS (Unaudited)**

 
| ** **                                         | ** ** | **For the Periods** | ** **  |
|----------------------------------------------------|------------|-------------------------------|-------------|
| ** **                                         | ** ** | **Post - Merger**   | ** **  | **Pre-Merger** | ** ** |
| ** **                                         | ** ** | **June 1, 2007-**   | ** **  | **June 13, 2006-** | ** ** | **May 26, 2006-** | ** ** |
| ** **                                         | ** ** | **August 30,2007**       | ** **  | **August 24, 2006** | ** ** | **June 12, 2006** | ** ** |
|                                               | ** ** | ** **                    | ** **  |   |   |   |   |
| Net sales                                          |       | $                             | 109,000,321 |   | $ | 68,562,386 |   | $ | 15,599,955 |   |
| Cost of goods sold                                 |       | 97,233,784                    |        | 65,217,759 |   | 14,262,654 |   |
| Gross profit                                       |       | 11,766,537                    |        | 3,344,627 |   | 1,337,301 |   |
|                                               |       |                          |        |   |   |   |   |
| Selling, general and  administrative expenses      |       | 4,519,992                     |        | 3,778,374 |   | 2,437,561 |   |
| Stock and related  compensation expense            |       | 186,203                       |        | 136,290 |   | — |   |
| Restructuring costs                                |       | —                        |        | 240,218 |   | — |   |
| Merger-related  transaction costs                  |       | —                        |        | 102,375 |   | 5,806,058 |   |
| Income (loss) from  operations                     |       | 7,060,342                     |        | (912,630 | ) | (6,906,318 | ) |
|                                               |       |                          |        |   |   |   |   |
| Interest expense, net                              |       | 5,102,666                     |        | 3,152,536 |   | 843,630 |   |
| Foreign currency loss  (gain)                      |       | 196,110                       |        | (66,676 | ) | 83,510 |   |
| Other income                                       |       | (40,261                       | )           | (17,453 | ) | (1,657 | ) |
| Income (loss) before  income tax expense (benefit) |       | 1,801,827                     |        | (3,981,037 | ) | (7,831,801 | ) |
|                                               |       |                          |        |   |   |   |   |
| Income tax expense  (benefit)                      |       | 731,997                       |        | (1,361,649 | ) | (1,772,489 | ) |
| Net income (loss)                                  |       | $                             | 1,069,830   |   | $ | (2,619,388 | ) | $ | (6,059,312 | ) |

 

See accompanying notes toconsolidated financial statements.

3

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| ** **                                         | ** ** | **For the Periods** | ** **  |
|----------------------------------------------------|------------|-------------------------------|-------------|
| ** **                                         | ** ** | **Post - Merger**   | ** **  | **Pre-Merger** | ** ** |
| ** **                                         | ** ** | **March 1, 2007-**  | ** **  | **June 13, 2006-** | ** ** | **March 1, 2006-** | ** ** |
| ** **                                         | ** ** | **August 30, 2007** | ** **  | **August 24, 2006** | ** ** | **June 12, 2006** | ** ** |
| Net sales                                          |       | $                             | 212,201,107 |   | $ | 68,562,386 |   | $ | 94,241,932 |   |
| Cost of goods  sold                                |       | 192,142,452                   |        | 65,217,759 |   | 86,053,812 |   |
| Gross profit                                       |       | 20,058,655                    |        | 3,344,627 |   | 8,188,120 |   |
|                                               |       |                          |        |   |   |   |   |
| Selling, general  and administrative expenses      |       | 9,002,729                     |        | 3,778,374 |   | 5,584,865 |   |
| Stock and  related compensation expense            |       | 419,322                       |        | 136,290 |   |   |   |
| Restructuring  costs                               |       | —                        |        | 240,218 |   | — |   |
| Merger-related  transaction costs                  |       | —                        |        | 102,375 |   | 5,933,265 |   |
| Income (loss)  from operations                     |       | 10,636,604                    |        | (912,630 | ) | (3,330,010 | ) |
|                                               |       |                          |        |   |   |   |   |
| Interest  expense, net                             |       | 10,121,760                    |        | 3,152,536 |   | 4,896,355 |   |
| Foreign currency  loss (gain)                      |       | 520,408                       |        | (66,676 | ) | 289,010 |   |
| Other income                                       |       | (82,500                       | )           | (17,453 | ) | (27,049 | ) |
| Income (loss)  before income tax expense (benefit) |       | 76,936                        |        | (3,981,037 | ) | (8,488,326 | ) |
| Income tax  expense (benefit)                      |       | 117,590                       |        | (1,361,649 | ) | (1,953,362 | ) |
| Net loss                                           |       | $                             | (40,654     | ) | $ | (2,619,388 | ) | $ | (6,534,964 | ) |

 

See accompanying notes toconsolidated financial statements.

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

 
| ** **                                                                                         | ** ** | **August 30** | ** **  | **February 28** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------|-------------|----------------------|------------|
| ** **                                                                                         | ** ** | **2007**           | ** **  | **2007**             | ** ** |
| ** **                                                                                         | ** ** | **(Unaudited)**    | ** **  | ** **           | ** ** |
| **ASSETS**                                                                                         |       |               |        |                 |       |
| CURRENT ASSETS:                                                                                    |       |               |        |                 |       |
| Cash and cash equivalents                                                                          |       | $                  | 2,335,306   |                 | $          | 16,260,601 |   |
| Receivables, net                                                                                   |       | 43,277,645         |        | 34,140,844           |       |
| Inventories                                                                                        |       | 30,742,895         |        | 29,603,809           |       |
| Prepaid expenses and other current assets                                                          |       | 6,097,851          |        | 2,809,014            |       |
| Income tax receivable                                                                              |       | 327,183            |        | 329,861              |       |
| Deferred income taxes                                                                              |       | 5,652,643          |        | 6,498,098            |       |
| TOTAL CURRENT ASSETS                                                                               |       | 88,433,523         |        | 89,642,227           |       |
| PROPERTY, PLANT  AND EQUIPMENT, NET                                                                |       | 291,711,662        |        | 228,851,765          |       |
| GOODWILL                                                                                           |       | 6,924,559          |        | —               |       |
| TRADEMARKS                                                                                         |       | 8,750,314          |        | 6,550,314            |       |
| OTHER ASSETS                                                                                       |       | 1,436,426          |        | 224,438              |       |
| TOTAL ASSETS                                                                                       |       | $                  | 397,256,484 |                 | $          | 325,268,744 |   |
|                                                                                               |       |               |        |                 |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                     |       |               |        |                 |       |
| CURRENT  LIABILITIES:                                                                              |       |               |        |                 |       |
| Revolving line of credit                                                                           |       | $                  | 2,600,000   |                 | $          | — |   |
| Accounts payable                                                                                   |       | 26,978,335         |        | 16,523,755           |       |
| Accrued expenses                                                                                   |       | 19,188,428         |        | 16,315,163           |       |
| Accrued interest                                                                                   |       | 8,294,935          |        | 7,226,753            |       |
| Current portion of long-term debt                                                                  |       | 760,000            |        | —               |       |
| TOTAL CURRENT LIABILITIES                                                                          |       | 57,821,698         |        | 40,065,671           |       |
| LONG-TERM DEBT,  LESS CURRENT PORTION                                                              |       | 198,350,283        |        | 160,355,507          |       |
| DEFERRED INCOME  TAXES                                                                             |       | 65,596,632         |        | 50,677,332           |       |
| OTHER  LIABILITIES                                                                                 |       | 35,159,782         |        | 35,179,252           |       |
| STOCKHOLDERS’  EQUITY:                                                                        |       |               |        |                 |       |
| Common stock, Class A, $.01 par value, 1,000 shares authorized,  100 shares issued and outstanding |       | 1                  |        | 1                    |       |
| Capital in excess of par value                                                                     |       | 46,641,601         |        | 46,259,101           |       |
| Accumulated deficit                                                                                |       | (6,233,020         | )           | (6,192,366           | )          |
| Accumulated other comprehensive loss                                                               |       | (80,493            | )           | (1,075,754           | )          |
| TOTAL STOCKHOLDERS’ EQUITY                                                                    |       | 40,328,089         |        | 38,990,982           |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                    |       | $                  | 397,256,484 |                 | $          | 325,268,744 |   |

 

See accompanying notes toconsolidated financial statements.

5

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**CELLU TISSUE HOLDINGS, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS****(Unaudited)**
| ** **                                                                                 | ** ** | **For the Periods** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                 | ** ** | **Post - Merger**   | ** ** | **Pre-Merger** | ** ** |
| ** **                                                                                 | ** ** | **March 1, 2007-**  | ** ** | **June 13, 2006-** | ** ** | **March 1, 2006-** | ** ** |
| ** **                                                                                 | ** ** | **August 30, 2007** | ** ** | **August 24, 2006** | ** ** | **June 12, 2006** | ** ** |
| ** **                                                                                 |       |                          |       |   |   |   |   |
| **Cash  flows from operating activities**                                                  |       |                          |       |   |   |   |   |
| Net loss                                                                                   |       | $                             | (40,654    | ) | $ | (2,619,388 | ) | $ | (6,534,964 | ) |
| Adjustments to reconcile net loss to net cash provided  by (used in) operating activities: |       |                          |       |   |   |   |   |
|  Noncash inventory charge                                                             |       | —                        |       | 909,264 |   | — |   |
| Stock-based compensation                                                                   |       | 382,500                       |       | 136,290 |   | 923,580 |   |
| Deferred income taxes                                                                      |       | (1,473,753                    | )          | (558,206 | ) | (396,024 | ) |
| Accretion of debt discount                                                                 |       | 304,776                       |       | 59,994 |   | 85,471 |   |
| Amortization of intangibles                                                                |       | —                        |       | — |   | 405,568 |   |
| Depreciation                                                                               |       | 12,194,748                    |       | 4,515,763 |   | 4,226,643 |   |
| Changes in operating assets and liabilities:                                               |       |                          |       |   |   |   |   |
| Receivables                                                                                |       | (3,565,303                    | )          | 2,998,825 |   | (1,994,674 | ) |
| Inventories                                                                                |       | 406,347                       |       | 2,185,566 |   | (2,208,757 | ) |
| Prepaid expenses, other current assets and income  tax receivable                          |       | (2,128,067                    | )          | 177,486 |   | (683,329 | ) |
| Other                                                                                      |       | 458,540                       |       | (15,410 | ) | (5,328 | ) |
| Accounts payable, accrued expenses and accrued  interest                                   |       | 6,685,112                     |       | (2,139,598 | ) | (358,006 | ) |
| Total adjustments                                                                          |       | 13,264,900                    |       | 8,269,974 |   | (4,856 | ) |
| *Net cash provided by (used in) operating  activities*                                     |       | 13,224,246                    |       | 5,650,586 |   | (6,539,820 | ) |
|                                                                                       |       |                          |       |   |   |   |   |
| **Cash  flows from investing activities**                                                  |       |                          |       |   |   |   |   |
| Cash paid for acquisition, net of cash received                                            |       | (43,617,819                   | )          |   |   |   |   |
| Equity investment by Weston Presidio                                                       |       | —                        |       | 45,761,997 |   | — |   |
| Capital expenditures, net                                                                  |       | (6,940,787                    | )          | (1,884,457 | ) | (1,937,610 | ) |
| *Net  cash (used in) provided by investing activities*                                     |       | (50,558,606                   | )          | 43,877,540 |   | (1,937,610 | ) |
|                                                                                            |            |                               |            |  |  |  |  |  |  |  |

 

6

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| ** **                                              | ** ** | **For the Periods** | ** ** |
|---------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                              | ** ** | **Post - Merger**   | ** ** | **Pre-Merger** | ** ** |
| ** **                                              | ** ** | **March 1, 2007-**  | ** ** | **June 13, 2006-** | ** ** | **March 1, 2006-** | ** ** |
| ** **                                              | ** ** | **August 30, 2007** | ** ** | **August 24, 2006** | ** ** | **June 12, 2006** | ** ** |
| ** **                                              |       |                          |       |   |   |   |   |
| **Cash  flows from financing activities**               |       |                          |       |   |   |   |   |
| Merger consideration paid to former shareholders        |       | —                        |       | (45,761,997 | ) | — |   |
| Payments of long-term debt                              |       | —                        |       | — |   | (290,000 | ) |
| Borrowings on revolving line of credit,net              |       | 2,600,000                     |       | — |   | — |   |
| Proceeds from bond offering                             |       | 20,000,000                    |       | — |   | — |   |
| *Net cash provided by (used in) financing  activities*  |       | 22,600,000                    |       | (45,761,997 | ) | (290,000 | ) |
|                                                    |       |                          |       |   |   |   |   |
| Effect of  foreign currency                             |       | 809,065                       |       | (48,535 | ) | 362,212 |   |
| *Net  (decrease) increase in cash and cash equivalents* |       | (13,925,295                   | )          | 3,717,594 |   | (8,405,218 | ) |
| *Cash  and cash equivalents at beginning of period*     |       | 16,260,601                    |       | 14,418,844 |   | 22,824,062 |   |
| *Cash  and cash equivalents at end of period*           |       | $                             | 2,335,306  |   | $ | 18,136,438 |   | $ | 14,418,844 |   |
|                                                         |            |                               |            |  |  |  |  |  |  |  |

 

*See accompanying notes toconsolidated financial statements.*

7

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated FinancialStatements (Unaudited)**

**August30, 2007**

**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.  The Company is a wholly owned subsidiary ofCellu 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 andcash flows for the prior year are presented in the accompanying financialstatements on a pre-merger (period from May 26, 2006 to June 12, 2006 and periodfrom March 1, 2006 to June 12, 2006) and post-merger (period from June 13, 2006to August 24, 2006) basis.  The currentyear operating results and cash flows are post-merger.

 These statements have been prepared inaccordance with U.S. generally accepted accounting principles for interimfinancial information and with the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by U.S. generallyaccepted accounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the quarter and six months ended August 30, 2007are not necessarily indicative of the results that may be expected for the fiscalyear ending February 29, 2008.  Forfurther information, refer to the Company’s consolidated financial statementsand footnotes thereto as of February 28, 2007 and for the year then endedcontained in the Company’s Annual Report on Form 10-K, from which the consolidatedbalance sheet at February 28, 2007 has been derived and the Company’s latestCurrent Reports on Form 8-K as filed with the Securities and ExchangeCommission (“SEC”).

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

8

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adjustments in theCompany’s consolidated financial statements for all periods subsequent to theMerger date (“Push Down Accounting”). Push Down Accounting requires the Company to establish a new basis forits assets and liabilities based on the amount paid for its equity at close ofbusiness on June 12, 2006.  Accordingly,Cellu Parent’s ownership basis is reflected in the Company’s consolidatedfinancial statements beginning upon completion of the Merger.  In order to apply Push Down Accounting, CelluParent’s purchase price of $207.8 million, including assumption of $162.0million in aggregate principal amount of the Company’s outstanding 9.75% seniorsecured notes (the “Notes”), was allocated to the assets and liabilities basedon their relative fair values.  Thepurchase price is subject to adjustment for certain tax benefits that theCompany may realize.  In addition, totalconsideration is subject to adjustment for up to an additional $35.0 million incontingent earnout consideration based upon the achievement of certainfinancial targets.  If any portion of theearned contingent payments is unable to be made, then Weston Presidio has agreedto provide the necessary funds to former holders of the Parent’s capital stock,options and warrants through an equity investment in Parent or otherwise.  In accordance with SFAS 141, the $35.0million has been recognized as a liability in the Company’s balance sheet and isrecorded in other liabilities as of August 30, 2007.

The Company has allocatedthe excess purchase price over the net assets acquired in the Merger based onits estimates of the fair value of assets and liabilities as follows:
|                                | ** ** | **Excess purchase price allocated to:** | ** ** |
|--------------------------------|------------|-------------------------------------------------------------|------------|
| Inventories                    |       | $                                                           | 909,264    |   |
| Property, plant  and equipment |       | 142,292,525                                                 |       |
| Trademarks                     |       | 6,550,314                                                   |       |
| Long-term debt                 |       | (900,729                                                    | )          |
| Contingent  consideration      |       | (35,000,000                                                 | )          |
| Deferred income  taxes         |       | (50,830,323                                                 | )          |
| Total                          |       | $                                                           | 63,021,051 |   |

 

In conjunction with thevaluation of the Company’s fixed assets, the lives over which the assets aredepreciated were re-evaluated and the resulting estimated useful lives of theprincipal classifications of depreciable assets are as follows:
|                             | ** ** | **Life in Years** | ** ** |
|-----------------------------|------------|-----------------------------|------------|
| Buildings and  improvements |       | 20-30                       |       |
| Machinery and  equipment    |       | 15-30                       |       |
| Furniture and  fixtures     |       | 10                          |       |
| Land  improvements          |       | 5                           |       |
| Computer software           |       | 5                           |       |

 

9

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Reclassification

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

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 to participate in the Plan.   Stock options are granted at the marketprice of the Company’s stock on the date of grant and have a 10-year term.  Generally, stock option grants vest ratablyover four years from the date of grant. The following describes how certain assumptions affecting the estimatedfair value of stock options are determined. The dividend yield is zero; the volatility is based on historical marketvalue of the Company’s stock; and the risk-free interest rate is based on U.S.Treasury securities with

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maturities equal to theexpected life of the option.  The Companyuses historical data in order to estimate exercise, termination and holdingperiod behavior for valuation purposes. A summary of the outstanding options as of August 30, 2007 is asfollows:  There was no activity duringthe three months then ended.
|                                                | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** **                         |
|------------------------------------------------|------------|-------------|------------|--------------------------------------------|------------|-------------------------------------------------------------|------------------------------------|
| Outstanding,  June 1, 2007 and August 30, 2007 |       | 1,150       |       | $                                          | 726.99     |                                                        | 9.53  and 9.28 years, respectively |   |
| Exercisable, August 30,  2007                  |       | —      |       | —                                     |       | —                                                      |                               |
|                                                |            |             |            |                                            |            |                                                             |                                    |  |

 

The fair value of thestock option grant was estimated on the date of grant using the Black-Scholesoption pricing model.  The weightedaverage assumptions used to value the grants were no dividend yield; 57%volatility; 4.9% risk free interest rate; and 10-year expected life.  The weighted average fair value of stockoptions granted was $472.69 per share and the unrecognized total compensationcost as of August 30, 2007 related to nonvested awards is $473,352.

On August 6, 2007, CelluParent entered into a Restricted Stock Agreement with the Company’s newlyappointed Chief Financial Officer, pursuant to which Cellu Parent granted 700restricted shares of its common stock to the named individual pursuant to thePlan.  The shares will vest and cease tobe restricted in four equal annual installments commencing on August 6, 2007,as long as the named individual is continuously employed by the Company untilsuch vesting date with respect to his shares. Any restricted stock outstanding at the time of a Covered Transaction(as defined in the Plan) shall become vested and cease to be restricted stockat the time of a change in control. Additionally, the Parent has agreed to pay an amount to the namedindividual equal to an amount that would be included in such individual’s grossincome and payable as income tax as a result of making a Section 83(b) electionunder the Internal Revenue Code of 1986, as amended.  The named individual has made a timelySection 83(b) election.

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

11

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2007,as long as the named individual, as the case may be, is continuously employedby the Company until each such vesting date with respect to his or hershares.  Any restricted stock outstandingat the time of a Covered Transaction (as defined in the Plan) shall becomevested and cease to be restricted stock at the time of a change incontrol.  Additionally, the Parent hasagreed to pay an amount to the named individuals equal to an amount that wouldbe included in such individuals’ gross income and payable as income tax as aresult of making a Section 83(b) election under the Internal Revenue Code of1986, as amended.  All named individualshave made a timely Section 83(b) election.

EffectiveJuly 31, 2007, the then Chief Financial Officer resigned and forfeited 2/3 ofthe restricted stock grant, and accordingly, the Company only recordedcompensation expense associated with this individual’s grant through June 12,2007 as all other shares were forfeited and no compensation expense is requiredto be recognized for forfeited shares.

Forthe three months ended August 30, 2007, the Company has recorded $152,822 ofcompensation expense related to the above restricted stock grants.  For the period from June 13, 2006 to August24, 2006, the Company has recorded $136,290 of compensation expense related tothe vesting of the grants at that time in accordance with SFAS 123R.

Immediatelyprior to consummation of the Merger, there were 341.3 restricted shares of theParent’s common stock.  In accordancewith the terms 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.

Derivativesand Hedging

TheCompany uses derivative financial instruments to offset a substantial portionof its exposure to market risk arising from changes in the price of naturalgas.  Hedging of this risk isaccomplished by entering into forward swap contracts, which are designated ashedges of specific quantities of natural gas expected to be purchased in futuremonths.  These contracts are held forpurposes other than trading and are designated as cash flow hedges.  The Company measures hedge effectiveness byformally assessing, at least quarterly, the correlation of the expected futurecash flows of the hedged item and the derivative hedging instrument.  The ineffective portions of the hedges, whichare not material for any period presented, are immediately recognized inearnings.  The fair value of these cashflow hedging instruments was a liability of $.6 million and an asset of lessthan $.1 million as of August 30, 2007 and February 28, 2007, respectively.  During the next 12 months, the entire$.6 million will be reclassified to earnings consistent with the timing of theunderlying hedged transactions.

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**Note 2 Inventories**

Components of inventoriesare as follows:
|                                   | ** ** | **August 30, 2007** | ** ** | **February 28, 2007** | ** ** |
|-----------------------------------|------------|-------------------------------|------------|---------------------------------|------------|
|                              |       |                          |       |                            |       |
| Finished goods                    |       | $                             | 17,017,370 |                            | $          | 18,896,790 |   |
| Raw materials                     |       | 4,858,104                     |       | 2,742,025                       |       |
| Packaging  materials and supplies |       | 9,082,168                     |       | 8,098,582                       |       |
|                              |       | 30,957,642                    |       | 29,737,397                      |       |
| Inventory  reserves               |       | (214,747                      | )          | (133,588                        | )          |
|                              |       | $                             | 30,742,895 |                            | $          | 29,603,809 |   |

 

**Note 3 Acquisitions**

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

The Acquisition has beenaccounted for as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statements of operations includes the results ofCityForest during the three months and six months ended August 30, 2007 fromthe date of acquisition.  Purchase priceallocations are subject to refinement until all pertinent information isobtained.  The Company has allocated theexcess of purchase price over the net assets acquired in the acquisition basedon its estimates of the fair value of assets and liabilities as follows:

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|                                | ** ** | **Excess purchase price allocated to:** | ** ** |
|--------------------------------|------------|-------------------------------------------------------------|------------|
| Property, plant  and equipment |       | $                                                           | 32,874,272 |   |
| Trademarks                     |       | 2,200,000                                                   |       |
| Goodwill                       |       | 6,924,559                                                   |       |
| Long-term debt                 |       | (1,724,684                                                  | )          |
| Deferred income  taxes         |       | (17,238,509                                                 | )          |
| Total                          |       | $                                                           | 23,035,638 |   |

 

The Company hasestimated the fair value of the assets and liabilities of the Acquisition,utilizing information available at the time the Company’s unaudited interimfinancial statements subsequent to the Acquisition were prepared, and theseestimates are subject to refinement until all pertinent information has beenobtained. At that time, the Company was in the process of obtaining outsidethird-party appraisals of its tangible and intangible assets and had assumed nointangible assets or goodwill arising from the acquisition.  In the second quarter of the fiscal year endingFebruary 29, 2008 (“fiscal year 2008”), the Company obtained a third-partyappraisal of CityForest’s tangible and intangible assets and has finalized itscalculation of deferred income taxes resulting from the book to tax differencesarising from the application of purchase accounting.  As a result thereof, trademarks of $2.2million and goodwill of $6.9 million have been recorded.  Furthermore, the net deferred income taxliability has increased $4.2 million from the Company’s original estimate.

The results ofCityForest’s operations from the date of acquisition (March 21, 2007) areincluded in the Company’s tissue segment and accordingly, are included for thethree months ended August 30, 2007.  Unauditedpro forma results of operations for the periods June 13, 2006-August 24, 2006and May 26, 2006-June 12, 2006, for the six months ended August 30, 2007, forthe period June 13, 2006-August 24, 2006 and for the period March 1, 2006-June12, 2006, as if the Company and CityForest had been combined as of March 1,2006, are presented below.  The pro formaresults include estimates and assumptions, which the Company’s managementbelieves are reasonable.  However, thepro forma results do not include any cost savings or other effects of the plannedintegration of CityForest and are not necessarily indicative of the resultswhich would have occurred if the business combination had been in effect on thedates indicated, or which may result in the future.

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| ** **               | ** ** | **June 13, 2006-August 24, 2006 (1)** | ** ** | **May 26, 2006 – June 12, 2006 (1)** | ** ** |
|--------------------------|------------|----------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **               | ** ** | **As Filed**                                              | ** ** | **Pro Forma**                                                           | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **               | ** ** | **(in thousands)**                                        | ** ** | **(in thousands)**                                                      | ** ** |
| Net sales                |       | $                                                              | 68,562     |                                                                         | $          | 78,146 |   | $ | 15,600 |   | $ | 17,802 |   |
| Operating (loss)  income |       | $                                                              | (913       | )                                                                            | $          | 1,715 |   | $ | (6,906 | ) | $ | (6,302 | ) |
| Net loss                 |       | $                                                              | (2,619     | )                                                                            | $          | (661 | ) | $ | (6,059 | ) | $ | (5,609 | ) |

 

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(1)Proforma operating results include the operating results for CityForest for thethree months ended June 30, 2006, prorated between the two reporting periodspresented for the Company,  as CityForestwas previously a calendar year-end company.
| ** **        | ** ** | **Six Months Ended August 30,2007(1)** | ** ** | **June 13, 2006-August 24, 2006 (2)** | ** ** | **March 1, 2006-June 12, 2006 (2)** | ** ** |
|-------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **        | ** ** | **As Filed**                                          | ** ** | **Pro Forma**                                             | ** ** | **As Filed**                                            | ** ** | **Pro Forma** | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(in thousands)**                                    | ** ** | **(in thousands)**                                        | ** ** | **(in thousands)**                                      | ** ** |
| Net sales         |       | $                                                          | 212,201    |                                                           | $          | 214,911                                                      |       | $ | 68,562 |   | $ | 78,146 |   | $ | 94,242 |   | $ | 107,644 |   |
| Operating income  |       | $                                                          | 10,637     |                                                           | $          | 11,223                                                       |       | $ | (913 | ) | $ | 1,715 |   | $ | (3,330 | ) | $ | (266 | ) |
| Net (loss) income |       | $                                                          | (41        | )                                                              | $          | 520                                                          |       | $ | (2,619 | ) | $ | (661 | ) | $ | (6,535 | ) | $ | (4,344 | ) |

 

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(1) Pro forma operating results include theoperating results for CityForest for the six months ended August 30, 2007. The “asfiled” operating results include the operating results for CityForest for theperiod from the acquisition date (March 21, 2007) to August 30, 2007.

(2)  Pro formaoperating results include the operating results for CityForest for the sixmonths ended June 30, 2006, prorated between the two reporting periodspresented for the Company, as CityForest was previously a calendar year-endcompany.

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**Note 4 Long-Term Debt**

Long-term debt consistsof the following:
|                                                                                                           | ** ** | **August 30, 2007** | ** **  | **February 28, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-------------------------------|-------------|---------------------------------|------------|
|  9 3⁄4%  senior secured notes due 2010                                                            |       | $                             | 182,255,572 |                            | $          | 162,000,000 |   |
| Less discount                                                                                             |       | (1,595,289                    | )           | (1,644,493                      | )          |
|                                                                                                      |       | 180,660,283                   |        | 160,355,507                     |       |
| Industrial  revenue bond payable, in semi-annual installments, plus variable interest,  due March 1, 2008 |       | 18,450,000                    |        | —                          |       |
|                                                                                                      |       | 199,110,283                   |        | 160,355,507                     |       |
| Less current  portion of debt                                                                             |       | 760,000                       |        | —                          |       |
|                                                                                                      |       | $                             | 198,350,283 |                            | $          | 160,355,507 |   |

 

In connection with theAcquisition (see Note 3), the Company entered into a Note Purchase Agreement(the “Note Purchase Agreement”) with Wingate Capital Ltd. (“Wingate”), datedMarch 21, 2007, pursuant to which it issued and sold $20.3 million aggregateprincipal amount of Additional Notes to Wingate for the purchase price of $20.0million, which is equal to 98.7383% of the aggregate principal amount of theAdditional Notes. The Additional Notes were issued pursuant to and will begoverned by the Indenture, dated as of March 12, 2004 (as amended andsupplemented, the “Cellu Tissue Indenture”) among the Company, the subsidiaryguarantors party thereto and The Bank of New York Trust Company, N.A., assuccessor trustee to the Bank of New York (the “Trustee”).

The Notes and AdditionalNotes mature on March 15, 2010 and require semi-annual interest payments onMarch 15 and September 15, which commenced on September 15, 2004.  The Notes and Additional Notes arecollateralized by a senior secured interest in substantially all of the Company’sassets.  Terms of the indenture underwhich the Notes and Additional Notes have been issued contain certaincovenants, including limitations on certain restricted payments and theincurrence of additional indebtedness. The Notes and Additional Notes are unconditionally guaranteed by all ofthe Company’s subsidiaries.

In connection with theMerger (see Note 1), the Company solicited consents with respect to theNotes.  Consents were received withrespect to 100% of the aggregate outstanding principal amount of the Notes. TheCompany accepted all of the consents delivered in the consent solicitation andpaid to the consenting noteholders a consent fee of $40 per $1,000 principalamount of Notes for which they delivered consents.  These payments were made in the Company’ssecond quarter of the fiscal year ended February 28, 2007

16

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

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, JPMorgan Chase Bank, N.A., Toronto Branch, as Canadian AdministrativeAgent, and the other lenders party thereto. The Credit Agreement provides for a $35.0 million working capitalfacility, including a letter of credit sub-facility and swing-line loansub-facility. The Credit Agreement provides that amounts under the facility maybe borrowed, repaid and re-borrowed, subject to a borrowing base test, untilthe maturity date, which is June 12, 2011. An amount equal to $32.0 million isavailable, in U.S. dollars, to the U.S. Borrower under the facility, and anamount equal to $3.0 million is available, in U.S. or Canadian dollars, to theCanadian Borrower under the facility. Borrowings of $17.4 million were made to finance a portion of theAcquisition.  As of August 30, 2007, $2.6million of borrowings remained outstanding under the working capital facility.

In addition to the NotePurchase Agreement, the following agreements were entered into in connectionwith the Acquisition:

***SecondSupplemental Indenture***

The Company, certain ofits subsidiaries, the Trustee and CityForest have executed the SecondSupplemental Indenture, dated March 21, 2007 (the “Second SupplementalIndenture”), pursuant to which CityForest became a party to the Cellu TissueIndenture as a subsidiary guarantor.  Asa subsidiary guarantor, CityForest, on a joint and several basis with all theexisting subsidiary guarantors, fully, unconditionally and irrevocablyguarantees to each holder of the Notes and the Trustee the obligations ofCompany under its Indenture and the Notes.

***Amendmentto Credit Agreement***

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

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

The Amendment (1)increases the working capital facility from $35.0 million to $40.0 million, (2)permits the issuance and sale by the Company of the Additional Notes, (3)provides for the consummation of the Acquisition and the conversion byCityForest from a Minnesota corporation to a Minnesota limited liabilitycompany, (4) permits the assumption of approximately $18.4 million inaggregate principal amount of indebtedness of CityForest in connection with theAcquisition in accordance with the terms of the CityForest Bond Documents (asdefined below under “CityForest Bond Documents”), and (5) permits the guaranteeby Cellu Tissue of certain obligations of CityForest under the CityForest BondDocuments.  In connection with theAmendment, CityForest became a guarantor of the obligations of the borrowersunder the Amended Credit Agreement.

***CityForestBond Documents***

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

The Bonds Trustee ispermitted to draw upon the Associated Bank Letter of Credit to pay principaland interest due on the Bonds, and to provide liquidity to purchase Bonds putto CityForest by bondholders and not remarketed; and CityForest is obligatedunder the Reimbursement Agreement to reimburse Associated Bank for any suchdraws. CityForest

18

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is also obligated to paya fee in respect of the aggregate amount available to be drawn under theAssociated Bank Letter of Credit at a rate per annum initially equal to 1.25%,subject to adjustment on a quarterly basis based on CityForest’s leverage.  The expiration date of the Associated BankLetter of Credit is February 15, 2011.

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

*The Reimbursement Agreement requires scheduled semi-annual payments ofprincipal of the Bonds equal to approximately 2.00% of the principal amountoutstanding as of the date of the Acquisition, with the balance payable atmaturity of the Bonds on March 1, 2028. The Reimbursement Agreement alsocontains a number of other provisions regarding reserve funds and othermandatory and optional repayments in connection with the Bonds.  In addition, the Reimbursement Agreementprovides that in certain circumstances where the Company incurs indebtedness,as defined, in excess of amounts currently permitted under the CityForestIndenture or refinances the indebtedness issued under the Indenture, AssociatedBank may require CityForest to repay all of its obligations to Associated Bankunder the Reimbursement Agreement and either to cause the Bonds to be redeemedor to replace the Associated Bank Letter of Credit with a Substitute CreditFacility, as such term is defined in the CityForest Indenture.*

The ReimbursementAgreement contains various affirmative and negative covenants customary forworking capital and term credit facilities, as well as additional covenantsrelating to the Bonds.  The negativecovenants include limitations on: indebtedness; liens; acquisitions, mergersand consolidations; investments; guarantees; asset sales; sale and leasebacktransactions; dividends and distributions; transactions with affiliates;capital expenditures; and changes to the status of the Bonds. CityForest isalso required to

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comply on a quarterlybasis with a maximum leverage covenant and a minimum fixed charge coveragecovenant.

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

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

**Note 5 Comprehensive Income (Loss)**

The components ofcomprehensive income (loss) for the three months ended August 30, 2007 and forthe periods from June 13, 2006 to August 24, 2006 and May 26, 2006 to June 12,2006 are as follows:
| ** **                                | ** ** | ** **                                                  | ** ** | **For the Periods**                           | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                | ** ** | **Three Months Ended  August 30, 2007** | ** ** | **June 13, 2006-  August 24, 2006** | ** ** | **May 26, 2006-  June 12, 2006** | ** ** |
| ** **                                | ** ** | **(Post-Merger)**                                           | ** ** | **(Pre-Merger)**                                        | ** ** |
| Net income  (loss)                        |       | $                                                           | 1,069,830  |                                                    | $          | (2,619,388 | ) | $ | (6,059,312 | ) |
| Foreign currency  translation adjustments |       | 370,020                                                     |       | (48,535                                                 | )          | 41,139 |   |
| Derivative loss                           |       | (643,300                                                    | )          | (154,672                                                | )          | — |   |
| Comprehensive income  (loss)              |       | $                                                           | 796,550    |                                                    | $          | (2,822,595 | ) | $ | (6,018,173 | ) |

 

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The components ofcomprehensive income (loss) for the six months ended August 30, 2007 and forthe periods from June 13, 2006 to August 24, 2006 and March 1, 2006 to June 12,2006 are as follows:
| ** **                                | ** ** | **Six Months Ended  August 30, 2007** | ** ** | **June 13, 2006-  August 24, 2006** | ** ** | **March 1, 2006-  June 12, 2006** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                | ** ** | **(Post-Merger)**                                         | ** ** | **(Pre-Merger)**                                        | ** ** |
| Net loss                                  |       | $                                                         | (40,654    | )                                                       | $          | (2,619,388                                            | )          | $ | (6,534,964 | ) |
| Foreign currency  translation adjustments |       | 809,065                                                   |       | (48,535                                                 | )          | 362,212                                               |       |
| Derivative loss                           |       | (633,170                                                  | )          | (154,672                                                | )          | —                                                |       |
| Comprehensive income  (loss)              |       | $                                                         | 135,241    |                                                    | $          | (2,822,595                                            | )          | $ | (6,172,752 | ) |

 

**Note 6 Business Segments**

The Company operates intwo reportable business segments:  tissueand machine-glazed paper.  The Companyassesses the performance of its reportable business segments using income fromoperations.  Income from operationsexcludes interest income, interest expense, other income (expense), income taxexpense (benefit) and the impact of foreign currency gains and losses.   A portion of corporate and shared expensesis allocated to each segment.  Includedin loss from operations for the period May 26, 2006 to June 12, 2006 is $5,806,058of merger-related transaction costs.  Ofthis amount, $3,773,938 impacts the tissue segment and $2,032,120 impacts themachine-glazed paper segment.  Includedin loss from operations for the period June 13, 2006 to August 24, 2006 is$102,375 of merger-related transaction costs, $240,218 of restructuring costs,$909,264 for a non-cash charge to cost of goods sold related to excess purchaseprice allocated to inventory and $1,518,430 of additional depreciation expenserelated to excess purchase price allocated to property, plant andequipment.  Of these amounts, $66,544,$156,142, $591,022 and $986,980, respectively, impacts the tissue segment and $35,831,$84,076, $318,242 and $531,450, respectively, impacts the machine-glazed papersegment. Also, included in loss from operations for the periods June 13, 2006to August 24, 2006 and May 26, 2006 to June 12, 2006 is compensation charges of$2,687,092 and $397,279, respectively, related to non-cash compensation expenserelated to the vesting of restricted stock awards, payments of taxes associatedwith such awards and other compensation expense related to the Merger.  Of theses amounts, $1,746,610 and $258,231,respectively, impacts the tissue segment and $940,482 and $139,048,respectively, impacts the machine-glazed segment.  Segment information for the three monthsended August 30, 2007 and for the periods June 13, 2006 to August 24, 2006 and May26, 2006 to June 12, 2006 follows:

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| ** **                                    | ** ** | **(Post-Merger)**                                           | ** **  | **(Pre-Merger)**                                        | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------------------|-------------|---------------------------------------------------------|------------|
| ** **                                    | ** ** | **Three Months Ended  August 30, 2007** | ** **  | **June 13, 2006-  August 24, 2006** | ** ** | **May 26, 2006-  June 12, 2006** | ** ** |
| ** **                                    | ** ** | ** **                                                  | ** **  | ** **                                              | ** ** | ** ** | ** ** |
| **Net  Sales**                                |       |                                                        |        |                                                    |       |   |   |
| Tissue                                        |       | $                                                           | 83,494,959  |                                                    | $          | 49,024,665 |   | $ | 11,870,989 |   |
| Machine-glazed  paper                         |       | 25,505,362                                                  |        | 19,537,721                                              |       | 3,728,966 |   |
| Consolidated                                  |       | $                                                           | 109,000,321 |                                                    | $          | 68,562,386 |   | $ | 15,599,955 |   |
|                                          |       |                                                        |        |                                                    |       |   |   |
| **Income  (loss) from operations**            |       |                                                        |        |                                                    |       |   |   |
| Tissue                                        |       | $                                                           | 6,383,420   |                                                    | $          | (119,515 | ) | $ | (4,149,980 | ) |
| Machine-glazed  paper                         |       | 676,922                                                     |        | (793,115                                                | )          | (2,756,338 | ) |
| Consolidated                                  |       | 7,060,342                                                   |        | (912,630                                                | )          | (6,906,318 | ) |
| Interest expense                              |       | (5,146,223                                                  | )           | (3,224,321                                              | )          | (865,095 | ) |
| Net foreign  currency transaction (loss) gain |       | (196,110                                                    | )           | 66,676                                                  |       | (83,510 | ) |
| Interest income                               |       | 43,557                                                      |        | 71,785                                                  |       | 21,465 |   |
| Other income                                  |       | 40,261                                                      |        | 17,453                                                  |       | 1,657 |   |
| Pretax income  (loss)                         |       | $                                                           | 1,801,827   |                                                    | $          | (3,981,037 | ) | $ | (7,831,801 | ) |
|                                          |       |                                                        |        |                                                    |       |   |   |
| **Capital  Expenditures**                     |       |                                                        |        |                                                    |       |   |   |
| Tissue                                        |       | $                                                           | 3,338,578   |                                                    | $          | 1,198,562 |   | $ | 42,068 |   |
| Machine-glazed  paper                         |       | 718,584                                                     |        | 304,582                                                 |       | 94,618 |   |
| Corporate                                     |       | 237,279                                                     |        | 381,313                                                 |       | 118,359 |   |
| Consolidated                                  |       | $                                                           | 4,294,441   |                                                    | $          | 1,884,457 |   | $ | 255,045 |   |
| ** **                                    |       |                                                        |        |                                                    |       |   |   |
| **Depreciation**                              |       |                                                        |        |                                                    |       |   |   |
| Tissue                                        |       | $                                                           | 4,154,703   |                                                    | $          | 3,190,553 |   | $ | 492,758 |   |
| Machine-glazed  paper                         |       | 1,361,900                                                   |        | 1,325,210                                               |       | 199,410 |   |
|                                          |       | $                                                           | 5,516,603   |                                                    | $          | 4,515,763 |   | $ | 692,168 |   |

 

Segment information forthe six months ended August 30, 2007 and for the periods June 13, 2006 toAugust 24, 2006 and March 1, 2006 to June 12, 2006 follows:

22

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| ** **                                    | ** ** | **(Post-Merger)**                                         | ** **  | **(Pre-Merger)**                                        | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------|-------------|---------------------------------------------------------|------------|
| ** **                                    | ** ** | **Six Months Ended  August 30, 2007** | ** **  | **June 13, 2006-  August 24, 2006** | ** ** | **March 1, 2006-  June 12, 2006** | ** ** |
| **Net  Sales**                                |       |                                                      |        |                                                    |       |   |   |
| Tissue                                        |       | $                                                         | 161,130,856 |                                                    | $          | 49,024,665 |   | $ | 67,199,611 |   |
| Machine-glazed  paper                         |       | 51,070,251                                                |        | 19,537,721                                              |       | 27,042,321 |   |
| Consolidated                                  |       | $                                                         | 212,201,107 |                                                    | $          | 68,562,386 |   | $ | 94,241,932 |   |
|                                          |       |                                                      |        |                                                    |       |   |   |
| **Income  (loss) from operations**            |       |                                                      |        |                                                    |       |   |   |
| Tissue                                        |       | $                                                         | 10,466,397  |                                                    | $          | (119,515 | ) | $ | (1,210,487 | ) |
| Machine-glazed  paper                         |       | 170,207                                                   |        | (793,115                                                | )          | (2,119,523 | ) |
| Consolidated                                  |       | 10, 636,604                                               |        | (912,630                                                | )          | (3,330,010 | ) |
| Interest expense                              |       | (10,184,898                                               | )           | (3,224,321                                              | )          | (5,000,732 | ) |
| Net foreign  currency transaction gain (loss) |       | (520,408                                                  | )           | 66,676                                                  |       | (289,010 | ) |
| Interest income                               |       | 63,138                                                    |        | 71,785                                                  |       | 104,377 |   |
| Other income                                  |       | 82,500                                                    |        | 17,453                                                  |       | 27,049 |   |
| Pretax income  (loss)                         |       | $                                                         | 76,936      |                                                    | $          | (3,981,037 | ) | $ | (8,488,326 | ) |
|                                          |       |                                                      |        |                                                    |       |   |   |
| **Capital  Expenditures**                     |       |                                                      |        |                                                    |       |   |   |
| Tissue                                        |       | $                                                         | 5,579,729   |                                                    | $          | 1,198,562 |   | $ | 711,857 |   |
| Machine-glazed  paper                         |       | 971,235                                                   |        | 304,582                                                 |       | 236,288 |   |
| Corporate                                     |       | 389,823                                                   |        | 381,313                                                 |       | 989,465 |   |
| Consolidated                                  |       | $                                                         | 6,940,787   |                                                    | $          | 1,884,457 |   | $ | 1,937,610 |   |
| ** **                                    |       |                                                      |        |                                                    |       |   |   |
| **Depreciation**                              |       |                                                      |        |                                                    |       |   |   |
| Tissue                                        |       | $                                                         | 9,156,870   |                                                    | $          | 3,190,553 |   | $ | 3,056,653 |   |
| Machine-glazed  paper                         |       | 3,037,878                                                 |        | 1,325,210                                               |       | 1,169,990 |   |
|                                          |       | $                                                         | 12,194,748  |                                                    | $          | 4,515,763 |   | $ | 4,226,643 |   |

 
| ** **            | ** ** | **August 30, 2007** | ** **  | **February 28, 2007** | ** ** |
|-----------------------|------------|---------------------|-------------|-----------------------|------------|
| **Segment  assets**   | ** ** | ** **          |        |                  |       |
| Tissue                |       | $                   | 307,801,310 |                  | $          | 214,039,270 |   |
| Machine-glazed  paper |       | 82,734,671          |        | 79,277,799            |       |
| Corporate assets      |       | 6,720,503           |        | 31,951,675            |       |
| Consolidated          |       | $                   | 397,256,484 |                  | $          | 325,268,744 |   |

 

23

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**Note 7 Income taxes**

The effective income taxexpense for the three months ended August 30, 2007 was 40.6% compared to effectiveincome tax benefit of 34.20% and 22.6%, respectively, for the periods June 13,2006 to August 24, 2006 and May 26, 2006 to June 12, 2006.  The effective income tax expense for the sixmonths ended August 30, 2007 was 152.8% compared to an effective income taxbenefit of 34.20% and 23.0%, respectively, for the periods June 13, 2006 toAugust 24, 2006 and March 1, 2006 to June 12, 2006.  Included in the income tax expense for thethree months and six months ended August 30, 2007 is approximately $90,000related to additional Canadian income taxes paid upon completion of the Company’sfiscal year 2007 tax returns.  Theeffective tax expense for the three months and six months ended August 30,2007, without the effect of the additional Canadian income tax expense, was35.6% and 35.1%, respectively.   The effective tax rate for the periods May 26,2006 to June 12, 2006 and March 1, 2006 to June 12, 2006 differs from thefederal statutory rate primarily due to non-deductible transaction costsexpensed for book purposes.

The Company adoptedFinancial Accounting Standards Board (“FASB”) Interpretation 48, “*Accounting for Uncertainty in Income Taxes*” (“FIN 48”), atthe beginning of fiscal year 2008.  Theimplementation of FIN 48 did not have a material impact on the Company’sresults of operations and financial position. At August 30, 2007, the Company did not have any unrecognized taxbenefits.

The Company recognizesinterest and penalties related to uncertain tax positions in income taxexpense.  As of August 30, 2007, theCompany has accrued interest and penalties, if any, related to uncertain taxpositions.

The fiscal tax years 2003through 2007 remain open to examination by the major taxing jurisdictions towhich the Company is subject.  As ofAugust 30, 2007, the Company does not expect any material changes tounrecognized tax positions within the next 12 months.

**Note 8 Union Contract**

*In July 2005, the United Steelworkers of America, referredto as USW, (formerly the Paper, Allied –**Industrial,Chemical & Energy Workers International Union, referred to as PACE prior toPACE’s merger with and into USW)* was elected to represent84 hourly employees at our Mississippi facility, and was certified by theNational Labor Relations Board as the exclusive collective bargainingrepresentative of such employees.  OnJune 29, 2007, a collective bargaining agreement with USW was ratified.

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

 

**OVERVIEW**

Certain statementscontained in this Quarterly Report on Form 10-Q may contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities 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 prospectsinclude, 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, 2007.  These risks and uncertainties should beconsidered in evaluating any forward-looking statements contained herein.

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

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

**Merger**

On June 12, 2006 CelluPaper Holdings, Inc., our parent, consummated an Agreement and Plan of Mergerwith Cellu Parent, a corporation organized and controlled by Weston Presidio,and Cellu Acquisition Corporation, a wholly owned subsidiary of Cellu Parentand a newly formed corporation indirectly controlled by Weston Presidio, orMerger Sub.  Pursuant to the agreement,on June 12, 2006, Merger Sub was merged with and into our parent, with our parentsurviving (referred to herein as the Merger). Accordingly, the operating results and cash flows for the prior year arepresented in the accompanying

25

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financial statements on apre-merger (period from March 1, 2006 to June 12, 2006) and post-merger (periodfrom June 13, 2006-August 24, 2006) basis. The current year operating results and cash flows are post-merger.

We accounted for the Mergeras a purchase in accordance with the provisions of Statement of FinancialAccounting Standards No. 141, or SFAS 141, *Business Combinations*,which resulted in a new valuation for our assets and liabilities 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*, wehave reflected all applicable purchase accounting adjustments in our consolidatedfinancial statements for all periods subsequent to the Merger date (referred toherein as push down accounting).  Push downaccounting requires us to establish a new basis for our assets and liabilities basedon the amount paid for our equity at close of business on June 12, 2006.  Accordingly, Cellu Parent’s equity basis isreflected in our consolidated financial statements beginning upon completion ofthe Merger.

In order to apply pushdown accounting, Cellu Parent’s purchase price of $207.8 million (includingassumption of $162.0 million in aggregate principal amount of our outstanding9.75% senior secured notes), or the Notes, was allocated to the assets andliabilities based on their relative fair values.  The 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 30, 2007.

We have allocated theexcess purchase price over the net assets acquired in the Merger based on ourestimates of the fair value of assets and liabilities as follows:
|                                | ** ** | **Excess purchase  price allocated to:** | ** ** |
|--------------------------------|------------|---------------------------------------------------------|------------|
| Inventories                    |       | $                                                       | 909,264    |   |
| Property, plant  and equipment |       | 142,292,525                                             |       |
| Trademarks                     |       | 6,550,314                                               |       |
| Long-term debt                 |       | (900,729                                                | )          |
| Contingent  consideration      |       | (35,000,000                                             | )          |
| Deferred income  taxes         |       | (50,830,323                                             | )          |
| Total                          |       | $                                                       | 63,021,051 |   |

 

**Acquisition**

On March 21, 2007, weexecuted the Acquisition Agreement with CityForest, Cellu City Merger Sub andWayne Gullstad as the shareholders’ representative.  Pursuant to the

26

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Acquisition Agreement,and subject to the terms and conditions therein, Cellu City Merger Sub, awholly owned subsidiary of ours, merged with and into CityForest, withCityForest surviving and becoming our wholly owned subsidiary.  The aggregate merger consideration (includingassumption of $18.4 million in aggregate principal amount of industrial revenuebonds) was approximately $61.0 million subject to certain working capital andnet cash adjustments.  Total cash paidfor the acquisition of $46.8 million (purchase price of $61.0 million lessassumed indebtedness of $18.4 million plus restricted cash and othermiscellaneous adjustments of $1.6 million and acquisition costs of $2.6million), was financed in part by issuance of unregistered 9 3/4% SeniorSecured Notes due 2010 (the “Additional Notes”) of approximately $20.0 million,borrowings on a revolving line of credit ($17.4 million) and available cash onhand.

The Acquisition has beenaccounted for as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statements of operations includes the results ofCityForest during the three months and six months ended August 30, 2007 fromthe date of Acquisition.  Purchase priceallocations are subject to refinement until all pertinent information isobtained.  We have allocated the excessof purchase price over the net assets acquired in the acquisition based on ourestimates of the fair value of assets and liabilities as follows:
|                                | ** ** | **Excess purchase price allocated to:** | ** ** |
|--------------------------------|------------|-------------------------------------------------------------|------------|
| Property, plant  and equipment |       | $                                                           | 32,874,272 |   |
| Trademarks                     |       | 2,200,000                                                   |       |
| Goodwill                       |       | 6,924,559                                                   |       |
| Long-term debt                 |       | (1,724,684                                                  | )          |
| Deferred income  taxes         |       | (17,238,509                                                 | )          |
| Total                          |       | $                                                           | 23,035,638 |   |

 

We have estimatedthe fair value of the assets and liabilities of the Acquisition, utilizinginformation available at the time our unaudited interim financial statementssubsequent to the Acquisition were prepared, and these estimates are subject torefinement until all pertinent information has been obtained. At that time, wewere in the process of obtaining outside third-party appraisals of our tangibleand intangible assets and had assumed no intangible assets or goodwill arisingfrom the acquisition.  In the secondquarter of fiscal year 2008, we obtained a third-party appraisal of CityForest’stangible and intangible assets and have finalized the calculation of deferredincome taxes resulting from the book to tax differences arising from theapplication of purchase accounting.  As aresult thereof, trademarks of $2.2 million and goodwill of $6.9 million havebeen recorded.  Furthermore, the netdeferred income tax liability has increased $4.2 million from our originalestimate.

The results ofCityForest’s operations from the date of acquisition (March 21, 2007) are includedin our  tissue segment and accordingly,are included for the three months ended August 30, 2007.  Unaudited pro forma results of operations forthe periods June 13, 2006-August 24, 2006 and May 26, 2006-June 12, 2006, for thesix months ended August 30, 2007, for the periods June 13, 2006-August 24, 2006and March 1, 2006-June 12, 2006,

27

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as if we andCityForest had been combined as of March 1, 2006, are presented below.  The pro forma results include estimates andassumptions, which our management believes are reasonable.  However, the pro forma results do not includeany cost savings or other effects of the planned integration of CityForest andare not necessarily indicative of the results which would have occurred if thebusiness combination had been in effect on the dates indicated, or which mayresult in the future.
| ** **              | ** ** | **June 13, 2006-August 24, 2006 (1)** | ** ** | **May 26, 2006 – June 12, 2006 (1)** | ** ** |
|-------------------------|------------|----------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **              | ** ** | **As Filed**                                              | ** ** | **Pro Forma**                                                           | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **              | ** ** | **(in thousands)**                                        | ** ** | **(in thousands)**                                                      | ** ** |
| Net sales               |       | $                                                              | 68,562     |                                                                         | $          | 78,146 |   | $ | 15,600 |   | $ | 17,802 |   |
| Operating (loss) income |       | $                                                              | (913       | )                                                                            | $          | 1,715 |   | $ | (6,906 | ) | $ | (6,302 | ) |
| Net loss                |       | $                                                              | (2,619     | )                                                                            | $          | (661 | ) | $ | (6,059 | ) | $ | (5,609 | ) |

 

----

(1) Pro forma operating results include theoperating results for CityForest for the three months ended June 30, 2006,prorated between the two reporting periods presented for the Company,  as CityForest was previously a calendaryear-end company.
| ** **        | ** ** | **Six Months Ended August 30,2007(1)** | ** ** | **June 13, 2006-August 24, 2006 (2)** | ** ** | **March 1, 2006-June 12, 2006 (2)** | ** ** |
|-------------------|------------|------------------------------------------------------------|------------|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **        | ** ** | **As Filed**                                          | ** ** | **Pro Forma**                                             | ** ** | **As Filed**                                            | ** ** | **Pro Forma** | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(in thousands)**                                    | ** ** | **(in thousands)**                                        | ** ** | **(in thousands)**                                      | ** ** |
| Net sales         |       | $                                                          | 212,201    |                                                           | $          | 214,911                                                      |       | $ | 68,562 |   | $ | 78,146 |   | $ | 94,242 |   | $ | 107,644 |   |
| Operating income  |       | $                                                          | 10,637     |                                                           | $          | 11,223                                                       |       | $ | (913 | ) | $ | 1,715 |   | $ | (3,330 | ) | $ | (266 | ) |
| Net (loss) income |       | $                                                          | (41        | )                                                              | $          | 520                                                          |       | $ | (2,619 | ) | $ | (661 | ) | $ | (6,535 | ) | $ | (4,344 | ) |

 

----

(1) Pro forma operating results include theoperating results for CityForest for the six months ended August 30, 2007.  The “as filed” operating results include theoperating results for CityForest for the period from the acquisition date(March 21, 2007) to August 30, 2007.

(2)  Pro formaoperating results include the operating results for CityForest for the sixmonths ended June 30, 2006, prorated between the two reporting periodspresented for us,  as CityForest waspreviously a calendar year-end company.

**Union Contract**

*In July 2005, the United Steelworkers of America, referred to as USW,(formerly represented by the Paper, Allied –Industrial, Chemical & EnergyWorkers International Union, referred to as PACE prior to PACE’s merger withand into USW)* was elected to represent 84hourly employees at our Mississippi facility, and was certified by the NationalLabor Relations Board as the exclusive collective bargaining representative ofsuch employees.  On June 29, 2007, acollective bargaining agreement with USW was ratified.

28

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**RESULTS OF OPERATIONS**

The three months and six monthsended August 30, 2007 have been compared to the combined three months and six monthsended August 24, 2006 pre- and post-Merger for purposes of management’sdiscussion and analysis of the results of operations.  Any references below to the three months andsix months ended August 24, 2006 shall refer to the combined periods.  
| ** **                                    | ** ** | **Pre-Merger**              | ** ** | **Post-Merger**               | ** ** | **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                   |       | 3,778,374                     |       | 6,215,935                        |       |
| Stock and related  compensation expense       |       | —                      |       | 136,290                       |       | 136,290                          |       |
| 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-Merger**               | ** ** | **Post-Merger**               | ** ** | **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                     |       |
|                                          |       |                         |       |                          |       |                           |       |
| Selling, general and  administrative expenses |       | 5,584,865                    |       | 3,778,374                     |       | 9,363,239                      |       |
| Stock and related  compensation expense       |       | —                       |       | 136,290                       |       | 136,290                        |       |
| 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 | ) |

 

29

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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-Merger**              | ** ** | **Post-Merger**               | ** ** | **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-Merger**               | ** ** | **Post-Merger**               | ** ** | **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 |   |
|                 |       |                         |       |                          |       |                           |       |

 

**Results of Operations for theThree Months Ended August 30, 2007 (the Fiscal 2008 Three-Month Period)compared to the Three Months Ended August 24, 2006 (the Fiscal 2007 Three-MonthPeriod) and the Six Months Ended August 30, 2007 (the Fiscal 2008 Six-Month Period)compared to the Six Months ended August 24, 2006 (the Fiscal 2007 Six-Month Period)**

**Net sales** forthe fiscal 2008 three-month period increased $24.8 million, or 29.5%, to****$109.0 million from $84.2 million for the comparable periodin the prior year. Net sales for the fiscal 2008 six-month period increased $49.4million, or 30.3%, to $212.2 from $162.8 million for the comparable period inthe prior year.  On a company-wide basis,tons sold increased for the fiscal 2008 three-month period and the fiscal 2008 six-monthperiod compared to the comparable periods of fiscal 2007.  For the fiscal 2008 three-month period, wesold 80,151 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products, an increase of 15,311 tons, or 23.6%, compared to thefiscal 2007 three-month period.  For thefiscal 2008 six-month period, we sold 158,403 tons of tissue hard rolls,machine-glazed paper hard rolls and converted paper products, 

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an increase of 32,204tons, or 25.5%, compared to the fiscal 2007 six-month period.  Of the increase for the fiscal 2008three-month period, $11.2 million and 11,393 tons resulted from the acquisitionof CityForest.  Of the increase for thefiscal 2008 six-month period, $20.1 million and 20,534 tons resulted from theacquisition of CityForest.  Net sellingprice per ton increased from $1,298 and $1,290 for the fiscal 2007 three-monthand six-month periods to $1,360 and $1,340 for the fiscal 2008 three-month andsix-month periods.

Net sales for our tissuesegment for the fiscal 2008 three-month period were $83.5 million, an increaseof $22.6 million, or 37.1%, from the comparable period in the****prior year.  Netsales for our tissue segment for the fiscal 2008 six-month period were $161.1million, an increase of $44.9 million, or 38.6%, from the comparable period inthe prior year.  These increases areattributable to the acquisition of CityForest, an increase in tonnage sold, primarilyin our converting business, and an increase in net selling price per ton overthe comparable periods in the prior year.

Net sales for our machine-glazedsegment for the 2008 three-month period were****$25.5million, an increase of $2.2 million, or 9.6%,****fromthe comparable period in the prior year. Net sales for our machine-glazed segment for the 2008 six-month periodwere $51.1 million, an increase of $4.5 million, or 9.6%, from the comparableperiod in the prior year.   These increasesare driven primarily by an increase in net selling price per ton over thecomparable periods in the prior year.

**Gross profit**for the fiscal 2008 three-month period increased to $11.8 million from $4.7 million,an increase of $7.1 million, or 151.3%, from the comparable period in the prior****year. **  **As a percentage of net sales,gross profit increased to 10.8% in the fiscal 2008 three-month period from 5.6%in the fiscal 2007 three-month period.  Grossprofit for the fiscal 2008 six-month period increased to $20.1 million from $11.5million, an increase of $8.6 million, or 73.9%, from the comparable period inthe prior year. As a percentage of net sales, gross profit increased to 9.5% inthe fiscal 2008 six-month period from 7.1% in the fiscal 2007 six-month period.** **Theincreases in gross profit is attributable to continued improvement in productmix, lower manufacturing cost and the strong market for tissue hard rolls,compared to the comparable period in the prior year.

Gross profit for ourtissue segment for the fiscal 2008 three-month period was $9.7 million, anincrease of $5.7 million, or 143.8%, from the comparable period in the prioryear.  Gross profit for our tissuesegment for the fiscal 2008 six-month period was $17.0 million, an increase of$7.8 million, or 84.7%, from the comparable period in the prior year.

Gross profit for our machine-glazedsegment for the fiscal 2008 three-month period was $2.1 million, an increase of$1.4 million, or 194.8%, from the comparable period in the prior year.  Gross profit for our machine-glazed segmentfor the fiscal 2008 six-month period was $3.1 million, an increase of $.7million, or 31.8%, from the comparable period in the prior year.

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Asa percentage of net sales, gross profit for the tissue segment increased to 11.6%in the fiscal 2008 three-month period and 10.5% in the fiscal 2008 six-monthperiod from****6.5% in the fiscal 2007three-month period and 7.9% in the fiscal 2007 six-month period**.**  As a percentage ofnet sales, gross profit for the machine-glazed segment increased to 8.0% in thefiscal 2008 three-month period and 6.1% in the fiscal 2008 six-month period from3.0% in the fiscal 2007 three-month period and 5.1% in the fiscal 2007six-month period.

**Selling,general and administrative expenses**in the fiscal 2008 three-month period decreased $1.7 million, or 27.3%,to $4.5 million from $6.2 million in the fiscal 2007 three-month period.  Selling, general and administrative expensesin the fiscal 2008 six-month period decreased $.4 million, or 3.9%, to $9.0million from $9.4 million in the fiscal 2007 six-month period.  As a percentage of net sales, selling, generaland administrative expenses decreased to****4.1% in thefiscal 2008 three-month period and decreased to 4.2% in the fiscal 2008 six-monthperiod from 7.3% and 5.8%, respectively, for the comparable periods in theprior year.  Included in the fiscal 2008three-month and six-month periods are $.4 million and $.8 million, respectively,of ongoing CityForest administrative expenses.  Also, included in the fiscal 2008 three-monthand six-month periods are additional costs incurred in connection with beingcompliant with Sarbanes Oxley and increases in incentive compensation expenseassociated with strong business performance. Included in the fiscal 2007 three-month and six-month periods****is $1.0 million of non-cash compensation expense related tothe vesting of restricted stock awards, $1.5 million of other compensationexpense related to tax payments associated with such awards and $.6 million ofother compensation expense related to the Merger.

**Stockand related compensation expense**in the fiscal 2008 three-month and six-month periods of $.2 million and$.4 million, respectively, and in each of the fiscal 2007 three-month andsix-month periods of $.1 million relates to the accounting for restricted stockand stock option grants.

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

**Merger-relatedtransaction costs**inthe fiscal 2007 three-month period were $5.9 million and in the fiscal 2007 six-monthperiod were $6.0 million associated with the Merger.

**Interestexpense, net**in thefiscal 2008 three-month period was $5.1 million compared to $4.0 million in thefiscal 2007 three-month period.  Interestexpense, net in the fiscal 2008 six-month period was $10.1 million compared to$8.0 million in the fiscal 2007 six-month period.  These increases are due to the assumption ofCityForest debt and additional debt incurred in connection with the acquisitionthereof.

**Foreigncurrency loss (gain)**inthe fiscal 2008 three-month period was a loss of $.2 million and in the fiscal2008 six-month period was a loss of $.5 million compared to a loss of less than$.1 million and a loss of $.2 million, respectively, for the comparable periodsin the prior year.  The fluctuationsrelate to the change in the Canadian currency period over period.

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**Income tax expense**forthe fiscal 2008 three-month period was $.7 million or an effective tax rate of40.6% compared to income tax benefit of $3.1 million or an effective tax rateof 26.5% for the fiscal 2007 three-month period.  The income tax expense for the fiscal year2008 six-month period was $.1 million or an effective tax rate of 152.8%compared to income tax benefit of $3.3 million or an effective tax rate of26.6% for the fiscal year 2007 six-month period.   Included in the income tax expense for thefiscal 2008 three-month and six-month periods is approximately $90,000 relatedto additional Canadian income taxes paid upon completion of our fiscal year 2007tax returns.  The effective tax expensefor the 2007 three-month and six-month periods, without the effect of theadditional Canadian income tax expense, was 35.6% and 35.1%, respectively.   The effective tax rate for the fiscal year2007 three-month and six-month periods differ from the federal statutory rateprimarily due to non-deductible transaction costs expensed for book purposes.

**Net income**forthe fiscal 2008 three-month period was $1.1 million, compared to a net loss of$8.6 million for the comparable period in the prior year. Net loss for the fiscal2008 six-month period was a net loss of $.1 million compared to a net loss of$9.2 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.
| ** **                                               | ** ** | **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 provided by operations**was $13.2 million for the fiscal 2008 six-month period, compared to net cashused in operations of $.9 million for the fiscal 2007 six-month period. ** **Non-cash items,consisting of inventory charge, stock-based compensation, deferred income taxes,depreciation and amortization for the fiscal 2008

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six-month period totaled$11.4 million compared to $10.3 million for the 2007 fiscal six-month period.** **Cash flows providedby changes in working capital totaled $1.9 million for the fiscal 2008 six-monthperiod, compared to cash flows used by changes in working capital of $2.0million in the fiscal 2007 six-month period. ** **With respect to the changes inaccounts receivable and inventory, cash used by these items was $3.1 millionfor the fiscal 2008 six-month period compared to cash provided by these itemsof $.9 million for the comparable period in the prior fiscal year.  Cash****used bychanges in prepaid expenses and other current assets was $1.7 million for thefiscal 2008 six-month period compared to cash used of $.4 million for thecomparable period in the prior fiscal year. Cash provided by changes in accounts payable, accrued expenses and accruedinterest for the fiscal 2008 six-month period was $6.7 million compared to cashused of $2.5 million for the comparable period in the prior year.

**Net cash used in investingactivities** for the fiscal 2008 six-month period was $50.6****million compared to net cash used in investing activitiesof $41.9 million for the fiscal 2007 six-month period.  The fiscal 2008 six-month period includes$43.7 million of cash paid for the Acquisition, net of cash received.  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 provided by financingactivities** for the fiscal 2008 six-month period was $22.6 millionrelated to financing obtained in connection with the Acquisition.  The net cash used by financing activities forthe fiscal 2007 six-month period includes $45.8 million related to mergerconsideration paid to former shareholders. The remaining $.3 million for the fiscal 2007 six-month period relatesto payments on our industrial revenue bond. Our last payment on our industrialrevenue bond was made in the first quarter of fiscal year 2007.

In connection with theacquisition of CityForest, we entered into the Note Purchase Agreement,pursuant to which we issued and sold $20.3 million aggregate principal amountof Additional Notes to the Wingate for the purchase price of $20.0 million,which is equal to 98.7383% of the aggregate principal amount of the AdditionalNotes.  The Additional Notes were issuedpursuant to and will be governed by Cellu Tissue Indenture among us, oursubsidiary guarantors party thereto and the Trustee.

Our Notes and AdditionalNotes mature on March 15, 2010 and require semi-annual interest payments onMarch 15 and September 15, which commenced on September 15, 2004.

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.  As a result of the acceptanceby us of the consents delivered by noteholders and the completion of theconsent solicitation, the amendments to the Cellu Tissue Indenture described inthe Consent Solicitation

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Statement dated May 9,2006 and related Supplement dated May 24, 2006 became operative and we were notrequired to make a change of control offer to purchase any Notes in connectionwith the Merger.

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

*TheCredit Agreement provides for a $35.0 million working capital facility, whichhas subsequently been increased to $40.0 million (see below), including aletter of credit sub-facility and swing-line loan sub-facility. The CreditAgreement provides that amounts under the facility may be borrowed, repaid andre-borrowed, subject to a borrowing base test, until the maturity date, whichis June 12, 2011. An amount equal to $32.0 million is available, in U.S.dollars, to the U.S. Borrower under the facility, and an amount equal to $3.0million is available, in U.S. or Canadian dollars, to the Canadian Borrowerunder the facility.  Borrowings of $17.4million were made to finance a portion of the acquisition of CityForest.    As ofAugust 30, 2007, there was $2.6 million of borrowings outstanding under theworking capital facility.*

In addition to the NotePurchase Agreement, the following agreements were entered into in connectionwith the acquisition of CityForest:

***SecondSupplemental Indenture***

We, certain of oursubsidiaries, the Trustee and CityForest have executed the Second SupplementalIndenture, pursuant to which CityForest became a party to the Cellu TissueIndenture as a subsidiary guarantor.  Asa subsidiary guarantor, CityForest, on a joint and several basis with all theexisting subsidiary guarantors, fully, unconditionally and irrevocablyguarantees to each holder of the Notes and the Trustee our obligations underits Indenture and the Notes.

***Amendmentto Credit Agreement***

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

The Amendment (1)increases the working capital facility from $35.0 million to $40.0 million, (2)permits the issuance and sale by us of the Additional Notes, (3) provides forthe consummation of the acquisition of CityForest and the conversion byCityForest from a Minnesota corporation to a Minnesota limited liabilitycompany, (4) permits the

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assumption of approximately$18.4 million in aggregate principal amount of indebtedness of CityForest inconnection with the acquisition of CityForest in accordance with the terms ofthe CityForest Bond Documents and (5) permits the guarantee by us of certainobligations of CityForest under the CityForest Bond Documents.  In connection with the Amendment, CityForestbecame a guarantor of the obligations of the borrowers under the Amended CreditAgreement.

***CityForestBond Documents***

CityForest is party to aLoan Agreement with the City of Ladysmith, Wisconsin, as Issuer.  Pursuant to the Loan Agreement, the Issuerloaned the proceeds of the Issuer’s Bonds to CityForest to finance theconstruction by CityForest of a solid waste disposal facility.  Approximately $18.4 million in aggregateprincipal amount of the Bonds was outstanding as of the date of the CityForestacquisition.  CityForest is required,under the terms of the CityForest Indenture, to provide a letter of credit infavor of the Bonds Trustee.  CityForesthas entered into the Reimbursement Agreement with Associated Bank, pursuant towhich Associated Bank has extended the Associated Bank Letter of Credit and hasprovided the Associated Bank Revolving Credit Facility to CityForest in anaggregate principal amount of up to $3.5 million.

The Bonds Trustee ispermitted to draw upon the Associated Bank Letter of Credit to pay principaland interest due on the Bonds, and to provide liquidity to purchase Bonds putto CityForest by bondholders and not remarketed; and CityForest is obligatedunder the Reimbursement Agreement to reimburse Associated Bank for any suchdraws. CityForest is also obligated to pay a fee in respect of the aggregateamount available to be drawn under the Associated Bank Letter of Credit at arate per annum initially equal to 1.25%, subject to adjustment on a quarterlybasis based on CityForest’s leverage. The expiration date of the Associated Bank Letter of Credit is February15, 2011.

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

*The Reimbursement Agreement requires scheduled semi-annual payments ofprincipal of the Bonds equal to approximately 2.00% of the principal amountoutstanding as of the date of the Acquisition, with the balance payable atmaturity of the Bonds on March 1, 2028.*

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*The Reimbursement Agreement also contains a number of other provisionsregarding reserve funds and other mandatory and optional repayments inconnection with the Bonds.  In addition,the Reimbursement Agreement provides that in certain circumstances where weincur indebtedness in excess of amounts currently permitted under the indentureor refinances the indebtedness issued under the CityForest Indenture,Associated Bank may require CityForest to repay all of its obligations toAssociated Bank under the Reimbursement Agreement and either to cause the Bondsto be redeemed or to replace the Associated Bank Letter of Credit with aSubstitute Credit Facility, as such term is defined in the CityForestIndenture.*

The ReimbursementAgreement contains various affirmative and negative covenants customary forworking capital and term credit facilities, as well as additional covenantsrelating to the Bonds.  The negativecovenants include limitations on: indebtedness; liens; acquisitions, mergersand consolidations; investments; guarantees; asset sales; sale and leasebacktransactions; dividends and distributions; transactions with affiliates;capital expenditures; and changes to the status of the Bonds. CityForest isalso required to comply on a quarterly basis with a maximum leverage covenantand a minimum fixed charge coverage covenant.

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

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

**Cash**as ofAugust 30, 2007 decreased to $2.3 million from $16.3 million as of the end of fiscalyear 2007.  The decrease in our cashposition was primarily due to cash on hand to finance a portion of theacquisition of CityForest, payment of our semi-annual interest in March 2007and paydown on the revolving line of credit.

**Receivables, net**asof August 30, 2007 increased to $43.3 million from $34.1 million as of the endof fiscal year 2007.  Included in the$43.3 million is $4.0 million of receivables related to CityForest.  Without the effect of the acquisition,receivables increased $5.2 million

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from the end of fiscalyear 2007, primarily due to the increase in net sales for the period.

**Inventory**as ofAugust 30, 2007 increased to $30.7 million from $29.6 million as of the end offiscal year 2007.   Included in the $30.7million is $1.3 million of inventories related to CityForest.  Without the effect of the acquisition,inventories decreased $.2 million from the end of fiscal year 2007.

**Prepaid expenses and othercurrent assets**as of August 30, 2007 increased to $6.1million from $2.8 million as of the end of fiscal year 2007.  Included in the $6.1 million is $1.2 ofprepaid expenses and other current assets related to CityForest.  Without the effect of the acquisition,prepaid expense and other current assets increased $2.1 million from the end offiscal year 2007.  The increase is due tothe timing of prepayments.

**Property, plant and equipment,net**as of August 30, 2007 increased to $291.7 million from$228.9 million as of the end of fiscal year 2007.  Included in the $291.7 million of property,plant and equipment, net is $67.0 million related to CityForest.  Without the effect of the acquisition,property, plant and equipment decreased $4.2 million from the end of fiscalyear 2007.  This decrease relates todepreciation expense for the period offset partially by capital expendituresfor the period.

**Goodwill**as ofAugust 30, 2007 of $6.9 million arose due to the acquisition of CityForest.

**Trademarks**asof August 30, 2007 increased to $8.8 million from $6.6 million as of the end offiscal year 2007.  The additions to trademarksrelate to the acquisition of CityForest.

**Other assets**asof August 30, 2007 increased to $1.4 million from $.2 million as of the end offiscal year 2007.  Included in the $1.4million of other assets is $1.2 million related to CityForest.  Without the effect of the acquisition, otherassets are consistent with the end of fiscal year 2007.

**Revolving line of credit**asof August 30, 2007 represents $17.4 million of borrowings to finance a portionof the acquisition of CityForest, offset by payments of $14.8 million since thedate of the acquisition.

**Accounts payable**asof August 30, 2007 increased to $27.0 million from $16.5 million as of the endof fiscal year 2007.  Included in the$27.0 million of accounts payable is $3.4 million related to CityForest.  Without the effect of the acquisition,accounts payable increased $7.1 million from the end of fiscal year 2007 due toincreased pulp purchases and the timing of payments.

**Accrued expenses**asof August 30, 2007 increased to $19.2 million from $16.3 million as of the endof fiscal year 2007.  Included in the$19.2 million of accrued expenses is $.8 million related to CityForest.  Without the effect of the acquisition,accrued expenses

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increased $2.1 milliondue to accrued legal expense and accrual of bonuses during the second quarterfiscal year 2007.

**Long-term debt**asof August 30, 2007 increased to $199.1 million from $160.4 million as of theend of fiscal year 2007 due to the assumption of CityForest debt and debtincurred to finance the acquisition.

**Deferred income taxes**asof August 30, 2007 increased to $65.6 million from $50.7 million as of the endof fiscal year 2007 primarily due to the deferred taxes recorded in purchaseaccounting for CityForest.

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 forfiscal year 2007.  The preparation of ourfinancial statements requires us to make estimates that affect the reportedamounts of assets, liabilities, revenue and expenses and related disclosures ofcontingent assets and liabilities.  Webase our accounting estimates on historical experience and other factors thatwe believe to be reasonable under the circumstances.  However, actual results may vary from theseestimates under different assumptions or conditions.

New AccountingPronouncements

We adopted FIN 48 at thebeginning of fiscal year 2008.  Theimplementation did not have a material impact on our results of operations andfinancial position. At August 30, 2007, we did not have any unrecognized taxbenefits.

We recognize interest andpenalties related to uncertain tax positions in income tax expense.  As of August 30, 2007, we have accruedinterest and penalties, if any, related to uncertain tax positions.

The fiscal tax years 2003through 2007 remain open to examination by the major taxing jurisdictions towhich we are subject.  As of August 30,2007, we do not expect any material changes to unrecognized tax positionswithin the next 12 months.

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**Item3.  Quantitative and QualitativeDisclosures about Market Risk**

In March 2004, wecompleted a private offering of the Notes. In connection with the acquisition of CityForest in March 2007, weissued and sold approximately $20 million of Additional Notes and assumed $18.4million of additional debt.  We also havethe ability to borrow under a revolving line of credit, up to $40.0 million, ofwhich as of August 30, 2007 we have outstanding borrowings of $2.6million.  As a result, we are highlyleveraged.

We have minimal foreigncurrency translation risk.  All internationalsales, other than sales originating from our Canadian subsidiary, aredenominated in U.S. dollars.  Due to ourCanadian operations, however, we could be adversely affected by unfavorablefluctuations in foreign currency exchange rates.

**Item4.  Controls and Procedures**

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

(b)       Changes in Internal ControlOver Financial Reporting.  There have notbeen any changes in the Company’s internal control over financial reporting (assuch term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)during the fiscal quarter to which this report relates that have materiallyaffected, or are reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

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PART II – OTHER INFORMATION

Item 1A.  Risk Factors

Therisk factors included in our Annual Report on Form 10-K for fiscal year 2007have not materially changed.

Item 6.  Exhibits

(a)  Exhibits
| 10.1   |   | Employment Agreement by and between the Company and  David J. Morris, effective August 6, 2007          |
|--------|--------|---------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                    |
| 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 the requirementsof the Securities Exchange Act of 1934, as amended, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|   |             | Cellu Tissue Holdings, Inc.              |
|--------|------------------|------------------------------------------|
|   |             |                                     |
|   |             |                                     |
| Date:  | October 12, 2007 |                                     |   |   | /s/ Russell C. Taylor |   |
|   |             |                                     |   |   | Mr. Russell C. Taylor |
|   |             | President and Chief Executive Officer    |
|   |             |                                     |
| Date:  | October 12, 2007 |                                     |   | /s/ David J. Morris |   |
|   |             | Mr. David J. Morris                      |
|   |             | Senior Vice President, Finance and Chief |
|   |             | Financial Officer                        |
|        |                  |                                          |  |  |  |  |  |

 

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