**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 

| ý                                             | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------|-----------------------------------------------------------------------------------------------|
|                                               |                                                                                          |
| **For the Quarterly Period Ended August 26, 2004** |
| ** **                                         |                                                                                          |
| **or**                                             |
|                                               |                                                                                          |
| o                                                  | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from                  to                 .**

 

**Commissionfile number 333-118829**

 

**Cellu Tissue Holdings, Inc.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                        |   | **06-1346495**                     |
|-----------------------------------------------------|--------|------------------------------------|
| (State  of incorporation)                           |   | (IRS  Employer Identification No.) |
|                                                |   |                               |
| **3442 Francis Road Suite 220 Alpharetta, Georgia** |   | **30004**                     |
| (Address  of principal executive offices)           |   | (zip  code)                        |

 

**(678)393-2651**

(Registrant’s telephonenumber, including area code)

 

**NotApplicable**

(Former name, former addressand former fiscal year, if changed since last report)

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for the past90 days.   Yes ý No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).  Yes o No ý

 

The number of sharesoutstanding of each of the registrant’s classes of common stock as of November1, 2004:

 

| **Title of Class**                     | ** ** | **Shares Outstanding** |
|----------------------------------------|------------|------------------------|
| Common  Stock, Class A, $.10 par value |       | 11,127                 |

 

 

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CELLUTISSUE HOLDINGS, INC.

FORM10-Q

QUARTERENDED AUGUST 26, 2004

 

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 6. Exhibits                                                                                     |
|                                                                                                 |
| SIGNATURES                                                                                           |

 

2

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**PART I FINANCIAL INFORMATION**

 

**Item 1. Consolidated Financial Statements**

 

**CELLU TISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)**

 
| ** **                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                 | ** ** | **August 26  2004**    | ** ** | **August 28  2003**  | ** ** | **August 26  2004** | ** ** | **August 28  2003** | ** ** |
|                                                       |       |                   |       |                 |       |   |   |   |   |
| Net sales                                                  |       | $                      | 86,275,437 |                 | $          | 73,198,521 |   | $ | 165,059,621 |   | $ | 136,795,245 |   |
| Cost of goods sold                                         |       | 75,353,411             |       | 65,304,905           |       | 145,183,926 |   | 122,251,182 |   |
| Gross profit                                               |       | 10,922,026             |       | 7,893,616            |       | 19,875,695 |   | 14,544,063 |   |
|                                                       |       |                   |       |                 |       |   |   |   |   |
| Selling, general and administrative  expenses              |       | 3,966,639              |       | 3,367,907            |       | 7,589,637 |   | 6,407,432 |   |
| Compensation from redemption of stock  options             |       |                   |       |                 |       | 3,414,441 |   |   |   |
| Accelerated vesting of stock options - non  cash           |       | 292,776                |       |                 |       | 533,551 |   |   |   |
| Amortization of intangibles                                |       | 336,240                |       | 186,535              |       | 692,727 |   | 373,070 |   |
| Income from operations                                     |       | 6,326,371              |       | 4,339,174            |       | 7,645,339 |   | 7,763,561 |   |
|                                                       |       |                   |       |                 |       |   |   |   |   |
| Write-off of debt issuance costs and  prepayment penalties |       |                   |       |                 |       | 3,318,495 |   |   |   |
| Interest expense, net                                      |       | 4,057,476              |       | 1,446,851            |       | 7,947,229 |   | 2,896,466 |   |
| Foreign currency (gain) loss                               |       | 212,445                |       | (31,247              | )          | 196,388 |   | 374,269 |   |
| (Gain) loss on sale of equipment                           |       | (2,381,316             | )          | (2,000               | )          | (2,381,316 | ) | 37,938 |   |
| Other (income) expense                                     |       | 25,758                 |       | (1,101               | )          | 25,158 |   | (1,465 | ) |
| Income (loss) before income tax                            |       | 4,412,008              |       | 2,926,671            |       | (1,460,615 | ) | 4,456,353 |   |
|                                                       |       |                   |       |                 |       |   |   |   |   |
| Income tax expense (benefit)                               |       | 875,903                |       | 1,061,211            |       | (3,998,374 | ) | 1,615,874 |   |
| Net income                                                 |       | $                      | 3,536,105  |                 | $          | 1,865,460 |   | $ | 2,537,759 |   | $ | 2,840,479 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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**CELLU TISSUE HOLDINGS, INC, AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                 | ** ** | **August 26  2004** | ** **  | **February 29  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|-------------|-----------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **(Unaudited)**     | ** **  | ** **            | ** ** |
| **ASSETS**                                                                                                                                                                 |       |                |        |                  |       |
| CURRENT ASSETS:                                                                                                                                                            |       |                |        |                  |       |
| Cash and cash equivalents                                                                                                                                                  |       | $                   | 12,165,596  |                  |       |   |
| Receivables, net                                                                                                                                                           |       | 41,717,865          |        | $                     | 37,437,876 |   |
| Receivables, other                                                                                                                                                         |       | 3,900,000           |        |                  |       |
| Inventories                                                                                                                                                                |       | 22,861,713          |        | 24,803,154            |       |
| Prepaid expenses and other current assets                                                                                                                                  |       | 2,055,379           |        | 2,119,340             |       |
| Income tax receivable                                                                                                                                                      |       | 5,769,804           |        | 711,645               |       |
| Deferred income taxes                                                                                                                                                      |       | 1,134,080           |        | 1,134,080             |       |
| Assets held for sale                                                                                                                                                       |       |                |        | 2,270,371             |       |
| TOTAL CURRENT ASSETS                                                                                                                                                       |       | 89,604,437          |        | 68,476,466            |       |
| PROPERTY, PLANT AND EQUIPMENT, NET                                                                                                                                         |       | 96,644,102          |        | 100,122,201           |       |
| DEBT ISSUANCE COSTS                                                                                                                                                        |       | 7,467,499           |        | 4,710,916             |       |
| GOODWILL                                                                                                                                                                   |       | 13,723,935          |        | 13,723,935            |       |
| OTHER ASSETS                                                                                                                                                               |       | 100,895             |        | 178,132               |       |
| TOTAL ASSETS                                                                                                                                                               |       | $                   | 207,540,868 |                  | $          | 187,211,650 |   |
|                                                                                                                                                                       |       |                |        |                  |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY(DEFICIENCY)**                                                                                                                 |       |                |        |                  |       |
| CURRENT LIABILITIES:                                                                                                                                                       |       |                |        |                  |       |
| Revolving lines of credit                                                                                                                                                  |       |                |        | $                     | 11,352,924 |   |
| Cash overdraft                                                                                                                                                             |       |                |        | 4,760,297             |       |
| Accounts payable                                                                                                                                                           |       | $                   | 21,829,439  |                  | 16,857,938 |   |
| Accrued expenses                                                                                                                                                           |       | 12,353,991          |        | 11,226,210            |       |
| Accrued interest                                                                                                                                                           |       | 7,464,379           |        | 292,077               |       |
| Current portion of long-term debt                                                                                                                                          |       | 270,000             |        | 7,470,000             |       |
| TOTAL CURRENT LIABILITIES                                                                                                                                                  |       | 41,917,809          |        | 51,959,446            |       |
| LONG-TERM DEBT, LESS CURRENT PORTION                                                                                                                                       |       | 160,647,289         |        | 36,963,541            |       |
| DEFERRED INCOME TAXES                                                                                                                                                      |       | 13,688,236          |        | 13,688,236            |       |
| OTHER LIABILITIES                                                                                                                                                          |       | 118,000             |        | 118,000               |       |
| STOCKHOLDERS’ EQUITY (DEFICIENCY):                                                                                                                                    |       |                |        |                  |       |
| Common stock, Class A, $.01 par value,  150,000 shares authorized, 11,127 and 20,328 shares issued and outstanding at  August 26, 2004 and February 29, 2004, respectively |       | 111                 |        | 204                   |       |
| Capital in excess of par value                                                                                                                                             |       |                |        | 65,976,390            |       |
| Accumulated earnings (deficit)                                                                                                                                             |       | (9,081,200          | )           | 18,659,808            |       |
| Unearned compensation                                                                                                                                                      |       | (91,405             | )           | (388,888              | )          |
| Accumulated other comprehensive income                                                                                                                                     |       | 342,028             |        | 234,913               |       |
| TOTAL STOCKHOLDERS’ EQUITY(DEFICIENCY)                                                                                                                                |       | (8,830,466          | )           | 84,482,427            |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’  EQUITY(DEFICIENCY)                                                                                                               |       | $                   | 207,540,868 |                  | $          | 187,211,650 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

4

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**CELLU TISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)**

 
| ** **                                                                             | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                             | ** ** | **August 26  2004**  | ** ** | **August 28  2003** | ** ** |
| **Cash flows from operating activities**                                               |       |                 |       |   |   |
| Net income                                                                             |       | $                    | 2,537,759  |   | $ | 2,840,479 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:     |       |                 |       |   |   |
| Write-off of debt issuance costs-noncash                                               |       | 2,894,868            |       |   |   |
| Accelerated vesting of stock  options-noncash                                          |       | 533,551              |       |   |   |
| Accretion of debt discount                                                             |       | 147,109              |       |   |   |
| Amortization of intangibles                                                            |       | 692,727              |       | 373,070 |   |
| Depreciation                                                                           |       | 7,309,353            |       | 7,814,517 |   |
| (Gain) loss on sale of property, plant and  equipment                                  |       | (2,381,316           | )          | 37,938 |   |
| Stock based compensation                                                               |       | 297,482              |       | 333,334 |   |
| Changes in operating assets and  liabilities:                                          |       |                 |       |   |   |
| Receivables                                                                            |       | (4,279,989           | )          | (6,323,114 | ) |
| Receivables, other                                                                     |       | (3,900,000           | )          |   |   |
| Inventories                                                                            |       | 1,941,441            |       | (3,545,924 | ) |
| Prepaid expenses and other current assets                                              |       | (4,994,198           | )          | (830,472 | ) |
| Other assets                                                                           |       | 77,241               |       | (173,560 | ) |
| Cash overdraft, accounts payable, accrued  expenses, accrued interest and income taxes |       | 8,511,287            |       | 1,575,603 |   |
| Total adjustments                                                                      |       | 6,849,556            |       | (738,608 | ) |
| *Net cash provided by operating activities*                                            |       | 9,387,315            |       | 2,101,871 |   |
|                                                                                   |       |                 |       |   |   |
| **Cash flows from investing activities**                                               |       |                 |       |   |   |
| Proceeds from sale of property, plant and  equipment, net                              |       | 4,003,727            |       |   |   |
| Capital expenditures                                                                   |       | (3,183,294           | )          | (5,259,501 | ) |
| *Net cash provided by (used) in investing  activities*                                 |       | 820,433              |       | (5,259,501 | ) |
|                                                                                   |       |                 |       |   |   |
| **Cash flows from financing activities**                                               |       |                 |       |   |   |
| Payments of long-term debt                                                             |       | (43,863,541          | )          | (5,681,959 | ) |
| Proceeds from note offering                                                            |       | 160,200,180          |       |   |   |
| Borrowings (payments) on revolving line of  credit, net                                |       | (10,953,999          | )          | 8,524,518 |   |
| Cash dividends                                                                         |       | (96,788,801          | )          |   |   |
| Prepayment penalties                                                                   |       | (423,627             | )          |   |   |
| Debt issuance costs                                                                    |       | (6,319,479           | )          |   |   |
| *Net cash provided by financing activities*                                            |       | 1,850,733            |       | 2,842,559 |   |
|                                                                                   |       |                 |       |   |   |
| Effect of foreign currency                                                             |       | 107,115              |       | 315,071 |   |
|                                                                                   |       |                 |       |   |   |
| *Net increase in cash and cash equivalents*                                            |       | 12,165,596           |       | — |   |
| *Cash and cash equivalents at beginning of  period*                                    |       | —               |       | — |   |
| *Cash and cash equivalents at end of period*                                           |       | $                    | 12,165,596 |   | $ | — |   |

 

*See accompanying notes to consolidated financial statements.*

 

5

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited)August 26, 2004**

 

**Note1 Basis of Presentation and Significant Accounting Policies**

 

Theaccompanying unaudited interim consolidated financial statements include theaccounts of Cellu Tissue Holdings, Inc. (the “Company” ) and its wholly-ownedsubsidiaries.  The Company is awholly-owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”).  These statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States forcomplete financial statements.  In theopinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation have been included.  Operating results for the three and six monthperiods ended August 26, 2004 are not necessarily indicative of the resultsthat may be expected for the fiscal year ending February 28, 2005.  For further information, refer to the Company’sconsolidated financial statements and footnotes thereto as of February 29, 2004and for the year then ended, from which the consolidated balance sheet atFebruary 29, 2004 has been derived.

 

Reclassification

 

Certain prioryear amounts have been reclassified to conform to the current fiscal year 2005presentation.

 

Stock BasedCompensation

 

The Companyaccounts for stock options using the intrinsic value method under AccountingPrinciples Board (APB) Opinion No. 25, “*Accountingfor Stock Issued to Employees”*(“APB No. 25”).  As such, it does not recognize compensationexpense associated with stock options to purchase the Parent’s common stockgranted under the Parent’s stock option plan, if the exercise price is at leastequal to the fair market value of the Parent’s common stock, as determined bythe Board of Directors, at the date granted. If applicable, stock-based compensation costs for stock awards arereflected in operating results over the awards’ vesting period.  If compensation expense for the Parent’sstock options had been determined using the fair value methodology consistentwith the method prescribed by Statement of Financial Standards (SFAS) No. 123, “*Accounting for Stock-Based Compensation”*(“FASNo. 123”), the Company’s net income would have been adjusted to the pro formaamounts indicated below.

 

6

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| ** **                                                                                                  | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                                  | ** ** | **August 26,  2004**           | ** ** | **August 28,  2003**         | ** ** | **August 26,  2004** | ** ** | **August 28,  2003** | ** ** |
|                                                                                                        |       |                           |       |                         |       |   |   |   |   |
| Net income, as reported                                                                                     |       | $                              | 3,536,105  |                         | $          | 1,865,460 |   | $ | 2,537,759 |   | $ | 2,840,479 |   |
| Add: stock-based employee compensation expense  included in reported net income, net of related tax effects |       | (74,219                        | )          | —                       |       | (988,024 | ) | — |   |
| Less: stock-based employee compensation expense  determined under fair value method, net of related tax     |       | —                         |       | 51,154                       |       | (113,775 | ) | 102,318 |   |
| Pro forma net income, fair value method                                                                     |       | $                              | 3,461,886  |                         | $          | 1,814,306 |   | $ | 1,435,960 |   | $ | 2,738,161 |   |

 

Pro formacompensation expense related to the stock options is generally recognized overthe vesting period.  The vesting periodused for all periods presented is three years. The fair value of each option grant was estimated on the date of grantusing the Black-Scholes option pricing model with the following weightedaverage assumptions:  risk-free interestrate of 4.16%, expected lives of 4 years, zero dividend payments, and novolatility.

 

In connectionwith the Company’s debt transaction (Note 4), the Company accelerated vestingof all unvested employee stock options. As a result thereof, the APB 25 expense for the six-months ended August26, 2004 recognized in the table above is larger than the expense calculatedunder FAS 123 as the expense associated with the accelerated vesting and cashpaid for redemption of stock options would have been previously recognized ifFAS 123 had been applied from the date of grant.

 

The Companymay need to recognize additional expense should management’s estimate of thenumber of employees that will actually benefit from the accelerated vesting ofthe options need to be adjusted.  TheCompany has estimated and recognized $.5 million of expense in the six-monthperiod ended August 26, 2004, associated with employees that will actuallybenefit from the accelerated vesting of the stock options.  The Company will update its estimate eachreporting period and adjust the total expense recognized until the originalvesting period associated with the stock options has expired.

 

7

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**Note 2 Inventories**

 

Components ofinventories are as follows:

 
| ** **                       | ** ** | **August 26, 2004** | ** ** | **February 29, 2004** | ** ** |
|----------------------------------|------------|---------------------|------------|-----------------------|------------|
|                             |       |                |       |                  |       |
| Finished goods                   |       | $                   | 13,162,085 |                  | $          | 14,644,430 |   |
| Raw materials                    |       | 4,216,343           |       | 4,527,340             |       |
| Packaging materials and supplies |       | 6,055,582           |       | 6,172,198             |       |
|                             |       | 23,434,010          |       | 25,343,968            |       |
| Inventory reserves               |       | (572,297            | )          | (540,814              | )          |
|                             |       | $                   | 22,861,713 |                  | $          | 24,803,154 |   |

 

**Note 3 Debt Issuance Costs**

 

Debt issuancecosts consist of the following:

 
| ** **                    | ** ** | **August 26, 2004** | ** ** | **February 29, 2004** | ** ** |
|-------------------------------|------------|---------------------|------------|-----------------------|------------|
|                          |       |                |       |                  |       |
| Debt issuance costs           |       | $                   | 8,126,724  |                  | $          | 5,654,208 |   |
| Less accumulated amortization |       | (659,225            | )          | (943,292              | )          |
|                          |       | $                   | 7,467,499  |                  | $          | 4,710,916 |   |

 

8

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**Note 4 Long-Term Debt**

 

Long-term debtconsists of the following:

 
| ** **                                                                                                          | ** ** | **August 26, 2004** | ** **  | **February 29, 2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|---------------------|-------------|-----------------------|------------|
| 9 3⁄4% senior secured notes due 2010                                                                             |       | $                   | 162,000,000 |                  |       |   |
| Less discount                                                                                                       |       | (1,652,711          | )           |                  |       |
|                                                                                                                |       | 160,347,289         |        |                  |       |
|                                                                                                                |       |                |        |                  |       |
| Term Loan A, $20.0 million principal due  October 31, 2007                                                          |       |                |        | $                     | 11,260,123 |   |
|                                                                                                                |       |                |        |                  |       |
| Term Loan B, $20.0 million principal, $14.5  million due September 30, 2005 and $5.5 million due September 30, 2007 |       |                |        | 17,333,418            |       |
|                                                                                                                |       |                |        |                  |       |
| Term Loan C, $15.0 million principal, $10.9  million due September 30, 2005 and $4.1 million due September 30, 2007 |       |                |        | 15,000,000            |       |
|                                                                                                                |       | 160,347,289         |        | 43,593,541            |       |
| Industrial revenue bond payable, in annual  installments, plus interest ranging from 4.8% to 6.65%, due in 2006     |       | 570,000             |        | 840,000               |       |
|                                                                                                                |       | 160,917,289         |        | 44,433,541            |       |
| Less current portion of debt                                                                                        |       | 270,000             |        | 7,470,000             |       |
|                                                                                                                |       | $                   | 160,647,289 |                  | $          | 36,963,541 |   |

 

In March 2004,the Company completed a Rule 144A offering of $162.0 million principal amountof 9 3⁄4% senior secured notes due 2010. The Company raised $152.2 million, net of debt issuance costs of $8.0million and original issuance discount of $1.8 million.  At the same time, the Company entered into anew $30.0 million revolving working capital facility.  A portion of these proceeds, along with adrawdown from the new working capital facility, were used to pay off existingdebt of approximately $56.0 million. Furthermore, the Company used approximately $100.2 million of theproceeds to fund a stockholder dividend and compensation from the redemption ofstock options ($3.4 million).  As aresult of the extinguishment of debt, approximately $2.9 million of debtissuance costs previously capitalized were written off and the Company incurredapproximately

 

9

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$.4 million inprepayment penalties.  The total amountof $3.3 million is reflected in write-off of debt issuance costs and prepaymentpenalties on the income statement.

 

The seniorsecured notes mature on March 15, 2010 and require semi-annual interestpayments on March 15 and September 15, with the first payment commencing onSeptember 15, 2004. The senior secured notes are unconditionally guaranteed byall of the Company’s subsidiaries.

 

As of August26, 2004, there were no outstanding borrowings under the working capitalfacility.

 

**Note5 Stockholders’ Equity (Deficiency)**

 

The Companyused approximately $96.8 million of the proceeds from the note offering to funda stockholder dividend to the Parent to purchase shares of common stock,warrants and options.  Approximately$66.2 million was charged to capital in excess of par value, reducing thisbalance to zero and the remaining $30.6 million was charged to accumulated earnings,resulting in the deficiency at August 26, 2004. Net income generated for the fiscal 2005 six-month period reduced thedeficiency.

 

**Note6 Comprehensive (Loss) Income**

 

The componentsof comprehensive (loss) income for the three months and six months ended August26, 2004 and August 28, 2003 are as follows:

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                               | ** ** | **August 26, 2004**    | ** ** | **August 28, 2003**  | ** ** | **August 26, 2004** | ** ** | **August 28,2003** | ** ** |
| Net income                               |       | $                      | 3,536,105  |                 | $          | 1,865,460 |   | $ | 2,537,759 |   | $ | 2,840,479 |   |
| Foreign currency translation adjustments |       | 189,673                |       | (60,576              | )          | 107,115 |   | 315,071 |   |
| Comprehensive income                     |       | $                      | 3,725,778  |                 | $          | 1,804,884 |   | $ | 2,644,874 |   | $ | 3,155,550 |   |

 

**Note7 Gain on Sale of Equipment**

 

In July 2005,the Company sold a previously idled paper machine at its Menominee mill andrecorded a gain on the sale of $2.4 million. The net proceeds from the sale were $4.0 million (gross proceeds of $5.2million less brokerage fees and other direct costs of $1.2 million), of which$1.3 million had been received through August 26, 2004.

 

10

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**Note8 Business Segments**

 

The Companyoperates in two reportable business segments: tissue and machine-glazed paper. The Company assesses the performance of its reportable business segmentsusing income from operations.  Incomefrom operations excludes interest income, interest expense, income tax expense,write-off of debt issuance costs and prepayment penalties the impact of foreigncurrency gains and losses, and gain on sale of equipment.  A portion of corporate and shared expenses isallocated to each segment.  There are nosales between segments.

 
| ** **                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                 | ** ** | **August 26,  2004**   | ** ** | **August 28,  2003** | ** ** | **August 26,  2004** | ** ** | **August 28,  2003** | ** ** |
| **Net Sales**                                              |       |                   |       |                 |       |   |   |   |   |
| Tissue                                                     |       | $                      | 60,500,858 |                 | $          | 48,228,098 |   | $ | 115,513,463 |   | $ | 88,608,531 |   |
| Machine-glazed paper                                       |       | 25,774,579             |       | 24,970,423           |       | 49,546,158 |   | 48,186,714 |   |
| Consolidated                                               |       | $                      | 86,275,437 |                 | $          | 73,198,521 |   | $ | 165,059,621 |   | $ | 136,795,245 |   |
|                                                       |       |                   |       |                 |       |   |   |   |   |
| **Income from operations**                                 |       |                   |       |                 |       |   |   |   |   |
| Tissue                                                     |       | $                      | 4,644,144  |                 | $          | 2,537,867 |   | $ | 6,016,545 |   | $ | 4,768,619 |   |
| Machine-glazed paper                                       |       | 2,018,467              |       | 1,987,842            |       | 2,321,521 |   | 3,368,012 |   |
| Corporate amortization of intangibles                      |       | (336,240               | )          | (186,535             | )          | (692,727 | ) | (373,070 | ) |
| Consolidated                                               |       | 6,326,371              |       | 4,339,174            |       | 7,645,339 |   | 7,763,561 |   |
| Write-off of debt issuance costs and prepayment  penalties |       |                   |       |                 |       | 3,318,495 |   |   |   |
| Interest expense                                           |       | 4,064,200              |       | 1,448,011            |       | 7,956,601 |   | 2,898,908 |   |
| Net foreign currency transaction (gain)  loss              |       | 212,445                |       | (31,247              | )          | 196,388 |   | 374,269 |   |
| Interest income                                            |       | (6,724                 | )          | (1,160               | )          | (9,372 | ) | (2,442 | ) |
| Other income (expense)                                     |       | 2,355,558              |       | 3,101                |       | 2,356,158 |   | (36,473 | ) |
| Pretax (loss) income                                       |       | $                      | 4,412,008  |                 | $          | 2,926,671 |   | $ | (1,460,615 | ) | $ | 4,456,353 |   |
|                                                       |       |                   |       |                 |       |   |   |   |   |
| **Capital Expenditures**                                   |       |                   |       |                 |       |   |   |   |   |
| Tissue                                                     |       | $                      | (1,889,793 | )                    | $          | (2,121,729 | ) | $ | (2,828,724 | ) | $ | (4,430,094 | ) |
| Machine-glazed paper                                       |       | (213,273               | )          | (43,614              | )          | (267,061 | ) | (375,223 | ) |
| Corporate                                                  |       | (20,000                | )          | (309,824             | )          | (87,509 | ) | (454,184 | ) |
| Consolidated                                               |       | $                      | (2,123,066 | )                    | $          | (2,475,167 | ) | $ | (3,183,294 | ) | $ | (5,259,501 | ) |

 

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| ** **           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------|------------|------------------------|------------|----------------------|------------|
| ** **           | ** ** | **August 26,  2004**   | ** ** | **August 28,  2003** | ** ** | **August 26,  2004** | ** ** | **August 28,  2003** | ** ** |
|                 |       |                   |       |                 |       |   |   |   |   |
| **Depreciation**     |       |                   |       |                 |       |   |   |   |   |
| Tissue               |       | $                      | 2,318,374  |                 | $          | 2,423,031 |   | $ | 4,568,968 |   | $ | 4,840,668 |   |
| Machine-glazed paper |       | 1,371,309              |       | 1,489,904            |       | 2,740,385 |   | 2,973,849 |   |
|                 |       | $                      | 3,689,683  |                 | $          | 3,912,935 |   | $ | 7,309,353 |   | $ | 7,814,517 |   |

 

**Note9 Income Taxes**

 

Income taxexpense for the three months ended August 26, 2004 was 20% compared to a 36%tax expense for the three months ended August 28, 2003.  Income tax benefit for the six months endedAugust 26, 2004 was 274% compared to a 36% tax expense for the six months endedAugust 28, 2004.  The Company hasrecorded taxes for the six-month period at a 125% effective tax rate (benefitof $4.8 million) on the cumulative loss before the gain on sale of equipment($3.8 million).  The effective tax rateis calculated based on the Company’s projected fiscal 2005 pretax income andexpected book to tax permanent differences, primarily related to deferred debtissuance costs and accelerated vesting of stock options, specifically theportion of deferred debt issuance costs amortizable for book purposes and stockcompensation expensed for book purposes but anticipated to be non-deductiblefor tax purposes.  Furthermore, theCompany has recorded approximately $.8 million of state and federal taxes onthe gain ($2.4 million) recognized in the current fiscal quarter related to thegain on sale of a paper machine.  Basedon the above and achievement of projected fiscal 2005 pre-tax income, theCompany anticipates an overall effective tax rate for the year of approximately59%.

 

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**Item 2. Management’s Discussion and Analysis of Consolidated Financial Conditionand Results of Operations-**

 

**OVERVIEW**

 

Certainstatements contained in this Quarterly Report on Form 10-Q may containforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934 and as suchmay involve known or unknown risks, uncertainties and other factors which maycause the Company’s actual results, performance or achievements to bematerially different from future results, performance or achievements expressedor implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions anddescribe the Company’s future plans, strategies and expectations are generallyidentifiable by use of the words “may”, “will”, “should”, “expect”, “anticipate”,“estimate”, “believe”, “intend”, “project”, or comparable terminology.  Factors which could have a material adverseeffect on the operations and future prospects of the Company include, but arenot limited to, those set forth in Forward-Looking Statements and Risk Factorsin our Registration Statement Form S-4 dated September 30, 2004.  These risks and uncertainties should beconsidered in evaluating any forward-looking statements contained herein.

 

The Companymanufactures and markets a variety of specialty tissue hard rolls andmachine-glazed paper used in the manufacture of various end products, includingdiapers, facial and bath tissue, assorted paper towels and food wraps.  In addition, the Company produces a varietyof converted tissue products.

 

The Companyoperates in two reportable business segments: tissue and machine-glazed paper. The Company assesses the performance of its reportable business segmentsusing income from operations.  Incomefrom operations excludes interest income, interest expense, income tax expense,write-off of debt issuance costs and prepayment penalties, the impact offoreign currency gains and losses, and gain on sale of equipment.

 

**RESULTSOF OPERATIONS**

 

**Resultsof Operations for the Three Months Ended August 26, 2004 (the fiscal 2005three-month period) compared to August 28, 2003 (the fiscal 2004 three-monthperiod) and for the Six Months Ended August 26, 2004 (the fiscal 2005 six-monthperiod) compared to August 28, 2003 (the fiscal 2004 six-month period)**

 

**Netsales** for the fiscal 2005 three-month period increased$13.1 million, or 17.9%, to $86.3 million from $73.2 million for the comparableperiod in the prior year. Net sales for the fiscal 2005 six-month periodincreased $28.3 million, or 20.7%, to $165.1 million from $136.8 million forthe comparable period in the prior year. The increase in net sales is attributable to improved product mix,higher selling prices, and an increase in volume sold over the prior year.  For the fiscal 2005 three-month period andfiscal 2005 six-month period, the Company sold 69,167 and 136,005 tons,respectively of tissue hard

 

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rolls,machine-glazed paper hard rolls and converted tissue products compared to63,632 and 122,271 tons, respectively for the comparable periods in the prioryear.  This is an increase of 5,535 tonsor 8.7% for the fiscal 2005 three-month period and an increase of 13,734 tonsor 11.2% for the fiscal 2005 six-month period over the comparable periods inthe prior year.

 

Net sales forthe Company’s tissue segment for the fiscal 2005 three-month period were $60.5million, an increase of $12.3 million, or 25.4% over the comparable period inthe prior year.  Net sales for theCompany’s tissue segment for the fiscal 2005 six-month period were $115.6million, an increase of $26.9 million, or 30.4% over the comparable period inthe prior year.  The increase for thetissue segment is attributable to improved product mix, higher selling prices,and an increase in volume sold over the comparable periods in the prior year.** **Netsales for the Company’s machine-glazed segment for the 2005 three-month periodwere $25.8 million, an increase of $.8 million, or 3.2% over the comparableperiod in the prior year.  Net sales forthe Company’s machine-glazed segment for the 2005 six-month period were $49.5million, an increase of $1.4 million, or 2.8% over the comparable period in theprior year.  The increase for themachine-glazed segment is attributable to improved product mix and higher netselling prices.

 

**Grossprofit** for the fiscal 2005 three-month periodincreased to $10.9 million from $7.9 million, an increase of $3.0 million, or38.4% over the comparable period in the prior year.  Gross profit for the fiscal 2005 six-monthperiod increased to $19.9 million from $14.5 million, an increase of $5.4million, or 36.7% over the comparable period in the prior year.  As a percentage of net sales, gross profitincreased to 12.7% in the fiscal 2005 three-month period and 12.0% in thefiscal 2005 six-month period from 10.8% in the fiscal 2004 three-month periodand 10.6% in the fiscal 2004 six-month period. ** **The increase in grossprofit in the fiscal 2005 three-month and six-month periods was primarily attributableto improved product mix, higher net selling prices, and increased volume.  This increase was partially offset byincreased pulp, energy and freight costs.

 

Gross profitfor the Company’s tissue segment for the fiscal 2005 three-month period was $7.4million, an increase of $2.7 million, or 57.1% over the comparable period inthe prior year.  Gross profit for theCompany’s tissue segment for the fiscal 2005 six-month period was $13.6million, an increase of $4.9 million, or 55.0% over the comparable period inthe prior year.  Gross profit for theCompany’s machine-glazed segment for the fiscal 2005 three-month period was$3.5 million, an increase of $.3 million, or 10.3% over the comparable periodin the prior year.  Gross profit for theCompany’s machine-glazed segment for the fiscal 2005 six-month period was $6.3million, an increase of $.5 million, or 8.9% over the comparable period in theprior year.  As a percentage of netsales, gross profit for the tissue segment increased to 12.3% in the fiscal2005 three-month period and 11.8% in the fiscal 2005 six-month period from 9.8%in the fiscal 2004 three-month period and 9.9% in the fiscal 2004 six-monthperiod.  As a percentage of net sales,gross profit for the machine-glazed segment increased to 13.5% in the fiscal2005 three-month period and 12.7% in the fiscal 2005 six-month period from12.7% in the fiscal 2004 three-month period and 12.0% in the fiscal 2004six-month period.  The increase for thetissue segment is attributable to****improvedproduct mix, higher net selling

 

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prices, andincreased volume, which was partially offset by increased pulp, energy, andfreight costs.  The increase for themachine-glazed segment is attributable to improved product mix and increasednet selling prices, partially offset by increased pulp costs.

 

**Selling,general and administrative expenses**in the fiscal 2005three-month period increased $.6 million, or 17.8%, to $4.0 million from $3.4million in the fiscal 2004 three-month period. Selling, general and administrative expenses in the fiscal 2005six-month period increased $1.2 million, or 18.5%, to $7.6 million from $6.4million in the fiscal 2004 six-month period. The increase is primarily due to additional staffing requirements andprofessional fees to support compliance with Sarbanes-Oxley and increasedmedical costs.** **The Company anticipates increasesin selling, general and administrative expenses for the year ending February28, 2005 related to achieving and maintaining compliance with required rulesand regulations of the Securities and Exchange Commission associated with theCompany becoming a public filer (See “Liquidity; Sources and Uses of Capital”).  As a percentage of net sales, selling,general and administrative expenses in the fiscal 2005 three-month period was4.6%, consistent with the comparable period in the prior year.  As a percentage of net sales, selling,general and administrative expenses in the fiscal 2005 six-month perioddecreased to 4.6% from 4.7% in the comparable fiscal 2004 six-month period.

 

**Compensationfrom the redemption of stock options and accelerated vesting of stock options**includedas expenses in the fiscal 2005 six-month period income from operations was $3.9million; $3.4 million related to compensation from the redemption of stockoptions and $.5 million related to accelerated vesting of certain stockoptions, both triggered by the note offering completed in March 2004.  With respect to the $.5 million related toaccelerated vesting of certain stock options, $.3 million was recorded in thefiscal 2005 three-month period and $.2 million was recorded in the firstquarter of 2005.  Management may need torecognize additional expense should management’s estimate of the number of employeesthat will actually benefit from the accelerated vesting of the options need tobe adjusted.  Management will continue toupdate its estimate each reporting period and adjust the total expenserecognized until the original vesting period associated with the options hasexpired.

 

**Write-offof debt issuance costs and prepayment penalties**of$3.3 million included in the fiscal  2005six-month period income from operations is an expense incurred primarilyrelated to the write-off of debt issuance costs (non-cash) previouslycapitalized and associated with debt that was extinguished in March 2004 inassociation with the note offering.

 

**Interestexpense, net**for the fiscal 2005 three-month periodincreased $2.6 million to $4.0 million, compared to $1.4 million for the fiscal2004 three-month period.  Interestexpense for the fiscal 2005 six-month period increased $5.0 million to $7.9million, compared to $2.9 million for the fiscal 2004 six-month period.  The increase is due to****the increased level of long-term debtoutstanding as a result of the $162.0 million note offering completed in March2004.

 

15

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**Gainon sale of equipment**of $2.4 million included in thefiscal 2005 three-month period relates to the sale of a paper machine at theCompany’s Menominee mill.  Net proceedsfrom the sale were $4.0 million (gross proceeds of $5.2 million less brokeragefees and other direct costs of $1.2 million), of which $1.3 million has beenreceived in the fiscal 2005 three-month period and the remainder is to bereceived by the end of the Company’s fiscal 2005 third quarter in accordancewith the terms of the sale.

 

**Incometax (benefit) expense** for the fiscal 2005 three-monthperiod was a 20% expense compared to a 36% expense for the comparable fiscal2004 three-month period. Income tax (benefit) expense for the fiscal 2005six-month period was a benefit of 274% compared to a 36% expense for thecomparable fiscal year 2004 six-month period. The Company has recorded taxes for the six-month period at a 125%effective rate (benefit of $4.8 million) on the cumulative loss before the gainon sale of equipment ($3.8 million).  Theeffective tax rate is calculated based on the Company’s projected fiscal 2005pre-tax income and expected book-to-tax permanent differences, related to theportion of deferred debt issuance costs amortizable for book purposes and stockcompensation expensed for book purposes, but anticipated to be non-deductiblefor tax purposes.  Furthermore, theCompany has recorded approximately $.8 million of state and federal taxes onthe gain ($2.4 million) recognized in the fiscal 2005 three-month periodrelated to the gain on sale of a paper machine sold in this period.  Based on the above and assuming achievement ofprojected fiscal 2005 pre-tax income, the Company anticipates an overalleffective tax rate for the year of approximately 59%.

 

**Netincome** for the fiscal 2005 three-month period was $3.5million, compared to net income of $1.9 million for the comparable period inthe prior year.  Net income for thefiscal 2005 six-month period was $2.5 million, compared to net income of $2.8million for the comparable period in the prior year.** **Included in the fiscal2005 three-month period is a $.3 million pretax charge related to acceleratedvesting of certain stock options as described above.  Included in fiscal 2005 six-month net incomeis a $3.9 million pretax charge related to compensation from redemption ofstock options and accelerated vesting of certain stock options as describedabove.  Furthermore, included in thisamount is a $3.3 million pretax charge related to the write-off of debtissuance costs and prepayment penalties. The Company also incurred $4.1 million of interest expense in the fiscal2005 three-month period and $7.9 million of interest expense in the fiscal 2005six-month period compared to $1.4 million in the comparable fiscal 2004three-month period and $2.9 million in the comparable fiscal 2004 six-monthperiod.  Offsetting these expense itemswas a gain of $2.4 million ($1.6 million after tax) recorded in the fiscal 2005three-month period related to the sale of a paper machine sold in this period.

 

**FINANCIALCONDITION**

 

**Liquidity;Sources and Uses of Capital**

 

**Netcash provided by operations** was $9.4 million for thefiscal 2005 six-month period, compared to $2.1 million for the comparablefiscal 2004 six-month period. Significant

 

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non- cashitems included in the fiscal 2005 six-month period were $2.9 million for thewrite-off of debt issuance costs and $.5 million related to accelerated vestingof stock options, both of which are related to the $162.0 million note offeringcompleted in March 2004.  These chargesare offset by a gain on sale of equipment of $2.4 million.  Net of these items, non-cash items for thefiscal 2005 six- month period totaled $8.4 million compared to $8.6 million forthe comparable period in the prior year. ** **Cash flows used by changes inworking capital totaled $2.6 million for the fiscal 2005 six-month periodcompared to net cash used of $9.3 million for the comparable period in theprior year.  With respect to the changesin accounts receivable and inventory, cash used by these items was $2.3 millionfor the fiscal 2005 six-month period compared to cash used by these items of$9.9 million for the comparable period in the prior year.  This improvement is attributable to shortercollection periods on accounts receivable and continued focus on inventorylevels.  Cash used by other receivablesrelates to the cash to be received in the third quarter fiscal 2005 related tothe machine sale recognized in the fiscal 2005 three-month period.  Cash used by changes in prepaid expenses andother current assets was $5.0 million for the fiscal 2005 six-month periodcompared to cash used of $.8 million in the prior year.  The fluctuation is primarily the result ofthe significant tax benefit recognized in the fiscal 2005 six-month period.  Cash provided by changes in cash overdraft,accounts payable, accrued expenses, accrued interest and income taxes for thefiscal 2005 six-month period was $8.5 million compared to cash provided of $1.6million for the comparable period in the prior year.  The fluctuation is primarily due to theincrease in accrued interest based on the timing of interest payments relativeto the new notes and an increase in accounts payable due to the timing ofvendor payments.

 

**Netcash provided by investing activities** for the fiscal2005 six-month period was $.8 million compared to cash used by investingactivities of $5.3 million for the comparable fiscal 2004 six-monthperiod.  The change relates to the levelof capital spending period over period, offset by machine sale proceeds.

 

**Netcash provided by financing activities** for the fiscal2005 six-month period was $1.9 million compared to $2.8 million for thecomparable fiscal 2004 six-month period. In the current fiscal period proceedsof $160.2 million, net of $1.8 million of original issue discount, from thenote offering (see discussion below) were offset by (i) net payments on longterm debt and a revolving line of credit of $43.9 million and $11.0 million,respectively; (ii) a stockholder dividend to our parent in the amount ofapproximately $100.2 million to fund the purchase of certain shares of itscommon stock and warrants ($96.8), and to fund $3.4 million of compensationresulting from the redemption of certain stock options to purchase common stockof our parent; (iii) prepayment penalties of $.4 million; and (iv) payment offees and expenses related to the note offering in the amount of  $6.3 million.

 

In March 2004,the Company completed a Rule 144A offering of $162.0 million aggregateprinciple amount of 9 3⁄4% senior secured notes due 2010.  The Company raised $152.2 million, net ofdebt issuance costs of $8.0 million and original issuance discount of $1.8million.  At the same time, the Companyentered into a new $30.0 million

 

17

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revolvingworking capital facility with CIT Group/Business Credit Inc. A portion of theproceeds, along with a drawdown from the new working capital facility, wereused to pay off existing debt of approximately $56.0 million.  Furthermore, the Company used $100.2 millionof the proceeds to fund a stockholder dividend and compensation from theredemption of stock options ($3.4 million). As a result of the extinguishment of debt, approximately $2.9 million ofdebt issuance costs previously capitalized were written-off and the Companyincurred approximately $.4 million in prepayment penalties.  The total amount of $3.3 million is reflectedin write-off of debt issuance costs and prepayment penalties on the incomestatement.

 

The seniorsecured notes mature on March 15, 2010 and require semi-annual interestpayments on March 15 and September 15, with the first payment commencing onSeptember 15, 2004.

 

As of August26, 2004, there were no outstanding borrowings under the working capitalfacility.

 

As a result ofthe note offering described above, the vesting of certain stock options wasaccelerated and certain stock options were redeemed.  Accordingly, the Company incurredapproximately $3.9 million of compensation expense.  Furthermore, the Company used approximately$96.8 million of the proceeds of the Rule 144A offering of senior secured notesto fund a stockholder dividend to the Company’s parent to purchase shares ofits common stock and warrants.

 

In addition,as a result of the note offering described above, the Company has filed aregistration statement on Form S-4 with the Securities and Exchange Commission(SEC).  The Company anticipates increasedexpenses related to achieving and maintaining compliance with required SECrules and regulations once the registration statement has been declaredeffective by the SEC.  These expensesinclude, but are not limited to, costs associated with the creation ofdisclosure controls and procedures, internal control over financial reportingand compliance with periodic filing requirements.

 

**Cash**as of August 26, 2004 increased to $12.2 million froman overdraft position of $4.8 million as of the end of the prior fiscalyear.  The improvement in the Company’scash position is primarily due to the significant cash provided by operationsin the first six months of fiscal 2005.

 

**Receivables,net**as of August 26, 2004 increased to $41.7 millionfrom $37.4 million as of the end of the prior fiscal year.  The increase is the result of the increase insales volume and a higher net sales per ton value for the fiscal 2005 six-monthperiod compared to the comparable period in the prior fiscal year.

 

**Receivables,other**as of August 26, 2004 of $3.9 million relates tothe proceeds from the sale of a previously idled paper machine at the Company’sMenominee mill which has not yet been received as of quarter-end.

 

18

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**Inventories**as of August 26, 2004 decreased to $22.9 million from$24.8 million as of the end of the prior fiscal year.  The decrease is the result of a continuedfocus on inventory levels.

 

**Incometax receivable**as of August 26, 2004 increased to $5.8million from $.7 million as of the end of the prior fiscal year primarily dueto the tax benefit recorded in the fiscal 2005 six-month period.  See the income tax discussion above.

 

**Assetsheld for sale**as of August 26, 2004 decreased to zerofrom $2.2 million as of the end of the prior fiscal year as these assetsrelated to the previously idled paper machine at the Company’s Menominee millthat was sold in the fiscal 2005 three-month period.

 

**Debtissuance costs**as of August 26, 2004 increased to $7.5million from $4.7 million as of the end of the prior fiscal year due primarilyto the costs incurred in connection with the $162.0 million note offering.  Unamortized debt issuance costs totaling $2.9million associated with the previous refinancing were written off during thefirst quarter 2005.

 

**Accountspayable**as of August 26, 2004 increased to $21.8million from $16.9 million as of the end of the prior fiscal year due to timingof payments.  See the cash discussionabove.

 

**Accruedinterest**as of August 26, 2004 increased to $7.5million from $.3 million as of the end of the prior fiscal year due to thetiming of payment (semi-annual) of interest on the senior secured notes.

 

**Stockholders’equity (deficiency)**as of August 26, 2004 decreased toa deficiency of $8.8 million compared to equity of $84.5 million as of the endof the prior fiscal year. The Company used approximately $96.8 million of theproceeds of the Rule 144A offering of senior secured notes to fund astockholder dividend to the Company’s parent to purchase shares of its commonstock and warrants.  Approximately $66.2million was charged to capital in excess of par value, reducing this balance tozero and the remaining $30.6 million was charged to accumulated earnings,resulting in the deficiency at August 26, 2004. Net income generated for the fiscal 2005 six-month period reduced thedeficiency.

 

**CriticalAccounting Policies**

 

***Revenue Recognition***

 

Sales are madeto customers primarily located throughout North America.  We recognize revenue when persuasive evidenceof an arrangement exists, delivery has occurred, the fee is fixed ordeterminable and collectibility is reasonably assured.  Revenue is recognized from product sales whentitle and risk of loss has passed to the customer consistent with the relatedshipping terms, generally at the time products are shipped.  Certain sales have freight on boarddestination terms, in which case revenue is recognized

 

19

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when theproduct is received by the customer.  Werecord a provision for estimated sales returns and other allowances as areduction of revenue at the time of revenue recognition.

 

***Goodwill***

 

Effective March1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.”   Under SFAS No. 142, goodwill and intangibleassets with indefinite useful lives are no longer amortized.  Instead, we evaluate the carrying value oflong lived assets for impairment at least annually, or whenever indicators ofimpairment are deemed to exist. Impairment losses are recognized in operating results in the period theimpairment is recognized.  We performedthe initial impairment test upon adoption of SFAS No. 142 and again as ofFebruary 28, 2003 and February 28, 2004. There was no impairment as of any of these dates.  There were no indicators of impairment duringfiscal year 2003, fiscal year 2004 or the fiscal 2005 six-month period thatrequired us to evaluate impairment at any interim dates.

 

***Stock based compensation***

 

We account forstock options using the intrinsic value method under Accounting PrinciplesBoard (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.”  This method does not recognize compensationexpense for stock options granted under our stock option plan, if the exerciseprice is at least equal to the fair market value of our common stock, asdetermined by our Board of Directors, at the date granted.  Stock based compensation costs for stockawards are reflected in net income over the awards’ vesting period.

 

***Income taxes***

 

We recognizedeferred tax assets and liabilities for expected future tax consequences ofevents that have been included in the financial statements or income tax returns.  Under this methodology, deferred tax assetsand liabilities are determined based on the difference between the financialstatements and the tax basis of assets and liabilities using enacted tax ratesin effect for the year in which the differences are expected to reverse.

 

***Business Combinations***

 

We apply theguidance of SFAS No. 141, “Business Combinations,” to all businesscombinations.  Accordingly, purchaseconsideration paid is allocated to the assets acquired based on determined fairvalues.  Any purchase consideration paidin excess of the fair value of the net assets acquired is capitalized asgoodwill, and accounted for in accordance with SFAS No. 142.

 

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

 

In March 2004,the Company completed a Rule 144A offering of $162 million aggregate principleamount of 9 3⁄4% senior secured notes due 2010. At the same time, the Company entered into a new $30 million revolvingworking capital facility.  The Companyraised approximately $152 million, net of debt issuance costs and originaldiscount on the notes.  The proceeds,along with a drawdown from the new revolver, were used to pay off existing debtof approximately $56 million and to fund a stockholder dividend to the Company’sparent to purchase shares of its common stock and warrants and fundcompensation from the redemption of stock options of $100.2 million.  As a result of these transactions, theCompany is highly leveraged.  As of August26, 2004, there were no borrowings on the new working capital facility but theCompany has the ability to borrow funds under this facility up to an aggregateof $30 million and could be adversely affected by a significant increase ininterest rates.  The Company also hasobligations under an industrial revenue bond (balance as of August 26, 2004 of$.6 million) that is payable in annual installments with interest ranging from4.8% to 6.65%.

 

The Companyhas minimal foreign currency translation risk. All international sales other than sales originating from its Canadiansubsidiary are denominated in U. S. dollars. Due to the Company’s Canadian operations however, the Company could beadversely affected by unfavorable fluctuations in foreign currency exchangerates.

 

**Item 4. Controls and Procedures**

 

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

 

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

 

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PARTII — OTHER INFORMATION

 

Item6. Exhibits

 

(a) Exhibits

 
| 31.1   | Certification by President  and Chief Executive Officer pursuant to Rule 13a—14(a)                                                                                                 |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                    |
| 31.2   | Certification by Senior  Vice President, Finance and Chief Financial Officer pursuant to Rule  13a-14(a)                                                                                |
|   |                                                                                                                                                                                    |
| 32.1   | Certification by President  and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                       |
|   |                                                                                                                                                                                    |
| 32.2   | Certification by Senior  Vice President, Finance and Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002 |

 

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SIGNATURES

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|   | Cellu Tissue  Holdings, Inc. |
|--------|------------------------------|
|   |                         |
|   |                         |
| Date:  | November 12,  2004           |   |   | /s/ Russell  C. Taylor |   |
|   |                         | Mr. Russell  C. Taylor |
|   |                         | President  and Chief Executive Officer |
|   |                         |   |
| Date:  | November 12,  2004           |   |   | /s/ Dianne  M. Scheu |   |
|   |                         | Ms. Dianne  M. Scheu |
|   |                         | Senior Vice  President, Finance and Chief |
|   |                         | Financial  Officer |

 

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