Table of Contents

 

 

** **

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

 

----

 

**FORM 10-Q**

 

| **(Mark One)**                                                                                                                                                                                                  | ** ** | ** **                                                                                              |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                            | ** ** | ** **                                                                                              |
| x                                                                                                                                                                                                               | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                                                                                                                                                                      |
| **For  the Quarterly Period Ended May 28, 2009**                                                                                                                                                           |
| ** **                                                                                                                                                                                                      |
| **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)     |

 

**NotApplicable** (Former name, former address andformer fiscal year, if changed since last report)

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for thepast 90 days.   Yes o  No o (Note:  As a voluntary filer, not subject to thefiling requirements, the registrant filed all reports under Section 13 or15(d) of the Exchange Act during the preceding twelve months.)

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files). Yes o  No o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer or asmaller reporting company in Rule 12b-2 of the Exchange Act (Check One):.

 

| Large accelerated filer o                |   | Accelerated filer o         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer x                  |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  YesoNox

 

The number of shares outstanding of each of theregistrant’s classes of common stock as of June 26, 2009:

 

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

 

 

 

----

Table ofContents

 

CELLU TISSUE HOLDINGS, INC.

FORM 10-Q

QUARTER ENDED MAY 28, 2009

 

INDEX

 
| PART I –  FINANCIAL INFORMATION                                                           |   |
|-----------------------------------------------------------------------------------------------------|--------|
|                                                                                                |   |
| Item  1. Consolidated Financial Statements (unaudited)                                              |   |
|                                                                                                |   |
| 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

----

Table of Contents

 

PART I FINANCIAL INFORMATION

 

**Item 1.  Consolidated Financial Statements**

 

**CELLUTISSUE HOLDINGS, INC.  AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS (Unaudited)**

 
| ** **                                        | ** ** | **Three Months Ended** | ** **  |
|---------------------------------------------------|------------|------------------------|-------------|
| ** **                                        | ** ** | **May 28**        | ** **  | **May 29** | ** ** |
| ** **                                        | ** ** | **2009**               | ** **  | **2008** | ** ** |
|                                              | ** ** | ** **             | ** **  | ** ** | ** ** |
| Net  sales                                        |       | $                      | 118,928,222 |   | $ | 114,527,561 |   |
| Cost  of goods sold                               |       | 99,114,910             |        | 102,739,657 |   |
| Gross  profit                                     |       | 19,813,312             |        | 11,787,904 |   |
|                                              |       |                   |        |   |   |
| Selling,  general and administrative expenses     |       | 5,269,934              |        | 4,959,842 |   |
| Terminated  acquisition-related transaction costs |       | —                 |        | 75,000 |   |
| Stock  and related compensation expense           |       | 231,220                |        | 218,506 |   |
| Amortization  expense                             |       | 1,056,424              |        | — |   |
| Income  from operations                           |       | 13,255,734             |        | 6,534,556 |   |
|                                              |       |                   |        |   |   |
| Interest  expense, net                            |       | 6,506,553              |        | 4,979,688 |   |
| Foreign  currency loss (gain)                     |       | 356,941                |        | (43,080 | ) |
| Other  expense (income)                           |       | (16,578                | )           | 29,508 |   |
| Income  before income tax                         |       | 6,408,818              |        | 1,568,440 |   |
|                                              |       |                   |        |   |   |
| Income  tax expense                               |       | 4,097,953              |        | 575,970 |   |
| Net  income                                       |       | $                      | 2,310,865   |   | $ | 992,470 |   |

 

See accompanyingnotes to consolidated financial statements.

 

3

----

Table of Contents

 

**CELLUTISSUE HOLDINGS, INC.  AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                 | ** ** | **May 28** | ** **  | **February 28** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------|-------------|----------------------|------------|
| ** **                                                                                 | ** ** | **2009**        | ** **  | **2009**             | ** ** |
| ** **                                                                                 | ** ** | **(Unaudited)** | ** **  | ** **           | ** ** |
| **ASSETS**                                                                                 |       |            |        |                 |       |
| CURRENT  ASSETS:                                                                           |       |            |        |                 |       |
| Cash  and cash equivalents                                                                 |       | $               | 1,369,985   |                 | $          | 361,035 |   |
| Receivables,  net                                                                          |       | 49,360,010      |        | 54,065,899           |       |
| Inventories                                                                                |       | 48,287,665      |        | 47,216,049           |       |
| Prepaid  expenses and other current assets                                                 |       | 2,846,963       |        | 2,085,774            |       |
| Income  tax receivable                                                                     |       | 114,077         |        | 174,084              |       |
| Deferred  income taxes                                                                     |       | 3,515,295       |        | 3,515,295            |       |
| TOTAL  CURRENT ASSETS                                                                      |       | 105,493,995     |        | 107,418,136          |       |
| PROPERTY,  PLANT AND EQUIPMENT, NET                                                        |       | 305,304,800     |        | 301,987,941          |       |
| GOODWILL                                                                                   |       | 41,020,138      |        | 41,020,138           |       |
| Other  Intangibles, net                                                                    |       | 30,616,053      |        | 31,672,477           |       |
| OTHER  ASSETS                                                                              |       | 1,826,619       |        | 1,948,108            |       |
| TOTAL  ASSETS                                                                              |       | $               | 484,261,605 |                 | $          | 484,046,800 |   |
|                                                                                       |       |            |        |                 |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                              |       |            |        |                 |       |
| CURRENT  LIABILITIES:                                                                      |       |            |        |                 |       |
| Bank  overdrafts                                                                           |       | $               | —      |                 | $          | 3,285,420 |   |
| Revolving  line of credit                                                                  |       | 16,000,000      |        | 18,530,824           |       |
| Accounts  payable                                                                          |       | 17,963,833      |        | 16,726,143           |       |
| Accrued  expenses                                                                          |       | 27,762,965      |        | 26,548,639           |       |
| Accrued  interest                                                                          |       | 4,606,991       |        | 10,160,124           |       |
| Other  current liabilities                                                                 |       | 16,963,319      |        | 17,448,707           |       |
| Current  portion of long-term debt                                                         |       | 760,000         |        | 760,000              |       |
| TOTAL  CURRENT LIABILITIES                                                                 |       | 84,057,108      |        | 93,459,857           |       |
| LONG-TERM  DEBT, LESS CURRENT PORTION                                                      |       | 242,578,859     |        | 242,361,944          |       |
| DEFERRED  INCOME TAXES                                                                     |       | 77,397,907      |        | 75,110,277           |       |
| OTHER  LIABILITIES                                                                         |       | 5,378,865       |        | 5,378,059            |       |
| STOCKHOLDERS’  EQUITY:                                                                |       |            |        |                 |       |
| Common  stock, $.01 par value, 1,000 shares authorized, 100 shares issued and  outstanding |       | 1               |        | 1                    |       |
| Capital  in excess of par value                                                            |       | 71,180,080      |        | 70,948,860           |       |
| Accumulated  earnings                                                                      |       | 6,008,936       |        | 3,698,071            |       |
| Accumulated  other comprehensive loss                                                      |       | (2,340,151      | )           | (6,910,269           | )          |
| TOTAL  STOCKHOLDERS’ EQUITY                                                           |       | 74,848,866      |        | 67,736,663           |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                           |       | $               | 484,261,605 |                 | $          | 484,046,800 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

----

Table of Contents

 

**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

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

 
| ** **                                                                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                    | ** ** | **May 28**        | ** ** | **May 29** | ** ** |
| ** **                                                                                    | ** ** | **2009**               | ** ** | **2008** | ** ** |
| **Cash flows from operating activities**                                                      |       |                   |       |   |   |
| Net  income                                                                                   |       | $                      | 2,310,865  |   | $ | 992,470 |   |
| Adjustments  to reconcile net income to net cash provided by (used in) operating  activities: |       |                   |       |   |   |
| Stock-based  compensation                                                                     |       | 231,220                |       | 218,506 |   |
| Deferred  income taxes                                                                        |       | 2,287,630              |       | 67,077 |   |
| Accretion  of debt discount                                                                   |       | 596,915                |       | 155,069 |   |
| Amortization  of intangibles                                                                  |       | 1,056,424              |       | — |   |
| Amortization  of debt issuance costs                                                          |       | 112,783                |       | — |   |
| Derivatve  loss                                                                               |       | —                 |       | 119,802 |   |
| Depreciation                                                                                  |       | 5,928,005              |       | 5,854,038 |   |
| Changes  in operating assets and liabilities                                                  |       |                   |       |   |   |
| Receivables                                                                                   |       | 5,402,133              |       | (7,654,871 | ) |
| Inventories                                                                                   |       | (453,669               | )          | (903,874 | ) |
| Prepaid  expenses and other current assets and income tax receivable                          |       | (641,016               | )          | 774,279 |   |
| Other                                                                                         |       | 52,314                 |       | (145,252 | ) |
| Accounts  payable, accrued expenses and accrued interest                                      |       | (3,427,546             | )          | (4,103,876 | ) |
| Total  adjustments                                                                            |       | 11,145,193             |       | (5,619,102 | ) |
| *Net cash provided by (used in) operating activities*                                         |       | 13,456,058             |       | (4,626,632 | ) |
|                                                                                          |       |                   |       |   |   |
| **Cash flows from investing activities**                                                      |       |                   |       |   |   |
| Capital  expenditures, net                                                                    |       | (6,262,050             | )          | (2,474,891 | ) |
| *Net cash used in investing activities*                                                       |       | (6,262,050             | )          | (2,474,891 | ) |
|                                                                                          |       |                   |       |   |   |
| **Cash flows from financing activities**                                                      |       |                   |       |   |   |
| Bank  overdrafts                                                                              |       | (3,285,420             | )          | — |   |
| Payments  of long-term debt                                                                   |       | (380,000               | )          | (380,000 | ) |
| Payments  on revolving line of credit                                                         |       | (24,245,095            | )          | (18,300,000 | ) |
| Borrowings  on revolving line of credit                                                       |       | 21,714,271             |       | 26,500,000 |   |
| *Net cash (used in) provided by financing activities*                                         |       | (6,196,244             | )          | 7,820,000 |   |
| * *                                                                                      |       |                   |       |   |   |
| Effect  of foreign currency on cash                                                           |       | 11,186                 |       | 23,559 |   |
|                                                                                          |       |                   |       |   |   |
| *Net increase in cash and cash equivalents*                                                   |       | 1,008,950              |       | 742,036 |   |
| *Cash and cash equivalents at beginning of period*                                            |       | 361,035                |       | 883,388 |   |
| *Cash and cash equivalents at end of period*                                                  |       | $                      | 1,369,985  |   | $ | 1,625,424 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

 

5

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited)**

**May 28, 2009**

 

**Note 1Basis of Presentation and Significant Accounting Policies**

 

Theaccompanying unaudited interim consolidated financial statements include theaccounts of Cellu Tissue Holdings, Inc. (“Cellu Tissue” or the “Company”) and its wholly-ownedsubsidiaries.  The Company is awholly-owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”),which is a wholly-owned subsidiary of Cellu Parent Corporation (“Cellu Parent”).

 

Thesestatements have been prepared in accordance with accounting principlesgenerally accepted in the United States for interim financial information andwith the instructions to Form 10-Q and Article 10 of RegulationS-X.  Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairstatement have been included.  Operatingresults for the quarter ended May 28, 2009 are not necessarily indicativeof the results that may be expected for the fiscal year ending February 28,2010.  For further information, refer tothe Company’s consolidated financial statements and footnotes thereto as of February 28,2009 and for the year then ended included in the Company’s Annual Report on Form 10-K,from which the consolidated balance sheet at February 28, 2009 has beenderived, as filed with the Securities and Exchange Commission (“SEC”).

 

Stock-BasedCompensation

 

TheCompany accounts for stock based compensation in accordance with Statement ofFinancial Accounting Standards No. 123R (“SFAS 123R”), *Share-Based Payment*, which requires the measurement of allemployee share-based payments to employees, including grants of employee stockoptions, using the fair-value-based method and the recording of such expense inthe Company’s consolidated statement of operations.  The Company has one share-based paymentarrangement under the 2006 Stock Option and Restricted Stock Plan (the “Plan”).  Under the Plan, the administrator of the Plan(the “Plan Administrator”) may make awards of options to purchase shares ofcommon stock of Cellu Parent and/or awards of restricted shares of common stockof Cellu Parent.  A maximum of 12,095shares of common stock of Cellu Parent may be delivered in satisfaction ofawards under the Plan, determined net of shares of common stock withheld byCellu Parent in payment of the exercise price of an award or in satisfaction oftax withholding requirements.   The maximumnumber was increased from 8,095 to accommodate the grant made during thequarter (see below).  Key employees anddirectors of, and consultants and advisors to, Cellu Parent or its affiliateswho, in the

 

6

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 1Basis of Presentation and Significant Accounting Policies (continued)**

 

opinionof the Plan Administrator, are in a position to make a significant contributionto the success of Cellu Parent and its affiliates are eligible to participatein the Plan.   Stock options are grantedat a strike price at the estimated fair value of Cellu Parent’s stock on thedate of grant and have a 10-year term. Generally, stock option grants vest ratably over four years from thedate of grant.  The following describeshow certain assumptions affecting the estimated fair value of stock options aredetermined.  The dividend yield is zero;the volatility is based on historical market value of Cellu Parent’s stock; andthe risk-free interest rate is based on U.S. Treasury securities.  The Company uses historical data to estimateexercise, termination and holding period behavior for valuation purposes.  The weighted average fair value of stockoptions granted was $336.55 per share and the unrecognized total compensationcost as of May 28, 2009 related to nonvested awards is $646,732.  A summary of the outstanding options as of May 28,2009 and the activity during the three months then ended is as follows:

 
| ** **                          | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** |
|-------------------------------------|------------|-------------|------------|---------------------------------------|------------|----------------------------------------------------|------------|
| Outstanding, February 28, 2009 |       | 1,444       |       | $                                     | 776.77     |                                               | 8.20 Years |   |
| Forfeited                           |       | (377        | )          | $                                     | 824.52     |                                               | 8.78 Years |   |
| Granted                             |       | 3,726       |       | $                                     | 883.27     |                                               | 9.84 Years |   |
| Outstanding, May 28, 2009      |       | 4,793       |       | $                                     | 855.81     |                                               | 9.38 Years |   |
| Exercisable, May 28, 2009      |       | 516         |       | $                                     | 745.11     |                                               | 7.83 Years |   |

 

OnApril 13, 2009, Cellu Parent granted 1,600 stock options to non-executiveemployees, 35% of each individual’s stock options vest ratably over 4 years and65% are earned only upon attainment of certain market conditions relative to achange in ownership of the Company. Furthermore, Cellu Parent granted 574 stock options, 829 stock optionsand 723 stock options to the Company’s Chief Executive Officer, Chief OperatingOfficer and Chief Financial Officer, respectively, which are earned only uponattainment of certain market conditions relative to a change in ownership ofthe Company.  The fair value of the stockoption grants related to service (35% of 1,600 or 562) was estimated on thedate of grant using the Black-Scholes option pricing model.  The assumptions used to value the grantswere: no dividend yield; 40% volatility; 1.4% risk free interest rate; and10-year expected life.  With respect tothe remaining stock options granted associated with the attainment of certainmarket conditions, the Company has determined the fair value of these stockoptions at the date of grant using the Monte-Carlo model and the followingsassumptions:  no dividend yield; 40%volatility; 1.4% risk-free interest rate;

 

7

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 1Basis of Presentation and Significant Accounting Policies (continued)**

 

and3.5 year expected term.  The total fairvalue estimated for these options was $.7 million.

 

OnSeptember 1, 2008, Cellu Parent entered into a Restricted Stock Agreementwith the Company’s newly appointed VP, Sales pursuant to which Cellu Parentgranted 300 restricted shares of its common stock to the named individualpursuant to the Plan.  The shares willvest and cease to be restricted in four equal annual installments commencing onSeptember 1, 2009, as long as the named individual is continuouslyemployed by the Company until such vesting date with respect to hisshares.  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 in control.  Additionally, Cellu Parent has agreed to payan amount to the named individual equal to an amount that would be included insuch individual’s gross income and payable as income tax as a result of makinga Section 83(b) election under the Internal Revenue Code of 1986, asamended.  The named individual has made atimely Section 83(b) election and the Company has paid and recordedas compensation expense $200,275 related to the taxes noted above during September 2008.

 

OnAugust 6, 2007, Cellu Parent entered into a Restricted Stock Agreementwith the Company’s newly appointed Chief Financial Officer, pursuant to whichCellu Parent granted 700 restricted shares of its common stock to the namedindividual pursuant to the Plan.  Theshares will vest and cease to be restricted in four equal annual installmentscommencing on August 6, 2008, as long as the named individual iscontinuously employed by the Company until such vesting date with respect tohis shares.  Any restricted stockoutstanding at the time of a Covered Transaction (as defined in the Plan) shallbecome vested and cease to be restricted stock at the time of a change incontrol.  Additionally, the Parent hasagreed to pay an amount to the named individual equal to an amount that wouldbe included in such individual’s gross income and payable as income tax as aresult of making a Section 83(b) election under the Internal RevenueCode of 1986, as amended.  The namedindividual has made a timely Section 83(b) election.

 

OnJune 12, 2006, Cellu Parent entered into Restricted Stock Agreements withthe Company’s Chief Executive Officer, Chief Operating Officer and ChiefFinancial Officer, pursuant to which Cellu Parent granted 3,778 restrictedshares of its common stock to the Chief Executive Officer and 1,349 restrictedshares of its common stock to each of the other two named individuals pursuantto the Plan.  The shares will vest andcease to be restricted in four equal annual installments commencing on June 12,2007, as long as the named individual, as the case may be, is continuouslyemployed by the Company until each such vesting date with respect to 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 that time.  Additionally, the Parent has

 

8

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 1Basis of Presentation and Significant Accounting Policies (continued)**

 

agreedto pay an amount to the named individual equal to an amount that would beincluded in gross income and payable as income tax as a result of making a Section 83(b) electionunder the Internal Revenue Code of 1986, as amended.  All named individuals have made a timely Section 83(b) election.  Effective July 31, 2007, the then ChiefFinancial Officer resigned and forfeited three-fourths of the individual’s restrictedstock grant.  Accordingly, the Companyonly recorded compensation expense associated with this individual’s grantthrough June 12, 2007 as all other shares were forfeited and nocompensation expense is required to be recognized for forfeited shares.

 

Forthe three months ended May 28, 2009 and May 29, 2008, the Company hasrecorded $192,387 and $134,853, respectively of compensation expense related tothe vesting of the above grants in accordance with SFAS 123R.

 

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 as hedgesof 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 Companymeasures fair value of its derivative financial instruments in accordance withStatement of Financial Accounting Standards No. 157, “*Fair ValueMeasurements”*(“SFAS 157”). SFAS 157 defines fair value as the price that would be received to sellan asset or paid to transfer a liability in an orderly transaction betweenmarket participants. SFAS 157 establishes a fair value hierarchy for valuationinputs that gives the highest priority to quoted prices in active markets foridentical assets or liabilities and the lowest priority to unobservable inputs.  The fair value hierarchy is as follows:  level 1-inputs utilize quoted prices(unadjusted) in active markets for identical assets or liabilities that theCompany has the ability to access; level 2-inputs utilize data points that areobservable such as quoted prices, interest rate and yield curves; level3-inputs are unobservable data points for the asset or liability, and includesituations where there is little, if any, market activity for the asset orliability.

 

Ourderivative contracts, natural gas forward contracts, are valued usingindustry-standard models that use observable market inputs (forward marketprices for natural gas) as their basis. We classify these instruments within level 2 of the valuation hierarchy.  SFAS 157 requires that for level 2 and 3 of thefair value hierarchy, where appropriate, valuations are adjusted for variousfactors such as liquidity, bid/offer spreads and credit considerations (nonperformance risk).  The fair valueof these cashflow hedging instruments was a liability of $2.2 million, of which $2.0 millionis included in other

 

9

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 1Basis of Presentation and Significant Accounting Policies (continued)**

 

currentliabilities and $0.2 million is included in other liabilities and was aliability of $2.7 million, of which $2.4 million is included in other currentliabilities and $0.3 million is included in other liabilities as of May 28,2009 and as of February 28, 2009, respectively.  Prior to the third quarter of the fiscal yearended February 28, 2009, these contracts have not been designated ashedges and accordingly, for the three months ended May 29, 2008 a $0.1million loss has been recorded to earnings. Hedging activities transacted since the third quarter of fiscal year2009 have been designated as hedges and during the next 12 months, $2.0 millionof the $2.2 million remains to be reclassified to earnings (cost of goods sold)consistent with the underlying hedging transactions.

 

RecentAccounting Pronouncements

 

InSeptember 2006, the Financial Accounting Standard Board (“FASB”) issuedSFAS 157.  SFAS 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements.  This statement applies under other accountingpronouncements that require or permit fair value measurements (see Derivativesand Hedging above).  In February 2008,The FASB issued FSP 157-2, “*Effective Date of FASBStatement No. 157*”, which delayed the effective date of SFAS157 for non financial assets and liabilities to fiscal years beginning after November 15,2008 and interim periods within those fiscal years.  The adoption of SFAS 157-2 did not have amaterial impact on the Company’s results of operations and financial position.

 

InDecember 2007, the FASB issued Statement of Financial Accounting StandardsNo. 141 (R), “*Business Combinations*”(“SFAS 141 (R)”), and Financial Accounting Standards No. 160, *“Accounting and Reporting of Noncontrolling Interestsin Consolidated Financial Statements, an amendment of ARB No. 51”*(“SFAS160”).  These new standards willsignificantly change the financial accounting and reporting of businesscombination transactions and noncontrolling (or minority) interests inconsolidated financial statements.  SFAS141 (R) is required to be adopted concurrently with SFAS 160 and iseffective for business combination transactions for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008.  Earlyadoption is prohibited.  The Company iscurrently assessing the impact that SFAS 141 (R) and SFAS 160 will have onour results of operations and financial position for future acquisitions.

 

InMarch 2008, the FASB issued Statement of Financial Accounting Standards No. 161,“*Disclosures about Derivative Instruments andHedging Activities-an amendment of FASB Statement No. 133”*(“SFAS161”).  SFAS 161 requires entities toprovide enhanced disclosures about derivative instruments and hedgingactivities.  SFAS 161 is effective forfiscal years and interim periods beginning on or after November 15, 2008.

 

10

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 1Basis of Presentation and Significant Accounting Policies (continued)**

 

Theadoption of this statement did not have a material effect on the Company’sresults of operations and financial position.

 

In April 2008, the FASB issued FASB StaffPosition (“FSP”) No. FAS 142-3, “Determination of the Useful Life ofIntangible Assets”.  This FSP amends thefactors that should be considered indeveloping renewal or extension assumptions used to determine the useful lifeof a recognized intangible asset under SFAS No. 142, “Goodwill and OtherIntangible Assets” (“SFAS 142”).  Theobjective of this FSP is to improve the consistency between the useful life ofa recognized intangible asset under SFAS 142 and the period of expected cashflows used to measure the fair value of the asset under SFAS 141R, and othergenerally accepted accounting principles. This FSP applies prospectively to all intangible assets acquired afterthe effective date, which are fiscal years beginning after December 15,2008, whether acquired in a business combination or otherwise.  Early adoption is prohibited.  The adoption of this statement did not have asignificant impact on the Company’s financial position or results ofoperations.

 

In April 2009, the FASB issued FSP No. 107-1and Accounting Principles Board (APB) 28-1, *InterimDisclosures about Fair Value of Financial Instruments*”.  This FSP amends SFAS No. 107, “*Disclosures about Fair Value of Financial Instruments”*to require an entity to provide disclosures about fair value of financialinstruments in interim financial information. This FSP is to be applied prospectively and is effective for interim andannual periods ending after June 15, 2009, with early adoption permittedfor periods ending after March 15, 2009. The adoption of this FSP is not expected to have a significant impact onthe Company’s consolidated financial statements.

 

In May 2009, the FASB issued SFAS No. 165,“*Subsequent Events*” (“SFAS 165”).  SFAS 165 establishes general standards ofaccounting for and disclosure of events that occur after the balance sheet datebut before financial statements are issued or are available to be issued.  It should not result in significant changesin the subsequent events that an entity reports, either through recognition ordisclosure in its financial statements. SFAS 165 introduces the concept of financial statements being availableto be issued.  It requires the disclosureof the date through which an entity has evaluated subsequent events and thebasis for that date, that is, whether that date represents the date thefinancial statements were issued or were available to be issued.  This disclosure should alert all users offinancial statements that an entity has not evaluated subsequent events afterthat date in the set of financial statements being presented.  SFAS 165 will apply to both interim financialstatements and annual financial statements after June 15, 2009.  Adoption of SFAS 165 would not result in asignificant impact to the Company’s financial condition or results ofoperations.

 

11

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 2Inventories**

 

Componentsof inventories are as follows:

 
| ** **                       | ** ** | **May 28, 2009** | ** ** | **February 28, 2009** | ** ** |
|----------------------------------|------------|-----------------------|------------|----------------------------|------------|
| Finished goods                   |       | $                     | 32,866,996 |                       | $          | 30,608,649 |   |
| Raw materials                    |       | 3,298,849             |       | 5,133,206                  |       |
| Packaging materials and supplies |       | 13,516,838            |       | 12,326,731                 |       |
|                             |       | 49,682,683            |       | 48,068,586                 |       |
| Inventory reserves               |       | (1,395,018            | )          | (852,537                   | )          |
|                             |       | $                     | 48,287,665 |                       | $          | 47,216,049 |   |

 

**Note 3Acquisition**

 

OnJuly 2, 2008, the Company, through two newly created, wholly-ownedsubsidiaries, Cellu Tissue — Hauppauge, LLC (“Cellu Hauppauge”) and CelluTissue — Thomaston, LLC (“Cellu Thomaston”) consummated the acquisition ofcertain assets, and assumption of certain liabilities, from Atlantic Paper &Foil Corp. of N.Y., Atlantic Lakeside Properties, LLC, Atlantic Paper &Foil, LLC, Atlantic Paper & Foil of Georgia, LLC and ConsumerLicensing Corporation (collectively, the “Sellers”) pursuant to a definitiveasset purchase agreement (the “Purchase Agreement”) between the Company and theSellers.  The aggregate purchase price paid was $68.0 million, including acash payment at closing of $61.7 million and the issuance of a promissory noteby the Company to Atlantic Paper & Foil Corp. of N.Y. in the principalamount of $6.3 million (the “Seller Note”), plus the assumption of certainliabilities.  The Company also incurred$2.5 million of transaction related costs. The purchase price, which was subject to certain post-closing workingcapital adjustments, was adjusted downward by approximately $63,000 for theworking capital adjustment settlement that was finalized in the third fiscalquarter 2009.  The acquisition of assetsand assumption of liabilities is referred to as the “APF Acquisition” and theacquired business is referred to as “APF”. The Company financed the cash portion of the purchase price with cashon-hand, the borrowings described at Note 4 and an equity contribution from theParent.

 

TheAPF Acquisition has been accounted for as a purchase in accordance with theprovisions of SFAS 141 and, accordingly, the consolidated statement ofoperations includes the results of APF from the date of acquisition.  The acquisition has resulted in therecognition of goodwill, which is attributable to our tissue segment and willbe

 

12

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 3Acquisition (continued)**

 

deductiblefor tax purposes.  Goodwill reflects thefuture earnings and cash flow potential of the acquired business in excess offair values that are assigned to all other identifiable assets and liabilities.  Goodwill arises because the purchase pricepaid reflects factors including the strategic fit and expected synergies thisbusiness brings to existing operations. The Company has allocated the purchase price to the net assets acquiredin the acquisition based on its estimates of the fair value of assets andliabilities as follows:

 

| ** **                                                     | ** ** | **Purchase price allocated to:** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|
| Current assets, primarily accounts receivable and  inventories |       | $                                | 15,241,036 |   |
| Property, plant and equipment                                  |       | 5,306,225                        |       |
| Goodwill                                                       |       | 29,685,383                       |       |
| Noncompete agreements                                          |       | 12,770,000                       |       |
| Customer lists                                                 |       | 12,319,000                       |       |
| Trademarks                                                     |       | 56,000                           |       |
| Current liabilities                                            |       | (4,922,736                       | )          |
| Total                                                          |       | $                                | 70,454,908 |   |

 

The Company has estimated the fair value of the assets and liabilitiesof the APF Acquisition, utilizing information available at the time ofacquisition.  The purchase priceallocations are preliminary with respect to finalizing the transferability ofcertain tax credits and other minor items. The Company considered outside third-party appraisals of the tangibleand intangible assets to determine the applicable fair market values.   Depreciation has been calculated on the fairvalue assigned to the tangible fixed assets based on an average remaininguseful life.   Intangible assets arebeing amortized on a straight-line basis, assuming no significant residualvalue, over the following lives: noncompete agreements-5 years, customer lists-7 years and trademarks- 3years.

 

The results of APF’s operations from the July 2, 2008 date ofacquisition are primarily included in the Company’s tissue segment.  Part of the acquisition related to thefoam business, which the Company reports as a separate segment (see Note7).  Unaudited pro forma results ofoperations for the three months ended May 29, 2008, as if the Company andAPF had been combined at the beginning of the period presented, are presentedbelow.  The pro forma results includeestimates and assumptions, which the Company’s management believes arereasonable.  However, the pro formaresults do not include any cost savings or other effects of the plannedintegration of APF and are not necessarily indicative of the results whichwould have occurred if the business combination had been in effect on the datesindicated, or which may result in the future.

 

13

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 3Acquisition (continued)**

 
| ** **       | ** ** | **Three Months Ended May 29, 2008 (1)** | ** ** |
|------------------|------------|----------------------------------------------|------------|
| ** **       | ** ** | **Actual**                                   | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | **(in thousands)**                           | ** ** |
| Net sales        |       | $                                            | 114,528    |   | $ | 134,851 |   |
|             |       |                                         |       |   |   |
| Operating income |       | $                                            | 6,535      |   | $ | 8,115 |   |
| Net income       |       | $                                            | 992        |   | $ | 915 |   |

 

----

(1) Pro forma operating results include the operatingresults for APF for the three months ended March 31, 2008, as APF waspreviously a calendar year-end company.

 

**Note 4Long-Term Debt**

 

Long-termdebt consists of the following:

 
| ** **                                                                                                   | ** ** | **May 28, 2009** | ** **  | **February 28, 2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|----------------------------|------------|
| 9 3⁄4% senior secured notes due 2010                                                                      |       | $                     | 222,255,572 |                       | $          | 222,255,572 |   |
| Less discount                                                                                                |       | (1,951,713            | )           | (2,548,628                 | )          |
|                                                                                                         |       | 220,303,859           |        | 219,706,944                |       |
| Industrial revenue bond payable in semi-annual  installments, plus variable interest, due March 1, 2028 |       | 16,735,000            |        | 17,115,000                 |       |
| Seller Note payable, quarterly interest payments  only at 12% annum with principal due July 2, 2011     |       | 6,300,000             |        | 6,300,000                  |       |
|                                                                                                         |       | 243,338,859           |        | 243,121,944                |       |
| Less current portion of debt                                                                                 |       | 760,000               |        | 760,000                    |       |
|                                                                                                         |       | $                     | 242,578,859 |                       | $          | 242,361,944 |   |

 

***9 3⁄4% Senior Secured Notes due 2010***

 

InMarch 2004, the Company completed a private offering of $162.0 millionaggregate principal amount of 9 3⁄4% senior secured notes due 2010 (the “OriginalNotes”) pursuant to and governed by the Indenture, dated as of March 12,2004 (as amended and

 

14

----

Table of Contents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 4Long-Term Debt (continued)**

 

supplemented,the “Cellu Tissue Indenture”) among the Company, the subsidiary guarantorsparty thereto and The Bank of New York Mellon Trust Company, N.A., as successortrustee to the Bank of New York (the “Trustee”).  In connection with the Company’s acquisitionof CityForest Corporation (“CityForest”) in fiscal year 2008 (the “CityForestAcquisition”), the Company entered into a Note Purchase Agreement (the “NotePurchase Agreement”) with Wingate Capital Ltd. (the “Purchaser”), dated March 21, 2007, pursuant to which itissued and sold $20.3 million aggregate principal amount of 9 3⁄4% senior securednotes due 2010 (“First Additional Notes”) to the Purchaser for the purchaseprice of $20.0 million, which is equal to 98.7383% of the aggregate principalamount of the Additional Notes.  TheFirst Additional Notes were issued pursuant to and are governed by the CelluTissue Indenture.

 

Inconnection with the APF Acquisition (see Note 3) the Company entered into NotePurchase Agreements (the “Note Purchase Agreements”, or “Second AdditionalNotes”) with each of (i) GMAM Investment Funds Trust II, for the accountof the Promark Alternative High Yield Bond Fund (Account No. 7M2E), GMAMInvestment Funds Trust, General Motors Welfare Benefit Trust (VEBA), GMAMInvestment Funds Trust II for the account of the Promark Alternative High YieldBond Fund (Account No. 7MWD), DDJ High Yield Fund, Multi-Style,Multi-Manager Funds PLC The Global Strategic Yield Fund (f/k/a Multi-Style,Multi-Manager Funds PLC The Global High Yield Fund), DDJ Capital ManagementGroup Trust, Stichting Pensioenfonds Hoogovens, Caterpillar Inc. MasterRetirement Trust, J.C. Penney Corporation, Inc. Pension Plan Trust,Stichting Bewaarder Interpolis Pensioenen Global High Yield Pool, DDJ/OntarioOS Investment Sub II, Ltd. and Stichting Pensioenfonds Metaal en Techniek, (ii) ClarenRoad Credit Master Fund, Ltd. and (iii) UBS High Yield Relationship Fund,a series of the UBS Relationship funds (the “Purchasers”), dated July 2,2008, pursuant to which the Company issued and sold $40,000,000 aggregateprincipal amount of unregistered 9 3/4% senior secured notes due 2010 (“SecondAdditional Notes”) to the Purchasers for the purchase price of $36,900,000which is equal to 92.25% of the aggregate principal amount of the SecondAdditional Notes (together with the Original Notes and the First AdditionalNotes, the “Notes”).  The SecondAdditional Notes were issued pursuant to and are governed by the Cellu TissueIndenture.

 

TheNotes mature on March 15, 2010 and require semi-annual interest paymentson March 15 and September 15. The Notes are collateralized by a senior secured interest insubstantially all of the Company’s assets. The Cellu Tissue Indenture contains certain covenants, includinglimitations on certain restricted payments, the incurrence of additionalindebtedness and the sale of certain assets. The Cellu Tissue Indenture hasbeen amended by subsequent amendments pursuant to which CityForest, CelluHappauge and Cellu Thomaston became parties to the Cellu Tissue Indenture assubsidiary guarantors (collectively, the “Additional Guarantors”).  As subsidiary guarantors, the AdditionalGuarantors, on a joint and several basis, with all the existing

 

15

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 4Long-Term Debt (continued)**

 

subsidiaryguarantors, fully, unconditionally and irrevocably guarantee the obligations ofCellu Tissue under the Cellu Tissue Indenture and Notes.  Cellu Tissue has no independent assets oroperations and the Notes are unconditionally guaranteed by all of the Company’ssubsidiaries.

 

***Seller Note Payable***

 

Aspart of the financing of the APF acquisition, the Company entered into theSeller Note in the principal amount of $6,300,000.  Interest only at 12% is payable on the notein quarterly installments with the principal due July 2, 2011.

 

***Credit Agreement***

 

TheCompany entered into a Credit Agreement, dated as of June 12, 2006 (the “CreditAgreement”), among Cellu Tissue, as U.S. Borrower, Interlake AcquisitionCorporation Limited (“Interlake”), a subsidiary of Cellu Tissue, as CanadianBorrower, Parent, the other loan guarantors party thereto, JPMorgan Chase Bank,N.A., as U.S. Administrative Agent the “U.S. Administrative Agent”), JPMorganChase Bank, N.A., Toronto Branch, as Canadian Administrative Agent (the “CanadianAdministrative Agent”) and the other lenders party thereto.  The CreditAgreement provides for a $35.0 million working capital facility, which wassubsequently increased to $60.0 million (see discussion following), 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 equalto $32.0 million, which was subsequently increased to $57.0 million (seediscussion following), is available, in U.S. dollars, to the U.S. Borrowerunder the facility and an amount equal to $3.0 million is available, in U.S. orCanadian dollars, to the Canadian Borrower under the facility.  Borrowings of $17.4 million were made tofinance a portion of the CityForest Acquisition and borrowings of $12.1 millionwere made to finance a portion of the APF Acquisition.  As of May 28, 2009, there was $16.0million of borrowings outstanding under the working capital facility and excessavailability was $36.0****million.

 

CelluTissue has entered into a First Amendment, dated March 21, 2007 (the “FirstAmendment”), to the Credit Agreement dated June 12, 2006 (as amended bythe First Amendment, the “Amended Credit Agreement”) among Cellu Tissue,Interlake, certain subsidiaries of Cellu Tissue, the Parent, the U.S.Administrative Agent and the Canadian Administrative Agent.

 

16

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 4Long-Term Debt (continued)**

 

TheFirst Amendment (1) increases the working capital facility from $35.0million to $40.0 million, (2) permits the issuance and sale by the Companyof the First Additional Notes, (3) provides for the consummation of theCityForest Acquisition and the conversion by CityForest from a Minnesota corporationto a Minnesota limited liability company, (4) permits the assumption ofapproximately $18.4 million in aggregate principal amount of indebtedness ofCityForest in connection with the CityForest Acquisition in accordance with theterms of the CityForest Bond Documents (as defined below under “CityForest BondDocuments”), and (5) permits the guarantee by Cellu Tissue of certainobligations of CityForest under the CityForest Bond Documents.  In connection with the First Amendment,CityForest became a guarantor of the obligations of the borrowers under theAmended Credit Agreement.

 

TheCompany has entered into a Second Amendment, dated July 2, 2008 (the “SecondAmendment”), to the Credit Agreement dated June 12, 2006 (as amended bythe First Amendment and the Second Amendment, “Credit Agreement, as Amended”),among Cellu Tissue, Interlake, certain****subsidiariesof Cellu Tissue, the Parent, the U.S. Administrative Agent and the CanadianAdministrative Agent.The Second Amendment (1) increases the working capitalfacility from $40.0 million to $60.0 million, (2) permits the issuance andsale by Cellu Tissue of the Second Additional Notes, (3) provides for theconsummation of the APF Acquisition and (4) permits the issuance of theSeller Note.  In connection with theSecond Amendment, Cellu Hauppauge and Cellu Thomaston became guarantors of theobligations of the borrowers under the Credit Agreement, as Amended.

 

OnSeptember 29, 2008 the Company entered into the Third Amendment to theCredit  Agreement,dated as of June 12,2006.  This Amendment increases theamount of the Canadian Commitments by $2.0 million and reduces the amount ofthe US Commitments by the same amount.

 

***CityForest Bond Documents***

 

CityForestis party to a Loan Agreement, dated March 1, 1998 (the “Loan Agreement”),with the City of Ladysmith, Wisconsin (the “Issuer”).  Pursuant to the Loan Agreement, the Issuerloaned the proceeds of the Issuer’s Variable Rate Demand Solid Waste DisposalFacility Revenue Bonds, Series 1998 (CityForest Corporation Project) (the “Bonds”)to CityForest to finance the construction by CityForest of a solid wastedisposal facility.  Approximately $18.4million in aggregate principal amount of the Bonds was outstanding as of thedate of the CityForest Acquisition.  CityForestis required, under the terms of the Indenture of Trust governing the Bonds (the“CityForest Indenture”), to 

 

17

----

Table of Contents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 4Long-Term Debt (continued)**

 

providea letter of credit in favor of the trustee under the CityForest Indenture (the “BondsTrustee”).  CityForest has entered intoan Amended and Restated Reimbursement Agreement, dated March 21, 2007 (the“Reimbursement Agreement” and, together with the CityForest Indenture and theLoan Agreement, the “CityForest Bond Documents”), with Associated Bank,National Association (“Associated Bank”), pursuant to which Associated Bank hasextended the required letter of credit (the “Associated Bank Letter of Credit”)and has provided a revolving credit facility to CityForest in an aggregateprincipal amount of up to $3.5 million (the “Associated Bank Revolving CreditFacility”).

 

The Bonds Trustee is permitted to draw uponthe Associated Bank Letter of Credit to pay principal and interest due on theBonds, and to provide liquidity to purchase Bonds put to CityForest bybondholders and not remarketed; and CityForest is obligated under theReimbursement Agreement to reimburse Associated Bank for any such draws.CityForest is also obligated to pay a fee in respect of the aggregate amountavailable to be drawn under the Associated Bank Letter of Credit at a rate perannum initially equal to 1.25%, subject to adjustment on a quarterly basisbased on CityForest’s leverage.  Theexpiration date of the Associated Bank Letter of Credit is February 15,2011.

 

Amountsborrowed by CityForest under the Associated Bank Revolving Credit Facility bearinterest at a rate per annum equal to the LIBOR Rate (as defined in theReimbursement Agreement), plus an applicable margin. The applicable marginpercentage initially is 1.75%, subject to adjustment on a quarterly basis basedupon CityForest’sleverage.  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 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, ifCityForest terminates the Associated Bank Revolving Credit Facility prior to February 15,2009, CityForest is obligated to pay to Associated Bank a fee equal to 1.00% ofthe commitment then being terminated. The maturity date of the Associated BankRevolving Credit Facility is February 15, 2011.

 

TheReimbursement Agreement requires scheduled semi-annual payments of principal ofthe Bonds equal to approximately 2.00% of the principal amount outstanding asof the date of the CityForest Acquisition, with the balance payable at maturityof the Bonds on March 1, 2028. The Reimbursement Agreement also contains anumber of other provisions regarding reserve funds and other mandatory andoptional repayments in connection with the Bonds.  In connection therewith, the Company has $1.3million of reserved cash as of May 28, 2009 and May 29, 2008, which

 

18

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 4Long-Term Debt (continued)**

 

isincluded in other assets on the balance sheet. In addition, the ReimbursementAgreement provides that in certain circumstances where the Company incursindebtedness, as defined, in excess of amounts currently permitted under theCityForest Indenture or refinances the indebtedness issued under the CityForestIndenture, Associated Bank may require CityForest to repay all of itsobligations to Associated Bank under the Reimbursement Agreement and either tocause the Bonds to be redeemed or to replace the Associated Bank Letter ofCredit with a Substitute Credit Facility, as such term is defined in theCityForest Indenture.

 

TheReimbursement Agreement contains various affirmative and negative covenantscustomary for working capital and term credit facilities, as well as additionalcovenants relating to the Bonds.  Thenegative covenants include limitations on: indebtedness; liens; acquisitions,mergers and consolidations; investments; guarantees; asset sales; sale andleaseback transactions; dividends and distributions; transactions withaffiliates; capital expenditures; and changes to the status of the Bonds.CityForest is also required to comply on a quarterly basis with a maximumleverage covenant and a minimum fixed charge coverage covenant. TheReimbursement Agreement also contains customary events of default,including:  payment defaults; breaches ofrepresentations and warranties; covenant defaults; cross-defaults to certainother debt, including the Notes and indebtedness under the Credit Agreement (asamended from time to time); certain events of bankruptcy and insolvency;judgment defaults; certain defaults related to the Employee Retirement IncomeSecurity Act of 1974, as amended; and a change of control of CityForest or theCompany.

 

TheCompany has guaranteed all of the obligations of CityForest under theReimbursement Agreement, pursuant to a Guaranty, dated March 21, 2007 (the“Cellu Tissue Guaranty”), executed by the Company in favor of Associated Bank.In addition, the obligations of CityForest under the Reimbursement Agreementare secured 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,on the one hand, and the U.S. Administrative Agent and the CanadianAdministrative Agent, on the other hand, as to the collateral of CityForestsecuring the Reimbursement Agreement and the Amended Credit Agreement.

 

**Note 5Debt and Note Issuance Costs**

 

Inconnection with the financing related to the APF Acquisition, the Companyincurred approximately $232,000 and $654,000 of costs related to the amendmentto the credit

 

19

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 5Debt and Note Issuance Costs (continued)**

 

agreementand note issuance, respectively.  Thesecosts have been capitalized as of the date of financing and are being amortizedover the respective terms of the financing. The debt issuance costs and related accumulated amortization balances asof May 28, 2009 and February 28, 2009 are as follows:

 
| ** **                           | ** ** | **May 28, 2009** | ** ** | **February 28, 2009** | ** ** |
|--------------------------------------|------------|-----------------------|------------|----------------------------|------------|
| Debt issuance costs-credit agreement |       | $                     | 231,651    |                       | $          | 231,651 |   |
| Note issuance costs                  |       | 654,307               |       | 654,307                    |       |
|                                 |       | 885,958               |       | 885,958                    |       |
| Accumulated amortization             |       | (419,453              | )          | (306,668                   | )          |
|                                 |       | $                     | 466,505    |                       | $          | 579,290 |   |

 

Thesecosts, net of accumulated amortization, are included in other assets on thebalance sheet as of May 28, 2009 and February 28, 2009.

 

**Note 6Comprehensive Income**

 

Thecomponents of comprehensive income for the three months ended May 28, 2009and May 29, 2008 are as follows:

 
| ** **                               | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------|------------|------------------------|------------|
| ** **                               | ** ** | **May 28,  2009** | ** ** | **May 29,  2008** | ** ** |
| Net income                               |       | $                      | 2,310,865  |   | $ | 992,470 |   |
| Derivative gain                          |       | 482,928                |       | — |   |
| Foreign currency translation adjustments |       | 4,087,190              |       | (148,594 | ) |
| Comprehensive  income                    |       | $                      | 6,880,983  |   | $ | 843,876 |   |

 

**Note 7Business Segments**

 

TheCompany operates in three business segments: tissue, machine-glazed paper and foam. The foam business segment was added in connection with the APFAcquisition (see Note 3).  The Companyassesses the performance of its business segments using income from operations.Income from operations for the three months ended May 29, 2008 includes$0.3 million of bad debt expense associated with a customer bankruptcy and $0.3million related to additional sales tax incurred at one of our facilities.  Of this $0.6 million, $0.2 million impactsthe machine-glazed paper segment and $0.4 million impacts the tissuesegment.  Income from operations excludesinterest income, interest expense, other income (expense), income tax expense(benefit) and the impact of foreign currency gains and losses.  A portion of corporate and shared expenses isallocated to

 

20

----

Table ofContents

 

**Cellu Tissue Holdings, Inc. and Subsidiaries**

**Notes to Consolidated Financial Statements (Unaudited) (continued)**

 

**Note 7Business Segments (continued)**

 

eachsegment.  Segment information for thethree months ended May 28, 2009 and May 29, 2008 is as follows:

 
| ** **                                   | ** ** | **Three Months Ended** | ** **  |
|----------------------------------------------|------------|------------------------|-------------|
| ** **                                   | ** ** | **May 28, 2009**  | ** **  | **May 29, 2008** | ** ** |
| **Net Sales**                                |       |                   |        |   |   |
| Tissue                                       |       | $                      | 93,467,361  |   | $ | 85,797,050 |   |
| Machine-glazed paper                         |       | 23,594,065             |        | 28,730,511 |   |
| Foam                                         |       | 1,866,796              |        | — |   |
| Consolidated                                 |       | $                      | 118,928,222 |   | $ | 114,527,561 |   |
|                                         |       |                   |        |   |   |
| **Segment income from operations**           |       |                   |        |   |   |
| Tissue                                       |       | $                      | 12,354,854  |   | $ | 6,052,591 |   |
| Machine-glazed paper                         |       | 1,340,387              |        | 481,965 |   |
| Foam                                         |       | 616,917                |        | — |   |
| Total segment income from operations         |       | 14,312,158             |        | 6,534,556 |   |
| Amortization expense                         |       | (1,056,424             | )           | — |   |
| Interest expense, net                        |       | (6,506,553             | )           | (4,979,688 | ) |
| Net foreign currency transaction (loss) gain |       | (356,941               | )           | 43,080 |   |
| Other income (expense)                       |       | 16,578                 |        | (29,508 | ) |
| Pretax income                                |       | $                      | 6,408,818   |   | $ | 1,568,440 |   |
|                                         |       |                   |        |   |   |
| **Capital Expenditures**                     |       |                   |        |   |   |
| Tissue                                       |       | $                      | 5,589,016   |   | $ | 2,029,529 |   |
| Machine-glazed paper                         |       | 302,801                |        | 254,830 |   |
| Foam                                         |       | —                 |        | — |   |
| Corporate                                    |       | 382,410                |        | 190,532 |   |
| Consolidated                                 |       | $                      | 6,274,227   |   | $ | 2,474,891 |   |
| ** **                                   |       |                   |        |   |   |
| **Depreciation**                             |       |                   |        |   |   |
| Tissue                                       |       | $                      | 4,439,143   |   | $ | 4,318,726 |   |
| Machine-glazed paper                         |       | 1,467,984              |        | 1,535,312 |   |
| Foam                                         |       | 20,878                 |        | — |   |
| Consolidated                                 |       | $                      | 5,928,005   |   | $ | 5,854,038 |   |

 

21

----

Tableof Contents

 

**Cellu Tissue Holdings, Inc.and Subsidiaries**

**Notes to Consolidated FinancialStatements (Unaudited) (continued)**

 

**Note 8 Income Taxes**

 

The effective income tax rate for the three months ended May 28,2009 is 63.9% compared to 36.7% for the three months ended May 29,2008.  Included in the income tax expensefor the three months ended May 28, 2009 is discrete tax expense of $1.8million associated with a change in the Company’s effective federal tax ratefrom 34% to 35% which is expected to be incurred in the current fiscal yearbased on projected taxable income.

 

The Company recognizes interest and penalties related to uncertain taxpositions in income tax expense.  Thefiscal tax years 2005 through 2009 remain open to examination by the majortaxing jurisdictions to which the Company is subject.  As of May 28, 2009, the Company does notexpect any material changes to unrecognized tax positions within the next 12months.

 

**Note 9 Goodwill and Other Intangibles, Net**

 

Goodwill, trademarks and other intangibles and related accumulatedamortization as of May 28, 2009 and February 28, 2009 are as follows:

 
| ** **               | ** ** | **May 28, 2009** | ** ** | **February 28, 2009** | ** ** |
|--------------------------|------------|-----------------------|------------|----------------------------|------------|
| Goodwill                 |       | $                     | 41,020,138 |                       | $          | 41,020,138 |   |
|                     |       |                  |       |                       |       |
| Trademarks               |       | $                     | 9,456,000  |                       | $          | 9,456,000 |   |
| Noncompete agreements    |       | 12,770,000            |       | 12,770,000                 |       |
| Customer lists           |       | 12,319,000            |       | 12,319,000                 |       |
|                     |       | 34,545,000            |       | 34,545,000                 |       |
| Accumulated amortization |       | (3,928,947            | )          | (2,872,523                 | )          |
| Other Intangibles, Net   |       | $                     | 30,616,053 |                       | $          | 31,672,477 |   |

 

Intangible assets are being amortized on a straight-line basis,assuming no significant residual value, over the following lives:  noncompete agreements-5 years, customerlists-7 years and trademarks- 3 years. Amortization expense for the three months ended May 28, 2009 was$1,056,424.  As the amortizableintangible assets arose as part of the APF Acquisition, no amortization expensewas applicable for the three months ended May 29, 2008 as the acquisitiondate was July 2, 2008.

 

**Note 10 Subsequent Event**

 

On June 3, 2009 the Company issued $255.0 million in aggregateprincipal amount of 11 1⁄2% Senior Secured Notes due 2014 (the “New Notes”),which mature on June 1, 2014, pursuant to an indenture, dated as of June 3,2009 (the “New Indenture”), among the Company, the subsidiary guarantors partythereto and The Bank of New York Mellon

 

22

----

Tableof Contents

 

**Cellu Tissue Holdings, Inc.and Subsidiaries**

**Notes to Consolidated FinancialStatements (Unaudited) (continued)**

 

**Note 10 Subsequent Event (continued)**

 

Trust Company, N.A., as trustee. Interest on the New Notes is payable semiannually on June 1 and December 1of each year, commencing on December 1, 2009. The New Notes were offeredin the United States to qualified institutional buyers pursuant to Rule 144Aof the Securities Act of 1933, as amended, and outside the United Statespursuant to Regulation S under the Securities Act of 1933, as amended.  In connection with the issuance of the NewNotes, the Company, and the Subsidiary Guarantors entered into a registrationrights agreement, dated as of June 3, 2009, with the initial purchasers ofthe New Notes (“the Registration Rights Agreement”), obligating the Company touse its reasonable best efforts to file with the SEC and cause to becomeeffective a registration statement (the “Exchange Offer Registration Statement”)relating to an offer to exchange the New Notes for exchange notes with termssubstantially identical in all material respects with the New Notes on orbefore June 4, 2010.  Once theExchange Offer Registration Statement has been declared effective, the Companywill offer the exchange notes in exchange for surrender of the New Notes.

 

The Company used the net cash proceeds from the offering of the NewNotes to pre-fund the redemption of its $222,255,572 in aggregate principalamount outstanding of its 9 3⁄4% Senior Secured Notes due 2010 and satisfy anddischarge its obligations under the Cellu Tissue Indenture.  As the Company issued new debt to payoff theold debt, the classification of the long-term debt as of May 28, 2009 isshown as long-term on the balance sheet and footnote disclosure (see Note5).  In addition, in connection with theoffering of the New Notes, the Company amended its Credit Agreement to allowfor the incurrence of indebtedness under the New Indenture in replacement ofindebtedness under the Cellu Tissue Indenture. The Company also received the written consent of Associated Bank, thelender under the loan agreement related to CityForest’s industrial revenuebonds, in connection with the transaction.

 

As of May 28, 2009, the Company had incurred and capitalized approximately$1.2 million of costs associated with the refinancing.

 

23

----

Tableof Contents

 

**Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

Certain statements contained in this Quarterly Report on Form 10-Qmay contain forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended and, as such, may involve known orunknown risks, uncertainties and other factors which may cause our actualresults, performance or achievements to be materially different from futureresults, performance or achievements expressed or implied by suchforward-looking statements. Forward-looking statements, which are based on certain assumptions anddescribe our future plans, strategies and expectations are generallyidentifiable by use of the words “may”, “will”, “should”, “expect”, “anticipate”,“estimate”, “believe”, “intend”, “project”, or comparable terminology.  Factors which could have a material adverseeffect on our operations and future prospects include, but are not limited to,those set forth in “Forward-Looking Statements” in our Annual Report on Form 10-Kfor our fiscal year ended February 28, 2009.  These risks and uncertainties should beconsidered in evaluating any forward-looking statements contained herein.

 

We produce converted tissue products, tissue hard rolls andmachine-glazed paper, and we believe we are one of the leaders in the valueretail converted tissue product market. Our customers include leading consumer retailers and away-from-homedistributors of tissue products, vertically integrated manufacturers andthird-party converters serving the tissue and machine-glazed segments.  Most of the tissue products we convert areinternally sourced from the tissue hard rolls that we manufacture to thespecifications requested by our customers. The tissue hard rolls that we manufacture, but do not convert, aremarketed to customers for use in various end products, including diapers, bathand facial tissue, assorted paper towels and napkins.  In addition to converted tissue products andtissue hard rolls, we also manufacture machine-glazed paper and polystyrenefoam used in various end products, including food wraps and foam plates,although foam products are not a significant portion of our business.

 

**Our Segments**

 

Weoperate in three segments:  tissue,machine-glazed paper and foam.  In ourtissue segment, we derive our revenues from the sale of:

 

·                  converted tissue products, including avariety of private label consumer and away-from-home bath and facial tissue,napkins and folded and rolled towels; and

 

·                  tissue hard rolls sold as facial and bathtissue, special medical tissue, industrial wipers, napkin and paper towel stockand absorbent cover stock.

 

We derive our revenues in our machine-glazedpaper segment from the sale of:

 

24

----

Table of Contents

 

·                  machine-glazed paper hard rolls tothird-party converters that manufacture fast food and commercial food wrap, aswell as niche market products such as gum wrappers, coffee filters,  paper used to line packs of cigarettes, waxpaper and butter wraps; and

 

·                  converted wax paper products, including wetand dry wax paper, sandwich bags and wax paper.

 

We derive our revenues in our foam segment, which was added in fiscalyear 2009 with the APF Acquisition, primarily from the sale of foam plates as aprivate branded product to a single customer.

 

***APF Acquisition***

 

On July 2, 2008, we consummated the APF Acquisition.  The aggregate purchase price paid was $68.0million, including a cash payment at closing of $61.7 million and the issuanceof a promissory note by us to Atlantic Paper & Foil Corp. of N.Y. inthe principal amount of $6.3 million (the “Seller Note”), plus the assumptionof certain liabilities.  We also incurred$2.5 million of transaction related costs. The purchase price, which was subject to post-closing working capitaladjustments, was adjusted downward by approximately $63,000 by the workingcapital adjustment settlement that was finalized in the third quarter of fiscalyear 2009.

 

The results of operations of the APF entities from the July 2, 2008date of acquisition are primarily included in our tissue segment.  Part of the acquisition related to thefoam business, which we report as a separate segment.  Unaudited pro forma results of operations forthe three months ended May 29, 2008, as if we and APF had been combined atthe beginning of the period presented, are presented in the notes to theconsolidated financial statements (see Note 3).

 

***Subsequent Event***

 

On June 3, 2009 we issued $255.0 million in New Notes, whichmature on June 1, 2014, pursuant to the New Indenture.   Interest on the New Notes is payablesemiannually on June 1 and December 1 of each year, commencing on December 1,2009.  The New Notes were offered in theUnited States to qualified institutional buyers pursuant to Rule 144A ofthe Securities Act of 1933, as amended, and outside the United States pursuantto Regulation S under the Securities Act of 1933, as amended.  In connection with the issuance of the NewNotes, we, and the our Subsidiary Guarantors entered into the RegistrationRights Agreement, dated as of June 3, 2009, with the initial purchasers ofthe New Notes, obligating us to use our reasonable best efforts to file withthe SEC and cause to become effective the Exchange Offer Registration Statementrelating to an offer to exchange the New Notes for exchange notes with termssubstantially identical in all material respects with the New Notes on orbefore June 4, 2010.  Once theExchange Offer Registration Statement has been declared effective, we willoffer the exchange notes in exchange for surrender of the New Notes.

 

25

----

Tableof Contents

 

We used the net cash proceeds from the offering of the New Notes topre-fund the redemption of our $222,255,572 in aggregate principal amountoutstanding of our 9 3⁄4% senior secured Notes due 2010 and satisfy and dischargeour obligations under the Cellu Tissue Indenture.  In addition, in connection with the offeringof the New Notes, we amended our Credit Agreement to allow for the incurrenceof indebtedness under the New Indenture in replacement of indebtedness underthe Cellu Tissue Indenture.  We alsoreceived the written consent of Associated Bank, the lender under the loanagreement related to CityForest’s industrial revenue bonds, in connection withthe transaction.

 

**RESULTS OF OPERATIONS**

 

**Results of Operations for the Three Months Ended May 28, 2009 (thefiscal 2010 three-month period) compared to the Three Months Ended May 29,2008 (the fiscal 2009 three-month period)**

 

**Net sales** for the fiscal 2010 three-month period increased$4.4 million, or 3.8%, to****$118.9 millionfrom $114.5 million for the comparable period in the prior year.   For the fiscal 2010 three-month period, wesold 78,008 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products.  This is anincrease of 559 tons, or approximately 1%, from the comparable period in theprior year.  During the quarter, wein-sourced approximately 6,500 tons of hardrolls for our converting operationsthat we had previously purchased on the hardroll market, which served to reduceexternal shipments by a similar amount. This is consistent with our strategy to increase the vertical integrationof the acquired operations, supporting improved quality control andprofitability.  Net selling price per tonincreased from $1,479 for the fiscal 2009 three-month period to $1,501 for thefiscal 2010 three-month period.  Thisslight increase in price primarily reflects significant improvements in productmix associated with APF Acquisition.  Theimpact of mix improvements is partially offset by downward pricing pressureassociated with declines in pulp prices, particularly in machine-glazed andtissue hardrolls.

 

Net sales for our tissue segment for the fiscal 2010 three-month periodwere $93.5 million, an increase of $7.7 million, or 8.9%, from the comparableperiod in the****prior year.  This increase is the result of the APFAcquisition partially offset by downward pressure on prices as noted above.

 

Net sales for our machine-glazed segment for the fiscal 2010three-month period were****$23.6 million,a decrease of $5.1 million, or 17.9%,****from thecomparable period in the prior year. This decrease is attributable to a decrease in tonnage sold and adecrease in net selling price per ton over the comparable period in the prioryear.

 

Net sales for our foam segment for the fiscal 2010 three-month periodwere $1.8 million.  We started reportingwith respect to the foam segment following the APF Acquisition  and therefore, do not have comparable periodinformation.

 

**Gross profit** for the fiscal 2010 three-month period increased to$19.8 million from $11.8 million, an increase of $8.0 million, or 68.1%, fromthe comparable period in the 

 

26

----

Tableof Contents

 

prior****year. **  **As a percentage of net sales,gross profit increased to 16.7% in the fiscal 2010 three-month period from10.2% in the fiscal 2009 three-month period. ** **The increase in gross profit in thefiscal 2010 three-month period is primarily attributable to the improvements inproduct mix, decreases in net pulp cost and net energy cost per ton, partiallyoffset by the downward pressure on prices noted above.

 

Gross profit for our tissue segment for the fiscal 2010 three-monthperiod increased to $16.6 million from $10.1 million, an increase of $6.5million, or 65.1%, from the comparable period in the prior year.  Gross profit for our machine-glazed segmentfor the fiscal 2010 three-month period increased to $2.6 million, an increaseof $0.9 million, or 49.5%, from the comparable period in the prior year.  Gross profit for our foam segment for thefiscal 2010 three-month period was $0.6 million.  As a percentage of net sales, gross profitfor the tissue segment increased to 17.8% in the fiscal 2010 three-month periodfrom 11.7% in the fiscal 2009 three-month period.  As a percentage of net sales, gross profitfor the machine-glazed segment increased to 11.1% in the fiscal 2010three-month period from 6.1% in the fiscal 2009 three-month period.  As a percentage of net sales, gross profitfor the foam segment was 33.5%.

 

**Selling, general and administrative expenses**in the fiscal2010 three-month period increased $0.3 million, or 6.3%, to $5.3 million from$5.0 million in the fiscal 2009 three-month period.  As a percentage of net sales, selling generaland administrative expenses increased slightly to 4.4% for the fiscal 2010three-month period from 4.3% for the comparable period in the prior year.

 

**Terminatedacquisition-related transaction costs** in the fiscal 2009 three-month period of less than $0.1 millionrelated to costs incurred related to an acquisition that did not transpire.

 

**Stock and related compensation expense**in the fiscal 2010 and 2009three-month periods of $0.2 million relates primarily to the accounting forrestricted stock and stock option grants.

 

**Amortization expense**in the fiscal 2010three-month period of $1.1 million relates to the amortization of theintangible assets recorded in connection with the APF Acquisition.

 

**Interest expense, net**in the fiscal 2010three-month period was $6.5 million compared to $5.0 million in the fiscal 2009three-month period.  This increase is dueto the additional debt incurred in connection with the APF Acquisition.

 

**Foreign currency loss (gain)**in the fiscal 2010 three-month period was aloss of $0.4 million compared to a gain of less than $0.1 million in the fiscal2009 three-month period.  The fluctuationrelates to the change in the Canadian currency exchange rate period overperiod.

 

**Income tax expense** for the fiscal 2010three-month period was $4.1 million or an effective tax rate of 63.9% comparedto income tax expense of $0.6 million or an 

 

27

----

Tableof Contents

 

effective tax rate 36.7% benefit for the fiscal 2009 three-monthperiod.  Included in the income taxexpense for the fiscal 2010 three-month period is discrete tax expense of $1.8million associated with a change in our effective federal tax rate from 34% to35% which is expected to be incurred in the current fiscal year based onprojected taxable income.

 

**Net income**for the fiscal 2010 three-month period was $2.3million compared to $1.0 million for the comparable period in the prior year.

 

**FINANCIAL CONDITION**

 

**Liquidity and Capital Resources**

 

Our principal liquidity requirements are to service debt and meetworking capital, tax and capital expenditure needs.  Our total debt at May 28, 2009 was$259.3 million.  We fund our workingcapital requirements, capital expenditure needs and tax liabilities from netcash provided by operating activities and borrowings under our working capitalfacility.  Additionally, in the past, wehave issued debt securities to fund acquisitions.

 

The following is a summary of our outstanding indebtedness.  For additional information regarding ourindebtedness, see the notes to consolidated financial statements.

 

***Working capital facility***

 

We have a $60.0 million working capital facility that matures June 12,2011.  As of May 28, 2009, $16.0million of borrowings remained outstanding under the working capital facilityand excess availability was $36.0 million, including letters of credit of $5.8million in the aggregate principal amount.

 

***2010 Notes***

 

As of May 28, 2009, approximately $222.3 million in aggregateprincipal amount of the Notes were outstanding. See Refinancing below.

 

***APF Note***

 

As part of the financing of the APF Acquisition, we entered into asubordinated, unsecured promissory note in the amount of $6.3 million thatbears interest at 12% per year payable in monthly installments with theprincipal due July 2, 2011.

 

***CityForest Industrial Revenue Bonds***

 

Our subsidiary, CityForest, had approximately $16.7 million inaggregate principal amount of industrial revenue bonds outstanding as of May 28,2009.  We have guaranteed all of theobligations of CityForest.  We arerequired to annually pay $760,000 of principal of the bonds in semi-annualpayments.

 

28

----

Tableof Contents

 

***Refinancing***

 

On June 3, 2009 we issued $255.0 million in New Notes, whichmature on June 1, 2014, pursuant to the New Indenture.  Interest on the New Notes is payablesemiannually on June 1 and December 1 of each year, commencing on December 1,2009.

 

We used the net cash proceeds from the offering of the New Notes topre-fund the redemption of our $222,255,572 in aggregate principal amountoutstanding of our 9 3⁄4% senior secured notes due 2010 and satisfy and dischargeour obligations under the Cellu Tissue Indenture.  In addition, in connection with the offeringof the New Notes, we amended our Credit Agreement to allow for the incurrenceof indebtedness under the New Indenture in replacement of indebtedness underthe Cellu Tissue Indenture.  We alsoreceived the written consent of Associated Bank, the lender under the loanagreement related to our subsidiary, CityForest’s industrial revenue bonds, inconnection with the transaction.

 

**Cash Flows**

 

**Net cash provided by operations** was $13.5 million for thefiscal 2010 three-month period, compared to net cash used in operations of $4.6million for the fiscal 2009 three-month period. ** **Non-cash items, consistingprimarily of depreciation, stock-based compensation and amortization for thefiscal 2010 three-month period totaled $10.2 million compared to $6.4 millionfor the 2009 fiscal three-month period.**   **Cash flows provided by changesin working capital totaled $0.9 million for the fiscal 2010 three-month periodcompared to cash flows used by changes in working capital of $12.0 million inthe fiscal 2009 three-month period. ** **With respect to the changes inaccounts receivable and inventory, cash provided by these items was $4.9million for the fiscal 2010 three-month period, compared to cash used by theseitems of $8.5 million for the comparable period in the prior fiscal year.**  **Cash****used by changes in prepaid expenses and other currentassets was $0.6 million for the 2010 fiscal three-month period compared to cashprovided of $0.6 million for the comparable period in the prior fiscalyear.  ** **Cash used in changes in accountspayable, accrued expenses and accrued interest for the fiscal 2010 three-monthperiod was $3.4 million, compared to cash used of $4.1 million for thecomparable period in the prior year.

 

**Net cash used in investing activities** for the fiscal 2010three-month period was $6.3****millioncompared to $2.5 million used in the fiscal 2009 three-month period, which isreflective of the level of capital spending period over period.

 

**Net cash used in financing activities** for the fiscal 2010three-month period was $6.2****millioncompared to net cash provided of $7.8 million for the fiscal 2009 three-monthperiod.  Net cash used for the fiscal2010 three-month period relates primarily to net payments on our workingcapital facility and payments on CityForest’s industrial revenue bonds.   Net cash provided for the fiscal 2009three-month period relates to net borrowings on our working capital facilityoffset by payment on CityForest’s industrial revenue bond.

 

29

----

Tableof Contents

 

**Balance Sheet**

 

**Cash**as of May 28, 2009 increased to $1.4 millionfrom $0.4 million as of the end of fiscal year 2009.

 

**Receivables, net**as of May 28, 2009 decreased to $49.4million from $54.1 million as of the end of fiscal year 2009 primarily as aresult of declines in price levels of some products in the quarter compared tothe fourth quarter of fiscal year 2009.

 

**Property, plant and equipment, net**as of May 28, 2009increased to $305.3 million from $302.0 million as of the end of fiscal year2009.  This increase relates to capitalexpenditures for the period offset partially by depreciation expense for theperiod.

 

**Other intangibles, net**as of May 28, 2009decreased to $30.6 million from $31.7 million as of the end of fiscal year 2009due to amortization expense for the fiscal 2010 three-month period.

 

**Bank overdrafts**as of May 28, 2009 were zero compared to$3.3 million as of the end of fiscal year 2009. As of the end of the prior fiscal year—end checks outstanding exceededcash balances in our lockbox account by this amount due to timing of payments.

 

**Revolving line of credit**amount outstanding as of May 28,2009 decreased to $16.0 million from $18.5 million as of the end of fiscal year2009 as cash generated during the period was used to pay down the revolver.

 

**Accrued interest**as of May 28, 2009 decreased to $4.6million from $10.2 million as of the end of fiscal year 2009 due primarily tothe timing of semi-annual interest payments on the Notes.

 

**Stockholders’ equity**as of May 28, 2009 was$74.8 million compared to $67.7 million as of the end of fiscal year 2009.   The increase is primarily attributable tothe net income generated for the three-month period and the change inaccumulated other comprehensive income due to the change in the Canadianforeign currency in the fiscal 2010 three-month period.

 

**Critical Accounting Policies**

 

Our critical accounting policies are discussed in Management’sDiscussion and Analysis of Financial Condition and Results of Operations in ourAnnual Report on Form 10-K for the fiscal year ended February 28,2009.  The preparation of our financialstatements requires us to make estimates that affect the reported amounts ofassets, liabilities, revenue and expenses and related disclosures of contingentassets and liabilities.  We base ouraccounting estimates on historical experience and other factors that we believeto be reasonable under the circumstances. However, actual results may vary from these estimates under differentassumptions or conditions.

 

30

----

Tableof Contents

 

**New Accounting Pronouncements**

 

In September 2006, the FASB issued SFAS 157.  SFAS 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements.  This statement applies under other accountingpronouncements that require or permit fair value measurements (see Derivativesand Hedging above).  In February 2008,The FASB issued FSP 157-2, “*Effective Date of FASBStatement No. 157*”, which delayed the effective date of SFAS157 for non financial assets and liabilities to fiscal years beginning after November 15,2008 and interim periods within those fiscal years.  The adoption of SFAS 157 did not have amaterial impact on our results of operations and financial position.

 

In December 2007, the FASB issued SFAS 141 (R ), and SFAS160.  These new standards willsignificantly change the financial accounting and reporting of businesscombination transactions and noncontrolling (or minority) interests inconsolidated financial statements.  SFAS141 (R) is required to be adopted concurrently with SFAS 160 and iseffective for business combination transactions for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008.  Earlyadoption is prohibited.  We are currentlyassessing the impact that SFAS 141 (R) and SFAS 160 will have on ourresults of operations and financial position for future acquisitions.

 

In March 2008, the FASB issued Statement of Financial AccountingStandards No. 161, “*Disclosures aboutDerivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133”*(“SFAS 161”).  SFAS 161requires entities to provide enhanced disclosures about derivative instrumentsand hedging activities.  SFAS 161 iseffective for fiscal years and interim periods beginning on or after November 15,2008.  The adoption of this statement didnot have a material effect on our results of operations and financial position.

 

In April 2008, the FASB issued FSP  No. FAS 142-3, “Determination of theUseful Life of Intangible Assets”.  ThisFSP amends the factors thatshould be considered in developing renewal or extension assumptions used todetermine the useful life of a recognized intangible asset under SFAS No. 142,“*Goodwill and Other Intangible Assets*”(“SFAS 142”).  The objective of this FSPis to improve the consistency between the useful life of a recognizedintangible asset under SFAS 142 and the period of expected cash flows used tomeasure the fair value of the asset under SFAS 141R, and other generallyaccepted accounting principles.  This FSPapplies prospectively to all intangible assets acquired after the effective date,which are fiscal years beginning after December 15, 2008, whether acquiredin a business combination or otherwise. Early adoption is prohibited.  Theadoption of this statement did not have a significant impact on our financialposition or results of operations.

 

31

----

Tableof Contents

 

In April 2009, the FASB issued FSPNo.107-1 and Accounting Principles Board (APB) 28-1, *Interim Disclosures about Fair Value of Financial Instruments*”.  This FSP amends SFAS No. 107, “*Disclosures about Fair Value of Financial Instruments”*to require an entity to provide disclosures about fair value of financialinstruments in interim financial information. This FSP is to be applied prospectively and is effective for interim andannual periods ending after June 15, 2009, with early adoption permittedfor periods ending after March 15, 2009. The adoption of this FSP is not expected to have an impact on ourconsolidated financial statements.

 

In May 2009, the FASB issued SFAS165.  SFAS 165 establishes generalstandards of accounting for and disclosure of events that occur after thebalance sheet date but before financial statements are issued or are availableto be issued.  It should not result insignificant changes in the subsequent events that an entity reports, eitherthrough recognition or disclosure in its financial statements.  SFAS 165 introduces the concept of financialstatements being available to be issued. It requires the disclosure of the date through which an entity hasevaluated subsequent events and the basis for that date, that is, whether thatdate represents the date the financial statements were issued or were availableto be issued.  This disclosure shouldalert all users of financial statements that an entity has not evaluatedsubsequent events after that date in the set of financial statements beingpresented.  SFAS 165 will apply to bothinterim financial statements and annual financial statements after June 15,2009.  Adoption of SFAS 165 would notresult in a significant impact on our financial condition or results ofoperations.

 

32

----

Tableof Contents

 

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

 

In March 2004, we completed a private offering of the Notes.  At the same time, we entered into a $30.0million revolving working capital facility. In connection with the acquisition of CityForest in March 2007, weissued and sold approximately $20.0 million of First Additional Notes andassumed $18.4 million of additional debt. In connection with the APF Acquisition, we issued and sold approximately$40.0 million of Second Additional Notes. These Notes were due to mature on March 15,2010.  On June 3, 2009, we used thenet cash proceeds from the offering of the New Notes (see below) to pre-fund theredemption of our $222,255,572 in aggregate principal amount outstanding of our9 3⁄4% senior secured notes due 2010 and satisfy and discharge our obligationsunder the Cellu Tissue Indenture.

 

On June 3, 2009 we issued $255.0 million in New Notes, whichmature on June 1, 2014, pursuant to the New Indenture.  Interest on the New Notes is payablesemiannually on June 1 and December 1 of each year, commencing on December 1,2009.

 

We also have the ability to borrow under our revolving working capitalfacility, up to $60.0 million, of which as of May 28, 2009 we haveoutstanding borrowings of $16.0 million and excess availability of $36.0million.  As a result, we are highlyleveraged.    The interest on ourrevolving working capital facility fluctuates based on prime plus .50% or LIBORplus 1.75% depending on whether our borrowing is based on prime or LIBOR rates.

 

We have minimal foreign currency translation risk.  All international sales, other than salesoriginating from our Canadian subsidiary, are denominated in U.S. dollars.  Due to our Canadian operations, however, wecould be adversely affected by unfavorable fluctuations in foreign currencyexchange rates.

 

We are also subject to commodity price risk associated withfluctuations in energy and pulp costs. We currently use derivative financial instruments to offset a portion ofour exposure to market risk arising from changes in the price of naturalgas.  We also continue to take advantageof spot prices on pulps to minimize market risk arising from changes in pulpcosts.  Approximately 50% of our naturalgas requirements are hedged through the first half of fiscal year 2011.  The prices achieved through this hedging arelower than the prices we paid for natural gas in fiscal year 2009.

 

**Item 4T.  Controls and Procedures**

 

(a)  Disclosure Controls and Procedures.  We maintain disclosure controls andprocedures designed to ensure that information required to be disclosed in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms.  Disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act, include controls and procedures designed to ensure thatinformation required to be disclosed in the reports we file or submit under theExchange Act is accumulated and communicated to our management, including theChief Executive Officer and the Chief Financial 

 

33

----

Tableof Contents

 

Officer, as appropriate, to allow timely decisions regarding requireddisclosure.  Any system of controls,however well designed and operated, can provide only reasonable, and notabsolute, assurance that the objectives of the system are met.

 

As required by SEC rules, we have evaluated the effectiveness of thedesign and operation of our disclosure controls and procedures as of the end ofthe period covered by this Quarterly Report on Form 10-Q.  This evaluation was carried out under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer. Based on this evaluation, our management, including our Chief ExecutiveOfficer and Chief Financial Officer has concluded that our disclosure controlsand procedures were effective as of May 28, 2009.

 

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

 

34

----

Tableof Contents

 

PART II — OTHERINFORMATION

 

Item 1.  Legal Proceedings

 

There are have been no significant developments with respect to thelegal proceedings included in our Annual Report on Form 10-K for thefiscal year ended February 28, 2009.

 

Item 1A.  Risk Factors

 

The risk factors included in our Annual Report on Form 10-K forthe fiscal year ended February 28, 2009 have not materially changed.

 

Item 6.  Exhibits

 

(a)     Exhibits

 
| 3.1    | Certificate of Incorporation of Cellu Tissue  Holdings, Inc. (the “Company”) (incorporated by reference to  Exhibit 3.1 of the Company’s Registration Statement on Form S-4  dated September 3, 2004 (No. 333-118829))                                                                        |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                  |
| 3.2    | By-Laws of the Company (incorporated by reference  to Exhibit 3.2 of the Company’s Registration Statement on Form S-4  dated September 3, 2004 (No. 333-118829))                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                                                                  |
| 4.1    | Indenture, dated as of June 3, 2009, by and  among Cellu Tissue Holdings, Inc., the subsidiary guarantors party  thereto and The Bank of New York Mellon Trust Company, N.A., as trustee  (incorporated by reference to Exhibit 4.1 of the Company’s Current  Report on Form 8-K filed on June 5, 2009) |
|   |                                                                                                                                                                                                                                                                                                                                  |
| 4.2    | Form of 111⁄2% Senior Secured Note due 2014  (incorporated by reference to Exhibit 4.2 of the Company’s Current  Report on Form 8-K filed on June 5, 2009)                                                                                                                                                |
|   |                                                                                                                                                                                                                                                                                                                                  |
| 10.1 * | Performance Stock Option Agreement by Cellu Parent  Corporation to David Morris, dated April 13, 2009                                                                                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                  |
| 10.2*  | Performance Stock Option Agreement by Cellu Parent  Corporation to Steven Ziessler, dated April 13, 2009                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                  |
| 10.3*  | Performance Stock Option Agreement by Cellu Parent  Corporation to Russell Taylor, dated April 13, 2009                                                                                                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                                                                  |
| 10.4   | Note Security Agreement, dated as of June 3,  2009, by and among Cellu Tissue Holdings, Inc., the subsidiary  guarantors party thereto and The Bank of New York Mellon Trust Company, N.A.,  as collateral agent                                                                                                            |

 

35

----

Table of Contents

 
|   | (incorporated  by reference to Exhibit 10.1 of the Company’s Current Report on  Form 8-K filed on June 5, 2009)                                                                                                                                                                                                                                                                                                                                                                                                                            |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.5   | Second Amended and Restated Intercreditor  Agreement, dated as of June 3, 2009, by and among the Cellu Tissue  Holdings, Inc., The Bank of New York Mellon Trust Company, N.A., as note  collateral agent, JPMorgan Chase Bank, N.A., as U.S. administrative agent, JP  Morgan Chase Bank, N.A., Toronto Branch, as Canadian administrative agent and  The Bank of New York Trust Company, N.A., as prior agent (incorporated by  reference to Exhibit 10.2 of the Company’s Current Report on  Form 8- K filed on June 5, 2009) |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.6   | Registration Rights Agreement, dated as of  June 3, 2009, by and among Cellu Tissue Holdings, Inc., the  subsidiary guarantors party thereto, and J.P. Morgan Securities Inc. and  Goldman, Sachs & Co., as the initial purchasers (incorporated by  reference to Exhibit 10.3 of the Company’s Current Report on  Form 8-K filed on June 5, 2009)                                                                                                                                                                      |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 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)                                                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

36

----

Tableof Contents

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, asamended, the Registrant has duly caused this report to be signed on its behalfby the undersigned thereunto duly authorized.

 
|   | Cellu Tissue Holdings, Inc.         |
|--------|------------------------------------------|
|   |                                     |
|   |                                     |
| Date:  | July 2 , 2009                       |   | /s/ Russell C. Taylor |
|   | Mr. Russell C. Taylor               |
|   | President and Chief Executive Officer    |
|   |                                     |
| Date:  | July 2, 2009                        |   | /s/ David J. Morris |
|   | Mr. David J. Morris                 |
|   | Senior Vice President, Finance and Chief |
|   | Financial Officer                        |

 

37

----