** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM10-Q**

 

**(Mark One)**

 

**ý****             ****QUARTERLY REPORT PURSUANT TO SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period EndedNovember 25, 2004**

 

**or**

 

**o****             ****TRANSITION REPORT PURSUANT TO SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from            to            .**

 

**Commission file number 333-118829**

 

**CelluTissue Holdings, Inc.**

(Exactname of registrant as specified in its charter)

 

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

 

**(678) 393-2651**

(Registrant’stelephone number, including area code)

 

**Not Applicable**

(Formername, former address and former fiscal year, if changed since last report)

 

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

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).   YesoNoý

 

The number of sharesoutstanding of each of the registrant’s classes of common stock as of January3, 2005:

 

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

 

 

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CELLUTISSUE HOLDINGS, INC.

FORM10-Q

QUARTERENDED NOVEMBER 25, 2004

 

INDEX

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

 

2

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**PART I FINANCIALINFORMATION**

 

**Item 1. Consolidated Financial Statements**

** **

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

**CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**

 
| ** **                                                 | ** ** | **Three  Months Ended** | ** **     | **Nine  Months Ended** | ** ** |
|------------------------------------------------------------|------------|-------------------------|----------------|------------------------|------------|
| ** **                                                 | ** ** | **November  25**        | ** **     | **November  27**       | ** ** | **November  25** | ** ** | **November  27** | ** ** |
| ** **                                                 | ** ** | **2004**                | ** **     | **2003**               | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                       |       |                    |           |                   |       |   |   |   |   |
| Net sales                                                  |       | $                       | 85,689,504     |                   | $          | 76,110,327 |   | $ | 250,749,125 |   | $ | 212,905,572 |   |
| Cost of goods sold                                         |       | 74,568,908              |           | 66,596,029             |       | 219,752,834 |   | 188,847,211 |   |
| Gross profit                                               |       | 11,120,596              |           | 9,514,298              |       | 30,996,291 |   | 24,058,361 |   |
|                                                       |       |                    |           |                   |       |   |   |   |   |
| Selling, general and administrative  expenses              |       | 3,572,364               |           | 3,001,904              |       | 11,162,001 |   | 9,409,336 |   |
| Compensation from redemption of stock  options             |       |                    |           |                   |       | 3,414,441 |   |   |   |
| Accelerated vesting of stock options -  noncash            |       |                    |           |                   |       | 533,551 |   |   |   |
| Amortization of intangibles                                |       | 346,128                 |           | 186,535                |       | 1,038,855 |   | 559,605 |   |
| Income from operations                                     |       | 7,202,104               |           | 6,325,859              |       | 14,847,443 |   | 14,089,420 |   |
|                                                       |       |                    |           |                   |       |   |   |   |   |
| Write-off of debt issuance costs and  prepayment penalties |       |                    |           |                   |       | 3,318,495 |   |   |   |
| Interest expense, net                                      |       | 4,083,578               |           | 1,372,008              |       | 12,030,807 |   | 4,268,474 |   |
| Foreign currency loss                                      |       | 658,371                 |           | 317,193                |       | 854,759 |   | 691,462 |   |
| (Gain) loss on sale of equipment                           |       | 7,195                   |           | (2,000                 | )          | (2,374,121 | ) | 35,938 |   |
| Other (income) expense                                     |       | (7,906                  | )              | (1,969                 | )          | 17,252 |   | (3,434 | ) |
| Income before income tax expense (benefit)                 |       | 2,460,866               |           | 4,640,627              |       | 1,000,251 |   | 9,096,980 |   |
|                                                       |       |                    |           |                   |       |   |   |   |   |
| Income tax expense (benefit)                               |       | 2,952,404               |           | 1,510,512              |       | (1,045,970 | ) | 3,126,386 |   |
| Net (loss) income                                          |       | $                       |  (491,538 | )                      | $          | 3,130,115 |   | $ | 2,046,221 |   | $ | 5,970,594 |   |

* *

*Seeaccompanying notes to consolidated financial statements.*

 

3

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

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                   | ** ** | **November  25** | ** **  | **February  29** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|-------------|------------------|------------|
| ** **                                                                                                                                                                   | ** ** | **2004**         | ** **  | **2004**         | ** ** |
| ** **                                                                                                                                                                   |       | **(Unaudited)**  |        |             |       |
| **ASSETS**                                                                                                                                                                   |       |             |        |             |       |
| CURRENT ASSETS:                                                                                                                                                              |       |             |        |             |       |
| Cash and cash equivalents                                                                                                                                                    |       | $                | 20,530,652  |             |       |   |
| Receivables, net                                                                                                                                                             |       | 34,624,033       |        | $                | 37,437,876 |   |
| Inventories                                                                                                                                                                  |       | 22,556,318       |        | 24,803,154       |       |
| Prepaid expenses and other current assets                                                                                                                                    |       | 2,158,565        |        | 2,119,340        |       |
| Income tax receivable                                                                                                                                                        |       | 5,245,803        |        | 711,645          |       |
| Deferred income taxes                                                                                                                                                        |       | 1,446,269        |        | 1,134,080        |       |
| Assets held for sale                                                                                                                                                         |       |             |        | 2,270,371        |       |
| TOTAL CURRENT ASSETS                                                                                                                                                         |       | 86,561,640       |        | 68,476,466       |       |
| PROPERTY, PLANT AND EQUIPMENT, NET                                                                                                                                           |       | 97,299,194       |        | 100,122,201      |       |
| DEBT ISSUANCE COSTS                                                                                                                                                          |       | 7,460,998        |        | 4,710,916        |       |
| GOODWILL                                                                                                                                                                     |       | 13,723,935       |        | 13,723,935       |       |
| OTHER ASSETS                                                                                                                                                                 |       | 54,833           |        | 178,132          |       |
| TOTAL ASSETS                                                                                                                                                                 |       | $                | 205,100,600 |             | $          | 187,211,650 |   |
|                                                                                                                                                                         |       |             |        |             |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY(DEFICIENCY)**                                                                                                                   |       |             |        |             |       |
| CURRENT LIABILITIES:                                                                                                                                                         |       |             |        |             |       |
| Revolving lines of credit                                                                                                                                                    |       |             |        | $                | 11,352,924 |   |
| Cash overdraft                                                                                                                                                               |       |             |        | 4,760,297        |       |
| Accounts payable                                                                                                                                                             |       | $                | 18,986,470  |             | 16,857,938 |   |
| Accrued expenses                                                                                                                                                             |       | 14,027,038       |        | 11,226,210       |       |
| Accrued interest                                                                                                                                                             |       | 3,445,117        |        | 292,077          |       |
| Current portion of long-term debt                                                                                                                                            |       | 270,000          |        | 7,470,000        |       |
| TOTAL CURRENT LIABILITIES                                                                                                                                                    |       | 36,728,625       |        | 51,959,446       |       |
| LONG-TERM DEBT, LESS CURRENT PORTION                                                                                                                                         |       | 160,722,076      |        | 36,963,541       |       |
| DEFERRED INCOME TAXES                                                                                                                                                        |       | 16,193,752       |        | 13,688,236       |       |
| OTHER LIABILITIES                                                                                                                                                            |       | 118,000          |        | 118,000          |       |
| STOCKHOLDERS’ EQUITY (DEFICIENCY):                                                                                                                                      |       |             |        |             |       |
| Common stock, Class A, $.01 par value,  150,000 shares authorized, 11,127 and 20,328 shares issued and outstanding at  November 25, 2004 and February 29, 2004, respectively |       | 111              |        | 204              |       |
| Capital in excess of par value                                                                                                                                               |       |             |        | 65,976,390       |       |
| Accumulated earnings (deficit)                                                                                                                                               |       | (9,572,738       | )           | 18,659,808       |       |
| Unearned compensation                                                                                                                                                        |       |             |        | (388,888         | )          |
| Accumulated other comprehensive income                                                                                                                                       |       | 910,774          |        | 234,913          |       |
| TOTAL STOCKHOLDERS’ EQUITY(DEFICIENCY)                                                                                                                                  |       | (8,661,853       | )           | 84,482,427       |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’  EQUITY(DEFICIENCY)                                                                                                                 |       | $                | 205,100,600 |             | $          | 187,211,650 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

 

4

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

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

 
| ** **                                                                             | ** ** | **Nine  Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                             | ** ** | **November  25**       | ** ** | **November  27** | ** ** |
| ** **                                                                             | ** ** | **2004**               | ** ** | **2003** |   |
| **Cash flows from operating activities**                                               |       |                   |       |   |   |
| Net income                                                                             |       | $                      | 2,046,221  |   | $ | 5,970,594 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:     |       |                   |       |   |   |
| Write-off of debt issuance costs-noncash                                               |       | 2,894,868              |       |   |   |
| Accelerated vesting of stock  options-noncash                                          |       | 533,551                |       |   |   |
| Deferred income taxes                                                                  |       | 2,193,327              |       |   |   |
| Accretion of debt discount                                                             |       | 221,896                |       |   |   |
| Amortization of intangibles                                                            |       | 1,038,855              |       | 559,605 |   |
| Depreciation                                                                           |       | 11,140,187             |       | 11,509,909 |   |
| (Gain) loss on sale of property, plant and  equipment                                  |       | (2,374,121             | )          | 35,938 |   |
| Stock based compensation                                                               |       | 388,888                |       | 500,000 |   |
| Changes in operating assets and  liabilities:                                          |       |                   |       |   |   |
| Receivables                                                                            |       | 2,813,843              |       | (3,752,000 | ) |
| Inventories                                                                            |       | 2,246,836              |       | (3,052,810 | ) |
| Prepaid expenses and other current assets                                              |       | (4,573,383             | )          | (428,983 | ) |
| Other assets                                                                           |       | 123,299                |       | (224,481 | ) |
| Cash overdraft, accounts payable, accrued expenses,  accrued interest and income taxes |       | 3,322,104              |       | 1,997,700 |   |
| Total adjustments                                                                      |       | 19,970,150             |       | 7,144,878 |   |
| *Net cash provided by operating activities*                                            |       | 22,016,371             |       | 13,115,472 |   |
|                                                                                   |       |                   |       |   |   |
| **Cash flows from investing activities**                                               |       |                   |       |   |   |
| Proceeds from sale of property, plant and  equipment, net                              |       | 4,003,727              |       |   |   |
| Capital expenditures                                                                   |       | (7,676,415             | )          | (8,319,693 | ) |
| *Net cash used in investing activities*                                                |       | (3,672,688             | )          | (8,319,693 | ) |
|                                                                                   |       |                   |       |   |   |
| **Cash flows from financing activities**                                               |       |                   |       |   |   |
| Payments of long-term debt                                                             |       | (43,863,541            | )          | (7,456,227 | ) |
| Proceeds from note offering                                                            |       | 160,200,180            |       |   |   |
| Borrowings (payments) on revolving line of  credit, net                                |       | (10,953,999            | )          | 2,055,382 |   |
| Cash dividends                                                                         |       | (96,788,801            | )          |   |   |
| Prepayment penalties                                                                   |       | (423,627               | )          |   |   |
| Debt issuance costs                                                                    |       | (6,659,104             | )          |   |   |
| *Net cash provided by (used in) financing  activities*                                 |       | 1,511,108              |       | (5,400,845 | ) |
|                                                                                   |       |                   |       |   |   |
| Effect of foreign currency                                                             |       | 675,861                |       | 605,066 |   |
|                                                                                   |       |                   |       |   |   |
| *Net increase in cash and cash equivalents*                                            |       | 20,530,652             |       | — |   |
| *Cash and cash equivalents at beginning of  period*                                    |       | —                 |       | — |   |
| *Cash and cash equivalents at end of period*                                           |       | $                      | 20,530,652 |   | $ | — |   |

 

*Seeaccompanying notes to consolidated financial statements.*

 

5

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**Cellu Tissue Holdings, Inc. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited)November 25, 2004**

 

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

 

Theaccompanying unaudited interim consolidated financial statements include theaccounts of Cellu Tissue Holdings, Inc. (the “Company” ) and its wholly-owned subsidiaries.  The Company is a wholly-owned subsidiary ofCellu Paper Holdings, Inc. (the “Parent”). These statements have been prepared in accordance with United Statesgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by United States generally acceptedaccounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the three - and nine - month periods endedNovember 25, 2004 are not necessarily indicative of the results that may beexpected for the fiscal year ending February 28, 2005.  For further information, refer to the Company’sconsolidated financial statements and footnotes thereto as of February 29, 2004and for the year then ended, from which the consolidated balance sheet atFebruary 29, 2004 has been derived.

 

Reclassification

 

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

 

Stock BasedCompensation

 

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

 

6

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| ** **                                                                                                      | ** ** | **For the  three months ended** | ** ** | **For the  nine months ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                      | ** ** | **November**                    | ** ** | **November**                   | ** ** | **November** | ** ** | **November** | ** ** |
| ** **                                                                                                      | ** ** | **25, 2004**                    | ** ** | **27, 2003**                   | ** ** | **25, 2004** | ** ** | **27, 2003** | ** ** |
|                                                                                                            |       |                            |       |                           |       |   |   |   |   |
| Net income (loss), as reported                                                                                  |       | $                               | (491,538   | )                              | $          | 3,130,115 |   | $ | 2,046,221 |   | $ | 5,970,594 |   |
| Add: stock-based employee compensation expense  included in reported net income, net of related tax effects     |       | —                          |       | —                         |       | (180,453 | ) | — |   |
| Less: stock-based employee compensation expense  determined under fair value method, net of related tax effects |       | —                          |       | 58,479                         |       | (29,983 | ) | 160,797 |   |
| Pro forma net income (loss), fair value  method                                                                 |       | $                               | (491,538   | )                              | $          | 3,071,636 |   | $ | 1,895,751 |   | $ | 5,809,797 |   |

 

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

 

In connectionwith the Company’s debt transaction (Note 4), the Company accelerated vestingof all unvested employee stock options. As a result thereof, the APB No. 25 expense for the nine months endedNovember 25, 2004 recognized in the table above is larger than the expensecalculated under FAS No. 123 as the expense associated with the acceleratedvesting and cash paid for redemption of stock options would have beenpreviously recognized if FAS No. 123 had been applied from the date of grant.

 

The Companymay need to recognize additional expense should management’s estimate of the numberof employees that will actually benefit from the accelerated vesting of theoptions need to be adjusted.  The Companyhas estimated and recognized $.5 million of expense in the nine-month periodended November 25, 2004, associated with employees that will actually benefitfrom the accelerated vesting of the stock options.  The Company will update its estimate eachreporting period and adjust the total expense recognized until the originalvesting period associated with the stock options has expired.

 

7

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RecentAccounting Pronouncements

 

In December2004, the Financial Accounting Standards Board issued SFAS No, 123R, “ShareBased Payment: An Amendment of FASB Statements No. 123 and 95”.  This statement requires that the costresulting from all share-based payment transactions be recognized in theconsolidated financial statements.  Thisstatement is effective for the Company in fiscal year 2006.  The Company is currently evaluating theimpact of this statement on its consolidated financial statements.

 

**Note2 Inventories**

 

Components ofinventories are as follows:

 
| ** **                       | ** ** | **November 25, 2004** | ** ** | **February 29, 2004** | ** ** |
|----------------------------------|------------|-----------------------|------------|-----------------------|------------|
|                             |       |                  |       |                  |       |
| Finished goods                   |       | $                     | 12,508,220 |                  | $          | 14,644,430 |   |
| Raw materials                    |       | 3,533,381             |       | 4,527,340             |       |
| Packaging materials and supplies |       | 6,951,652             |       | 6,172,198             |       |
|                             |       | 22,993,253            |       | 25,343,968            |       |
| Inventory reserves               |       | (436,935              | )          | (540,814              | )          |
|                             |       | $                     | 22,556,318 |                  | $          | 24,803,154 |   |

 

**Note 3 Debt Issuance Costs**

 

Debt issuance costs consist of the following:

 
| ** **                    | ** ** | **November  25, 2004** | ** ** | **February  29, 2004** | ** ** |
|-------------------------------|------------|------------------------|------------|------------------------|------------|
|                          |       |                   |       |                   |       |
| Debt issuance costs           |       | $                      | 8,466,351  |                   | $          | 5,654,208 |   |
| Less accumulated amortization |       | (1,005,353             | )          | (943,292               | )          |
|                          |       | $                      | 7,460,998  |                   | $          | 4,710,916 |   |

 

8

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**Note 4 Long-Term Debt**

** **

Long-term debt consists of the following:

 
| ** **                                                                                                          | ** ** | **November  25, 2004** | ** **  | **February  29, 2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|------------------------|------------|
| 9 3/4% senior secured  notes due 2010                                                                               |       | $                      | 162,000,000 |                   |       |   |
| Less discount                                                                                                       |       | (1,577,924             | )           |                   |       |
|                                                                                                                |       | 160,422,076            |        |                   |       |
|                                                                                                                |       |                   |        |                   |       |
| Term Loan A, $20.0 million principal due  October 31, 2007                                                          |       |                   |        | $                      | 11,260,123 |   |
|                                                                                                                |       |                   |        |                   |       |
| Term Loan B, $20.0 million principal, $14.5  million due September 30, 2005 and $5.5 million due September 30, 2007 |       |                   |        | 17,333,418             |       |
|                                                                                                                |       |                   |        |                   |       |
| Term Loan C, $15.0 million principal, $10.9  million due September 30, 2005 and $4.1 million due September 30, 2007 |       |                   |        | 15,000,000             |       |
|                                                                                                                |       |                   |        | 43,593,541             |       |
| Industrial revenue bond payable, in annual  installments, plus interest ranging from 4.8% to 6.65%, due in 2006     |       | 570,000                |        | 840,000                |       |
|                                                                                                                |       | 160,992,076            |        | 44,433,541             |       |
| Less current portion of debt                                                                                        |       | 270,000                |        | 7,470,000              |       |
|                                                                                                                |       | $                      | 160,722,076 |                   | $          | 36,963,541 |   |

 

In March 2004,the Company completed a Rule 144A offering of $162.0 million principal amountof 9 3⁄4% senior secured notes due 2010. The Company raised $152.2 million, net of debt issuance costs of $8.0million and original issuance discount of $1.8 million.  At the same time, the Company entered into anew $30.0 million revolving working capital facility with CIT Group/BusinessCredit Inc.  A portion of the proceeds,along with a drawdown from the new working capital facility, were used to payoff existing debt of approximately $56.0 million.  Furthermore, the Company used approximately$100.2 million of the proceeds to fund a stockholder dividend to Parent torepurchase a portion of its common stock and warrants and compensation from theredemption of stock options ($3.4 million). As a result of the extinguishment of debt,

 

9

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approximately$2.9 million of debt issuance costs previously capitalized were written off andthe Company incurred approximately $.4 million in prepayment penalties.  The total amount of $3.3 million is reflectedin write-off of debt issuance costs and prepayment penalties on the incomestatement.

 

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

 

As of November25, 2004, there were no outstanding borrowings under the working capitalfacility.

 

**Note5 Stockholders’ Equity (Deficiency)**

 

The Companyused approximately $96.8 million of the proceeds from the note offering to funda stockholder dividend to the Parent to purchase shares of the Parent’s commonstock and warrants.  Approximately $66.2million was charged to capital in excess of par value, reducing this balance tozero and the remaining $30.6 million was charged to accumulated earnings,resulting in the deficiency at November 25, 2004.  Net income generated for the fiscal 2005nine-month period reduced the deficiency.

 

**Note6 Comprehensive (Loss) Income**

 

The componentsof comprehensive (loss) income for the three months and nine months endedNovember 25, 2004 and November 27, 2003 are as follows:

 
| ** **                               | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **November 25, 2004**  | ** ** | **November 27, 2003** | ** ** | **November 25, 2004** | ** ** | **November 27, 2003** | ** ** |
| Net (loss) income                        |       | $                      | (491,538   | )                     | $          | 3,130,115 |   | $ | 2,046,221 |   | $ | 5,970,594 |   |
| Foreign currency translation adjustments |       | 568,746                |       | 289,995               |       | 675,861 |   | 605,066 |   |
| Comprehensive income                     |       | $                      | 77,208     |                  | $          | 3,420,110 |   | $ | 2,722,082 |   | $ | 6,575,660 |   |

 

**Note 7 Gain on Sale of Equipment**

 

In July 2005,the Company sold a previously idled paper machine at its Menominee mill andrecorded a gain on the sale of $2.4 million. The net proceeds from the salewere $4.0 million (gross proceeds of $5.2 million less brokerage fees and otherdirect costs of $1.2 million).  Allmonies have been received as of November 25, 2004.

 

10

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**Note8 Business Segments**

 

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

 
| ** **                                                 | ** ** | **Three months ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                 | ** ** | **November 25,**       | ** ** | **November 27,**      | ** ** | **November 25,** | ** ** | **November 27,** | ** ** |
| ** **                                                 | ** ** | **2004**               | ** ** | **2003**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Net Sales**                                              |       |                   |       |                  |       |   |   |   |   |
| Tissue                                                     |       | $                      | 56,606,229 |                  | $          | 49,447,829 |   | $ | 172,119,692 |   | $ | 138,056,360 |   |
| Machine-glazed paper                                       |       | 29,083,275             |       | 26,662,498            |       | 78,629,433 |   | 74,849,212 |   |
| Consolidated                                               |       | $                      | 85,689,504 |                  | $          | 76,110,327 |   | $ | 250,749,125 |   | $ | 212,905,572 |   |
|                                                       |       |                   |       |                  |       |   |   |   |   |
| **Income from operations**                                 |       |                   |       |                  |       |   |   |   |   |
| Tissue                                                     |       | $                      | 4,391,221  |                  | $          | 4,221,815 |   | $ | 10,407,766 |   | $ | 8,990,434 |   |
| Machine-glazed paper                                       |       | 3,157,011              |       | 2,290,579             |       | 5,478,532 |   | 5,658,591 |   |
| Corporate amortization of intangibles                      |       | (346,128               | )          | (186,535              | )          | (1,038,855 | ) | (559,605 | ) |
| Consolidated                                               |       | 7,202,104              |       | 6,325,859             |       | 14,847,443 |   | 14,089,420 |   |
| Write-off of debt issuance costs and prepayment  penalties |       |                   |       |                  |       | 3,318,495 |   |   |   |
| Interest expense                                           |       | 4,106,944              |       | 1,373,238             |       | 12,063,545 |   | 4,272,146 |   |
| Net foreign currency transaction loss                      |       | 658,371                |       | 317,193               |       | 854,759 |   | 691,462 |   |
| Interest income                                            |       | (23,366                | )          | (1,230                | )          | (32,738 | ) | (3,672 | ) |
| Other income (expense)                                     |       | 711                    |       | 3,969                 |       | 2,356,869 |   | (32,504 | ) |
| Pretax income                                              |       | $                      | 2,460,866  |                  | $          | 4,640,627 |   | $ | 1,000,251 |   | $ | 9,096,980 |   |
|                                                       |       |                   |       |                  |       |   |   |   |   |
| **Capital Expenditures**                                   |       |                   |       |                  |       |   |   |   |   |
| Tissue                                                     |       | $                      | 3,963,961  |                  | $          | 2,285,810 |   | $ | 6,792,685 |   | $ | 6,715,904 |   |
| Machine-glazed paper                                       |       | 441,226                |       | 768,856               |       | 708,287 |   | 1,144,079 |   |
| Corporate                                                  |       | 87,934                 |       | 5,526                 |       | 175,443 |   | 459,710 |   |
| Consolidated                                               |       | $                      | 4,493,121  |                  | $          | 3,060,192 |   | $ | 7,676,415 |   | $ | 8,319,693 |   |

 

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| ** **           | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|----------------------|------------|------------------------|------------|-----------------------|------------|
| ** **           | ** ** | **November 25,**       | ** ** | **November 27,**      | ** ** | **November 25,** | ** ** | **November 27,** | ** ** |
| ** **           | ** ** | **2004**               | ** ** | **2003**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Depreciation**     |       |                   |       |                  |       |   |   |   |   |
| Tissue               |       | $                      | 2,373,774  |                  | $          | 2,272,143 |   | $ | 6,942,742 |   | $ | 7,112,811 |   |
| Machine-Glazed Paper |       | 1,457,060              |       | 1,423,249             |       | 4,197,445 |   | 4,397,098 |   |
|                 |       | $                      | 3,830,834  |                  | $          | 3,695,392 |   | $ | 11,140,187 |   | $ | 11,509,909 |   |

 

**Note9 Income Taxes**

 

Income taxexpense for the three months ended November 25, 2004 was 120% compared to a 33%tax expense for the three months ended November 27, 2003.  Income tax benefit for the nine months endedNovember 25, 2004 was 105% compared to a 34% tax expense for the nine monthsended November 27, 2003.  The Company hasrecorded taxes for the nine-month period at a 104% effective tax rate (benefitof $1.4 million) on the cumulative loss before the gain on sale of equipment($1.3 million).  The effective tax rateis calculated based on the Company’s projected fiscal 2005 pretax income andexpected book to tax permanent differences, primarily related to acceleratedvesting of stock options, specifically stock compensation expensed for bookpurposes but anticipated to be non-deductible for tax purposes.  In addition, the Company has recordedapproximately $.8 million of state and federal taxes on the gain ($2.4 million)recognized in the second fiscal quarter related to the gain on sale of a papermachine. Furthermore, the Company has recorded a tax benefit of $.2 millionrelated to federal net operating loss carryforwards and a tax credit of $.2million related to alternative minimum taxes. Based on the above and achievement of projected fiscal 2005 pre-taxincome, the Company anticipates an overall effective tax rate for the fiscalyear of approximately 49%. The decrease in the overall effective tax rateanticipated for the fiscal year from the second quarter of fiscal 2005 of 59%is primarily related to a revision in the availability of federal net operatingloss carryforwards and alternative tax credits to be utilized in fiscal year2005 determined upon filing of the Company’s fiscal 2004 tax returns in thethird quarter of fiscal 2005.  The effectof the federal net operating loss carryforwards and the alternative minimum taxcredits have been recorded in current quarter, as discussed above, as theimpact is considered discrete to this quarter.

 

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

 

**OVERVIEW**

 

Certainstatements contained in this Quarterly Report on Form 10-Q may containforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended, and as such may involve known or unknown risks, uncertaintiesand other factors which may cause the Company’s actual results, performance orachievements to be materially different from future results, performance orachievements expressed or implied by such forward-looking statements.  Forward-looking statements, which are basedon certain assumptions and describe the Company’s future plans, strategies andexpectations, are generally identifiable by use of the words “may”, “will”, “should”,“expect”, “anticipate”, “estimate”, “believe”, “intend”, “project”, orcomparable terminology.  Factors whichcould have a material adverse effect on the operations and future prospects ofthe Company include, but are not limited to, those set forth in Forward-LookingStatements and Risk Factors in our Registration Statement Form S-4 datedSeptember 30, 2004.  These risks anduncertainties should be considered in evaluating any forward-looking statementscontained herein.

 

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

 

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

 

**RESULTSOF OPERATIONS**

 

**Resultsof Operations for the Three Months Ended November 25, 2004 (the fiscal 2005three-month period) compared to November 27, 2003 (the fiscal 2004 three-monthperiod) and for the Nine Months Ended November 25, 2004 (the fiscal 2005nine-month period) compared to November 27, 2003 (the fiscal 2004 nine-monthperiod)**

 

**Netsales** for the fiscal 2005 three-month period increased$9.6 million, or 12.6%, to $85.7 million from $76.1 million for the comparableperiod in the prior year. Net sales for the fiscal 2005 nine-month periodincreased $37.8 million, or 17.8%, to $250.7 million from $212.9 million forthe comparable period in the prior year. The increase in net sales is attributable to improved product mix,higher selling prices, and an increase in volume sold over the prior year.  For the fiscal 2005 three-month period and fiscal2005

 

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nine-monthperiod, the Company sold  67,217 and203,222 tons, respectively, of tissue hard rolls, machine-glazed paper hardrolls and converted tissue products compared to 65,032 and 187,303 tons,respectively, for the comparable periods in the prior year.  This is an increase of 2,185 tons, or 3.4%for the fiscal 2005 three-month period and an increase 15,919 tons, or****8.5% for the fiscal 2005 nine-month periodover the comparable periods in the prior year.

 

Net sales forthe Company’s Tissue Segment for the fiscal 2005 three-month period were $56.6million, an increase of $7.2 million, or 14.5%, over the comparable period inthe prior year.  Net sales for theCompany’s Tissue Segment for the fiscal 2005 nine-month period were $172.1million, an increase of $34.0 million, or 24.7%, over the comparable period inthe prior year. ** **The increase for the Tissue Segmentfor the three-month and nine-month periods is attributable to improved productmix, higher selling prices, and an increase in volume sold over the comparableperiods in the prior year.** **Net sales for the Company’sMachine-Glazed segment for the 2005 three-month period were $29.1 million, anincrease of $2.4 million, or 9.1%, over the comparable period in the prioryear.  Net sales for the Company’sMachine-Glazed Segment for the 2005 nine-month period were $78.6 million, anincrease of $3.8 million, or 5.1% over the comparable period in the prioryear.  The increase for theMachine-Glazed Segment for the 2005 three-month and nine-month periods over theprior year is attributable to improved product mix and higher net sellingprices.

 

**Grossprofit** for the fiscal 2005 three-month periodincreased to $11.1 million from $9.5 million, an increase of $1.6 million, or16.9%, over the comparable period in the prior year.   Gross profit for the fiscal 2005 nine-monthperiod increased to $31.0 million from $24.1 million, an increase of $6.9million, or 28.8%, over the comparable period in the prior year.  As a percentage of net sales, gross profitincreased to 13.0% in the fiscal 2005 three-month period and 12.4% in thefiscal 2005 nine-month period from 12.5% in the fiscal 2004 three-month periodand 11.3% in the fiscal 2004 nine-month period. ** **The increase in grossprofit in the fiscal 2005 three-month and nine-month periods was primarilyattributable to improved product mix, higher net selling prices, and increasedvolume.  This increase was partiallyoffset by increased pulp, energy and freight costs.

 

Gross profitfor the Company’s Tissue Segment for the fiscal 2005 three-month period was$6.7 million, an increase of $.6 million, or 9.8%, over the comparable periodin the prior year.  Gross profit for theCompany’s Tissue Segment for the fiscal 2005 nine-month period was $20.3million, an increase of $5.4 million, or 36.4%, over the comparable period inthe prior year.  Gross profit for theCompany’s Machine-Glazed Segment for the fiscal 2005 three-month period was$4.4 million, an increase of $1.0 million, or 29.7%, over the comparable periodin the prior year.  Gross profit for theCompany’s Machine-Glazed Segment for the fiscal 2005 nine-month period was$10.7 million, an increase of $1.5 million, or 16.5%, over the comparableperiod in the prior year.  The increasefor the Tissue Segment for the three-month and nine-month periods isattributable to improved product mix, higher net selling prices, and increasedvolume, which was partially offset by increased pulp, energy, and freightcosts.** **The increase for the Machine-Glazed Segment for the 2005three-month and nine-month period over the

 

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prior year isattributable to improved product mix and increased net selling prices,partially offset by increased pulp costs. As a percentage of net sales, gross profit for the Tissue Segmentdecreased to 11.9 % in the fiscal 2005 three-month period from 12.4% in thefiscal 2004 three-month period and increased to 11.8% in the fiscal 2005nine-month period from 10.8% in the fiscal 2004 nine-month period.  The decrease in the three-month period isreflective of a 14.5% increase in net sales more than offset by a 15.0%increase in cost of goods sold over the comparable period in the prior year. Asa percentage of net sales, gross profit for the Machine-Glazed Segmentincreased to 15.1% in the fiscal 2005 three-month period and 13.6% in thefiscal 2005 nine-month period from 12.7% in the fiscal 2004 three-month periodand 12.2% in the fiscal 2004 nine-month period.

 

**Selling,general and administrative expenses**in the fiscal 2005three-month period increased $.6 million, or 19%, to $3.6 million from $3.0million in the fiscal 2004 three-month period. Selling, general and administrative expenses in the fiscal 2005 nine-monthperiod increased $1.8 million, or 18.6%, to $11.2 million from $9.4 million inthe fiscal 2004 nine-month period.  Theincrease is primarily due to the accrual of bonuses due to stronger year overyear performance and additional staffing requirements and professional fees toachieve and maintain compliance with required rules and regulations of theSecurities and Exchange Commission (SEC) associated with the Company becoming apublic reporting company (See “Liquidity; Sources and Uses of Capital”).  As a percentage of net sales, selling,general and administrative expenses in the fiscal 2005 three-month periodincreased to 4.2% from 3.9% in the comparable fiscal 2004 three-monthperiod  As a percentage of net sales,selling, general and administrative expenses in the fiscal 2005 nine-monthperiod increased to 4.5% from 4.4% in the comparable fiscal 2004 nine-monthperiod.

 

**Compensationfrom the redemption of stock options and accelerated vesting of stock options**includedas expenses in the fiscal 2005 nine-month period income from operations was$3.9 million; $3.4 million related to compensation from the redemption of stockoptions and $.5 million related to accelerated vesting of certain stockoptions, both triggered by the note offering completed in March 2004.  With respect to the $.5 million related toaccelerated vesting of certain stock options, $.3 million was recorded in thesecond quarter and $.2 million was recorded in the first quarter of fiscal2005.  Management may need to recognizeadditional expense should management’s estimate of the number of employees thatwill actually benefit from the accelerated vesting of the options need to beadjusted.  Management will continue toupdate its estimate each reporting period and adjust the total expenserecognized until the original vesting period associated with the options hasexpired.

 

**Write-offof debt issuance costs and prepayment penalties**of$3.3 million included in the fiscal  2005nine-month period income from operations is an expense incurred primarilyrelated to the write-off of debt issuance costs (noncash) previouslycapitalized and associated with debt that was extinguished in March 2004 inconnection with the $162 million note offering completed in March 2004.

 

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**Interestexpense, net**for the fiscal 2005 three-month periodincreased $2.7 million to $4.1 million, compared to $1.4 million for the fiscal2004 three-month period.  Interestexpense for the fiscal 2005 nine-month period increased $7.7 million to $12.0million, compared to $4.3 million for the fiscal 2004 nine-month period.  The increase is due to****the increased level of long-term debtoutstanding as a result of the $162.0 million note offering completed in March2004.

 

**Foreigncurrency loss**for the fiscal 2005 three-month periodwas $.7 million compared to $.3 million for the comparable fiscal 2004three-month period.  Foreign currencyloss for the fiscal 2005 nine-month period was $.9 million compared to $.7million for the comparable fiscal 2004 nine-month period.  The increases are the result of thefluctuation in the Canadian currency.

 

**Gainon sale of equipment**of $2.4 million included in thefiscal 2005 nine-month period relates to the sale of a paper machine at theCompany’s Menominee mill in the second quarter of 2005.  Net proceeds from the sale were $4.0 million(gross proceeds of $5.2 million less brokerage fees and other direct costs of$1.2 million).

 

**Incometax expense** for the three months ended November 25,2004 was 120% compared to a 33% tax expense for the three months ended November27, 2003.  Income tax benefit for thenine months ended November 25, 2004 was 105% compared to a 34% tax expense forthe nine months ended November 27, 2003. The Company has recorded taxes for the nine-month period at a 104%effective tax rate (benefit of $1.4 million) on the cumulative loss before thegain on sale of equipment ($1.3 million). The effective tax rate is calculated based on the Company’s projectedfiscal 2005 pretax income and expected book to tax permanent differences,primarily related to accelerated vesting of stock options, specifically stockcompensation expensed for book purposes but anticipated to be non-deductiblefor tax purposes. In addition, the Company has recorded approximately $.8million of state and federal taxes on the gain ($2.4 million) recognized in thesecond fiscal quarter related to the gain on sale of a paper machine.  Furthermore, the Company has recorded a tax benefitof $.2 million related to federal net operating loss carryforwards and a taxcredit of $.2 million related to alternative minimum taxes.  Based on the above and achievement ofprojected fiscal 2005 pre-tax income, the Company anticipates an overalleffective tax rate for the fiscal year of approximately 49%. The decrease inthe overall effective tax rate anticipated for the fiscal year from the secondquarter fiscal 2005 of 59% is primarily related to a revision in theavailability of federal net operating loss carryforwards and alternativeminimum tax credits to be utilized in fiscal year 2005 determined upon filingof the Company’s fiscal 2004 tax returns in the third quarter fiscal 2005.  The effect of the federal net operating losscarryforwards and the alternative minimum tax credits have been recorded in thecurrent quarter, as discussed above, as the impact is considered discrete tothis quarter.

 

**Netloss** for the fiscal 2005 three-month period was $.5million, compared to net income of $3.1 million for the comparable period inthe prior year.  Net income for thefiscal 2005 nine-month period was $2.0 million, compared to net income of $6.0million for the comparable period in the prior year.** **Included in fiscal2005 nine-month net income is a

 

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$3.9 millionpretax charge related to compensation from redemption of stock options andaccelerated vesting of certain stock options as described above.  Furthermore, included in this amount is a$3.3 million pretax charge related to the write-off of debt issuance costs andprepayment penalties.   The Company alsoincurred $4.1 million of interest expense in the fiscal 2005 three-month periodand $12.0 million of interest expense in the fiscal 2005 nine-month periodcompared to $1.4 million in the comparable fiscal 2004 three-month period and$4.3 million in the comparable fiscal 2004 nine-month period.  Offsetting these expense items was a gain of$2.4 million ($1.6 million after tax) recorded in the fiscal 2005 nine-monthperiod related to the sale of a paper machine sold in the second quarter.

 

**FINANCIALCONDITION**

 

**Liquidity;Sources and Uses of Capital**

 

**Netcash provided by operations** was $22.0 million for thefiscal 2005 nine-month period, compared to $13.1 million for the comparablefiscal 2004 nine-month period. Significant noncash items included in the fiscal 2005 nine-month periodwere $2.9 million for the write-off of debt issuance costs and $.5 millionrelated to accelerated vesting of stock options, both of which are related tothe $162.0 million note offering completed in March 2004, and deferred incometaxes of $2.2 million.  These charges areoffset by a gain on sale of equipment of $2.4 million.  Net of these items, noncash items for thefiscal 2005 nine-month period totaled $12.8 million, consistent with the prioryear. ** **Cashflows provided by changes in working capital totaled $3.9 million for thefiscal 2005 nine-month period compared to net cash used of $5.5 million for thecomparable period in the prior year.  With respect to the changes in accounts receivable and inventory, cashprovided by these items was $5.1 million for the fiscal 2005 nine-month periodcompared to cash used by these items of $6.8 million for the comparable periodin the prior year.  This improvement isattributable to shorter collection periods on accounts receivable and continuedfocus on inventory levels.  Cash used bychanges in prepaid expenses and other current assets was $4.5 million for thefiscal 2005 nine-month period compared to $.7 million in the prior year.  The fluctuation is primarily the result ofthe significant tax benefit recognized in the fiscal 2005 nine-monthperiod.  Cash provided by changes in cashoverdraft, accounts payable, accrued expenses, accrued interest and incometaxes for the fiscal 2005 nine-month period was $3.3 million compared to $2.0million for the comparable period in the prior year.  The fluctuation is primarily due to theincrease in accrued interest based on the timing of interest payments relativeto the new notes offset by fluctuations in accounts payable and accruedexpenses due to the timing of****payments.

 

**Netcash used in investing activities** for the fiscal 2005nine-month period was $3.7 million compared to cash used in investingactivities of $8.3 million for the fiscal 2004 nine-month period.  The change relates to the level of capitalspending period over period, offset by machine sale proceeds.

 

17

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**Netcash provided by financing activities** for the fiscal2005 nine-month period was $1.5 million compared to net cash used in financingactivities of $5.4 million for the fiscal 2004 nine-month period. In thecurrent fiscal period gross proceeds of $160.2 million, net of $1.8 million oforiginal issue discount, from the note offering (see discussion below) wereoffset by (i) net payments on long-term debt and a revolving line of credit of$43.9 million and $11.0 million, respectively; (ii) a stockholder dividend tothe Parent in the amount of approximately $100.2 million to fund the purchaseof certain shares of its common stock, options, and warrants ($96.8), and tofund $3.4 million of compensation resulting from the redemption of certainstock options to purchase common stock of the Parent; (iii) prepaymentpenalties of $.4 million; and (iv) payment of fees and expenses related to thenote offering in the amount of  $6.7million.

 

In March 2004,the Company completed a Rule 144A offering of $162.0 million aggregateprincipal amount of 9 3⁄4% senior secured notes due 2010.  The Company raised $152.2 million, net ofdebt issuance costs of $8.0 million and original issuance discount of $1.8million.   At the same time, the Companyentered into a new $30.0 million revolving working capital facility with CITGroup/Business Credit Inc. A portion of the proceeds, along with a drawdownfrom the new working capital facility, were used to pay off existing debt ofapproximately $56.0 million. Furthermore, the Company used approximately $100.2 million of theproceeds to fund a stockholder dividend to the Parent to purchase shares of theParent’s common stock and warrants and to fund compensation from the redemptionof stock options ($3.4 million).  As aresult of the extinguishment of debt, approximately $2.9 million of debtissuance costs previously capitalized were written off and the Company incurredapproximately $.4 million in prepayment penalties.  The total amount of $3.3 million is reflectedin write-off of debt issuance costs and prepayment penalties on the incomestatement.

 

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

 

As of November25, 2004, there were no outstanding borrowings under the working capitalfacility.

 

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

 

In addition,as a result of the note offering described above, the Company filed aregistration statement on Form S-4 with the SEC.  The Company has experienced increasedexpenses related to achieving and maintaining compliance with required SECrules and regulations.  These expensesinclude, but are not limited to, costs associated

 

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with thecreation of disclosure controls and procedures, internal control over financialreporting and compliance with periodic filing requirements.

 

**Cash**as of November 25, 2004 increased to $20.5 millionfrom an overdraft position of $4.8 million as of the end of the prior fiscalyear.  The improvement in the Company’scash position is primarily due to the significant cash provided by operationsin the first nine months of fiscal 2005.

 

**Receivables,net**as of November 25, 2004 decreased to $34.6 millionfrom $37.4 million as of the end of the prior fiscal year**. **Thedecrease is the result of a continued effort by the Company to reduce dayssales outstanding.

 

**Inventories**as of November 25, 2004 decreased to $22.6 millionfrom $24.8 million as of the end of the prior fiscal year.  The decrease is the result of a continuedfocus on inventory levels.

 

**Incometax receivable**as of November 25, 2004 increased to$5.2 million from $.7 million as of the end of the prior fiscal year primarilydue to the tax benefit recorded in the fiscal 2005 nine-month period.  See the income tax discussion above.

 

**Assetsheld for sale**as of November 25, 2004 decreased tozero from $2.2 million as of the end of the prior fiscal year as these assetsrelated to the previously idled paper machine at the Company’s Menominee millthat was sold in the second quarter of fiscal 2005.

 

**Debtissuance costs**as of November 25, 2004 increased to$7.5 million from $4.7 million as of the end of the prior fiscal year dueprimarily to the costs incurred in connection with the $162.0 million noteoffering in March 2004, offset by amortization expense through the nine monthperiod.  Unamortized debt issuance coststotaling $2.9 million associated with the previous refinancing were written offduring the first quarter of fiscal 2005.

 

**Accountspayable**as of November 25, 2004 increased to $19.0million from $16.9 million as of the end of the prior fiscal year due to timingof payments.

 

**Accruedinterest**as of November 25, 2004 increased to $3.4million from $.3 million as of the end of the prior fiscal year due to thetiming of payment (semi-annual) of interest on the senior secured notes.

 

**Stockholders’equity (deficiency)**as of November 25, 2004 decreasedto a deficiency of $8.7 million compared to equity of $84.5 million as of theend of the prior fiscal year. The Company used approximately $96.8 million ofthe proceeds of the Rule 144A offering of senior secured notes to fund astockholder dividend to the Parent to purchase shares of the Parent’s commonstock and warrants.  Approximately $66.2million was charged to capital in excess of par value, reducing this balance tozero and the remaining

 

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$30.6 millionwas charged to accumulated earnings, resulting in the deficiency at November25, 2004.  Net income generated for thefiscal 2005 nine-month period reduced the deficiency.

 

**Accumulatedother comprehensive income**as of November 25, 2004increased to $.9 million compared to $.2 million as of the end of the priorfiscal year due to the fluctuation in the Canadian currency for the fiscal 2005nine-month period.

 

**CriticalAccounting Policies**

 

***Revenue Recognition***

 

Sales are madeto customers primarily located throughout North America.  The Company recognizes revenue whenpersuasive evidence of an arrangement exists, delivery has occurred, the fee isfixed or determinable and collectibility is reasonably assured.  Revenue is recognized from product sales whentitle and risk of loss has passed to the customer consistent with the relatedshipping terms, generally at the time products are shipped.  Certain sales have freight on boarddestination terms, in which case revenue is recognized when the product isreceived by the customer.  We record aprovision for estimated sales returns and other allowances as a reduction ofrevenue at the time of revenue recognition.

 

***Goodwill***

 

EffectiveMarch 1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.”   Under SFAS No. 142, goodwill and intangibleassets with indefinite useful lives are no longer amortized.  Instead, the Company evaluates the carryingvalue of long lived assets for impairment at least annually, or wheneverindicators of impairment are deemed to exist. Impairment losses are recognized in operating results in the period theimpairment is recognized.  The Companyperformed the initial impairment test upon adoption of SFAS No. 142 and againas of February 28, 2003 and February 28, 2004. There was no impairment as of any of these dates.  There were no indicators of impairment duringthe fiscal year 2004 or the fiscal 2005 nine-month periods that required theCompany to evaluate impairment at any interim dates.

 

***Stock-based compensation***

 

The Companyaccounts for stock options using the intrinsic value method under APB No. 25, “Accountingfor Stock Issued to Employees.”  Thismethod does not recognize compensation expense for stock options granted underthe Company’s stock option plan, if the exercise price is at least equal to thefair market value of the Company’s common stock, as determined by the Company’sBoard of Directors, at the date granted. Stock-based compensation costs for stock awards are reflected in netincome over the awards’ vesting period.

 

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***Income taxes***

 

The Companyrecognizes deferred tax assets and liabilities for expected future taxconsequences of events that have been included in the financial statements orincome tax returns.  Under thismethodology, deferred tax assets and liabilities are determined based on thedifference between the financial statements and the tax basis of assets andliabilities using enacted tax rates in effect for the year in which thedifferences are expected to reverse.

 

***Business Combinations***

 

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

 

**RecentAccounting Pronouncements**

 

In December2004, the Financial Accounting Standards Board issued SFAS No, 123R, “ShareBased Payment: An Amendment of FASB Statements No. 123 and 95”.  This statement requires that the costresulting from all share-based payment transactions be recognized in theconsolidated financial statements.  Thisstatement is effective for the Company in fiscal year 2006.  The Company is currently evaluating theimpact of this statement on its consolidated financial statements.

 

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

 

In March 2004,the Company completed a Rule 144A offering of $162 million aggregate principleamount of 9 3⁄4% senior secured notes due 2010. At the same time, the Company entered into a new $30 million revolvingworking capital facility.  The Companyraised approximately $152 million, net of debt issuance costs and originaldiscount on the notes.  The proceeds,along with a drawdown from the new revolver, were used to pay off existing debtof approximately $56 million and to fund a stockholder dividend to the Company’sparent to purchase shares of its common stock and warrants and fundcompensation from the redemption of stock options of $100.2 million.  As a result of these transactions, theCompany is highly leveraged.  As ofNovember 25, 2004, there were no borrowings on the new working capital facilitybut the Company has the ability to borrow funds under this facility up to anaggregate of $30 million and could be adversely affected by a significantincrease in interest rates.  The Companyalso has obligations under an industrial revenue bond (balance as of November25, 2004 of $.6 million) that is payable in annual installments with interestranging from 4.8% to 6.65%.

 

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

 

**Item 4. Controls and Procedures**

 

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

 

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

 

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PARTII – OTHER INFORMATION

 

Item6.  Exhibits

 

(a)  Exhibits

 

31.1  Certification by President and ChiefExecutive Officer pursuant to Rule 13a-14(a)

 

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

 

32.1 Certification by President and ChiefExecutive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

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

 

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SIGNATURES

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, as amended, theRegistrant has duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 
|   | Cellu Tissue  Holdings, Inc.              |
|--------|-------------------------------------------|
|   |                                      |
|   |                                      |
|   |                                      |
| Date:  | January 10,  2005                         |   | /s/ Russell  C. Taylor |   |
|   | Mr. Russell  C. Taylor                    |
|   | President  and Chief Executive Officer    |
|   |                                      |
| Date:  | January 10,  2005                         |   | /s/ Dianne  M. Scheu |   |
|   | Ms. Dianne  M. Scheu                      |
|   | Senior Vice  President, Finance and Chief |
|   | Financial  Officer                        |
|        |                                           |  |  |  |  |

 

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