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

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**FORM 10-Q**

| **(Mark One)** |       | ** **                                                                                                                                                                                                     |
|----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **     |       | ** **                                                                                                                                                                                                     |
| **x**          | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                   |
|           |       | **For the  Quarterly Period Ended May 31, 2007**                                                                                                                                                               |
|           |       | **or**                                                                                                                                                                                                         |
| o              |       | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                  |
|           |       | ** **                                                                                                                                                                                                     |
| ** **     |       | **For the  transition period from              to              .** |

**Commission file number 333-118829**

**Cellu Tissue Holdings, Inc.**

(Exact name ofregistrant as specified in its charter)

| **Delaware**                                               |   | **06-1346495**                     |
|------------------------------------------------------------|--------|------------------------------------|
| (State of  incorporation)                                  |   | (IRS Employer  Identification No.) |
|                                                       |   |                               |
| **1855  Lockeway Drive, Suite 501, Alpharetta , Georgia**  |   | **30004**                          |
| (Address of  principal executive offices)                  |   | (zip code)                         |
|                                                       |   |                               |
| **(678)  393-2651**                                        |
| (Registrant’s  telephone number, including area code) |

**Not Applicable**

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

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

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

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

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

The number of shares outstanding of each of theregistrant’s classes of common stock as of July 2, 2007:
| Title of Class                | ** ** | **Shares Outstanding** |
|-------------------------------|------------|------------------------|
| Common Stock,  $.01 par value |       | 100                    |

 

 

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CELLU TISSUE HOLDINGS,INC.

FORM 10-Q

QUARTER ENDED MAY31, 2007

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

 

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**PART I FINANCIAL INFORMATION**

**Item1.  Consolidated Financial Statements**

**CELLUTISSUE HOLDINGS, INC.  AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS (Unaudited)**
| ** **                                    | ** ** | **Three Months Ended** | ** **  |
|-----------------------------------------------|------------|----------------------------------|-------------|
| ** **                                    | ** ** | **May 31**                  | ** **  | **May 25** | ** ** |
| ** **                                    | ** ** | **2007**                         | ** **  | **2006** | ** ** |
| ** **                                    | ** ** | **(Post-Merger)**                | ** **  | **(Pre-Merger)** | ** ** |
|                                          | ** ** | ** **                       | ** **  | ** ** | ** ** |
| Net sales                                     |       | $                                | 103,200,786 |   | $ | 78,641,977 |   |
| Cost of goods sold                            |       | 94,908,668                       |        | 71,791,158 |   |
| Gross profit                                  |       | 8,292,118                        |        | 6,850,819 |   |
|                                          |       |                             |        |   |   |
| Selling, general and  administrative expenses |       | 4,482,737                        |        | 3,094,646 |   |
| Stock and related  compensation expense       |       | 233,119                          |        | 52,658 |   |
| Merger-related  transaction costs             |       | —                           |        | 127,207 |   |
| Income from operations                        |       | 3,576,262                        |        | 3,576,308 |   |
|                                          |       |                             |        |   |   |
| Interest expense, net                         |       | 5,019,094                        |        | 4,052,725 |   |
| Foreign currency loss                         |       | 324,298                          |        | 205,500 |   |
| Other income                                  |       | (42,239                          | )           | (25,392 | ) |
| Loss before income tax                        |       | (1,724,891                       | )           | (656,525 | ) |
|                                          |       |                             |        |   |   |
| Income tax benefit                            |       | (614,407                         | )           | (180,873 | ) |
| Net loss                                      |       | $                                | (1,110,484  | ) | $ | (475,652 | ) |

 

See accompanying notes toconsolidated financial statements.

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**CELLUTISSUE HOLDINGS, INC.  AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**
| ** **                                                                                | ** ** | **May 31** | ** **  | **February 28** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------|-------------|----------------------|------------|
| ** **                                                                                | ** ** | **2007**        | ** **  | **2007**             | ** ** |
| ** **                                                                                | ** ** | **(Unaudited)** | ** **  | ** **           | ** ** |
| **ASSETS**                                                                                |       |            |        |                 |       |
| CURRENT ASSETS:                                                                           |       |            |        |                 |       |
| Cash and cash equivalents                                                                 |       | $               | 7,986,947   |                 | $          | 16,260,601 |   |
| Receivables, net                                                                          |       | 39,518,190      |        | 34,140,844           |       |
| Inventories                                                                               |       | 30,281,752      |        | 29,603,809           |       |
| Prepaid expenses and other current assets                                                 |       | 3,505,433       |        | 2,809,014            |       |
| Income tax receivable                                                                     |       | 327,183         |        | 329,861              |       |
| Deferred income taxes                                                                     |       | 6,451,082       |        | 6,498,098            |       |
| TOTAL CURRENT ASSETS                                                                      |       | 88,070,587      |        | 89,642,227           |       |
| PROPERTY, PLANT  AND EQUIPMENT, NET                                                       |       | 297,588,925     |        | 228,851,765          |       |
| TRADEMARKS                                                                                |       | 6,550,314       |        | 6,550,314            |       |
| OTHER ASSETS                                                                              |       | 1,530,601       |        | 224,438              |       |
| TOTAL ASSETS                                                                              |       | $               | 393,740,427 |                 | $          | 325,268,744 |   |
|                                                                                      |       |            |        |                 |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                            |       |            |        |                 |       |
| CURRENT  LIABILITIES:                                                                     |       |            |        |                 |       |
| Revolving line of credit                                                                  |       | $               | 14,400,000  |                 | $          | — |   |
| Accounts payable                                                                          |       | 21,592,503      |        | 16,523,755           |       |
| Accrued expenses                                                                          |       | 17,920,586      |        | 16,315,163           |       |
| Accrued interest                                                                          |       | 3,902,625       |        | 7,226,753            |       |
| Current portion of long-term debt                                                         |       | 760,000         |        | —               |       |
| TOTAL CURRENT LIABILITIES                                                                 |       | 58,575,714      |        | 40,065,671           |       |
| LONG-TERM DEBT,  LESS CURRENT PORTION                                                     |       | 198,196,279     |        | 160,355,507          |       |
| DEFERRED INCOME  TAXES                                                                    |       | 62,404,895      |        | 50,677,332           |       |
| OTHER  LIABILITIES                                                                        |       | 35,167,602      |        | 35,179,252           |       |
| STOCKHOLDERS’  EQUITY:                                                               |       |            |        |                 |       |
| Common stock, $.01 par value, 1,000 shares authorized,  100 shares issued and outstanding |       | 1               |        | 1                    |       |
| Capital in excess of par value                                                            |       | 46,455,398      |        | 46,259,101           |       |
| Accumulated deficit                                                                       |       | (7,302,850      | )           | (6,192,366           | )          |
| Accumulated other comprehensive income (loss)                                             |       | 243,388         |        | (1,075,754           | )          |
| TOTAL STOCKHOLDERS’ EQUITY                                                           |       | 39,395,937      |        | 38,990,982           |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                          |       | $               | 393,740,427 |                 | $          | 325,268,744 |   |

 

See accompanying notes toconsolidated financial statements.

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**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS (Unaudited)**
| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **May 31**                  | ** ** | **May 25** | ** ** |
| ** **                                                                                 | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| ** **                                                                                 | ** ** | **(Post-Merger)**                | ** ** | **(Pre-Merger)** | ** ** |
| **Cash  flows from operating activities**                                                  |       |                             |       |   |   |
| Net loss                                                                                   |       | $                                | (1,110,484 | ) | $ | (475,652 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                             |       |   |   |
| Stock-based compensation                                                                   |       | 196,297                          |       | 52,658 |   |
| Deferred income taxes                                                                      |       | (1,217,891                       | )          | (396,024 | ) |
| Accretion of debt discount                                                                 |       | 150,772                          |       | 70,678 |   |
| Amortization of intangibles                                                                |       | —                           |       | 335,374 |   |
| Depreciation                                                                               |       | 6,678,145                        |       | 3,534,475 |   |
| Changes in operating assets and liabilities:                                               |       |                             |       |   |   |
| Receivables                                                                                |       | 194,152                          |       | (2,614,653 | ) |
| Inventories                                                                                |       | 867,490                          |       | (1,732,249 | ) |
| Prepaid expenses and other current assets and income  tax receivable                       |       | 464,351                          |       | (79,142 | ) |
| Other                                                                                      |       | (1,521                           | )          | (4,924 | ) |
| Accounts payable, accrued expenses and accrued  interest                                   |       | (3,727,701                       | )          | (4,155,057 | ) |
| Total adjustments                                                                          |       | 3,604,094                        |       | (4,988,864 | ) |
| *Net cash provided by (used) in operating  activities*                                     |       | 2,493,610                        |       | (5,464,516 | ) |
|                                                                                       |       |                             |       |   |   |
| **Cash  flows from investing activities**                                                  |       |                             |       |   |   |
| Cash paid for acquisition, net of cash received                                            |       | (43,343,798                      | )          | — |   |
| Capital expenditures,net                                                                   |       | (2,646,346                       | )          | (1,682,565 | ) |
| Other                                                                                      |       | 383,835                          |       | — |   |
| *Net cash used in investing activities*                                                    |       | (45,606,309                      | )          | (1,682,565 | ) |
|                                                                                       |       |                             |       |   |   |
| **Cash  flows from financing activities**                                                  |       |                             |       |   |   |
| Payments of long-term debt                                                                 |       | —                           |       | (290,000 | ) |
| Borrowings on revolving line of credit, net                                                |       | 14,400,000                       |       | — |   |
| Proceeds from bond offering                                                                |       | 20,000,000                       |       | — |   |
| *Net cash provided by (used in) financing  activities*                                     |       | 34,400,000                       |       | (290,000 | ) |
| * *                                                                                   |       |                             |       |   |   |
| Effect of  foreign currency                                                                |       | 439,045                          |       | 321,073 |   |
|                                                                                       |       |                             |       |   |   |
| *Net  decrease in cash and cash equivalents*                                               |       | (8,273,654                       | )          | (7,116,008 | ) |
| *Cash  and cash equivalents at beginning of period*                                        |       | 16,260,601                       |       | 22,824,062 |   |
| *Cash and cash equivalents at  end of period*                                              |       | $                                | 7,986,947  |   | $ | 15,708,054 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

**Notes to Consolidated FinancialStatements (Unaudited)**

**May 312007**

**Note 1 Basis of Presentation andSignificant Accounting Policies**

The accompanyingunaudited interim consolidated financial statements include the accounts ofCellu Tissue Holdings, Inc.  (the “Company”) and its wholly-owned subsidiaries.  TheCompany is a wholly-owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”).

On June 12, 2006, theParent consummated an Agreement and Plan of Merger with Cellu ParentCorporation (“Cellu Parent”), a corporation organized and controlled by WestonPresidio V, L.P. (“Weston Presidio”), and Cellu Acquisition Corporation (“MergerSub”), a wholly-owned subsidiary of Cellu Parent and a newly-formed corporationindirectly controlled by Weston Presidio. Pursuant to the agreement, on June 12, 2006, Merger Sub was merged withand into Parent, with the Parent surviving (the “Merger”).

These statements havebeen prepared in accordance with accounting principles generally accepted inthe United States for interim financial information and with the instructionsto Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States for completefinancial statements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been included.  Operating results for the quarter ended May31, 2007 are not necessarily indicative of the results that may be expected forthe fiscal year ending February 29, 2008. For further information, refer to the Company’s consolidated financialstatements and footnotes thereto as of February 28, 2007 and for the year thenended included in the Company’s Annual Report on Form 10-K, from which theconsolidated balance sheet at February 28, 2007 has been derived, and theCompany’s latest current reports on Form 8-K, each as filed with the Securitiesand Exchange Commission (“SEC”).

The Company accounted forthe Merger as a purchase in accordance with the provisions of Statement ofFinancial Accounting Standards No. 141 (“SFAS 141”), *BusinessCombinations*, which resulted in a new valuation for the assets andliabilities of the Company based upon fair values as of the date of theMerger.  As allowed under SEC StaffAccounting Bulletin No. 54, *Push Down Basis ofAccounting Required in Certain Limited Circumstances*, the Companyhas reflected all applicable purchase accounting adjustments in the Company’sconsolidated financial statements for all periods subsequent to the Merger date(“Push Down Accounting”).  Push Down

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Accounting requires theCompany to establish a new basis for its assets and liabilities based on theamount paid for its equity at the close of business on June 12, 2006.  Accordingly, Cellu Parent’s equity basis isreflected in the Company’s consolidated financial statements beginning uponcompletion of the Merger.

In order to apply Push DownAccounting, Cellu Parent’s purchase price of $207.8 million, includingassumption of $162.0 million in aggregate principal amount of the Company’soutstanding 9.75% senior secured notes (the “Notes”), was allocated to theassets and liabilities based on their relative fair values.  The purchase price is subject to adjustmentfor certain tax benefits that the Company may realize.  In addition, total consideration is subjectto adjustment for up to an additional $35.0 million in contingent earnoutconsideration based upon the achievement of certain financial targets.  If any portion of the earned contingentpayments is unable to be made, then Weston Presidio has agreed to provide thenecessary funds to former holders of the Parent’s capital stock, options andwarrants through an equity investment in the Parent or otherwise.  In accordance with SFAS 141, the $35.0million has been recognized as a liability in the Company’s balance sheet.  This amount is included in other liabilitiesas of May 31, 2007.

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

 

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

 

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Reclassification

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

Stock-Based Compensation

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123R (“SFAS 123R”), *Share-BasedPayment*, which requires the measurement of all employee share-basedpayments to employees, including grants of employee stock options, using thefair-value-based method and the recording of such expense in the Company’sconsolidated statement of operations. The Company adopted the provisions of SFAS 123R using the prospectivemethod effective March 1, 2006.  As such,there was no accounting effect on any awards outstanding at the date ofadoption.  At the time of adoption ofSFAS 123R, the Company had only one share-based payment arrangement, the CelluPaper Holdings, Inc. 2001 Stock Incentive Plan (the “Old Plan”), under whichthe Parent granted stock options to certain members of the Company’smanagement.  In accordance with the OldPlan, each option outstanding at the time of a change in control immediatelyvested and became exercisable. Furthermore, in accordance with the terms of the Merger, all outstandingoptions were cancelled and automatically converted into the right to receivethe per share merger consideration for any in-the-money options.

On June 12, 2006, theBoard of Directors of Cellu Parent adopted the 2006 Stock Option and RestrictedStock Plan (the “Plan”).  Under the Plan,the Plan Administrator may make awards of options to purchase shares of commonstock of Cellu Parent and/or awards of restricted shares of common stock ofCellu Parent.  A maximum of 8,095 sharesof common stock of Cellu Parent may be delivered in satisfaction of awardsunder the Plan, determined net of shares of common stock withheld by CelluParent in payment of the exercise price of an award or in satisfaction of taxwithholding requirements.  Key employeesand directors of, and consultants and advisors to, Cellu Parent or itsaffiliates who, in the opinion of the Plan Administrator, are in a position tomake a significant contribution to the success of Cellu Parent and itsaffiliates are eligible to participate in the Plan.   Stock options are granted at the marketprice of the Cellu Parent’s stock on the date of grant and have a 10-yearterm.  Generally, stock option grantsvest ratably over four years from the date of grant.  The following describes how certainassumptions affecting the estimated fair value of stock options aredetermined.  The dividend yield is zero;the volatility is based on historical market value of Cellu 

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Parent’s stock; and therisk-free interest rate is based on U.S. Treasury securities with maturitiesequal to the expected life of the option. The Company uses historical value to estimate exercise, termination andholding period behavior for valuation purposes. A summary of the outstanding options as of May 31, 2007 and the activityduring the three months then ended is as follows:
|                                 | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** |
|---------------------------------|------------|-------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|
| Outstanding,  February 28, 2007 |       | 575         |       | $                                          | 426.69     |                                                    | 9.20 Years |   |
| Forfeited                       |       | (50         | )          | 426.69                                     |       | 9.20 Years                                              |       |
| Granted                         |       | 625         |       | 979.25                                     |       | 9.80 Years                                              |       |
| Outstanding, May  31, 2007      |       | 1,150       |       | $                                          | 726.99     |                                                    | 9.53 Years |   |
| Exercisable, May 31,  2007      |       | —      |       | $                                          | —     |                                                    | —     |   |

 

The fair value of thestock option grants was estimated on the date of grant using the Black-Scholesoption pricing model.  The weightedaverage assumptions used to value the grants were: no dividend yield; 57%volatility; 5.0% risk free interest rate during the three-months ended May 31,2007; and 10-year expected life.  Theweighted average fair value of stock options granted was $472.69 per share andthe unrecognized total compensation cost as of May 31, 2007 related tononvested awards is $507,233.

On June 12, 2006, CelluParent entered into Restricted Stock Agreements with the Company’s ChiefExecutive Officer, Chief Operating Officer and Chief Financial Officer,pursuant to which Cellu Parent granted 3,778 restricted shares of its commonstock to the Chief Executive Officer and 1,349 restricted shares of its commonstock to each of the other two named individuals pursuant to the Plan.  The shares will vest and cease to berestricted in four equal annual installments commencing on June 12, 2007, aslong as the named individual, as the case may be, is continuously employed bythe Company until each such vesting date with respect to his or 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 agreed to pay anadditional amount to the named individual, as the case may be, to fully grossup him or her as applicable, for the amount included in gross income for incometax purposes as a result of making a Section 83(b) election under the InternalRevenue Code of 1986, as amended, or the payment of any gross-up amountpayment.  All named individuals have madea timely Section 83(b) election.

For the three monthsended May 31, 2007, the Company has recorded $196,297 of compensation expenserelated to the vesting of the above grants in accordance with SFAS  123R. Immediately prior to consummation of the Merger, there were 341.3restricted

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shares of Parent’s commonstock.  In accordance with the terms ofthe Old Plan, the restricted stock immediately vested.  The Company had previously recorded $52,658related to the normal vesting in the three months ended May 25, 2006.

Derivatives and Hedging

The Company usesderivative financial instruments to offset a substantial portion of itsexposure to market risk arising from changes in the price of natural gas.  Hedging of this risk is accomplished byentering into forward swap contracts, which are designated as hedges ofspecific quantities of natural gas expected to be purchased in futuremonths.    These contracts are held forpurposes other than trading and are designated as cash flow hedges.  The Company measures hedge effectiveness byformally assessing, at least quarterly, the correlation of the expected futurecash flows of the hedged item and the derivative hedging instrument.  The ineffective portions of the hedges arerecorded in the statement of operations in the current period.  As the hedges were considered highlyeffective for the three months ended May 31, 2007 and May 25, 2006, the Companyexperienced minimal impact to operating results.

Recent AccountingPronouncements

In September 2006, theFASB issued FAS No. 157,”*Fair Value Measurements*”(“FAS 157”).  The Company was required toadopt the provisions of FAS 157 effective March 1, 2007.  FAS 157 provides a common fair valuehierarchy for companies to follow in determining fair value measurements in thepreparation of financial statements and expands disclosure requirementsrelating to how such fair value measurements were developed.  FAS 157 clarifies the principle that fairvalue should be based on the assumptions that the marketplace would use whenpricing an asset or liability, rather than company specific data.  The adoption of FAS No. 157 did not have amaterial impact on the Company’s results of operations and financial position.

**Note 2 Inventories**

Components of inventoriesare as follows:
| ** **                        | ** ** | **May 31, 2007** | ** ** | **February 28, 2007** | ** ** |
|-----------------------------------|------------|----------------------------|------------|---------------------------------|------------|
| Finished goods                    |       | $                          | 18,819,080 |                            | $          | 18,896,790 |   |
| Raw materials                     |       | 4,298,068                  |       | 2,742,025                       |       |
| Packaging  materials and supplies |       | 7,294,409                  |       | 8,098,582                       |       |
|                              |       | 30,441,557                 |       | 29,737,397                      |       |
| Inventory  reserves               |       | (129,805                   | )          | (133,588                        | )          |
|                              |       | $                          | 30,281,752 |                            | $          | 29,603,809 |   |

 

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**Note 3 Acquisition**

On March 21, 2007, theCompany executed a definitive merger agreement (the “Acquisition Agreement”)with CityForest Corporation (“CityForest”), Cellu City Acquisition Corporation(“Cellu City Merger Sub”) and Wayne Gullstad as the shareholders’representative.  Pursuant to theAcquisition Agreement, and subject to the terms and conditions therein, CelluCity Merger Sub, a wholly-owned subsidiary of the Company, merged with and intoCityForest, with CityForest surviving and becoming a wholly-owned subsidiary ofthe Company (the “Acquisition”).  Theaggregate merger consideration (including assumption of $18.4 million in aggregateprincipal amount of industrial revenue bonds) was approximately $61.0 millionsubject to certain working capital and net cash adjustments.  Total cash paid for the acquisition of $46.5million (purchase price of $61.0 million less assumed indebtedness of $18.4million plus restricted cash and other miscellaneous adjustments of $1.6million and acquisition costs of $2.3 million), was financed in part byissuance of unregistered 10 1/4% Senior Secured Notes due 2010 (the “AdditionalNotes”) of approximately $20.0 million, borrowings on a revolving line ofcredit ($17.4 million) and available cash on hand.

The Acquisition has beenaccounted for as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statement of operations includes the results ofCityForest during the first quarter of the fiscal year ending February 29, 2008(fiscal year 2008”) from the date of acquisition.  Purchase price allocations are subject torefinement until all pertinent information is obtained.  The Company has allocated the excess ofpurchase price over the net assets acquired in the acquisition based on itsestimates of the fair value of assets and liabilities as follows:
|                                | ** ** | **Excess purchase price allocated to:** | ** ** |
|--------------------------------|------------|-------------------------------------------------------------|------------|
| Property, plant  and equipment |       | $                                                           | 37,435,700 |   |
| Long-term debt                 |       | (1,724,684                                                  | )          |
| Deferred income  taxes         |       | (12,992,470                                                 | )          |
| Total                          |       | $                                                           | 22,718,546 |   |

 

The Company hasestimated the fair value of the assets and liabilities of the Acquisition,utilizing information available at the time the Company’s unaudited interimfinancial statements were prepared and these estimates are subject torefinement until all pertinent information has been obtained. The Company is inthe process of obtaining outside third-party appraisals of its tangible andintangible assets and for purposes herein has assumed no intangible assets orgoodwill arising from the acquisition. Furthermore, depreciation has been calculated on the excess purchaseprice allocated to the tangible fixed assets based on an average remaining20-year life.  The actual lives to beused in calculating depreciation will be finalized with the aforementionedappraisal.

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The results ofCityForest’s operations from the March 21, 2007 date of acquisition areincluded in the Company’s tissue segment. Unaudited pro forma results of operations for the three months ended May31, 2007 and May 25, 2006, as if the Company and CityForest had been combinedas of March 1, 2006, are presented below. The pro forma results include estimates and assumptions, which theCompany’s management believes are reasonable. However, the pro forma results do not include any cost savings or othereffects of the planned integration of CityForest, and are not necessarilyindicative of the results which would have occurred if the business combinationhad been in effect on the dates indicated, or which may result in the future.
| ** **        | ** ** | **Three Months Ended May 31, 2007 (1)** | ** ** | **Three Months Ended May 25, 2006 (2)** | ** ** |
|-------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **        | ** ** | **As Filed**                                                     | ** ** | **Pro Forma**                                                    | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(in thousands)**                                               | ** ** | **(in thousands)**                                               | ** ** |
| Net sales         |       | $                                                                     | 103,201    |                                                                  | $          | 105,911 |   | $ | 78,642 |   | $ | 89,842 |   |
| Operating income  |       | $                                                                     | 3,576      |                                                                  | $          | 4,162 |   | $ | 3,576 |   | $ | 6,037 |   |
| Net (loss) income |       | $                                                                     | (1,110     | )                                                                     | $          | (549 | ) | $ | (476 | ) | $ | 1,265 |   |

 

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(1)          Pro forma operatingresults include the operating results for CityForest for the three months endedMay 31, 2007.   The “as filed” operatingresults include the operating results for CityForest for the period from theacquisition date (March 21, 2007) to May 31, 2007.

(2)          Pro forma operatingresults include the operating results for CityForest for the three months endedMarch 31, 2006 as CityForest was previously a calendar year-end company.

**Note 4 Long-Term Debt**

Long-term debt consistsof the following:
|                                                                                                          | ** ** | **May 31, 2007** | ** **  | **February 28, 2007** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------|-------------|---------------------------------|------------|
| 9 3⁄4% and 10 1⁄4%  senior secured notes due 2010                                                  |       | $                          | 182,255,572 |                            | $          | 162,000,000 |   |
| Less discount                                                                                            |       | (1,749,293                 | )           | (1,644,493                      | )          |
|                                                                                                     |       | 180,506,279                |        | 160,355,507                     |       |
| Industrial  revenue bond payable in semi-annual installments, plus variable interest, due  March 1, 2028 |       | 18,450,000                 |        | —                          |       |
|                                                                                                     |       | 198,956,279                |        | 160,355,507                     |       |
| Less current  portion of debt                                                                            |       | 760,000                    |        | —                          |       |
|                                                                                                     |       | $                          | 198,196,279 |                            | $          | 160,355,507 |   |

 

In connection with theAcquisition (see Note 3), the Company entered into a Note Purchase Agreement(the “Note Purchase Agreement”) with Wingate Capital Ltd. (the “Purchaser”),dated March 21, 2007, pursuant to which it issued and sold $20.3 million

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aggregate principalamount of Additional Notes to the Purchaser for the purchase price of $20.0million which is equal to 98.7383% of the aggregate principal amount of theAdditional Notes.  The Additional Noteswere issued pursuant to and will be governed by the Indenture, dated as ofMarch 12, 2004 (as amended and supplemented, the “Cellu Tissue Indenture”)among the Company, the subsidiary guarantors party thereto and The Bank of NewYork Trust Company, N.A., as successor trustee to the Bank of New York (the “Trustee”).

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

In connection with theMerger (see Note 1), the Company solicited consents with respect to theNotes.   Consents were received withrespect to 100% of the aggregate outstanding principal amount of the Notes. TheCompany accepted all of the consents delivered in the consent solicitation andpaid to the consenting noteholders a consent fee of $40 per $1,000 principalamount of Notes for which they delivered consents.  These payments were made in the Company’ssecond quarter of the fiscal year ended February 28, 2007.  As a result of the acceptance by the Companyof the consents delivered by noteholders and the completion of the consentsolicitation, the amendments to the indenture governing the Notes described inthe Consent Solicitation Statement dated May 9, 2006 and related Supplementdated May 24, 2006 became operative and the Company was not  required to make a change of control offer topurchase any Notes in connection with the Merger.

The Company entered intoa Credit Agreement, dated as of June 12, 2006 (the “Credit Agreement”), amongthe Company, as U.S. Borrower, Interlake Acquisition Corporation Limited, asubsidiary of the Company, as Canadian Borrower, Parent, the other loanguarantors party thereto, JPMorgan Chase Bank, N.A., as U.S. AdministrativeAgent, JPMorgan Chase Bank, N.A., Toronto Branch, as Canadian AdministrativeAgent, and the other lenders party thereto. The Credit Agreement provides for a $35.0 million working capitalfacility, including a letter of credit sub-facility and swing-line loansub-facility. The Credit Agreement provides that amounts under the facility maybe borrowed, repaid and re-borrowed, subject to a borrowing base test, untilthe maturity date, which is June 12, 2011. An amount equal to $32.0 million isavailable, in U.S. dollars, to the U.S. Borrower under the facility, and an amount equal to $3.0 million isavailable, in U.S. or Canadian dollars, to the Canadian Borrower under thefacility.  Borrowings of

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$17.4 million were made to finance a portion of theAcquisition.  As of May 31, 2007, therewas $14.4 million of borrowings outstanding under the working capital facility.

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

***SecondSupplemental Indenture***

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

***Amendmentto Credit Agreement***

The Company has enteredinto a First Amendment, dated March 21, 2007 (the “Amendment”), to the CreditAgreement dated June 12, 2006 (as amended by the Amendment, the “Amended CreditAgreement”) among Cellu Tissue, as U.S. Borrower, Interlake AcquisitionCorporation Limited, a subsidiary of Cellu Tissue, as Canadian Borrower,certain subsidiaries of Cellu Tissue, Cellu Paper Holdings, Inc., the parent corporationof Cellu Tissue, JPMorgan Chase Bank, N.A. (the “U.S. Administrative Agent”)and JPMorgan Chase Bank, N.A., Toronto Branch (the “Canadian AdministrativeAgent”).

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

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***CityForestBond Documents***

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

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

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

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

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

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

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

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**Note 5 Comprehensive Loss**

The components ofcomprehensive loss for the three months ended May 31, 2007 and May 25, 2006 areas follows:
|                                           | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **May 31, 2007**       | ** ** | **May 25, 2006** | ** ** |
| Net loss                                  |       | $                                | (1,110,484 | ) | $ | (475,652 | ) |
| Foreign currency  translation adjustments |       | 439,045                          |       | 321,073 |   |
| Comprehensive loss                        |       | $                                | (671,439   | ) | $ | (154,579 | ) |

 

**Note 6 Business Segments**

The Company operates intwo reportable business segments:  tissueand machine-glazed paper.  The Companyassesses the performance of its reportable business segments using income fromoperations.  Income from operationsexcludes interest income, interest expense, other income (expense), income taxexpense (benefit) and the impact of foreign currency gains and losses.  A portion of corporate and shared expenses isallocated to each segment.  Segmentinformation for the three months ended May 31, 2007 and May 25, 2006 follows:
|                                        | ** ** | **Three Months Ended** | ** **  |
|----------------------------------------|------------|----------------------------------|-------------|
| ** **                             | ** ** | **May 31, 2007**       | ** **  | **May 25, 2006** | ** ** |
| ** **                             | ** ** | **(Post-Merger)**                | ** **  | **(Pre-Merger)** | ** ** |
| **Net Sales**                     |       |                             |        |   |   |
| Tissue                                 |       | $                                | 77,635,897  |   | $ | 55,328,622 |   |
| Machine-glazed  paper                  |       | 25,564,889                       |        | 23,313,355 |   |
| Consolidated                           |       | $                                | 103,200,786 |   | $ | 78,641,977 |   |
| ** **                             |       |                             |        |   |   |
| **Income  (loss) from operations**     |       |                             |        |   |   |
| Tissue                                 |       | $                                | 4,082,978   |   | $ | 2,939,493 |   |
| Machine-glazed  paper                  |       | (506,716                         | )           | 636,815 |   |
| Consolidated                           |       | 3,576,262                        |        | 3,576,308 |   |
|                                   |       |                             |        |   |   |
| Interest expense                       |       | (5,038,675                       | )           | (4,135,637 | ) |
| Net foreign  currency transaction loss |       | (324,298                         | )           | (205,500 | ) |
| Interest income                        |       | 19,581                           |        | 82,912 |   |
| Other income                           |       | 42,239                           |        | 25,392 |   |
| Pretax loss                            |       | $                                | (1,724,891  | ) | $ | (656,525 | ) |

 

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** **
| **Capital Expenditures** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------|------------|------------|------------|------------|------------|
| Tissue                   |       | $          | 2,241,151  |       | $          | 669,789 |   |
| Machine-glazed  paper    |       | 252,651    |       | 141,670    |       |
| Corporate                |       | 152,544    |       | 871,106    |       |
| Consolidated             |       | $          | 2,646,346  |       | $          | 1,682,565 |   |
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Depreciation**         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Tissue                   |       | $          | 5,002,167  |       | $          | 2,563,895 |   |
| Machine-glazed  paper    |       | 1,675,978  |       | 970,580    |       |
|                     |       | $          | 6,678,145  |       | $          | 3,534,475 |   |

 
|                       | ** ** | **May 31, 2007** | ** **  | **February 28, 2007** | ** ** |
|-----------------------|------------|----------------------------|-------------|---------------------------------|------------|
| **Segment  assets**   | ** ** | ** **                 |        |                            |       |
| Tissue                |       | $                          | 292,184,877 |                            | $          | 214,039,270 |   |
| Machine-glazed  paper |       | 73,800,131                 |        | 79,277,799                      |       |
| Corporate assets      |       | 27,755,419                 |        | 31,951,675                      |       |
| Consolidated          |       | $                          | 393,740,427 |                            | $          | 325,268,744 |   |

 

**Note 7 Income taxes**

The effective income taxbenefit for the three months ended May 31, 2007 was 35.6% compared to a 27.6%benefit for the three months ended May 25, 2006. The reduction in the effectivetax rate for the three months ended May 25, 2006 is due to the differencebetween book and tax treatment relative to compensation matters.

The Company adoptedFinancial Accounting Standards Board (“FASB”) Interpretation 48, “Accountingfor Uncertainty in Income Taxes” (“FIN 48”), at the beginning of fiscal year2008.  The implementation of FIN 48 didnot have a material impact on the Company’s results of operations and financialposition.  At May 31, 2007, the Company didnot have any unrecognized tax benefits.

The Company recognizesinterest and penalties related to uncertain tax positions in income taxexpense.  As of May 31, 2007, the Companyhas accrued interest and penalties, if any, related to uncertain tax positions.

The tax years 2003through 2007 remain open to examination by the major taxing jurisdictions towhich the Company is subject.  As of May31, 2007, the Company does

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not expect any materialchanges to unrecognized tax positions within the next twelve months.

**Note 8 Bonus Agreements**

On March 27, 2006, theCompany entered into agreements with Russell Taylor, its President and ChiefExecutive Officer; Dianne Scheu, its Senior Vice President, Finance and ChiefFinancial Officer; and Steven Ziessler, its President, Tissue &Machine-Glazed and Chief Operating Officer, pursuant to which each received alump sum cash payment equal to one year’s current base salary.  As of that date, the current base salary foreach of Mr. Taylor, Ms. Scheu, and Mr. Ziessler was $425,000, $230,000 and $250,000,respectively.  The payment did not affectany other terms of such executive’s employment arrangements with the Companyand will not be taken into account in computing any future compensation.  Pursuant to the terms of his agreement, ifMr. Taylor’s employment with the Company was terminated on or prior toSeptember 27, 2006, for any reason, other than due to his death or disability,he was required to repay the bonus to the Company.  Pursuant to the terms of her agreement, ifMs. Scheu’s employment with the Company was terminated on or prior to March 27,2007, for any reason, other than due to her death or disability, she wasrequired to repay the bonus to the Company. Pursuant to the terms of his agreement, if Mr. Ziessler’s employmentwith the Company was terminated on or prior to March 27, 2007, for any reason,other than due to his death or disability, he was required to repay the bonusto the Company.  These payments were madeduring the quarter ended May 25, 2006 and have been amortized over the serviceperiods noted above.  Compensationexpense recorded for the three months ended May 31, 2007 was $36,822.

**Note 9 Subsequent Event**

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

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

 

**OVERVIEW**

Certain statementscontained in this Quarterly Report on Form 10-Q may contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities and Exchange Act of 1934, as amendedand, as such, may involve known or unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from future results, performance or achievements expressedor implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions anddescribe 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, 2007. These risks and uncertainties should be considered in evaluating anyforward-looking statements contained herein.

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

We operate in two reportablebusiness segments:  tissue andmachine-glazed paper.  We assess theperformance of our reportable business segments using income from operations.  Income from operations excludes interestincome, interest expense, income tax expense (benefit), other income andexpense and the impact of foreign currency gains and losses.

***Merger***

On June 12, 2006, ourParent consummated an Agreement and Plan of Merger with Cellu ParentCorporation, a corporation organized and controlled by Weston Presidio andMerger Sub, a wholly-owned subsidiary of Cellu Parent and a newly-formedcorporation indirectly controlled by Weston Presidio.  Pursuant to the agreement, on June 12, 2006,Merger Sub was merged with and into our Parent, with our Parent surviving (the “Merger”).

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We accounted for theMerger as a purchase in accordance with the provisions of SFAS 141, whichresulted in a new valuation for our assets and liabilities based upon fairvalues as of the date of the Merger.  Asallowed under SEC Staff Accounting Bulletin No. 54, *Push DownBasis of Accounting Required in Certain Limited Circumstances*, wehave reflected all applicable purchase accounting adjustments in ourconsolidated financial statements for all periods subsequent to the Mergerdate.  Push Down Accounting requires usto establish a new basis for our assets and liabilities based on the amountpaid for our equity at the close of business on June 12, 2006.  Accordingly, Cellu Parent’s equity basis isreflected in our consolidated financial statements beginning upon completion ofthe Merger.

In order to apply PushDown Accounting, Cellu Parent’s purchase price of $207.8 million, includingassumption of $162.0 million in aggregate principal amount of our Notes, wasallocated to the assets and liabilities based on their relative fairvalues.  The purchase price is subject toadjustment for certain tax benefits that we may realize.  In addition, total consideration is subjectto adjustment for up to an additional $35.0 million in contingent earnoutconsideration based upon the achievement of certain financial targets.  If any portion of the earned contingentpayments is unable to be made, then Weston Presidio has agreed to provide thenecessary funds to former holders of our Parent’s capital stock, options andwarrants through an equity investment in our Parent or otherwise.  In accordance with SFAS 141, $35.0 millionhas been recognized as a liability in our balance sheet. This amount isincluded in other liabilities as of May 31, 2007.

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

 

***Acquisition***

On March 21, 2007, weexecuted the Acquisition Agreement with CityForest, Cellu City Merger Sub andWayne Gullstad as the shareholders’ representative.  Pursuant to the Acquisition Agreement, andsubject to the terms and conditions therein, Cellu City Merger Sub, awholly-owned subsidiary of ours, merged with and into CityForest, withCityForest surviving and becoming our wholly-owned subsidiary.  The aggregate merger

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consideration (includingassumption of $18.4 million in aggregate principal amount of industrial revenuebonds) was approximately $61.0 million subject to certain working capital andnet cash adjustments.  Total cash paidfor the acquisition of $46.5 million (purchase price of $61.0 million lessassumed indebtedness of $18.4 million plus restricted cash and othermiscellaneous adjustments of $1.6 million and acquisition costs of $2.3million), was financed in part by issuance of the Additional Notes ofapproximately $20.0 million, borrowings on a revolving line of credit ($17.4million) and available cash on hand.

The Acquisition has beenaccounted for as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statement of operations includes the results ofCityForest during the first quarter of fiscal year 2008 from the date ofacquisition.  Purchase price allocationsare subject to refinement until all pertinent information is obtained.  We have allocated the excess of purchaseprice over the net assets acquired in the acquisition based on our estimates ofthe fair value of assets and liabilities as follows:
|                                | ** ** | **Excess purchase price allocated to:** | ** ** |
|--------------------------------|------------|-------------------------------------------------------------|------------|
| Property, plant  and equipment |       | $                                                           | 37,435,700 |   |
| Long-term debt                 |       | (1,724,684                                                  | )          |
| Deferred income  taxes         |       | (12,992,470                                                 | )          |
| Total                          |       | $                                                           | 22,718,546 |   |

 

We have estimatedthe fair value of the assets and liabilities of the Acquisition, utilizinginformation available at the time our unaudited interim financial statementswere prepared and these estimates are subject to refinement until all pertinentinformation has been obtained. We are in the process of obtaining outsidethird-party appraisals of its tangible and intangible assets and for purposesherein have assumed no intangible assets or goodwill arising from theacquisition.  Furthermore, depreciationhas been calculated on the excess purchase price allocated to the tangiblefixed assets based on an average remaining 20-year life.  The actual lives to be used in calculatingdepreciation will be finalized with the aforementioned apprapisal.

The results ofCityForest’s operations from the March 21, 2007 date of acquisition are includedin our tissue segment.  Unaudited proforma results of operations for the three months ended May 31, 2007 and May 25,2006, as if we and CityForest had been combined as of March 1, 2006, arepresented below.  The pro forma resultsinclude estimates and assumptions, which our management believes arereasonable.  However, the pro formaresults do not include any cost savings or other effects of the plannedintegration of CityForest, and are not necessarily indicative of the resultswhich would have occurred if the business combination had been in effect on thedates indicated, or which may result in the future.
| ** **        | ** ** | **Three Months Ended May 31, 2007 (1)** | ** ** | **Three Months Ended May 25, 2006 (2)** | ** ** |
|-------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **        | ** ** | **As Filed**                                                     | ** ** | **Pro Forma**                                                    | ** ** | **As Filed** | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(in thousands)**                                               | ** ** | **(in thousands)**                                               | ** ** |
| Net sales         |       | $                                                                     | 103,201    |                                                                  | $          | 105,911 |   | $ | 78,642 |   | $ | 89,842 |   |
| Operating income  |       | $                                                                     | 3,576      |                                                                  | $          | 4,162 |   | $ | 3,576 |   | $ | 6,037 |   |
| Net (loss) income |       | $                                                                     | (1,110     | )                                                                     | $          | (549 | ) | $ | (476 | ) | $ | 1,265 |   |

 

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(1)          Pro forma operatingresults include the operating results for CityForest for the three months endedMay 31, 2007.  The “as filed” operatingresults include the operating results for CityForest for the period from theacquisition date (March 21, 2007) to May 31, 2007.

(2)          Pro forma operatingresults include the operating results for CityForest for the three months endedMarch 31, 2006 as CityForest was previously a calendar year-end company.

***SubsequentEvent***

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

**RESULTS OF OPERATIONS**

**Results of Operations for theThree Months Ended May 31, 2007 (the fiscal 2008 three-month period) comparedto the Three Months Ended May 25, 2006 (the fiscal 2007 three-month period)**

**Net sales** forthe fiscal 2008 three-month period increased $24.6 million, or 31.2%, to****$103.2****million from$78.6 million for the comparable period in the prior year.   For the fiscal 2008 three-month period, wesold 79,387 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products.  This is anincrease of 18,028 tons, or 29.4%, from the comparable period in the prioryear.  Of the increase for the fical 2008three-month period, $8.9 million and 10,276 tons resulted from the acquisitionof CityForest.  Net selling price per tonincreased from $1,282 for the fiscal 2007 three-month period to $1,300 for thefiscal 2008 three-month period.

Net sales for our tissuesegment for the fiscal 2008 three-month period were $77.6 million, an increaseof $22.3 million, or 40.3%, from the comparable period in the****prior year.   Theincrease is primarily attributable to the acquisition of CityForest.   Net sales for our machine-glazed segment forthe 2008 three-month period were****$25.6 million,an increase of $2.3 million, or 9.7%,****from thecomparable period in the prior year. This increase is attributable to an increase in tonnage sold and anincrease in net selling price per ton.

**Gross profit**for the fiscal 2008 three-month period increased to $8.3 million from $6.9million, an increase of $1.4 million, or 21.0%, from the comparable period inthe prior****year. **  **As a percentage of net sales,gross profit decreased to 8.0% in the fiscal 2008 three-month period from 8.7%in the fiscal 2007 three-month period. ** **The increase in gross profit in thefiscal 2008 three-month period is attributable to the acquisition of CityForestand a decrease per ton in energy costs over the comparable period in the prior

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year, despite an increasein depreciation expense relating to purchase accounting.  For the fiscal 2008 three-month perioddepreciation expense was $6.7 million, or 6.5%, of net sales compared to $3.5million, or 4.5%, of net sales for the comparable period in the prior year.

Gross profit for ourtissue segment for the fiscal 2008 three-month period increased to $7.3 millionfrom $5.3 million, an increase of $2.0 million, or 39.4%, from the comparableperiod in the prior year.  Gross profitfor our machine-glazed segment for the fiscal 2008 three-month period decreasedto $1.0 million, a decrease of $.6 million, or 36.3%, from the comparableperiod in the prior year.  As apercentage of net sales, gross profit for the tissue segment decreased to 9.3%in the fiscal 2008 three-month period from 9.4% in the fiscal 2007 three-monthperiod.  As a percentage of net sales,gross profit for the machine-glazed segment decreased to 4.1% in the fiscal2008 three-month period from 7.1% in the fiscal 2007 three-month period.  These decreases are reflective of theincreased depreciation due to purchase accounting as noted above.

**Selling, general andadministrative expenses**in the fiscal 2008 three-month periodincreased $1.4 million, or 44.9%, to $4.5 million from $3.1 million in thefiscal 2007 three-month period.  Of thisincrease, $.3 million relates to the acquisition of CityForest The remainingincrease relates to additional costs incurred in connection with beingcompliant with Sarbanes Oxley, increased workers compensation expense andbonuses accrued in the fiscal 2008 three-month period.  As a percentage of net sales, selling,general and administrative expenses increased to****4.3%in the fiscal 2008 three-month period from 3.9% in the fiscal 2007 three-monthperiod.

**Stock and related compensationexpense**in the fiscal 2008 three-month period of $.2 millionand fiscal 2007 three-month period of $.1 million relates primarily to theaccounting for restricted stock and stock option grants.

***Merger-related transaction costs***inthe fiscal 2007 three-month period were $.1 million associated with the Mergercompleted in the second quarter of the fiscal year ended February 28, 2007, orfiscal year 2007.  There were nomerger-related transaction costs in the fiscal 2008 three-month period.

***Interest expense, net***in the fiscal 2008three-month period was $5.0 million compared to $4.1 million in the fiscal 2007three-month period.  The increase is dueto the assumption of CityForest debt and additional debt incurred in connectionwith the acquisition thereof.

***Foreign currency loss***in the fiscal 2008three-month period was $.3 million compared to $.2 million in the fiscal 2007three-month period.  The fluctuationrelates to the change in the Canadian currency period over period.

**Income tax benefit**for the fiscal 2008 three-month period was a 35.6% benefit compared to a 27.6%benefit for the fiscal 2007 three-month period. The reduction in the effective

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tax rate for the fiscal2007 three-month period is due to the difference between book and tax treatmentrelative to compensation matters.

**Net loss**forthe fiscal 2008 three-month period was a net loss of $1.1 million compared tonet loss of $.5 million for the comparable period in the prior year.

**FINANCIAL CONDITION**

**Liquidity and Capital Resources**

**Net cash provided by operations**was $2.5 million for the fiscal 2008 three-month period, compared to cash usedin operations of $5.5 million for the fiscal 2007 three-month period. ** **Non-cash items,consisting primarily of depreciation, amortization and deferred income taxes,for the fiscal 2008 three-month period totaled $5.8 million compared to $3.6million for the 2007 fiscal three-month period.**   **Cash flows used by changes inworking capital totaled $2.2 million for the fiscal 2008 three-month periodcompared to $8.6 million in the fiscal 2007 three-month period. ** **With respect to thechanges in accounts receivable and inventory, cash provided by these items was$1.0 million for the fiscal 2008 three-month period, compared to cash used of$4.3 million for the comparable period in the prior fiscal year.**  ** Cash****provided bychanges in prepaid expenses and other current assets was $.5 million for the2008 fiscal three-month period compared to cash used in changes in prepaidexpenses and other current assets of $.1 million for the comparable period inthe prior fiscal year.  ** **Cash used in changesin accounts payable, accrued expenses and accrued interest for the fiscal 2008three-month period was $3.7 million, compared to cash used of $4.2 million forthe comparable period in the prior year.

**Net cash used in investingactivities** for the fiscal 2008 three-month period was $45.6****million compared to $1.7 million used in the fiscal 2007three-month period.  The increase isprimarily attributable to the cash paid for the acquisition of CityForest.  The remaining change relates to the level ofcapital spending period over period.

**Net cash provided by  financing activities** forthe fiscal 2008 three-month period was $34.4****millioncompared to net cash used in financing activities of $.3 million for the fiscal2007 three-month period.  Net cashprovided for the fiscal 2008 three-month period relates to financing obtainedin connection with the acquisition of CityForest.  Net cash used in the comparable period in theprior year relates to payments on our industrial revenue bond.

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

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

In connection with theMerger, we solicited consents with respect to the Notes.   Consents were received with respect to 100%of the aggregate outstanding principal amount of the Notes.  We accepted all of the consents delivered inthe consent solicitation and paid to the consenting noteholders a consent feeof $40 per $1,000 principal amount of Notes for which they deliveredconsents.  As a result of the acceptanceby us of the consents delivered by noteholders and the completion of theconsent solicitation, the amendments to the indenture governing the Notesdescribed in the Consent Solicitation Statement dated May 9, 2006 and relatedSupplement dated May 24, 2006 became operative and we were not required to makea change of control offer to purchase any Notes in connection with the Merger.

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

*TheCredit Agreement provides for a $35.0 million working capital facility, whichhas subsequently been increased to $40.0 million (see below), including aletter of credit sub-facility and swing-line loan sub-facility. The CreditAgreement provides that amounts under the facility may be borrowed, repaid andre-borrowed, subject to a borrowing base test, until the maturity date, whichis June 12, 2011. An amount equal to $32.0 million is available, in U.S.dollars, to the U.S. Borrower under the facility, and an amount equal to $3.0million is available, in U.S. or Canadian dollars, to the Canadian Borrowerunder the facility.  Borrowings of $17.4million were made to finance a portion of the acquisition of CityForest.    As of May 31, 2007, there was $14.4 millionof borrowings outstanding under the working capital facility.*

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

***SecondSupplemental Indenture***

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

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***Amendmentto Credit Agreement***

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

The Amendment (1)increases the working capital facility from $35.0 million to $40.0 million, (2)permits the issuance and sale by us of the Additional Notes, (3) provides forthe consummation of the acquisition of CityForest and the conversion byCityForest from a Minnesota corporation to a Minnesota limited liabilitycompany, (4) permits the assumption of approximately $18.4 million inaggregate principal amount of indebtedness of CityForest in connection with theacquisition of CityForest in accordance with the terms of the CityForest BondDocuments and (5) permits the guarantee by us of certain obligations ofCityForest under the CityForest Bond Documents. In connection with the Amendment, CityForest became a guarantor of theobligations of the borrowers under the Amended Credit Agreement.

***CityForestBond Documents***

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

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

*Amounts borrowed by CityForest under the Associated Bank RevolvingCredit Facility bear interest at a rate per annum equal to the LIBOR Rate (asdefined in the Reimbursement Agreement), plus an applicable margin. Theapplicable margin percentage initially is 1.75%, subject to adjustment on aquarterly basis based upon CityForest’s leverage.  During the continuance of an event ofdefault, the outstanding*

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*principal balance bears interest at a rate per annum equal to the thenapplicable interest rate plus 2.00%. CityForest is also obligated to pay a commitment fee in respect of anyunused commitment under the Associated Bank Revolving Credit Facility in anamount equal to 0.50% per annum.  Inaddition, subject to certain exceptions, if CityForest terminates theAssociated Bank Revolving Credit Facility prior to February 15, 2009,CityForest is obligated to pay to Associated Bank a fee equal to 1.00% of thecommitment then being terminated. The maturity date of the Associated BankRevolving Credit Facility is February 15, 2011.*

*The Reimbursement Agreement requires scheduled semi-annual payments ofprincipal of the Bonds equal to approximately 2.00% of the principal amountoutstanding as of the date of the Acquisition, with the balance payable atmaturity of the Bonds on March 1, 2028. The Reimbursement Agreement alsocontains a number of other provisions regarding reserve funds and othermandatory and optional repayments in connection with the Bonds.  In addition, the Reimbursement Agreementprovides that in certain circumstances where we incur indebtedness in excess ofamounts currently permitted under the indenture or refinances the indebtednessissued under the indenture, Associated Bank may require CityForest to repay allof its obligations to Associated Bank under the Reimbursement Agreement andeither to cause the Bonds to be redeemed or to replace the Associated BankLetter of Credit with a Substitute Credit Facility, as such term is defined inthe CityForest Indenture.*

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

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

We have guaranteed all ofthe obligations of CityForest under the Reimbursement Agreement, pursuant to theCellu Tissue Guaranty executed by us in favor of Associated Bank. In addition,the obligations of CityForest under the Reimbursement Agreement are secured byfirst-priority liens in favor of Associated Bank in all of CityForest’sassets.  The U.S. Administrative Agent,the Canadian Administrative Agent, Associated Bank and CityForest have enteredinto an Intercreditor Agreement, dated March 21, 2007, which sets forth therespective rights and priorities of Associated Bank, on the one hand, and theU.S. Administrative Agent and the Canadian Administrative Agent, on the other

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hand, as to thecollateral of CityForest securing the Reimbursement Agreement and the AmendedCredit Agreement.

**Cash**as of May31, 2007 decreased to $8.0 million from $16.3 million as of the end of fiscalyear 2007.  The decrease in our cashposition was primarily due to cash on hand used to finance a portion of theacquisition of CityForest and payment of our semi-annual interest in March2007.

**Receivables, net**asof May 31, 2007 increased to $39.5 million from $34.1 million as of the end offiscal year 2007.  Included in the $39.5million is $3.6 million of receivables related to CityForest.  Without the effect of the acquisition,receivables increased $1.8 million from the end of fiscal year 2007.

**Inventory**as ofMay 31, 2007 increased to $30.3 million from $29.6 million as of the end offiscal year 2007.   Included in the $30.3million is $1.5 million of inventories related to CityForest.  Without the effect of the acquisition, inventoriesdecreased $.8 million from the end of fiscal year 2007.

**Prepaid expenses and othercurrent assets**as of May 31, 2007 increased to $3.5 millionfrom $2.8 million as of the end of fiscal year 2007.  Included in the $3.5 million is $1.0 ofprepaid expenses and other current assets related to CityForest.  Without the effect of the acquisition,prepaid expense and other current assets decreased $.3 million from the end offiscal year 2007.

**Property, plant and equipment,net**as of May 31, 2007 increased to $297.6 million from$228.9 million as of the end of fiscal year 2007.  Included in the $297.6 million of property,plant and equipment, net is $71.2 million related to CityForest.  Without the effect of the acquisition,property, plant and equipment decreased $2.5 million from the end of fiscalyear 2007.  This decrease relates todepreciation expense for the period offset partially by capital expendituresfor the period.

**Other assets**asof May 31, 2007 increased to $1.5 million from $.2 million as of the end offiscal year 2007.  Included in the $1.5million of other assets is $1.2 million related to CityForest.  Without the effect of the acquisition, otherassets are consistent with the end of fiscal year 2007.

**Revolving line of credit**asof May 31, 2007 represents $17.4 million of borrowings to finance a portion ofthe acquisition of CityForest, offset by payments of $3.0 million since thedate of the acquisition.

**Accounts payable**asof May 31, 2007 increased to $21.6 million from $16.5 million as of the end offiscal year 2007.  Included in the $21.6million of accounts payable is $3.3 million related to CityForest.  Without the effect of the acquisition,accounts payable increased $1.8 million from the end of fiscal year 2007 due tothe timing of payments.

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**Accrued interest**asof May 31, 2007 decreased to $3.9 million from $7.2 million as of the end offiscal year 2007 due primarily to the timing (semi-annual) of interest paymentson the Notes.

**Long-term debt**asof May 31, 2007 increased to $199.0 million from $160.4 million as of the endof fiscal year 2007 due to the assumption of CityForest debt and debt incurredto finance the acquisition.

**Stockholders’ equity**asof May 31, 2007 was $39.4 million compared to $39.0 as of the end of fiscalyear 2007.   The net loss generated forthe fiscal 2008 three-month period was offset by the increase in accumulatedother comprehensive income due to the increase in Canadian exchange rates forthe fiscal 2008 three-month period.

Critical AccountingPolicies

Our critical accountingpolicies are discussed in Management’s Discussion and Analysis of FinancialCondition and Results of Operations in our Annual Report on Form 10-K for thefiscal year ended February 28, 2007.  Thepreparation of our financial statements requires us to make estimates thataffect the reported amounts of assets, liabilities, revenue and expenses andrelated disclosures of contingent assets and liabilities.  We base our accounting estimates onhistorical experience and other factors that we believe to be reasonable underthe circumstances.  However, actualresults may vary from these estimates under different assumptions orconditions.

New AccountingPronouncements

In September 2006, theFASB issued FAS 157. We were required to adopt the provisions of FAS 157effective March 1, 2007.  FAS 157provides a common fair value hierarchy for companies to follow in determiningfair value measurements in the preparation of financial statements and expandsdisclosure requirements relating to how such fair value measurements weredeveloped.  FAS 157 clarifies theprinciple that fair value should be based on the assumptions that themarketplace would use when pricing an asset or liability, rather than companyspecific data.  The adoption of FAS No.157 did not have a material impact on our results of operations and financialposition.

We adopted FIN 48, at thebeginning of fiscal year 2008.  Theimplementation did not have a material impact on the Company’s results ofoperations and financial position. At May 31, 2007, we did not have anyunrecognized tax benefits.

We recognize interest andpenalties related to uncertain tax positions in income tax expense.  As of May 31, 2007, we have accrued interestand penalties, if any, related to uncertain tax positions.

The tax years 2003through 2007 remain open to examination by the major taxing jurisdictions towhich we are subject.  As of May 31, 2007,we do not expect any material changes to unrecognized tax positions within thenext twelve months.

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

In March 2004, wecompleted a private offering of the Notes. In connection with the acquisition of CityForest in March 2007, weissued and sold approximately $20 million of Additional Notes and assumed $18.4million of additional debt.  We also havethe ability to borrow under a revolving line of credit, up to $40.0 million, ofwhich as of May 31, 2007 we have outstanding borrowings of $14.4 million.  As a result, we are highly leveraged.

We have minimal foreigncurrency translation risk.  Allinternational sales, other than sales originating from our Canadian subsidiary,are denominated in U. S. dollars.  Due toour Canadian operations, however, we could be adversely affected by unfavorablefluctuations in foreign currency exchange rates.

**Item4.  Controls and Procedures**

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

(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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PART II – OTHER INFORMATION

Item 1A.  Risk Factors

Therisk factors included in our Annual Report on Form 10-K for the fiscal yearended February 28, 2007 have not materially changed.

Item 6.  Exhibits

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

 

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SIGNATURES

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the Registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.
|                           | Cellu Tissue Holdings, Inc.               |
|---------------------------|-------------------------------------------|
|                      |                                      |
|                      |                                      |
| Date:  July 13, 2007 | /s/ Russell C. Taylor                     |   |
|                      | Mr. Russell C.  Taylor                    |
|                      | President and  Chief Executive Officer    |
|                      |                                      |
| Date:  July 13, 2007 | /s/ Dianne M. Scheu                       |   |
|                      | Ms. Dianne M.  Scheu                      |
|                      | Senior Vice  President, Finance and Chief |
|                      | Financial  Officer                        |
|                           |                                           |  |  |

 

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