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**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION****Washington,D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 

**x****   QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

** **

**For the Quarterly Period Ended November 27, 2008**

 

**or**

 

o    **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**For thetransition period from                to                  .**

 

**Commission file number 333-118829**

 

**Cellu Tissue Holdings, Inc.****(Exactname of registrant as specified in its charter)**

 

| **Delaware**                                                  | ** ** | **06-1346495**                    |
|---------------------------------------------------------------|------------|-----------------------------------|
| (State of incorporation)                                      |       | (IRS Employer Identification No.) |
|                                                          |       |                              |
| **1855 Lockeway Drive, Suite 501, Alpharetta , Georgia** | ** ** | **30004**                         |
| (Address of principal executive offices)                      |       | (zip code)                        |

 

**(678) 393-2651**

(Registrant’s telephone number, including area code)

 

**Not Applicable** (Former name,former address and former fiscal year, if changed since last report)

 

Indicate bycheck mark whether the registrant: (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports) and (2) has been subject tosuch filing requirements for the past 90 days.  Yes x No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company.    See definition of “large accelerated filer”,“accelerated filer”, and “smaller reporting company” in Rule 12b-2 of theExchange Act.

 

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

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yeso Nox

 

The number of shares outstanding of each of theregistrant’s classes of common stock as of January 2, 2009:

 

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

 

 

 

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CELLU TISSUE HOLDINGS, INC.

FORM 10-Q

QUARTER ENDED NOVEMBER 27, 2008

 

INDEX

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

 

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**PART I FINANCIAL INFORMATION**

** **

**Item 1. Consolidated Financial Statements**

 

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

**CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)**

 
| ** **                                        | ** ** | **Three Months Ended** | ** **  | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                        | ** ** | **November 27, 2008**  | ** **  | **November 29, 2007** | ** ** | **November 27, 2008** | ** ** | **November 29, 2007** | ** ** |
| ** **                                        | ** ** | ** **                       | ** **  | **(Restated)**                  | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Net sales                                         |       | $                                | 143,042,017 |                            | $          | 112,194,182 |   | $ | 390,582,434 |   | $ | 330,447,140 |   |
| Cost of goods sold                                |       | 126,941,122                      |        | 100,477,845                     |       | 351,693,706 |   | 299,980,042 |   |
| Gross profit                                      |       | 16,100,895                       |        | 11,716,337                      |       | 38,888,728 |   | 30,467,098 |   |
|                                              |       |                             |        |                            |       |   |   |   |   |
| Selling, general and administrative  expenses     |       | 5,225,520                        |        | 4,835,215                       |       | 14,348,712 |   | 13,874,266 |   |
| Terminated acquisition-related transaction  costs |       | —                           |        | —                          |       | 140,044 |   | — |   |
| Stock compensation expense                        |       | 244,039                          |        | 714,812                         |       | 689,534 |   | 1,097,812 |   |
| Amortization expense                              |       | 1,258,994                        |        | —                          |       | 2,061,429 |   | — |   |
| Income from operations                            |       | 9,372,342                        |        | 6,166,310                       |       | 21,649,009 |   | 15,495,020 |   |
|                                              |       |                             |        |                            |       |   |   |   |   |
| Interest expense, net                             |       | 6,910,402                        |        | 4,843,976                       |       | 17,951,147 |   | 14,965,736 |   |
| Foreign currency (gain) loss                      |       | (241,333                         | )           | (15,220                         | )          | (156,713 | ) | 104,247 |   |
| Other (income) expense                            |       | (36,975                          | )           | (104,573                        | )          | 1,443 |   | (187,073 | ) |
| Income before income tax expense (benefit)        |       | 2,740,248                        |        | 1,442,127                       |       | 3,853,132 |   | 612,110 |   |
|                                              |       |                             |        |                            |       |   |   |   |   |
| Income tax expense (benefit)                      |       | 901,500                          |        | (202,922                        | )          | 1,268,999 |   | (432,247 | ) |
| Net income                                        |       | $                                | 1,838,748   |                            | $          | 1,645,049 |   | $ | 2,584,133 |   | $ | 1,044,357 |   |

 

See accompanying notes to consolidated financial statements.

 

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

**CONSOLIDATED BALANCE SHEETS (Unaudited)**

 
| ** **                                                                                              | ** ** | **November 27** | ** **  | **February 29** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------|-------------|----------------------|------------|
| ** **                                                                                              | ** ** | **2008**             | ** **  | **2008**             | ** ** |
| ** **                                                                                              | ** ** | ** **           | ** **  | **(Note 1)**    | ** ** |
| ** **                                                                                              | ** ** | ** **           | ** **  | **(Restated)**       | ** ** |
| **ASSETS**                                                                                              | ** ** | ** **           | ** **  | ** **           | ** ** |
| CURRENT ASSETS:                                                                                         |       |                 |        |                 |       |
| Cash and cash equivalents                                                                               |       | $                    | 513,362     |                 | $          | 883,388 |   |
| Receivables, net                                                                                        |       | 61,944,227           |        | 44,542,337           |       |
| Inventories                                                                                             |       | 44,930,183           |        | 33,996,439           |       |
| Prepaid expenses and other current assets                                                               |       | 3,086,205            |        | 3,745,989            |       |
| Income tax receivable                                                                                   |       | 123,341              |        | 177,281              |       |
| Deferred income taxes                                                                                   |       | 5,681,071            |        | 7,157,191            |       |
| TOTAL CURRENT ASSETS                                                                                    |       | 116,278,389          |        | 90,502,625           |       |
| PROPERTY, PLANT AND EQUIPMENT, NET                                                                      |       | 302,128,845          |        | 310,488,081          |       |
| GOODWILL                                                                                                |       | 35,887,998           |        | 11,334,755           |       |
| OTHER INTANGIBLES, NET                                                                                  |       | 37,504,571           |        | 9,400,000            |       |
| OTHER ASSETS                                                                                            |       | 2,239,705            |        | 1,491,218            |       |
| TOTAL ASSETS                                                                                            |       | $                    | 494,039,508 |                 | $          | 423,216,679 |   |
|                                                                                                    |       |                 |        |                 |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                           |       |                 |        |                 |       |
| CURRENT LIABILITIES:                                                                                    |       |                 |        |                 |       |
| Bank overdrafts                                                                                         |       | $                    | 1,348,876   |                 | $          | — |   |
| Revolving line of credit                                                                                |       | 28,500,000           |        | 9,800,000            |       |
| Accounts payable                                                                                        |       | 22,229,450           |        | 24,055,782           |       |
| Accrued expenses                                                                                        |       | 27,919,789           |        | 19,085,912           |       |
| Accrued interest                                                                                        |       | 4,705,660            |        | 8,253,915            |       |
| Other current liabilities                                                                               |       | 16,281,182           |        | 15,000,000           |       |
| Current portion of long-term debt                                                                       |       | 760,000              |        | 760,000              |       |
| TOTAL CURRENT LIABILITIES                                                                               |       | 101,744,957          |        | 76,955,609           |       |
| LONG-TERM DEBT, LESS CURRENT PORTION                                                                    |       | 241,738,202          |        | 198,086,944          |       |
| DEFERRED INCOME TAXES                                                                                   |       | 80,641,587           |        | 81,940,082           |       |
| OTHER LIABILITIES                                                                                       |       | 5,122,501            |        | 20,148,590           |       |
| STOCKHOLDERS’ EQUITY:                                                                              |       |                 |        |                 |       |
| Common stock, Class A, $.01 par value,  1,000 shares authorized, 100 shares issued and outstanding |       | 1                    |        | 1                    |       |
| Capital in excess of par value                                                                          |       | 70,698,864           |        | 47,035,214           |       |
| Accumulated deficit                                                                                     |       | (277,984             | )           | (2,862,117           | )          |
| Accumulated other comprehensive (loss)  income                                                          |       | (5,628,620           | )           | 1,912,356            |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                                         |       | 64,792,261           |        | 46,085,454           |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                         |       | $                    | 494,039,508 |                 | $          | 423,216,679 |   |

 

See accompanying notes to consolidated financial statements.

 

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

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

 
| ** **                                                                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **November 27, 2008** | ** ** | **November 29, 2007** | ** ** |
| ** **                                                                         |       |                            |       | **(Restated)** |   |
| **Cash flows from operating activities**                                           |       |                            |       |   |   |
| Net income                                                                         |       | $                               | 2,584,133  |   | $ | 1,044,357 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                            |       |   |   |
| Stock-based compensation                                                           |       | 689,534                         |       | 595,461 |   |
| Deferred income taxes                                                              |       | 177,625                         |       | (3,385,531 | ) |
| Accretion of debt discount                                                         |       | 1,211,258                       |       | 458,780 |   |
| Amortization of bond costs                                                         |       | 188,816                         |       | — |   |
| Amortization of intangibles                                                        |       | 2,061,429                       |       | — |   |
| Derivative loss                                                                    |       | 953,523                         |       | 186,193 |   |
| Depreciation                                                                       |       | 17,614,651                      |       | 18,346,768 |   |
| Changes in operating assets and  liabilities, net of effects of acquisitions:      |       |                            |       |   |   |
| Receivables                                                                        |       | (11,531,614                     | )          | (3,811,469 | ) |
| Inventories                                                                        |       | (3,417,251                      | )          | 289,534 |   |
| Prepaid expenses, other current assets and  income tax receivable                  |       | 645,075                         |       | (2,513,629 | ) |
| Accounts payable, accrued expenses and  accrued interest                           |       | (1,530,539                      | )          | 2,925,556 |   |
| Other                                                                              |       | (45,630                         | )          | 357,991 |   |
| Total adjustments                                                                  |       | 7,016,877                       |       | 13,449,654 |   |
| *Net cash provided by operating activities*                                        |       | 9,601,010                       |       | 14,494,011 |   |
|                                                                               |       |                            |       |   |   |
| **Cash flows from investing activities**                                           |       |                            |       |   |   |
| Cash paid for acquisition, net of cash  acquired                                   |       | (64,148,096                     | )          | (43,637,578 | ) |
| Capital expenditures                                                               |       | (9,734,100                      | )          | (10,965,313 | ) |
| *Net cash used in investing activities*                                            |       | (73,882,196                     | )          | (54,602,891 | ) |
|                                                                                    |            |                                 |            |  |  |  |  |

 

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

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

 
| ** **                                          | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **November 27, 2008** | ** ** | **November 29, 2007** | ** ** |
| ** **                                          | ** ** | ** **                      | ** ** | **(Restated)** | ** ** |
| **Cash flows from financing activities**            |       |                            |       |   |   |
| Equity investment by shareholders                   |       | 15,001,463                      |       | — |   |
| Cash portion of earnout payment                     |       | (7,027,346                      | )          | — |   |
| Bank overdrafts                                     |       | 1,348,876                       |       | 2,213,043 |   |
| Borrowings on revolving line of credit              |       | 76,600,000                      |       | 46,600,000 |   |
| Repayments on revolving line of credit              |       | (57,900,000                     | )          | (43,100,000 | ) |
| Payments of long-term debt                          |       | (760,000                        | )          | (575,000 | ) |
| Debt issuance costs                                 |       | (885,959                        | )          | — |   |
| Net proceeds from bond offering                     |       | 36,900,000                      |       | 20,000,000 |   |
| *Net cash provided by financing activities*         |       | 63,277,034                      |       | 25,138,043 |   |
|                                                |       |                            |       |   |   |
| Effect of foreign currency                          |       | 634,126                         |       | 391,308 |   |
| *Net decrease in cash and cash equivalents*         |       | (370,026                        | )          | (14,579,529 | ) |
| *Cash and cash equivalents at beginning of  period* |       | 883,388                         |       | 16,260,601 |   |
| *Cash and cash equivalents at end of period*        |       | $                               | 513,362    |   | $ | 1,681,072 |   |
|                                                     |            |                                 |            |  |  |  |  |

 

*See accompanying notes to consolidatedfinancial statements.*

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

**November 27, 2008**

 

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

 

The accompanying unaudited interim consolidated financial statementsinclude the accounts of Cellu Tissue Holdings, Inc.  (“Cellu Tissue” or the “Company”) and itswholly owned subsidiaries.  The Companyis a wholly owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”),which is a wholly owned subsidiary of Cellu Parent Corporation (“Cellu Parent”).

 

These statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring adjustments) considered necessary for a fairstatement have been included.  Operatingresults for the three and nine months ended November 27, 2008 are not necessarilyindicative of the results that may be expected for the fiscal year ending February 28,2009.  For further information, refer tothe significant accounting policies included in the footnotes to theconsolidated financial statements as of February 29, 2008 and for the yearthen ended contained in the Company’s Annual Report on Form 10-K, as filedwith the Securities and Exchange Commission (“SEC”).

 

Stock-Based Compensation

 

The Company accounts for stock based compensation in accordance withStatement of Financial Accounting Standards No. 123R (“SFAS 123R”), *Share-Based Payments*, which requires the measurement of allshare-based payments to employees, including grants of employee stock options,using the fair-value-based method and the recording of compensation expense inthe Company’s consolidated statements of operations.  Cellu Parent has one share-based paymentarrangement under the 2006 Stock Option and Restricted Stock Plan (the “Plan”).  Under the Plan, the administrator of the Plan(the “Plan Administrator”) may make awards of options to purchase shares ofcommon stock of Cellu Parent and/or awards of restricted shares of common stockof Cellu Parent.  A maximum of 8,095shares of common stock of Cellu Parent may be delivered in satisfaction ofawards under the Plan, determined net of shares of common stock withheld byCellu Parent in payment of the exercise price of an award or in satisfaction oftax withholding requirements.  Keyemployees and directors of, and consultants and advisors to, Cellu Parent orits affiliates who, in the opinion of the Plan Administrator, are in a

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

position to make a significant contribution to the success of CelluParent and its affiliates are eligible to participate in the Plan.   Stock options are granted with a strikeprice at the estimated fair value of Cellu Parent’s stock on the date of grantand have a 10-year term.  Generally,stock option grants vest 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 Parent’s stock; andthe risk-free interest rate is based on U.S. Treasury securities.   The Company uses historical data in order toestimate exercise, termination and holding period behavior for valuationpurposes. The fair value of the stock option grant was estimated on the date ofgrant using the Black-Scholes option pricing model.  The weighted average assumptions used tovalue the grants were: no dividend yield; 55% volatility; 1.4% risk freeinterest rate; and 10-year expected life. The weighted average fair value of stock options granted was $498.18 pershare and the unrecognized total compensation cost as of November 27, 2008related to nonvested awards is $495,346.

 

A summary of the outstanding options as of November 27, 2008 andthe activity during the nine months then ended is as follows:

 
| ** **                          | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted Average  Remaining Contractual  Life** | ** ** |
|-------------------------------------|------------|-------------|------------|--------------------------------------------|------------|-------------------------------------------------------------|------------|
| Outstanding, February 29, 2008 |       | 1,125       |       | $                                          | 733.67     |                                                        | 8.06 Years |   |
| Forfeited                           |       | (125        | )          | 979.25                                     |       | 8.06 Years                                                  |       |
| Granted                             |       | 444         |       | 942.99                                     |       | 9.36 Years                                                  |       |
| Outstanding, November 27, 2008 |       | 1,444       |       | 776.77                                     |       | 8.46 Years                                                  |       |
|                                |       |        |       |                                       |       |                                                        |       |
| Exercisable, November 27, 2008 |       | 356         |       | 620.57                                     |       | 7.96 Years                                                  |       |
|                                     |            |             |            |                                            |            |                                                             |            |  |

 

On September 1, 2008, Cellu Parent entered into a Restricted StockAgreement with the Company’s newly appointed VP, Sales pursuant to which CelluParent granted 300 restricted shares of its common stock to the namedindividual pursuant to the Plan.  Theshares will vest and cease to be restricted in four equal annual installmentscommencing on September 1, 2009, as long as the named individual iscontinuously employed by the Company until such vesting date with respect tohis shares.  Any restricted stockoutstanding at the time of a Covered Transaction (as defined in the Plan) shallbecome vested and cease to be restricted stock at the time of a change incontrol.  Additionally, Cellu Parent hasagreed to pay an amount to the named individual equal to an amount that wouldbe included in such individual’s gross income and payable as income tax as a

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

result of making a Section 83(b) election under the InternalRevenue Code of 1986, as amended.  Thenamed individual has made a timely Section 83(b) election.

 

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

 

On June 12, 2006, Cellu Parent entered into Restricted StockAgreements with each of the Company’s Chief Executive Officer, Chief OperatingOfficer and the then Chief Financial Officer, pursuant to which Cellu Parentgranted 3,778 restricted shares of its common stock to the Chief Executive Officerand 1,349 restricted shares of its common stock to each of the other two namedindividuals pursuant to the Plan.  Theshares will vest and cease to be restricted in four equal annual installmentscommencing on June 12, 2007, as long as the named individual, as the case may be, iscontinuously employed by the Company until each such vesting date with respectto his or her shares.  Any restrictedstock outstanding at the time of a Covered Transaction (as defined in the Plan)shall become vested and cease to be restricted stock at the time of a change incontrol.  Additionally, the Parent hasagreed to pay an amount to the named individuals equal to an amount that wouldbe included in such individuals’ gross income and payable as income tax as aresult of making a Section 83(b) election under the Internal RevenueCode of 1986, as amended.  All namedindividuals have made a timely Section 83(b) election.

 

Effective July 31, 2007, the then Chief Financial Officer resignedand forfeited three-fourths of the individual’s restricted stock grant, andaccordingly, the Company only recorded compensation expense associated withthis individual’s grant through June 12, 2007 as all other shares wereforfeited and no compensation expense is required to be recognized forforfeited shares.

 

For the three and nine months ended November 27, 2008, the Companyhas recorded $196,130 and $552,317, respectively of compensation expenserelated to the above restricted stock grants.  For the three and nine months ended November 29, 2007 the

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

Company has recorded $179,078 and $506,022, respectively ofcompensation expense related to the vesting of the grants at that time inaccordance with SFAS 123R.

 

Derivatives and Hedging

 

The Company uses derivative financial instruments to offset asubstantial portion of its exposure to market risk arising from changes in theprice of natural gas. Hedging of this risk is accomplished by entering intoforward swap contracts, certain of which are designated as hedges of specificquantities of natural gas expected to be purchased in future months.    These contracts are held for purposes otherthan trading and are designated as cash flow hedges.  The Company measures fair value of itsderivative financial instruments in accordance with Statement of FinancialAccounting Standard No. 157, “*Fair Value Measurements”*(“SFAS 157”).  SFAS 157 defined fairvalue as the price that would be received to sell an asset or paid to transfera liability in an orderly transaction between market participants. SFAS 157establishes a fair value hierarchy for valuation inputs that gives the highestpriority to quoted prices in active markets for identical assets or liabilitiesand the lowest priority to unobservable inputs. The fair value hierarchy is as follows: level 1-inputs utilize quoted prices (unadjusted) in active markets foridentical assets or liabilities that the Company has the ability to access;level 2-inputs utilize data points that are observable such as quoted prices,interest rate and yield curves; level 3-inputs are unobservable data points forthe asset or liability, and include situations where there is little, if any,market activity for the asset or liability.

 

Our derivative contracts, natural gas forward contracts, are valuedusing industry-standard models that use observable market inputs (forwardmarket prices for natural gas) as their basis. We classify these instruments within level 2 of the valuationhierarchy.  SFAS 157 requires that forlevel 2 and 3 of the fair value hierarchy, where appropriate, valuations areadjusted for various factors such as liquidity, bid/offer spreads and creditconsiderations (non performance risk). The fair value of these cash flow hedging instruments was a liability of $1.3 million,which is included in other current liabilities, and an asset of $.2 million,which is included in other current assets, as of November 27, 2008 and February 29,2008, respectively.  Prior to the threemonths ended November 27, 2008 these contracts have not been designated ashedges and accordingly, for the nine months ended November 27, 2008 andfor the three and nine months ended November 29, 2007, $.9 million loss,$.5 million gain and $.2 million loss, respectively have been recorded toearnings.  Hedging activities transactedin the three months ended November 27, 2008 have been designated as hedgesand during the next 12 months, $.5 million of the $1.3 million remains to bereclassified to earnings consistent with the underlying hedging transactions.

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standards Board (“FASB”)issued SFAS 157.  The Company wasrequired to adopt the provisions of SFAS 157 effective March 1, 2008.  SFAS 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.  SFAS 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 SFAS 157 did not have amaterial impact on the Company’s results of operations and financialposition.  In February 2008, theFASB issued Financial Statement Position (“FSP”) No. 157-1, *Application of FASB Statement No. 157 to FASB StatementNo. 13 and Other Accounting Pronouncements That Address Fair ValueMeasurements for Purposes of Lease Classification or Measurement underStatement 13*, which removed leasing transactions accounted for underStatement 13 and related guidance from the scope of SFAS 157, and FSP No. 157-2,*Partial Deferral of the Effective Date ofStatement 157* (“FSP 157-2”), which deferred the effective date ofSFAS 157 for all non-financial assets and liabilities, except those that arerecognized or disclosed in the financial statements at fair value at leastannually, to fiscal years beginning after November 15,2008.  The Company implemented SFAS 157 for financial assets andliabilities at the beginning of its fiscal year 2009 and elected to defer theadoption of SFAS 157 for non-financial assets and liabilities until thebeginning of its fiscal year 2010 as allowed under FSP 157-2.  Theimplementation of SFAS 157 for financial assets and liabilities did not have amaterial impact on the Company’s consolidated financial position and results ofoperations.  The Company is still assessing the impact that adoptingSFAS 157 for non-financial assets and liabilities will have to its consolidatedfinancial position and results of operations.  The major categoriesof non-financial assets and liabilities that are measured at fair value, forwhich the Company has not yet applied the provisions of SFAS 157, are asfollows: reporting units measured at fair value in the first step of theCompany’s goodwill impairment testing and indefinite-lived intangible assetsmeasured at fair value for impairment testing.

 

In February 2007, the FASB issued Statement of FinancialAccounting Standards No.159, “*The Fair ValueOption for Financial Assets and Liabilities, Including an amendment of FASBStatement No. 115*” (“SFAS 159”).  This Standard permits entities to choose tomeasure many financial instruments and certain other items at fair value thatare not currently required to be measured at fair value.  SFAS 159 was effective as of the beginning offiscal 2009.  The Company evaluated itsexisting eligible financial assets

 

11

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Tableof Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

and liabilities and elected not to adopt the fair value option for anyeligible items for the three or nine months ended November 27, 2008.

 

In December 2007, the FASB issued Statement of FinancialAccounting Standards No. 141 (R), “*BusinessCombinations*” (“SFAS 141 (R)”), and Financial Accounting Standards No. 160,*“Accounting and Reporting of NoncontrollingInterests in Consolidated Financial Statements, an amendment of ARB No. 51”*(“SFAS 160”).  These newstandards will significantly change the financial accounting and reporting ofbusiness combination transactions and noncontrolling (or minority) interests inconsolidated financial statements.  SFAS141 (R) is required to be adopted concurrently with SFAS 160 and iseffective for business combination transactions for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008.  Earlyadoption is prohibited.  The Company iscurrently assessing the impact that SFAS 141 (R) and SFAS 160 will have onits results of operations and financial position.

 

In March 2008, the FASB issued Statement of Financial AccountingStandards No. 161, “*Disclosures aboutDerivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133”*(“SFAS 161”).  SFAS 161requires entities to provide enhanced disclosures about derivative instrumentsand hedging activities.  SFAS 161 iseffective for fiscal years and interim periods beginning on or after November 15,2008.  The Company is currently assessingthe impact that SFAS 161 will have on its results of operations and financialposition.

 

In April 2008, the FASB issued FASBStaff Position (“FSP”) No. FAS 142-3, “Determination of the Useful Life ofIntangible Assets”.  This FSP amends thefactors that should beconsidered in developing renewal or extension assumptions used to determine the useful life of a recognizedintangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets”(“SFAS 142”).  The objective of this FSPis to improve the consistency between the useful life of a recognizedintangible asset under SFAS 142 and the period of expected cash flows used tomeasure the fair value of the asset under SFAS 141R, and other generallyaccepted accounting principles.  This FSPapplies prospectively to all intangible assets acquired after the effectivedate, which is fiscal years beginning after December 15, 2008, whetheracquired in a business combination or otherwise.  Early adoption is prohibited.  The Company is evaluating this guidance butdoes not expect it to have a significant impact on its financial position orresults of operations.

 

12

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

In May 2008, the FASB issued SFAS No. 162,“The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 162”).  This standard is intended to improve financialreporting by identifying a consistent framework, or hierarchy, for selectingaccounting principles to be used in preparing financial statements that arepresented in conformity with generally accepted accounting principles in theUnited States for non-governmental entities. SFAS No. 162 is effective 60 days following approval by the SEC ofthe Public Company Accounting Oversight Board’s amendments to AU Section 411,“The Meaning of Present Fairly in Conformity with Generally Accepted AccountingPrinciples”.  The Company does not expectSFAS 162 to have a material impact on the preparation of its consolidatedfinancial statements.

 

**Note 2 Restatement of Financial Statements**

 

The Company has restated herein its consolidated financial statementsas of February 29, 2008 and for the three and nine months ended November 29,2007.  This restatement corrects errorsin (i) accounting for deferred income taxes in connection with purchaseaccounting applied in fiscal 2007, (ii) classification of borrowings and repaymentson the revolving credit facility in the statement of cash flows, and certainother adjustments that were initially deemed to be not material by management,including (a)  classification of shippingand handling costs in accordance with EITF 00-10, *Accountingfor Shipping and Handling Fees and Costs* (EITF 00-10), (b)accounting for derivative instruments, (c) accounting for foreign exchangegains and losses in fiscal 2008 and 2007, and (d) certain other miscellaneousadjustments. The tax effect of the above items has also been recorded.  These adjustments do not have a negativeimpact on the Company’s compliance with the covenants under any of its currentdebt agreements (see Note 5 — Long-Term Debt to our accompanyingconsolidated financial statements).

 

These adjustments are discussed in more detail below. The tables thatfollow the discussion detail the impact on the Company’s consolidated balancesheets, statements of operations, and statements of cash flows.

 

***Deferred taxesassociated with purchase accounting***

 

The Company erroneously recorded a deferred tax asset related to $35.0million liability for the contingent consideration in connection with theCompany’s merger (the “Merger”) with Cellu Parent, a corporation organized andcontrolled by Weston Presidio V, L.P. (“Weston Presidio”).  This error has resulted in an understatementof the amounts allocated to long-lived assets in connection with theMerger.  The Company has corrected thiserror by (i) reducing the deferred tax asset amount recorded in purchaseaccounting for the contingent consideration by approximately$14.0 million; (ii) increasing the amount allocated to acquiredproperty, plant and equipment and trademarks by approximately $15.6 million and$.6 million, respectively; (iii) increasing deferred tax

 

13

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Tableof Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 2 Restatement of Financial Statements(continued)**

 

liabilities associated with the increased allocation of purchase priceto property, plant and equipment by approximately $6.6 million; and (iv) recognizinggoodwill of approximately $4.4 million as a result of these adjustments.  The increase in property, plant and equipmentresulted in increased depreciation expense of approximately $.3 million and $.8million for the three and nine month periods ended November 29, 2007,respectively.

 

***Borrowings and repayments on revolving creditfacility***

 

The Company has consistently recorded borrowings and repayments on itsrevolving credit facility as a net amount in the statement of cash flows, whichhas been determined to be inconsistent with Statement of Financial AccountingStandards No. 95, Statements of Cash Flows. The Company has corrected thiserror by showing borrowings and repayments on a gross basis.

 

***Shipping andhandling fees and costs***

 

The Companyhas consistently recorded outbound shipping and handling costs as a reductionof sales, which is inconsistent with the accounting in accordance with EITF00-10.  The Company has corrected thiserror by reclassifying these costs to cost of goods sold from net sales.  The outbound costs were $3.0 million and $9.1million for the three and nine month periods ended November 29, 2007,respectively.

 

***Foreign exchangegains and losses***

 

The Companyincorrectly remeasured an intercompany loan account with its foreign subsidiarythrough other comprehensive income   Inaccordance with FASB Statement No. 52*,**Foreign Currency Translation,*theremeasurement of the portion of the loan functioning as a short-term settlementaccount and not a permanent investment should have been recorded toearnings.  The Company has corrected thiserror by increasing (decreasing) foreign currency (loss) gain and decreasing(increasing) accumulated other comprehensive income.  The correction resulted in an increase toforeign currency gain of approximately $.2 million and $.6 million for thethree and nine month periods ended November 29, 2007, respectively.

 

***Derivatives***

 

The Company’sdocumentation relating to derivative instruments entered into in fiscal 2007and 2008 did not meet the requirements of SFAS 133 for hedge accounting.  We have corrected this error by reversing theamounts relating to the mark-to-market adjustment that were originally recordedin accumulated other comprehensive income, with the offsetting amount recordedto cost of goods sold in each corresponding period.  The correction resulted in a decrease to costof goods sold of approximately $.5 million and an increase to cost of goodssold of $.2 million for the three and nine month periods ended November 29,2007, respectively.

 

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** **

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 2 Restatement of Financial Statements(continued)**

 

***Other miscellaneousadjustments***

 

The Company has also included in the appropriate periods in itsrestated consolidated financial statements certain other miscellaneousadjustments that were initially deemed to be not material by management, eitherindividually or in the aggregate.  Theseadjustments primarily relate to the reversal of certain vacation and freightaccruals in the first quarter of fiscal 2008.   The net impact of correcting theseitems increased net income by approximately $.1 million for the nine monthsended November 29, 2007.

 

15

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

**CONSOLIDATED BALANCE SHEET (Unaudited)**

 
| ** **                                                                                | ** ** | **As of February 29, 2008** | ** **  |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------------------|-------------|
| ** **                                                                                | ** ** | **As Previously  Reported**                | ** **  | **Adjustment** | ** ** | **Restated** | ** ** |
|                                                                                      |       |                                            |        |   |   |   |   |
| **ASSETS**                                                                                |       |                                            |        |   |   |   |   |
| CURRENT ASSETS:                                                                           |       |                                            |        |   |   |   |   |
| Cash and cash equivalents                                                                 |       | $                                               | 883,388     |   |   |   | $ | 883,388 |   |
| Receivables, net                                                                          |       | 44,542,337                                      |        |   |   | 44,542,337 |   |
| Inventories                                                                               |       | 33,996,439                                      |        |   |   | 33,996,439 |   |
| Prepaid expenses and other current assets                                                 |       | 3,745,989                                       |        |   |   | 3,745,989 |   |
| Income tax receivable                                                                     |       | 177,281                                         |        |   |   | 177,281 |   |
| Deferred income taxes                                                                     |       | 7,157,191                                       |        |   |   | 7,157,191 |   |
| TOTAL CURRENT ASSETS                                                                      |       | 90,502,625                                      |        |   |   | 90,502,625 |   |
| PROPERTY, PLANT AND EQUIPMENT, NET                                                        |       | 296,597,888                                     |        | $ | 13,890,193 |   | 310,488,081 |   |
| GOODWILL                                                                                  |       | 6,970,001                                       |        | 4,364,754 |   | 11,334,755 |   |
| OTHER INTANGIBLES, NET                                                                    |       | 8,750,314                                       |        | 649,686 |   | 9,400,000 |   |
| OTHER ASSETS                                                                              |       | 1,491,218                                       |        |   |   | 1,491,218 |   |
| TOTAL ASSETS                                                                              |       | $                                               | 404,312,046 |   | $ | 18,904,633 |   | $ | 423,216,679 |   |
|                                                                                      |       |                                            |        |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                             |       |                                            |        |   |   |   |   |
| CURRENT LIABILITIES:                                                                      |       |                                            |        |   |   |   |   |
| Revolving line of credit                                                                  |       | $                                               | 9,800,000   |   |   |   | $ | 9,800,000 |   |
| Accounts payable                                                                          |       | 24,055,782                                      |        |   |   | 24,055,782 |   |
| Accrued expenses                                                                          |       | 18,860,526                                      |        | $ | 225,386 |   | 19,085,912 |   |
| Accrued interest                                                                          |       | 8,253,915                                       |        |   |   | 8,253,915 |   |
| Other current liabilities                                                                 |       | 15,000,000                                      |        |   |   | 15,000,000 |   |
| Current portion of long-term debt                                                         |       | 760,000                                         |        |   |   | 760,000 |   |
| TOTAL CURRENT LIABILITIES                                                                 |       | 76,730,223                                      |        | 225,386 |   | 76,955,609 |   |
| LONG-TERM DEBT, LESS CURRENT PORTION                                                      |       | 198,086,944                                     |        |   |   | 198,086,944 |   |
| DEFERRED INCOME TAXES                                                                     |       | 62,008,004                                      |        | 19,932,078 |   | 81,940,082 |   |
| OTHER LIABILITIES                                                                         |       | 20,148,590                                      |        |   |   | 20,148,590 |   |
| STOCKHOLDERS’ EQUITY:                                                                |       |                                            |        |   |   |   |   |
| Common stock, $.01 par value, 1,000 shares authorized,  100 shares issued and outstanding |       | 1                                               |        |   |   | 1 |   |
| Capital in excess of par value                                                            |       | 47,035,214                                      |        |   |   | 47,035,214 |   |
| Accumulated deficit                                                                       |       | (2,199,615                                      | )           | (662,502 | ) | (2,862,117 | ) |
| Accumulated other comprehensive (loss)  income                                            |       | 2,502,685                                       |        | (590,329 | ) | 1,912,356 |   |
| TOTAL STOCKHOLDERS’ EQUITY                                                           |       | 47,338,285                                      |        | (1,252,831 | ) | 46,085,454 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                           |       | $                                               | 404,312,046 |   | $ | 18,904,633 |   | $ | 423,216,679 |   |

 

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

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

 

**Note 2 Restatement of Financial Statements (continued)**

 

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

**CONSOLIDATED STATEMENT OF OPERATIONS (UNAUDITED)**

** **
| ** **                                    | ** ** | **Three Months  Ended  11/29/2007** | ** **  | **Nine Months  Ended  11/29/2007** | ** ** |
|-----------------------------------------------|------------|------------------------------------------|-------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **As  Previously Reported**              | ** **  | **Adjustment**                          | ** ** | **Restated** | ** ** | **As  Previously Reported** | ** ** | **Adjustment** | ** ** | **Restated** | ** ** |
|                                          |       |                                     |        |                                    |       |   |   |   |   |   |   |   |   |
| Net  sales                                    |       | $                                        | 109,161,988 |                                    | $          | 3,032,194 |   | $ | 112,194,182 |   | $ | 321,363,095 |   | $ | 9,084,045 |   | $ | 330,447,140 |   |
|                                          |       |                                     |        |                                    |       |   |   |   |   |   |   |   |   |
| Cost  of goods sold                           |       | 97,646,110                               |        | 2,831,735                               |       | 100,477,845 |   | 289,788,562 |   | 10,191,480 |   | 299,980,042 |   |
|                                          |       |                                     |        |                                    |       |   |   |   |   |   |   |   |   |
| Gross  profit                                 |       | 11,515,878                               |        | 200,459                                 |       | 11,716,337 |   | 31,574,533 |   | (1,107,435 | ) | 30,467,098 |   |
|                                          |       |                                     |        |                                    |       |   |   |   |   |   |   |   |   |
| Selling,  general and administrative expenses |       | 4,835,215                                |        |                                    |       | 4,835,215 |   | 13,874,266 |   |   |   | 13,874,266 |   |
| Stock  compensation expense                   |       | 714,812                                  |        |                                    |       | 714,812 |   | 1,097,812 |   |   |   | 1,097,812 |   |
| Income  (loss) from operations                |       | 5,965,851                                |        | 200,459                                 |       | 6,166,310 |   | 16,602,455 |   | (1,107,435 | ) | 15,495,020 |   |
|                                          |       |                                     |        |                                    |       |   |   |   |   |   |   |   |   |
| Interest  expense, net                        |       | 4,843,976                                |        |                                    |       | 4,843,976 |   | 14,965,736 |   |   |   | 14,965,736 |   |
| Foreign  currency (gain) loss                 |       | 220,348                                  |        | (235,568                                | )          | (15,220 | ) | 740,756 |   | (636,509 | ) | 104,247 |   |
|                                          |       |                                     |        |                                    |       |   |   |   |   |   |   |   |   |
| Other  income                                 |       | (104,573                                 | )           |                                    |       | (104,573 | ) | (187,073 | ) |   |   | (187,073 | ) |
| Income  before income tax (benefit) expense   |       | 1,006,100                                |        | 436,027                                 |       | 1,442,127 |   | 1,083,036 |   | (470,926 | ) | 612,110 |   |
|                                          |       |                                     |        |                                    |       |   |   |   |   |   |   |   |   |
| Income  tax (benefit) expense                 |       | (369,572                                 | )           | 166,650                                 |       | (202,922 | ) | (251,982 | ) | (180,265 | ) | (432,247 | ) |
|                                          |       |                                     |        |                                    |       |   |   |   |   |   |   |   |   |
| Net  income (loss)                            |       | $                                        | 1,375,672   |                                    | $          | 269,377 |   | $ | 1,645,049 |   | $ | 1,335,018 |   | $ | (290,661 | ) | $ | 1,044,357 |   |

 

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

**Notes to ConsolidatedFinancial Statements (Unaudited) (continued**

 

**Note 2  Restatement of FinancialStatements (continued)**

 

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

**CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)**

 
| ** **                                                                                |       | **Nine  Months  Ended  11/29/2007** |       |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                | ** ** | **As  Previously Reported**         | ** ** | **Adjustment** | ** ** | **Restated** | ** ** |
|                                                                                      |       |                                |       |   |   |   |   |
| **Cash flows from operating activities**                                                  |       |                                |       |   |   |   |   |
| Net  income (loss)                                                                        |       | $                                   | 1,335,018  |   | $ | (290,661 | ) | $ | 1,044,357 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                                |       |   |   |   |   |
| Stock-based  compensation                                                                 |       | 595,461                             |       |   |   | 595,461 |   |
| Deferred  income taxes                                                                    |       | (3,088,003                          | )          | (297,528 | ) | (3,385,531 | ) |
| Accretion  of debt discount                                                               |       | 458,780                             |       |   |   | 458,780 |   |
| Derivative  loss                                                                          |       |                                |       | 186,193 |   | 186,193 |   |
| Depreciation                                                                              |       | 17,568,304                          |       | 778,464 |   | 18,346,768 |   |
| Receivables                                                                               |       | (3,811,469                          | )          |   |   | (3,811,469 | ) |
| Inventories                                                                               |       | 250,334                             |       | 39,200 |   | 289,534 |   |
| Prepaid  expenses, other current assets and income tax receivable                         |       | (2,604,297                          | )          | 90,668 |   | (2,513,629 | ) |
| Accounts  payable, accrued expenses and accrued interest                                  |       | 2,795,383                           |       | 130,173 |   | 2,925,556 |   |
| Other                                                                                     |       | 357,991                             |       |   |   | 357,991 |   |
| Total  adjustments                                                                        |       | 12,522,484                          |       | 927,170 |   | 13,449,654 |   |
| *Net cash provided by operating activities*                                               |       | 13,857,502                          |       | 636,509 |   | 14,494,011 |   |
|                                                                                      |       |                                |       |   |   |   |   |
| **Cash flows from investing activities**                                                  |       |                                |       |   |   |   |   |
| Cash  paid for acquisition, net of cash acquired                                          |       | (43,637,578                         | )          |   |   | (43,637,578 | ) |
| Capital  expenditures                                                                     |       | (10,965,313                         | )          |   |   | (10,965,313 | ) |
| *Net cash used in investing activities*                                                   |       | (54,602,891                         | )          |   |   | (54,602,891 | ) |
|                                                                                           |            |                                     |            |  |  |  |  |  |  |  |

 

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

**Notes to ConsolidatedFinancial Statements (Unaudited) (continued**

 

**Note 2 Restatement of Financial Statements (continued)**

 

**CELLU TISSUE HOLDINGS, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENT OF CASHFLOWS (UNAUDITED)**

 
| ** **                                         | ** ** | **Nine  Months  Ended  11/29/2007** | ** ** |
|----------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                         | ** ** | **As  Previously  Reported**        | ** ** | **Adjustment** | ** ** | **Restated** | ** ** |
|                                               |       |                                |       |   |   |   |   |
| **Cash flows from financing activities**           |       |                                |       |   |   |   |   |
| Bank  overdrafts                                   |       | 2,213,043                           |       | — |   | 2,213,043 |   |
| Borrowings  on revolving line of credit            |       | 3,500,000                           |       | 43,100,000 |   | 46,600,000 |   |
| Payments  on revolving line of credit              |       | —                              |       | (43,100,000 | ) | (43,100,000 | ) |
| Payments  of long-term debt                        |       | (575,000                            | )          |   |   | (575,000 | ) |
| Net  proceeds form bond offering                   |       | 20,000,000                          |       |   |   | 20,000,000 |   |
| *Net cash provided by financing activities*        |       | 25,138,043                          |       |   |   | 25,138,043 |   |
|                                               |       |                                |       |   |   |   |   |
| Effect  of foreign currency                        |       | 1,027,817                           |       | (636,509 | ) | 391,308 |   |
| *Net decrease in cash and cash equivalents*        |       | (14,579,529                         | )          |   |   | (14,579,529 | ) |
| *Cash and cash equivalents at beginning of period* |       | 16,260,601                          |       |   |   | 16,260,601 |   |
| *Cash and cash equivalents at end of period*       |       | $                                   | 1,681,072  |   |   |   | $ | 1,681,072 |   |
|                                                    |            |                                     |            |  |  |  |  |  |  |

 

**Note 3 Inventories**

 

Components of inventories are as follows:

 
| ** **                        | ** ** | **November 27, 2008** | ** ** | **February 29, 2008** | ** ** |
|-----------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | ** **                      | ** ** | ** **                      | ** ** |
| Finished  goods                   |       | $                               | 27,252,236 |                            | $          | 17,961,802 |   |
| Raw  materials                    |       | 4,553,706                       |       | 7,073,131                       |       |
| Packaging  materials and supplies |       | 13,402,050                      |       | 9,082,592                       |       |
|                              |       | 45,207,992                      |       | 34,117,525                      |       |
| Inventory  reserves               |       | (277,809                        | )          | (121,086                        | )          |
|                              |       | $                               | 44,930,183 |                            | $          | 33,996,439 |   |

 

**Note 4 Acquisitions**

 

On July 2, 2008, the Company, through two newly created, wholly-ownedsubsidiaries, Cellu Tissue – Hauppauge, LLC (“Cellu Hauppauge”) and CelluTissue – Thomaston, 

 

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

**Notes to ConsolidatedFinancial Statements (Unaudited) (continued)**

 

**Note 4 Acquisitions (continued)**

 

LLC (“Cellu Thomaston”) consummated the acquisition of certain assets,and assumption of certain liabilities, from Atlantic Paper & FoilCorp. of N.Y., Atlantic Lakeside Properties, LLC, Atlantic Paper &Foil, LLC, Atlantic Paper & Foil of Georgia, LLC and ConsumerLicensing Corporation (collectively, the “Sellers”) pursuant to a definitiveasset purchase agreement (the “Purchase Agreement”) between Cellu Tissue andthe Sellers.  The aggregate purchase price paid was $68,000,000, includinga cash payment at closing of $61,700,000 and the issuance of a promissory noteby Cellu Tissue to Atlantic Paper & Foil Corp. of N.Y. in theprincipal amount of $6,300,000 (the “Seller Note”), plus the assumption ofcertain liabilities.  The Company alsoincurred $2.1 million of transaction related costs.  The purchase price, which was subject tocertain post-closing working capital adjustments, was adjusted downward byapproximately $98,000 by the working capital adjustment settlement that wasfinalized in the third quarter 2009.  Theacquisition of assets and assumption of liabilities is referred to as the “APFAcquisition” and the acquired business is referred to as “APF”.  The Company financed the cash portion of thepurchase price with cash on-hand, the borrowings described below (Note 5) andan equity contribution from the Parent.

 

The APF Acquisition has been accounted for as a purchase in accordancewith the provisions of SFAS 141 and, accordingly, the consolidated statement ofoperations includes the results of APF during the three and nine months ended November 27,2008 from the date of acquisition.  Theacquisition has resulted in the recognition of goodwill, which is attributableto our tissue segment and will be deductible for tax purposes.  Goodwill reflects the future earnings andcash flow potential of the acquired business in excess of fair values that areassigned to all other identifiable assets and liabilities.  Goodwill arises because the purchase pricepaid reflects factors including the strategic fit and expected synergies thisbusiness brings to existing operations. Purchase price allocations are subject to refinement until all pertinentinformation is obtained.    The Companyhas allocated the purchase price over the net assets acquired in theacquisition based on its estimates of the fair value of assets and liabilitiesas follows:

 
| ** **                                                     | ** ** | **Purchase price allocated to:** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Current  assets, primarily accounts receivable and inventories |       | $                                               | 15,412,456 |   |
| Property,  plant and equipment                                 |       | 5,306,225                                       |       |
| Goodwill                                                       |       | 24,553,243                                      |       |
| Noncompete  agreements                                         |       | 12,770,000                                      |       |
| Customer  lists                                                |       | 17,340,000                                      |       |
| Trademarks                                                     |       | 56,000                                          |       |
| Current  liabilities                                           |       | (4,989,828                                      | )          |
| Total                                                          |       | $                                               | 70,448,096 |   |

 

20

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Tableof Contents

 

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

**Notes to ConsolidatedFinancial Statements (Unaudited) (continued)**

 

**Note 4 Acquisitions (continued)**

 

The Company has estimated the fair value of the assets and liabilitiesof the APF Acquisition, utilizing information available at the time the Company’sunaudited interim financial statements were prepared and these estimates aresubject to refinement until all pertinent information has been obtained. Thepurchase price allocations are preliminary with respect to finalizing thetransferability of certain tax credits and other minor items.  The Company considered outside third-partyappraisals of the tangible and intangible assets to determine the applicablefair market values.   Depreciation hasbeen calculated on the fair value assigned to the tangible fixed assets basedon an average remaining useful life.  Intangibleassets are being amortized on a straight-line basis, assuming no significantresidual value, over the following lives: noncompete agreements-5 years, customer lists-7 years and trademarks- 3years.

 

The results of APF’s operations from the July 2, 2008 date ofacquisition are primarily included in the Company’s tissue segment.  Part of the acquisition related to thefoam business, which the Company will show as a separate segment (see Note7).  Unaudited pro forma results ofoperations for the three months ended November 29, 2007 and for the ninemonths ended November 27, 2008 and November 29, 2007, as if theCompany and APF had been combined at the beginning of the periods presented,are presented below.  The pro formaresults include estimates and assumptions, which the Company’s managementbelieves are reasonable.  However, thepro forma results do not include any cost savings or other effects of theplanned integration of APF 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 November 29, 2007 (1)** | ** ** |
|-------------------|------------|----------------------------------------------------------------------------|------------|
| ** **        | ** ** | **Actual**                                                                 | ** ** | **Pro Forma** | ** ** |
| ** **        | ** ** | **(Restated)**                                                             | ** ** | **(Restated)** | ** ** |
| ** **        | ** ** | **(in thousands)**                                                         | ** ** |
| Net  sales        |       | $                                                                          | 112,194    |   | $ | 131,547 |   |
| Operating  income |       | $                                                                          | 6,166      |   | $ | 8,673 |   |
| Net  income       |       | $                                                                          | 1,645      |   | $ | 4,991 |   |

 

----

(1) Pro forma operating results include theoperating results for APF for the three months ended September 30, 2007,as APF was previously a calendar year-end company.

 
| ** **       | ** ** | **Nine Months Ended November 27, 2008  (2)** | ** ** | **Nine Months Ended November 29, 2007  (3)** | ** ** |
|------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **       | ** ** | **Actual**                                                            | ** ** | **Pro Forma**                                                    | ** ** | **Actual** | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | ** **                                                            | ** ** | ** **                                                            | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ** **       | ** ** | **(in thousands)**                                                    | ** ** | **(in thousands)**                                                    | ** ** |
| Net sales        |       | $                                                                     | 390,582    |                                                                  | $          | 423,576 |   | $ | 330,447 |   | $ | 387,364 |   |
| Operating income |       | $                                                                     | 21,649     |                                                                  | $          | 25,162 |   | $ | 15,495 |   | $ | 22,719 |   |
| Net income       |       | $                                                                     | 2,584      |                                                                  | $          | 5,454 |   | $ | 1,044 |   | $ | 8,210 |   |

 

21

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Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 4 Acquisitions (continued)**

 

----

(2)  Pro forma operating results include theoperating results for APF for the period March 1, 2008 to June 30,2008, prior to its acquisition on July 2, 2008.   The actual operating results include theoperating results for APF for the period from the acquisition date (July 2,2008) to November 27, 2008.

 

(3) Pro forma operating results include theoperating results for APF for the nine months ended September 30, 2007, asAPF was previously a calendar year-end company.

 

On March 21, 2007, the Company executed a definitive mergeragreement (the “Acquisition Agreement”) with CityForest Corporation (“CityForest”),Cellu City Acquisition Corporation (“Cellu City Merger Sub”) and Wayne Gullstadas the shareholders’ representative. Pursuant to the Acquisition Agreement, and subject to the terms andconditions therein, Cellu City Merger Sub, a wholly owned subsidiary of theCompany, merged with and into CityForest, with CityForest surviving andbecoming a wholly owned subsidiary of the Company (the “CityForest Acquisition”).  The aggregate merger consideration (includingassumption of $18.4 million in aggregate principal amount of industrial revenuebonds) was approximately $61.0 million subject to certain working capital andnet cash adjustments.  Total cash paidfor the acquisition of $46.8 million (purchase price of $61.0 million lessassumed indebtedness of $18.4 million plus restricted cash and othermiscellaneous adjustments of $1.6 million and acquisition costs of $2.6million) was financed in part by issuance of unregistered 9 3/4% Senior Secured Notes due 2010 ofapproximately $20.0 million, borrowings on a revolving line of credit ($17.4million) and available cash on hand.

 

The CityForest Acquisition has been accounted for as a purchase inaccordance with the provisions of SFAS 141 and, accordingly, the consolidatedstatements of operations includes the results of CityForest during the threemonths and nine months ended November 27, 2008, during the three monthsended November 29, 2007 and during the nine months ended November 29,2007 from the date of acquisition.

 

The results of CityForest’s operations from the date of acquisition (March 21,2007) are included in the Company’s tissue segment. Unaudited pro forma resultsof operations for the nine months ended November 29, 2007, as if theCompany and CityForest had been combined at the beginning of the periodpresented, are presented below.  The proforma results include estimates and assumptions, which the Company’s managementbelieves are reasonable.  However, thepro forma results do not include any cost savings or other effects of theplanned integration of CityForest and are not necessarily indicative of theresults which would have occurred if the business combination had been ineffect on the dates indicated, or which may result in the future.

 

22

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Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 4 Acquisitions (continued)**

 
| ** **       | ** ** | **Nine Months Ended November 29, 2007 (1)** | ** ** |
|------------------|------------|---------------------------------------------------------------------------|------------|
| ** **       | ** ** | **Actual**                                                                | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | **(Restated)**                                                            | ** ** | **(Restated)** | ** ** |
| ** **       |       | **(in  thousands)**                                                       |       |
| Net sales        |       | $                                                                         | 330,447    |   | $ | 333,157 |   |
| Operating income |       | $                                                                         | 15,495     |   | $ | 16,081 |   |
| Net income       |       | $                                                                         | 1,044      |   | $ | 1,605 |   |

 

----

(1) Pro forma operating results include theoperating results for CityForest for the nine months ended November 29,2007.  The actual operating resultsinclude the operating results for CityForest for the period from theacquisition date (March 21, 2007) to November 29, 2007.

 

**Note 5 Long-Term Debt**

 

Long-term debt consists of the following:

 
| ** **                                                                                                    | ** ** | **November 27,  2008** | ** **  | **February 29, 2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| 9 3/4% senior secured notes due  2010                                                                         |       | $                           | 222,255,572 |                            | $          | 182,255,572 |   |
| Less discount                                                                                                 |       | (3,172,370                  | )           | (1,283,628                      | )          |
|                                                                                                          |       | 219,083,202                 |        | 180,971,944                     |       |
| Industrial revenue bond payable, in  semi-annual installments, plus variable interest, due March 1, 2028 |       | 17,115,000                  |        | 17,875,000                      |       |
| Seller Note payable, quarterly interest  payments only at 12% annum, with principal due July 2, 2011     |       | 6,300,000                   |        | —                          |       |
|                                                                                                          |       | 242,498,202                 |        | 198,846,944                     |       |
| Less current portion of debt                                                                                  |       | 760,000                     |        | 760,000                         |       |
|                                                                                                          |       | $                           | 241,738,202 |                            | $          | 198,086,944 |   |

 

***9******3/******4% Senior SecuredNotes due 2010***

 

In March 2004, the Company completed a private offering of $162.0million aggregate principal amount of 9 3/4%senior secured notes due 2010 (the “Original Notes”) pursuant to and governedby the Indenture, dated as of March 12, 2004 (as amended and supplemented,the “Cellu Tissue Indenture”) among the Company, the subsidiary guarantorsparty thereto and The Bank of New York Trust Company, N.A., as successortrustee to the Bank of New York (the “Trustee”).  In connection with the CityForest Acquisition(see Note 3), the Company entered into a Note Purchase Agreement (the

 

23

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Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 5 Long-Term Debt (continued)**

 

“Note Purchase Agreement”) with Wingate Capital Ltd.  (“the Purchaser”), dated March 21, 2007,pursuant to which it issued and sold $20.3 million aggregate principal amountof 9 3/4% senior secured notes due 2010(“First 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 First AdditionalNotes were issued pursuant to and are governed by the Cellu Tissue Indenture.

 

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

 

The Notes mature on March 15, 2010 and require semi-annualinterest payments on March 15 and September 15.  The Notes are collateralized by a seniorsecured interest in substantially all of the Company’s assets.  The Cellu Tissue Indenture contains certaincovenants, including limitations on certain restricted payments, the incurrenceof additional indebtedness and the sale of certain assets. The Cellu TissueIndenture has been amended by two subsequent amendments pursuant to whichCityForest, Cellu Happauge and Cellu Thomaston became parties to the CelluTissue Indenture as subsidiary guarantors (collectively, the “AdditionalGuarantors”).  Cellu Tissue has noindependent assets or operations and the Notes are fully and unconditionally,on a joint and several basis, guaranteed by all of the Company’s subsidiaries.

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 5 Long-Term Debt (continued)**

 

***Seller Note Payable***

 

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

 

***Credit Agreement***

 

The Company entered into a Credit Agreement, dated as of June 12,2006 (the “Credit Agreement”), among Cellu Tissue, as U.S. Borrower, InterlakeAcquisition Corporation Limited (“Interlake”), a subsidiary of Cellu Tissue, asCanadian Borrower, Parent, the other loan guarantors party thereto, JPMorganChase Bank, N.A., as U.S. Administrative Agent the “U.S. Administrative Agent”),JPMorgan Chase Bank, N.A., Toronto Branch, as Canadian Administrative Agent(the “Canadian Administrative Agent”) and the other  lenders party thereto.  The Credit Agreement provides for a $35.0million working capital facility, which was subsequently increased to $60.0million (see discussion following), including a letter of credit sub-facilityand swing-line loan sub-facility. The Credit Agreement provides that amountsunder the facility may be borrowed, repaid and re-borrowed, subject to aborrowing base test, until the maturity date, which is June 12, 2011. Inthe event that the Notes are not refinanced by December 2009, theborrowings under the credit agreement are due and payable and accordingly,outstanding borrowings as of November 27, 2008 are classified ascurrent.  An amount equal to $32.0million, which was subsequently increased to $57.0 million (see discussionfollowing), is available, in U.S. dollars, to the U.S. Borrower under thefacility and an amount equal to $3.0 million is available, in U.S. or Canadiandollars, to the Canadian Borrower under the facility.  Borrowings of $17.4 million were made tofinance a portion of the CityForest Acquisition and borrowings of $12.1 millionwere made to finance a portion of the APF Acquisition.   As of November 27, 2008, there was$28.5 million of borrowings outstanding under the working capital facility andexcess availability was $27.6****million.

 

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

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 5 Long-Term Debt (continued)**

 

The First Amendment (1) increases the working capital facilityfrom $35.0 million to $40.0 million, (2) permits the issuance and sale bythe Company of the First Additional Notes, (3) provides for theconsummation of the CityForest Acquisition and the conversion by CityForestfrom a Minnesota corporation to a Minnesota limited liability company, (4) permitsthe assumption of approximately $18.4 million in aggregate principal amount ofindebtedness of CityForest in connection with the CityForest Acquisition inaccordance with the terms of the CityForest Bond Documents (as defined belowunder “CityForest Bond Documents”), and (5) permits the guarantee by CelluTissue of certain obligations of CityForest under the CityForest BondDocuments.  In connection with the FirstAmendment, CityForest became a guarantor of the obligations of the borrowersunder the Amended Credit Agreement.

 

The Company has entered into a Second Amendment, dated July 2,2008 (the “Second Amendment”), to the Credit Agreement dated June 12, 2006(as amended by the First Amendment and the Second Amendment, “Credit Agreement,as Amended”), among Cellu Tissue, Interlake, certain****subsidiariesof Cellu Tissue, the Parent, the U.S. Administrative Agent and the CanadianAdministrative Agent.The Second Amendment (1) increases the workingcapital facility from $40.0 million to $60.0 million, (2) permits theissuance and sale by Cellu Tissue of the Second Additional Notes, (3) providesfor the consummation of the APF Acquisition and (4) permits the issuanceof the Seller Note.  In connection withthe Second Amendment, Cellu Hauppauge and Cellu Thomaston became guarantors ofthe obligations of the borrowers under the Credit Agreement, as Amended.

 

On September 29, 2008 the Company entered into the Third Amendmentto the Credit  Agreement, dated as of June 12,2006 (as amended by the First Amendment and the Second Amendment) and asfurther amended, supplemented or otherwise modified from time to time, by andamong the Parent, Cellu Tissue, Interlake, the Loan Guarantors party thereto, the lenders party thereto,  the US Administrative Agent and the CanadianAdministrative Agent.  This Amendmentincreases the amount of the Canadian Commitments by $2.0 million and reducesthe amount of the US Commitments by the same amount.

 

***CityForest Bond Documents***

 

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

 

26

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Table of Contents

 

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

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

 

**Note 5Long-Term Debt (continued)**

 

terms of the Indenture ofTrust governing the Bonds (the “CityForest Indenture”), to provide a letter ofcredit in favor of the trustee under the CityForest Indenture (the “BondsTrustee”).  CityForest has entered intoan Amended and Restated ReimbursementAgreement, dated March 21, 2007 (the“Reimbursement Agreement” and, together with 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”).

 

TheBonds Trustee is permitted to draw upon the Associated Bank Letter of Credit topay principal and interest due on the Bonds, and to provide liquidity topurchase Bonds put to CityForest by bondholders and not remarketed; andCityForest is obligated under the Reimbursement Agreement to reimburseAssociated Bank for any such draws. CityForest is also obligated to pay a feein respect of the aggregate amount available to be drawn under the AssociatedBank Letter of Credit at a rate per annum 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 byCityForest under the Associated Bank Revolving Credit Facility bear interest ata rate per annum equal to the LIBOR Rate (as defined in the ReimbursementAgreement), plus an applicable margin. The applicable margin percentageinitially is 1.75%, subject to adjustment on a quarterly basis based uponCityForest’sleverage.  During the continuance of anevent of default, the outstanding principal balance bears interest at a rateper annum equal to the then applicable interest rate plus 2.00%.  CityForest is also obligated to pay acommitment fee in respect of any unused commitment under the Associated BankRevolving Credit Facility in an amount equal to 0.50% per annum.  In addition, subject to certain exceptions,if CityForest terminates the Associated Bank Revolving Credit Facility prior toFebruary 15, 2009, CityForest is obligated to pay to Associated Bank a feeequal to 1.00% of the commitment then being terminated. The maturity date ofthe Associated Bank Revolving Credit Facility is February 15, 2011.

 

The Reimbursement Agreementrequires scheduled semi-annual payments of principal of the Bonds equal toapproximately 2.00% of the principal amount outstanding as of the date of theCityForest Acquisition, with the balance payable at maturity of the Bonds on March 1,2028. The Reimbursement Agreement also contains a number of other provisionsregarding reserve funds and other mandatory and optional repayments inconnection with the Bonds.  In addition,the Reimbursement Agreement provides that in certain circumstances where theCompany incurs indebtedness, as defined, in excess of

 

27

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Table of Contents

 

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

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

 

**Note 5Long-Term Debt (continued)**

 

amounts currently permittedunder the CityForest Indenture or refinances the indebtedness issued under theCityForest Indenture, Associated Bank may require CityForest to repay all ofits obligations to Associated Bank under the Reimbursement Agreement and eitherto cause the Bonds to be redeemed or to replace the Associated Bank Letter ofCredit with a Substitute Credit Facility, as such term is defined in theCityForest Indenture.

 

The Reimbursement Agreementcontains various affirmative and negative covenants customary for workingcapital and term credit facilities, as well as additional covenants relating tothe Bonds.  The negative covenantsinclude limitations on: indebtedness; liens; acquisitions, mergers and consolidations;investments; guarantees; asset sales; sale and leaseback transactions;dividends and distributions; transactions with affiliates; capitalexpenditures; and changes to the status of the Bonds. CityForest is alsorequired to comply on a quarterly basis with a maximum leverage covenant and aminimum fixed charge coverage covenant. The Reimbursement Agreement alsocontains customary events of default, including:  payment defaults; breaches of representationsand warranties; covenant defaults; cross-defaults to certain other debt,including the Notes and indebtedness under the Credit Agreement (as amendedfrom time to time); certain events of bankruptcy and insolvency; judgmentdefaults; certain defaults related to the Employee Retirement Income SecurityAct of 1974, as amended; and a change of control of CityForest or the Company.

 

The Company has guaranteedall of the obligations of CityForest under the Reimbursement Agreement,pursuant to a Guaranty, dated March 21, 2007 (the “Cellu Tissue Guaranty”),executed by the Company in favor of Associated Bank. In addition, theobligations of CityForest under the Reimbursement Agreement are secured byfirst-priority liens in favor of Associated Bank in all of CityForest’s assets.  The U.S. Administrative Agent, the CanadianAdministrative Agent, Associated Bank and CityForest have entered into anIntercreditor 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.

 

**Note 6 Debtand Note Issuance Costs**

 

In connection with thefinancing related to the APF acquisition, the Company incurred approximately$232,000 and $654,000 of costs related to the amendment to the credit agreementand note issuance, respectively.  Thesecosts have been capitalized as of the date of financing and are being amortizedover the respective terms of the financing. The

 

28

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Table of Contents

 

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

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

 

**Note 6 Debtand Note Issuance Costs (continued)**

 

debt issuance costs andrelated accumulated amortization balances as of November 27, 2008 are asfollows:

 
| ** **                           | ** ** | **November 27, 2008** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|
| Debt issuance costs-credit agreement |       | $                               | 231,653    |   |
| Note issuance costs                  |       | 654,307                         |       |
|                                 |       | 885,960                         |       |
| Accumulated amortization             |       | (188,816                        | )          |
|                                 |       | $                               | 697,144    |   |

 

These costs, net ofaccumulated amortization, are included in other assets on the balance sheet asof November 27, 2008.

 

**Note 7Comprehensive Income**

 

The components ofcomprehensive income for the three months and nine months ended November 27,2008 and November 29, 2007 are as follows:

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **November 27, 2008**  | ** ** | **November 29, 2007** | ** ** | **November 27, 2008** | ** ** | **November 29,  2007** | ** ** |
| ** **                               | ** ** | ** **                       | ** ** | **(Restated)**                  | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Net income                               |       | $                                | 1,838,748  |                            | $          | 1,645,049 |   | $ | 2,584,133 |   | $ | 1,044,357 |   |
| Foreign currency translation adjustments |       | (4,808,189                       | )          | 1,799,006                       |       | (6,970,275 | ) | 3,026,326 |   |
| Derivative loss                          |       | (570,701                         | )          | —                          |       | (570,701 | ) | — |   |
| Comprehensive (loss) income              |       | $                                | (3,540,142 | )                               | $          | 3,444,055 |   | $ | (4,956,843 | ) | $ | 4,070,683 |   |

 

**Note 8Business Segments**

 

The Company operates inthree business segments:  tissue,machine-glazed paper and foam.  The foambusiness segment was added in connection with the APF Acquisition (see Note3).  The Company assesses the performanceof its business segments using segment income from operations.  Segment income from operations excludesinterest income, interest expense, other income (expense), income tax expense,amortization expense and the impact of foreign currency gains and losses.   A portion of corporate and shared expensesis allocated to each segment.  Segmentinformation for the three months and nine months ended November 27, 2008and November 29, 2007 follows:

 

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

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

 

**Note 8Business Segments (continued)**

** **
| ** **                                    | ** ** | **Three Months Ended** | ** **  | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                    | ** ** | **November 27,  2008**      | ** **  | **November 29,  2007**     | ** ** | **November 27,  2008** | ** ** | **November 29,  2007** | ** ** |
| ** **                                    | ** ** | ** **                       | ** **  | **(Restated)**                  | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| **Net Sales**                                 |       |                             |        |                            |       |   |   |   |   |
| Tissue                                        |       | $                                | 111,144,412 |                            | $          | 84,060,637 |   | $ | 300,355,288 |   | $ | 249,456,678 |   |
| Machine-glazed paper                          |       | 30,455,456                       |        | 28,133,545                      |       | 87,904,091 |   | 80,990,462 |   |
| Foam                                          |       | 1,442,149                        |        | —                          |       | 2,323,055 |   | — |   |
| Consolidated                                  |       | $                                | 143,042,017 |                            | $          | 112,194,182 |   | $ | 390,582,434 |   | $ | 330,447,140 |   |
| **Segment income from operations**            |       |                             |        |                            |       |   |   |   |   |
| Tissue                                        |       | $                                | 8,590,369   |                            | $          | 6,046,046 |   | $ | 20,759,448 |   | $ | 15,333,763 |   |
| Machine-glazed paper                          |       | 1,969,014                        |        | 120,264                         |       | 2,700,380 |   | 161,257 |   |
| Foam                                          |       | 71,953                           |        | —                          |       | 250,610 |   | — |   |
| Total segment income from operations          |       | 10,631,336                       |        | 6,166,310                       |       | 23,710,438 |   | 15,495,020 |   |
| Amortization expense                          |       | (1,258,994                       | )           | —                          |       | (2,061,429 | ) | — |   |
| Consolidated income from operations           |       | 9,372,342                        |        | 6,166,310                       |       | 21,649,009 |   | 15,495,020 |   |
| Interest expense, net                         |       | (6,910,402                       | )           | (4,843,976                      | )          | (17,951,147 | ) | (14,965,736 | ) |
| Net foreign currency transaction gain  (loss) |       | 241,333                          |        | 15,220                          |       | 156,713 |   | (104,247 | ) |
| Other income (expense)                        |       | 36,975                           |        | 104,573                         |       | (1,443 | ) | 187,073 |   |
| Income before income tax expense              |       | $                                | 2,740,248   |                            | $          | 1,442,127 |   | $ | 3,853,132 |   | $ | 612,110 |   |
| **Capital Expenditures**                      |       |                             |        |                            |       |   |   |   |   |
| Tissue                                        |       | $                                | 4,359,725   |                            | $          | 3,392,489 |   | $ | 8,168,666 |   | $ | 8,972,218 |   |
| Machine-glazed paper                          |       | 300,714                          |        | 258,712                         |       | 977,484 |   | 1,229,947 |   |
| Foam                                          |       | —                           |        | —                          |       | — |   | — |   |
| Corporate                                     |       | 253,112                          |        | 373,325                         |       | 587,950 |   | 763,148 |   |
| Consolidated                                  |       | $                                | 4,913,551   |                            | $          | 4,024,526 |   | $ | 9,734,100 |   | $ | 10,965,313 |   |

 
| ** **           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **           | ** ** | **November 27,  2008**      | ** ** | **November 29,  2007**     | ** ** | **November 27, 2008** | ** ** | **November 29,  2007** | ** ** |
| ** **           | ** ** | ** **                       | ** ** | **(Restated)**                  | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| **Depreciation**     |       |                             |       |                            |       |   |   |   |   |
| Tissue               |       | $                                | 4,381,706  |                            | $          | 4,144,733 |   | $ | 13,032,038 |   | $ | 13,692,311 |   |
| Machine-glazed paper |       | 1,489,430                        |       | 1,487,365                       |       | 4,547,660 |   | 4,654,457 |   |
| Foam                 |       | 21,347                           |       | —                          |       | 34,953 |   | — |   |
| Consolidated         |       | $                                | 5,892,483  |                            | $          | 5,632,098 |   | $ | 17,614,651 |   | $ | 18,346,768 |   |

 

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

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

 

**Note 8Business Segments (continued)**

 
| ** **              | ** ** | **November 27, 2008** | ** **  | **February 29, 2008** | ** ** |
|-------------------------|------------|---------------------------------|-------------|---------------------------------|------------|
| ** **              | ** ** | ** **                      | ** **  | **(Restated)**                  | ** ** |
| **Segment assets** |       |                            |        |                            |       |
| Tissue                  |       | $                               | 395,890,080 |                            | $          | 325,526,456 |   |
| Machine-glazed paper    |       | 91,739,403                      |        | 91,007,538                      |       |
| Foam                    |       | 2,245,334                       |        | —                          |       |
| Corporate assets        |       | 4,164,691                       |        | 6,682,685                       |       |
| Consolidated            |       | $                               | 494,039,508 |                            | $          | 423,216,679 |   |

 

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

 

Goodwill, trademarks andother intangibles and related accumulated amortization as of November 27,2008 and February 29, 2008 are as follows:

 
| ** **               | ** ** | **November 27, 2008** | ** ** | **February 29, 2008** | ** ** |
|--------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | ** **                      | ** ** | **(Restated)**                  | ** ** |
| Goodwill                 |       | $                               | 35,887,998 |                            | $          | 11,334,755 |   |
|                     |       |                            |       |                            |       |
| Trademarks               |       | $                               | 9,456,000  |                            | $          | 9,400,000 |   |
| Noncompete agreements    |       | 12,770,000                      |       | —                          |       |
| Customer lists           |       | 17,340,000                      |       | —                          |       |
|                     |       | 39,566,000                      |       | 9,400,000                       |       |
| Accumulated amortization |       | (2,061,429                      | )          | —                          |       |
| Other Intangibles, Net   |       | $                               | 37,504,571 |                            | $          | 9,400,000 |   |

 

The increase in goodwill isattributable to the APF Acquisition. Intangible assets are being amortized on a straight-line basis, assumingno significant residual value, over the following lives:  noncompete agreements-5 years, customerlists-7 years and trademarks- 3 years. Annual aggregate amortization expense estimated for each of the 5succeeding years is approximately $5.0 million. Amortization expense for the three months and nine months ended November 27,2008 was $1,258,994 and $2,061,429, respectively.

 

**Note 10Income taxes**

 

The effective income taxrate for the three months and nine months ended November 27, 2008 was32.9% and 33.0%, respectively compared to 14.1% (benefit) and 70.6% (benefit),respectively for the three months and nine months ended November 29,2007.   Included in the income taxbenefit for the three months and nine months ended November

 

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 10 Income taxes (continued)**

 

29, 2007 is $.7 million of benefit primarily related to the differentbook and tax treatment of deductions related to transaction costs.

 

At November 27, 2008, the Company did not have any unrecognizedtax benefits.  The fiscal tax years 2004through 2008 remain open to examination by the major taxing jurisdictions towhich the Company is subject.  As of November 27,2008, the Company does not expect any material changes to unrecognized taxpositions within the next 12 months.

 

**Note 11 Earnout Payment**

 

On August 29, 2008, $15.0 million in contingent consideration inconnection with the Agreement and Plan of Merger that the Parent consummated onJune 12, 2006 with Cellu Parent, a corporation organized and controlled byWeston Presidio, and Cellu Acquisition Corporation (“Merger Sub”), a whollyowned subsidiary of Cellu Parent and a newly formed corporation indirectlycontrolled by Weston Presidio was paid out due to the achievement of certainfinancial targets for fiscal year 2008.  Of the $15.0 million, $1.3 million was issued in stock of Cellu Parent,which was accounted for by the Company as a capital contribution from itsParent.  The remaining $13.7 million waspaid out in cash and funded by an equity contribution of $6.7 million by WestonPresidio to Cellu Parent and $7.0 million by Cellu Tissue, which was fundedthrough borrowings on the Company’s revolving line of credit.   The Company anticipates paying out theremaining $20.0 million as follows: $15.0 million for fiscal year 2009 and the remaining $5.0 million for fiscalyear 2010.

 

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

 

**OVERVIEW**

 

Certain statements contained in this Quarterly Report on Form 10-Qmay contain forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities and Exchange Act of 1934, as amended, and, as such, may involveknown or unknown risks, uncertainties and other factors which may cause ouractual results, performance or achievements to be materially different fromfuture results, performance or achievements expressed or implied by suchforward-looking statements. Forward-looking statements, which are based on certain assumptions anddescribe our future plans, strategies and expectations, are generallyidentifiable by use of the words “may,” “will,” “should,” “expect,” “anticipate,”“estimate,” “believe,” “intend,” “project,” or comparable terminology.  Factors which could have a material adverseeffect on our operations and future prospects include, but are not limited to,those set forth in Item 1. Business-Forward-Looking Statements and Item1A.  Risk Factors in our Annual Report onForm 10-K for our fiscal year ended February 29, 2008.  These risks and uncertainties should beconsidered in evaluating any forward-looking statements contained herein.

 

The Company has restated herein its consolidated financial statementsas of February 29, 2008 and for the three and nine months ended November 29,2007.  This restatement corrects errorsin (i) accounting for deferred income taxes in connection with purchaseaccounting applied in fiscal 2007, (ii) classification of borrowings andrepayments on the revolving credit facility in the statement of cash flows, andcertain other adjustments that were initially deemed to be not material bymanagement, including (a)  classificationof shipping and handling costs in accordance with EITF 00-10, Accounting forShipping and Handling Fees and Costs (EITF 00-10), (b) accounting forderivative instruments, (c) accounting for foreign exchange gains and losses infiscal 2008, and (d) certain other miscellaneous adjustments. See Note2-Restatement of Financial Statements in the accompanying consolidatedfinancial statements for further information.

 

We manufacture and market a variety of specialty tissue hard rolls andmachine-glazed paper used in the manufacture of various end products, includingdiapers, facial and bath tissue, assorted paper towels and food wraps.  In addition, we produce a variety ofconverted tissue products.  Our customersinclude major North American producers of branded and unbranded disposableconsumer absorbent and tissue products for the personal and health caremarkets; consumer and away-from-home tissue products companies; national andregional tissue products distributors; and third-party converters who selltheir products to food, bakery and confections companies.  We service a diverse group of high-qualitycustomers, with three of our top 10 customers belonging to the Fortune 150group of companies.

 

We operate in three business segments: tissue, machine-glazed paper and foam.   The foam business segment was added in connection with the APFAcquisition (see discussion below).  Weassess the performance of our business segments using segment income fromoperations.  Segment income fromoperations excludes interest income, 

 

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interest expense, income tax expense, amortization expense, otherincome (expense) and the impact of foreign currency gains and losses.

 

**Acquisitions**

 

On July 2, 2008, we, through two newly created,wholly-owned subsidiaries, Cellu Hauppauge and Cellu Thomaston consummated theacquisition of certain assets, and assumption of certain liabilities, fromAtlantic Paper & Foil Corp. of N.Y., Atlantic Lakeside Properties,LLC, Atlantic Paper & Foil, LLC, Atlantic Paper & Foil ofGeorgia, LLC and Consumer Licensing Corporation (collectively, the “Sellers”)pursuant to the Purchase Agreement between Cellu Tissue and the Sellers. The aggregate purchase price paid was $68,000,000, including a cash payment atclosing of $61,700,000 and the issuance of a promissory note by Cellu Tissue toAtlantic Paper & Foil Corp. of N.Y. in the principal amount of$6,300,000 (the “Seller Note”), plus the assumption of certainliabilities.  We also incurred $2.1million of transaction related costs. The purchase price, which was subject to certain post-closing workingcapital adjustments, was adjusted downward by approximately $98,000 by theworking capital adjustment settlement that was finalized in the third quarter2009.  We financed the cash portion ofthe purchase price with cash on-hand, the borrowings described below and anequity contribution from our Parent.

 

The APF Acquisition has been accounted for as a purchase in accordancewith the provisions of SFAS 141 and, accordingly, the consolidated statement ofoperations includes the results of APF during the three and nine months ended November 27,2008 from the date of acquisition.  Theacquisition has resulted in the recognition of goodwill, which is attributableto our tissue segment and will be deductible for tax purposes.  Goodwill reflects the future earnings andcash flow potential of the acquired business in excess of fair values that areassigned to all other identifiable assets and liabilities.  Goodwill arises because the purchase pricepaid reflects factors including the strategic fit and expected synergies thisbusiness brings to existing operations. Purchase price allocations are subject to refinement until all pertinentinformation is obtained.  We haveallocated the purchase price over the net assets acquired in the acquisitionbased on an estimate of the fair value of assets and liabilities as follows:

 
| ** **                                                     | ** ** | **Purchase price allocated to:** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------|------------|
| Current assets, primarily accounts  receivable and inventories |       | $                                               | 15,412,456 |   |
| Property, plant and equipment                                  |       | 5,306,225                                       |       |
| Goodwill                                                       |       | 24,553,243                                      |       |
| Noncompete agreements                                          |       | 12,770,000                                      |       |
| Customer lists                                                 |       | 17,340,000                                      |       |
| Trademarks                                                     |       | 56,000                                          |       |
| Current liabilities                                            |       | (4,989,828                                      | )          |
| Total                                                          |       | $                                               | 70,448,096 |   |

 

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We have estimated the fair value of theassets and liabilities of the APF Acquisition, utilizing information availableat the time our unaudited interim financial statements were prepared and theseestimates are subject to refinement until all pertinent information has beenobtained.  The purchase price allocationsare preliminary with respect to finalizing the transferability of tax creditsand other minor items.  We haveconsidered outside third-party appraisals of our tangible and intangible assetsto determine the applicable fair market values.    Depreciation has been calculated on thefair value assigned to the tangible fixed assets based on an average remaininguseful life.   Intangible assets arebeing amortized on a straight-line basis, assuming no significant residualvalue, over the following lives:  noncompeteagreements-5 years, customer lists-7 years and trademarks- 3 years.

 

The results of APF’s operations from the July 2,2008 date of acquisition are primarily included in our tissue segment.  Part of the acquisition related to thefoam business, which we show as a separate segment as noted above.  Unaudited pro forma results of operations forthe three months ended November 29, 2007 and for the nine months ended November 27,2008 and November 29, 2007, as if we and APF had been combined at the beginningof the periods presented, are presented below. The pro forma results include estimates and assumptions, which ourmanagement believes are reasonable. However, the pro forma results do not include any cost savings or othereffects of the planned integration of APF and are not necessarily indicative ofthe results which would have occurred if the business combination had been ineffect on the dates indicated, or which may result in the future.

 
| ** **       | ** ** | **Three Months Ended November 29, 2007  (1)** | ** ** |
|------------------|------------|------------------------------------------------------------------------|------------|
| ** **       | ** ** | **Actual**                                                             | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | **(Restated)**                                                         | ** ** | **(Restated)** | ** ** |
| ** **       | ** ** | **(in  thousands)**                                                    | ** ** |
| Net sales        |       | $                                                                      | 112,194    |   | $ | 131,547 |   |
| Operating income |       | $                                                                      | 6,166      |   | $ | 8,673 |   |
| Net income       |       | $                                                                      | 1,645      |   | $ | 4,991 |   |

 

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(1) Pro forma operating results include theoperating results for APF for the three months ended September 30, 2007,as APF was previously a calendar year-end company.

 
| ** **       | ** ** | **Nine Months Ended November 27, 2008 (2)** | ** ** | **Nine Months Ended November 29, 2007  (3)** | ** ** |
|------------------|------------|---------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **       | ** ** | **Actual**                                                                | ** ** | **Pro Forma**                                                    | ** ** | **Actual ** | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | ** **                                                                | ** ** | ** **                                                            | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ** **       | ** ** | **(in thousands)**                                                   | ** ** | **(in thousands)**                                               | ** ** |
| Net sales        |       | $                                                                         | 390,582    |                                                                  | $          | 423,576 |   | $ | 330,447 |   | $ | 387,364 |   |
| Operating income |       | $                                                                         | 21,649     |                                                                  | $          | 25,162 |   | $ | 15,495 |   | $ | 22,719 |   |
| Net income       |       | $                                                                         | 2,584      |                                                                  | $          | 5,454 |   | $ | 1,044 |   | $ | 8,210 |   |

 

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(2)          Pro forma operatingresults include the operating results for APF for the period March 1, 2008to June 30, 2008, prior to its acquisition date on July 2, 2008.

 

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(3) Pro forma operating results includethe operating results for APF for the nine months ended September 30,2007, as APF was previously a calendar year-end company.

 

On March 21, 2007, we executed the Acquisition Agreement withCityForest, 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 ours, merged with and intoCityForest, with CityForest surviving and becoming our wholly ownedsubsidiary.  The aggregate mergerconsideration (including assumption of $18.4 million in aggregate principalamount of industrial revenue bonds) was approximately $61.0 million subject tocertain working capital and net cash adjustments.  Total cash paid for the acquisition of $46.8million (purchase price of $61.0 million less assumed indebtedness of $18.4million plus restricted cash and other miscellaneous adjustments of $1.6 millionand acquisition costs of $2.6 million), was financed in part by the FirstAdditional Notes, (approximately $20.0 million), borrowings on a revolving lineof credit ($17.4 million) and available cash on hand.

 

The CityForest Acquisition has been accountedfor as a purchase in accordance with the provisions of SFAS 141 and,accordingly, the consolidated statements of operations includes the results ofCityForest during the three months and nine months ended November 27,2008, during the three months ended November 29, 2007 and during the ninemonths ended November 29, 2007 from the date of acquisition.   The results of CityForest’s operations areincluded in our tissue segment.  Unaudited pro forma results of operations for the nine months ended November 29,2007, as if we and CityForest had been combined at the beginning of the periodpresented, are presented below.  The proforma results include estimates and assumptions, which our management believesare reasonable.  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 thedate indicated, or which may result in the future.

 
| ** **       | ** ** | **Nine Months Ended November 29, 2007 (1)** | ** ** |
|------------------|------------|---------------------------------------------------------------------------|------------|
| ** **       | ** ** | **Actual**                                                                | ** ** | **Pro Forma** | ** ** |
| ** **       | ** ** | **(Restated)**                                                            | ** ** | **(Restated)** | ** ** |
| ** **       | ** ** | **(in  thousands)**                                                       | ** ** |
| Net sales        |       | $                                                                         | 330,447    |   | $ | 333,157 |   |
| Operating income |       | $                                                                         | 15,495     |   | $ | 16,081 |   |
| Net income       |       | $                                                                         | 1,044      |   | $ | 1,605 |   |

 

----

(1) Pro forma operating results include theoperating results for CityForest for the nine months ended November 29,2007.   The actual operating resultsinclude the operating results for CityForest for the period from theacquisition date (March 21, 2007) to November 29, 2007.

 

**Results of Operations for the Three Months Ended November 27, 2008(the Fiscal 2009 Three-Month Period) compared to the Three Months Ended November 29,2007 (the Fiscal 2008 Three-Month Period) and the Nine Months Ended November**

 

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**27, 2008 (the Fiscal 2009 Nine-Month Period) compared to the NineMonths ended November 29, 2007 (the Fiscal 2008 Nine-Month Period)**

 

**Net sales** for the fiscal 2009 three-monthperiod increased $30.8 million, or 27.5%, to****$143.0million from $112.2 million for the comparable period in the prior year. Netsales for the fiscal 2009 nine-month period increased $60.1 million, or 18.2%,to $390.6 million from $330.5 million for the comparable period in the prioryear.  On a company-wide basis, tons soldincreased for the fiscal 2009 three-month period and the fiscal 2009 nine-monthperiod compared to the comparable periods of fiscal 2008.  For the fiscal 2009 three-month period, wesold 91,931 tons of tissue hard rolls, machine-glazed paper hard rolls andconverted paper products, an increase of 12,389 tons, or 15.6%, compared to thefiscal 2008 three-month period.  For thefiscal 2009 nine-month period, we sold 256,416 tons of tissue hard rolls,machine-glazed paper hard rolls and converted paper products, an increase of18,613 tons, or 7.8%, compared to the fiscal 2008 nine-month period.  Of these increases, $25.2 million of net salesand 14,437 tons sold for the three-month period and $38.4 million of net salesand 22,378 tons sold for the nine-month period related to APF.  Net selling price per ton increased from$1,411 and $1,390 for the fiscal 2008 three-month and nine-month periods to$1,541 and $1,514 for the fiscal 2009 three-month and nine-month periods.

 

Net sales for our tissue segment for the fiscal 2009 three-month periodwere $111.1 million, an increase of $27.1 million, or 32.2%, from thecomparable period in the****prioryear.  Net sales for our tissue segment forthe fiscal 2009 nine-month period were $300.4 million, an increase of $50.9million, or 20.4%, from the comparable period in the prior year.  These increases are the result of the APFAcquisition, supporting an increase in tonnage sold in our converting business,and an increase in net selling price per ton over the comparable periods in theprior year.

 

Net sales for our machine-glazed segment for the 2009 three-monthperiod were****$30.5 million, an increase of$2.3 million, or 8.3%,****from thecomparable period in the prior year.  Netsales for our machine-glazed segment for the 2009 nine-month period were $87.9million, an increase of $6.9 million, or 8.5%, from the comparable period inthe prior year.  These increases aredriven primarily by an increase in tonnage sold and an increase in net sellingprice per ton over the comparable periods in the prior year.

 

Net sales for our foam segment for the 2009 three-month and nine-monthperiods were $1.4 million and $2.3 million, respectively.  We started reporting with respect to the foamsegment following the APF Acquisition.

 

**Gross profit** for the fiscal 2009 three-monthperiod increased to $16.1 million from $11.7 million, an increase of $4.4million, or 37.4%, from the comparable period in the prior****year. As a percentage of net sales, grossprofit increased to 11.3% in the fiscal 2009 three-month period from 10.4% inthe fiscal 2008 three-month period. Gross profit for the fiscal 2009 nine-month period increased to $38.9million from $30.5 million, an increase of $8.4 million, or 27.6%, from thecomparable period in the prior year.

 

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As a percentage of net sales, gross profit increased to 10.0% in thefiscal 2009 nine-month period from 9.2% in the fiscal 2008 nine-month period. ** **The increase in grossprofit as a percentage of net sales in the fiscal 2009 three-month period isthe result of an increase in net selling price per ton, which more than offsetincreased fiber costs per ton over the comparable period in the prioryear.  The increase in gross profit as apercentage of net sales in the fiscal 2009 nine-month period is the result ofan increase in net selling price per ton, which more than offset increases infiber and energy costs per ton over the comparable period in the prior year.

 

Gross profit for our tissue segment for the fiscal 2009 three-monthperiod was $12.7 million, an increase of $2.8 million, or 28.2%, from thecomparable period in the prior year. Gross profit for our tissue segment for the fiscal 2009 nine-monthperiod was $32.3 million, an increase of $6.6 million, or 25.8%, from thecomparable period in the prior year.

 

Gross profit for our machine-glazed segment for the fiscal 2009three-month period was $3.3 million, an increase of $1.5 million, or 84.1%,from the comparable period in the prior year. Gross profit for our machine-glazed segment for the fiscal 2009nine-month period was $6.3 million, an increase of $1.5 million or 32.3% fromthe comparable period in the prior year.

 

Gross profit for our foam segment for the fiscal 2009 three-month andnine-month periods was $.1 million and $.3 million, respectively.

 

As a percentage of net sales, gross profit for the tissue segmentdecreased to 11.5% in the fiscal 2009 three-month period and increased to 10.8%in the fiscal 2009 nine-month period from****11.8% in thefiscal 2008 three-month period and 10.3% in the fiscal 2008 nine-month period**.**  As a percentage ofnet sales, gross profit for the machine-glazed segment increased to 10.8% inthe fiscal 2009 three-month period and 7.2% in the fiscal 2009 nine-monthperiod from 6.4% in the fiscal 2008 three-month period and 5.9% in the fiscal2008 nine-month period.  As a percentageof net sales, gross profit for the foam segment for the three-month andnine-month periods was 5.4% and 11.2%, respectively.

 

**Selling, general and administrative expenses**inthe fiscal 2009 three-month period increased $.4 million, or 8.1%, to $5.2million from $4.8 million in the fiscal 2008 three-month period.  Selling, general and administrative expensesin the fiscal 2009 nine-month period increased $.5 million, or 3.4%, to $14.3million from $13.8 million in the fiscal 2008 nine-month period.  As a percentage of net sales, selling,general and administrative expenses decreased to****3.7%in the fiscal 2009 three-month period and in the fiscal 2009 nine-month periodfrom 4.3% and 4.2%, respectively, for the comparable periods in the prioryear.  Included in the fiscal 2008three-month and nine-month periods are additional costs incurred in connectionwith being compliant with Sarbanes Oxley as this was the first year we had tomeet such requirements.

 

**Terminated acquisition-related transaction costs**forthe fiscal 2009 nine-month period of $.1 million relate to costs incurred inconnection with acquisitions that did not transpire.

 

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**Stock compensation expense**in the fiscal 2009three-month and nine-month periods of $.2 million and $.7 million,respectively, and fiscal 2008 three-month and nine-month periods of $.7 and$1.1 million, respectively relates to the accounting for restricted stock andstock option grants.

 

**Amortization expense**in the fiscal 2009three-month and nine-month periods of $1.3 million and $2.1 million,respectively, relates to amortization of the intangible assets recorded inconnection with the APF Acquisition.

 

**Interest expense, net**in the fiscal 2009three-month period was $6.9 million compared to $4.8 million in the fiscal 2008three-month period.  Interest expense,net in the fiscal 2009 nine-month period was $18.0 million compared to $15.0million in the fiscal 2008 nine-month period. These increases are due to the additional debt incurred in connectionwith the APF Acquisition.

 

**Foreign currency (gain) loss**in the fiscal2009 three-month period and nine-month period was a gain of $.2 millioncompared to a gain of less than $.1 million and a loss of $.1 million,respectively, for the comparable periods in the prior year.  The fluctuations relate to the change in theCanadian currency period over period.

 

**Income tax expense**for the fiscal 2009three-month period was $.9 million or an effective tax rate of 32.9% comparedto income tax benefit of $.2 million or an effective tax rate of 14.1% for thefiscal 2008 three-month period.  The incometax expense for the fiscal year 2009 nine-month period was $1.3 million or aneffective tax rate of 32.9% compared to income tax benefit of $.4 million or aneffective tax rate of 70.6% for the fiscal year 2008 nine-month period.  Included in the income tax benefit for thethree-month and nine-month period ended November 29, 2007 is $.7 millionof benefit primarily related to the different book and tax treatment of deductionsrelated to transaction costs.  Thisbenefit was recorded in the third quarter of fiscal 2008 upon completion of theCompany’s 2007 tax return as the impact is considered discrete to thatquarter.  Also, included in the incometax benefit for the fiscal 2008 nine-month period is approximately $90,000related to additional Canadian income taxes paid upon completion of our fiscalyear 2007 tax returns, which was recorded in the second quarter upon completionof those returns.

 

**Net income**for the fiscal 2009 three-monthperiod was $1.8 million compared to net income of $1.6 million for thecomparable period in the prior year. Net income for the fiscal 2009 nine-monthperiod was $2.6 million compared to a net income of $1.0 million for thecomparable period in the prior year.

 

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**FINANCIAL CONDITION**

 

**Liquidity and Capital Resources**

 

**Net cash provided by operations** was $9.6million for the fiscal 2009 nine-month period compared to $14.5 million for thefiscal 2008 nine-month period. ** **Non-cash items, consisting ofstock-based compensation, deferred income taxes, depreciation and amortizationfor the fiscal 2009 nine-month period totaled $22.9 million compared to $16.2million for the 2008 fiscal nine-month period. Cash flows used by changes in working capital totaled $14.0 million forthe fiscal 2009 nine-month period compared to $2.7 million in the fiscal 2008nine-month period. ** **With respect to the changes inaccounts receivable and inventory, cash used by these items was $14.9 millionfor the fiscal 2009 nine-month period compared to $3.5 million for thecomparable period in the prior fiscal year. This increase is reflective of a change in payment terms with a keycustomer, timing of customer payments and an increase in sales.  Cash****provided bychanges in prepaid expenses and other current assets was $.6 million for thefiscal 2009 nine-month period compared to cash used of $2.5 million for thecomparable period in the prior fiscal year. Cash used by changes in accounts payable, accrued expenses and accruedinterest for the fiscal 2009 nine-month period was $1.5 million compared tocash provided of $2.9 million for the comparable period in the prior year.

 

**Net cash used in investing activities** for thefiscal 2009 nine-month period was $73.9 million compared to net cash used ininvesting activities of $54.6 million for the fiscal 2008 nine-monthperiod.  The fiscal 2009 nine-monthperiod includes $64.1 million of cash paid for the APF Acquisition.  The fiscal 2008 nine-month period includes$43.6 million of cash paid for the CityForest Acquisition, net of cashreceived.  The remaining change relatesto the level of capital spending period over period.

 

**Net cash provided by financing activities**forthe fiscal 2009 nine-month period was $63.3 million, primarily related tofinancing obtained in connection with the APF Acquisition and $7.0 million ofcash paid by the company in connection with the earnout payment related to themerger.  Net cash provided by financingactivities for the fiscal 2008 nine-month period was $25.1 million related tofinancing obtained in connection with the City Forest Acquisition.

 

**Earnout Payment**

 

On August 29, 2008, $15.0 million in contingent consideration inconnection with the Agreement and Plan of Merger that the Parent consummated onJune 12, 2006 with Cellu Parent, a corporation organized and controlled byWeston Presidio, and Cellu Acquisition Corporation (“Merger Sub”), a whollyowned subsidiary of Cellu Parent and a newly formed corporation indirectly controlledby Weston Presidio was paid out due to the achievement of certain financialtargets for fiscal year 2008.  Of the$15.0 million, $1.3 million was issued in stock of Cellu Parent, which wasaccounted for by us as a capital contribution from our Parent.  The remaining $13.7 million was paid out incash and funded by an equity contribution of $6.7 million by Weston Presidio toCellu Parent and $7.0 million by us, which was funded through borrowings on theour revolving line of 

 

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credit.  We anticipate paying outthe remaining $20.0 million as follows: $15.0 million for fiscal year 2009 and the remaining $5.0 million forfiscal year 2010.

 

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

 

In March 2004, we completed a private offering of the OriginalNotes pursuant to and governed by the Cellu Tissue Indenture among us, thesubsidiary guarantors party thereto and the Trustee.  In connection with the CityForestAcquisition, we entered into the Note Purchase Agreement with the Purchaser,dated March 21, 2007, pursuant to which we issued and sold the FirstAdditional 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 First Additional Notes wereissued pursuant to and are governed by the Cellu Tissue Indenture.

 

In connection with the APF Acquisition, we entered into the Note PurchaseAgreements  with each of the Purchasers,dated July 2, 2008, pursuant to which we issued and sold the SecondAdditional Notes to the Purchasers for the purchase price of $36,900,000 whichis equal to 92.25% of the aggregate principal amount of the Second AdditionalNotes.  The Second Additional Notes wereissued pursuant to and are governed by the Cellu Tissue Indenture.

 

The Notes mature on March 15, 2010 and require semi-annualinterest payments on March 15 and September 15.  The Notes are collateralized by a seniorsecured interest in substantially all of our assets.  The Cellu Tissue Indenture contains certaincovenants, including limitations on certain restricted payments, the incurrenceof additional indebtedness and the sale of certain assets.  The Cellu Tissue Indenture has been amended bytwo subsequent amendments pursuant to which CityForest, Cellu Happauge andCellu Thomaston became parties to the Cellu Tissue Indenture as subsidiaryguarantors (collectively, the “Additional Guarantors”).  As subsidiary guarantors, the AdditionalGuarantors, on a joint and several basis, with all the existing subsidiaryguarantors, fully, unconditionally and irrevocably guarantee the obligations ofCellu Tissue under the Cellu Tissue Indenture and Notes.  The Notes are unconditionally guaranteed byall of our subsidiaries.

 

***Seller Note Payable***

 

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

 

***Credit Agreement***

 

We entered into the Credit Agreement, among Cellu Tissue, Interlake,our Parent, the other loan guarantors party thereto, the U.S. AdministrativeAgent, the  Canadian Administrative Agentand the other lenders party thereto.  TheCredit Agreement provides for a $35.0 million working capital facility, whichwas subseqeuently increased 

 

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to $60.0 million (see discussion following), including a letter ofcredit sub-facility and swing-line loan sub-facility. The Credit Agreementprovides 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, which was subsequentlyincreased to $57.0 million (see discussion following), 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 CityForest Acquisition andborrowings of $12.1 million were made to finance a portion of the APFAcquisition.  As of November 27,2008, there was $28.5 million of borrowings outstanding under the workingcapital facility and excess availability was $27.6 million.

 

We haveentered into the First Amendment, to the Credit Agreement dated June 12,2006 (as amended by the First Amendment, the “Amended Credit Agreement”) amongCellu Tissue, Interlake, certain subsidiaries of Cellu Tissue, the Parent, theU.S. Administrative Agent and the Canadian Administrative Agent.

 

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

 

We have entered into the Second Amendment, to the Credit Agreementdated June 12, 2006 (as amended by the First Amendment and the SecondAmendment, “Credit Agreement, as Amended”), among Cellu Tissue, Interlake,certain****subsidiaries of Cellu Tissue, theParent, the U.S. Administrative Agent and the Canadian Administrative Agent.

 

The Second Amendment (1) increases the working capital facilityfrom $40.0 million to $60.0 million, (2) permits the issuance and sale byCellu Tissue of the Second Additional Notes, (3) provides for theconsummation of the APF Acquisition and (4) permits the issuance of theSeller Note.  In connection with theSecond Amendment, Cellu Hauppauge and Cellu Thomaston became guarantors of theobligations of the borrowers under the Credit Agreement, as Amended.

 

On September 29, 2008, we entered into the Third Amendment, to theCredit  Agreement, dated as of June 12,2006 (as amended by the First Amendment and the Second Amendment and as furtheramended, supplemented or otherwise modified from time to time, by and amongParent, Cellu Tissue,  Interlake, theLoan Guarantors party thereto, the lenders party thereto,  the US Administrative Agent and the CanadianAdministrative 

 

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Agent.  This Amendment increases the amount ofthe Canadian Commitments by $2.0 million and reduces the amount of the USCommitments by the same amount.

 

***CityForest Bond Documents***

 

CityForest isparty to a Loan Agreement with the City of Ladysmith, Wisconsin, asIssuer.  Pursuant to the Loan Agreement,the Issuer loaned the proceeds of the Issuer’s Bonds to CityForest to financethe 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 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 BondsTrustee is permitted to draw upon the Associated Bank Letter of Credit to payprincipal and interest due on the Bonds, and to provide liquidity to purchaseBonds put to CityForest by bondholders and not remarketed; and CityForest isobligated under the Reimbursement Agreement to reimburse Associated Bank forany such draws. CityForest is also obligated to pay a fee in respect of theaggregate amount available to be drawn under the Associated Bank Letter ofCredit at a rate per annum initially equal to 1.25%, subject to adjustment on aquarterly basis based on CityForest’s leverage. The expiration date of the Associated Bank Letter of Credit is February 15,2011.

 

Amountsborrowed by CityForest under the Associated Bank Revolving Credit Facility bearinterest at a rate per annum equal to the LIBOR Rate (as defined in theReimbursement Agreement), plus an applicable margin. The applicable marginpercentage initially is 1.75%, subject to adjustment on a quarterly basis basedupon CityForest’s leverage.  During thecontinuance of an event of default, the outstanding principal balance bearsinterest at a rate per annum equal to the then applicable interest rate plus2.00%.  CityForest is also obligated topay a commitment fee in respect of any unused commitment under the AssociatedBank Revolving Credit Facility in an amount equal to 0.50% per annum.  In addition, subject to certain exceptions,if CityForest terminates the Associated Bank Revolving Credit Facility prior toFebruary 15, 2009, CityForest is obligated to pay to Associated Bank a feeequal to 1.00% of the commitment then being terminated. The maturity date ofthe Associated Bank Revolving Credit Facility is February 15, 2011.

 

TheReimbursement Agreement requires scheduled semi-annual payments of principal ofthe Bonds equal to approximately 2.00% of the principal amount outstanding asof the date of the Acquisition, with the balance payable at maturity of theBonds on March 1, 2028. The Reimbursement Agreement also contains a numberof other provisions regarding reserve funds and other mandatory and optionalrepayments in connection with the Bonds. In addition, the Reimbursement Agreement provides that in certaincircumstances where we incur indebtedness in excess of amounts currentlypermitted 

 

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under theindenture or refinances the indebtedness issued under the CityForest Indenture,Associated Bank may require CityForest to repay all of its obligations toAssociated Bank under the Reimbursement Agreement and either to cause the Bondsto be redeemed or to replace the Associated Bank Letter of Credit with aSubstitute Credit Facility, as such term is defined in the CityForestIndenture.

 

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

 

We haveguaranteed all of the obligations of CityForest under the ReimbursementAgreement, pursuant to the Cellu Tissue Guaranty executed by us in favor ofAssociated Bank. In addition, the obligations of CityForest under theReimbursement Agreement are secured by first-priority liens in favor ofAssociated Bank in all of CityForest’s assets. The U.S. Administrative Agent, the Canadian Administrative Agent, AssociatedBank and CityForest have entered into an Intercreditor Agreement, dated March 21,2007, which sets forth the respective rights and priorities of Associated Bank,on the one hand, and the U.S. Administrative Agent and the CanadianAdministrative Agent, on the other hand, as to the collateral of CityForestsecuring the Reimbursement Agreement and the Amended Credit Agreement.

 

In addition, we have entered into a ThirdAmendment to the Credit Agreement which changes the borrowings under the CreditAgreement so that $55.0 million is available, in U.S. dollars, to the U.S.Borrower and $5.0 million is available, in U.S. or Canadian dollars, to theCanadian Borrower.

 

**Cash**as of November 27, 2008 decreased to$.5 million from $.9 million as of the end of fiscal year 2008.

 

**Receivables, net**as of November 27, 2008increased to $61.9 million from $44.5 million as of the end of fiscal year2008.  Included in the $61.9 million is$10.7 million of receivables related to APF. Without the effect of the acquisition, receivables increased $6.7million from the end of fiscal year 2008 due primarily to a change in paymentterms for a significant customer and timing of customer payments.

 

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**Inventory**as of November 27, 2008increased to $44.9 million from $34.0 million as of the end of fiscal year2008.  Included in the $44.9 million is$9.1 million of inventories related to APF.  Without the effect of the acquisition,inventories increased $1.8 million from the end of fiscal year 2008, primarilydue to a build in coal inventories at our Menominee mill.

 

**Property, plant and equipment, net**as of November 27,2008 decreased to $302.1 million from $310.5 million as of the end of fiscalyear 2008.  Included in the $302.1million of property, plant and equipment, net is $6.9 million related toAPF.  Without the effect of theacquisition, property, plant and equipment decreased $15.3 million from the endof fiscal year 2008.  This decreaserelates to depreciation expense for the period offset partially by capitalexpenditures for the period.

 

**Goodwill**as of November 27, 2008increased to $35.9 million from $11.3 million as of the end of fiscal year 2008due to the acquisition of APF.

 

**Other intangibles, net**as of November 27,2008 increased to $37.5 million from $9.4 million as of the end of fiscal year2008.  The additions to other intangiblesrelate to the acquisition of APF, reduced by amortization expense from the dateof acquisition through November 27, 2008.

 

**Other assets**as of November 27, 2008increased to $2.2 million from $1.5 million as of the end of fiscal year 2008due to debt and bond issuance costs capitalized and included in other assetsresulting from the financing in connection with the APF Acquisition.

 

**Bank overdrafts**as of November 27, 2008were $1.3 million compared to zero as of the end of fiscal year 2008.  As of the end of the current quarter checksoutstanding exceeded cash balances in our lockbox account by this amount.

 

**Revolving line of credit borrowings**as of November 27,2008 increased to $28.5 million from $9.8 million as of the end of fiscal year2008 primarily due to additional borrowings in connection with the financing ofthe APF Acquisition, the semi-annual interest payment on the Notes and theearnout payment.

 

**Accounts payable**as of November 27, 2008decreased to $22.2 million from $24.1 million as of the end of fiscal year2008.  Included in the $22.2 million ofaccounts payable is $2.7 million related to APF.  Without the effect of the acquisition,accounts payable decreased $4.6 million from the end of fiscal year 2008 due totiming of payments.

 

**Accrued expenses**as of November 27, 2008increased to $28.0 million from $19.1 million as of the end of fiscal year2008.  Included in the $28.0 million ofaccrued expenses is $2.9 million related to APF.  Without the effect of the acquisition,accrued expenses increased $6.0 million primarily due to the timing lag betweenreceipt of goods and receipt of invoices at quarter-end.

 

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**Accrued interest**as of November 27, 2008decreased to $4.7 million from $8.3 million as of the end of fiscal year2008.  The decrease is due to the timingof our semi-annual interest payments.

 

**Other current liabilities**as of November 27,2008 increased to $16.3 million from $15.0 million as of the end of fiscal year2008.  Included in the $16.3 million is aliability of $1.3 million related to the fair value of our cash flow hedginginstruments.

 

**Long-term debt**as of November 27, 2008increased to $242.5 million from $198.8 million as of the end of fiscal year2008 due to debt incurred to finance the APF Acquisition.

 

**Other liabilities**as of November 27, 2008decreased to $5.1 million from $20.1 million as of the end of fiscal year 2008due to the earnout payment of $15.0 million in August 2008.

 

**Capital in excess of par value**as of November 27,2008 increased to $70.7 million from $47.0 million as of the end of fiscal year2008 due to an equity investment by Parent to fund a portion of the APFAcquisition and the stock portion of the earnout payment in August 2008and the equity investment by Weston Presidio used to fund a part of the cashportion of the earnout payment in August 2008.

 

Critical Accounting Policies

 

Our critical accounting policies are discussed in Management’sDiscussion and Analysis of Financial Condition and Results of Operations in ourAnnual Report on Form 10-K for fiscal year 2008.  The preparation of our financial statementsrequires us to make estimates that affect the reported amounts of assets,liabilities, revenue and expenses and related disclosures of contingent assetsand liabilities.  We base our accountingestimates on historical experience and other factors that we believe to bereasonable under the circumstances. However, actual results may vary from these estimates under differentassumptions or conditions.

 

Derivatives and Hedging

 

We use derivative financial instruments to offset a substantial portionof its exposure to market risk arising from changes in the price of naturalgas. Hedging of this risk is accomplished by entering into forward swapcontracts, certain of which are designated as hedges of specific quantities ofnatural gas expected to be purchased in future months.  These contracts are held for purposes otherthan trading and are designated as cash flow hedges.  We measure fair value of its derivativefinancial instruments in accordance with SFAS 157.  SFAS 157 defined fair value as the price thatwould be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants. SFAS 157 establishes a fairvalue hierarchy for valuation inputs that gives the highest priority to quotedprices in active markets for identical assets or liabilities and the lowestpriority to unobservable inputs.  Thefair value hierarchy is as follows: level 1-inputs utilize quoted

 

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prices (unadjusted) inactive markets for identical assets or liabilities that we have the ability toaccess; level 2-inputs utilize data points that are observable such as quotedprices, interest rate and yield curves; level 3-inputs are unobservable datapoints for the asset or liability, and include situations where there islittle, if any, market activity for the asset or liability.

 

Our derivative contracts, naturalgas forward contracts, are valued using industry-standard models that useobservable market inputs (forward market prices for natural gas) as theirbasis.  We classify these instrumentswithin level 2 of the valuation hierarchy. SFAS 157 requires that for level 2 and 3 of the fair value hierarchy,where appropriate, valuations are adjusted for various factors such asliquidity, bid/offer spreads and credit considerations (non performancerisk).  The fair value of these cash flowhedging instruments was a liability of $1.3 million, which is included in othercurrent liabilities, and an asset of $.2 million, which is included in othercurrent assets, as of November 27, 2008 and February 29, 2008,respectively.  Prior to the three monthsended November 27, 2008 these contracts have not been designated as hedgesand accordingly, for the nine months ended November 27, 2008 and for thethree and nine months ended November 29, 2007, $.9 million loss, $.5million gain and $.2 million loss, respectively have been recorded toearnings.  Hedging activities transactedin the three months ended November 27, 2008 have been designated as hedgesand during the next 12 months, $.5 million of the $1.3 million remains to be reclassifiedto earnings consistent with the underlying hedging transactions.

 

Recent AccountingPronouncements

 

In September 2006, theFASB issued SFAS 157.  We were requiredto adopt the provisions of SFAS 157 effective March 1, 2008.  SFAS 157 provides a common fair value hierarchyfor 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.  SFAS 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 SFAS 157 did not have amaterial impact on our results of operations and financial position.  In February 2008, FSP No. 157-1which removed leasing transactions accounted for under Statement 13 and relatedguidance from the scope of SFAS 157, and FSP No. 157-2, which deferred theeffective date of SFAS 157 for all non-financial assets and liabilities, exceptthose that are recognized or disclosed in the financial statements at fairvalue at least annually, to fiscal years beginning after November 15,2008.  We implemented SFAS 157 for financial assets and liabilitiesat the beginning of its fiscal year 2009 and elected to defer the adoption ofSFAS 157 for non-financial assets and liabilities until the beginning of itsfiscal year 2010 as allowed under FSP 157-2.  The implementation ofSFAS 157 for financial assets and liabilities did not have a material impact onour consolidated financial position and results of operations.   We are still assessing the impact thatadopting SFAS 157 for non-financial assets and liabilities will have on ourconsolidated financial position and results of operations.  The majorcategories of non-financial assets and liabilities that are measured at fairvalue, for which we have not yet

 

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applied the provisions ofSFAS 157, are as follows: reporting units measured at fair value in the firststep of the our goodwill impairment testing and indefinite-lived intangibleassets measured at fair value for impairment testing.

 

In February 2007, theFASB issued SFAS 159.  This Standardpermits entities to choose to measure many financial instruments and certainother items at fair value that are not currently required to be measured atfair value.  SFAS 159 was effective as ofthe beginning of fiscal 2009.  We evaluatedour existing eligible financial assets and liabilities and elected not to adoptthe fair value option for any eligible items for the three or nine months endedNovember 27, 2008.

 

In December 2007, theFASB issued SFAS 141(R), and SFAS 160. These new standards will significantly change the financial accountingand reporting of business combination transactions and noncontrolling (orminority) interests in consolidated financial statements.  SFAS 141 (R) is required to be adoptedconcurrently with SFAS 160 and is effective for business combinationtransactions for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15,2008.  Early adoption is prohibited.  We are currently assessing the impact thatSFAS 141 (R) and SFAS 160 will have on our results of operations andfinancial position.

 

In March 2008, the FASBissued SFAS 161.  SFAS 161 requiresentities to provide enhanced disclosures about derivative instruments andhedging activities.  SFAS 161 iseffective for fiscal years and interim periods beginning on or afterNovember 15, 2008.  We are currentlyassessing the impact that SFAS 161 will have on our results of operations andfinancial position.

 

In April 2008, the FASBissued FSP No. FAS 142-3.  This FSPamends the factors that should be considered in developing renewal or extensionassumptions used to determine the useful life of a recognized intangible assetunder SFAS 142.  The objective of thisFSP is to improve the consistency between the useful life of a recognizedintangible asset under SFAS 142 and the period of expected cash flows used tomeasure the fair value of the asset under SFAS 141R, and other generallyaccepted accounting principles.  This FSPapplies prospectively to all intangible assets acquired after the effectivedate, which is fiscal years beginning after December 15, 2008, whetheracquired in a business combination or otherwise.  Early adoption is prohibited.  We are evaluating this guidance but do notexpect it to have a significant impact on our financial position or results ofoperations.

 

In May 2008, the FASBissued SFAS No. 162.  This standardis intended to improve financial reporting by identifying a consistentframework, or hierarchy, for selecting accounting principles to be used inpreparing financial statements that are presented in conformity with generallyaccepted accounting principles in the United States for non-governmentalentities.  SFAS No. 162 is effective60 days following approval by the SEC of the Public Company AccountingOversight Board’s amendments to AU Section 411, “The Meaning of PresentFairly in Conformity with Generally Accepted Accounting

 

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Principles”.  We do not expect SFAS 162 to have a materialimpact on the preparation of our consolidated financial statements.

 

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

 

In March 2004, we completeda private offering of the Notes.  Inconnection with the acquisition of CityForest in March 2007, we issued and soldapproximately $20.0 million of First Additional Notes and assumed $18.4 millionof additional debt.  In connection withthe APF Acquisition, we issued and sold approximately $40.0 million of SecondAdditional Notes. Our Notes mature on March 15, 2010.  We also have the ability to borrow under ourrevolving line of credit, up to $60.0 million, of which as of November 27, 2008we have outstanding borrowings of $28.5 million.  Borrowings of $12.1 million were made tofinance a portion of the APF Acquisition. As a result, we are highly leveraged.   The interest on our revolving line of credit fluctuates based on primeplus .75% or LIBOR plus 2.00% depending on whether our borrowing is based onprime or LIBOR rates.

 

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.

 

We are also subject tocommodity price risk associated with fluctuations in energy and pulpcosts.  We currently use derivativefinancial instruments to offset a portion of our exposure to market riskarising from changes in the price of natural gas.  We also continue to take advantage of spotprices on pulps to minimize market risk arising from changes in pulp costs.

 

**Item 4.  Controls and Procedures**

 

**Disclosure Controls andProcedures**

 

We maintain disclosure controlsand procedures designed to ensure that information required to be disclosed inthe reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSEC’s rules and forms. Disclosure controls and procedures, as defined in Rules13a–15(e) and 15d–15(e) under the Exchange Act, include controls and proceduresdesigned to ensure that information required to be disclosed in the reports wefile or submit under the Exchange Act is accumulated and communicated to ourmanagement, including the Chief Executive Officer and the Chief FinancialOfficer, as appropriate, to allow timely decisions regarding requireddisclosure. Any system of controls, however well designed and operated, can provideonly reasonable, and not absolute, assurance that the objectives of the systemare met. 

 

As required by SEC rules, wehave evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered by this QuarterlyReport on Form 10-Q. This evaluation was carried out under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer. Based on this evaluation, our management, includingour Chief Executive Officer and Chief Financial Officer,

 

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concluded that, in light ofthe material weakness in our internal control over financial reportingdescribed below, as of November 27, 2008, our disclosure controls andprocedures were not effective.

 

As a result of this materialweakness, management performed additional procedures to ensure that ourcondensed consolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States of America (US GAAP).  Accordingly, we believe that the financialstatements for the periods covered by and included in this Quarterly Report onForm 10-Q fairly present in all material respects our financial condition,results of operations and cash flows. 

 

**Material Weakness**

 

A material weakness is adeficiency, or combination of deficiencies, in internal control over financialreporting, such that there is a reasonable possibility that a materialmisstatement of the Company’s annual or interim financial statements will notbe prevented or detected on a timely basis. 

 

In connection with therestatement of the Company’s financials statements as of February 29, 2008, weidentified the following material weakness in our internal control overfinancial reporting, which continued to exist as of November 27, 2008: 

 

We did not maintaineffective internal control over financial reporting with respect to theapplication of US GAAP as it relates to complex purchase accounting issues andaccounting for derivatives.  The Companylacks sufficient US GAAP expertise to properly assess and record complexaccounting matters, specifically (i) deferred income taxes associated withpurchase accounting; (ii) shipping and handling fees and costs; (iii) foreignexchange gains and losses; and (iv) derivatives.  See Note 2 Restatement of Financial Statementsin the consolidated financial statements.  

 

**Plan of Remediation forIdentified Material Weakness**

 

The material weakness hasnot been fully remediated. Accordingly, management has determined that thesecontrol deficiencies continue to constitute a material weakness at November 27,2008. 

 

Management has prepared anaction plan for all identified deficiencies as of February 29, 2008. The statusof this plan will be monitored by management and reviewed by the AuditCommittee periodically. 

 

With respect to theidentified material weakness, we will review and assess our internal controls,processes and procedures to timely and properly monitor, evaluate and recordcomplex tax and accounting matters in accordance with US GAAP. We intend toreview the responsibilities within our accounting and finance departments andmay hire additional finance and accounting resources to focus on research andthe application of US GAAP.  In addition,we may supplement our internal resources with assistance from outside advisorsfor the evaluation of unusual and non-routine transactions. 

 

**Changes in Internal Control OverFinancial Reporting**

 

There were no changes to ourinternal control over financial reporting during the quarter ended November 27,2008 that materially affected, or are reasonably likely to materially affect,our internal control over financial reporting

 

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PART II – OTHERINFORMATION

 

Item 1A.  Risk Factors

 

***If we fail to establish and maintaineffective internal control over financial reporting, we may have materialmisstatements in our financial statements and we may not be able to report ourfinancial results in a timely manner.***

 

In conjunction with the restatement of certain of our financialstatements (see Note 2) and under the authorization and direction of our AuditCommittee, management has reassessed the effectiveness of the Company’sinternal control over financial reporting and determined that a materialweakness exists relating to the Company’s GAAP expertise in properly assessingand recording complex accounting matters, specifically (i) deferred incometaxes associated with purchase accounting; (ii) shipping and handling fees andcosts; (iii) foreign exchange gains and losses; and (iv) derivatives.

 

This material weakness inour internal control over financial reporting led to the restatement of ourconsolidated financial statements for the fiscal years ended February 29, 2008 andFebruary 28, 2007 and interim financial statements for the periodsended August 28, 2008 and May 29, 2008. We cannot be certain that any remedialmeasures we take will ensure that we implement and maintain effective internalcontrol over financial reporting in the future. Any failure to implement new orimproved controls or difficulties encountered in their implementation couldcause us to fail to meet our reporting obligations. In particular, if thematerial weakness described above is not remediated, it could result in amisstatement of our accounts and disclosures that could result in a materialmisstatement to our annual or interim consolidated financial statements infuture periods that would not be prevented or detected. For further discussionof our disclosure controls and procedures and internal control over financialreporting, see “Item 4. Controls and Procedures.”

 

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

 
|   | Cellu Tissue  Holdings, Inc. |
|--------|------------------------------|
|   |                         |   |
|   |                         |   |
| Date:  | January 30,  2009            |   |   | /s/ Russell  C. Taylor |
|   |                         | Mr. Russell  C. Taylor |
|   |                         | President  and Chief Executive Officer |
|   |                         |   |
| Date:  | January 30,  2009            |   |   | /s/ David J.  Morris |
|   |                         | Mr. David J.  Morris |
|   |                         | Senior Vice  President, Finance and Chief |
|   |                         | Financial  Officer |
|        |                              |  |  |  |  |  |

 

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