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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

**FORM 10-Q/A**

 

**AmendmentNo. 1**

 

**(Mark One)**

 
|                                                                                                                                               | x | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------|---|----------------------------------------------------------------------------------------------------------|
| **For the Quarterly Period Ended May 29, 2008**                                                                                               |
| **or**                                                                                                                                             |
|                                                                                                                                               | o | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| **For the transition period from          to         .** |

 

**Commission file number 333-118829**

 

**CelluTissue Holdings, Inc.**

(Exact name of registrant as specified in itscharter)

 

| **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 sincelast 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 in Rule 12b-2 of theExchange Act (Check One):.

 
|   |   | Large  accelerated filer o |   | Accelerated  filer o |   | Non-accelerated  filer x |   | Smaller  reporting company  o |
|--------|--------|----------------------------|--------|----------------------|--------|--------------------------|--------|------------------------------------|

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).  Yes oNox

 

The number of shares outstanding of each of the registrant’s classes ofcommon stock as of July 3, 2008:

 

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

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**Explanatory Note**

 

This Amendment No. 1 on Form 10-Q/A (this “Amendment”) amendsthe Quarterly Report of Cellu Tissue Holdings, Inc. (the “Company”) on Form 10-Qfor the quarterly period ended May 29, 2008, as filed with the Securitiesand Exchange Commission on July 11, 2008 (the “Original Filing”).  This Amendment is being filed for the purposeof restatement to correct errors in (i) accounting for deferred incometaxes in connection with purchase accounting applied in fiscal 2007, (ii)classification of borrowings and repayments on the revolving credit facility inthe statement of cash flows, and certain other adjustments that were initiallydeemed to be not material by management, including (a) classification ofshipping and 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 as described in Note 2 to the consolidated financial statements.Allapplicable amounts relating to this restatement have been reflected in theconsolidated financial statements and disclosed in the notes to theconsolidated financial statements in this amended Form 10-Q/A. Fordiscussion of the individual restatement adjustments, see Note 2 to theconsolidated financial statements. Additionally, see Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

 

 For the convenience of thereader, this Form 10-Q/A sets forth the first quarter 2008 Form 10-Qin its entirety. However, this Form 10-Q/A only amends and restatescertain information in Items 1, 2 and 4 of Part I, and Item 6****of Part II of the Original Filing, and no other itemsin the Original Filing are amended hereby. Except for the amended and restatedinformation described above, the foregoing items have not been updated toreflect events subsequent to July 11, 2008, the filing date of theOriginal Filing. Accordingly, this Form 10-Q/A should be read inconjunction with our filings made with the Securities and Exchange Commission(SEC) on and after the filing of the Original Filing. Pursuant to the rules ofthe SEC, Item 6 of Part II of the Original Filing has been amended tocontain currently-dated certifications from our chief executive officer andchief financial officer, as required by Section 302 of the Sarbanes-OxleyAct of 2002.

 

Except as expressly stated or where the context requires otherwise, theinformation in this amended Form 10-Q/A generally speaks as of July 11,2008, the date on which the Original Filing was filed with the SEC.

 

**Background**

 

On January 8, 2009, we announced that we were reviewing (i) accountingfor deferred income taxes in connection with purchase accounting in fiscal year2007 and other purchase accounting items from that fiscal year, (ii) classificationof shipping and handling fees and costs under EITF 00-10 and (iii) accountingtreatment of other selected accounts.  OnJanuary 20, 2009, our management and the audit committee of our Board ofDirectors have determined that our consolidated financial statements for fiscalyears 2007 and 2008 and the first two quarters of fiscal 2009 should no longerbe relied upon.  In addition to this Form 10-Q/A,we are amending our Annual Report on Form 10-K for fiscal 2008 and ourQuarterly Report on Form 10-Q for the second quarter of fiscal 2009 toreflect the restatements described above.

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CELLU TISSUE HOLDINGS, INC.

FORM 10-Q/A

QUARTER ENDED MAY 29, 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

 

**Item1.  Consolidated Financial Statements**

 

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

**CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)**

 
| ** **                                        | ** ** | **Three Months Ended** |       |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **May 29**                  | ** ** | **May 31** |   |
| ** **                                        | ** ** | **2008**                         | ** ** | **2007** |   |
| ** **                                        | ** ** | **(Restated)**                   | ** ** | **(Restated)** |   |
| ** **                                        | ** ** |                             |       |   |   |
| Net sales                                         |       | $114,527,561                     |       | $106,226,949 |   |
| Cost of goods sold                                |       | 102,739,657                      |       | 98,341,184 |   |
| Gross profit                                      |       | 11,787,904                       |       | 7,885,765 |   |
|                                              |       |                             |       |   |   |
| Selling, general and administrative  expenses     |       | 4,959,842                        |       | 4,482,737 |   |
| Terminated acquisition-related transaction  costs |       | 75,000                           |       | - |   |
| Stock and related compensation expense            |       | 218,506                          |       | 233,119 |   |
| Income from operations                            |       | 6,534,556                        |       | 3,169,909 |   |
|                                              |       |                             |       |   |   |
| Interest expense, net                             |       | 4,979,688                        |       | 5,019,094 |   |
| Foreign currency gain                             |       | (43,080                          | )          | (30,850 | ) |
| Other expense (income)                            |       | 29,508                           |       | (42,239 | ) |
| Income (loss) before income tax                   |       | 1,568,440                        |       | (1,776,096 | ) |
|                                              |       |                             |       |   |   |
| Income tax expense (benefit)                      |       | 575,970                          |       | (634,255 | ) |
| Net income (loss)                                 |       | $992,470                         |       | ($1,141,841 | ) |

 

See accompanying notes toconsolidated financial statements.

 

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

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                | ** ** | **May 29** | ** ** | **February 29** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------|------------|----------------------|------------|
| ** **                                                                                | ** ** | **2008**        | ** ** | **2008**             | ** ** |
| ** **                                                                                | ** ** | **(Unaudited)** | ** ** | ** **           | ** ** |
| ** **                                                                                | ** ** | **(Restated)**  | ** ** | **(Restated)**       | ** ** |
| **ASSETS**                                                                                |       |            |       |                 |       |
| CURRENT ASSETS:                                                                           |       |            |       |                 |       |
| Cash and cash equivalents                                                                 |       | $1,625,424      |       | $883,388             |       |
| Receivables, net                                                                          |       | 52,197,208      |       | 44,542,337           |       |
| Inventories                                                                               |       | 34,900,313      |       | 33,996,439           |       |
| Prepaid expenses and other current assets                                                 |       | 3,006,025       |       | 3,745,989            |       |
| Income tax receivable                                                                     |       | 142,966         |       | 177,281              |       |
| Deferred income taxes                                                                     |       | 6,216,017       |       | 7,157,191            |       |
| TOTAL CURRENT ASSETS                                                                      |       | 98,087,953      |       | 90,502,625           |       |
| PROPERTY, PLANT AND EQUIPMENT, NET                                                        |       | 306,936,967     |       | 310,488,081          |       |
| GOODWILL                                                                                  |       | 11,334,755      |       | 11,334,755           |       |
| TRADEMARKS                                                                                |       | 9,400,000       |       | 9,400,000            |       |
| OTHER ASSETS                                                                              |       | 1,515,762       |       | 1,491,218            |       |
| TOTAL ASSETS                                                                              |       | $427,275,437    |       | $423,216,679         |       |
|                                                                                      |       |            |       |                 |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                             |       |            |       |                 |       |
| CURRENT LIABILITIES:                                                                      |       |            |       |                 |       |
| Revolving line of credit                                                                  |       | $18,000,000     |       | $9,800,000           |       |
| Accounts payable                                                                          |       | 22,002,057      |       | 24,055,782           |       |
| Accrued expenses                                                                          |       | 21,536,099      |       | 19,085,912           |       |
| Accrued interest                                                                          |       | 3,765,379       |       | 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                                                                 |       | 81,063,535      |       | 76,955,609           |       |
| LONG-TERM DEBT, LESS CURRENT PORTION                                                      |       | 197,862,013     |       | 198,086,944          |       |
| DEFERRED INCOME TAXES                                                                     |       | 81,065,985      |       | 81,940,082           |       |
| OTHER LIABILITIES                                                                         |       | 20,136,068      |       | 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                                                            |       | 47,253,720      |       | 47,035,214           |       |
| Accumulated deficit                                                                       |       | (1,869,647      | )          | (2,862,117           | )          |
| Accumulated other comprehensive income                                                    |       | 1,763,762       |       | 1,912,356            |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                           |       | 47,147,836      |       | 46,085,454           |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                           |       | $427,275,437    |       | $423,216,679         |       |

 

Seeaccompanying notes to consolidated financial statements.

 

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**CELLU TISSUE HOLDINGS, INC. ANDSUBSIDIARIES**

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

 
| ** **                                                                                          | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                          | ** ** | **May 29**                  | ** ** | **May 31** | ** ** |
| ** **                                                                                          | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| ** **                                                                                          | ** ** | **(Restated)**                   | ** ** | **(Restated)** | ** ** |
| **Cash flows from operating activities**                                                            |       |                             |       |   |   |
| Net income (loss)                                                                                   |       | $992,470                         |       | ($1,141,841 | ) |
| Adjustments to reconcile net income (loss)  to net cash (used in) provided by operating activities: |       |                             |       |   |   |
| Stock-based compensation                                                                            |       | 218,506                          |       | 196,297 |   |
| Deferred income taxes                                                                               |       | 67,077                           |       | (1,317,791 | ) |
| Accretion of debt discount                                                                          |       | 155,069                          |       | 150,772 |   |
| Derivatve loss (gain)                                                                               |       | 119,802                          |       | (13,359 | ) |
| Depreciation                                                                                        |       | 5,854,038                        |       | 6,939,527 |   |
| Changes in operating assets and  liabilities, net of the effects of acquisition:                    |       |                             |       |   |   |
| Receivables                                                                                         |       | (7,654,871                       | )          | 194,152 |   |
| Inventories                                                                                         |       | (903,874                         | )          | 906,690 |   |
| Prepaid expenses and other current assets  and income tax receivable                                |       | 774,279                          |       | 555,019 |   |
| Other                                                                                               |       |                             |       | (1,521 | ) |
| Accounts payable, accrued expenses and  accrued interest                                            |       | (4,103,876                       | )          | (3,619,187 | ) |
| Total adjustments                                                                                   |       | (5,473,850                       | )          | 3,990,599 |   |
| *Net cash (used in) provided by operating  activities*                                              |       | (4,481,380                       | )          | 2,848,758 |   |
|                                                                                                |       |                             |       |   |   |
| **Cash flows from investing activities**                                                            |       |                             |       |   |   |
| Cash paid for acquisition, net of cash  received                                                    |       | -                                |       | (43,343,798 | ) |
| Capital expenditures                                                                                |       | (2,474,891                       | )          | (2,646,346 | ) |
| Other                                                                                               |       | (145,252                         | )          | 383,835 |   |
| *Net cash used in investing activities*                                                             |       | (2,620,143                       | )          | (45,606,309 | ) |
|                                                                                                |       |                             |       |   |   |
| **Cash flows from financing activities**                                                            |       |                             |       |   |   |
| Payments of long-term debt                                                                          |       | (380,000                         | )          | - |   |
| Payment on revolving line of credit                                                                 |       | (18,300,000                      | )          | (3,000,000 | ) |
| Borrowings on revolving line of credit                                                              |       | 26,500,000                       |       | 17,400,000 |   |
| Proceeds from bond offering                                                                         |       | -                                |       | 20,000,000 |   |
| *Net cash provided by financing activities*                                                         |       | 7,820,000                        |       | 34,400,000 |   |
|                                                                                                |       |                             |       |   |   |
| Effect of foreign currency                                                                          |       | 23,559                           |       | 83,897 |   |
|                                                                                                |       |                             |       |   |   |
| *Net increase (decrease) in cash and cash  equivalents*                                             |       | 742,036                          |       | (8,273,654 | ) |
| *Cash and cash equivalents at beginning of  period*                                                 |       | 883,388                          |       | 16,260,601 |   |
| *Cash and cash equivalents at end of period*                                                        |       | $1,625,424                       |       | $7,986,947 |   |

 

*See accompanying notes to consolidated financial statements.*

 

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**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited)**

**May 29,2008**

 

**Note 1 Basis of Presentation and SignificantAccounting Policies**

 

The accompanying unaudited interimconsolidated financial statements include the accounts of Cellu Tissue Holdings, Inc.  (the “Company” ) and its wholly-ownedsubsidiaries.  The Company is awholly-owned subsidiary of Cellu Paper Holdings, Inc. (the “Parent”), whois a wholly-owned subsidiary of Cellu Parent Corporation (“Cellu Parent”).

 

These statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States forcomplete financial statements.  In theopinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation have been included.  Operating results for the quarter ended May 29,2008 are not necessarily indicative of the results that may be expected for thefiscal year ending February 28, 2009. For further information, refer to the Company’s consolidated financialstatements and footnotes thereto as of February 29, 2008 and for the yearthen ended included in the Company’s Annual Report on Form 10-K/A, fromwhich the consolidated balance sheet at February 29, 2008 has beenderived, and the Company’s latest current reports on Form 8-K, each asfiled with the Securities and Exchange Commission (“SEC”).

 

Stock-Based Compensation

 

The Company accounts for stock basedcompensation in accordance with Statement of Financial Accounting Standards No. 123R(“SFAS 123R”), *Share-Based Payment*, whichrequires the measurement of all employee share-based payments to employees,including grants of employee stock options, using the fair-value-based methodand the recording of such expense in the Company’s consolidated statement ofoperations.  The Company has oneshare-based payment arrangement under the 2006 Stock Option and RestrictedStock Plan (the “Plan”).  Under the Plan,the administrator of the Plan (the “Plan Administrator”) may make awards ofoptions to purchase shares of common stock of Cellu Parent and/or awards ofrestricted shares of common stock of Cellu Parent.  A maximum of 8,095 shares of common stock ofCellu Parent may be delivered in satisfaction of awards under the Plan,determined net of shares of common stock withheld by Cellu Parent in payment ofthe exercise price of an

 

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**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

 

**Note 1 Basis of Presentation and SignificantAccounting Policies (continued)**

 

award or in satisfaction of tax withholdingrequirements.  Key employees anddirectors of, and consultants and advisors to, Cellu Parent or its affiliateswho, in the opinion of the Plan Administrator, are in a position to make asignificant contribution to the success of Cellu Parent and its affiliates areeligible to participate in the Plan.  Stock options are granted at the market price of Cellu Parent’s stock onthe date of grant and have a 10-year term. Generally, stock option grants vest ratably over four years from thedate of grant.  The following describeshow certain assumptions affecting the estimated fair value of stock options aredetermined.  The dividend yield is zero;the volatility is based on historical market value of Cellu Parent’s stock; andthe risk-free interest rate is based on U.S. Treasury securities.  The Company includes historical data toestimate exercise, termination and holding period behavior for valuationpurposes.  A summary of the outstandingoptions as of May 29, 2008 and the activity during the three months thenended is as follows:

 
|                                |   | Options |   | Weighted  Average  Exercise Price |   | Weighted  Average  Remaining  Contractual Life | ** ** |
|-------------------------------------|--------|---------|--------|----------------------------------------|--------|-----------------------------------------------------|------------|
| Outstanding, February 29, 2008 |   | 1,125   |   | $ 733.67                          |   | 8.59 Years                                          |       |
| Forfeited                           |   | (125    | )      | $ 979.25                          |   | 8.86 Years                                          |       |
| Granted                             |   | 444     |   | $ 942.99                          |   | 9.85 Years                                          |       |
| Outstanding, May 29, 2008      |   | 1,444   |   | $ 776.77                          |   | 8.95 Years                                          |       |
| Exercisable, May 29, 2008      |   | 250     |   | $ 702.97                          |   | 8.56 Years                                          |       |

 

The fair value of the stock option grants wasestimated on the date of grant using the Black-Scholes option pricingmodel.  The assumptions used to value thegrants were: no dividend yield; 55% volatility; 1.4% risk free interest rate;and 10-year expected life.  The weightedaverage fair value of stock options granted was $498.18 per share and theunrecognized total compensation cost as of May 29, 2008 related tononvested awards is $591,166.

 

On August 6, 2007, Cellu Parent enteredinto a Restricted Stock Agreement with the Company’s newly appointed ChiefFinancial Officer, pursuant to which Cellu Parent granted 700 restricted sharesof its common stock to the named individual pursuant to the Plan.  The shares will vest and cease to berestricted in four equal annual installments commencing on August 6, 2008,as long as the named individual is continuously employed by the Company untilsuch vesting date with respect to his shares. Any restricted stock outstanding at the time of a Covered Transaction(as defined in the Plan) shall become vested and cease to be restricted stockat the time of a change in control. Additionally, the Parent has agreed to pay an amount to the namedindividual equal to an amount that would be included in such individual’s grossincome and payable as income

 

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**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

 

**Note 1 Basis of Presentation and SignificantAccounting Policies (continued)**

 

tax as a result of making a Section 83(b) electionunder the Internal Revenue Code of 1986, as amended.  The named individual has made a timely Section 83(b) election.  In connection with this election, the Companyhas recorded compensation expense of $42,255 for the three months ended May 29,2008.

 

On June 12, 2006, Cellu Parent enteredinto Restricted Stock Agreements with the Company’s Chief Executive Officer,Chief Operating Officer and Chief Financial Officer, pursuant to which CelluParent granted 3,778 restricted shares of its common stock to the ChiefExecutive Officer and 1,349 restricted shares of its common stock to each ofthe other two named individuals pursuant to the Plan.  The shares will vest and cease to berestricted in four equal annual installments commencing on June 12, 2007,as long as the named individual, as the case may be, is continuously employedby the Company until each such vesting date with respect to his or hershares.  Any restricted stock outstandingat the time of a Covered Transaction (as defined in the Plan) shall becomevested and cease to be restricted stock at that time.  Additionally, the Parent has agreed to pay anamount to the named individual equal to an amount that would be included ingross income and payable as income tax as a result of making a Section 83(b) electionunder the Internal Revenue Code of 1986, as amended.  All named individuals have made a timely Section 83(b) election.  Effective July 31, 2007, the then ChiefFinancial Officer resigned and forfeited two-thirds of the individual’srestricted stock grant and, accordingly, the Company only recorded compensationexpense associated with this individual’s grant through June 12, 2007 asall other shares were forfeited and no compensation expense is required to berecognized for forfeited shares.

 

For the three months ended May 29, 2008and May 31, 2007, the Company has recorded $134,853 and $196,297 ofcompensation expense related to the vesting of the above grants in accordancewith SFAS 123R.

 

Derivatives and Hedging

 

The Company uses derivative financialinstruments to offset a substantial portion of its exposure to market riskarising from changes in the price of natural gas.  Hedging of this risk is accomplished byentering into forward swap contracts, which have not been designated as hedgesof specific quantities of natural gas expected to be purchased in futuremonths.   The fair value of these cashflow hedging instruments was an asset of $.1 million and $.2 million as of May 29,2008 and February 29, 2008, respectively.  For the three months ended May 29, 2008 and May 31, 2007, $.1million loss and less than $.1 gain, respectively, has been recorded toearnings.

 

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**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

 

**Note 1 Basis of Presentation and SignificantAccounting Policies (continued)**

 

Recent Accounting Pronouncements

 

In September 2006, the FinancialAccounting Standard Board (“FASB”) issued Statement of Financial AccountingStandards No. 157,”*Fair Value Measurements*”(“SFAS 157”).  The Company was requiredto 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 requirements relatingto 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 a material impact onthe Company’s results of operations and financial position.

 

In February 2007, the FASB issuedStatement of Financial Accounting Standards No.159, “*The Fair Value Option for Financial Assets and Liabilities, Includingan amendment of FASB Statement 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 and the Company chose not to adopt these fair value provisions.

 

In December 2007, the FASB issuedStatement of Financial Accounting Standards No. 141 (R), “*Business Combinations*” (“SFAS 141 (R)”),and Financial Accounting Standards No. 160, *“Accounting and Reporting of Noncontrolling Interests in ConsolidatedFinancial Statements, an amendment of ARB No. 51”*(“SFAS 160”).  These new standards will significantly changethe financial accounting and reporting of business combination transactions andnoncontrolling (or minority) interests in consolidated financialstatements.  SFAS 141 (R ) is required tobe adopted concurrently with FAS 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.  The Company is currently assessing the impactthat SFAS 141 (R) and SFAS 160 will have on our results of operations andfinancial position.

 

**Note 2 Restatement of Financial Statements**

 

The Company has restated hereinits consolidated financial statements as of May 29, 2008 and February 29,2008 and for the three month periods ended May 29, 2008 and

 

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**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

 

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

 

May 31, 2007.  This restatement corrects errors in (i) accountingfor deferred income taxes in connection with purchase accounting applied infiscal 2007, (ii) classification of borrowings and repayments on the revolvingcredit facility in the statement of cash flows, and certain other adjustmentsthat were initially deemed to be not material by management, including (a)classification of shipping and handling costs in accordance with EITF 00-10, *Accounting for Shipping and Handling Fees and Costs*(EITF00-10), (b) accounting for derivative instruments, (c) accounting for foreignexchange gains and losses in fiscal 2008 and 2007, and (d) certain othermiscellaneous adjustments. The tax effect of the above items has also beenrecorded. The restatements do not have a negative impact on the Company’scompliance with the covenants under any of its current debt agreements (seeNote 5 — Long-Term Debt to our accompanying consolidated financialstatements).

 

These adjustments are discussedin more detail below. The tables that follow the discussion detail the impacton the Company’s consolidated balance sheets, statements of operations, andstatements of cash flows.

 

***Deferred income taxes associated withpurchase accounting***

 

The Company erroneously recorded a deferredtax asset related to the $35.0 million liability for contingent considerationrecorded in connection with the Company’s merger (the “Merger”) with CelluParent, a corporation organized and controlled by Weston Presidio V, L.P. (‘WestonPresidio”).  This error has resulted inan understatement of the amounts allocated to long-lived assets in connectionwith the merger.  The Company hascorrected this error by (i) reducing the deferred tax asset amount recordedin purchase accounting 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 liabilitiesassociated with the increased allocation of purchase price allocated toproperty, 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 foreach of the three months ended May 29, 2008 and May 31, 2007,respectively.

 

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

 

The Company has consistently recorded borrowings and repayments on its revolvingcredit facility as a net amount in the statement of cash flows, which has beendetermined to be inconsistent with Statement of Financial Accounting StandardsNo. 95 Statement of Cash Flows.  TheCompany has corrected this error by showing borrowings and repayments on a grossbasis.

 

***Shipping and handling fees and costs***

 

The Company has consistently recordedoutbound shipping and handling costs as a reduction of sales, which isinconsistent with the accounting in accordance with EITF 00-10.  The Company has corrected this error byreclassifying these costs to cost of goods sold from net sales.  The outbound costs were approximately $3.0million for each of the three months ended May 29, 2008 and May 31,2007, respectively.

 

10

Table of Contents

 

**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

 

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

 

***Foreign exchange gains and losses***

 

The Company incorrectly recordedthe remeasurement of an intercompany loan account with its foreign subsidiary throughaccumulated other comprehensive income. In accordance with FASB Statement No. 52*,**ForeignCurrency Translation,*the remeasurement of the portion of the loanfunctioning as a short-term settlement account and not deemed to be of a longterm investment nature should have been recorded to earnings.  The Company has corrected this error byincreasing (decreasing) foreign currency (loss) gain and decreasing(increasing) accumulated other comprehensive income.  The correction resulted in an increase to foreigncurrency gain of approximately $.4 million for the three months ended May 31,2007.

 

***Derivatives***

 

The Company’s documentation relating toderivative instruments entered into in fiscal 2007 and 2008 did not meet therequirements of Statement of Financial Accounting No. 133, *Accounting for Derivative Instruments and HedgingActivities*for hedge accounting. The Company has corrected thiserror by reversing the amounts relating to the mark-to-market adjustment thatwere originally recorded in accumulated other comprehensive income, with theoffsetting amount recorded to cost of goods sold in each correspondingperiod.  The correction resulted in anincrease to cost of goods sold of approximately $.1 million for the threemonths ended May 29, 2008 and a decrease to cost of goods sold of lessthan $.1 million for the three months ended May 31, 2007.

 

***Other miscellaneous adjustments***

 

The Company has also included in theappropriate periods in its restated consolidated financial statements certainother miscellaneous adjustments the effect of which were initially deemed to benot material by management, either individually or in the aggregate.  These adjustments primarily relate to thereversal of certain vacation and freight accruals in the first quarterof fiscal 2008.   The net impact ofcorrecting these items decreased net income by approximately $.1 million forthe three months ended May 31, 2007.

 

11

 

Tableof Contents

 

**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

 

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

 

**CELLUTISSUE HOLDINGS, INC.  AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                | ** ** | ** **         | ** ** | **As of May 29, 2008  (unaudited)** | ** ** | ** **         | ** ** | **As of February 29, 2008** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------------------------------------------|------------|--------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                | ** ** | **As  Previously** | ** ** | ** **                                              | ** ** | **As  Previously** | ** ** | ** **                                      | ** ** |
| ** **                                                                                | ** ** | **Reported**       | ** ** | **Adjustment**                                          | ** ** | **Restated**       | ** ** | **Reported**                                    | ** ** | **Adjustment** | ** ** | **Restated** | ** ** |
|                                                                                      |       |               |       |                                                    |       |               |       |                                            |       |   |   |   |   |
| **ASSETS**                                                                                | ** ** | ** **         | ** ** | ** **                                              | ** ** | ** **         | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| CURRENT ASSETS:                                                                           |       |               |       |                                                    |       |               |       |                                            |       |   |   |   |   |
| Cash and cash  equivalents                                                                |       | $1,625,424         |       |                                                    |       | $1,625,424         |       | $883,388                                        |       |   |   | $883,388 |   |
| Receivables, net                                                                          |       | 52,197,208         |       |                                                    |       | 52,197,208         |       | 44,542,337                                      |       |   |   | 44,542,337 |   |
| Inventories                                                                               |       | 34,900,313         |       |                                                    |       | 34,900,313         |       | 33,996,439                                      |       |   |   | 33,996,439 |   |
| Prepaid expenses and  other current assets                                                |       | 3,006,025          |       |                                                    |       | 3,006,025          |       | 3,745,989                                       |       |   |   | 3,745,989 |   |
| Income tax receivable                                                                     |       | 142,966            |       |                                                    |       | 142,966            |       | 177,281                                         |       |   |   | 177,281 |   |
| Deferred income taxes                                                                     |       | 6,216,017          |       |                                                    |       | 6,216,017          |       | 7,157,191                                       |       |   |   | 7,157,191 |   |
| TOTAL CURRENT ASSETS                                                                      |       | 98,087,953         |       |                                                    |       | 98,087,953         |       | 90,502,625                                      |       |   |   | 90,502,625 |   |
| PROPERTY, PLANT AND  EQUIPMENT, NET                                                       |       | 293,302,474        |       | $13,634,493                                             |       | 306,936,967        |       | 296,597,888                                     |       | $13,890,193 |   | 310,488,081 |   |
| GOODWILL                                                                                  |       | 6,970,001          |       | 4,364,754                                               |       | 11,334,755         |       | 6,970,001                                       |       | 4,364,754 |   | 11,334,755 |   |
| TRADEMARKS                                                                                |       | 8,750,314          |       | 649,686                                                 |       | 9,400,000          |       | 8,750,314                                       |       | 649,686 |   | 9,400,000 |   |
| OTHER ASSETS                                                                              |       | 1,515,762          |       |                                                    |       | 1,515,762          |       | 1,491,218                                       |       |   |   | 1,491,218 |   |
| TOTAL ASSETS                                                                              |       | $408,626,504       |       | $18,648,933                                             |       | $427,275,437       |       | $404,312,046                                    |       | $18,904,633 |   | $423,216,679 |   |
|                                                                                      |       |               |       |                                                    |       |               |       |                                            |       |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                            | ** ** | ** **         | ** ** | ** **                                              | ** ** | ** **         | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| CURRENT LIABILITIES:                                                                      |       |               |       |                                                    |       |               |       |                                            |       |   |   |   |   |
| Revolving line of credit                                                                  |       | $18,000,000        |       |                                                    |       | $18,000,000        |       | $9,800,000                                      |       |   |   | $9,800,000 |   |
| Accounts payable                                                                          |       | 22,002,057         |       |                                                    |       | 22,002,057         |       | 24,055,782                                      |       |   |   | 24,055,782 |   |
| Accrued expenses                                                                          |       | 21,352,023         |       | $184,076                                                |       | 21,536,099         |       | 18,860,526                                      |       | $225,386 |   | 19,085,912 |   |
| Accrued interest                                                                          |       | 3,765,379          |       |                                                    |       | 3,765,379          |       | 8,253,915                                       |       |   |   | 8,253,915 |   |
| Other current  liabilities                                                                |       | 15,000,000         |       |                                                    |       | 15,000,000         |       | 15,000,000                                      |       |   |   | 15,000,000 |   |
| Current portion of  long-term debt                                                        |       | 760,000            |       |                                                    |       | 760,000            |       | 760,000                                         |       |   |   | 760,000 |   |
| TOTAL CURRENT  LIABILITIES                                                                |       | 80,879,459         |       | 184,076                                                 |       | 81,063,535         |       | 76,730,223                                      |       | 225,386 |   | 76,955,609 |   |
| LONG-TERM DEBT, LESS  CURRENT PORTION                                                     |       | 197,862,013        |       |                                                    |       | 197,862,013        |       | 198,086,944                                     |       |   |   | 198,086,944 |   |
| DEFERRED INCOME TAXES                                                                     |       | 61,231,712         |       | 19,834,273                                              |       | 81,065,985         |       | 62,008,004                                      |       | 19,932,078 |   | 81,940,082 |   |
| OTHER LIABILITIES                                                                         |       | 20,136,068         |       |                                                    |       | 20,136,068         |       | 20,148,590                                      |       |   |   | 20,148,590 |   |
| STOCKHOLDERS’ EQUITY:                                                                |       |               |       |                                                    |       |               |       |                                            |       |   |   |   |   |
| Common stock, $.01 par  value, 1,000 shares authorized, 100 shares issued and outstanding |       | 1                  |       |                                                    |       | 1                  |       | 1                                               |       |   |   | 1 |   |
| Capital in excess of par  value                                                           |       | 47,253,720         |       |                                                    |       | 47,253,720         |       | 47,035,214                                      |       |   |   | 47,035,214 |   |
| Accumulated deficit                                                                       |       | (982,560           | )          | (887,087                                                | )          | (1,869,647         | )          | (2,199,615                                      | )          | (662,502 | ) | (2,862,117 | ) |
| Accumulated other  comprehensive income                                                   |       | 2,246,091          |       | (482,329                                                | )          | 1,763,762          |       | 2,502,685                                       |       | (590,329 | ) | 1,912,356 |   |
| TOTAL STOCKHOLDERS’  EQUITY                                                          |       | 48,517,252         |       | (1,369,416                                              | )          | 47,147,836         |       | 47,338,285                                      |       | (1,252,831 | ) | 46,085,454 |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                          |       | $408,626,504       |       | $18,648,933                                             |       | $427,275,437       |       | $404,312,046                                    |       | $18,904,633 |   | $423,216,679 |   |

 

12

Table of Contents

 

**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

 

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

 

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

**CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**

** **
|                                              |       |              |        | Three Months Ended    |       |               |         | Three Months Ended    |         |
|---------------------------------------------------|------------|-------------------|-------------|-----------------------|------------|--------------------|--------------|-----------------------|--------------|
| ** **                                        | ** ** | ** **        | ** **  | **May 29, 2008** | ** ** | ** **         | ** **   | **May 31, 2007** | ** **   |
| ** **                                        | ** ** | **As Previously** | ** **  | ** **            | ** ** | **As  Previously** | ** **   | ** **            | ** **   |
| ** **                                        | ** ** | **Reported**      | ** **  | **Adjustment**        | ** ** | **Restated**       | ** **   | **Reported**          | ** **   | **Adjustment** | ** ** | **Restated** | ** ** |
| ** **                                        | ** ** | ** **        | ** **  | ** **            | ** ** | ** **         | ** **   | ** **            | ** **   | ** ** | ** ** | ** ** | ** ** |
| Net sales                                         |       | $                 | 111,496,083 |                  | $3,031,478 |               | $114,527,561 |                  | $103,200,786 |   | $3,026,163 |   | $106,226,949 |   |
| Cost of goods sold                                |       | 99,344,479        |        | 3,395,178             |       | 102,739,657        |         | 94,908,668            |         | 3,432,516 |   | 98,341,184 |   |
|                                              |       |              |        |                  |       |               |         |                  |         |   |   |   |   |
| Gross profit                                      |       | 12,151,604        |        | (363,700              | )          | 11,787,904         |         | 8,292,118             |         | (406,353 | ) | 7,885,765 |   |
|                                              |       |              |        |                  |       |               |         |                  |         |   |   |   |   |
| Selling, general and  administrative expenses     |       | 4,959,842         |        |                  |       | 4,959,842          |         | 4,482,737             |         |   |   | 4,482,737 |   |
| Terminated  acquisition-related transaction costs |       | 75,000            |        |                  |       | 75,000             |         |                  |         |   |   |   |   |
| Stock and related  compensation expense           |       | 218,506           |        |                  |       | 218,506            |         | 233,119               |         |   |   | 233,119 |   |
| Income from operations                            |       | 6,898,256         |        | (363,700              | )          | 6,534,556          |         | 3,576,262             |         | (406,353 | ) | 3,169,909 |   |
|                                              |       |              |        |                  |       |               |         |                  |         |   |   |   |   |
| Interest expense, net                             |       | 4,979,688         |        |                  |       | 4,979,688          |         | 5,019,094             |         |   |   | 5,019,094 |   |
| Foreign currency (gain)  loss                     |       | (43,080           | )           |                  |       | (43,080            | )            | 324,298               |         | (355,148 | ) | (30,850 | ) |
| Other expense (income)                            |       | 29,508            |        |                  |       | 29,508             |         | (42,239               | )            |   |   | (42,239 | ) |
|                                              |       |              |        |                  |       |               |         |                  |         |   |   |   |   |
| Income (loss) before  income tax                  |       | 1,932,140         |        | (363,700              | )          | 1,568,440          |         | (1,724,891            | )            | (51,205 | ) | (1,776,096 | ) |
|                                              |       |              |        |                  |       |               |         |                  |         |   |   |   |   |
| Income tax expense  (benefit)                     |       | 715,085           |        | (139,115              | )          | 575,970            |         | (614,407              | )            | (19,848 | ) | (634,255 | ) |
| Net income (loss)                                 |       | $                 | 1,217,055   |                  | $(224,585  | )                  | $992,470     |                  | ($1,110,484  | ) | ($31,357 | ) | ($1,141,841 | ) |
|                                                   |            |                   |             |                       |            |                    |              |                       |              |  |  |  |  |  |  |

 

13

Table of Contents

 

**CelluTissue Holdings, Inc. and Subsidiaries**

**Notes toConsolidated Financial Statements (Unaudited) (continued)**

 

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

 

**CELLUTISSUE HOLDINGS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS (Unaudited)**

 
| ** **                                                                                          | ** ** | ** **         | ** ** | **Three Months Ended May  29, 2008** | ** ** | ** **         | ** ** | **Three  Months   Ended  May 31, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------|------------|----------------------------------------------------------|------------|--------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **As  Previously** | ** ** | ** **                                               | ** ** | **As  Previously** | ** ** | ** **                                             | ** ** |
| ** **                                                                                          | ** ** | **Reported**       | ** ** | **Adjustment**                                           | ** ** | **Restated**       | ** ** | **Reported**                                           | ** ** | **Adjustment** | ** ** | **Restated** | ** ** |
|                                                                                                |       |               |       |                                                     |       |               |       |                                                   |       |   |   |   |   |
| **Cash  flows from operating activities**                                                           | ** ** | ** **         | ** ** | ** **                                               | ** ** | ** **         | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                   |       | $1,217,055         |       | $(224,585                                                | )          | $992,470           |       | ($1,110,484                                            | )          | ($31,357 | ) | ($1,141,841 | ) |
| Adjustments to reconcile  net income (loss) to net cash (used in) provided by operating activities: |       |               |       |                                                     |       |               |       |                                                   |       |   |   |   |   |
| Stock-based compensation                                                                            |       | 218,506            |       |                                                     |       | 218,506            |       | 196,297                                                |       |   |   | 196,297 |   |
| Deferred income taxes                                                                               |       | 164,882            |       | (97,805                                                  | )          | 67,077             |       | (1,217,891                                             | )          | (99,900 | ) | (1,317,791 | ) |
| Accretion of debt  discount                                                                         |       | 155,069            |       |                                                     |       | 155,069            |       | 150,772                                                |       |   |   | 150,772 |   |
| Derivative (gain) loss                                                                              |       |               |       | 119,802                                                  |       | 119,802            |       |                                                   |       | (13,359 | ) | (13,359 | ) |
| Depreciation                                                                                        |       | 5,598,338          |       | 255,700                                                  |       | 5,854,038          |       | 6,678,145                                              |       | 261,382 |   | 6,939,527 |   |
| Changes in operating  assets and liabilities, net of the effects of acquisition:                    |       |               |       |                                                     |       |               |       |                                                   |       |   |   |   |   |
| Receivables                                                                                         |       | (7,654,871         | )          |                                                     |       | (7,654,871         | )          | 194,152                                                |       |   |   | 194,152 |   |
| Inventories                                                                                         |       | (903,874           | )          |                                                     |       | (903,874           | )          | 867,490                                                |       | 39,200 |   | 906,690 |   |
| Prepaid expenses and  other current assets and  income tax  receivable                    |       | 774,279       |       |                                                     |       | 774,279            |       | 464,351                                           |       | 90,668  |   | 555,019  |   |
| Other                                                                                               |       | -                  |       |                                                     |       |               |       | (1,521                                                 | )          |   |   | (1,521 | ) |
| Accounts payable,  accrued expenses and accrued interest                                            |       | (4,050,764         | )          | (53,112                                                  | )          | (4,103,876         | )          | (3,727,701                                             | )          | 108,514 |   | (3,619,187 | ) |
| Total adjustments                                                                                   |       | (5,698,435         | )          | 224,585                                                  |       | (5,473,850         | )          | 3,604,094                                              |       | 386,505 |   | 3,990,599 |   |
| *Net cash  (used in) provided by operating activities*                                              |       | (4,481,380         | )          | -                                                        |       | (4,481,380         | )          | 2,493,610                                              |       | 355,148 |   | 2,848,758 |   |
|                                                                                                |       |               |       |                                                     |       |               |       |                                                   |       |   |   |   |   |
| **Cash  flows from investing activities**                                                           | ** ** | ** **         | ** ** | ** **                                               | ** ** | ** **         | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for  acquisition, net of cash received                                                    |       |               |       |                                                     |       |               |       | (43,343,798                                            | )          |   |   | (43,343,798 | ) |
| Capital expenditures                                                                                |       | (2,474,891         | )          |                                                     |       | (2,474,891         | )          | (2,646,346                                             | )          |   |   | 2,848,758 | ) |
| Other                                                                                               |       | (145,252           | )          |                                                     |       | (145,252           | )          | 383,835                                                |       | - |   | 383,835 |   |
| *Net cash  used in investing activities*                                                            |       | (2,620,143         | )          |                                                     |       | (2,620,143         | )          | (45,606,309                                            | )          |   |   | (45,606,309 | ) |
|                                                                                                |       |               |       |                                                     |       |               |       |                                                   |       |   |   |   |   |
| **Cash  flows from financing activities**                                                           | ** ** | ** **         | ** ** | ** **                                               | ** ** | ** **         | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Payments of long-term  debt                                                                         |       | (380,000           | )          |                                                     |       | (380,000           | )          |                                                   |       |   |   |   |   |
| Payments on revolving  line of credit                                                               |       |               |       | (18,300,000                                              | )          | (18,300,000        | )          |                                                   |       | (3,000,000 | ) | (3,000,000 | ) |
| Borrowings on revolving  line of credit                                                             |       | 8,200,000          |       | 18,300,000                                               |       | 26,500,000         |       | 14,400,000                                             |       | 3,000,000 |   | 17,400,000 |   |
| Proceeds from bond  offering                                                                        |       |               |       |                                                     |       |               |       | 20,000,000                                             |       |   |   | 20,000,000 |   |
| *Net cash  provided by financing activities*                                                        |       | 7,820,000          |       | -                                                        |       | 7,820,000          |       | 34,400,000                                             |       | - |   | 34,400,000 |   |
| Effect of foreign  currency                                                                         |       | 23,559             |       | -                                                        |       | 23,559             |       | 439,045                                                |       | (355,148 | ) | 83,897 |   |
| *Net  increase (decrease) in cash and cash equivalents*                                             |       | 742,036            |       | -                                                        |       | 742,036            |       | (8,273,654                                             | )          | - |   | (8,273,654 | ) |
| *Cash and  cash equivalents at beginning of period*                                                 |       | 883,388            |       | -                                                        |       | 883,388            |       | 16,260,601                                             |       | - |   | 16,260,601 |   |
| *Cash and  cash equivalents at end of period*                                                       |       | $1,625,424         |       | -                                                        |       | $1,625,424         |       | $7,986,947                                             |       | - |   | $7,986,947 |   |

 

14

 

Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 3 Inventories**

 

Components of inventories are as follows:

 
| ** **                       | ** ** | May 29,  2008 | ** ** | ** ** | February 29, 2008 | ** ** |
|----------------------------------|------------|--------------------|------------|------------|------------------------|------------|
| Finished goods                   |       | $ 19,048,274  |       |       | $ 17,961,802      |       |
| Raw materials                    |       | 5,852,935          |       |       | 7,073,131              |       |
| Packaging materials and supplies |       | 10,088,420         |       |       | 9,082,592              |       |
|                             |       | 34,989,629         |       |       | 34,117,525             |       |
| Inventory reserves               |       | (89,316            | )          |       | (121,086               | )          |
|                             |       | $ 34,900,313  |       |       | $ 33,996,439      |       |

** **

**Note 4 Acquisition**

 

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 “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% SeniorSecured Notes due 2010 (the “Additional Notes”) of approximately $20.0 million,borrowings on a revolving line of credit ($17.4 million) and available cash onhand.

 

The Acquisition has been accounted for as a purchase in accordance withthe provisions of SFAS 141 and, accordingly, the consolidated statement ofoperations includes the results of CityForest during the three-months ended May 29,2008 and during the three-months ended May 31, 2007 from the date ofacquisition.

 

The results of CityForest’s operations fromthe March 21, 2007 date of acquisition are included in the Company’stissue segment.  Unaudited pro formaresults of operations for the three months ended May 31, 2007, as if theCompany and CityForest had been combined as of March 1, 2007, arepresented below.  The pro forma resultsinclude estimates and assumptions, which the Company’s management believes arereasonable.

 

15

Table of Contents

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 4 Acquisition (continued)**

 

However, the pro forma results do not includeany cost savings or other effects of the planned integration of CityForest, andare not necessarily indicative of the results which would have occurred if thebusiness combination had been in effect on the dates indicated, or which mayresult in the future.

 
|             |   | Three Months Ended May 31, 2007 (1) |       |
|------------------|--------|-------------------------------------------------------------------|------------|
|             |   | Actual                                                            |       | Pro Forma |   |
|             |   | **(Restated)**                                                    | ** ** | **(Restated)** |   |
|             |   | (in thousands)                                               |       |
| Net sales        |   | $106,227                                                          |       | $108,937 |   |
| Operating income |   | $    3,170                                    |       | $    3,756 |   |
| Net loss         |   | $   (1,142)                                        |       | $     (581) |   |

 

(1)          Pro forma operating results include theoperating results for CityForest for the three months ended May 31,2007.   The actual operating resultsinclude the operating results for CityForest for the period from theacquisition date (March 21, 2007) to May 31, 2007.

 

**Note 5 Long-Term Debt**

 

Long-term debt consists of the following:

 
| ** **                                                                                                    | ** ** | May 29, 2008 | ** ** | February 29, 2008 | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------------|------------|
| 93/4 % senior secured notes due  2010                                                                    |       | $182,255,572           |       | $182,255,572                |       |
| Less discount                                                                                                 |       | (1,128,559             | )          | (1,283,628                  | )          |
|                                                                                                          |       | 181,127,013            |       | 180,971,944                 |       |
| Industrial  revenue bond payable in semi-annual installments, plus variable interest, due  March 1, 2028 |       | 17,495,000             |       | 17,875,000                  |       |
|                                                                                                          |       | 198,622,013            |       | 198,846,944                 |       |
| Less current portion of debt                                                                                  |       | 760,000                |       | 760,000                     |       |
|                                                                                                          |       | $197,862,013           |       | $198,086,944                |       |

 

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 “OriginalNotes”).  In connection with theAcquisition (see Note 4), the Company entered into a Note Purchase Agreement(the “Note Purchase Agreement”) with Wingate Capital Ltd. (the “Purchaser”),dated March 21, 2007, pursuant to which it issued and sold $20.3 million

 

16

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

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

 

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.  Terms of the indenture under which the Noteshave been issued contain certain covenants, including limitations on certainrestricted payments and the incurrence of additional indebtedness.  The Notes are unconditionally guaranteed byall of the Company’s subsidiaries.

 

The Company entered into a Credit Agreement, dated as of June 12,2006 (the “Credit Agreement”), among the Company, as U.S. Borrower, InterlakeAcquisition Corporation Limited, a subsidiary of the Company, as CanadianBorrower, Parent, the other loan guarantors party thereto, JPMorgan Chase Bank,N.A., as U.S. Administrative Agent, JPMorgan Chase Bank, N.A., Toronto Branch,as 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 and footnote 9), including a letter of creditsub-facility and swing-line loan sub-facility. The Credit Agreement providesthat amounts under the facility may be borrowed, repaid and re-borrowed,subject to a borrowing base test, until the maturity date, which is June 12,2011. An amount equal to $32.0 million, which was subsequently increased to$57.0 million (see discussion following and footnote 9) 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 Acquisition.  Asof May 29, 2008, there was $18.0 million of borrowings outstanding underthe working capital facility and excess availability was $18.1 million.

 

In addition to the Note Purchase Agreement, the following agreementswere entered into in connection with the Acquisition:

 

***Second Supplemental Indenture***

 

The Company, certain of its subsidiaries, the Trustee and CityForesthave executed the Second Supplemental Indenture, dated March 21, 2007 (the“Second Supplemental Indenture”), pursuant to which CityForest became a partyto the Cellu Tissue Indenture as

 

17

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

a subsidiary guarantor.  As asubsidiary guarantor, CityForest, on a joint and several basis with all theexisting subsidiary guarantors, fully, unconditionally and irrevocablyguarantees to each holder of the Notes and the Trustee the obligations ofCompany under its Indenture and the Notes.

 

***Amendment to Credit Agreement***

 

The Company has entered into a First Amendment, dated March 21,2007 (the “Amendment”), to the Credit Agreement dated June 12, 2006 (asamended by the Amendment, the “Amended Credit Agreement”) among Cellu Tissue,as U.S. Borrower, Interlake Acquisition Corporation Limited, a subsidiary ofCellu Tissue, as Canadian Borrower, certain subsidiaries of Cellu Tissue, CelluPaper Holdings, Inc., the parent corporation of Cellu Tissue, JPMorganChase Bank, N.A. (the “U.S. Administrative Agent”) and JPMorgan Chase Bank,N.A., Toronto Branch (the “Canadian Administrative Agent”).

 

The Amendment (1) increases the working capital facility from$35.0 million to $40.0 million, (2) permits the issuance and sale by theCompany of the Additional Notes, (3) provides for the consummation of theAcquisition and the conversion by CityForest from a Minnesota corporation to aMinnesota limited liability company, (4) permits the assumption of approximately$18.4 million in aggregate principal amount of indebtedness of CityForest inconnection with the Acquisition in accordance with the terms of the CityForestBond Documents (as defined below under “CityForest Bond Documents”), and (5) permitsthe guarantee by the Company of certain obligations of CityForest under theCityForest Bond Documents.  In connectionwith the Amendment, CityForest became a guarantor of the obligations of theborrowers under the Amended Credit Agreement.

 

***CityForest Bond Documents***

 

CityForest is party to a Loan Agreement, dated March 1, 1998 (the “LoanAgreement”), 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 Acquisition.  CityForest isrequired, under the terms of the Indenture of Trust governing the Bonds (the “CityForestIndenture”), to provide a letter of credit in favor of the trustee under theCityForest Indenture (the “Bonds Trustee”). CityForest has entered into an Amended and Restated ReimbursementAgreement, dated March 21, 2007 (the “Reimbursement Agreement” and,together with

 

18

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

the CityForest Indenture and the Loan Agreement, the “CityForest BondDocuments”), with Associated Bank, National Association (“Associated Bank”),pursuant to which Associated Bank has extended the required letter of credit(the “Associated Bank Letter of Credit”) and has provided a revolving creditfacility to CityForest in an aggregate principal amount of up to $3.5 million(the “Associated Bank Revolving Credit Facility”).

 

The Bonds Trustee is permitted to draw upon the Associated Bank Letterof Credit to pay principal and interest due on the Bonds, and to provideliquidity to purchase Bonds put to CityForest by bondholders and not remarketed;and CityForest 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 toadjustment on a quarterly basis based on CityForest’s leverage.  The expiration date of the Associated BankLetter 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’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.

 

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 theAcquisition, 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 amounts currentlypermitted under its Indenture or refinances the indebtedness issued under itsIndenture, Associated Bank may require CityForest to repay all of itsobligations to Associated Bank under the Reimbursement Agreement and either tocause the Bonds to be redeemed or to replace the Associated Bank Letter ofCredit with a Substitute Credit Facility, as such term is defined in theCityForest Indenture.

 

19

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

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

 

The Reimbursement Agreement contains various affirmative and negativecovenants customary for working capital and term credit facilities, as well asadditional covenants relating to the Bonds. The negative covenants include limitations on: indebtedness; liens;acquisitions, mergers and consolidations; investments; guarantees; asset sales;sale and leaseback 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 contains customary events of default,including:  payment defaults; breaches ofrepresentations and warranties; covenant defaults; cross-defaults to certainother debt, including the Additional Notes and indebtedness under the AmendedCredit Agreement; 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 guaranteed all of the obligations of CityForest underthe Reimbursement Agreement, pursuant to a Guaranty, dated March 21, 2007(the “Cellu Tissue Guaranty”), executed by the Company in favor of AssociatedBank. In addition, the obligations of CityForest under the ReimbursementAgreement are secured by first-priority liens in favor of Associated Bank inall of CityForest’s assets.  The U.S.Administrative Agent, the Canadian Administrative Agent, Associated Bank andCityForest have entered into an Intercreditor Agreement, dated March 21,2007, which sets forth the respective rights and priorities of Associated Bank,on the one hand, and the U.S. Administrative Agent and the CanadianAdministrative Agent, on the other hand, as to the collateral of CityForestsecuring the Reimbursement Agreement and the Amended Credit Agreement.

 

**Note 6 Comprehensive Income**

 

The components of comprehensive income for the three months ended May 29,2008 and May 31, 2007 are as follows:

 
| ** **

** **                   | ** ** | Three Months Ended | ** ** |
|------------------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | May 29, 2008       |       | May 31, 2007 | ** ** |
| ** **                               | ** ** | **(Restated)**               | ** ** | **(Restated)** | ** ** |
| Net income (loss)                        |       | $992,470                     |       | $(1,141,841 | ) |
| Foreign currency translation adjustments |       | (148,594                     | )          | 953,994 |   |
| Comprehensive (loss) income              |       | $843,876                     |       | $(187,847 | ) |

 

20

 

**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 7 Business Segments**

 

The Company operates in two business segments:  tissue and machine-glazed paper.  The Company assesses the performance of itsbusiness segments using income from operations. Income from operations for thethree months ended May 29, 2008 includes $.3 million of bad debt expenseassociated with a customer bankruptcy and $.3 million related to additionalsales tax incurred at one of our facilities. Of this $.6 million, $.2 million impacts the machine-glazed papersegment and $.4 million impacts the tissue segment.   Income from operations excludes interestincome, interest expense, other income (expense), income tax expense (benefit)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 ended May 29, 2008 and May 31, 2007follows:

 
| ** **                            | ** ** | Three Months Ended | ** ** |
|---------------------------------------|------------|------------------------------|------------|
| ** **                            | ** ** | May 29, 2008       |       | May 31, 2007 | ** ** |
| ** **                            | ** ** | **(Restated)**               | ** ** | **(Restated)** | ** ** |
| **Net Sales**                         |       |                         |       |   |   |
| Tissue                                |       | $85,797,050                  |       | $79,784,855 |   |
| Machine-glazed paper                  |       | 28,730,511                   |       | 26,442,094 |   |
| Consolidated                          |       | $114,527,561                 |       | $106,226,949 |   |
|                                  |       |                         |       |   |   |
| **Income (loss) from operations**     |       |                         |       |   |   |
| Tissue                                |       | $6,052,591                   |       | $3,745,653 |   |
| Machine-glazed paper                  |       | 481,965                      |       | (575,744 | ) |
| Consolidated                          |       | 6,534,556                    |       | 3,169,909 |   |
|                                  |       |                         |       |   |   |
| Interest expense, net                 |       | (4,979,688                   | )          | (5,019,094 | ) |
| Net foreign currency transaction gain |       | 43,080                       |       | 30,850 |   |
| Other (expense) income                |       | (29,508                      | )          | 42,239 |   |
| Pretax income (loss)                  |       | $1,568,440                   |       | $(1,776,096 | ) |
|                                  |       |                         |       |   |   |   |   |
| **Capital Expenditures**              |       |                         |       |   |   |
| Tissue                                |       | $2,029,529                   |       | $2,241,151 |   |
| Machine-glazed paper                  |       | 254,830                      |       | 252,651 |   |
| Corporate                             |       | 190,532                      |       | 152,544 |   |
| Consolidated                          |       | $2,474,891                   |       | $2,646,346 |   |
|                                  |       |                         |       |   |   |
| **Depreciation**                      |       |                         |       |   |   |
| Tissue                                |       | $4,318,726                   |       | $5,194,521 |   |
| Machine-glazed paper                  |       | 1,535,312                    |       | 1,745,006 |   |
| Consolidated                          |       | $5,854,038                   |       | $6,939,527 |   |
|                                       |            |                              |            |  |  |  |  |

 

21

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**Cellu Tissue Holdings, Inc. andSubsidiaries**

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

 

**Note 8 Income taxes**

 

The effective income tax rate for the three months ended May 29,2008 was 36.7% compared to a 35.7% benefit for the three months ended May 31,2007.

 

The Company recognizes interest and penalties related to uncertain taxpositions in income tax expense.  As of May 29,2008, the Company had accrued $1.6 million related to uncertain tax positions.

 

The tax years 2004 through 2008 remain open to examination by the majortaxing jurisdictions to which the Company is subject.  As of May 29, 2008, the Company does notexpect any material changes to unrecognized tax positions within the nexttwelve months.

 

**Note 9 Subsequent Event**

 

On July 2, 2008, the Company, through two newly created,wholly-owned subsidiaries, Cellu Tissue-Hauppauge, LLC (“Cellu Tissue-Hauppauge”)and Cellu Tissue-Thomaston, LLC (“Cellu Tissue-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 a definitive asset purchase agreement between the Company and theSellers.  The aggregate purchase price paid was $68,000,000, including acash payment at closing of $61,700,000 and the issuance of a promissory note bythe Company to Atlantic Paper & Foil Corp. of N.Y. in the aggregateprincipal amount equal of $6,300,000 plus the assumption of certainliabilities.  The Company financed thecash portion of the purchase price with cash on-hand, the borrowings describedbelow and an equity contribution from Parent. The purchase price is subject to certain post-closing working capitaladjustments.

 

In connection with the Acquisition, the following agreements wereentered into:

 

**Note Purchase Agreement**

 

The Company has entered into Note Purchase Agreements (the “NotePurchase Agreements”) 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

 

22

Tableof Contents

 

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

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

 

**Note 9 Subsequent Event (continued)**

 

Yield Fund), DDJ Capital Management Group Trust, StichtingPensioenfonds Hoogovens, Caterpillar Inc. Master Retirement Trust, J.C. PenneyCorporation, Inc. Pension Plan Trust, Stichting Bewaarder InterpolisPensioenen Global High Yield Pool, DDJ/Ontario OS Investment Sub II, Ltd. and Stichting PensioenfondsMetaal en Techniek, (ii) Claren Road Credit Master Fund, Ltd. and (iii) UBSHigh Yield Relationship Fund, a series of the UBS Relationship funds (the “Purchaser”),dated July 2, 2008, pursuant to which the Company issued and sold$40,000,000 aggregate principal amount of unregistered 9 3/4% Senior SecuredNotes due 2010 (the “New Notes”) to the Purchasers for the purchase price of$36,900,000 which is equal to 92.25% of the aggregate principal amount of theNew Notes. The New Notes were issued pursuant to and will be governed by theIndenture, dated as of March 12, 2004 (as amended and supplemented, the “CelluTissue Indenture”) among the Company, the subsidiary guarantors party theretoand The Bank of New York Mellon Trust Company, N.A., as successor trustee tothe Bank of New York (the “Trustee”). The proceeds of the sale were used tofinance a portion of the Acquisition.

 

**Third Supplemental Indenture**

 

The Company, certain subsidiaries of the Company and the Trustee haveexecuted the Third Supplemental Indenture, dated July 2, 2008 (the “ThirdSupplemental Indenture”), pursuant to which Cellu Hauppauge and Cellu Thomastonbecame parties to the Cellu Tissue Indenture as subsidiary guarantors.  As subsidiary guarantors, Cellu Hauppauge andCellu Thomaston, on a joint and several basis, with all the existing subsidiaryguarantors, fully, unconditionally and irrevocably guarantees to each holder ofthe New Notes and the Trustee the obligations of the Company under the CompanyIndenture and the New Notes.

 

**Amendment to Credit Agreement**

 

The Company has entered into a Second Amendment, dated July 2, 2008(the “Amendment”), to the Credit Agreement dated June 12, 2006 (as amendedby the First Amendment, dated as of March 21, 2007, and the Amendment, the“Amended Credit Agreement”) among the Company, as U.S. Borrower, InterlakeAcquisition Corporation Limited, a subsidiary of  the Company, as Canadian Borrower, certainsubsidiaries of the Company,  Parent,JPMorgan Chase Bank, N.A. (the “U.S. Administrative Agent”) and JPMorgan ChaseBank, N.A., Toronto Branch (the “Canadian Administrative Agent”).

 

The Amendment (1) increases the working capital facility from$40.0 million to $60.0 million, (2) permits the issuance by the Company ofthe Notes, (3) provides for the consummation of the Acquisition and (4) permitsthe issuance of the Seller Note.  Inconnection with Amendment, Cellu Hauppauge and Cellu Thomaston becameguarantors of the obligations of the borrowers under the Amended CreditAgreement.

 

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Tableof Contents

 
| **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-Q/Amay contain forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended and, as such, may involve known orunknown risks, uncertainties and other factors which may cause our actualresults, performance or achievements to be materially different from futureresults, performance or achievements expressed or implied by suchforward-looking statements. Forward-looking statements, which are based on certain assumptions anddescribe our future plans, strategies and expectations are generallyidentifiable by use of the words “may”, “will”, “should”, “expect”, “anticipate”,“estimate”, “believe”, “intend”, “project”, or comparable terminology.  Factors which could have a material adverseeffect on our operations and future prospects include, but are not limited to,those set forth in Forward-Looking Statements in our Annual Report on Form 10-K/Afor 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 itsconsolidated financial statements as of May 29, 2008 and February 29,2008 and for the three month periods ended May 29, 2008 and May 31,2007.  This restatement correctserrors in (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) classification of shipping and handling costs inaccordance with EITF 00-10, *Accounting for Shippingand Handling Fees and Costs*(EITF 00-10), (b) accounting forderivative instruments, (c) accounting for foreign exchange gains and losses infiscal 2008 and 2007, and (d) certain other miscellaneous adjustments.  See Note 2 — Restatement ofFinancial Statements in the accompanying consolidated financial statements forfurther 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 diversegroup of high-quality customers, with three of our top 10 customers belongingto the Fortune 150 group of companies

 

We operate in two business segments: tissue and machine-glazed paper. We assess the performance of our business segments using income fromoperations.  Income from 

 

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operations excludes interest income, interest expense, income taxexpense (benefit), other income and expense and the impact of foreign currencygains and losses.

 

***Acquisition***

 

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 $1.6million and acquisition costs of $2.6 million), was financed in part byissuance of the Additional Notes of approximately $20.0 million, borrowings ona revolving line of credit ($17.4 million) and available cash on hand.

 

The Acquisition has been accounted for as apurchase in accordance with the provisions of SFAS 141 and, accordingly, theconsolidated statement of operations includes the results of CityForest duringthe three-months ended May 29, 2008 and during the three-months ended May 31.,2007 from the date of acquisition.  Theresults of CityForest’s operations from the March 21, 2007 date ofacquisition are included in our tissue segment. Unaudited pro forma results of operations for the three months ended May 31,2007 as if we and CityForest had been combined as of March 1, 2007, arepresented below.  The pro forma resultsinclude estimates and assumptions, which our management believes arereasonable.  However, the pro formaresults do not include any cost savings or other effects of the plannedintegration of CityForest, and are not necessarily indicative of the resultswhich would have occurred if the business combination had been in effect on thedates indicated, or which may result in the future.

 
|             |   | Three Months Ended May 31, 2007 (1) |   |
|------------------|--------|-------------------------------------------------------------------|--------|
|             |   | Actual**(Restated)**                                              |   | Pro Forma**(Restated)** |   |
|             |   | (in thousands)                                               |   |
| Net sales        |   | $106,227                                                          |   | $108,937 |   |
| Operating income |   | $    3,170                                    |   | $    3,756 |   |
| Net loss         |   | $ (1,142                                                     | )      | $    (581 | ) |

 

(1)          Pro forma operating results include theoperating results for CityForest for the three months ended May 31,2007.  The actual operating resultsinclude the operating results for CityForest for the period from theacquisition date (March 21, 2007) to May 31, 2007.

 

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***Subsequent Event***

 

On July 2, 2008, we, through two newly created, wholly-ownedsubsidiaries, Cellu Tissue-Hauppauge, LLC (“Cellu Tissue-Hauppauge”) and CelluTissue-Thomaston, LLC (“Cellu Tissue-Thomaston”) consummated the acquisition ofcertain assets, and assumption of certain liabilities, from Atlantic Paper &Foil Corp. of N.Y., Atlantic Lakeside Properties, LLC, Atlantic Paper &Foil, LLC, Atlantic Paper & Foil of Georgia, LLC and ConsumerLicensing Corporation (collectively, the “Sellers”) pursuant to a definitiveasset purchase agreement between us and the Sellers.  The aggregatepurchase price paid was $68,000,000, including a cash payment at closing of$61,700,000 and the issuance of a promissory notes by us to the Atlantic Paper &Foil Corp. of N.Y. in the aggregate principal amount equal of $6,300,000 plusassumption of certain liabilities.  TheCompany financed the cash portion of the purchase price with cash on-hand, theborrowings described below and an equity contribution from Parent.  The purchase price is subject to certainpost-closing working capital adjustments.

 

In connection with the Acquisition, the following agreements wereentered into:

 

**Note Purchase Agreement**

 

We have entered into Note Purchase Agreements (the “Note PurchaseAgreements”) with each of (i) GMAM Investment Funds Trust II, for theaccount 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 “Purchaser”), dated July 2,2008, pursuant to which we issued and sold $40,000,000 aggregate principalamount of unregistered 9 3/4% Senior Secured Notes due 2010 (the “New Notes”)to the Purchasers for the purchase price of $36,900,000 which is equal to92.25% of the aggregate principal amount of the New Notes. The New Notes wereissued pursuant to and will be governed by the Indenture, dated as of March 12,2004 (as amended and supplemented, the “Cellu Tissue Indenture”) among us, thesubsidiary guarantors party thereto and The Bank of New York Mellon TrustCompany, N.A., as successor trustee to the Bank of New York (the “Trustee”).The proceeds of the sale were used to finance a portion of the Acquisition.

 

**Third Supplemental Indenture**

 

We, certain subsidiaries of us and the Trustee have executed the ThirdSupplemental Indenture, dated July 2, 2008 (the “Third SupplementalIndenture”), pursuant to which Cellu Hauppauge and Cellu Thomaston becameparties to the Cellu Tissue Indenture as subsidiary guarantors.  As subsidiary guarantors, Cellu Hauppauge andCellu Thomaston, on a joint and several basis, with all the existing subsidiaryguarantors, fully,

 

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unconditionally and irrevocably guarantees to each holder of the NewNotes and the Trustee the obligations of us under the Company Indenture and theNew Notes.

 

**Amendment to Credit Agreement**

 

We have entered into a Second Amendment, dated July 2, 2008 (the “Amendment”),to the Credit Agreement dated June 12, 2006 (as amended by the FirstAmendment, dated as of March 21, 2007, and the Amendment, the “AmendedCredit Agreement”) among us, as U.S. Borrower, Interlake AcquisitionCorporation Limited, a subsidiary of  us,as Canadian Borrower, certain subsidiaries of the Company,  Parent, JPMorgan Chase Bank, N.A. (the “U.S.Administrative Agent”) and JPMorgan Chase Bank, N.A., Toronto Branch (the “CanadianAdministrative Agent”).

 

The Amendment (1) increases the working capital facility from$40.0 million to $60.0 million, (2) permits the issuance by us of theNotes, (3) provides for the consummation of the Acquisition and (4) permitsthe issuance of the Seller Note.  Inconnection with Amendment, Cellu Hauppauge and Cellu Thomaston becameguarantors of the obligations of the borrowers under the Amended CreditAgreement.

 

**RESULTS OF OPERATIONS**

 

**Results of Operations for the Three Months Ended May 29, 2008 (thefiscal 2009 three-month period) compared to the Three Months Ended May 31,2007 (the fiscal 2008 three-month period)**

 

**Net sales** for the fiscal 2009 three-monthperiod increased $8.3 million, or 7.8%, to****$114.5****million from $106.2 million for the comparable period inthe prior year.   For the fiscal 2009three-month period, we sold 77,449 tons of tissue hard rolls, machine-glazedpaper hard rolls and converted paper products. This is a decrease of 656 tons, or less than 1%, from the comparableperiod in the prior year.  Net sellingprice per ton increased from $1,360 for the fiscal 2008 three-month period to$1,479 for the fiscal 2009 three-month period.

 

Net sales for our tissue segment for the fiscal 2009 three-month periodwere $85.8 million, an increase of $6.0 million, or 7.5%, from the comparableperiod in the****prior year.  Net sales for our machine-glazed segment forthe 2009 three-month period were****$28.7 million,an increase of $2.3 million, or 8.7%,****from thecomparable period in the prior year. These increases are primarily attributable to increases in net sellingprice per ton.

 

**Gross profit** for the fiscal 2009 three-monthperiod increased to $11.8 million from $7.9 million, an increase of $3.9million, or 49.5%, from the comparable period in the prior****year.**  **Asa percentage of net sales, gross profit increased to 10.3% in the fiscal 2009three-month period from 7.4% in the fiscal 2008 three-month period. ** **The increase in grossprofit in the fiscal 2008 three-month period is primarily attributable to theincrease 

 

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in net selling price per ton, despite an increase in net pulp cost andnet energy cost per ton.

 

Gross profit for our tissue segment for the fiscal 2009 three-monthperiod increased to $10.1 million from $6.9 million, an increase of $3.1million, or 45.7%, from the comparable period in the prior year.  Gross profit for our machine-glazed segmentfor the fiscal 2009 three-month period increased to $1.7 million, an increaseof $.8 million, or 76.1%, from the comparable period in the prior year.  As a percentage of net sales, gross profitfor the tissue segment increased to 11.7% in the fiscal 2009 three-month periodfrom 8.6% in the fiscal 2008 three-month period.  As a percentage of net sales, gross profitfor the machine-glazed segment increased to 6.1% in the fiscal 2009 three-monthperiod from 3.8% in the fiscal 2008 three-month period.  These increases are reflective of increasesin net selling price per ton, which more than offset increases in net pulp andenergy cost per ton, over the comparable period in the prior year.

 

**Selling, general and administrative expenses**inthe fiscal 2009 three-month period increased $.5 million, or 10.6%, to $5.0million from $4.5 million in the fiscal 2008 three-month period.  This increase reflects $.3 million of baddebt expense associated with a customer bankruptcy and $.3 million related toadditional sales tax incurred at one of our facilities.

 

**Terminated acquisition-related transactioncosts** in thefiscal 2009 three-month period of less than $.1 million related to costsincurred related to an acquisition that did not transpire.

 

**Stock and related compensation expense**in thefiscal 2009 and 2008 three-month periods of $.2 million relates primarily tothe accounting for restricted stock and stock option grants.

 

**Foreign currency gain**in the fiscal 2009three-month period and in the fiscal 2008 three-month period was less than $.1million.

 

**Income tax expense** for the fiscal 2009three-month period was $.6 million or an effective tax rate of 36.7% comparedto income tax benefit of $.6 million or an effective tax rate 35.7% benefit forthe fiscal 2008 three-month period.

 

**Net income**for the fiscal 2009 three-monthperiod was $1.0 million compared to net loss of $1.1 million for the comparableperiod in the prior year.

 

**FINANCIAL CONDITION**

 

**Liquidity and Capital Resources**

 

**Net cash used in operations** was $4.5 millionfor the fiscal 2009 three-month period, compared to cash provided by operationsof $2.8 million for the fiscal 2008 three-month 

 

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period. ** **Non-cashitems, consisting primarily of depreciation, stock-based compensation, derivativesand deferred income taxes, for the fiscal 2009 three-month period totaled $6.4million compared to $6.0 million for the 2008 fiscal three-month period.**   **Cash flows used bychanges in working capital totaled $12.0 million for the fiscal 2009three-month period compared to $1.6 million in the fiscal 2008 three-monthperiod. ** **Withrespect to the changes in accounts receivable and inventory, cash used by theseitems was $8.6 million for the fiscal 2009 three-month period, compared to cashprovided of $1.1 million for the comparable period in the prior fiscal year.**  ** This increase is reflective of changes insales terms with a key customer and timing of customer payments. Cash****provided by changes in prepaid expenses and other currentassets was $.8 million for the 2009 fiscal three-month period compared to cashprovided by changes in prepaid expenses and other current assets of $.6 millionfor the comparable period in the prior fiscal year.  ** **Cash used in changes in accountspayable, accrued expenses and accrued interest for the fiscal 2009 three-monthperiod was $4.1 million, compared to cash used of $3.6 million for thecomparable period in the prior year.

 

**Net cash used in investing activities** for thefiscal 2009 three-month period was $2.6****millioncompared to $45.6 million used in the fiscal 2008 three-month period.  Included in the prior year is $43.3attributable to the cash paid for the acquisition of CityForest.  The remaining change relates to the level ofcapital spending period over period.

 

**Net cash provided by financing activities** forthe fiscal 2009 three-month period was $7.8****millioncompared to $34.4 million for the fiscal 2008 three-month period.  Net cash provided for the fiscal 2009three-month period relates to net borrowings on our revolving line of creditoffset by payment on CityForest’s industrial revenue bond.   Net cash provided for the fiscal 2008three-month period relates to financing obtained in connection with theacquisition of CityForest.

 

In connection with the acquisition of CityForest, we entered into theNote Purchase Agreement, pursuant to which we issued and sold $20.3 millionaggregate principal amount of Additional Notes to the Purchaser for thepurchase price of $20.0 million, which is equal to 98.7383% of the aggregateprincipal amount of the Additional Notes. The Additional Notes were issued pursuant to and will be governed byCellu Tissue Indenture among us, our subsidiary guarantors party thereto andthe Trustee.

 

Our Notes mature on March 15, 2010 and require semi-annualinterest payments on March 15 and September 15.

 

We entered into the Credit Agreement, dated as of June 12, 2006,among us, as U.S. Borrower, Interlake Acquisition Corporation Limited, one ofour subsidiaries, as Canadian Borrower, our Parent, the other loan guarantorsparty thereto, JPMorgan Chase Bank, N.A., as U.S. Administrative Agent,JPMorgan Chase Bank, N.A., Toronto Branch, as Canadian Administrative Agent,and the other lenders party thereto.

 

The Credit Agreement provides for a $35.0 million working capitalfacility, which has subsequently been increased to $60.0 million (see below andpreceding discussion),

 

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including a letter of credit sub-facility and swing-line loansub-facility. The Credit Agreement provides that amounts under the facility maybe borrowed, repaid and re-borrowed, subject to a borrowing base test, untilthe maturity date, which is June 12, 2011. An amount equal to $32.0million, which was subsequently increased to $57.0 million, is available, inU.S. dollars, to the U.S. Borrower under the facility, and an amount equal to$3.0 million is available, in U.S. or Canadian dollars, to the CanadianBorrower under the facility.  Borrowingsof $17.4 million were made to finance a portion of the acquisition ofCityForest.    As of May 29, 2008,there was $18.0 million of borrowings outstanding under the working capitalfacility and excess availability was $18.1 million.

 

In addition to the Note Purchase Agreement, the following agreementswere entered into in connection with the acquisition of CityForest:

 

***Second Supplemental Indenture***

 

We, certain of our subsidiaries, the Trustee and CityForest haveexecuted the Second Supplemental Indenture, pursuant to which CityForest becamea party to the Cellu Tissue Indenture as a subsidiary guarantor.  As a subsidiary guarantor, CityForest, on ajoint and several basis with all the existing subsidiary guarantors, fully,unconditionally and irrevocably guarantees to each holder of the Notes and theTrustee our obligations under its Indenture and the Notes.

 

***Amendment to Credit Agreement***

 

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

 

The Amendment (1) increases the working capital facility from$35.0 million to $40.0 million, (2) permits the issuance and sale by us ofthe Additional Notes, (3) provides for the consummation of the acquisitionof CityForest and the conversion by CityForest from a Minnesota corporation toa Minnesota limited liability company, (4) permits the assumption ofapproximately $18.4 million in aggregate principal amount of indebtedness ofCityForest in connection with the acquisition of CityForest in accordance withthe terms of the CityForest Bond Documents and (5) permits the guaranteeby us of certain obligations of CityForest under the CityForest BondDocuments.  In connection with theAmendment, CityForest became a guarantor of the obligations of the borrowersunder the Amended Credit Agreement.

 

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***CityForest Bond Documents***

 

CityForest is party to a Loan Agreement with the City of Ladysmith,Wisconsin, as Issuer.  Pursuant to theLoan Agreement, the Issuer loaned the proceeds of the Issuer’s Bonds toCityForest to finance the construction by CityForest of a solid waste disposalfacility.  Approximately $18.4 million inaggregate principal amount of the Bonds was outstanding as of the date of theCityForest acquisition.  CityForest isrequired, under the terms of the CityForest Indenture to provide a letter ofcredit in favor of the Bonds Trustee. CityForest has entered into the Reimbursement Agreement with AssociatedBank, pursuant to which Associated Bank has extended the Associated Bank Letterof Credit and has provided the Associated Bank Revolving Credit Facility toCityForest in an aggregate principal amount of up to $3.5 million.

 

The Bonds Trustee is permitted to draw upon the Associated Bank Letterof Credit to pay principal and interest due on the Bonds, and to provideliquidity to purchase Bonds put to CityForest by bondholders and notremarketed; and CityForest is obligated under the Reimbursement Agreement toreimburse Associated Bank for any such draws. CityForest is also obligated topay a fee in respect of the aggregate amount available to be drawn under theAssociated Bank Letter of Credit at a rate per annum initially equal to 1.25%,subject to adjustment on a quarterly basis based on CityForest’s leverage.  The expiration date of the Associated BankLetter of Credit is February 15, 2011.

 

Amounts borrowed by CityForest under the Associated Bank RevolvingCredit Facility bear interest at a rate per annum equal to the LIBOR Rate (asdefined in the Reimbursement Agreement), plus an applicable margin. Theapplicable margin percentage initially is 1.75%, subject to adjustment on aquarterly basis based upon CityForest’s leverage.  During the continuance of an event ofdefault, the outstanding principal balance bears interest at a rate per annumequal 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 Agreement requires scheduled semi-annual payments ofprincipal of the Bonds equal to approximately 2.00% of the principal amountoutstanding as of the date of the Acquisition, with the balance payable atmaturity of the Bonds on March 1, 2028. The Reimbursement Agreement alsocontains a number of other provisions regarding reserve funds and othermandatory and optional repayments in connection with the Bonds.  In addition, the Reimbursement Agreementprovides that in certain circumstances where we incur indebtedness in excess ofamounts currently permitted under the indenture or refinances the indebtednessissued under the indenture, Associated Bank may require CityForest to repay allof its obligations to Associated Bank under the Reimbursement Agreement andeither to cause the Bonds to be redeemed or to replace the Associated BankLetter of Credit with a Substitute Credit Facility, as such term is defined inthe CityForest Indenture.

 

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The Reimbursement Agreement contains various affirmative and negativecovenants customary for working capital and term credit facilities, as well asadditional covenants relating to the Bonds. The negative covenants include limitations on: indebtedness; liens;acquisitions, mergers and consolidations; investments; guarantees; asset sales;sale and leaseback 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 contains customary events of default,including:  payment defaults; breaches ofrepresentations and warranties; covenant defaults; cross-defaults to certainother debt, including the Additional Notes and indebtedness under the AmendedCredit Agreement; 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 us.

 

We have guaranteed all of the obligations of CityForest under theReimbursement Agreement, pursuant to the Cellu Tissue Guaranty executed by usin favor of Associated Bank. In addition, the obligations of CityForest underthe Reimbursement 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,Associated Bank and CityForest have entered into an Intercreditor Agreement,dated March 21, 2007, which sets forth the respective rights andpriorities of Associated Bank, on the one hand, and the U.S. AdministrativeAgent and the Canadian Administrative Agent, on the other hand, as to thecollateral of CityForest securing the Reimbursement Agreement and the AmendedCredit Agreement.

 

**Cash**as of May 29, 2008 increased to $1.6 million from$.9 million as of the end of fiscal year 2008.

 

**Receivables,net**as of May 29, 2008 increased to $52.2 millionfrom $44.5 million as of the end of fiscal year 2008.  The increase is attributable to a change inpayments terms for a significant customer and timing of customer payments.

 

**Property,plant and equipment, net**as of May 29, 2008decreased to $306.9 million from $310.5 million as of the end of fiscal year2008.  This decrease relates todepreciation expense for the period offset partially by capital expendituresfor the period.

 

**Revolvingline of credit**amount outstanding as of May 29,2008 increased to $18.0 million from $9.8 million as of the end of fiscal year2008 primarily due to increased borrowing to pay the semi-annual interestpayments due on the Notes and funding of increases in accounts receivable.

 

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**Accruedinterest**as of May 29, 2008 decreased to $3.8million from $8.3 million as of the end of fiscal year 2008 due primarily tothe timing of semi-annual interest payments on the Notes.

 

**Stockholders’equity**as of May 29, 2008 was $47.1 millioncompared to $46.1 as of the end of fiscal year 2008.   The increase is primarily attributable tothe net income generated for the three-month period.

 

CriticalAccounting Policies

 

Our criticalaccounting policies are discussed in Management’s Discussion and Analysis ofFinancial Condition and Results of Operations in our Annual Report on Form 10-Kfor the fiscal year ended February 29, 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.

 

New AccountingPronouncements

 

In September 2006,the FASB issued SFAS 157.  We wererequired 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 our results of operations and financial position.

 

In February 2007,the FASB issue 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 and the Company chose not to adopt these fairvalue provisions.

 

In December 2007,the FASB 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.

 

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

 

In March 2004,we completed a private offering of the Notes. In connection with the acquisition of CityForest in March 2007, weissued and sold approximately $20.0 million of Additional Notes and assumed$18.4 million of additional debt.  Inconnection with our recent acquisition by Cellu Tissue-Hauppauge and CelluTissue-Thomaston, we issued and sold approximately $40.0 million of New Notes.We also have the ability to borrow under our revolving line of credit, up to$60.0 million, of which as of May 29, 2008 we have outstanding borrowingsof $18.0 million.  Furthermore, weborrowed an additional $12.1 million under the revolving line of credit tofinance a portion of our recent acquisition. As a result, we are highly leveraged.   The interest on our revolving line of credit fluctuates based on primeplus .50% or LIBOR plus 1.75% depending on whether our borrowing is based onprime or LIBOR rates.

 

We haveminimal foreign currency translation risk. All international sales, other than sales originating from our Canadiansubsidiary, are denominated in U. S. dollars. Due to our Canadian operations, however, we could be adversely affectedby unfavorable fluctuations in foreign currency exchange rates.

 

We are alsosubject to commodity 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.

 

**Item4.  Controls and Procedures**

 

**Disclosure Controls and Procedures (Restated)**

 

We maintain disclosurecontrols and procedures designed to ensure that information required to bedisclosed in the reports that we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms. Disclosure controls and procedures, asdefined in Rules 13a–15(e) and 15d–15(e) under the Exchange Act,include controls and procedures designed to ensure that information required tobe disclosed in the reports we file or submit under the Exchange Act isaccumulated and communicated to our management, including the Chief ExecutiveOfficer and the Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosure. Any system of controls, however welldesigned and operated, can provide only reasonable, and not absolute, assurancethat the objectives of the system are met.

 

At the time ofour quarterly filing of Form 10Q which was filed on July 11, 2008, ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were effective as of May 29, 2008. Subsequent to therestatement described in Note 2 — Restatement of Financial Statements inthe consolidated financial statements, we have re-evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures covered by this Quarterly Report on Form 10Q/A. The re-evaluationwas carried out under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer.Based on this re-evaluation, our management including our Chief ExecutiveOfficer and Chief Financial Officer have concluded that, in light of thematerial weakness in our internal control over financial reporting describedbelow, as of May 29, 2008 our disclosure controls and procedures were noteffective.

 

As a result of the materialweakness, management performed additional procedures to ensure that ourconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States of America (US GAAP).Accordingly, we believe that the financial statements for the periods coveredby and included in this Quarterly Report on Form 10-Q/A fairly present inall material respects our financial condition, results of operations and cashflows.

 

**MaterialWeakness**

 

A material weakness is adeficiency, or combination of deficiencies, in internal controls 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, we identified the following material weakness in our internal controlover financial reporting, which continued to exist as of May 29, 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 FinancialStatements in the consolidated financial statements.

 

**Plan ofRemediation for Identified Material Weakness**

 

These deficiencies have notbeen fully remediated. Accordingly, management has determined that thesecontrol deficiencies continue to constitute a material weakness at May 29,2008.

 

Management has prepared anaction plan for all identified deficiencies as of February 29, 2008. Thestatus of 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 inInternal Control Over Financial Reporting**

 

There were no changes to ourinternal control over financial reporting during the quarter ended May 29,2008 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

 

The risk factorsincluded in our Annual Report on Form 10-K/A for the fiscal year ended February 29,2008 have not materially changed.

 

Item 6.  Exhibits

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

 

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SIGNATURES

 

Pursuant 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: February 3,  2009 | /s/ Russell  C. Taylor                    |
|                         | Mr. Russell  C. Taylor               |
|                         | President  and Chief Executive Officer    |
|                         |                                      |
| Date: February 3,  2009 | /s/ David J.  Morris                      |
|                         | Mr. David  J. Morris                 |
|                         | Senior Vice  President, Finance and Chief |
|                         | Financial  Officer                        |

 

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