Cellu Tissue 10Q 2008 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	For the Quarterly Period Ended November 29, 2007
	or
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

	For the transition period from to .

	Commission file number 333-118829

Cellu Tissue Holdings, Inc.
(Exact name of registrant as specified in its charter)

Delaware		06-1346495
(State of incorporation)		(IRS Employer Identification No.)

1855 Lockeway Drive, Suite 501, Alpharetta, Georgia		30004
(Address of principal executive offices)		(zip code)

(678) 393-2651
(Registrant’s telephone number, including area code)

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

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

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

Large accelerated filer o

Accelerated filer o

Non-accelerated filer x

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

The number of shares outstanding of each of the registrant’s classes of common stock as of January 4, 2008:

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

CELLU TISSUE HOLDINGS, INC.

FORM 10-Q

QUARTER ENDED NOVEMBER 29, 2007

INDEX

PART I – FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements

Item 2.	Management’s Discussion and Analysis of Financial Conditionand 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

Part 1 FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

		CELLU TISSUE HOLDINGS, INC. AND SUBSIDIARIES
		CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

	Three Months Ended
	November 29, 2007			November 23, 2006
	(Post-Merger)			(Post-Merger)

Net sales	$	109,161,988		$	83,281,206
Cost of goods sold	97,646,110			77,390,427
Gross profit	11,515,878			5,890,779

Selling, general and administrative expenses	4,835,215			3,240,571
Stock and related compensation expense	714,812			169,806
Merger-related transaction costs	—			53,474
Income from operations	5,965,851			2,426,928

Interest expense, net	4,843,976			4,066,402
Foreign currency loss (gain)	220,348			(79,440		)
Other income	(104,573		)	(3,501		)
Income (loss) before income tax benefit	1,006,100			(1,556,533		)

Income tax benefit	(369,572		)	(481,798		)
Net income (loss)	$	1,375,672		$	(1,074,735	)

See accompanying notes to consolidated financial statements.

		CELLU TISSUE HOLDINGS, INC. AND SUBSIDIARIES
		CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (continued)

	For the Periods
	(Post - Merger)						(Pre-Merger)
	March 1, 2007-			June 13, 2006-			March 1, 2006-
	November 29, 2007			November 23, 2006			June 12, 2006
Net sales	$	321,363,095		$	151,843,592		$	94,241,932
Cost of goods sold	289,788,562			142,608,186			86,053,812
Gross profit	31,574,533			9,235,406			8,188,120

Selling, general and administrative expenses	13,874,266			7,018,962			5,584,865
Stock and related compensation expense	1,097,812			306,076			—
Restructuring costs	—			240,218			—
Merger-related transaction costs	—			155,849			5,933,265
Income (loss) from operations	16,602,455			1,514,301			(3,330,010		)

Interest expense, net	14,965,736			7,218,938			4,896,355
Foreign currency loss (gain)	740,756			(146,116		)	289,010
Other income	(187,073		)	(20,954		)	(27,049		)
Income (loss) before income tax benefit	1,083,036			(5,537,567		)	(8,488,326		)
Income tax benefit	(251,982		)	(1,843,447		)	(1,953,362		)
Net income (loss)	$	1,335,018		$	(3,694,120	)	$	(6,534,964	)

See accompanying notes to consolidated financial statements.

CELLU TISSUE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	November 29			February 28
	2007			2007
	(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	1,681,072		$	16,260,601
Receivables, net	43,523,811			34,140,844
Inventories	30,898,908			29,603,809
Prepaid expenses and other current assets	6,574,081			2,809,014
Income tax receivable	327,183			329,861
Deferred income taxes	6,262,777			6,498,098
TOTAL CURRENT ASSETS	89,267,832			89,642,227
PROPERTY, PLANT AND EQUIPMENT, NET	292,178,158			228,851,765
GOODWILL	6,944,317			—
TRADEMARKS	8,750,314			6,550,314
OTHER ASSETS	1,531,631			224,438
TOTAL ASSETS	$	398,672,252		$	325,268,744

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Bank overdrafts	$	2,213,043		$	—
Revolving line of credit	3,500,000			—
Accounts payable	23,094,400			16,523,755
Accrued expenses	23,271,781			16,315,163
Accrued interest	3,746,490			7,226,753
Current portion of long-term debt	760,000			—
TOTAL CURRENT LIABILITIES	56,585,714			40,065,671
LONG-TERM DEBT, LESS CURRENT PORTION	197,929,287			160,355,507
DEFERRED INCOME TAXES	64,592,517			50,677,332
OTHER LIABILITIES	35,154,438			35,179,252
STOCKHOLDERS' EQUITY :
Common stock, Class A, $.01 par value, 1,000 shares authorized, 100 shares issued and outstanding at November 29, 2007 and February 28, 2007

	1			1
Capital in excess of par value	46,854,562			46,259,101
Accumulated deficit	(4,857,348		)	(6,192,366		)
Accumulated other comprehensive (loss) income	2,413,081			(1,075,754		)
TOTAL STOCKHOLDERS' EQUITY	44,410,296			38,990,982
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$	398,672,252		$	325,268,744

See accompanying notes to consolidated financial statements.

CELLU TISSUE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	For the Periods
	Post		-	Merger			Pre-Merger
	March 1, 2007-			June 13, 2006-			March 1, 2006-
	November 29, 2007			November 23, 2006			June 12, 2006

Cash flows from operating activities
Net income (loss)	$	1,335,018		$	(3,694,120	)	$	(6,534,964	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

Noncash inventory charge	—			909,264			—
Stock-based compensation	595,461			306,096			923,580
Deferred income taxes	(3,088,003		)	(1,760,180		)	(396,024		)
Accretion of debt discount	458,780			239,092			85,471
Amortization of intangibles	—			—			405,568
Depreciation	17,568,304			10,041,824			4,226,643
Changes in operating assets and liabilities:
Receivables	(3,811,469		)	2,956,053			(1,994,674		)
Inventories	250,334			(1,601,320		)	(2,208,757		)
Prepaid expenses, other current assets and income tax receivable
	(2,604,297		)	96,906			(683,329		)
Other	357,991			(35,240		)	(5,328		)
Accounts payable, accrued expenses, accrued interest and income taxes
	2,795,383			(5,138,065		)	(358,006		)
Total adjustments	12,522,484			6,014,430			(4,856		)
Net cash provided by (used in) operating activities	13,857,502			2,320,310			(6,539,820		)

Cash flows from investing activities
Cash paid for acquisition, net of cash received	(43,637,578		)	—			—
Equity investment by Weston Presidio	—			45,761,997			—
Capital expenditures, net	(10,965,313		)	(3,995,243		)	(1,937,610		)
Net cash (used in) provided by investing activities	(54,602,891		)	41,766,754			(1,937,610		)

CELLU TISSUE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (continued)

	For the Periods
	Post		-	Merger			Pre-Merger
	March 1, 2007-			June 13, 2006-			March 1, 2006-
	November 29, 2007			November 23, 2006			June 12, 2006

Cash flows from financing activities
Bank overdrafts	2,213,043			—			—
Merger consideration paid to former shareholders	—			(45,761,997		)	—
Payments of long-term debt	(575,000		)	—			(290,000		)
Borrowings on revolving line of credit, net	3,500,000			—			—
Proceeds from bond offering	20,000,000			—			—
Net cash provided by (used in) financing activities	25,138,043			(45,761,997		)	(290,000		)

Effect of foreign currency	1,027,817			(406,629		)	362,212
Net decrease in cash and cash equivalents	(14,579,529		)	(2,081,562		)	(8,405,218		)
Cash and cash equivalents at beginning of period	16,260,601			14,418,844			22,824,062
Cash and cash equivalents at end of period	$	1,681,072		$	12,337,282		$	14,418,844

See accompanying notes to consolidated financial statements.

Cellu Tissue Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
November 29, 2007

Note 1 Basis of Presentation and Significant Accounting Policies

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

On June 12, 2006 the Parent consummated an Agreement and Plan of Merger with Cellu Parent Corporation (“Cellu Parent”), a corporation organized and controlled by Weston Presidio V, L.P. (“Weston Presidio”), and Cellu Acquisition Corporation, a wholly owned subsidiary of Cellu Parent and a newly formed corporation indirectly controlled by Weston Presidio (“Merger Sub”). Pursuant to the agreement, on June 12, 2006, Merger Sub was merged with and into Parent, with Parent surviving (the “Merger”). Accordingly, the operating results and cash flows for the prior year are presented in the accompanying financial statements on a pre-merger (period from March 1, 2006 to June 12, 2006) and post-merger (three months ended November 23, 2006 and the period June 13, 2006 to November 23, 2006) basis. The current year operating results and cash flows are post-merger.

These statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the quarter and nine months ended November 29, 2007 are not necessarily indicative of the results that may be expected for the fiscal year ending February 29, 2008. For further information, refer to the Company’s consolidated financial statements and footnotes thereto as of February 28, 2007 and for the year then ended contained in the Company’s Annual Report on Form 10-K, from which the consolidated balance sheet at February 28, 2007 has been derived and the Company’s latest Current Reports on Form 8-K as filed with the Securities and Exchange Commission (“SEC”).

The Company accounted for the Merger as a purchase in accordance with the provisions of Statement of Financial Accounting Standards No. 141 (“SFAS 141”), Business Combinations, which resulted in a new valuation for the assets and liabilities of the Company based upon fair values as of the date of the Merger. As allowed under SEC Staff Accounting Bulletin No. 54, Push Down Basis of Accounting Required in Certain Limited Circumstances, the Company has reflected all applicable purchase accounting

Cellu Tissue Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited) (continued)

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

adjustments in the Company’s consolidated financial statements for all periods subsequent to the Merger date (“Push Down Accounting”). Push Down Accounting requires the Company to establish a new basis for its assets and liabilities based on the amount paid for its equity at close of business on June 12, 2006. Accordingly, Cellu Parent’s ownership basis is reflected in the Company’s consolidated financial statements beginning upon completion of the Merger. In order to apply Push Down Accounting, Cellu Parent’s purchase price of $207.8 million, including assumption of $162.0 million in aggregate principal amount of the Company’s outstanding 9.75% senior secured notes (the “Notes”), was allocated to the assets and liabilities based on their relative fair values. The total consideration is subject to adjustment for up to an additional $35.0 million in contingent earnout consideration based upon the achievement of certain financial targets. If any portion of the earned contingent payments is unable to be made, then Weston Presidio has agreed to provide the necessary funds to former holders of the Parent’s capital stock, options and warrants through an equity investment in Parent or otherwise. In accordance with SFAS 141, the $35.0 million has been recognized as a liability in the Company’s balance sheet and is recorded in other liabilities as of November 29, 2007.

The Company has allocated the excess purchase price over the net assets acquired in the Merger based on its estimates of the fair value of assets and liabilities as follows:

	Excess purchase price allocated to:
Inventories	$	909,264
Property, plant and equipment	142,292,525
Trademarks	6,550,314
Long-term debt	(900,729		)
Contingent consideration	(35,000,000		)
Deferred income taxes	(50,830,323		)
Total	$	63,021,051

In conjunction with the valuation of the Company’s fixed assets, the lives over which the assets are depreciated were re-evaluated and the resulting estimated useful lives of the principal classifications of depreciable assets are as follows:

		Life in Years
Buildings and improvements		20-30
Machinery and equipment		15-30
Furniture and fixtures		10
Land improvements		5
Computer software		5

Cellu Tissue Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited) (continued)

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

Reclassification

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

Stock-Based Compensation

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS 123R”), Share-Based Payment, which requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using fair-value-based method and the recording of such expense in the Company’s consolidated statement of operations. The Company adopted the provisions of SFAS 123R using the prospective method effective March 1, 2006. As such, there was no accounting effect on any outstanding awards. Upon adoption of SFAS 123R, the Company had only one share-based payment arrangement under which the Parent granted stock options to certain members of the Company’s management under the Cellu Paper Holdings, Inc. 2001 Stock Incentive Plan (the “old Plan”). In accordance with the old Plan, each option outstanding at the time of a change in control immediately vested and became exercisable. Furthermore, in accordance with the terms of the Merger, all outstanding options were cancelled and automatically converted into the right to receive the per share merger consideration for in-the-money options.

On June 12, 2006, the Board of Directors of Cellu Parent adopted the 2006 Stock Option and Restricted Stock Plan (the “Plan”). Under the Plan, the Plan Administrator may make awards of options to purchase shares of common stock of Cellu Parent and/or awards of restricted shares of common stock of Cellu Parent. A maximum of 8,095 shares of common stock of Cellu Parent may be delivered in satisfaction of awards under the Plan, determined net of shares of common stock withheld by Cellu Parent in payment of the exercise price of an award or in satisfaction of tax withholding requirements. Key employees and directors of, and consultants and advisors to, Cellu Parent or its affiliates who, in the opinion of the Plan Administrator, are in a position to make a significant contribution to the success of Cellu Parent and its affiliates are eligible to participate in the Plan. Stock options are granted at the market price of the Company’s stock on the date of grant and have a 10-year term. Generally, stock option grants vest ratably over four years from the date of grant. The following describes how certain assumptions affecting the estimated fair value of stock options are determined. The dividend yield is zero; the volatility is based on historical market value of the Company’s stock; and the risk-free interest rate is based on U.S. Treasury securities with

Cellu Tissue Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited) (continued)

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

maturities equal to the expected life of the option. The Company uses historical data in order to estimate exercise, termination and holding period behavior for valuation purposes. A summary of the outstanding options as of November 29, 2007 is as follows: There was no activity during the three months then ended.

	Options	Weighted Average Exercise Price		Weighted Average Remaining Contractual Life
Outstanding, August 31, 2007
and November 29, 2007	1,150	$	726.99	9.28 and 9.10 years,
				respectively
Exercisable, November 29, 2007	—	—		—

The fair value of the stock option grant was estimated on the date of grant using the Black-Scholes option pricing model. The weighted average assumptions used to value the grants were no dividend yield; 57% volatility; 4.9% risk free interest rate; and 10-year expected life. The weighted average fair value of stock options granted was $472.69 per share and the unrecognized total compensation cost as of November 29, 2007 related to nonvested awards is $439,471.

On August 6, 2007, Cellu Parent entered into a Restricted Stock Agreement with the Company’s newly appointed Chief Financial Officer, pursuant to which Cellu Parent granted 700 restricted shares of its common stock to the named individual pursuant to the Plan. The shares will vest and cease to be restricted in four equal annual installments commencing on August 6, 2007, as long as the named individual is continuously employed by the Company until such 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 stock at the time of a change in control. Additionally, the Parent has agreed to pay an amount to the named individual equal to an amount that would be included in such individual’s gross income and payable as income tax as a result of making a Section 83(b) election under 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 Company has recorded compensation expense of $501,853 for the three months ended November 29, 2007.

On June 12, 2006, Cellu Parent entered into Restricted Stock Agreements with the Company’s Chief Executive Officer, Chief Operating Officer and the then Chief Financial Officer, pursuant to which Cellu Parent granted 3,778 restricted shares of its common stock to the Chief Executive Officer and 1,349 restricted shares of its common stock to each of the other two named individuals pursuant to the Plan. The shares will vest and cease to be restricted in four equal annual installments commencing on June 12,

Cellu Tissue Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited) (continued)

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

2007, as long as the named individual, as the case may be, is continuously employed by the Company until each such vesting date with respect to his or her 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 stock at the time of a change in control. Additionally, the Parent has agreed to pay an amount to the named individuals equal to an amount that would be included in such individuals’ gross income and payable as income tax as a result of making a Section 83(b) election under 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 Chief Financial Officer resigned and forfeited two-thirds of the individual’s restricted stock grant and, accordingly, the Company only recorded compensation expense associated with this individual’s grant through June 12, 2007 as all other shares were forfeited and no compensation expense is required to be recognized for forfeited shares.

For the three months and nine months ended November 29, 2007, the Company has recorded $179,078 and $506,022, respectively, of compensation expense related to the above restricted stock grants. For the three months ended November 23, 2006 and for the period June 13, 2006 to November 23, 2006, the Company has recorded $169,806 and $306,076, respectively of compensation expense related to the vesting of the grants at that time in accordance with SFAS 123R.

Immediately prior to consummation of the Merger, there were 341.3 restricted shares of the Parent’s common stock. In accordance with the terms of the old Plan, the restricted stock immediately vested. Accordingly, for the period from May 26, 2006 to June 12, 2006, the Company has recorded $870,922 of compensation expense related to the vesting of the above restricted stock in accordance with SFAS 123R. The Company had previously recorded $52,658 related to the normal vesting in the three-month period ended May 25, 2006.

Derivatives and Hedging

The Company uses derivative financial instruments to offset a substantial portion of its exposure to market risk arising from changes in the price of natural gas. Hedging of this risk is accomplished by entering into forward swap contracts, which are designated as hedges of specific quantities of natural gas expected to be purchased in future months. These contracts are held for purposes other than trading and are designated as cash flow hedges. The Company measures hedge effectiveness by formally assessing, at least quarterly, the correlation of the expected future cash flows of the hedged item and the derivative hedging instrument. The ineffective portions of the hedges, which are not material for any period presented, are immediately recognized in earnings. The fair value of these cash flow hedging instruments was a liability of $.1 million and an asset of less than $.1 million as of November 29, 2007 and February 28, 2007, respectively. During the next 12 months, the entire $.1 million will be reclassified to earnings consistent with the timing of the underlying hedged transactions.

Cellu Tissue Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 2 Inventories

Components of inventories are as follows:

	November 29, 2007			February 28, 2007

Finished goods	$	15,738,863		$	18,896,790
Raw materials	5,397,337			2,742,025
Packaging materials and supplies	9,948,053			8,098,582
	31,084,253			29,737,397
Inventory reserves	(185,345		)	(133,588		)
	$	30,898,908		$	29,603,809

Note 3 Acquisitions

On March 21, 2007, the Company executed a definitive merger agreement (the “Acquisition Agreement”) with CityForest Corporation (“CityForest”), Cellu City Acquisition Corporation (“Cellu City Merger Sub”) and Wayne Gullstad as the shareholders’ representative. Pursuant to the Acquisition Agreement, and subject to the terms and conditions therein, Cellu City Merger Sub, a wholly owned subsidiary of the Company, merged with and into CityForest, with CityForest surviving and becoming a wholly owned subsidiary of the Company (the “Acquisition”). The aggregate merger consideration (including assumption of $18.4 million in aggregate principal amount of industrial revenue bonds) was approximately $61.0 million subject to certain working capital and net cash adjustments. Total cash paid for the acquisition of $46.8 million (purchase price of $61.0 million less assumed indebtedness of $18.4 million plus restricted cash and other miscellaneous adjustments of $1.6 million and acquisition costs of $2.6 million) was financed in part by issuance of unregistered 9 3/4% Senior Secured Notes due 2010 (the “Additional Notes”) of approximately $20.0 million, borrowings on a revolving line of credit ($17.4 million) and available cash on hand.

The Acquisition has been accounted for as a purchase in accordance with the provisions of SFAS 141 and, accordingly, the consolidated statements of operations includes the results of CityForest during the three months and nine months ended November 29, 2007 from the date of acquisition. Purchase price allocations are subject to refinement until all pertinent information is obtained. The Company has allocated the excess of purchase price over the net assets acquired in the acquisition based on its estimates of the fair value of assets and liabilities as follows:

Cellu Tissue Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 3 Acquisitions (continued)

	Excess purchase price allocated to:
Property, plant and equipment	$	32,854,514
Trademarks	2,200,000
Goodwill	6,944,317
Long-term debt	(1,724,684		)
Deferred income taxes	(17,238,509		)
Total	$	23,035,638

The Company has estimated the fair value of the assets and liabilities of the Acquisition, utilizing information available at the time the Company’s unaudited interim financial statements subsequent to the Acquisition were prepared, and these estimates are subject to refinement until all pertinent information has been obtained. At that time, the Company was in the process of obtaining outside third-party appraisals of its tangible and intangible assets and had assumed no intangible assets or goodwill arising from the acquisition. In the second quarter of the fiscal year ending February 29, 2008 (“fiscal year 2008”), the Company obtained a third-party appraisal of CityForest’s tangible and intangible assets and finalized its calculation of deferred income taxes resulting from the book to tax differences arising from the application of purchase accounting. As a result thereof, trademarks of $2.2 million and goodwill of $6.9 million have been recorded. Furthermore, the net deferred income tax liability has increased $4.2 million from the Company’s original estimate.

The results of CityForest’s operations from the date of acquisition (March 21, 2007) are included in the Company’s tissue segment and accordingly, are included for the three months ended November 29, 2007. Unaudited pro forma results of operations for the three months ended November 23, 2006, for the nine months ended November 29, 2007, for the period June 13, 2006-November 23, 2006 and for the period March 1, 2006-June 12, 2006, as if the Company and CityForest had been combined as of March 1, 2006, are presented below. The pro forma results include estimates and assumptions, which the Company’s management believes are reasonable. However, the pro forma results do not include any cost savings or other effects of the planned integration of CityForest and are not necessarily indicative of the results which would have occurred if the business combination had been in effect on the dates indicated, or which may result in the future.

Cellu Tissue Holdings, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 3 Acquisitions (continued)

	Three Months Ended November 23, 2006(1)
	As Filed			Pro Forma
	(in thousands)
Net sales	$	83,281		$	95,422
Operating income	$	2,427		$	5,336
Net (loss) income	$	(1,075	)	$	1,461

(1)	Pro forma operating results include the operating results for CityForest for the three months ended September 30, 2006 as CityForest was previously a calendar year-end company.

	Nine Months Ended November 29, 2007(1)				June 13, 2006-November 23, 2006(2)					March 1, 2006-June 12, 2006(2)
	As Filed		Pro Forma		As Filed			Pro Forma		As Filed			Pro Forma
	(in thousands)				(in thousands)					(in thousands)
Net sales	$	321,363	$	324,073	$	151,844		$	173,272	$	94,242		$	107,942
Operating income (loss)	$	16,602	$	17,188	$	1,514		$	6,761	$	(3,330	)	$	25
Net income (loss)	$	1,335	$	1,896	$	(3,694	)	$	384	$	(6,535	)	$	(3,928	)

(1)	Pro forma operating results include the operating results for CityForest for the nine months ended November 29, 2007. The “as filed” operating results include the operating results for CityForest for the period from the acquisition date (March 21, 2007) to November 29, 2007.

(2)	Pro forma operating results include the operating results for CityForest for the nine months ended September 30, 2006, prorated between the two reporting periods presented for the Company, as CityForest was previously a calendar year-end company.

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 4 Long-Term Debt

Long-term debt consists of the following:

	November 29, 2007			February 28, 2007
9 ¾% senior secured notes due 2010	$	182,255,572		$	162,000,000
Less discount	(1,441,285		)	(1,644,493		)
	180,814,287			160,355,507
Industrial revenue bond payable, in semi-annual installments, plus variable interest, due March 1, 2028	17,875,000			—
	198,689,287			160,355,507
Less current portion of debt	760,000			—
	$	197,929,287		$	160,355,507

In connection with the Acquisition (see Note 3), the Company entered into a Note Purchase Agreement (the “Note Purchase Agreement”) with Wingate Capital Ltd. (“Wingate”), dated March 21, 2007, pursuant to which it issued and sold $20.3 million aggregate principal amount of Additional Notes to Wingate for the purchase price of $20.0 million, which is equal to 98.7383% of the aggregate principal amount of the Additional Notes. The Additional Notes were 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 the Company, the subsidiary guarantors party thereto and The Bank of New York Trust Company, N.A., as successor trustee to the Bank of New York (the “Trustee”).

The Notes and Additional Notes mature on March 15, 2010 and require semi-annual interest payments on March 15 and September 15, which commenced on September 15, 2004. The Notes and Additional Notes are collateralized by a senior secured interest in substantially all of the Company’s assets. Terms of the indenture under which the Notes and Additional Notes have been issued contain certain covenants, including limitations on certain restricted payments and the incurrence of additional indebtedness. The Notes and Additional Notes are unconditionally guaranteed by all of the Company’s subsidiaries.

In connection with the Merger (see Note 1), the Company solicited consents with respect to the Notes. Consents were received with respect to 100% of the aggregate outstanding principal amount of the Notes. The Company accepted all of the consents delivered in the consent solicitation and paid to the consenting noteholders a consent fee of $40 per $1,000 principal amount of Notes for which they delivered consents. These payments were made in the Company’s second quarter of the fiscal year ended February 28, 2007

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 4 Long-Term Debt (continued)

(“fiscal year 2007”). These payments along with other transaction costs totaling $5.9 million are reflected as merger-related transaction costs on the statement of operations for the prior year. The Company had previously incurred $.1 million in the first quarter of fiscal year 2007. As a result of the acceptance by the Company of the consents delivered by noteholders and the completion of the consent solicitation, the amendments to the Cellu Tissue Indenture described in the Consent Solicitation Statement dated May 9, 2006 and related Supplement dated May 24, 2006 became operative and the Company was not required to make a change of control offer to purchase any Notes in connection with the Merger.

The Company entered into a Credit Agreement, dated as of June 12, 2006 (the “Credit Agreement”), among the Company, as U.S. Borrower, Interlake Acquisition Corporation Limited, a subsidiary of the Company, as Canadian Borrower, 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 $35.0 million working capital facility, including a letter of credit sub-facility and swing-line loan sub-facility. The Credit Agreement provides that 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 is available, in U.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 Canadian Borrower under the facility. Borrowings of $17.4 million were made to finance a portion of the Acquisition. As of November 29, 2007, $3.5 million of borrowings remained outstanding under the working capital facility and excess availability was $33.3 million. In addition to the Note Purchase Agreement, the following agreements were entered into in connection with the Acquisition:

Second Supplemental Indenture

The Company, certain of its subsidiaries, the Trustee and CityForest have executed the Second Supplemental Indenture, dated March 21, 2007 (the “Second Supplemental Indenture”), pursuant to which CityForest became a party to the Cellu Tissue Indenture as a subsidiary guarantor. As a subsidiary guarantor, CityForest, on a joint and several basis with all the existing subsidiary guarantors, fully, unconditionally and irrevocably guarantees to each holder of the Notes and the Trustee the obligations of Company 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 (as amended by the

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 4 Long-Term Debt (continued)

Amendment, the “Amended Credit Agreement”) among Cellu Tissue, as U.S. Borrower, Interlake Acquisition Corporation Limited, a subsidiary of Cellu Tissue, as Canadian Borrower, certain subsidiaries of Cellu Tissue, Cellu Paper Holdings, Inc., the parent corporation of Cellu Tissue, JPMorgan Chase 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 the Company of the Additional Notes, (3) provides for the consummation of the Acquisition and the conversion by CityForest from a Minnesota corporation to a Minnesota limited liability company, (4) permits the assumption of approximately $18.4 million in aggregate principal amount of indebtedness of CityForest in connection with the Acquisition in accordance with the terms of the CityForest Bond Documents (as defined below under “CityForest Bond Documents”) and (5) permits the guarantee by Cellu Tissue of certain obligations of CityForest under the CityForest Bond Documents. In connection with the Amendment, CityForest became a guarantor of the obligations of the borrowers under the Amended Credit Agreement.

CityForest Bond Documents

CityForest is party to a Loan Agreement, dated March 1, 1998 (the “Loan Agreement”), with the City of Ladysmith, Wisconsin (the “Issuer”). Pursuant to the Loan Agreement, the Issuer loaned the proceeds of the Issuer’s Variable Rate Demand Solid Waste Disposal Facility Revenue Bonds, Series 1998 (CityForest Corporation Project) (the “Bonds”) to CityForest to finance the construction by CityForest of a solid waste disposal facility. Approximately $18.4 million in aggregate principal amount of the Bonds was outstanding as of the date of the Acquisition. CityForest is required, under the terms of the Indenture of Trust governing the Bonds (the “CityForest Indenture”), to provide a letter of credit in favor of the trustee under the CityForest Indenture (the “Bonds Trustee”). CityForest has entered into an Amended and Restated Reimbursement Agreement, dated March 21, 2007 (the “Reimbursement Agreement” and, together with the CityForest Indenture and the Loan Agreement, the “CityForest Bond Documents”), 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 credit facility 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 Letter of Credit to pay principal and interest due on the Bonds, and to provide liquidity to purchase Bonds put to

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 4 Long-Term Debt (continued)

CityForest by bondholders and not remarketed; and CityForest is obligated under the Reimbursement Agreement to reimburse Associated Bank for any such draws. CityForest is also obligated to pay a fee in respect of the aggregate amount available to be drawn under the Associated 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 Bank Letter of Credit is February 15, 2011.

Amounts borrowed by CityForest under the Associated Bank Revolving Credit Facility bear interest at a rate per annum equal to the LIBOR Rate (as defined in the Reimbursement Agreement), plus an applicable margin. The applicable margin percentage initially is 1.75%, subject to adjustment on a quarterly basis based upon CityForest’s leverage. During the continuance of an event of default, the outstanding principal balance bears interest at a rate per annum equal to the then applicable interest rate plus 2.00%. CityForest is also obligated to pay a commitment fee in respect of any unused commitment under the Associated Bank 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 to February 15, 2009, CityForest is obligated to pay to Associated Bank a fee equal to 1.00% of the commitment then being terminated. The maturity date of the Associated Bank Revolving Credit Facility is February 15, 2011.

The Reimbursement Agreement requires scheduled semi-annual payments of principal of the Bonds equal to approximately 2.00% of the principal amount outstanding as of the date of the Acquisition, with the balance payable at maturity of the Bonds on March 1, 2028. The Reimbursement Agreement also contains a number of other provisions regarding reserve funds and other mandatory and optional repayments in connection with the Bonds. In addition, the Reimbursement Agreement provides that in certain circumstances where the Company incurs indebtedness, as defined, in excess of amounts currently permitted under the CityForest Indenture or refinances the indebtedness issued under the Indenture, Associated Bank may require CityForest to repay all of its obligations to Associated Bank under the Reimbursement Agreement and either to cause the Bonds to be redeemed or to replace the Associated Bank Letter of Credit with a Substitute Credit Facility, as such term is defined in the CityForest Indenture.

The Reimbursement Agreement contains various affirmative and negative covenants customary for working capital and term credit facilities, as well as additional 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 with affiliates; capital expenditures; and changes to the status of the Bonds. CityForest is also required to

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 4 Long-Term Debt (continued)

comply on a quarterly basis with a maximum leverage covenant and a minimum fixed charge coverage covenant.

The Reimbursement Agreement also contains customary events of default, including: payment defaults; breaches of representations and warranties; covenant defaults; cross-defaults to certain other debt, including the Additional Notes and indebtedness under the Amended Credit Agreement; certain events of bankruptcy and insolvency; judgment defaults; certain defaults related to the Employee Retirement Income Security Act of 1974, as amended; and a change of control of CityForest or the Company.

The Company has guaranteed all of the obligations of CityForest under the Reimbursement Agreement, pursuant to a Guaranty, dated March 21, 2007 (the “Cellu Tissue Guaranty”), executed by the Company in favor of Associated Bank. In addition, the obligations of CityForest under the Reimbursement Agreement are secured by first-priority liens in favor of Associated 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 and priorities of Associated Bank, on the one hand, and the U.S. Administrative Agent and the Canadian Administrative Agent, on the other hand, as to the collateral of CityForest securing the Reimbursement Agreement and the Amended Credit Agreement.

Note 5 Comprehensive Income (Loss)

The components of comprehensive income (loss) for the three months ended November 29, 2007 and November 23, 2006 are as follows:

	For the Three Months Ended
	November 29, 2007 (Post-Merger)		November 23, 2006 (Post-Merger)
Net income (loss)	$	1,375,672	$	(1,074,735	)
Foreign currency translation adjustments	218,752		(358,094		)
Derivative gain	459,296		—
Comprehensive income (loss)	$	2,053,720	$	(1,432,829	)

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 5 Comprehensive Income (Loss) (continued)

The components of comprehensive income (loss) for the nine months ended November 29, 2007 and for the periods from June 13, 2006 to November 23, 2006 and March 1, 2006 to June 12, 2006 are as follows:

	Nine Months Ended November 29, 2007			June 13, 2006- November 23, 2006			March 1, 2006- June 12, 2006
	(Post-Merger)						(Pre-Merger)
Net income (loss)	$	1,335,018		$	(3,694,120	)	$	(6,534,964	)
Foreign currency translation adjustments	1,027,817			(406,629		)	362,212
Derivative loss	(173,874		)	(154,672		)	—
Comprehensive income (loss)	$	2,188,961		$	(4,255,421	)	$	(6,172,752	)

Note 6 Business Segments

The Company operates in two reportable business segments: tissue and machine-glazed paper. The Company assesses the performance of its reportable business segments using income from operations. Income from operations excludes interest income, interest expense, other income (expense), income tax expense (benefit) and the impact of foreign currency gains and losses. A portion of corporate and shared expenses is allocated to each segment. Included in income from operations for the three months ended November 23, 2006 is $53,474 of restructuring costs and $1,892,770 of additional depreciation expense related to excess purchase price allocated to property, plant and equipment. Of these amounts, $34,758 and $1,230,301, respectively, impacts the tissue segment and $18,716 and $662,469, respectively impacts the machine-glazed paper segment. Included in loss from operations for the period March 1, 2006 to June 12, 2006 is $5,933,265 of merger-related transaction costs. Of this amount, $3,856,622 impacts the tissue segment and $2,076,643 impacts the machine-glazed paper segment. Included in loss from operations for the period June 13, 2006 to November 23, 2006 is $155,849 of merger-related transaction costs, $240,218 of restructuring costs, $909,264 for a non-cash charge to cost of goods sold related to excess purchase price allocated to inventory and $3,411,200 of additional depreciation expense related to excess purchase price allocated to property, plant and equipment. Of these amounts, $101,302, $156,142, $591,022 and $2,217,280, respectively, impact the tissue segment and $54,547, $84,076, $318,242 and $1,193,920, respectively, impact the machine-glazed paper segment. Also, included in loss from operations for the three months ended November 23, 2006 are compensation charges of $370,320 million related to the vesting of restricted stock awards granted after the Merger and other compensation expense related to the Merger. Of this amount, $240,708 and $129,522, respectively, impacts the tissue segment and machine-glazed

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 6 Business Segments (continued)

segment, respectively. Also, included in loss from operations for the periods June 13, 2006 to November 23, 2006 and March 1, 2006 to June 12, 2006 are compensation charges of $2,205,384 and $1,301,945, respectively, related to non-cash compensation expense related to the vesting of restricted stock awards, payments of taxes associated with such awards and other compensation expense related to the Merger. Of these amounts, $1,433,500 and $846,264, respectively, impact the tissue segment and $771,884 and $455,681, respectively, impact the machine-glazed segment. Segment information for the three months ended November 29, 2007 and November 23, 2006 follows:

	(Post-Merger)
	Three Months Ended November 29, 2007			Three Months Ended November 23, 2006
Net Sales
Tissue	$	81,998,560		$	58,059,690
Machine-glazed paper	27,163,428			25,221,516
Consolidated	$	109,161,988		$	83,281,206

Income (loss) from operations
Tissue	$	5,777,310		$	1,962,656
Machine-glazed paper	188,541			464,272
Consolidated	5,965,851			2,426,928
Interest expense	(4,856,452		)	(4,122,043		)
Net foreign currencytransaction (loss) gain	(220,348		)	79,440
Interest income	12,476			55,641
Other income	104,573			3,501
Pretax income (loss)	$	1,006,100		$	(1,556,533	)

Capital Expenditures
Tissue	$	3,392,489		$	1,730,828
Machine-glazed paper	258,712			391,777
Corporate	373,325			(11,819		)
Consolidated	$	4,024,526		$	2,110,786

Depreciation
Tissue	$	3,954,469		$	3,897,453
Machine-glazed paper	1,419,088			1,628,608
	$	5,373,557		$	5,526,061

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 6 Business Segments (continued)

Segment information for the nine months ended November 29, 2007 and for the periods June 13, 2006 to November 23, 2006 and March 1, 2006 to June 12, 2006 follows:

	(Post-Merger)						(Pre-Merger)
	Nine Months Ended November 29, 2007			June 13, 2006- November 23,2006			March 1, 2006- June 12, 2006
Net Sales
Tissue	$	243,129,416		$	107,084,355		$	67,199,611
Machine-glazed paper	78,233,679			44,759,237			27,042,321
Consolidated	$	321,363,095		$	151,843,592		$	94,241,932

Income (loss) from operations
Tissue	$	16,243,707		$	1,843,141		$	(1,210,487	)
Machine-glazed paper	358,748			(328,840		)	(2,119,523		)
Consolidated	16,602,455			1,514,301			(3,330,110		)
Interest expense	(15,041,350		)	(7,346,364		)	(5,000,732		)
Net foreign currency transaction gain (loss)	(740,756		)	146,116			(289,010		)
Interest income	75,614			127,426			104,377
Other income	187,073			20,954			27,049
Pretax income (loss)	$	1,083,036		$	(5,537,567	)	$	(8,488,326	)

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 6 Business Segments (continued)

Capital Expenditures
Tissue	$	8,972,218	$	2,929,390	$	711,857
Machine-glazed paper	1,229,947		696,359		236,288
Corporate	763,148		369,494		989,465
Consolidated	$	10,965,313	$	3,995,243	$	1,937,610

Depreciation
Tissue	$	13,111,338	$	7,088,006	$	3,056,653
Machine-glazed paper	4,456,966		2,953,818		1,169,990
	$	17,568,304	$	10,041,824	$	4,226,643

	November 29, 2007		February 28, 2007
Segment assets
Tissue	$	308,527,012	$	214,039,270
Machine-glazed paper	82,574,836		79,277,799
Corporate assets	7,570,404		31,951,675
Consolidated	$	398,672,252	$	325,268,744

Note 7 Income taxes

The effective income tax benefit for the three months ended November 29, 2007 was 36.7% compared to effective income tax benefit of 31.0% for the three months ended November 23, 2006. The effective income tax benefit for the nine months ended November 29, 2007 was 23.3% compared to an effective income tax benefit of 33.3% and 23.0%, respectively, for the periods June 13, 2006 to November 23, 2006 and March 1, 2006 to June 12, 2006. Included in the income tax benefit for the three months and nine months ended November 29, 2007 is $.7 million of benefit primarily related to the different book and tax treatment of deductions related to transaction costs. This benefit has been recorded in the current quarter upon completion of the Company’s 2007 tax return as the impact is considered discrete to this quarter. Also, included in the effective benefit for the nine months ended November 29, 2007 is approximately $90,000 related to additional Canadian income taxes paid upon completion of the Company’s fiscal year 2007 tax returns, which was recorded in the second quarter upon completion of those returns. The effective income tax rate for the three months and nine months ended November 29, 2007 without the effect of the above items was 29.2% and 29.6%, respectively. The effective income tax rate for the period March 1, 2006 to June 12, 2006 differs from the federal statutory rate primarily due to non-deductible transactions costs expensed for book purposes.

Cellu Tissue Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited) (continued)

Note 7 Income Taxes (continued)

The Company adopted Financial Accounting Standards Board (“FASB”) Interpretation 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), at the beginning of the fiscal year ending February 29, 2008 (‘fiscal year 2008”). The implementation of FIN 48 did not have a material impact on the Company’s results of operations and financial position. At November 29, 2007, the Company did not have any unrecognized tax benefits.

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of November 29, 2007, the Company has accrued interest and penalties, if any, related to uncertain tax positions.

The fiscal tax years 2003 through 2007 remain open to examination by the major taxing jurisdictions to which the Company is subject. As of November 29, 2007, the Company does not expect any material changes to unrecognized tax positions within the next 12 months.

Note 8 Union Contract

In July 2005, the United Steelworkers of America, referred to as USW, (formerly the Paper, Allied —Industrial, Chemical & Energy Workers International Union, referred to as PACE prior to PACE’s merger with and into USW) was elected to represent 84 hourly employees at our Mississippi facility, and was certified by the National Labor Relations Board as the exclusive collective bargaining representative of such employees. On June 29, 2007, a collective bargaining agreement with USW was ratified.

Note 9 Subsequent Event

In December 2007, the Company purchased machinery and equipment for $5.4 million that it had been leasing under a 10-year operating lease. The lease had a remaining term of two years and lease payments were approximately $1.5 million a year.

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 may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, and, as such, may involve known or unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identifiable by use of the words “may,” “will,” “should,” “expect,” “anticipate,” “estimate,” “believe,” “intend,” “project,” or comparable terminology. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to, those set forth in Item 1. Business-Forward-Looking Statements and Item 1A. Risk Factors in our Annual Report on Form 10-K for our fiscal year ended February 28, 2007. These risks and uncertainties should be considered in evaluating any forward-looking statements contained herein.

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

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

Merger

On June 12, 2006 Cellu Paper Holdings, Inc., our parent, consummated an Agreement and Plan of Merger with Cellu Parent, a corporation organized and controlled by Weston Presidio, and Cellu Acquisition Corporation, a wholly owned subsidiary of Cellu Parent and a newly formed corporation indirectly controlled by Weston Presidio, or Merger Sub. Pursuant to the agreement, on June 12, 2006, Merger Sub was merged with and into our parent, with our parent surviving (referred to herein as the Merger). Accordingly, the operating results and cash flows for the prior year are presented in the accompanying

financial statements on a pre-merger (period from March 1, 2006 to June 12, 2006) and post-merger (period from June 13, 2006-November 23, 2006) basis. The current year operating results and cash flows are post-merger.

We accounted for the Merger as a purchase in accordance with the provisions of Statement of Financial Accounting Standards No. 141, or SFAS 141, Business Combinations, which resulted in a new valuation for our assets and liabilities based upon fair values as of the date of the Merger. As allowed under SEC Staff Accounting Bulletin No. 54, Push Down Basis of Accounting Required in Certain Limited Circumstances, we have reflected all applicable purchase accounting adjustments in our consolidated financial statements for all periods subsequent to the Merger date (referred to herein as push down accounting). Push down accounting requires us to establish a new basis for our assets and liabilities based on the amount paid for our equity at close of business on June 12, 2006. Accordingly, Cellu Parent’s equity basis is reflected in our consolidated financial statements beginning upon completion of the Merger.

In order to apply push down accounting, Cellu Parent’s purchase price of $207.8 million (including assumption of $162.0 million in aggregate principal amount of our outstanding 9.75% senior secured notes), or the Notes, was allocated to the assets and liabilities based on their relative fair values. The total consideration is subject to adjustment for up to an additional $35.0 million in contingent earnout consideration based upon the achievement of certain financial targets. If any portion of the contingent payments are unable to be made, then Weston Presidio has agreed to provide the necessary funds to former holders of our parent’s capital stock, options and warrants through an equity investment in our parent or otherwise. In accordance with SFAS 141, the $35.0 million has been recognized as a liability and is recorded in other liabilities as of November 29, 2007.

We have allocated the excess purchase price over the net assets acquired in the Merger based on our estimates of the fair value of assets and liabilities as follows:

	Excess purchase price allocated to:
Inventories	$	909,264
Property, plant and equipment	142,292,525
Trademarks	6,550,314
Long-term debt	(900,729		)
Contingent consideration	(35,000,000		)
Deferred income taxes	(50,830,323		)
Total	$	63,021,051

Acquisition

On March 21, 2007, we executed the Acquisition Agreement with CityForest, Cellu City Merger Sub and Wayne Gullstad as the shareholders’ representative. Pursuant to the Acquisition Agreement, and subject to the terms and conditions therein, Cellu City Merger Sub, a wholly owned subsidiary of ours, merged with and into CityForest, with

CityForest surviving and becoming our wholly owned subsidiary. The aggregate merger consideration (including assumption of $18.4 million in aggregate principal amount of industrial revenue bonds) was approximately $61.0 million subject to certain working capital and net cash adjustments. Total cash paid for the acquisition of $46.8 million (purchase price of $61.0 million less assumed indebtedness of $18.4 million plus restricted cash and other miscellaneous adjustments of $1.6 million and acquisition costs of $2.6 million), was financed in part by issuance of unregistered 9 3/4% Senior Secured Notes due 2010 (the “Additional Notes”) of approximately $20.0 million, borrowings on a revolving line of credit ($17.4 million) and available cash on hand.

The Acquisition has been accounted for as a purchase in accordance with the provisions of SFAS 141 and, accordingly, the consolidated statements of operations includes the results of CityForest during the three months and nine months ended November 29, 2007 from the date of Acquisition. Purchase price allocations are subject to refinement until all pertinent information is obtained. We have allocated the excess of purchase price over the net assets acquired in the acquisition based on our estimates of the fair value of assets and liabilities as follows:

	Excess purchase price allocated to:
Property, plant and equipment	$	32,854,514
Trademarks	2,200,000
Goodwill	6,944,317
Long-term debt	(1,724,684		)
Deferred income taxes	(17,238,509		)
Total	$	23,035,638

We have estimated the fair value of the assets and liabilities of the Acquisition, utilizing information available at the time our unaudited interim financial statements subsequent to the Acquisition were prepared, and these estimates are subject to refinement until all pertinent information has been obtained. At that time, we were in the process of obtaining outside third-party appraisals of our tangible and intangible assets and had assumed no intangible assets or goodwill arising from the acquisition. In the second quarter of fiscal year 2008, we obtained a third-party appraisal of CityForest’s tangible and intangible assets and finalized the calculation of deferred income taxes resulting from the book to tax differences arising from the application of purchase accounting. As a result thereof, trademarks of $2.2 million and goodwill of $6.9 million have been recorded. Furthermore, the net deferred income tax liability has increased $4.2 million from our original estimate.

The results of CityForest’s operations from the date of acquisition (March 21, 2007) are included in our tissue segment and accordingly, are included for the three months ended November 29, 2007. Unaudited pro forma results of operations for the three months ended November 23, 2006, for the nine months ended November 29, 2007, for the periods June 13, 2006-November 23, 2006 and March 1, 2006-June 12, 2006, as if we and CityForest had been combined as of March 1, 2006, are presented below. The pro forma results include estimates and assumptions, which our management believes are

reasonable. However, the pro forma results do not include any cost savings or other effects of the planned integration of CityForest and are not necessarily indicative of the results which would have occurred if the business combination had been in effect on the dates indicated, or which may result in the future.

	Three Months Ended November 23, 2006(1)
	As Filed			Pro Forma
	(in thousands)
Net sales	$	83,281		$	95,422
Operating income	$	2,427		$	5,336
Net income (loss)	($1,075		)	$	1,461

(1)	Pro forma operating results include the operating results for CityForest for the three months ended September 30, 2006 as CityForest was previously a calendar year-end company.

	Nine Months Ended November 29, 2007(1)				June 13, 2006-November 23, 2006(2)					March 1, 2006-June 12, 2006(2)
	As Filed		Pro Forma		As Filed			Pro Forma		As Filed			Pro Forma
	(in thousands)				(in thousands)					(in thousands)
Net sales	$	321,363	$	324,073	$	151,844		$	173,272	$	94,242		$	107,942
Operating income (loss)	$	16,602	$	17,188	$	1,514		$	6,761	($3,330		)	$	25
Net income (loss)	$	1,335	$	1,896	($3,694		)	$	384	($6,535		)	($3,928		)

(1)		Pro forma operating results include the operating results for CityForest for the nine months ended November 29, 2007. The “as filed” operating results include the operating results for CityForest for the period from the acquisition date (March 21, 2007) to November 29, 2007.

(2)		Pro forma operating results include the operating results for CityForest for the nine months ended September 30, 2006, prorated between the two reporting periods presented for us, as CityForest was previously a calendar year-end company.

Union Contract

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

Subsequent Event

In December 2007, we purchased machinery and equipment for $5.4 million that we had been leasing under a 10-year operating lease. The lease had a remaining term of 2 years and lease payments were approximately $1.5 million a year.

RESULTS OF OPERATIONS

The three months ended November 29, 2007 (post-merger) has been compared to the three months ended November 23, 2006 (post-merger). The nine months ended November 29, 2007(post-merger) have been compared to the combined nine months ended November 23, 2006 pre- and post-Merger for purposes of management’s discussion and analysis of the results of operations. Any references below to the nine months ended November 23, 2006 shall refer to the combined periods.

	Three Months Ended
	November 23, 2006			November 29, 2007
	(Post-Merger)

Net sales	$	83,281,206		$	109,161,988
Cost of goods sold	77,390,427			97,646,110
Gross profit	5,890,779			11,515,878

Selling, general and administrative expenses	3,240,571			4,835,215
Stock and related compensation expense	169,806			714,812
Merger-related transaction costs	53,474			—
Income from operations	2,426,928			5,965,851

Interest expense, net	4,066,402			4,843,976
Foreign currency (gain) loss	(79,440		)	220,348
Other income	(3,501		)	(104,573		)
Income (loss) before income tax benefit	(1,556,533		)	1,006,100
Income tax benefit	(481,798		)	(369,572		)
Net income (loss)	$	(1,074,735	)	$	1,375,672

	Pre-Merger			Post-Merger			Combined			Post-Merger
	March 1, 2006-			June 13, 2006-			Nine Months Ended			Nine Months Ended
	June 12, 2006			November 23, 2006			November 23, 2006			November 29, 2007

Net sales	$	94,241,932		$	151,843,592		$	246,085,524		$	321,363,095
Cost of goods sold	86,053,812			142,608,186			228,661,998			289,788,562
Gross profit	8,188,120			9,235,406			17,423,526			31,574,533

Selling, general and administrative expenses	5,584,865			7,018,962			12,603,827			13,874,266
Stock and related compensation expense	—			306,076			306,076			1,097,812
Restructuring costs	—			240,218			240,218			—
Merger-related transaction costs	5,933,265			155,849			6,089,114			—
Income (loss) from operations	(3,330,010		)	1,514,301			(1,815,709		)	16,602,455

Interest expense, net	4,896,355			7,218,938			12,115,293			14,965,736
Foreign currency loss (gain)	289,010			(146,116		)	142,894			740,756
Other income	(27,049		)	(20,954		)	(48,003		)	(187,073		)
Income (loss) before income tax benefit	(8,488,326		)	(5,537,567		)	(14,025,893		)	1,083,036
Income tax benefit	(1,953,362		)	(1,843,447		)	(3,796,809		)	(251,982		)
Net income (loss)	$	(6,534,964	)	$	(3,694,120	)	$	(10,229,084	)	$	1,335,018

The tables that follow present unaudited net sales and gross profit for our principal segments for the three months ended November 29, 2007 and November 23, 2006, nine months ended November 29, 2007 and the combined nine months ended November 23, 2006.

	Three Months Ended
	November 23, 2006		November 29, 2007
	(Post-Merger)		(Post-Merger)
Net Sales
Tissue	$	58,059,690	$	81,998,560
Machine-glazed paper	25,221,516		27,163,428
Consolidated	$	83,281,206	$	109,161,988

Gross Profit
Tissue	$	4,332,155	$	9,662,245
Machine-glazed paper	1,558,624		1,853,633
Consolidated	$	5,890,779	$	11,515,878

	Pre-Merger		Post-Merger		Combined
	March 1, 2006-		June 13, 2006-		Nine Months Ended		Nine Months Ended
	June 12, 2006		November 23, 2006		November 23, 2006		November 29, 2007
Net Sales
Tissue	$	67,199,611	$	107,084,355	$	174,283,966	$	243,129,416
Machine-glazed paper	27,042,321		44,759,237		71,801,558		78,233,679
Consolidated	$	94,241,932	$	151,843,592	$	246,085,524	$	321,363,095

Gross Profit
Tissue	$	6,423,465	$	7,085,890	$	13,509,355	$	26,616,813
Machine-glazed paper	1,764,655		2,149,516		3,914,171		4,957,720
Consolidated	$	8,188,120	$	9,235,406	$	17,423,526	31,574,533

Results of Operations for the Three Months Ended November 29, 2007 (the Fiscal 2008 Three-Month Period) compared to the Three Months Ended November 23, 2006 (the Fiscal 2007 Three-Month Period) and the Nine Months Ended November 29, 2007 (the Fiscal 2008 Nine-Month Period) compared to the Nine Months ended November 23, 2006 (the Fiscal 2007 Nine-Month Period)

Net sales for the fiscal 2008 three-month period increased $25.9 million, or 31.1%, to $109.2 million from $83.3 million for the comparable period in the prior year. Net sales for the fiscal 2008 nine-month period increased $75.3 million, or 30.6%, to $321.4 from $246.1 million for the comparable period in the prior year. On a company-wide basis, tons sold increased for the fiscal 2008 three-month period and the fiscal 2008 nine-month period compared to the comparable periods of fiscal 2007. For the fiscal 2008 three-month period, we sold 79,541 tons of tissue hard rolls, machine-glazed paper hard rolls and converted paper products, an increase of 17,705 tons, or 28.6%, compared to the fiscal 2007 three-month period. For the fiscal 2008 nine-month period, we sold 237,950 tons of tissue hard rolls, machine-glazed paper hard rolls and converted paper products, an increase of 49,919 tons, or 26.5%, compared to the fiscal 2007 nine-month period. Net selling price per ton increased from $1,347 and $1,309 for the fiscal 2007 three-month and nine-month periods to $1,372 and $1,351 for the fiscal 2008 three-month and nine-month periods.

Net sales for our tissue segment for the fiscal 2008 three-month period were $82.0 million, an increase of $24.0 million, or 41.2%, from the comparable period in the prior year. Net sales for our tissue segment for the fiscal 2008 nine-month period were $243.1 million, an increase of $68.8 million, or 39.5%, from the comparable period in the prior year. These increases are attributable to the acquisition of CityForest and an increase in tonnage sold, primarily in our converting business, over the comparable periods in the prior year.

Net sales for our machine-glazed segment for the 2008 three-month period were $27.2 million, an increase of $1.9 million, or 7.7%, from the comparable period in the prior year. Net sales for our machine-glazed segment for the 2008 nine-month period were

$78.3 million, an increase of $6.5 million, or 9.0%, from the comparable period in the prior year. These increases are driven primarily by an increase in net selling price per ton over the comparable periods in the prior year.

Gross profit for the fiscal 2008 three-month period increased to $11.5 million from $5.9 million, an increase of $5.6 million, or 95.5%, from the comparable period in the prior year. As a percentage of net sales, gross profit increased to 10.5% in the fiscal 2008 three-month period from 7.1% in the fiscal 2007 three-month period. Gross profit for the fiscal 2008 nine-month period increased to $31.6 million from $17.4 million, an increase of $14.2 million, or 81.2%, from the comparable period in the prior year.

As a percentage of net sales, gross profit increased to 9.8% in the fiscal 2008 nine-month period from 7.1% in the fiscal 2007 nine-month period. The increases in gross profit are attributable to continued improvement in product mix, lower manufacturing cost and the strong market for tissue hard rolls, compared to the comparable period in the prior year.

Gross profit for our tissue segment for the fiscal 2008 three-month period was $9.7 million, an increase of $5.3 million, or 123.0%, from the comparable period in the prior year. Gross profit for our tissue segment for the fiscal 2008 nine-month period was $26.6 million, an increase of $13.1 million, or 97.0%, from the comparable period in the prior year.

Gross profit for our machine-glazed segment for the fiscal 2008 three-month period was $1.8 million, an increase of $.3 million, or 18.9%, from the comparable period in the prior year. Gross profit for our machine-glazed segment for the fiscal 2008 nine-month period was $5.0 million, an increase of $1.1 million, or 26.7%, from the comparable period in the prior year.

As a percentage of net sales, gross profit for the tissue segment increased to 11.8% in the fiscal 2008 three-month period and 10.9% in the fiscal 2008 nine-month period from 7.5% in the fiscal 2007 three-month period and 7.8% in the fiscal 2007 nine-month period. As a percentage of net sales, gross profit for the machine-glazed segment increased to 6.8% in the fiscal 2008 three-month period and 6.3% in the fiscal 2008 nine-month period from 6.2% in the fiscal 2007 three-month period and 5.5% in the fiscal 2007 nine-month period.

Selling, general and administrative expenses in the fiscal 2008 three-month period increased $1.6 million, or 49.2%, to $4.8 million from $3.2 million in the fiscal 2007 three-month period. Selling, general and administrative expenses in the fiscal 2008 nine-month period increased $1.3 million, or 10.1%, to $13.9 million from $12.6 million in the fiscal 2007 nine-month period. As a percentage of net sales, selling, general and administrative expenses increased to 4.4% in the fiscal 2008 three-month period and decreased to 4.3% in the fiscal 2008 nine-month period from 3.9% and 5.1%, respectively, for the comparable periods in the prior year. Included in the fiscal 2008 three-month and nine-month periods are $.4 million and $1.2 million, respectively, of ongoing CityForest administrative expenses. Also, included in the fiscal 2008 three-month and nine-month periods are additional costs incurred in connection with being compliant with Sarbanes-Oxley and increases in incentive compensation expense associated with strong business performance. Included in the fiscal 2007 nine-month period is $.9 million of non-cash compensation expense related to merger related vesting of restricted stock awards, $1.4 million of

other compensation expense related to tax payments associated with such awards and $.8 million of other compensation expense related to the merger.

Stock and related compensation expense in the fiscal 2008 three-month and nine-month periods of $.7 million and $1.1 million, respectively, and in the fiscal 2007 three-month and nine-month periods of $.2 million and $.3 million, respectively, relates to the accounting for restricted stock and stock option grants.

Restructuring costs in the fiscal 2007 three-month and nine-month periods were $.2 million related to severance costs associated with the elimination of a corporate position.

Merger-related transaction costs in the fiscal 2007 three-month period were less than $.1 million and in the fiscal 2007 nine-month period were $6.1 million associated with the Merger.

Interest expense, net in the fiscal 2008 three-month period was $4.8 million compared to $4.1 million in the fiscal 2007 three-month period. Interest expense, net in the fiscal 2008 nine-month period was $15.0 million compared to $12.1 million in the fiscal 2007 nine-month period. These increases are due to the assumption of CityForest debt and additional debt incurred in connection with the acquisition thereof.

Foreign currency loss (gain) in the fiscal 2008 three-month period was a loss of $.2 million and in the fiscal 2008 nine-month period was a loss of $.7 million compared to a gain of less than $.1 million and a loss of $.2 million, respectively, for the comparable periods in the prior year. The fluctuations relate to the change in the Canadian currency period over period.

Income tax benefit for the fiscal 2008 three-month period was $.4 million or an effective tax rate of 36.7% compared to income tax benefit of $.5 million or an effective tax rate of 31.0% for the fiscal 2007 three-month period. The income tax benefit for the fiscal year 2008 nine-month period was $.3 million or an effective tax rate of 23.3% compared to income tax benefit of $3.8 million or an effective tax rate of 27.1% for the fiscal year 2007 nine-month period. Included in the income tax benefit for the three months and nine months ended November 29, 2007 is $.7 million of benefit primarily related to the different book and tax treatment of deductions related to transaction costs. This benefit has been recorded in the current quarter upon completion of the Company’s 2007 tax return as the impact is considered discrete to this quarter. Also, included in the effective benefit for the nine months ended November 29, 2007 is approximately $90,000 related to additional Canadian income taxes paid upon completion of the Company’s fiscal year 2007 tax returns, which was recorded in the second quarter upon completion of those returns. The effective income tax rate for the three months and nine months ended November 29, 2007 without the effect of the above items was 29.2% and 29.6%, respectively. The effective income tax rate for the period March 1, 2006 to June 12, 2006 differs from the federal statutory rate primarily due to non-deductible transactions costs expensed for book purposes.

Net income for the fiscal 2008 three-month period was $1.4 million, compared to a net loss of $1.1 million for the comparable period in the prior year. For the fiscal 2008 nine-

month period, net income was $1.3 million compared to a net loss of $10.2 million for the comparable period in the prior year.

FINANCIAL CONDITION

Liquidity and Capital Resources

The table that follows presents cash flows information for the nine months ended November 29, 2007 compared to the combined nine months ended November 23, 2006.

	Pre-Merger			Post-Merger			Combined			Post-Merger
	March 1, 2006-			June 13, 2006-			Nine Months Ended			Nine Months Ended
	June 12, 2006			November 23, 2006			November 23, 2006			November 29, 2007
Net Provided by (Used in) Operating Activities
Net income (loss)	$	(6,534,964	)	$	(3,694,120	)	$	(10,229,084	)	$	1,335,018
Non-cash items	5,245,238			9,736,096			14,981,334			15,534,542
Changes in working capital	(5,250,094		)	(3,721,666		)	(8,971,760		)	(3,012,058		)
Net cash provided by (used in) operating activities	$	(6,539,820	)	$	2,320,310		$	(4,219,510	)	$	13,857,502

Net Cash Provided by (Used in) Investing Activities	$	(1,937,610	)	$	41,766,754		$	39,829,144		$	(54,602,891	)

Net Cash Provided by (Used in) Financing Activities	$	(290,000	)	$	(45,761,997	)	$	(46,051,997	)	$	25,138,043

Net cash provided by operations was $13.9 million for the fiscal 2008 nine-month period, compared to net cash used in operations of $4.2 million for the fiscal 2007 nine-month period. Non-cash items, consisting of inventory charge, stock-based compensation, deferred income taxes, depreciation and amortization for the fiscal 2008 nine-month period totaled $15.5 million compared to $15.0 million for the 2007 fiscal nine-month period. Cash flows used by changes in working capital totaled $3.0 million for the fiscal 2008 nine-month period, compared to cash flows used by changes in working capital of $9.0 million in the fiscal 2007 nine-month period. With respect to the changes in accounts receivable and inventory, cash used by these items was $3.5 million for the fiscal 2008 nine-month period compared to cash used by these items of $2.9 million for the comparable period in the prior fiscal year. Cash used by changes in prepaid expenses and other current assets was $2.2 million for the fiscal 2008 nine-month period compared to cash used of $.6 million for the comparable period in the prior fiscal year. Cash provided by changes in accounts payable, accrued expenses and accrued interest for the fiscal 2008 nine-month period was $2.7 million compared to cash used of $5.5 million for the comparable period in the prior year.

Net cash used by investing activities for the fiscal 2008 nine-month period was $54.6 million compared to net cash provided by investing activities of $39.8 million for the fiscal 2007 nine-month period. The fiscal 2008 nine-month period includes $43.6 million of cash paid for the acquisition, net of cash received. The fiscal 2007 nine-month period includes $45.8 million related to the equity investment by Weston Presidio. The remaining change relates to the level of capital spending period over period.

Net cash provided by financing activities for the fiscal 2008 nine-month period was $25.1 million related primarily to financing obtained in connection with the Acquisition. The net cash used by financing activities for the fiscal 2007 nine-month period includes $45.8 million related to merger consideration paid to former shareholders. The remaining $.3 million for the fiscal 2007 nine-month period relates to payments on our industrial revenue bond. Our last payment on our industrial revenue bond was made in the first quarter of fiscal year 2007.

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

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

In connection with the Merger, we solicited consents with respect to the Notes. Consents were received with respect to 100% of the aggregate outstanding principal amount of the Notes. We accepted all of the consents delivered in the consent solicitation and paid to the consenting noteholders a consent fee of $40 per $1,000 principal amount of Notes for which they delivered consents. As a result of the acceptance by us of the consents delivered by noteholders and the completion of the consent solicitation, the amendments to the Cellu Tissue Indenture described in the Consent Solicitation Statement dated May 9, 2006 and related Supplement dated May 24, 2006 became operative and we were not required to make a change of control offer to purchase any Notes in connection with the Merger.

Furthermore, in connection with the Merger, we entered into the Credit Agreement, among us, as U.S. Borrower, Interlake Acquisition Corporation Limited, one of our subsidiaries, as Canadian Borrower, our 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 $35.0 million working capital facility, which has subsequently been increased to $40.0 million (see below), including a letter of credit sub-

facility and swing-line loan sub-facility. The Credit Agreement provides that 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 is available, in U.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 Canadian Borrower under the facility. Borrowings of $17.4 million were made to finance a portion of the acquisition of CityForest. As of November 29, 2007, there was $3.5 million of borrowings outstanding under the working capital facility and excess availability of $33.3 million.

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

Second Supplemental Indenture

We, certain of our subsidiaries, the Trustee and CityForest have executed the Second Supplemental Indenture, pursuant to which CityForest became a party to the Cellu Tissue Indenture as a subsidiary guarantor. As a subsidiary guarantor, CityForest, on a joint and several basis with all the existing subsidiary guarantors, fully, unconditionally and irrevocably guarantees to each holder of the Notes and the Trustee 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, one of our subsidiaries, as Canadian Borrower, certain other of our subsidiaries and our Parent, JPMorgan Chase Bank, N.A. (the “U.S. Administrative Agent”) and JPMorgan 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 of the Additional Notes, (3) provides for the consummation of the acquisition of CityForest and the conversion by CityForest from a Minnesota corporation to a Minnesota limited liability company, (4) permits the assumption of approximately $18.4 million in aggregate principal amount of indebtedness of CityForest in connection with the acquisition of CityForest in accordance with the terms of the CityForest Bond Documents and (5) permits the guarantee by us of certain obligations of CityForest under the CityForest Bond Documents. In connection with the Amendment, CityForest became a guarantor of the obligations of the borrowers under the Amended Credit Agreement.

CityForest Bond Documents

CityForest is party to a Loan Agreement with the City of Ladysmith, Wisconsin, as Issuer. Pursuant to the Loan Agreement, the Issuer loaned the proceeds of the Issuer’s

Bonds to CityForest to finance the construction by CityForest of a solid waste disposal facility. Approximately $18.4 million in aggregate principal amount of the Bonds was outstanding as of the date of the CityForest acquisition. CityForest is required, under the terms of the CityForest Indenture, to provide a letter of credit in favor of the Bonds Trustee. CityForest has entered into the Reimbursement Agreement with Associated Bank, pursuant to which Associated Bank has extended the Associated Bank Letter of Credit and has provided the Associated Bank Revolving Credit Facility to CityForest in an aggregate principal amount of up to $3.5 million.

The Bonds Trustee is permitted to draw upon the Associated Bank Letter of Credit to pay principal and interest due on the Bonds, and to provide liquidity to purchase Bonds put to CityForest by bondholders and not remarketed; and CityForest is obligated under the Reimbursement Agreement to reimburse Associated Bank for any such draws. CityForest is also obligated to pay a fee in respect of the aggregate amount available to be drawn under the Associated 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 Bank Letter of Credit is February 15, 2011.

The Reimbursement Agreement requires scheduled semi-annual payments of principal of the Bonds equal to approximately 2.00% of the principal amount outstanding as of the date of the Acquisition, with the balance payable at maturity of the Bonds on March 1, 2028. The Reimbursement Agreement also contains a number of other provisions regarding reserve funds and other mandatory and optional repayments in connection with the Bonds. In addition, the Reimbursement Agreement provides that in certain circumstances where we incur indebtedness in excess of amounts currently permitted under the indenture or refinances the indebtedness issued under the CityForest Indenture, Associated Bank may require CityForest to repay all of its obligations to Associated Bank under the Reimbursement Agreement and either to cause the Bonds to be redeemed or to replace the Associated Bank Letter of Credit with a Substitute Credit Facility, as such term is defined in the CityForest Indenture.

We have guaranteed all of the obligations of CityForest under the Reimbursement Agreement, pursuant to the Cellu Tissue Guaranty executed by us in favor of Associated Bank. In addition, the obligations of CityForest under the Reimbursement Agreement are secured by first-priority liens in favor of Associated 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 and priorities of Associated Bank, on the one hand, and the U.S. Administrative Agent and the Canadian Administrative Agent, on the other hand, as to the collateral of CityForest securing the Reimbursement Agreement and the Amended Credit Agreement.

Cash as of November 29, 2007 decreased to $1.7 million from $16.3 million as of the end of fiscal year 2007. The decrease in our cash position was primarily due to using cash on hand to finance a portion of the acquisition of CityForest, payment of our semi-annual interest in March 2007 and paydown on the revolving line of credit.

Receivables, net as of November 29, 2007 increased to $43.5 million from $34.1 million as of the end of fiscal year 2007. Included in the $43.5 million is $5.8 million of receivables related to CityForest. Without the effect of the acquisition, receivables increased $3.6 million from the end of fiscal year 2007, primarily due to increased net sales and timing of customer payments.

Inventory as of November 29, 2007 increased to $30.9 million from $29.6 million as of the end of fiscal year 2007. Included in the $30.9 million is $1.3 million of inventories related to CityForest. Without the effect of the acquisition, inventory levels remained consistent period to period.

Prepaid expenses and other current assets as of November 29, 2007 increased to $6.6 million from $2.8 million as of the end of fiscal year 2007. Included in the $6.6 million is $1.2 of prepaid expenses and other current assets related to CityForest. Without the effect of the acquisition, prepaid expense and other current assets increased $2.6 million

from the end of fiscal year 2007. Also, included in the $6.6 million is approximately $2.6 millioof costs incurred with respect to potential acquisitions.

Property, plant and equipment, net as of November 29, 2007 increased to $292.2 million from $228.9 million as of the end of fiscal year 2007. Included in the $292.2 million of property, plant and equipment, net is $67.1 million related to CityForest. Without the effect of the acquisition, property, plant and equipment decreased $3.8 million from the end of fiscal year 2007. This decrease relates to depreciation expense for the period offset partially by capital expenditures for the period.

Goodwill as of November 29, 2007 of $6.9 million arose due to the acquisition of CityForest.

Trademarks as of November 29, 2007 increased to $8.8 million from $6.6 million as of the end of fiscal year 2007. The additions to trademarks relate to the acquisition of CityForest.

Other assets as of November 29, 2007 increased to $1.5 million from $.2 million as of the end of fiscal year 2007. Included in the $1.5 million of other assets is $1.2 million related to CityForest. Without the effect of the acquisition, other assets are consistent with the end of fiscal year 2007.

Bank overdrafts as of November 29, 2007 were $2.2 million compared to zero as of the end of fiscal year 2007. As of the end of the current quarter checks outstanding exceeded cash balances in our lockbox account by this amount, reflecting a shift in cash management practices to use all excess cash on a daily basis to pay down our revolving line of credit.

Revolving line of credit as of November 29, 2007 represents $17.4 million of borrowings to finance a portion of the acquisition of CityForest, offset by payments of $13.9 million since the date of the acquisition.

Accounts payable as of November 29, 2007 increased to $23.1 million from $16.5 million as of the end of fiscal year 2007. Included in the $23.1 million of accounts payable is $4.0 million related to CityForest. Without the effect of the acquisition, accounts payable increased $2.6 million from the end of fiscal year 2007 due to increased pulp purchases and the timing of payments.

Accrued expenses as of November 29, 2007 increased to $23.3 million from $16.3 million as of the end of fiscal year 2007. Included in the $23.3 million of accrued expenses is $.9 million related to CityForest. Without the effect of the acquisition, accrued expenses increased $6.1 million due to accrued legal expense and other costs associated with potential acquisitions and accrual of bonuses during the second and third quarters of fiscal year 2008.

Accrued interest as of November 29, 2007 decreased to $3.7 million from $7.2 million as of the end of fiscal year 2007. The decrease is due to the timing of our semi-annual interest payments.

Long-term debt as of November 29, 2007 increased to $198.7 million from $160.4 million as of the end of fiscal year 2007 due to the assumption of CityForest debt and debt incurred to finance the acquisition.

Deferred income taxes as of November 29, 2007 increased to $64.6 million from $50.7 million as of the end of fiscal year 2007 primarily due to the deferred taxes recorded in purchase accounting for CityForest.

Critical Accounting Policies

Our critical accounting policies are discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for fiscal year 2007. The preparation of our financial statements requires us to make estimates that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures of contingent assets and liabilities. We base our accounting estimates on historical experience and other factors that we believe to be reasonable under the circumstances. However, actual results may vary from these estimates under different assumptions or conditions.

New Accounting Pronouncements

We adopted FIN 48 at the beginning of fiscal year 2008. The implementation did not have a material impact on our results of operations and financial position. At November 29, 2007, we did not have any unrecognized tax benefits.

We recognize interest and penalties related to uncertain tax positions in income tax expense. As of November 29, 2007, we have accrued interest and penalties, if any, related to uncertain tax positions.

The fiscal tax years 2003 through 2007 remain open to examination by the major taxing jurisdictions to which we are subject. As of November 29, 2007, we do not expect any material changes to unrecognized tax positions within the next 12 months.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

In March 2004, we completed a private offering of the Notes. In connection with the acquisition of CityForest in March 2007, we issued and sold approximately $20 million of Additional Notes and assumed $18.4 million of additional debt. We also have the ability to borrow under a revolving line of credit, up to $40.0 million, of which as of November 29, 2007 we have outstanding borrowings of $3.5 million. As a result, we are highly leveraged.

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

Item 4. Controls and Procedures

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

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

PART II - - OTHER INFORMATION

Item 1A. Risk Factors

The risk factors included in our Annual Report on Form 10-K for fiscal year 2007 have not materially changed.

Item 6. Exhibits

(a) Exhibits

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

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

SIGNATURES

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

		Cellu Tissue Holdings, Inc.



Date:	January 11, 2008	/s/ Russell C. Taylor
		Mr. Russell C. Taylor
		President and Chief Executive Officer

Date:	January 11, 2008	/s/ David J. Morris
		Mr. David J. Morris
		Senior Vice President, Finance and Chief
		Financial Officer

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Cellu Tissue (CLU) Inactive 10-Q2008 Q3 Quarterly report

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