Clearwater Paper Corp - Quarter Report: 2009 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

For the quarterly period ended June 30, 2009

Or

For the transition period from                     to                     

Commission File Number: 001-34146

CLEARWATER PAPER CORPORATION

(Exact name of registrant as specified in its charter)

(509) 344-5900

Registrant’s telephone number, including area code

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  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  ¨    No  ¨

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

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

The number of shares of common stock of the registrant outstanding as of July 31, 2009 was 11,361,639.

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CLEARWATER PAPER CORPORATION

Index to Form 10-Q

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Part I

Clearwater Paper Corporation

Condensed Statements of Operations

Unaudited (Dollars in thousands - except per-share amounts)

The accompanying notes are an integral part of these financial statements.

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Clearwater Paper Corporation

Condensed Balance Sheets

Unaudited (Dollars in thousands)

The accompanying notes are an integral part of these financial statements.

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Clearwater Paper Corporation

Condensed Statements of Cash Flows

Unaudited (Dollars in thousands)

Net interest payments for the six months ended June 30, 2009 were $7.2 million. Net income tax payments for the six months ended June 30, 2009 were $41.3 million. We paid no interest or income taxes, nor did we receive any income tax refunds, for the six months ended June 30, 2008, due to Potlatch’s centralized approach to cash management prior to the spin-off.

See Note 10 for discussion of non-cash financing activities associated with the issuance of our senior unsecured notes and the repayment of our obligation to Potlatch.

The accompanying notes are an integral part of these financial statements.

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Clearwater Paper Corporation

Notes to Condensed Financial Statements

Unaudited

NOTE 1.

Spin-off from Potlatch Corporation

On December 1, 2008, the board of directors of Potlatch Corporation, which we refer to in this report as Potlatch, approved the distribution of our common stock to Potlatch’s stockholders in a tax-free spin-off, which we refer to in this report as the spin-off. On December 16, 2008, Potlatch distributed 100% of the issued and outstanding shares of our common stock to the holders of record of Potlatch common stock as of the close of business on December 9, 2008. Each Potlatch stockholder received one share of our common stock for every 3.5 shares of Potlatch common stock held on the record date.

Unless the context otherwise requires or indicates, references in this report to “Clearwater Paper,” “we,” “our company” and “us” refer:

NOTE 2.

General

Clearwater Paper is principally engaged in the manufacturing and selling of pulp-based products. We are a leading producer of private label tissue products sold in grocery stores in the United States, and we manufacture and market bleached paperboard for the high-end segment of the packaging industry. We also manufacture and market bleached pulp and wood products, including appearance grade cedar and dimensional framing lumber products.

Our businesses were owned by, and we were a subsidiary of, Potlatch until our spin-off on December 16, 2008.

The accompanying Condensed Balance Sheets at June 30, 2009 and December 31, 2008, the Condensed Statements of Operations for the quarters and six months ended June 30, 2009 and 2008, and the Condensed Statements of Cash Flows for the six months ended June 30, 2009 and 2008 have been prepared in conformity with accounting principles generally accepted in the United States of America. We believe that all adjustments necessary for a fair statement of the results of the interim periods presented have been included. The results of operations for any interim period are not necessarily indicative of the results of operations to be expected for the full year.

This Quarterly Report on Form 10-Q should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2008, as filed with the Securities and Exchange Commission, or SEC, on March 18, 2009.

We have evaluated subsequent events through the time we filed this Quarterly report on Form 10-Q on August 4, 2009.

NOTE 3.

Recent Accounting Standards

In September 2006, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice. SFAS No. 157 (as amended by FASB Staff Position, or FSP, FAS No. 157-2) is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, for financial assets and liabilities, and nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). For nonfinancial assets and nonfinancial liabilities that are not remeasured at fair value on a recurring basis in the financial statements, the statement is effective for fiscal years beginning after November 15, 2008. With the exception of the deferred portion of SFAS No. 157, we adopted this Statement effective January 1, 2008, which did not have a material effect on our financial condition and results of operations. Adoption of the deferred portion of this Statement on January 1, 2009, did not have a material effect on our financial condition and results of operations.

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In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51. This Statement requires all companies to report noncontrolling or minority interests in subsidiaries as equity in the financial statements. The intention of SFAS No. 160 is to eliminate the diversity in practice regarding the accounting for transactions between a company and noncontrolling interests. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Adoption of this Statement on January 1, 2009, did not have a material effect on our financial condition and results of operations.

In December 2007, the FASB also issued SFAS No. 141 (Revised 2007), Business Combinations. This revised Statement, which we refer to as SFAS No. 141R, is intended to simplify existing guidance and converge rulemaking under U.S. GAAP with international accounting rules. SFAS No. 141R will significantly change the accounting for business combinations in a number of areas, including the treatment of contingent consideration, contingencies, acquisition costs and restructuring costs. Also under this Statement, changes in deferred tax asset valuation allowances and acquired income tax uncertainties in a business combination after the measurement period will impact income tax expense. SFAS No. 141R is effective for fiscal years beginning after December 15, 2008. Adoption of this Statement on January 1, 2009 did not have a material effect on our financial condition and results of operations.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of SFAS No. 133. This Statement amends and expands the disclosure requirements by requiring qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of, and gains and losses on, derivative instruments, and disclosures about credit risk-related contingent features in derivative agreements. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We adopted SFAS No. 161 effective January 1, 2009. See Note 12 – Derivatives.

In December 2008, the FASB issued Staff Position, or FSP, FAS 132(R)-1, Employers’ Disclosures about Postretirement Benefit Plan Assets, which amends SFAS No. 132(R), Employers’ Disclosures about Pensions and Other Postretirement Benefits to provide guidance on an employers’ disclosures about assets of a defined pension or other postretirement plan. The additional disclosures include investment policies and strategies, categories of plan assets, and information about the fair value measurements of plan assets. The disclosures required by this FSP are effective for fiscal years ending after December 15, 2009. Adoption of this Statement is not expected to have a material effect on our financial condition and results of operations. However, we are currently reviewing what effect this FSP will have on our financial statement disclosures.

In April 2009, the FASB issued FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments. This FSP requires disclosures about fair value of financial instruments whenever summarized financial information for interim reporting periods is presented. Entities shall disclose the methods and significant assumptions used to estimate the fair value of financial instruments, as well as describe changes in methods and significant assumptions, if any, during the period. This FSP is effective for interim reporting periods ending after June 15, 2009. See Note 11 –Fair Value Measurements.

In May 2009, the FASB issued SFAS No. 165, Subsequent Events. This Statement establishes the accounting and disclosure of events occurring after the balance sheet date but before financial statements are issued or are available to be issued. SFAS No. 165 requires disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. This Statement was effective for interim or annual financial periods ending after June 15, 2009. The adoption of this Statement did not have an effect on our financial condition and results of operations.

In June 2009, the FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets, an amendment of SFAS No. 140. SFAS No. 166 amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement in transferred financial assets. This Statement is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. We are currently reviewing SFAS No. 166 to determine what effect, if any, it will have on our financial condition and results of operations.

In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R). This Statement amends certain requirements of FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements. SFAS No. 167 is effective as of the

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beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. We do not expect adoption of this Statement to have a material effect on our financial condition and results of operations.

In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification^TM and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162. The Codification will become the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. SFAS No. 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. Adoption of this Statement is not expected to have a material effect on our financial condition and results of operations.

NOTE 4.

Income Taxes

The income tax provisions presented in the Condensed Statements of Operations have been computed by applying an estimated annual effective tax rate. This effective rate was 36.9% for the quarter and six months ended June 30, 2009, 35.3% for the quarter ended June 30, 2008, and 34.6% for the six months ended June 30, 2008. The tax provision for the second quarter and six months ended June 30, 2008 was calculated on a carve-out basis, whereas the 2009 tax provision is reflective of the company’s operations and tax attributes as a stand-alone entity.

We reflect accrued interest related to tax obligations, as well as penalties, in our provision for income taxes. During the three month and six month periods ended June 30, 2009 and 2008, no such amounts were reflected in our provision for income taxes.

During the quarter ended June 30, 2009, we recognized an income tax benefit under Section 45 of the Internal Revenue Code of $9.8 million attributable to the federal tax credit allowed with respect to electricity produced from qualified energy resources and sold to an unrelated person for the tax years 2006 through 2008. The credit is available for the production and sale of electricity from open-loop biomass, which includes wood bark and wood fiber derived from mill or timber harvesting residues. The amount we recognized is related to the years 2006 through 2008. The credit is set to expire at the end of 2009. We also recognized a $0.2 million benefit associated with the six months ended June 30, 2009, which is reflected in the tax provision for this period.

During the quarter ended June 30, 2009, we also recognized a benefit of $3.6 million attributable to a reduction in the valuation allowance previously established with respect to state investment credit carryovers. The valuation allowance for this deferred tax asset as of December 31, 2008 and 2007 was $3.6 million. Based upon taxable income projections for 2009, including income from the alternative fuel mixture tax credits discussed in Note 7 and ITEM 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on page 19, and future taxable income over the periods for which the deferred tax assets are creditable against state tax liabilities, management now believes that it is more likely than not that we will realize the benefits of these tax credits.

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NOTE 5.

Earnings per Common Share

Earnings per common share are computed by dividing net earnings by the weighted average number of common shares outstanding in accordance with SFAS No. 128, Earnings Per Share. The following table reconciles the number of common shares used in calculating the basic and diluted net earnings per share:

For the quarter ended June 30, 2009, 3,846 shares of common stock underlying outstanding restricted stock units, or RSUs, and 11,541 shares of common stock underlying outstanding performance shares were excluded from the computation of diluted net earnings per share because their effect was anti-dilutive. For the six months ended June 30, 2009, 4,596 shares of common stock underlying outstanding RSUs, and 18,291 shares of common stock underlying outstanding performance shares were excluded from the computation of diluted net earnings per share because their effect was anti-dilutive. There were no RSUs or performance shares outstanding during the quarter or six months ended June 30, 2008. The basic average common shares outstanding as of the spin-off date were utilized for the 2008 periods presented above.

NOTE 6.

Equity-Based Compensation

In connection with the spin-off, our board of directors approved and adopted, and Potlatch, in its capacity as our sole stockholder, approved, the Clearwater Paper Corporation 2008 Stock Incentive Plan, or Stock Plan. The Stock Plan provides for equity-based awards in the form of restricted shares, RSUs, performance shares, stock options or stock appreciation rights to selected employees, outside directors and consultants of the company. Under the Stock Plan, we are authorized to issue up to approximately 1.7 million shares. The Stock Plan became effective on December 16, 2008. At June 30, 2009, approximately 709,000 shares were available for future issuance under the Stock Plan.

As of the spin-off date, the performance share and RSU awards previously granted to our employees by Potlatch were automatically cancelled, per the terms of the awards, as a result of the spin-off. Under the employee matters agreement we entered into with Potlatch in connection with the spin-off, we agreed to issue new equity awards of equivalent value to replace the equity awards previously received from Potlatch. Replacement awards were granted in the form of RSU grants. The awards will accrue dividend equivalents, if any are paid, based on dividends paid during the RSU vesting period. The dividend equivalents will be converted into additional RSUs that will vest in the same manner as the underlying RSUs to which they relate. The terms of the awards state that the awards will vest after a set period of time has passed, which approximates the remaining vesting or settlement period associated with the cancelled Potlatch equity awards.

As required by SFAS No. 123R, Share-Based Payment, we prepared a calculation as of the date of the spin-off to determine whether any additional compensation cost existed for any excess of the fair value of the modified replacement awards granted by us over the fair value of the original Potlatch performance share and RSU awards. The resulting additional expense of $0.4 million is being recognized over the remaining vesting period for the outstanding replacement grants.

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We recorded equity-based compensation expense of $0.6 million for the quarter ended June 30, 2009, of which $0.4 million related to RSUs and $0.2 million related to performance shares. We recorded equity-based compensation expense of $1.3 million for the six months ended June 30, 2009, of which $1.0 million related to RSUs and $0.3 million related to performance shares. The equity-based compensation expense we recorded for the quarter and six months ended June 30, 2008, which was allocated to us by Potlatch, was $0.9 million and $1.7 million, respectively. The net income tax benefit associated with equity-based compensation totaled $0.2 million and $0.4 million for the quarters ended June 30, 2009 and 2008, respectively, and $0.3 million and $0.7 million for the six months ended June 30, 2009 and 2008, respectively.

In connection with joining our board of directors, in January 2009 our outside directors were granted an award of phantom common stock units, which were credited to an account established on behalf of each director and will vest ratably over a three-year period. In May 2009, our outside directors were granted equity awards in the form of common stock units as part of their annual compensation, which were credited to their accounts. Certain of the awards granted will vest ratably over one year. These accounts will be credited with additional common stock units equal in value to dividends paid, if any, on the same amount of common stock. Upon separation from service as a director, the vested portion of the common stock units held by the director in his stock unit account will be converted to cash based upon the then market price of the common stock and paid to the director. Due to the cash-settlement feature of the awards, we recognize equity-based compensation expense or income at the end of each reporting period based on the portion of the award that is vested and the increase or decrease in the value of our common stock.

Directors of the company also can each elect to defer compensation in the form of stock units. We record compensation expense or income during each reporting period based on the amount of compensation deferred during the period and the increase or decrease in the value of the company’s common stock. We recorded director equity-based compensation and deferred expense totaling $0.6 million for the quarter ended June 30, 2009, and $0.7 million for the six months ended June 30, 2009. We were a wholly owned subsidiary of Potlatch prior to our spin-off, and thus there was no director equity-based compensation or deferred expense or income for the quarter and six months ended June 30, 2008.

RESTRICTED STOCK UNITS

RSUs granted under our Stock Plan are generally subject to a vesting period. Certain officers and other employees of the company have been granted RSU awards that will accrue dividend equivalents based on dividends paid, if any, during the RSU vesting period. The dividend equivalents will be converted into additional RSUs that will vest in the same manner as the underlying RSUs to which they relate. The terms of certain outstanding RSU awards state that 20% of the RSUs vest on each of the first and second anniversaries of the grant date of the awards, with the remaining 60% vesting on the third anniversary. The terms of certain other outstanding RSU awards provide for vesting of such RSUs upon the expiration of a set period of approximately three years.

A summary of the status of outstanding RSU awards as of June 30, 2009, and changes during the first six months of 2009, is presented below:

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For RSU awards granted during 2009, the fair value of each share was estimated on the date of grant using the grant date market price of our common stock. The total fair value of share awards that vested during the first half of 2009 was $0.2 million.

As of June 30, 2009, there was $3.0 million of total unrecognized compensation cost related to outstanding RSU awards. The cost is expected to be recognized over a weighted average period of 1.5 years.

PERFORMANCE SHARES

Performance share awards granted under our Stock Plan have a three-year performance period, and shares are issued after the end of the period if the performance measure is met. The performance measure is a comparison of the percentile ranking of our total shareholder return compared to the total shareholder return performance of a selected peer group. The number of shares actually issued, as a percentage of the amount subject to the performance share award, could range from 0% - 200%. Performance share awards granted under our Stock Plan do not represent common stock, and therefore the holders do not have voting rights unless and until shares are issued upon settlement. During the performance period, dividend equivalents accrue based on dividends paid, if any, and are converted into additional performance shares, which vest or are forfeited in the same manner as the underlying performance shares to which they relate.

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The fair value of performance share awards is estimated using a Monte Carlo simulation model. A summary of the status of outstanding performance share awards as of June 30, 2009, and changes during the first six months of 2009, is presented below:

As of June 30, 2009, there was $2.4 million of unrecognized compensation cost related to outstanding performance share awards. The cost is expected to be recognized over a weighted average period of 2.5 years.

NOTE 7.

Alternative Fuel Mixture Tax Credits

We are registered with the Internal Revenue Service, or IRS, as an alternative fuel mixer and have received refundable tax credit payments in connection with our use of “black liquor,” a by-product of the pulp manufacturing process, in an alternative fuel mixture to produce energy at our pulp mills. The amount of the refundable tax credit is equal to $0.50 per gallon of alternative fuel mixture used. We recorded $76.4 million of pre-tax income during the second quarter of 2009 related to the alternative fuel mixture tax credit. This income was for the period from late January through June 30, 2009. The portion of the alternative fuel mixture tax credit attributable to operations occurring during the second quarter was $45.0 million. Through June 30, 2009, we had received refundable tax credit payments totaling $57.6 million. We had $18.8 million included in “Receivables, net” on our Condensed Balance Sheet at June 30, 2009, which represented amounts we were eligible to receive but had not received as of that date.

The income for the alternative fuel mixture tax credits has been recorded as taxable income in our financial statements, including a provision for income taxes. However, we are still evaluating the likelihood that any credits received would be subject to corporate income tax, as well as the manner in which we will report the credits on our corporate income tax returns.

The alternative fuel mixture tax credit is currently set to expire on December 31, 2009.

NOTE 8.

Inventories

Inventories at the balance sheet dates consist of:

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NOTE 9.

Pension and Other Postretirement Employee Benefit Plans

The following table details the components of net periodic cost (benefit) of our pension and other postretirement employee benefit plans for the periods presented:

Quarters ended June 30:

As discussed in the notes to our financial statements as of and for the year ended December 31, 2008, our company-sponsored pension plans were underfunded by $91.2 million at December 31, 2008. As a result, we expected to be required to make contributions of approximately $8.7 million (plus interest) to our qualified pension plans for the 2009 tax year. However, we are currently reviewing guidance from the IRS that may result in lower required pension contributions for 2009. Although related to the 2009 tax year, payment of these contributions is not required until September 2010, which is when we expect to make these payments. In addition, we estimate contributions will total approximately $0.2 million in 2009 to our non-qualified pension plan. During the six months ended June 30, 2009, we made $0.1 million of contributions to our non-qualified pension plan. We do not anticipate funding our postretirement employee benefit plans in 2009 except to pay benefit costs as incurred during the year by plan participants.

NOTE 10.

Notes Payable

On June 11, 2009, we sold $150 million aggregate principal amount of senior unsecured notes. The notes are due on June 15, 2016, have an interest rate of 10.625% and were issued at a price equal to 98.792% of their face value. The issuance of these notes generated net proceeds of approximately $144.0 million after deducting discounts and offering expenses. We transferred approximately $107 million of these proceeds to a trustee in satisfaction of our obligation related to the indenture under which $100 million principal amount of credit sensitive debentures due December 1, 2009 were originally issued by an affiliate of Potlatch. The obligation to repay the credit sensitive debentures was retained by us prior to the spin-off. The $107 million consisted of the $100 million principal amount underlying the credit sensitive debentures, plus approximately $6.3 million recorded as “Debt retirement costs” on our Condensed Statement of Operations representing our current estimate of the remaining interest obligation due to holders of the debentures on December 1, 2009, and plus approximately $0.7 million included as “Restricted cash” on our Condensed Balance Sheet. The $0.7 million of restricted cash represents the difference between our current estimate of the interest payment due to holders of the debentures on December 1, 2009, and the interest payment that would be owing on December 1, 2009, if the maximum interest rate applicable to the credit sensitive debentures were to apply. Any amounts held by the trustee after payment of the $100 million principal amount and accrued interest on December 1, 2009, will be returned to us.

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On our Condensed Statement of Cash Flows for the six months ended June 30, 2009, $38.2 million is reported as “Net proceeds from long-term debt.” This represents the net proceeds received upon completion of the issuance of the senior notes, and consisted of the $150 million note proceeds less discounts, net of the direct transfer of $107 million to a trustee to satisfy our obligation related to the $100 million principal amount of credit sensitive debentures, as discussed above, and $3.0 million of expenses associated with the offering. An additional $1.2 million of expenses associated with the issuance of the notes is included in “Deferred loan fees” on our Condensed Statement of Cash Flows for the six months ended June 30, 2009.

The 10.625% senior notes due 2016 are general unsecured obligations and are therefore not secured by our assets. They are equal in right of payment with all existing and future unsecured senior indebtedness and are senior in right of payment to any future subordinated indebtedness. The notes are effectively subordinated to all of our existing and future secured indebtedness, including borrowings under our secured revolving credit facility, which is secured by all accounts receivable, inventory and cash. The notes are unconditionally guaranteed by any future restricted subsidiary guarantors.

Prior to June 15, 2012, we may redeem, at any time at our option, up to 35% of the aggregate principal amount of the notes with the net proceeds of qualified equity offerings at a redemption price equal to 110.625% of the principal amount thereof plus accrued and unpaid interest. We have the option to redeem all or a portion of the notes at any time prior to June 15, 2013 at a redemption price equal to 100% of the principal amount thereof plus a premium and accrued and unpaid interest.

In connection with the issuance of the senior notes, we entered into a registration rights agreement with the initial purchasers of the senior notes. Under this agreement, we agreed, to the extent the senior notes do not become freely tradable under the Securities Act on or before the 380th day after the date of their issuance, to file a registration statement with the SEC pursuant to which we will offer to exchange the senior notes for notes with substantially similar terms that are registered under the Securities Act. In addition, if applicable interpretations of the staff of the SEC do not permit us to exchange the senior notes, we will be required to make available an effective shelf registration statement registering the resale of the senior notes. If the senior notes do not become freely tradable on or before the 380th day after the date of their issuance, the interest rate applicable to the senior notes will be increased by 0.25% per annum for the first 90-day period and thereafter will be increased by an additional 0.25% per annum for each 90-day period that elapses, subject to a maximum of 1% per annum. The additional interest will accrue on the senior notes until they become freely tradable, until an exchange offer has been completed or a shelf registration statement has been declared effective, as applicable. No amounts associated with the registration rights agreement have been recorded within the accompanying condensed financial statements, as the likelihood that we would have to make any payments under the arrangement is considered remote.

The terms of the notes limit our ability and the ability of any restricted subsidiaries to borrow money; pay dividends; redeem or repurchase capital stock; make investments; sell assets; create restrictions on the payment of dividends or other amounts to us from any restricted subsidiaries; enter into transactions with affiliates; enter into sale and lease back transactions; create liens; and consolidate, merge or sell all or substantially all of our assets.

NOTE 11.

Fair Value Measurements

The estimated fair values of our financial instruments at the dates presented below are as follows:

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SFAS No. 157 establishes a framework for measuring fair value, which provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities, or “Level 1” measurements, and the lowest priority to unobservable inputs, or “Level 3” measurements. The three levels of the fair value hierarchy under SFAS No. 157 are described below:

The asset’s or liability’s fair value measurement level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques used need to maximize the use of observable inputs and minimize the use of unobservable inputs.

Assets measured at fair value on a recurring basis at June 30, 2009, under SFAS No. 157, are summarized below:

The carrying amount of our short-term investments approximates fair value due to their very short maturity periods.

NOTE 12.

Derivatives

We use derivative financial instruments from time to time as a tool to help us manage our exposure to certain market risks. We enter into derivative financial instruments as hedges against our exposure to market risks only if we believe there is a high probability that changes in the value of the hedging instrument will offset corresponding changes in the underlying exposure. Relationships between hedging instruments and hedged items are formally documented, as well as our risk management objectives and strategies for entering into the transactions. Designated cash flow hedges are linked to forecasted transactions. We also periodically assess whether the derivative financial instruments are effective in offsetting changes in cash flows or the fair value of the hedged items. If a hedge ceases to be highly effective, hedge accounting will be discontinued and derivative instrument gains and losses will be recognized in earnings. We do not enter into derivative contracts for speculative purposes, whether or not we utilize hedge accounting treatment for a specific transaction.

We had no activity during the second quarters or the first six months of 2009 and 2008 that required hedge or derivative accounting treatment. However, to partially mitigate our exposure to market risk for changes in utility commodity pricing, we use firm price contracts to supply a portion of the natural gas requirements for our

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manufacturing facilities. As of June 30, 2009, these contracts covered approximately 50% of our expected average monthly natural gas requirements for the Pulp and Paperboard and Consumer Products segments for the remainder of 2009, plus lesser amounts for 2010. These contracts qualify for treatment as “normal purchases or normal sales” under SFAS No. 133 and require no mark-to-market adjustment.

NOTE 13.

Comprehensive Income

The components of comprehensive income for the quarters and six months ended June 30, 2009 and 2008 were as follows:

Of the $1.6 million reported as other comprehensive income, net of tax, for the quarter ended June 30, 2009, $1.2 million related to our defined benefit pension plans and $0.4 million related to our other postretirement employee benefit plans. Of the $2.8 million reported as other comprehensive income, net of tax, for the six months ended June 30, 2009, $2.4 million related to our defined benefit pension plans and $0.4 million related to our other postretirement employee benefit plans. Of the $0.3 million reported in other comprehensive income, net of tax, for the quarter ended June 30, 2008, $0.4 million of income and $0.1 million of expense related to our defined benefit pension and other postretirement employee benefit plans, respectively. Of the $0.5 million reported in other comprehensive income, net of tax, for the first six months of 2008, $0.7 million of income and $0.2 million of expense related to our defined benefit pension and other postretirement employee benefit plans, respectively.

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NOTE 14.

Segment Information

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FORWARD-LOOKING STATEMENTS

This report contains, in addition to historical information, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 as amended, including without limitation, statements regarding future revenues, cash flows, energy costs, wood fiber costs, future dividends, manufacturing output, additional corporate overhead and administrative expenses associated with being a stand-alone company, benefit plan funding levels, the effect of recent accounting standards on our financial condition and results of operations, our expectation that we will receive substantial alternative fuel refundable tax credits, our expectation regarding the need to periodically draw upon our credit facility to meet cash requirements and capital expenditures. Words such as “anticipate,” “expect,” “will,” “intend,” “plan,” “target,” “project,” “believe,” “seek,” “schedule,” “estimate,” “could,” “can,” “may,” and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are based on management’s current expectations, estimates, assumptions and projections that are subject to change. Our actual results of operations may differ materially from those expressed or implied by the forward-looking statements contained in this report. Important factors that could cause or contribute to such differences include the risk factors described in Item 1A of Part II of this Report on Form 10-Q and in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2008, as well as the following:

Forward-looking statements contained in this report present management’s views only as of the date of this report. Except as required under applicable law, we do not intend to issue updates concerning any future revisions of management’s views to reflect events or circumstances occurring after the date of this report.

OVERVIEW

Executive summary. We reported net earnings for the second quarter of 2009 of $75.4 million, or $6.43 per diluted common share, compared to net earnings of $5.0 million, or $0.44 per diluted common share, for the second quarter of 2008. Results for the second quarter of 2009 included the following items:

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Compared to the second quarter of 2008, and excluding the above items, the increase in net earnings for the second quarter of 2009 resulted primarily from:

Net sales were $316.9 million for the second quarter of 2009, slightly higher than the $316.0 million of net sales for the same period in 2008. Higher net selling prices for consumer tissue and paperboard products and increased shipments of tissue and pulp to external customers were nearly offset by decreased shipments of paperboard and lower net selling prices and decreased shipments of lumber.

For the first six months of 2009, we reported net earnings of $89.1 million, or $7.68 per diluted common share, compared to net earnings of $7.2 million, or $0.64 per diluted common share for the first six months of 2008. First half 2009 results also included the $76.4 million of pre-tax alternative fuel mixture tax credit income, the $9.8 million of renewable energy tax credits, the $3.6 million state investment credit related tax valuation adjustment and the $6.3 million of debt retirement costs. Compared to the first half of 2008, and excluding these items, net earnings for the first half of 2009 were favorably affected by the following:

Net sales were $603.6 million for the six months ended June 30, 2009, or 3.2% less than the $623.4 million of net sales for the same period in 2008. The reduction in net sales was due primarily to decreased shipments of paperboard, lumber and pulp to external customers, combined with lower selling prices for pulp and lumber, partially offset by higher net selling prices for our consumer tissue and paperboard products.

Corporate allocations. Historically, we shared corporate functions with Potlatch for a variety of services, including treasury, accounting, tax, legal, internal audit, human resources, information systems and public and investor relations. Upon completion of the spin-off, we became a stand-alone company and our expenses include payment for services provided by Potlatch under a transition services agreement. These services include employee benefits administration, information systems, accounting and other services for a period of up to eighteen months following the spin-off. Charges for these services have been set based on actual cost and will be partially offset by charges for certain accounts payable, purchasing, human resources, transportation, treasury, accounting, payroll and information systems related services we provide to Potlatch under the transition services agreement. We have been, and will continue to be, in the process of setting up stand-alone functions during the period of the transition services agreement, and we may incur some duplicative expenses in this process.

Our historical financial statements, prior to December 16, 2008, contain allocations of direct and indirect corporate overhead expenses, including costs for services of the type covered by the transition services agreement, as well as allocations for administrative and selling expenses based on the relative revenues of our wood products operations in relation to Potlatch’s Wood Products segment. We were allocated corporate overhead and wood products administrative and selling expenses of $2.1 million for the second quarter 2008 and $5.0 million for the six months ended June 30, 2008. We believe that the methodology applied to the allocation of these expenses was reasonable. However, on a comparable basis we expect to incur approximately $10 million of additional costs in 2009, compared to 2008, associated with being an independent, publicly traded company, not including additional expenses associated with incentive compensation based on company performance.

Except for interest expense associated with our note payable to Potlatch (in connection with our retained debt obligation further described below under the heading “Debt Arrangements”), no interest expense or interest income was allocated from Potlatch to us prior to the spin-off.

Significant changes could have occurred in our funding and operations if we had operated as an independent stand-alone entity, including a possible change in our capital structure, for example the incurrence of debt, which could have had a significant impact on our financial position and results of operations.

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Components of Net Sales and Expenses

Net sales. Net sales consist of sales of consumer tissue, pulp and paperboard and wood products, net of discounts, returns and allowances and any sales taxes collected. Sales taxes, when collected, are recorded as a current liability until remitted to the appropriate governmental entities.

Cost of sales. Cost of sales expenses consist primarily of personnel costs and the cost of raw materials, including wood fiber, energy and chemicals, depreciation and repair and maintenance expenses related to our facilities and freight associated with customer shipments.

Selling, general and administrative expenses. Selling, general and administrative expenses primarily consist of compensation and associated costs for sales and administrative personnel, as well as commission expenses related to sales of our products.

Alternative fuel mixture tax credits. We are registered with the IRS as an alternative fuel mixer and have received refundable tax credit payments in connection with our use of “black liquor,” a by-product of the pulp manufacturing process, in an alternative fuel mixture to produce energy at our pulp mills. The amount of the refundable tax credit is equal to $0.50 per gallon of alternative fuel mixture used. We recorded $76.4 million of pre-tax income during the second quarter of 2009 related to the alternative fuel mixture tax credit. This income was for the period from late January through June 30, 2009. The portion of the alternative fuel mixture tax credit attributable to operations occurring during the second quarter was $45.0 million. Through June 30, 2009, we had received refundable tax credit payments totaling $57.6 million.

The income for the alternative fuel mixture tax credits has been recorded as taxable income in our financial statements, including a provision for income taxes. However, we are still evaluating the likelihood that any credits received would be subject to corporate income tax, as well as the manner in which we will report the credits on our corporate income tax returns.

The alternative fuel mixture tax credit is currently set to expire on December 31, 2009, and legislation has been proposed that would terminate the credit with respect to black liquor prior to that time. There is relatively little guidance regarding the alternative fuel mixture tax credits and the law governing the issue is complex. Accordingly, there can be no assurance that the alternative fuel mixture tax credit for the use of black liquor will continue in effect, that we will remain qualified to receive the tax credits, that our applications for additional payments will be approved and paid, or that we will be entitled to retain the amounts we receive. In addition, there can be no assurance as to whether or not the amounts we receive will be subject to taxation or subject to further review by the IRS.

Interest expense. Interest expense is the interest related to the $100 million note payable to Potlatch in connection with our retained obligation agreement, prior to the satisfaction of that obligation in June 2009, as well as interest associated with $150 million of senior notes issued by us in June 2009 and with our credit facility.

Income taxes. Income taxes are based on reported earnings and tax rates in the jurisdictions in which our operations occur and offices are located, adjusted for available credits, changes in valuation allowances and differences between reported earnings and taxable income using current tax laws and rates.

RESULTS OF OPERATIONS

Our results of operations and financial condition discussed below for the quarter and six months ended June 30, 2008, were prepared on a combined basis from Potlatch’s consolidated financial statements. The historical results of operations and book value of the assets and liabilities of Potlatch’s Consumer Products and Pulp and Paperboard business and its Wood Products operations at Lewiston, Idaho, were used and give effect to allocations of expenses from Potlatch. This information is not necessarily indicative of what our financial position and results of operations would have been had we operated as a separate, stand-alone entity during the quarter and six months ended June 30, 2008.

At June 30, 2009, our business was organized into three reporting segments: Consumer Products, Pulp and Paperboard, and Wood Products. Sales or transfers between segments are recorded as intersegment net sales based on prevailing market prices.

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Quarter Ended June 30, 2009 Compared to Quarter Ended June 30, 2008

The following table sets forth period-to-period changes in items included in our Condensed Statements of Operations for the quarters ended June 30, 2009 and 2008.

Net sales—We experienced higher net selling prices for our consumer tissue and paperboard products and increased shipments of our consumer tissue products and pulp to external customers in the second quarter of 2009, compared to the same period in 2008. These improvements were largely offset by decreased shipments of paperboard and lumber, combined with lower selling prices for pulp and lumber. These items are discussed further below under “Business Segment Discussion.”

Cost of sales—Cost of sales was 84.3% of net sales for the quarter ended June 30, 2009, and 93.0% of net sales for the same period in 2008. The decrease of $26.8 million, or 9.1%, in the 2009 period compared to 2008 was primarily due to the following items:

Selling, general and administrative expenses—Selling, general and administrative expenses increased 62.5% for the quarter ended June 30, 2009 compared to the same period in 2008. The increase was primarily due to additional corporate administration expenses associated with being an independent, publicly traded company, as well as higher incentive compensation related expenses recorded in the second quarter of 2009.

Alternative fuel mixture tax credits—For the quarter ended June 30, 2009, we recorded $76.4 million of income related to alternative fuel mixture tax credits for the period from late January 2009 through June 2009. The portion of the alternative fuel mixture tax credit attributable to operations occurring during the second quarter was approximately $45.0 million.

Interest expense—Interest expense increased 5.6% in the second quarter of 2009 compared to the second quarter of 2008. Interest expense on the note payable to Potlatch was $2.1 million in the second quarter of 2009, compared to $3.3 million in the second quarter of 2008. During the second quarter, we issued $150 million of senior notes and in turn satisfied our $100 million note payable obligation to Potlatch. Interest expense on the $150 million senior notes was $0.9 million in the second quarter of 2009. In the second quarter of 2009, we also recorded approximately $0.4 million of interest related to our credit facility.

Debt retirement costs—We recorded $6.3 million of expenses in the second quarter of 2009 associated with the retirement of our $100 million note payable obligation to Potlatch. The $100 million note payable represented the principal amount of credit sensitive debentures originally issued by an affiliate of Potlatch. Prior to our spin-off, we agreed to retain the obligation to pay all amounts due to the holders of these debentures. The $6.3 million represents our current estimate of the interest payment that will be required on the December 1, 2009, maturity date of the credit sensitive debentures.

Income tax provision—Our income tax provision increased $20.2 million for the quarter ended June 30, 2009, compared to the same period in 2008, due to increased operating earnings and pre-tax income of $76.4 million from alternative fuel mixture tax credits. The increase in the income tax provision was partially offset by the recognition of federal renewable energy tax credits of $9.8 million and the reduction of a valuation allowance of $3.6 million previously established with respect to state investment credit carryovers in the second quarter of 2009. Excluding these items, the effective tax rate was 36.9% for the second quarter of 2009, compared to an effective tax rate of 35.3% for the second quarter of 2008. The tax provision for the second quarter of 2008 was calculated on a carve-out accounting basis, whereas the 2009 tax provision is reflective of the company’s operations and tax attributes as a stand-alone entity.

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BUSINESS SEGMENT DISCUSSION

Consumer Products

The Consumer Products segment reported a 13.4% increase in net sales (before intersegment net sales eliminations) and a $25.1 million increase in operating income for the second quarter of 2009 compared to the second quarter of 2008. The significant increase in operating income was due to the combination of increased net sales, which were attributable to higher net selling prices, increased shipments, and decreased costs. Average net selling prices for the second quarter of 2009 were 7.3% higher than the average for the second quarter of 2008 due to higher overall pricing. Shipment volumes were 5.6% higher in the second quarter of 2009 compared to the same period in 2008 due largely to increased production at our tissue converting facilities.

Operating costs for the segment were $8.6 million lower in the second quarter of 2009 versus the same period in 2008, or a 7.5% decrease. The decrease was due primarily to lower pulp, freight and energy costs. Equipment maintenance and repair costs, including labor, were $5.7 million for the second quarter of 2009, compared to $4.7 million for the second quarter of 2008.

Pulp and Paperboard

Operating income for the Pulp and Paperboard segment increased $81.7 million in the second quarter of 2009 compared to the second quarter of 2008. The significant increase in income for the segment was due to the $76.4 million of pre-tax income recorded in the second quarter of 2009 associated with the alternative fuel mixture tax credit, as previously discussed. Excluding the alternative fuel mixture tax credits income, operating income for the segment was $11.4 million in the second quarter of 2009, or 88.8% higher than the operating income for the second quarter of 2008.

Net sales, before intersegment net sales eliminations, were 5.8% lower in the second quarter of 2009 compared to the second quarter of 2008. The decrease in net sales was due to an 8.0% decrease in paperboard shipments and significantly lower net selling prices for pulp, partially offset by 2.6% higher net selling prices for paperboard and increased shipments of pulp to external customers and our Consumer Products segment. The higher paperboard selling prices were primarily attributable to price increases implemented in 2008, while the lower pulp net selling prices were largely due to the weakening of pulp markets beginning in the second half of 2008 and continuing through the second quarter of 2009.

The decrease in net sales discussed above was largely offset by a $16.1 million decrease in operating expenses for the segment. In addition to lower costs associated with the decreased shipments of paperboard, operating expenses for the second quarter of 2009 were favorably affected by lower input costs for wood fiber, chemicals, energy and freight. Cost levels for wood chips to supply our Lewiston, Idaho, pulp and paperboard mill have moderated some in 2009 but remain at historically high levels, due largely to the limited supplies resulting from the slowdown or shutdown of operations of many lumber mills in response to the continued U.S. economic and home construction market downturn. Equipment maintenance and repair expenses, including labor, for the segment were $14.9 million in the second quarter of 2009, compared to $12.4 million in the second quarter of 2008. The maintenance and repair expenses for the 2009 quarter included $1.8 million of major maintenance costs, while in the second quarter of 2008 no such costs were incurred. During the second quarter of 2009, we took eight days of downtime on one of our paperboard machines and five days of downtime on one of our pulp lines, both in Idaho. We utilized a portion of the downtime to shift certain major maintenance work originally planned for the third quarter of 2009 to the second quarter.

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Wood Products

The Wood Products segment reported an operating loss of $4.5 million for the second quarter of 2009, compared to an operating loss of $3.6 million recorded in the same period of 2008. The continued and prolonged downturn in the housing market had a significant negative effect on the results in both quarters. The larger loss for the segment in the 2009 period was due to a significant decrease in net sales, before intersegment net sales eliminations, which was attributable to a 26.4% decrease in shipments and 17.2% lower average net selling prices. The decreased shipments and lower average net selling prices were due to unfavorable pricing and a lower percentage of higher-value cedar product sales. During the second quarter of 2009, our lumber mill in Lewiston, Idaho operated on a reduced production schedule and took six days of downtime.

The decreased net sales in the second quarter of 2009 were partially offset by a $10.2 million decrease in segment expenses, which were primarily due to lower log costs and lower overall costs associated with the decreased lumber shipments.

Corporate and Eliminations

Corporate expenses and eliminations were $7.4 million for the second quarter of 2009, compared to income of $1.5 million for the second quarter of 2008. The corporate and eliminations income amount for the second quarter of 2008 was the result of a positive intra-company inventory adjustment, partially offset by corporate administration and other expenses calculated on a carve-out basis. Excluding the positive intra-company inventory adjustment in the second quarter of 2008, the increase in the second quarter of 2009 was due largely to increased corporate administration expenses primarily associated with being an independent, publicly traded company after our spin-off on December 16, 2008, as well as higher incentive compensation related expenses recorded in the second quarter of 2009.

Six Months Ended June 30, 2009 Compared to Six Months Ended June 30, 2008

The following table sets forth period-to-period changes in items included in our Condensed Statements of Operations for the six months ended June 30, 2009 and 2008.