MERCER INTERNATIONAL INC. - Quarter Report: 2006 June (Form 10-Q)

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


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

For the quarterly period ended June 30, 2006


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 No.: 000-51826

MERCER INTERNATIONAL INC.

(Exact name of Registrant as specified in its charter)


Washington		47-0956945
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

Suite 2840, 650 West Georgia Street, Vancouver, British Columbia, Canada, V6B 4N8
(Address of office)

(604) 684-1099
(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 þ 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. (Check one):

Large Accelerated Filer o Accelerated Filer þ Non-Accelerated Filer o

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

YES o NO þ

The Registrant had 33,179,140 shares of common stock outstanding as at August 8, 2006.

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

MERCER INTERNATIONAL INC.

CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)

FORM 10-Q
QUARTERLY REPORT - PAGE 2

MERCER INTERNATIONAL INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

As at June 30, 2006 and December 31, 2005
(Unaudited)
(Euros in thousands)


	June 30,			December 31,
	2006			2005
ASSETS
Current Assets
Cash and cash equivalents	€	73,079		€	83,547
Cash restricted		5,892			7,039
Receivables		87,020			74,315
Inventories		69,544			81,147
Prepaid expenses and other		6,240			5,474

Total current assets		241,775			251,522

Long-Term Assets
Cash restricted		66,537			24,573
Property, plant and equipment		1,008,319			1,024,662
Investments		7,695			6,314
Deferred note issuance and other costs		7,674			8,364
Deferred income tax		38,798			78,381

		1,129,023			1,142,294

Total assets	€	1,370,798		€	1,393,816

LIABILITIES
Current Liabilities
Accounts payable and accrued expenses	€	109,113		€	112,726
Debt, current portion		75,375			27,601

Total current liabilities		184,488			140,327

Long-Term Liabilities
Debt, less current portion		898,379			922,619
Unrealized foreign exchange rate derivative loss		11,735			61,979
Unrealized interest rate derivative losses		42,320			78,646
Pension and other post-retirement benefit obligations		16,541			17,113
Capital leases and other		9,980			9,945
Deferred income tax		17,428			14,444

		996,383			1,104,746

Total liabilities		1,180,871			1,245,073

Minority Interest		—			—
SHAREHOLDERS’ EQUITY
Common shares		181,655			181,586
Additional paid-in capital, stock options		87			14
Deficit		(12,961	)		(47,970	)
Accumulated other comprehensive income		21,146			15,113

Total shareholders’ equity		189,927			148,743


Total liabilities and shareholders’ equity	€	1,370,798		€	1,393,816

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

FORM 10-Q
QUARTERLY REPORT - PAGE 3

MERCER INTERNATIONAL INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

For Six Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands, except for per share data)


	2006			2005
Revenues	€	325,769		€	227,502

Costs and expenses:
Cost of sales		298,045			210,167

		27,724			17,335
General and administrative expenses		(18,591	)		(15,316	)
Sale of emission allowances		13,246			6,288

Income from operations		22,379			8,307


Other income (expense)
Interest expense		(46,037	)		(41,463	)
Investment income		3,011			981
Unrealized foreign exchange gain (loss) on debt		12,173			(7,509	)
Realized loss on derivative instruments		(5,219	)		(295	)
Unrealized gain (loss) on derivative instruments		90,724			(73,015	)
Impairment of investments		—			(1,645	)

Total other income (expense)		54,652			(122,946	)


Income (loss) before income taxes and minority interest		77,031			(114,639	)
Income tax (provision) benefit		(42,920	)		21,412

Income (loss) before minority interest		34,111			(93,227	)
Minority interest		898			11,409

Net income (loss)	€	35,009		€	(81,818	)

(Deficit) retained earnings, beginning of period		(47,970	)		69,176

Deficit, end of period	€	(12,961	)	€	(12,642	)


Income (loss) per share
Basic	€	1.06		€	(2.80	)

Diluted	€	0.86		€	(2.80	)

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

FORM 10-Q
QUARTERLY REPORT - PAGE 4

MERCER INTERNATIONAL INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

For Three Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands, except for per share data)


	2006			2005
Revenues	€	166,705		€	129,609

Costs and expenses:
Cost of sales		153,706			119,178

		12,999			10,431
General and administrative expenses		(9,733	)		(7,518	)
Sale of emission allowances		7,608			6,288

Income from operations		10,874			9,201


Other income (expense)
Interest expense		(23,112	)		(22,200	)
Investment income		1,267			806
Unrealized foreign exchange gain (loss) on debt		6,060			(9,806	)
Realized loss on derivative instruments		(1,657	)		—
Unrealized gain (loss) on derivative instruments		46,347			(69,451	)

Total other income (expense)		28,905			(100,651	)


Income (loss) before income taxes and minority interest		39,779			(91,450	)
Income tax (provision) benefit		(21,807	)		24,447

Income (loss) before minority interest		17,972			(67,003	)
Minority interest		449			4,852

Net income (loss)	€	18,421		€	(62,151	)

(Deficit) retained earnings, beginning of period		(31,382	)		49,509

Deficit, end of period	€	(12,961	)	€	(12,642	)


Income (loss) per share
Basic	€	0.56		€	(1.88	)

Diluted	€	0.45		€	(1.88	)

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

FORM 10-Q
QUARTERLY REPORT - PAGE 5

MERCER INTERNATIONAL INC.

CONSOLIDATED CONDENSED STATEMENTS OF
COMPREHENSIVE INCOME (LOSS)

For Six Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands)


	2006			2005
Net income (loss)	€	35,009		€	(81,818	)


Other comprehensive gain:
Foreign currency translation adjustment		5,360			1,118
Pension plan additional minimum liability		(17	)		—
Unrealized gains on securities
Unrealized holding gains arising during the period		690			305


Other comprehensive gain		6,033			1,423


Total comprehensive income (loss)	€	41,042		€	(80,395	)

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

FORM 10-Q
QUARTERLY REPORT - PAGE 6

MERCER INTERNATIONAL INC.

CONSOLIDATED CONDENSED STATEMENTS OF
COMPREHENSIVE INCOME (LOSS)

For Three Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands)


	2006		2005
Net income (loss)	€	18,421	€	(62,151	)


Other comprehensive gain:
Foreign currency translation adjustment		8,345		1,750
Pension plan additional minimum liability		2		—
Unrealized gains on securities
Unrealized holding gains arising during the period		569		—


Other comprehensive gain		8,916		1,750


Total comprehensive income (loss)	€	27,337	€	(60,401	)

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

FORM 10-Q
QUARTERLY REPORT - PAGE 7

MERCER INTERNATIONAL INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

For Six Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands)


	2006			2005
Cash Flows from (used in) Operating Activities:
Net income (loss)	€	35,009		€	(81,818	)
Adjustments to reconcile net income (loss) to cash flows from operating activities
Unrealized (gains) losses on derivatives		(85,505	)		73,015
Depreciation and amortization		29,082			25,299
Unrealized foreign exchange (gain) loss on debt		(12,173	)		7,509
Impairment of investments and securities		—			1,645
Minority interest		(898	)		(11,409	)
Deferred income taxes		42,567			(21,638	)
Stock compensation expense		207			72
Other		(490	)		125

Changes in current assets and liabilities
Receivables		(13,486	)		(20,742	)
Inventories		10,670			(16,757	)
Accounts payable and accrued expenses		(3,347	)		41,319
Other		(252	)		(1,853	)

Net cash from (used in) operating activities		1,384			(5,233	)


Cash Flows used in Investing Activities:
Cash restricted		(40,817	)		35,808
Purchase of property, plant and equipment		(15,439	)		(8,493	)
Acquisition of Celgar pulp mill		—			(146,608	)

Net cash used in investing activities		(56,256	)		(119,293	)


Cash Flows from Financing Activities:
Decrease in construction costs payable		(212	)		(31,346	)
Proceeds from borrowings of notes payable and debt		48,634			325,195
Repayment of notes payable and debt		(375	)		(183,691	)
Proceeds from investment grants		—			342
Repayment of capital lease obligations		(2,431	)		(1,907	)
Issuance of shares of common stock		69			66,645

Net cash from financing activities		45,685			175,238


Effect of exchange rate changes on cash and cash equivalents		(1,281	)		5,594

Net (decrease) increase in cash and cash equivalents		(10,468	)		56,306
Cash and cash equivalents, beginning of period		83,547			49,568

Cash and cash equivalents, end of period	€	73,079		€	105,874

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

FORM 10-Q
QUARTERLY REPORT - PAGE 8

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED June 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 1. Basis of Presentation

Effective March 1, 2006, the Company was converted from a business trust organized under the laws of the State of Washington to a corporation organized under the laws of the State of Washington. The conversion was effected through the merger of Mercer Inc. with and into an indirect wholly owned Delaware subsidiary company followed by a merger with a direct wholly owned Washington subsidiary company. The conversion effected a change in the Company’s legal form, but did not result in any change in its business, management, fiscal year, accounting practices, assets or liabilities (except to the extent of legal and other costs of effecting the conversion and maintaining ongoing corporate status) or location of its principal executive offices and facilities. The Company continues to operate under the name “Mercer International Inc.” following consummation of the conversion and continues to be engaged in the same business that it was engaged in prior to the conversion and its shares of common stock are quoted and listed for trading on the NASDAQ National Market and the Toronto Stock Exchange, respectively.

The interim period consolidated financial statements contained herein include the accounts of Mercer International Inc. (“Mercer Inc.”) and its wholly-owned and majority-owned subsidiaries (collectively, the “Company”).

The interim period consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such SEC rules and regulations. The interim period consolidated financial statements should be read together with the audited consolidated financial statements and accompanying notes included in the Company’s latest annual report on Form 10-K for the fiscal year ended December 31, 2005. In the opinion of the Company, the unaudited consolidated financial statements contained herein contain all adjustments necessary to present a fair statement of the results of the interim periods presented. The results for the periods presented herein may not be indicative of the results for the entire year.

FORM 10-Q
QUARTERLY REPORT - PAGE 9

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 2. Stock-Based Compensation

The Company adopted Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment, on January 1, 2006. This statement requires the Company to recognize the cost of employee services received in exchange for the Company’s equity instruments. Under SFAS No. 123R, the Company is required to record compensation expense over an award’s vesting period based on the award’s fair value at the date of grant. The Company has elected to adopt SFAS No. 123R on a modified prospective basis; accordingly, the financial statements for periods prior to January 1, 2006 will not include compensation cost calculated under the fair value method.

Prior to January 1, 2006, the Company applied Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees, and, therefore, recorded the intrinsic value of stock-based compensation as expense and applied the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation prior to January 1, 2006.


	Six Months Ended
	June 30, 2005
Net Loss
As reported	€	(81,818	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of any related tax effects		(21	)

Pro forma	€	(81,839	)

Basic and Diluted Loss Per Share
As reported	€	(2.80	)

Pro forma	€	(2.80	)


	Three Months Ended
	June 30, 2005
Net Loss
As reported	€	(62,151	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of any related tax effects		(11	)

Pro forma	€	(62,162	)

Basic and Diluted Loss Per Share
As reported	€	(1.88	)

Pro forma	€	(1.88	)

The fair value of each option granted is estimated on the grant date using the Black-Scholes model. During the six month period ended June 30, 2006 and 2005, no options were granted, exercised or cancelled.

FORM 10-Q
QUARTERLY REPORT - PAGE 10

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 2. Stock-Based Compensation (cont’d)

Summarized information about stock options outstanding and exercisable at June 30, 2006 is as follows:


Outstanding Options										Exercisable Options
						Weighted
						Average		Weighted				Weighted
Exercise						Remaining		Average				Average
Price Range				Number		Contractual Life		Exercise price		Number		Exercise Price
(In U.S. Dollars)						(Years)		(In U.S. Dollars)				(In U.S. Dollars)
$	5.65	-	6.375		920,000		4.00	$	6.30		886,666	$	6.32
			8.50		135,000		1.00		8.50		135,000		8.50
			7.30		30,000		9.00		7.30		10,000		7.30
			7.92		100,000		9.25		7.92		33,333		7.92

					1,185,000			$	6.71		1,064,999	$	6.66

As at June 30, 2006, the total remaining unrecognized compensation cost related to non-vested stock options amounted to €218, which will be amortized over their remaining vesting period.

During the six-month period ended June 30, 2006, there was no change in the number of non-vested options.

Restricted Stock

The fair value of restricted stock is determined based upon the number of shares granted and the quoted price of the Company’s stock on the date of grant. Restricted stock generally vests over two years. Expense is recognized on a straight-line basis over the vesting period. Expense recognized for the six months ended June 30, 2006 and 2005 was €207 and €72, respectively.

As at June 30, 2006, the total remaining unrecognized compensation cost related to restricted stock amounted to €240, which will be amortized over their remaining vesting period.

During the six month period ended June 30, 2006, there were restricted stock awards of an aggregate of 10,000 of our common shares to independent directors.

FORM 10-Q
QUARTERLY REPORT - PAGE 11

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 3. Income (Loss) Per Share

Basic income (loss) per share is computed by dividing income (loss) available to common shareholders by the weighted average number of shares outstanding during a period. Diluted income (loss) per share takes into consideration shares outstanding (computed under basic earnings (loss) per share) and potentially dilutive shares. The following table sets out the computation of basic income (loss) per share for the six and three months ended June 30, 2006 and 2005, respectively:


	Six Months Ended June 30,					Three Months Ended June 30,
	2006		2005			2006		2005
Income (loss) from continuing operations – basic	€	35,009	€	(81,818	)	€	18,421	€	(62,151	)
Interest on convertible notes, net of tax		2,767		—			1,441		—

Income (loss) from continuing operations – diluted	€	37,776	€	(81,818	)	€	19,862	€	(62,151	)

Weighted average number of common shares outstanding:
Basic		33,169,637		29,270,388			33,170,129		33,055,103
Effect of dilutive shares:
Stock options and awards		274,686		—			292,002		—
Convertible notes		10,645,161		—			10,645,161		—

Diluted		44,089,484		29,270,388			44,107,292		33,055,103

Income (loss) from continuing operations per share:
Basic	€	1.06	€	(2.80	)	€	0.56	€	(1.88	)

Diluted	€	0.86	€	(2.80	)	€	0.45	€	(1.88	)

The calculation of diluted income (loss) per share for the comparative 2005 period does not assume the exercise of stock options and awards or the conversion of convertible notes that would have an anti-dilutive effect on earnings per share. Stock options and awards excluded from the calculation of diluted income (loss) per share because they are anti-dilutive represented 253,969 for the six months ended June 30, 2005. Convertible notes excluded from the calculation of diluted income (loss) per share because they are anti-dilutive represented 10,645,161 for the six months ended June 30, 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 12

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 4. Acquisition of the Celgar Mill and Related Financings

Acquisition

On February 14, 2005, the Company completed its acquisition of the Celgar NBSK pulp mill. The aggregate consideration for the acquisition was €177,422, which included €142,940 in cash, acquisition related expenditures of €3,668 and €30,814 was paid in common shares of the Company. The results of the Celgar mill are included in the consolidated statement of operations since the acquisition date.

The allocation of the purchase price is summarized below.


Purchase price:
Cash (including defined working capital)	€	142,940
Equity – common shares		30,814
Acquisition costs		3,668

	€	177,422


Net assets acquired:
Receivables	€	32
Inventories		19,969
Prepaids and other assets		616
Property, plant and equipment		175,096
Accrued expenses and other liabilities		(4,103	)
Pension plan and post-retirement benefits obligations		(14,188	)

	€	177,422

In October 2005, our wholly owned subsidiary, Zellstoff Celgar Limited, received a re-assessment for real property transfer tax payable in British Columbia, Canada, in the amount of approximately €3.5 million in connection with the transfer of the land where the Celgar mill is situated. The Company is contesting the assessment and the amount, if any, that may be payable in connection therewith is not yet determinable. Any additional amount paid in connection with the re-assessment will increase the cost basis of the assets acquired.

FORM 10-Q
QUARTERLY REPORT - PAGE 13

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 5. Business Segment Information

The Company operates in two reportable business segments: pulp and paper. The segments are managed separately because each business requires different production and marketing strategies. The results of the Celgar mill presented below are from the date of its acquisition on February 14, 2005.

Summarized financial information concerning the segments is shown in the following table:


															Corporate,
	Rosenthal			Celgar			Stendal			Total					Other and			Consolidated
	Pulp			Pulp			Pulp			Pulp			Paper		Eliminations			Total
Six Months Ended June 30, 2006
Sales to external customers	€	68,941		€	100,811		€	122,510		€	292,262		€	33,507	€	—		€	325,769
Intersegment net sales		(152	)		23			4,688			4,559			108		(4,667	)		—

		68,789			100,834			127,198			296,821			33,615		(4,667	)		325,769

Operating costs		49,453			98,702			95,571			243,726			29,971		(4,434	)		269,263
Operating depreciation and amortization		7,750			6,291			14,129			28,170			456		156			28,782
General and administrative		3,592			4,939			5,940			14,471			2,276		1,844			18,591
(Sale) purchase of emission allowances		(3,651	)		—			(9,595	)		(13,246	)		—		—			(13,246	)

		57,144			109,932			106,045			273,121			32,703		(2,434	)		303,390

Income (loss) from operations		11,645			(9,098	)		21,153			23,700			912		(2,233	)		22,379
Interest expense																			(46,037	)
Investment income																			3,011
Derivative financial instruments, net																			85,505
Unrealized foreign exchange gain on debt																			12,173

Income before income taxes and minority interest																		€	77,031

Segment assets	€	332,485		€	237,175		€	746,557		€	1,316,217		€	22,020	€	32,561		€	1,370,798


															Corporate,
	Rosenthal			Celgar⁽¹⁾		Stendal			Total						Other and			Consolidated
	Pulp			Pulp		Pulp			Pulp			Paper			Eliminations			Total
Six Months Ended June 30, 2005
Sales to external customers	€	65,936		€	48,480	€	81,606		€	196,022		€	31,480		€	—		€	227,502
Intersegment net sales		—			—		3,340			3,340			—			(3,340	)		—

		65,936			48,480		84,946			199,362			31,480			(3,340	)		227,502

Operating costs		47,405			40,554		71,546			159,505			29,601			(3,822	)		185,284
Operating depreciation and amortization		6,630			4,097		13,454			24,181			379			323			24,883
General and administrative		3,810			2,837		1,677			8,324			2,562			4,430			15,316
(Sale) purchase of emission allowances		(2,135	)		—		(4,153	)		(6,288	)		—			—			(6,288	)

		55,710			47,488		82,524			185,722			32,542			931			219,195

Income (loss) from operations		10,226			992		2,422			13,640			(1,062	)		(4,271	)		8,307
Interest expense																			(41,463	)
Investment income																			981
Derivative financial instruments, net																			(73,310	)
Unrealized foreign exchange loss on debt																			(7,509	)
Impairment of investments																			(1,645	)

Loss before income taxes and minority interest																		€	(114,639	)

Segment assets	€	347,935		€	244,361	€	906,244		€	1,498,540		€	24,294		€	15,995		€	1,538,829


(1)		The results of the Celgar pulp mill are from the date of its acquisition on February 14, 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 14

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 5. Business Segment Information (cont’d)


															Corporate,
	Rosenthal			Celgar			Stendal			Total					Other and			Consolidated
	Pulp			Pulp			Pulp			Pulp			Paper		Eliminations			Total
Three Months Ended June 30, 2006
Sales to external customers	€	34,269		€	54,514		€	61,811		€	150,594		€	16,111	€	—		€	166,705
Intersegment net sales		(194	)		23			2,373			2,202			108		(2,310	)		—

		34,075			54,537			64,184			152,796			16,219		(2,310	)		166,705

Operating costs		25,466			53,137			47,446			126,049			14,453		(1,664	)		138,838
Operating depreciation and amortization		4,213			3,277			7,070			14,560			230		78			14,868
General and administrative		2,265			2,815			3,183			8,263			1,135		335			9,733
(Sale) purchase of emission allowances		(1,884	)		—			(5,724	)		(7,608	)		—		—			(7,608	)

		30,060			59,229			51,975			141,264			15,818		(1,251	)		155,831

Income (loss) from operations		4,015			(4,692	)		12,209			11,532			401		(1,059	)		10,874
Interest expense																			(23,112	)
Investment income																			1,267
Derivative financial instruments, net																			44,690
Unrealized foreign exchange gain on debt																			6,060

Income before income taxes and minority interest																		€	39,779


															Corporate,
	Rosenthal			Celgar		Stendal			Total						Other and			Consolidated
	Pulp			Pulp		Pulp			Pulp			Paper			Eliminations			Total
Three Months Ended June 30, 2005
Sales to external customers	€	31,840		€	40,864	€	40,808		€	113,512		€	16,097		€	—		€	129,609
Intersegment net sales		—			—		1,786			1,786			—			(1,786	)		—

		31,840			40,864		42,594			115,298			16,097			(1,786	)		129,609

Operating costs		22,217			35,419		34,411			92,047			15,370			(2,135	)		105,282
Operating depreciation and amortization		3,362			3,274		6,773			13,409			198			289			13,896
General and administrative		1,909			1,162		702			3,773			1,326			2,419			7,518
(Sale) purchase of emission allowances		(2,135	)		—		(4,153	)		(6,288	)		—			—			(6,288	)

		25,353			39,855		37,733			102,941			16,894			573			120,408

Income (loss) from operations		6,487			1,009		4,861			12,357			(797	)		(2,359	)		9,201
Interest expense																			(22,200	)
Investment income																			806
Derivative financial instruments, net																			(69,451	)
Unrealized foreign exchange loss on debt																			(9,806	)

Loss before income taxes and minority interest																		€	(91,450	)

FORM 10-Q
QUARTERLY REPORT - PAGE 15

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 6. Inventories


	June 30, 2006		December 31, 2005
Raw materials	€	44,277	€	42,649
Finished goods		25,267		38,498

	€	69,544	€	81,147

Note 7. Pension and Other Post-Retirement Benefit Obligations

Included in pension and other post-retirement benefit obligations are amounts related to our Celgar and German pulp mills.

The Celgar mill maintains defined benefit pension and post-retirement benefit plans for certain employees. Pension benefits are based on employees’ earnings and years of service. The pension plans are funded by contributions from the Company based on management’s best estimates. Pension contributions for the six month period ended June 30, 2006 and the period from acquisition to June 30, 2005 totaled €908 and €369, respectively.


	Six Months Ended June 30,
	2006					2005
	Pension			Post-Retirement		Pension			Post-Retirement
	Benefits			Benefits		Benefits			Benefits
Service cost	€	448		€	227	€	245		€	107
Interest cost		706			382		481			234
Expected return on plan assets		(786	)		—		(471	)		—
Recognized net loss		—			50		—			—

Net periodic benefit cost	€	368		€	659	€	255		€	341


	Three Months Ended June 30,
	2006					2005
	Pension			Post-Retirement		Pension			Post-Retirement
	Benefits			Benefits		Benefits			Benefits
Service cost	€	222		€	112	€	161		€	58
Interest cost		350			190		323			146
Expected return on plan assets		(389	)		—		(321	)		—
Recognized net loss		—			25		—			—

Net periodic benefit cost	€	183		€	327	€	163		€	204

FORM 10-Q
QUARTERLY REPORT - PAGE 16

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 8. Derivatives Transactions


	Six Months Ended June 30,
	2006			2005
Realized loss on derivative financial instruments	€	(5,219	)	€	(295	)


Unrealized net gain (loss) on interest rate derivatives		36,326			(20,475	)
Unrealized net gain (loss) on foreign exchange derivatives		54,398			(52,540	)

Unrealized gain (loss) on derivative financial instruments	€	90,724		€	(73,015	)


	Three Months Ended June 30,
	2006			2005
Realized loss on derivative financial instruments	€	(1,657	)	€	—


Unrealized net gain (loss) on interest rate derivatives		12,820			(20,819	)
Unrealized net gain (loss) on foreign exchange derivatives		33,527			(48,632	)

Unrealized gain (loss) on derivative financial instruments	€	46,347		€	(69,451	)

FORM 10-Q
QUARTERLY REPORT - PAGE 17

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 9. Restricted Group Supplemental Disclosure

The terms of the indenture governing our 9.25% senior unsecured notes requires that we provide the results of operations and financial condition of Mercer Inc. and our restricted subsidiaries under the indenture, collectively referred to as the “Restricted Group”. From February 14, 2005, the Restricted Group includes Mercer Inc., certain holding subsidiaries, Rosenthal and the Celgar mill. The Restricted Group excludes our paper operations and the Stendal mill.

Combined Condensed Balance Sheet


	June 30, 2006
	Restricted		Unrestricted						Consolidated
	Group		Subsidiaries			Eliminations			Group
ASSETS
Current assets
Cash and cash equivalents	€	37,018	€	36,061		€	—		€	73,079
Cash restricted		—		5,892			—			5,892
Receivables		47,468		39,552			—			87,020
Inventories		36,653		32,891			—			69,544
Prepaid expenses and other		3,620		2,620			—			6,240

Total current assets		124,759		117,016			—			241,775
Cash restricted		—		66,537			—			66,537
Property, plant and equipment		400,046		608,273			—			1,008,319
Other		10,048		5,321			—			15,369
Deferred income tax		18,149		20,649			—			38,798
Due from unrestricted group		49,302		—			(49,302	)		—

Total assets	€	602,304	€	817,796		€	(49,302	)	€	1,370,798


LIABILITIES
Current liabilities
Accounts payable and accrued expenses	€	43,851	€	65,262		€	—		€	109,113
Debt, current portion		—		75,375			—			75,375

Total current liabilities		43,851		140,637			—			184,488
Debt, less current portion		322,732		575,647			—			898,379
Due to restricted group		—		49,302			(49,302	)		—
Unrealized derivative loss		—		54,055			—			54,055
Other		21,160		5,361			—			26,521
Deferred income tax		2,379		15,049			—			17,428

Total liabilities		390,122		840,051			(49,302	)		1,180,871

SHAREHOLDERS’ EQUITY
Total shareholders’ equity (deficit)		212,182		(22,255	)⁽¹⁾		—			189,927

Total liabilities and shareholders’ equity	€	602,304	€	817,796		€	(49,302	)	€	1,370,798


(1)		Shareholders’ equity does not include government grants received or receivable related to the Stendal mill. Shareholders’ equity is impacted by the unrealized non-cash marked to market valuation losses on derivative financial instruments.

FORM 10-Q
QUARTERLY REPORT - PAGE 18

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 9. Restricted Group Supplemental Disclosure (cont’d)

Combined Condensed Balance Sheet


	December 31, 2005
	Restricted		Unrestricted						Consolidated
	Group		Subsidiaries			Eliminations			Group
ASSETS
Current
Cash and cash equivalents	€	48,790	€	34,757		€	—		€	83,547
Cash restricted		—		7,039			—			7,039
Receivables		41,349		32,966			—			74,315
Inventories		47,100		34,047			—			81,147
Prepaid expenses and other		2,940		2,534			—			5,474

Total current assets		140,179		111,343			—			251,522
Cash restricted		—		24,573			—			24,573
Property, plant and equipment		404,151		620,511			—			1,024,662
Other		10,533		4,145			—			14,678
Deferred income tax		24,303		54,078			—			78,381
Due from unrestricted group		46,412		—			(46,412	)		—

Total assets	€	625,578	€	814,650		€	(46,412	)	€	1,393,816


LIABILITIES
Current
Accounts payable and accrued expenses	€	46,867	€	65,859		€	—		€	112,726
Debt, current portion		—		27,601			—			27,601

Total current liabilities		46,867		93,460			—			140,327
Debt, less current portion		342,023		580,596			—			922,619
Due to restricted group		—		46,412			(46,412	)		—
Unrealized derivative loss		—		140,625			—			140,625
Other		20,722		6,336			—			27,058
Deferred income tax		1,851		12,593			—			14,444

Total liabilities		411,463		880,022			(46,412	)		1,245,073

SHAREHOLDERS’ EQUITY
Total shareholders’ equity (deficit)		214,115		(65,372	)⁽¹⁾		—			148,743

Total liabilities and shareholders’ equity	€	625,578	€	814,650		€	(46,412	)	€	1,393,816


(1)		Shareholders’ equity does not include government grants received or receivable related to the Stendal mill. Shareholders’ equity is impacted by the unrealized non-cash marked to market valuation losses on derivative financial instruments.

FORM 10-Q
QUARTERLY REPORT - PAGE 19

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 9. Restricted Group Supplemental Disclosure (cont’d)

Combined Condensed Statement of Operations


	Six Months Ended June 30, 2006
	Restricted			Unrestricted						Consolidated
	Group			Subsidiaries			Eliminations			Group
Revenues	€	169,623		€	160,813		€	(4,667	)	€	325,769


Operating costs		148,388			125,309			(4,434	)		269,263
Operating depreciation and amortization		14,197			14,585			—			28,782
General and administrative expenses		10,375			8,216			—			18,591
(Sale) purchase of emission allowances		(3,651	)		(9,595	)		—			(13,246	)

		169,309			138,515			(4,434	)		303,390

Income from operations		314			22,298			(233	)		22,379


Other income (expense)
Interest expense		(16,442	)		(31,355	)		1,760			(46,037	)
Investment income		2,119			2,652			(1,760	)		3,011
Derivative financial instruments, net		—			85,505			—			85,505
Unrealized foreign exchange gain on debt		12,173			—			—			12,173

Total other (expense) income		(2,150	)		56,802			—			54,652

Income (loss) before income taxes and minority interest		(1,836	)		79,100			(233	)		77,031
Income tax provision		(6,905	)		(36,015	)		—			(42,920	)

Income (loss) before minority interest		(8,741	)		43,085			(233	)		34,111
Minority interest		—			898			—			898

Net income (loss)	€	(8,741	)	€	43,983		€	(233	)	€	35,009


	Six Months Ended June 30, 2005
	Restricted			Unrestricted						Consolidated
	Group			Subsidiaries			Eliminations			Group
Revenues	€	114,416		€	113,086		€	—		€	227,502


Operating costs		87,260			98,024			—			185,284
Operating depreciation and amortization		10,829			13,616			438			24,883
General and administrative		11,077			4,239			—			15,316
(Sale) purchase of emission allowances		(2,135	)		(4,153	)		—			(6,288	)

		107,031			111,726			438			219,195

Income from operations		7,385			1,360			(438	)		8,307


Other income (expense)
Interest expense		(15,985	)		(26,571	)		1,093			(41,463	)
Investment income		1,297			777			(1,093	)		981
Derivative financial instruments, net		(463	)		(72,847	)		—			(73,310	)
Unrealized foreign exchange loss on debt		(7,509	)		—			—			(7,509	)
Impairment of investments		(1,645	)		—			—			(1,645	)

Total other expense		(24,305	)		(98,641	)		—			(122,946	)

Loss before income taxes and minority interest		(16,920	)		(97,281	)		(438	)		(114,639	)
Income tax (provision) benefit		(4,776	)		26,188			—			21,412

Loss before minority interest		(21,696	)		(71,093	)		(438	)		(93,227	)
Minority interest		—			11,409			—			11,409

Net loss	€	(21,696	)	€	(59,684	)	€	(438	)	€	(81,818	)

FORM 10-Q
QUARTERLY REPORT - PAGE 20

MERCER INTERNATIONAL INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006

(Unaudited)
(Euros in thousands, except for shares and per share data)

Note 9. Restricted Group Supplemental Disclosure (cont’d)

Combined Condensed Statement of Operations


	Three Months Ended June 30, 2006
	Restricted			Unrestricted						Consolidated
	Group			Subsidiaries			Eliminations			Group
Revenues	€	88,612		€	80,403		€	(2,310	)	€	166,705


Operating costs		79,249			61,253			(1,664	)		138,838
Operating depreciation and amortization		7,568			7,300			—			14,868
General and administrative expenses		5,415			4,318			—			9,733
(Sale) purchase of emission allowances		(1,884	)		(5,724	)		—			(7,608	)

		90,348			67,147			(1,664	)		155,831

Income (loss) from operations		(1,736	)		13,256			(646	)		10,874


Other income (expense)
Interest expense		(7,979	)		(16,018	)		885			(23,112	)
Investment income		(142	)		2,294			(885	)		1,267
Derivative financial instruments, net		79			44,611			—			44,690
Unrealized foreign exchange gain on debt		6,060			—			—			6,060

Total other (expense) income		(1,982	)		30,887			—			28,905

Income (loss) before income taxes and minority interest		(3,718	)		44,143			(646	)		39,779
Income tax provision		(3,872	)		(17,935	)		—			(21,807	)

Income (loss) before minority interest		(7,590	)		26,208			(646	)		17,972
Minority interest		—			449			—			449

Net income (loss)	€	(7,590	)	€	26,657		€	(646	)	€	18,421


	Three Months Ended June 30, 2005
	Restricted			Unrestricted						Consolidated
	Group			Subsidiaries			Eliminations			Group
Revenues	€	72,704		€	56,905		€	—		€	129,609


Operating costs		57,287			47,995			—			105,282
Operating depreciation and amortization		6,704			6,971			221			13,896
General and administrative		5,490			2,028			—			7,518
(Sale) purchase of emission allowances		(2,135	)		(4,153	)		—			(6,288	)

		67,346			52,841			221			120,408

Income from operations		5,358			4,064			(221	)		9,201

Other income (expense)
Interest expense		(8,314	)		(14,585	)		699			(22,200	)
Investment income		970			467			(631	)		806
Derivative financial instruments, net		(358	)		(69,093	)		—			(69,451	)
Unrealized foreign exchange loss on debt		(9,806	)		—			—			(9,806	)
Impairment of investments		(467	)		—			467			—

Total other income (expense)		(17,975	)		(83,211	)		535			(100,651	)

Income (loss) before income taxes and minority interest		(12,617	)		(79,147	)		314			(91,450	)
Income tax (provision) benefit		(1,661	)		26,108			—			24,447

Income (loss) before minority interest		(14,278	)		(53,039	)		314			(67,003	)
Minority interest		—			4,852			—			4,852

Net loss	€	(14,278	)	€	(48,187	)	€	314		€	(62,151	)

FORM 10-Q
QUARTERLY REPORT - PAGE 21

Note 10. Subsequent Event

In August 2006, we reorganized and divested our equity interests in certain paper production assets, including our Heidenau paper mill, for aggregate consideration of approximately €5.0 million of indebtedness and €5.0 million in cash.

FORM 10-Q
QUARTERLY REPORT - PAGE 22

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In this document: (i) unless the context otherwise requires, references to “we”, “our”, “us”, the “Company” or “Mercer” mean Mercer International Inc. and its subsidiaries; (ii) references to “Mercer Inc.” mean the Company excluding its subsidiaries; (iii) information is provided as of June 30, 2006, unless otherwise stated; (iv) all references to monetary amounts are to “Euros”, unless otherwise stated; (v) “€” refers to Euros and C$ refers to Canadian dollars; and (vi) “ADMTs” refers to air-dried metric tonnes.

The following discussion and analysis of our results of operations and financial condition for the six months ended June 30, 2006 should be read in conjunction with our consolidated financial statements and related notes included in this quarterly report, as well as our most recent annual report on Form 10-K for the fiscal year ended December 31, 2005 filed with the Securities and Exchange Commission (the “SEC”). Certain reclassifications have been made to the prior period financial statements to conform with the current period presentation.

Results of Operations

Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005

Selected sales data for the six months ended June 30, 2006 and 2005 is as follows:


	Six Months Ended June 30,
	2006		2005
	(ADMTs)
Sales Volume by Product Class
Pulp sales volume by mill:
Rosenthal		149,236		154,800
Stendal		277,408		204,988
Celgar		229,722		118,188

Total pulp sales volume⁽¹⁾		656,366		477,976
Paper sales volume		32,084		34,478

Total sales volume⁽¹⁾		688,450		512,454


	(in thousands)
Revenues by Product Class
Pulp revenues by mill:
Rosenthal	€	67,545	€	64,504
Stendal		120,522		80,873
Celgar⁽¹⁾		100,811		48,480

Total pulp revenues⁽¹⁾		288,878		193,857
Paper revenues		33,335		31,463

Total pulp and paper sales revenues⁽¹⁾		322,213		225,320
Third party transportation revenues		3,556		2,182

Total sales revenues	€	325,769	€	227,502


(1)		Excluding intercompany sales volumes of 9,857 and 7,594 ADMTs of pulp and intercompany net sales revenues of approximately €4.7 million and €3.3 million in the six months ended June 30, 2006 and 2005, respectively.

FORM 10-Q
QUARTERLY REPORT - PAGE 23

Selected production data for the six months ended June 30, 2006 and 2005 is as follows:


	Six Months Ended June 30,
	2006		2005
	(ADMTs)
Production by Product Class
Pulp production by mill:
Rosenthal		143,530		157,315
Stendal		270,592		231,719
Celgar⁽¹⁾		212,088		171,833

Total pulp production		626,210		560,867
Paper production		33,602		33,937

Total production		659,812		594,804


(1)		The results of the Celgar pulp mill are included from the date of its acquisition on February 14, 2005.

Revenues for the six months ended June 30, 2006 increased to €325.8 million from €227.5 million in the comparative period of 2005, primarily due to higher sales from our Celgar and Stendal pulp mills. Pulp sales by volume increased to 656,366 ADMTs in the first half of 2006 from 477,976 ADMTs in the comparative period of 2005.

Cost of sales and general, administrative and other expenses in the first half of 2006 increased to €303.4 million from €219.2 million in the comparative period of 2005, primarily as a result of higher sales from our Celgar and Stendal mills.

For the first half of 2006, revenues from our pulp operations increased to €292.3 million from €196.0 million in the same period a year ago. List prices for NBSK pulp in Europe were approximately €522 ($642) per ADMT in the first half of 2006, approximately €488 ($628) per ADMT in the first half of 2005 and approximately €506 ($600) in the fourth quarter of 2005.

Mill net pulp sales realizations increased to €440 per ADMT on average in the first half of 2006 from €411 per ADMT in the first half of 2005, primarily as a result of higher pulp prices.

During the current period, we took an aggregate of 42 days scheduled maintenance and strategic capital expenditure downtime at our pulp mills, including 20 days at our Rosenthal mill and 13 days at our Celgar mill. During the downtime at our Rosenthal mill, we completed the installation of a new brownstock washer at a cost of approximately €9.7 million, which is expected to further improve pulp quality and lower chemical costs and effluents. The total maintenance costs associated with such shutdowns were approximately €6.5 million and were expensed as incurred. This negatively impacted our production volumes, costs and operating results. The Stendal mill also underwent extensive testing of various departments and converted some production to TCF pulp pursuant to the terms of its EPC contract which curtailed production during such period. During the comparative period of 2005, our pulp mills took approximately 32 days maintenance and strategic capital expenditure downtime.

Cost of sales and general, administrative and other expenses for the pulp operations increased to €273.1 million in the first half of 2006 from €185.7 million in the comparative period of 2005 primarily as a result of higher sales from our Celgar and Stendal mills.

Fiber costs at our German pulp mills increased by approximately 9% in the first half of 2006 versus the same period of 2005. This resulted from lower availability because of severe winter conditions in Germany and central Europe, which caused sawmillers and log harvesters to curtail operations and increased competition for fiber primarily from renewable energy operations. The

FORM 10-Q
QUARTERLY REPORT - PAGE 24

increase in worldwide energy prices has made projects generating energy from renewable sources such as wood residuals more viable in Europe. As a result, there has been increased fiber demand and competition in our fiber base. In the first six months of 2006, average fiber costs at our Celgar mill decreased by approximately 18% versus the same period of 2005, primarily because of increased regional wood chip availability.

In the first half of 2006, we recorded a contribution to income from operations of €13.2 million resulting from the sale of emission allowances compared to €6.3 million in the comparative period of 2005.

Depreciation for the pulp operations increased to €28.2 million in the first half of 2006, from €24.2 million in the first half of 2005, primarily as a result of the inclusion of depreciation for the Celgar mill for the full period.

For the first six months of 2006, our pulp operations generated operating income of €23.7 million, versus operating income of €13.6 million in the same period of 2005, primarily due to improving pulp markets and the higher operating income at our German pulp mills, including a contribution of €13.2 million from the sale of emission allowances, partially offset by maintenance and strategic capital expenditure downtime at our pulp mills. The overall strength of the Canadian dollar versus the U.S. dollar negatively impacted our Celgar mill’s results.

Revenues from our paper operations in the first half of 2006 increased to €33.5 million from €31.5 million in the same period of last year as a result of higher sales volumes and a change in the product mix.

Cost of sales and general, administrative and other expenses for the paper operations in the first half of 2006 increased to €32.7 million from €32.5 million in the comparative quarter of 2005.

In the first half of 2006, our paper operations generated operating income of €0.9 million, compared to an operating loss of €1.1 million in the first half of 2005.

In the first half of 2006, income from operations increased to €22.4 million from €8.3 million in the same period last year, primarily as a result of higher pulp prices and improved results from our German pulp mills.

Interest expense in the first half of 2006 increased to €46.0 million from €41.5 million in the year ago period, primarily due to higher borrowings relating to the Stendal mill.

Stendal entered into certain foreign currency derivatives to swap all of its long-term bank indebtedness from Euros to U.S. dollars in 2005 and certain currency forwards. In addition, Stendal previously entered into interest rate swaps to fix the interest rate on its outstanding bank indebtedness. Due to the weakening of the U.S. dollar versus the Euro and an increase in long-term interest rates, we recorded a net unrealized non-cash holding gain of €90.7 million before minority interests upon the marked to market valuation of such derivatives that were outstanding at the end of the current period, compared to a net non-cash holding loss of €73.0 million before minority interests upon the marked to market valuation of our outstanding derivatives in the comparative period of 2005. In the first six months of 2006 we recorded a realized loss in derivative instruments of €5.2 million compared to a realized loss of €0.3 million in the comparative period of 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 25

In the first half of 2006, minority interest, representing the two minority shareholders’ proportionate interest in the Stendal mill’s losses for the period, was €0.9 million, compared to €11.4 million in the first half of 2005.

We reported net income for the first six months of 2006 of €35.0 million, or €1.06 per basic and €0.86 per diluted share, which reflected a net unrealized gain of €85.5 million on our interest rate and currency derivatives, an unrealized non-cash foreign exchange gain on our long-term debt of €12.2 million and improved results at our German pulp mills. In the first half of 2005, we reported a net loss of €81.8 million, or €2.80 per basic and diluted share, which reflected a net unrealized non-cash holding losses on our currency and interest rate derivatives of €73.3 million and the unrealized non-cash foreign exchange loss on our long-term debt of €7.5 million, partially offset by the non-cash benefit for income taxes of €21.4 million, and interest expense related to our Stendal mill of €26.3 million and a non-cash impairment charge of €1.6 million relating to investments.

We generated “Operating EBITDA” of €51.2 million and €33.2 million in the six months ended June 30, 2006 and 2005, respectively. Operating EBITDA is defined as income (loss) from operations plus depreciation and amortization and non-recurring capital asset impairment charges.

Management uses Operating EBITDA as a benchmark measurement of its own operating results, and as a benchmark relative to its competitors. Management considers it to be a meaningful supplement to operating income as a performance measure primarily because depreciation expense and non-recurring capital asset impairment charges are not an actual cash cost, and depreciation expense varies widely from company to company in a manner that management considers largely independent of the underlying cost efficiency of their operating facilities. In addition, we believe Operating EBITDA is commonly used by securities analysts, investors and other interested parties to evaluate our financial performance.

Operating EBITDA does not reflect the impact of a number of items that affect our net income (loss), including financing costs and the effect of derivative instruments. Operating EBITDA is not a measure of financial performance under GAAP, and should not be considered as an alternative to net income (loss) or income (loss) from operations as a measure of performance, nor as an alternative to net cash from operating activities as a measure of liquidity.

Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are that Operating EBITDA does not reflect: (i) our cash expenditures, or future requirements, for capital expenditures or contractual commitments; (ii) changes in, or cash requirements for, working capital needs; (iii) the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our outstanding debt; (iv) minority interests on our Stendal NBSK pulp mill operations; (v) the impact of realized or marked to market changes in our derivative positions, which can be substantial; and (vi) the impact of impairment charges against our investments or assets. Because of these limitations, Operating EBITDA should only be considered as a supplemental performance measure and should not be considered as a measure of liquidity or cash available to us to invest in the growth of our business. See the Statement of Cash Flows set out in our consolidated financial statements included herein. Because all companies do not calculate Operating EBITDA in the same manner, Operating EBITDA as calculated by us may differ from Operating EBITDA or EBITDA as calculated by other companies. We compensate for these limitations by using Operating

FORM 10-Q
QUARTERLY REPORT - PAGE 26

EBITDA as a supplemental measure of our performance and relying primarily on our GAAP financial statements.

The following table provides a reconciliation of net income (loss) to income from operations and Operating EBITDA for the periods indicated:


	Six Months Ended
	June 30,
	2006			2005⁽¹⁾
	(in thousands)
Net income (loss)	€	35,009		€	(81,818	)
Minority interest		(898	)		(11,409	)
Income taxes (benefit)		42,920			(21,412	)
Interest expense		46,037			41,463
Investment income		(3,011	)		(981	)
Derivative financial instruments, net (gain) loss		(85,505	)		73,310
Foreign exchange (gain) loss on debt		(12,173	)		7,509
Impairment of investments		—			1,645

Income from operations		22,379			8,307
Add: Depreciation and amortization		28,782			24,883

Operating EBITDA	€	51,161		€	33,190


(1)		The results of the Celgar pulp mill are included from the date of its acquisition on February 14, 2005.

Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005

Selected sales data for the three months ended June 30, 2006 and 2005 is as follows:


	Three Months Ended June 30,
	2006		2005
	(ADMTs)
Sales Volume by Product Class
Pulp sales volume by mill:
Rosenthal		73,010		75,996
Stendal		136,894		102,915
Celgar		119,361		99,841

Total pulp sales volume⁽¹⁾		329,265		278,752
Paper sales volume		15,482		17,840

Total sales volume⁽¹⁾		344,747		296,592


	(in thousands)
Revenues by Product Class
Pulp revenues by mill:
Rosenthal	€	33,776	€	31,115
Stendal		60,741		40,345
Celgar		54,514		40,864

Total pulp revenues⁽¹⁾		149,031		112,324
Paper revenues		16,097		16,097

Total pulp and paper sales revenues⁽¹⁾		165,128		128,421

Third party transportation revenues		1,577		1,188

Total sales revenues	€	166,705	€	129,609


(1)		Excluding intercompany sales volumes of 4,871 and 4,105 ADMTs of pulp and intercompany net sales revenues of approximately €2.3 million and €1.7 million in the three months ended June 30, 2006 and 2005, respectively.

FORM 10-Q
QUARTERLY REPORT - PAGE 27

Selected production data for the three months ended June 30, 2006 and 2005 is as follows:


	Three Months Ended June 30,
	2006		2005
	(ADMTs)
Production by Product Class
Pulp production by mill:
Rosenthal		67,376		81,443
Stendal		139,715		123,738
Celgar		100,651		111,071

Total pulp production		307,742		316,252
Paper production		16,427		17,979

Total production		324,169		334,231

Revenues for the three months ended June 30, 2006 increased to €166.7 million from €129.6 million in the comparative period of 2005, primarily due to higher sales from our Celgar and Stendal pulp mills. Pulp sales by volume increased to 329,265 ADMTs in the second quarter of 2006 from 278,752 ADMTs in the comparative period of 2005.

Cost of sales and general, administrative and other expenses in the second quarter of 2006 increased to €155.8 million from €120.4 million in the comparative period of 2005, primarily as a result of higher sales from our Celgar and Stendal mills.

For the second quarter of 2006, revenues from our pulp operations increased to €150.6 million from €113.5 million in the same period a year ago. List prices for NBSK pulp in Europe were approximately €529 ($665) per ADMT in the second quarter of 2006, approximately €514 ($618) per ADMT in the first quarter of 2006, compared to approximately €487 ($613) per ADMT in the second quarter of 2005.

Mill net pulp sales realizations increased to €453 per ADMT on average in the second quarter of 2006 from €403 per ADMT in the second quarter of 2005, primarily as a result of higher pulp prices.

During the current quarter, we took an aggregate of approximately 30 days scheduled maintenance and strategic capital expenditure downtime at our pulp mills, including 16 days at our Rosenthal mill and 8 days at our Celgar mill. During the downtime at our Rosenthal mill, we completed the installation of a new brownstock washer at a cost of approximately €9.7 million, which is expected to further improve pulp quality and lower chemical costs and effluents. The total maintenance costs associated with such shutdowns were approximately €4.3 million and were expensed in the current quarter. The Stendal mill also underwent testing of various departments and converted some production to TCF pulp pursuant to the terms of its EPC contract which curtailed production during such period. Total production volume at our Rosenthal and Celgar mills was down by approximately 24,000 tonnes or 13% in the current quarter of 2006 compared to the same period of 2005. This negatively impacted our production volumes, costs and operating results. During the same period of 2005, we had 12 days of down time at our pulp mills.

Cost of sales and general, administrative and other expenses for the pulp operations increased to €141.3 million in the second quarter of 2006 from €102.9 million in the comparative period of 2005, primarily as a result of higher sales from our Celgar and Stendal mills.

Fiber costs at our German pulp mills increased by approximately 8% in the second quarter of 2006 versus the same period of 2005. This resulted from lower availability because of severe

FORM 10-Q
QUARTERLY REPORT - PAGE 28

winter conditions in Germany and central Europe, which caused sawmillers and log harvesters to curtail operations and increased competition for fiber primarily from renewable energy operations. In the second quarter of 2006, average fiber costs at our Celgar mill decreased by approximately 23% versus the same quarter of 2005, primarily because of fluctuations in regional wood chip availability. Subsequent to June 30, 2006, lower chip availability resulting from softer lumber markets and an increase in chip demand from coastal pulp and paper mills is expected to put upward pressure on Celgar’s fiber costs in the second half of 2006.

In the second quarter of 2006, we recorded a contribution to income from operations of €7.6 million resulting from the sale of emission allowances compared to €6.3 million in the comparative quarter of 2005.

Depreciation for the pulp operations increased to €14.6 million in the second quarter of 2006, from €13.4 million in the comparative quarter of 2005.

For the second quarter of 2006, our pulp operations generated operating income of €11.5 million, versus operating income of €12.4 million in the comparative quarter of 2005 as scheduled downtime resulted in weaker performance by our pulp mills which offset improvements in markets and the improvements in Stendal’s results. The overall strength of the Canadian dollar versus the U.S. dollar negatively impacted our Celgar mill’s continued results.

Revenues from our paper operations were stable at €16.1 million in the current quarter as well as the same quarter of last year.

Cost of sales and general, administrative and other expenses for the paper operations in the second quarter of 2006 decreased to €15.8 million from €16.9 million in the comparative quarter of 2005.

For the second quarter of 2006, our paper operations generated operating income of €0.4 million, compared to an operating loss of €0.8 million in the second quarter of 2005.

In the second quarter of 2006, we had income from operations of €10.9 million, compared to €9.2 million in the same quarter last year. Interest expense in the second quarter of 2006 increased marginally to €23.1 million from €22.2 million in the year ago period, primarily due to higher borrowings relating to the Stendal mill.

Stendal entered into certain foreign currency derivatives to swap all of its long-term bank indebtedness from Euros to U.S. dollars in 2005 and certain currency forwards. In addition, Stendal previously entered into interest rate swaps to fix the interest rate on its outstanding bank indebtedness. Due to the weakening of the U.S. dollar versus the Euro and an increase in long-term interest rates, we recorded a net unrealized non-cash holding gain of €44.7 million before minority interests upon the marked to market valuation of such derivatives that were outstanding at the end of the current quarter, compared to a net non-cash holding loss of €69.5 million before minority interests upon the marked to market valuation of our outstanding derivatives in the comparative quarter of 2005.

In the second quarter of 2006, minority interest, representing the two minority shareholders’ proportionate interest in the Stendal mill, was €0.4 million, compared to €4.9 million in the second quarter of 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 29

We reported net income for the three months ended June 30, 2006 of €18.4 million, or €0.56 per basic and €0.45 per diluted share, which included an aggregate of €50.8 million unrealized gains on our outstanding derivatives and a foreign exchange gain on our long-term debt. In the second quarter of 2005, we reported a net loss of €62.2 million, or €1.88 per basic and diluted share, which reflected the net unrealized non-cash holding losses on our currency and interest rate derivatives of €69.5 million and the unrealized non-cash foreign exchange loss on our long-term debt of €9.8 million, partially offset by the non-cash benefit for income taxes of €24.4 million, and interest expense related to our Stendal mill of €14.5 million.

We generated “Operating EBITDA” of €25.7 million and €23.1 million in the three months ended June 30, 2006 and 2005, respectively. Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of our results for the first half of 2006 for additional information relating to Operating EBITDA.

The following table provides a reconciliation of net income (loss) to income from operations and Operating EBITDA for the periods indicated:


	Three Months Ended
	June 30,
	2006			2005
	(in thousands)
Net income (loss)	€	18,421		€	(62,151	)
Minority interest		(449	)		(4,852	)
Income taxes (benefit)		21,807			(24,447	)
Interest expense		23,112			22,200
Investment income		(1,267	)		(806	)
Derivative financial instruments, net (gain) loss		(44,690	)		69,451
Foreign exchange (gain ) loss on debt		(6,060	)		9,806

Income from operations		10,874			9,201
Add: Depreciation and amortization		14,868			13,896

Operating EBITDA	€	25,742		€	23,097

Liquidity and Capital Resources

The following table is a summary of selected financial information for the periods indicated:


	As at			As at
	June 30,			December 31,
	2006			2005
	(in thousands)
Financial Position
Cash and cash equivalents	€	73,079		€	83,547
Working capital⁽¹⁾		57,287			111,195
Property, plant and equipment		1,008,319			1,024,662
Total assets		1,370,798			1,393,816
Long-term liabilities		996,383	⁽²⁾		1,104,746
Shareholders’ equity		189,927			148,743


(1)		Does not include approximately €7.0 million of government grants in 2006, which we expect to receive in 2006, and approximately €65.9 million of government grants in 2005, all of which has been received, related to the Stendal mill from German federal and state governments.

(2)		Includes €15.6 million outstanding under the revolving credit facilities for the Celgar mill.

At June 30, 2006, our cash and cash equivalents were €73.1 million, compared to €83.5 million at December 31, 2005. We also had €5.9 million of cash restricted to pay current Stendal construction costs payable of €1.0 million and for debt service.

FORM 10-Q
QUARTERLY REPORT - PAGE 30

During the second quarter of 2006, Stendal built up the restricted cash in its debt service account for the Stendal project financing to €66.5 million by drawing down €42.0 million under a tranche of the Stendal project financing facility as planned, or the “Stendal Loan Facility”. Approximately €57.0 million of this restricted cash is a debt service security or reserve equal to approximately one year’s worth of Stendal’s scheduled principal and interest payments under the Stendal Loan facility. As this debt service account secures Stendal’s obligations under the Stendal Loan Facility, it is recorded as a long-term asset.

Our reduction in working capital at June 30, 2006 compared to December 31, 2005 of approximately €53.9 million resulted principally from the build-up of the restricted cash in the Stendal debt service account, which is classified as a long-term asset, and the reclassification as current liabilities of certain principal payments on the Stendal Loan Facility that mature within one year.

At June 30, 2006, we qualified for investment grants related to the Stendal mill totaling approximately €7.0 million from the federal and state governments of Germany, which we expect to receive in 2006. These grants, when received, will be applied to repay the amounts drawn under the current portion of a dedicated tranche of the Stendal Loan Facility. Under our accounting policies, we do not record these grants until they are received. The grants are not reported in our income and reduce the cost basis of the assets purchased when they are received.

As at June 30, 2006, we had not drawn any amount under the €40.0 million Rosenthal revolving term credit facility and had drawn down approximately €15.6 million of the C$40 million Celgar revolving credit facility. At June 30, 2006, we had utilized the entire €4.7 million available under the credit facilities for our paper operations.

We expect to meet our interest and debt service expenses and the working and maintenance capital requirements for our operations (other than at Stendal) from cash flow from operations, cash on hand and the two revolving working capital facilities for the Rosenthal and Celgar mills.

We expect to meet the capital requirements for the Stendal mill, including working capital and potential losses during ramp up, interest and principal service expenses through cash on hand, cash flow from operations, shareholder advances already made to Stendal, the Stendal Loan Facility (which includes a revolving working capital tranche and a debt service reserve account) and the receipt of government grants.

Operating Activities

Operating activities in the first half of 2006 provided cash of €1.4 million, compared to using cash of €5.2 million in the comparative period of 2005. An increase in receivables due primarily to higher sales used cash of €13.5 million in the first half of 2006, compared to an increase in receivables using cash of €20.7 million in the comparative period of 2005. A decrease in inventories due primarily to a reduction in raw materials and finished goods at the Stendal mill provided cash of €10.7 million in the first half of 2006, compared to using cash of €16.8 million in the comparative period of 2005. A decrease in accounts payable and accrued expenses used cash of €3.3 million in the first half of 2006, compared to an increase that provided cash of €41.3 million in the comparative period of 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 31

Working capital is subject to cyclical operating needs, the timing of collections, receivables and government grants and the payment of payables and expenses.

Investing Activities

Investing activities in the six months ended June 30, 2006 used cash of €56.3 million, compared to the six months ended June 30, 2005 when investing activities used cash of €119.3 million, of which the acquisition of the Celgar pulp mill comprised €146.6 million. In the six months ended June 30, 2006, a drawdown under a tranche of the Stendal project financing facility to increase our restricted cash in the Stendal debt service reserve account used cash of €40.8 million versus a decrease in restricted cash providing cash of €35.8 million in the comparative period of 2005.

Financing Activities

Financing activities provided cash of €45.7 million in the six months ended June 30, 2006, compared to the first six months of 2005 when, in connection with the acquisition of the Celgar pulp mill, financing activities, including the issuance of common stock and senior notes, provided cash of €175.2. In the first half of 2005, we fully repaid the project loan facility relating to the Rosenthal mill of approximately €143.1 million (net of restricted cash) and indebtedness relating to the landfill at the Rosenthal mill of approximately €7.6 million from the proceeds of such share and senior note offerings.

We have no material commitments to acquire assets or operating businesses. We anticipate that there will be acquisitions of businesses or commitments to projects in the future. To achieve our long-term goals of expanding our asset and earnings base through the acquisition of interests in companies and assets in the pulp and paper and related businesses, and organically through high return capital expenditures at our operating facilities, we will require substantial capital resources. The required necessary resources for such long-term goals will be generated from cash flow from operations, cash on hand, the sale of securities and/or assets, and borrowing against our assets.

Contractual Obligations and Commitments

There were no material changes outside the ordinary course to any of our contractual obligations during the first half of 2006.

Capital Resources

In addition to our revolving credit facilities for the Rosenthal and Celgar mills and the revolving working capital tranche of the Stendal Loan Facility, respectively, we may seek to raise future funding in the debt markets if our indenture relating to our 9.25% senior notes permits, subject to compliance with the indenture. The indenture governing the senior notes provides that, in order for Mercer Inc. and its restricted subsidiaries (as defined in the indenture and which excludes the Stendal mill and our paper operations) to enter into certain types of transactions, including the incurrence of additional indebtedness, the making of restricted payments and the completion of mergers and consolidations (other than, in each case, those specifically permitted by our senior note indenture), we must meet a minimum ratio of Indenture EBITDA to Fixed Charges as defined in the senior note indenture of 2.0 to 1.0 on a pro forma basis for the most recently ended four full fiscal quarters. This ratio is referred to and defined as the Fixed Charge Coverage Ratio in the senior note indenture. As at June 30, 2006, Mercer Inc. and our restricted subsidiaries under the indenture governing the senior notes did not meet the Fixed Charge Coverage Ratio of 2.0 to 1.0 as set out in the senior note indenture.

FORM 10-Q
QUARTERLY REPORT - PAGE 32

Stendal Pulp Mill EPC Contract

The Stendal mill was constructed under a €716.0 million fixed price turn-key EPC contract between Stendal and RWE, as head contractor. The contractor’s obligations under the contract are guaranteed by its parent company.

Pursuant to the EPC contract, each department of the mill is to be tested on a stand-alone basis for compliance with its design specifications. Under the EPC contract, RWE warrants conformity to specifications, compliance with permits and laws, suitability for intended use, compliance with performance requirements and against defects in construction for a stipulated period, subject to extension in certain circumstances. The testing and warranty are highly technical and include very detailed design and performance specifications. Much of the prescribed testing, other than testing waived by prior agreement, had been concluded by the quarter ended June 30, 2006 and was unsatisfactory to Stendal. Unless extended, the period under which Stendal can make claims under the warranties in the EPC contract currently expires in September 2006. As is common in large greenfield projects like the Stendal mill, Stendal currently anticipates that it will make a number of claims and seek penalties against the contractor under the EPC contract. Such claims are often highly technical and relate to, among other things, design and performance specifications and reliability, as well as penalties in regards to delays. Currently, we cannot predict with any certainty which or the amount of claims and penalties that Stendal may make against the contractor, the amount, if any, of any recoveries associated therewith or the final determination of such claims whether through further work and retesting by the contractor, legal proceedings, negotiation or other settlement.

Paper Mill Assets

We view our paper mill assets as non-core operations and have been reviewing strategic alternatives therefor. In August 2006, we reorganized and divested our equity interests in certain paper production assets, including our Heidenau paper mill, for aggregate consideration of approximately €5.0 million of indebtedness and approximately €5.0 million in cash. We currently continue to operate and review strategic alternatives for our Fährbrücke paper mill.

Foreign Currency

Effective January 1, 2002, we changed our reporting currency from the U.S. dollar to the Euro as a significant majority of our business transactions are originally denominated in Euros. By adopting the Euro, most cumulative foreign currency translation losses were eliminated. However, we hold certain assets and liabilities in U.S. dollars, Swiss francs and in Canadian dollars. Accordingly, our consolidated financial results are subject to foreign currency exchange rate fluctuations.

We translate foreign denominated assets and liabilities into Euros at the rate of exchange on the balance sheet date. Unrealized gains or losses from these translations are recorded in our consolidated statement of comprehensive income and impact on shareholders’ equity on the balance sheet but do not affect our net earnings.

In the six months ended June 30, 2006, we reported a net €5.4 million foreign exchange translation gain and, as a result, the cumulative foreign exchange translation gain increased to €21.1 million at June 30, 2006 from €15.6 million at December 31, 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 33

Based upon the exchange rate at June 30, 2006, the U.S. dollar decreased by approximately 6% in value against the Euro since June 30, 2005. See “Quantitative and Qualitative Disclosures about Market Risk”.

Results of Operations of the Restricted Group Under Our Senior Note Indenture

The indenture governing our 9.25% senior notes requires that we also provide a discussion in annual and quarterly reports we file with the SEC under Management’s Discussion and Analysis of Financial Condition and Results of Operations of the results of operations and financial condition of Mercer Inc. and our restricted subsidiaries under the indenture, referred to as the “Restricted Group”. As at and during the six months ended June 30, 2006, the Restricted Group was comprised of Mercer Inc., certain holding subsidiaries, Rosenthal and Celgar. During the six months ended June 30, 2005 and as at December 31, 2005, the Restricted Group was comprised of Mercer Inc., certain holding subsidiaries, Rosenthal and the Celgar mill from February 14, 2005, the date of the acquisition of the mill . The Restricted Group excludes our paper operations and our Stendal mill.

The following is a discussion of the results of operations and financial condition of the Restricted Group. For further information regarding the operating results of the Rosenthal and Celgar mills, see Note 5 of our quarterly financial statements included herein. For further information regarding the Restricted Group including, without limitation, a reconciliation to our consolidated results of operations, see Note 9 of our quarterly financial statements included herein.

Restricted Group Results — Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005

Total revenues for the Restricted Group for the six months ended June 30, 2006 increased to €169.6 million from €114.4 million in the comparative period of 2005, primarily because of higher pulp sales from the Celgar mill and higher pulp prices. Pulp sales realizations for the Restricted Group were €444 per ADMT on average in the six months ended June 30, 2006 and €427 per ADMT in the comparative period of 2005. The increase in NBSK pulp prices was partially offset by the strength of the Canadian dollar versus the U.S. dollar during the current period.

Costs of sales and general, administrative and other expenses for the Restricted Group in the six months ended June 30, 2006 increased to €169.3 million from €107.0 million in the comparative period of 2005 primarily as a result of the inclusion of higher sales from our Celgar mill, partially offset by lower production costs at the Rosenthal mill.

During the current period, we took an aggregate of 33 days scheduled maintenance and strategic capital expenditure downtime comprising 20 days at our Rosenthal mill and 13 days at our Celgar mill. During the downtime at our Rosenthal mill, we completed the installation of a new brownstock washer at a cost of approximately €9.7 million, which is expected to further improve pulp quality and lower chemical costs and effluents. The total maintenance costs associated with such shutdowns were approximately €6.5 million and were expensed as incurred. This negatively impacted our production volumes, costs and operating results. During the comparative period of 2005, the Rosenthal and Celgar mills took approximately 9 days of maintenance and strategic capital expenditure downtime.

In the first half of 2006, we recorded a contribution to income from operations of €3.7 million through the sale of emission allowances by our Rosenthal pulp mill, compared to €2.1 million in the same period of 2005.

On average, fiber costs at our Rosenthal pulp mill increased by approximately 14% in the first half of 2006 versus the same period of 2005. This resulted from lower availability because of severe winter conditions in Germany and central Europe, which caused sawmillers and log

FORM 10-Q
QUARTERLY REPORT - PAGE 34

harvesters to curtail operations and increased competition for fiber primarily from renewable energy operations. In the first half of 2006, average fiber costs at our Celgar mill decreased by approximately 18% versus the same period of 2005, primarily because of increased regional wood chip availability.

Depreciation and amortization for the Restricted Group increased to €14.2 million in the current period from €10.8 million in the comparative period of 2005, primarily as a result of the inclusion of depreciation of the Celgar mill for the full period, partially offset by lower depreciation at our Rosenthal mill.

In the first half of 2006, the Restricted Group reported income from operations of €0.3 million, compared to €7.4 million in the first half of 2005, primarily as a result of a higher operating loss at our Celgar mill which more than offset higher operating income from our Rosenthal mill. Interest expense for the Restricted Group in the six months ended June 30, 2006 increased marginally to €16.4 million from €16.0 million in the first half of 2005.

In the first half of 2006, the Restricted Group recorded a foreign exchange gain on debt of €12.2 million, compared to a loss of €7.5 million in the comparative period of 2005. In the first half of 2005, the Restricted Group reported a non-cash impairment charge of €1.6 million related to an investment in a venture company.

For the six months ended June 30, 2006, the net loss reported by the Restricted Group narrowed to €8.7 million from €21.7 million in the first half of 2005 as a result of improved operating income of our Rosenthal mill, partially offset by the weaker results of our Celgar mill and scheduled downtime. The overall strength of the Canadian dollar versus the U.S. dollar and 13 days of scheduled maintenance downtime negatively impacted the results of our Celgar mill.

The Restricted Group generated “Operating EBITDA” of €14.5 million and €18.2 million in the six months ended June 30, 2006 and 2005, respectively. Operating EBITDA is defined as income (loss) from operations plus depreciation and amortization and non-recurring capital asset impairment charges. Operating EBITDA for the Restricted Group is calculated by adding depreciation and amortization and non-recurring capital asset impairment charges of €nil and €1.6 million to the income from operations of €0.3 million and €7.4 million for the six months ended June 30, 2006 and 2005, respectively.

Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of Mercer’s results for the six months ended June 30, 2006 for additional information relating to such limitations and Operating EBITDA.

FORM 10-Q
QUARTERLY REPORT - PAGE 35

The following table provides a reconciliation of net loss to income from operations and Operating EBITDA for the Restricted Group for the periods indicated:


	Six Months Ended
	June 30,
	2006			2005⁽¹⁾
	(in thousands)
Restricted Group⁽²⁾
Net loss	€	(8,741	)	€	(21,696	)
Income taxes		6,905			4,776
Interest expense		16,442			15,985
Investment and other income		(2,119	)		(1,297	)
Derivative financial instruments, net		—			463
Unrealized foreign exchange (gain) loss on debt		(12,173	)		7,509
Impairment of investments		—			1,645

(Loss) income from operations		314			7,385
Add: Depreciation and amortization		14,197			10,829

Operating EBITDA	€	14,511		€	18,214


(1)		The results of the Celgar pulp mill are from the date of its acquisition on February 14, 2005.

(2)		See Note 9 of the financial statements included elsewhere herein for a reconciliation to our consolidated results.

Restricted Group Results —Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005

Total revenues for the Restricted Group for the three months ended June 30, 2006 increased to €88.6 million from €72.7 million in the comparative period of 2005, primarily due to higher sales from our Celgar pulp mill and higher pulp prices. Pulp sales realizations for the Restricted Group were €459 per ADMT on average in the three months ended June 30, 2006 and €430 per ADMT in the comparative period of 2005. The increase in NBSK pulp prices was partially offset by the strength of the Canadian dollar versus the U.S. dollar during the current period. In the second quarter of 2006, Mercer Inc. had responsibility for all pulp sales of the Stendal mill and received fees from Stendal ranging from 0.5% to 1.4% of sales.

Costs of sales and general, administrative and other expenses for the Restricted Group in the three months ended June 30, 2006 increased to €90.3 million from €67.3 million in the comparative period of 2005, primarily as a result of higher pulp sales from the Celgar mill, partially offset by lower production costs of the Rosenthal mill.

During the current quarter we took an aggregate of 24 days scheduled maintenance and strategic capital expenditure downtime comprising 16 days at our Rosenthal mill and 8 days at our Celgar mill. During the downtime at our Rosenthal mill, we completed the installation of a new brownstock washer at a cost of approximately €9.7 million, which is expected to further improve pulp quality and lower chemical costs and effluents. The total maintenance costs associated with such shutdowns were approximately €4.3 million and were expensed in the current quarter. Total volume production at our Rosenthal and Celgar mills was down by approximately 24,000 tonnes or 13% in the current quarter of 2006 compared to the same period of 2005. This negatively impacted our production volumes, costs and operating results. During the same period of 2005, we had approximately 4 days of maintenance and strategic capital expenditure downtime at our Rosenthal and Celgar mills.

In the second quarter of 2006, we recorded a contribution to income from operations of €1.9 million through the sale of emission allowances by our Rosenthal pulp mill, compared to €2.1 million in the same period of 2005.

On average, fiber costs at our Rosenthal pulp mill increased by approximately 8% in the second quarter of 2006 versus the same period of 2005. This resulted from lower availability because of severe winter conditions in Germany and central Europe, which caused sawmillers and log harvesters to curtail operations and increased competition for fiber primarily from renewable energy operations. In the second quarter of 2006, average fiber costs at our Celgar mill decreased by approximately 23% versus the same period of 2005 because of increased regional wood chip availability. Subsequent to June 30, 2006, lower chip availability resulting from softer lumber markets and an increase in chip demand from coastal pulp and paper mills is expected to put upward pressure on Celgar’s fiber costs in the second half of 2006.

FORM 10-Q
QUARTERLY REPORT - PAGE 36

Depreciation and amortization for the Restricted Group increased to €7.6 million in the current quarter from €6.7 million in the comparative period of 2005.

In the second quarter of 2006, the Restricted Group reported a loss from operations of €1.7 million, compared to reported income from operations of €5.4 million in the second quarter of 2005, primarily as a result of a higher operating loss at our Celgar mill which more than offset higher operating income from our Rosenthal mill.

Interest expense for the Restricted Group in the three months ended June 30, 2006 decreased to €8.0 million from €8.3 million in the second quarter of 2005.

In the second quarter of 2006, the Restricted Group recorded a foreign exchange gain on debt of €6.1 million, compared to a loss of €9.8 million in the comparative period of 2005. In the second quarter of 2005, the Restricted Group reported a non-cash impairment charge of €0.5 million related to an investment in a venture company.

For the three months ended June 30, 2006, the net loss reported by the Restricted Group narrowed to €7.6 million from €14.3 million in the second quarter of 2005 as a result of improved operating income of our Rosenthal mill, partially offset by the weaker results of our Celgar mill. The overall strength of the Canadian dollar versus the U.S. dollar and 24 days of scheduled maintenance and strategic capital expenditure downtime at our Rosenthal and Celgar pulp mills in the second quarter of 2006 negatively impacted our results.

The Restricted Group generated “Operating EBITDA” of €5.8 million and €12.1 million in the three months ended June 30, 2006 and 2005, respectively. Operating EBITDA for the Restricted Group is calculated by adding depreciation and amortization and non-recurring capital asset impairment charges of €nil million and €0.5 million to the (loss) income from operations of €(1.7) million and €5.4 million for the three months ended June 30, 2006 and 2005, respectively.

Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of Mercer’s results for the six months ended June 30, 2006 for additional information relating to such limitations and Operating EBITDA.

FORM 10-Q
QUARTERLY REPORT - PAGE 37

The following table provides a reconciliation of net loss to income from operations and Operating EBITDA for the Restricted Group for the periods indicated:


	Three Months Ended
	June 30,
	2006			2005
	(in thousands)
Restricted Group⁽¹⁾
Net loss	€	(7,590	)	€	(14,278	)
Income taxes		3,872			1,661
Interest expense		7,979			8,314
Investment and other expense (income)		142			(970	)
Derivative financial instruments, net		(79	)		358
Unrealized foreign exchange (gain) loss on debt		(6,060	)		9,806
Impairment of investments		—			467

(Loss) income from operations		(1,736	)		5,358
Add: Depreciation and amortization		7,568			6,704

Operating EBITDA	€	5,832		€	12,062


(1)		See Note 9 of the financial statements included elsewhere herein for a reconciliation to our consolidated results.

Liquidity and Capital Resources of the Restricted Group

The following table is a summary of selected financial information for the Restricted Group for the periods indicated:


	As at		As at
	June 30,		December 31,
	2006		2005
	(in thousands)
Restricted Group Financial Position⁽¹⁾
Cash and cash equivalents	€	37,018	€	48,790
Working capital		80,908		93,312
Property, plant and equipment		400,045		404,151
Total assets		602,304		625,578
Long-term liabilities		346,271		364,596
Shareholders’ equity		212,182		214,115


(1)		See Note 9 of the financial statements included elsewhere herein for a reconciliation to our consolidated results.

At June 30, 2006, the Restricted Group had cash and cash equivalents of €37.0 million, compared to €48.8 million at December 31, 2005. At June 30, 2006, the Restricted Group had working capital of €80.9 million.

We expect the Restricted Group to meet its interest and debt service expenses and meet the working and maintenance capital requirements for its current operations from cash flow from operations, cash on hand and the revolving working capital loan facilities for the Rosenthal and Celgar mills. As at June 30, 2006, we had not drawn any amount under the Rosenthal revolving term credit facility and had drawn down approximately €15.6 million under the C$40 million Celgar revolving credit facility.

FORM 10-Q
QUARTERLY REPORT - PAGE 38

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Estimates are used for, but not limited to, the accounting for doubtful accounts, depreciation and amortization, asset impairments, derivative financial instruments, environmental conservation, asset retirement obligations, pensions and post-retirement benefit obligations, income taxes, and contingencies. Actual results could differ from these estimates.

Our management routinely makes judgments and estimates about the effects of matters that are inherently uncertain. As the number of variables and assumptions affecting the probable future resolution of the uncertainties increase, these judgments become even more subjective and complex. We have identified certain accounting policies that are the most important to the portrayal of our current financial condition and results of operations.

For information about our significant accounting policies, see our annual report on Form 10-K for the year ended December 31, 2005.

Cautionary Statement Regarding Forward-Looking Information

The statements in this report that are not reported financial results or other historical information are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. These statements appear in a number of different places in this report and can be identified by words such as “estimates”, “projects”, “expects”, “intends”, “believes”, “plans”, or their negatives or other comparable words. Also look for discussions of strategy that involve risks and uncertainties. Forward-looking statements include statements regarding the outlook for our future operations, forecasts of future costs and expenditures, the evaluation of market conditions, the outcome of legal proceedings, the adequacy of reserves, or other business plans. You are cautioned that any such forward-looking statements are not guarantees and may involve risks and uncertainties. Our actual results may differ materially from those in the forward-looking statements due to risks facing us or due to actual facts differing from the assumptions underlying our estimates. Some of these risks and assumptions include those set forth in reports and other documents we have filed with or furnished to the SEC, including in our annual report on Form 10-K for the year ended December 31, 2005. We advise you that these cautionary remarks expressly qualify in their entirety all forward-looking statements attributable to us or persons acting on our behalf. Unless required by law, we do not assume any obligation to update forward-looking statements based on unanticipated events or changed expectations. However, you should carefully review the reports and other documents we file from time to time with the SEC.

FORM 10-Q
QUARTERLY REPORT - PAGE 39

Cyclical Nature of Business

Revenues

The pulp and paper business is cyclical in nature and markets for our principal products are characterized by periods of supply and demand imbalance, which in turn affects product prices. The markets for pulp and paper are highly competitive and are sensitive to cyclical changes in industry capacity and in the global economy, all of which can have a significant influence on selling prices and our earnings. Demand for pulp and paper products has historically been determined by the level of economic growth and has been closely tied to overall business activity. Although pulp prices have improved recently, we cannot predict the level of economic activity or growth in certain world markets or the impact of war, terrorist activity or other events on our markets and prices for our products.

Commencing in 2005, our German operations became subject to the European Union Emissions Trading Scheme pursuant to which our German mills were granted emission allowances. Emission allowances are granted based upon production volumes and the types of fuels consumed by the manufacturing facilities in Germany. Since then, we have benefited from the sale of emission allowances. However, the market for such sales is relatively new and volatile and we cannot predict the level of any sales thereafter.

Costs

Our production costs are influenced by the availability and cost of raw materials, energy and labor, and our plant efficiencies and productivity. Our main raw material is fiber in the form of wood chips and pulp logs for pulp production, and waste paper and pulp for paper production. Fiber costs are primarily affected by the supply of, and demand for, lumber and pulp, which are both highly cyclical in nature and can vary significantly by location. Recently, fiber demand in Europe has also increased because of a demand from renewable energy projects. Production costs also depend on the total volume of production. Lower operating rates and production efficiencies during periods of cyclically low demand result in higher average production costs and lower margins.

FORM 10-Q
QUARTERLY REPORT - PAGE 40

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risks from changes in interest rates and foreign currency exchange rates, particularly the exchange rate between the U.S. dollar and the Euro and to a lesser extent the Canadian dollar, which may affect our results of operations and financial condition and, consequently, our fair value. We manage these risks through internal risk management policies and, with respect to risks related to changes in exchange rates between the U.S. dollar and the Euro, with the use of derivatives. We use derivatives to reduce or limit our exposure to interest rate and U.S. dollar/Euro currency risks. We may in the future use derivatives to reduce or limit our exposure to fluctuations in pulp prices. We also use derivatives to reduce our potential losses or to augment our potential gains, depending on our management’s perception of future economic events and developments. These types of derivatives are generally highly speculative in nature. They are also very volatile as they are highly leveraged given that margin requirements are relatively low in proportion to notional amounts.

Many of our strategies, including the use of derivatives, and the types of derivatives selected by us, are based on historical trading patterns and correlations and our management’s expectations of future events. However, these strategies may not be fully effective in all market environments or against all types of risks. Unexpected market developments may affect our risk management strategies during this time, and unanticipated developments could impact our risk management strategies in the future. If any of the variety of instruments and strategies we utilize are not effective, we may incur losses.

All of our derivatives are marked to market at the end of each reporting period, and all unrealized gains and losses are recognized in earnings for a reporting period. We determine market valuations based primarily upon valuations provided by our counterparties.

In the first quarter of 2005, Stendal entered into currency swaps to convert a portion of its indebtedness under the Stendal Loan Facility from Euros into U.S. dollars and certain currency forwards. In April 2005, Stendal entered into a currency swap to convert the balance of its long-term indebtedness under the Stendal Loan Facility from Euros into U.S. dollars. During the first half of 2006, we recorded a net unrealized non-cash holding gain of €90.7 million before minority interests upon the marked to market valuation of such derivatives compared to a net non-cash holding loss of €73.0 million before minority interests upon the marked to market valuation of our outstanding derivatives in the first half of 2005. In the first half of 2006, we had a realized loss of €5.2 million on certain currency forwards which had matured, compared to a realized loss of €0.3 million on derivative instruments in the first half of 2005

FORM 10-Q
QUARTERLY REPORT - PAGE 41

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures. Our management, with the participation of our Principal Executive Officer and Principal Financial Officer, has evaluated the effectiveness of our 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. Based on such evaluation, our Principal Executive Officer and Principal Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms and to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to management, including its Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

It should be noted that any system of controls is based in part upon certain assumptions designed to obtain reasonable (and not absolute) assurance as to its effectiveness, and there can be no assurance that any design will succeed in achieving its stated goals.

Changes in Internal Controls. There have been no significant changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

FORM 10-Q
QUARTERLY REPORT - PAGE 42

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are subject to routine litigation incidental to our business. We do not believe that the outcome of such litigation will have a material adverse effect on our business or financial condition.

ITEM 1A. RISK FACTORS

There have been no material changes to the factors disclosed in Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2005.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

We held our annual meeting of shareholders on June 12, 2006. At the meeting, our six directors were re-elected to our board of directors and the selection of Deloitte & Touche LLP as our independent auditors was ratified.

The votes cast by shareholders at the meeting as to the election of directors were as follows:


	Votes For		Votes Withheld		Abstentions and Broker Non-Votes
Jimmy S.H. Lee		16,840,127		129,064		—
Kenneth A. Shields		16,843,181		126,010		—
William D. McCartney		16,841,981		121,010		—
Graeme A. Witts		16,841,981		127,210		—
Eric Lauritzen		16,843,171		126,020		—
Guy W. Adams		16,841,981		127,210		—

FORM 10-Q
QUARTERLY REPORT - PAGE 43

ITEM 6. EXHIBITS


Exhibit No.		Description
31.1		Section 302 Certification of Chief Executive Officer

31.2		Section 302 Certification of Chief Financial Officer

32.1*		Section 906 Certification of Chief Executive Officer

32.2*		Section 906 Certification of Chief Financial Officer


*		In accordance with Release 33-8212 of the Commission, these Certifications: (i) are “furnished” to the Commission and are not “filed” for the purposes of liability under the Securities Exchange Act of 1934, as amended; and (ii) are not to be subject to automatic incorporation by reference into any of the Company’s registration statements filed under the Securities Act of 1933, as amended for the purposes of liability thereunder or any offering memorandum, unless the Company specifically incorporates them by reference therein.

FORM 10-Q
QUARTERLY REPORT - PAGE 44

SIGNATURES

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


	MERCER INTERNATIONAL INC.
	By:	/s/ David M. Gandossi
		David M. Gandossi
		Secretary and Chief Financial Officer

Date: August 8, 2006

FORM 10-Q
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