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MERCER INTERNATIONAL INC. - Quarter Report: 2008 September (Form 10-Q)

For the Quarterly Period Ended Sept. 30, 2008
Table of Contents

 
 
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 September 30, 2008
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission File No.: 000-51826
MERCER INTERNATIONAL INC.
(Exact name of Registrant as specified in its charter)
     
Washington
(State or other jurisdiction
of incorporation or organization)
  47-0956945
(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, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer oAccelerated filer þ Non-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company 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 36,422,487 shares of common stock outstanding as at November 3, 2008.
 
 

 


TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 1A. RISK FACTORS
ITEM 6. EXHIBITS
SIGNATURES
Section 302 - CEO Certification
Section 302 - CFO Certification
Section 906 - CEO Certification
Section 906 - CFO Certification


Table of Contents

PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
MERCER INTERNATIONAL INC.
INTERIM CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2008
(Unaudited)
FORM 10-Q
QUARTERLY REPORT — PAGE 2

 


Table of Contents

MERCER INTERNATIONAL INC.
INTERIM CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands of Euros)
                 
    September 30,     December 31,  
    2008     2007  
ASSETS
               
Current assets
               
Cash and cash equivalents
  75,779     84,848  
Receivables
    81,503       89,890  
Note receivable, current portion
    628       5,896  
Inventories (Note 4)
    129,965       103,610  
Prepaid expenses and other
    10,126       6,015  
 
           
Total current assets
    298,001       290,259  
 
           
Long-term assets
               
Cash, restricted (Note 8)
    13,000       33,000  
Property, plant and equipment
    904,653       933,258  
Investments (Note 8)
    646       96  
Deferred note issuance and other costs
    4,326       5,303  
Deferred income tax
    25,432       17,624  
Note receivable, less current portion
    3,650       3,977  
 
           
 
    951,707       993,258  
 
           
Total assets
  1,249,708     1,283,517  
 
           
 
               
LIABILITIES
               
Current liabilities
               
Accounts payable and accrued expenses
  87,315     87,000  
Pension and other post-retirement benefit obligations, current portion
    955       493  
Debt, current portion
    36,599       34,023  
 
           
Total current liabilities
    124,869       121,516  
 
           
Long-term liabilities
               
Debt, less current portion
    795,445       815,832  
Unrealized interest rate derivative losses (Note 8)
    17,370       21,885  
Pension and other post-retirement benefit obligations (Note 6)
    18,361       19,983  
Capital leases and other
    12,290       8,999  
Deferred income tax
    29,277       18,640  
 
           
 
    872,743       885,339  
 
           
Total liabilities
    997,612       1,006,855  
 
           
 
               
SHAREHOLDERS’ EQUITY
               
Share capital (Note 7)
    203,438       202,844  
Additional paid-in capital
    461       134  
Retained earnings
    23,986       37,419  
Accumulated other comprehensive income
    24,211       36,265  
 
           
Total shareholders’ equity
    252,096       276,662  
 
           
Total liabilities and shareholders’ equity
  1,249,708     1,283,517  
 
           
Commitments and Contingencies (Note 9)
The accompanying notes are an integral part of these interim consolidated financial statements.
FORM 10-Q
QUARTERLY REPORT — PAGE 3

 


Table of Contents

MERCER INTERNATIONAL INC.
INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands of Euros, except per share data)
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
 
    
Revenues
  178,603     191,111     528,289     537,245  
 
                               
Costs and expenses
                               
Operating costs
    144,762       148,529       427,105       426,831  
Operating depreciation and amortization
    14,033       14,284       41,668       42,003  
 
                       
 
    19,808       28,298       59,516       68,411  
Selling, general and administrative expenses
    9,954       6,841       24,803       22,300  
(Sale) purchase of emission allowances
                      (766 )
 
                       
Operating income from continuing operations
    9,854       21,457       34,713       46,877  
 
                       
 
                               
Other income (expense)
                               
Interest expense
    (16,424 )     (17,299 )     (49,057 )     (54,108 )
Investment income (loss)
    (2,031 )     1,491       (300 )     3,786  
Foreign exchange gain (loss) on debt
    (9,560 )     4,626       (3,291 )     7,229  
Realized gain on derivative instruments (Note 5)
                      6,820  
Unrealized gain (loss) on derivative instruments (Note 5)
    (8,215 )     (5,696 )     4,515       12,156  
 
                       
Total other income (expense)
    (36,230 )     (16,878 )     (48,133 )     (24,117 )
 
                       
Income (loss) before income taxes and minority interest from continuing operations
    (26,376 )     4,579       (13,420 )     22,760  
Income tax benefit (provision) — current
    (231 )     (144 )     (68 )     (877 )
                                         — deferred
    6,144       7,013       (2,982 )     (5,959 )
 
                       
Income (loss) before minority interest from continuing operations
    (20,463 )     11,448       (16,470 )     15,924  
Minority interest
    3,290       (742 )     3,037       (785 )
 
                       
Net income (loss) from continuing operations
    (17,173 )     10,706       (13,433 )     15,139  
Net income (loss) from discontinued operations
          (10 )           (198 )
 
                       
Net income (loss)
    (17,173 )     10,696       (13,433 )     14,941  
 
                               
Retained earnings, beginning of period
    41,159       19,485       37,419       15,240  
 
                       
Retained earnings, end of period
  23,986     30,181     23,986     30,181  
 
                       
 
                               
Net income (loss) from continuing operations per share (Note 3):
                               
Basic
  (0.47 )   0.30     (0.37 )   0.42  
 
                       
Diluted
  (0.47 )   0.26     (0.37 )   0.40  
 
                       
Net income (loss) per share:
                               
Basic
  (0.47 )   0.29     (0.37 )   0.41  
 
                       
Diluted
  (0.47 )   0.26     (0.37 )   0.39  
 
                       
The accompanying notes are an integral part of these interim consolidated financial statements.
FORM 10-Q
QUARTERLY REPORT — PAGE 4

 


Table of Contents

MERCER INTERNATIONAL INC.
INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(In thousands of Euros)
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
 
                               
Net income (loss)
  (17,173 )   10,696     (13,433 )   14,941  
 
                       
 
                               
Other comprehensive income (loss):
                               
Foreign currency translation adjustment
    (3,992 )     11,665       (12,040 )     29,919  
Unrealized (losses) gains on securities arising during the period
    8       (16 )     (14 )     71  
 
                       
 
                               
Other comprehensive (loss) income
    (3,984 )     11,649       (12,054 )     29,990  
 
                       
 
                               
Total comprehensive (loss) income
  (21,157 )   22,345     (25,487 )   44,931  
 
                       
The accompanying notes are an integral part of these interim consolidated financial statements.
FORM 10-Q
QUARTERLY REPORT — PAGE 5

 


Table of Contents

MERCER INTERNATIONAL INC.
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands of Euros)
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
Cash flows from (used in) operating activities:
                               
Net income (loss)
  (17,173 )   10,696     (13,433 )   14,941  
Adjustments to reconcile net income to cash flows from operating activities
                               
Unrealized (gain) loss on derivatives
    8,215       5,696       (4,515 )     (12,156 )
Foreign exchange (gain) loss on debt
    9,560       (4,626 )     3,291       (7,229 )
Loss (gain) on sale of assets
    177       151       (781 )     128  
Operating depreciation and amortization
    14,033       14,284       41,668       42,003  
Non-operating amortization
    70       67       211       194  
Minority interest
    (3,290 )     742       (3,037 )     785  
Deferred income taxes
    (6,144 )     (7,013 )     2,982       5,959  
Stock compensation expense
    213       154       568       350  
Pension and other post-retirement expense
    497       411       1,502       1,366  
Pension and other post-retirement benefit funding
    (402 )     (367 )     (1,527 )     (1,201 )
Other
    108       (37 )     (377 )     912  
Changes in current assets and liabilities
                               
Receivables
    18,352       7,407       7,674       (19,314 )
Inventories
    (19,753 )     (1,479 )     (27,436 )     (31,149 )
Accounts payable and accrued expenses
    (3,806 )     (9,519 )     1,995       5,610  
Other
    (3,546 )     659       (2,245 )     1,939  
 
                       
Net cash from (used in) operating activities
    (2,889 )     17,226       6,540       3,138  
 
                       
 
                               
Cash flows from (used in) investing activities:
                               
Purchase of property, plant and equipment(1)
    (9,269 )     7,833       (17,130 )     (2,704 )
Proceeds on sale of property, plant and equipment
    271       11       1,884       538  
Cash, restricted
    20,000       12,000       20,000       24,000  
Notes receivable
          (11 )     5,303       4,720  
 
                       
Net cash from (used in) investing activities
    11,002       19,833       10,057       26,554  
 
                       
 
                               
Cash flows from (used in) financing activities:
                               
Repayment of notes payable and debt
    (17,132 )     (13,412 )     (34,023 )     (26,865 )
Repayment of capital lease obligations
    300       (1,646 )     (532 )     (4,222 )
Proceeds from borrowings of notes payable and debt
                8,431        
Issuance of common shares
                      305  
 
                       
Net cash from (used in) financing activities
    (16,832 )     (15,058 )     (26,124 )     (30,782 )
 
                       
 
                               
Effect of exchange rate changes on cash and cash equivalents
    1,203       (407 )     458       1,764  
 
                       
 
                               
Net increase (decrease) in cash and cash equivalents
    (7,516 )     21,594       (9,069 )     674  
Cash and cash equivalents, beginning of period(2)
    83,295       48,884       84,848       69,804  
 
                       
Cash and cash equivalents, end of period(3)
  75,779     70,478     75,779     70,478  
 
                       
 
(1)   2007 includes amounts received in the third quarter of 2007, and recorded as a reduction of property, plant and equipment (approximately 9,100) upon the settlement of the Stendal engineering, procurement and construction (EPC) contract.
 
(2)   Includes amounts related to discontinued operations of: 2008 — nil (2007 — 437).
 
(3)   Includes amounts related to discontinued operations of: 2008 — nil (2007 — 1,037).
The accompanying notes are an integral part of these interim consolidated financial statements.
FORM 10-Q
QUARTERLY REPORT — PAGE 6

 


Table of Contents

MERCER INTERNATIONAL INC.
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Unaudited)
(In thousands of Euros)
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
 
                               
Supplemental disclosure of cash flow information:
                               
Cash paid (received) during the period for:
                               
Interest
  26,209     48,512     56,975     66,136  
Income taxes
    59       (218 )     (259 )     397  
Supplemental schedule of non-cash investing and financing activities:
                               
Acquisition of production and other equipment under capital lease obligations
  1,085     (127 )   4,784     2,088  
Common shares issued in satisfaction of floating rate note
                      6,728  
The accompanying notes are an integral part of these interim consolidated financial statements.
FORM 10-Q
QUARTERLY REPORT — PAGE 7

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 1. Basis of Presentation
The interim 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 Company’s shares of common stock are quoted and listed for trading on the NASDAQ Global Market and the Toronto Stock Exchange, respectively.
The interim 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”). The year-end consolidated balance sheet data was derived from audited financial statements. The footnote disclosure included herein has been prepared in accordance with accounting principles generally accepted for interim financial statements in the United States. The interim 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, 2007. In the opinion of the Company, the unaudited interim consolidated financial statements contained herein contain all adjustments necessary to fairly present the results of the interim periods included. The results for the periods included herein may not be indicative of the results for the entire year.
The Company has three operating pulp mills that are aggregated into one reportable business segment, market pulp. Accordingly the results presented are those of the reportable business segment.
Certain prior year amounts in the unaudited interim consolidated financial statements have been reclassified to conform to the current year presentation.
New Accounting Standards
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. FAS 159 is intended to improve financial reporting by mitigating volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The Company adopted FAS 159 effective January 1, 2008, the impact of which was not material.
FORM 10-Q
QUARTERLY REPORT — PAGE 8

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 1. Basis of Presentation (continued)
In February 2008, FASB issued FASB Staff Position No. FAS 157-2 (“FSP 157-2”), Effective Date of FASB Statement No. 157, which provides a one year deferral of the effective date of the statement of Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”) for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. In accordance with this interpretation, the Company has only adopted the provisions of FAS 157 with respect to its financial assets and liabilities that are measured at fair value within the financial statements as of December 31, 2007. The provisions of FAS 157 have not been applied to non-financial assets and non-financial liabilities, such as asset retirement obligations.
In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities (“FAS 161”). FAS 161 requires enhanced disclosures about how and why companies use derivatives, how derivative instruments and related hedged items are accounted for and how derivative instruments and related hedged items affect a company’s financial position, financial performance and cash flows. The provisions of FAS 161 are effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged. Consequently, FAS 161 will be effective for the Company’s quarter ended March 31, 2009. The Company is in the process of determining the impact, if any, the adoption of FAS 161 will have on its financial statement disclosures.
In May 2008, the FASB issued Statement of Financial Accounting Standards No. 162, The Hierarchy of Generally Accepted Accounting Principles (“FAS 162”). FAS 162 defines the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States. The provisions of FAS 162 are effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendment to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Company is in the process of determining the impact, if any, the adoption of FAS 162 will have on its financial statements and disclosures.
In May 2008, the FASB issued FASB Staff Position APB 14-1 Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Settlement) (“FSP 14-1”). FSP 14-1 states that convertible debt instruments that are within its scope are required to be separated into both a debt component and an equity component. In addition, any debt discount is to be accreted to interest expense over the expected life of the debt. The provisions of FSP 14-1 are effective for financial statements issued for fiscal years beginning after December 15, 2008, and implementation is generally required to be retrospective. Early adoption is not permitted. The Company is in the process of determining the impact, if any, the adoption of FSP 14-1 will have on its financial statements and disclosures.
FORM 10-Q
QUARTERLY REPORT — PAGE 9

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 2. Stock-Based Compensation
The Company has a non-qualified stock option plan which provides for options to be granted to officers and employees to acquire a maximum of 3,600,000 common shares including options for 130,000 shares to directors who are not officers or employees. The Company adopted a stock incentive plan which provides for options, stock appreciation rights and restricted shares to be awarded to employees and outside directors to a maximum of 1,000,000 common shares. During the first quarter of 2008, the Company implemented a new form of stock-based compensation called performance stock under its existing stock incentive plan.
Stock Options
Following is a summary of the status of options outstanding at September 30, 2008:
                                         
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
    830,000       1.75     $ 6.29       830,000     $ 6.29  
7.30
    30,000       6.75       7.30       30,000       7.30  
7.92
    68,334       7.00       7.92       68,334       7.92  
During the three and nine month periods ended September 30, 2008, no options were exercised, cancelled or expired.
During the nine month period ended September 30, 2007, 30,000 options were exercised at an exercise price of $6.375 and 26,666 options were exercised at an exercise price of $7.92 for cash proceeds of $402,435. 5,000 options were cancelled and 135,000 options expired during the period. The average intrinsic value of the options exercised was $4.58 per option.
FORM 10-Q
QUARTERLY REPORT — PAGE 10

 


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MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 2. Stock-Based Compensation (continued)
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 three and nine months ended September 30, 2008 were 38 and 139, respectively (2007 — 88 and 231).
As at September 30, 2008, the total remaining unrecognized compensation cost related to restricted stock amounted to approximately 82 (2007 — 173), which will be amortized over their remaining vesting period.
During the three month period ended September 30, 2008, no restricted stock awards were granted to independent directors and officers of the Company (2007 — 21,000). During the nine month period ended September 30, 2008, 21,000 restricted stock awards were granted (2007 — 21,000). There were nil (2007 — nil) restricted stock awards cancelled during the three and nine month periods ended September 30, 2008.
As at September 30, 2008, the total number of restricted stock awards outstanding was 232,685.
Performance Stock
Grants of performance stock comprise rights to receive stock at a future date that are contingent on the Company and the grantee achieving certain performance objectives. During the nine months ended September 30, 2008, potential stock based performance awards totaled 570,615 shares, which vest on December 31, 2010. Expense recognized for the three and nine month periods ended September 30, 2008, was 175 and 429, respectively (2007 — nil and nil).
As at September 30, 2008, the total remaining unrecognized compensation cost associated with the performance stock totaled approximately 1,633 which will be amortized over their remaining vesting period.
FORM 10-Q
QUARTERLY REPORT — PAGE 11

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 3. Income Per Share
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2008     2007     2008     2007  
 
Net income (loss) from continuing operations — basic
  (17,173 )   10,706     (13,433 )   15,139  
Interest on convertible notes, net of tax
      1,050         2,956  
 
                       
Net income (loss) from continuing operations — diluted
  (17,173 )   11,756     (13,433 )   18,095  
 
                       
 
                               
Net income (loss) from continuing operations per share:
                               
Basic
  (0.47 )   0.30     (0.37 )   0.42  
 
                       
Diluted
  (0.47 )   0.26     (0.37 )   0.40  
 
                       
 
                               
Net income (loss) from continuing operations
  (17,173 )   10,706     (13,433 )   15,139  
Net income (loss) from discontinued operations
          (10 )           (198 )
 
                       
Net income (loss) — basic
    (17,173 )     10,696       (13,433 )     14,941  
Interest on convertible notes, net of tax
          1,050             2,956  
 
                       
Net income (loss) — diluted
    (17,173 )   11,746     (13,433 )   17,897  
 
                       
 
                               
Net income (loss) per share:
                               
Basic
  (0.47 )   0.29     (0.37 )   0.41  
 
                       
Diluted
  (0.47 )   0.26     (0.37 )   0.39  
 
                       
 
                               
Weighted average number of common shares outstanding:
                               
Basic
    36,422,487       36,284,343       36,388,666       36,012,152  
Effect of dilutive instruments:
                               
Stock options and awards
    6,066       285,684       70,054       405,326  
Convertible notes
          8,678,065             8,920,022  
 
                       
Diluted
    36,428,553       45,248,092       36,458,720       45,337,500  
 
                       
The calculation of diluted income per share does not include the exercise of instruments that would have an anti-dilutive effect on earnings per share.
Convertible notes excluded from the calculation of diluted income per share for the three and nine month periods ended September 30, 2008 because they are anti-dilutive represented 8,678,065 shares (2007 — nil). Performance stock excluded from the calculation of diluted income per share for both the three and nine month periods ended September 30, 2008 because they are anti-dilutive represented 285,297 shares (2007 — nil).
FORM 10-Q
QUARTERLY REPORT — PAGE 12

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 4. Inventories
                 
    September 30, 2008     December 31, 2007  
 
               
Raw materials
  46,981     38,045  
Finished goods
    57,143       43,127  
Work in process and other
    25,841       22,438  
 
           
 
  129,965     103,610  
 
           
Note 5. Derivatives Transactions
                 
    Three Months Ended September 30,  
    2008     2007  
 
               
Realized net gain on foreign exchange derivatives
       
 
           
 
               
Unrealized net gain (loss) on interest rate derivatives
  (8,215 )   (5,696 )
Unrealized net gain (loss) on foreign exchange derivatives
           
 
           
Unrealized net gain (loss) on derivative financial instruments
  (8,215 )   (5,696 )
 
           
                 
    Nine Months Ended September 30,  
    2008     2007  
 
               
Realized net gain (loss) on foreign exchange derivatives
      6,820  
 
           
 
               
Unrealized net gain (loss) on interest rate derivatives
  4,515     18,089  
Unrealized net gain (loss) on foreign exchange derivatives
          (5,933 )
 
           
Unrealized net gain (loss) on derivative financial instruments
  4,515     12,156  
 
           
FORM 10-Q
QUARTERLY REPORT — PAGE 13

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 6. Pension and Other Post-Retirement Benefit Obligations
Included in pension and other post-retirement benefit obligations are amounts related to the Company’s Celgar and German mills.
The largest component of this obligation is with respect to the Celgar mill which 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 actuarial estimates and statutory requirements. Pension contributions for the three and nine month periods ended September 30, 2008 totaled 402 and 1,527, respectively (2007 — 367 and 1,201).
The Company anticipates based on actuarial estimates that it will make contributions to the defined benefit pension plan of approximately 1,614 (C$2.5 million) in 2008.
Effective December 31, 2008, the defined benefit plan will be closed to new members. In addition, the defined benefit service accrual will cease on December 31, 2008, and members will begin to accrue benefits under a new defined contribution plan effective January 1, 2009.
                                 
    Three Months Ended September 30,  
    2008     2007  
            Post-             Post-  
    Pension     Retirement     Pension     Retirement  
    Benefits     Benefits     Benefits     Benefits  
 
                               
Service cost
  197     125     215     121  
Interest cost
    339       200       349       190  
Expected return on plan assets
    (385 )           (428 )      
Recognized net loss
          21             16  
 
                       
Net periodic benefit cost
  151     346     136     327  
 
                       
                                 
    Nine Months Ended September 30,  
    2008     2007  
            Post-             Post-  
    Pension     Retirement     Pension     Retirement  
    Benefits     Benefits     Benefits     Benefits  
 
                               
Service cost
  596     379     623     351  
Interest cost
    1,025       605       1,014       551  
Expected return on plan assets
    (1,165 )           (1,241 )      
Recognized net loss
          62             46  
 
                       
Net periodic benefit cost
  456     1,046     396     948  
 
                       
FORM 10-Q
QUARTERLY REPORT — PAGE 14

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 7. Share Capital
Authorized
Preferred shares with U.S. $1 par value issuable in series: 50,000,000 (2007 — 50,000,000)
     Series A: 2,000,000 (2007 — 2,000,000)
Common shares with U.S. $1 par value: 200,000,000 (2007 — 200,000,000)
Issued and Outstanding
Common shares — 36,422,487 (2007 — 36,285,027)
Note 8. Financial Instruments
The Company adopted FAS 157 effective January 1, 2008. The adoption of FAS 157 resulted in no impact on the Company’s consolidated financial position or results from operations.
The fair value methodologies and, as a result, the fair value of the Company’s investments and derivative instruments are determined based on the fair value hierarchy provided in FAS 157. The fair value hierarchy per FAS 157 is as follows:
Level 1 — Valuations based on quoted prices in active markets for identical assets and liabilities.
Level 2 — Valuations based on observable inputs in active markets for similar assets and liabilities, other than Level 1 prices, such as quoted interest or currency exchange rates.
Level 3 — Valuations based on significant unobservable inputs that are supported by little or no market activity, such as discounted cash flow methodologies based on internal cash flow forecasts.
The Company classified its investments within Level 1 of the valuation hierarchy where quoted prices are available in an active market. The Company also holds highly liquid investments within restricted cash, which are marked to market at the end of each period. Level 1 investments include exchange-traded equities.
The Company’s derivatives are classified within Level 2 of the valuation hierarchy, as they are traded on the over-the-counter market and are valued using internal models that use as their basis readily observable market inputs, such as forward interest rates.
FORM 10-Q
QUARTERLY REPORT — PAGE 15

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 8. Financial Instruments (continued)
The valuation techniques used by Mercer are based upon observable inputs. Observable inputs reflect market data obtained from independent sources. In addition, the Company considered the risk of non-performance of the obligor, which in some cases reflects the Company’s own credit risk, in determining the fair value of the derivative instruments. The counterparty to our interest rate swap derivative is a multi-national financial institution. The fair value of the interest rate swaps represents the Company’s exposure on the derivative contracts.
The following table presents a summary of the Company’s outstanding financial instruments and their estimated fair values under the hierarchy defined in FAS 157:
Fair value measurements at September 30, 2008 using:
                                 
    Quoted prices in           Significant        
    active markets     Significant other     unobservable        
    for identical assets      observable inputs      inputs        
Description   (Level 1)     (Level 2)     (Level 3)     Total  
 
                               
Assets
                               
Investments held in restricted cash (a)
  7,974                 7,974  
Investments (a)
  646                 646  
 
                       
Total assets
  8,620                 8,620  
 
                       
 
                               
Liabilities
                               
Derivatives (b)
                               
- Interest rate swaps
        17,370           17,370  
 
                       
 
(a)   Based on observable market data.
 
(b)   Based on observable inputs for the liability (interest rates and yield curves observable at specific intervals).
Note 9. Commitments and Contingencies
In April 2008, as part of a new energy project for the Celgar mill, the Company entered into a contract for the purchase of a new 48 megawatt condensing turbine-generator set. The value of the contract is approximately 7,300 (C$11.0 million). The Company has made subsequent payments totaling approximately 1,700 (C$2.8 million). In the third quarter, the Company continued to make progress with the Celgar energy project and as a result has made additional commitments, primarily for equipment totalling approximately 6,200 (C$9.3 million), of which approximately 66 (C$0.1 million) was paid during the period.
In July 2008, as part of a bleaching project line renewal at the Rosenthal mill, the Company entered into a contract for the purchase of equipment. The value of the contract is approximately 4,200, and as at September 30, 2008, the Company had made payments totaling 630.
FORM 10-Q
QUARTERLY REPORT — PAGE 16

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 10. Restricted Group Supplemental Disclosure
The terms of the indenture governing our 9.25% senior unsecured notes require that we provide the results of operations and financial condition of Mercer International Inc. and our restricted subsidiaries under the indenture, collectively referred to as the “Restricted Group”. As at and during the three and nine months ended September 30, 2008 and 2007, the Restricted Group was comprised of Mercer International Inc., certain holding subsidiaries and our Rosenthal and Celgar mills. The Restricted Group excludes the Stendal mill.
Combined Condensed Balance Sheet
                                 
    September 30, 2008  
    Restricted     Unrestricted             Consolidated  
    Group     Subsidiaries     Eliminations     Group  
ASSETS
                               
Current
                               
Cash and cash equivalents
  61,689     14,090         75,779  
Receivables
    37,388       44,115             81,503  
Note receivable, current portion
    628                   628  
Inventories
    80,543       49,422             129,965  
Prepaid expenses and other
    7,341       2,785             10,126  
 
                       
Total current assets
    187,589       110,412             298,001  
Cash, restricted
          13,000             13,000  
Property, plant and equipment
    370,672       533,981             904,653  
Other
    4,967       5             4,972  
Deferred income tax
    20,321       5,111             25,432  
Due from unrestricted group
    54,646             (54,646 )      
Note receivable, less current portion
    3,650                   3,650  
 
                       
Total assets
  641,845     662,509     (54,646 )   1,249,708  
 
                       
 
                               
LIABILITIES
                               
Current
                               
Accounts payable and accrued expenses
  49,739     37,576         87,315  
Pension and other post-retirement benefit obligations, current portion
    955                   955  
Debt, current portion
          36,599             36,599  
 
                       
Total current liabilities
    50,694       74,175             124,869  
Debt, less current portion
    291,372       504,073             795,445  
Due to restricted group
          54,646       (54,646 )      
Unrealized derivative loss
          17,370             17,370  
Pension and other post-retirement benefit obligations
    18,361                   18,361  
Capital leases and other
    7,599       4,691             12,290  
Deferred income tax
    12,065       17,212             29,277  
 
                       
Total liabilities
    380,091       672,167       (54,646 )     997,612  
 
                       
 
                               
SHAREHOLDERS’ EQUITY
                               
Total shareholders’ equity (deficit)
    261,754       (9,658 )           252,096  
 
                       
Total liabilities and shareholders’ equity
  641,845     662,509     (54,646 )   1,249,708  
 
                       
FORM 10-Q
QUARTERLY REPORT — PAGE 17

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 10.   Restricted Group Supplemental Disclosure (continued)
Combined Condensed Balance Sheet
                                 
    December 31, 2007  
    Restricted     Unrestricted             Consolidated  
    Group     Subsidiaries     Eliminations     Group  
ASSETS
                               
Current
                               
Cash and cash equivalents
  59,371     25,477         84,848  
Receivables
    37,482       52,408             89,890  
Note receivable, current portion
    589       5,307             5,896  
Inventories
    63,444       40,166             103,610  
Prepaid expenses and other
    3,714       2,301             6,015  
 
                       
Total current assets
    164,600       125,659             290,259  
Cash, restricted
          33,000             33,000  
Property, plant and equipment
    385,569       547,689             933,258  
Other
    5,399                   5,399  
Deferred income tax
    10,852       6,772             17,624  
Due from unrestricted group
    57,457             (57,457 )      
Note receivable, less current portion
    3,977                   3,977  
 
                       
Total assets
  627,854     713,120     (57,457 )   1,283,517  
 
                       
 
                               
LIABILITIES
                               
Current
                               
Accounts payable and accrued expenses
  43,621     43,379         87,000  
Pension and other post-retirement benefit obligations, current portion
    493                   493  
Debt, current portion
          34,023             34,023  
 
                       
Total current liabilities
    44,114       77,402             121,516  
Debt, less current portion
    273,589       542,243             815,832  
Due to restricted group
          57,457       (57,457 )      
Unrealized derivative loss
          21,885             21,885  
Pension and other post-retirement benefit obligations
    19,983                   19,983  
Capital leases and other
    7,033       1,966             8,999  
Deferred income tax
    4,553       14,087             18,640  
 
                       
Total liabilities
    349,272       715,040       (57,457 )     1,006,855  
 
                       
 
                               
SHAREHOLDERS’ EQUITY
                               
Total shareholders’ equity (deficit)
    278,582       (1,920 )           276,662  
 
                       
Total liabilities and shareholders’ equity
  627,854     713,120     (57,457 )   1,283,517  
 
                       
FORM 10-Q
QUARTERLY REPORT — PAGE 18

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 10.   Restricted Group Supplemental Disclosure (continued)
Combined Condensed Statements of Operations
                                 
    Three Months Ended September 30, 2008  
    Restricted     Unrestricted             Consolidated  
    Group     Subsidiaries     Eliminations     Group  
Revenues
  102,604     75,999         178,603  
 
                       
 
                               
Operating costs
    88,718       56,044             144,762  
Operating depreciation and amortization
    7,333       6,700             14,033  
Selling, general and administrative expenses
    6,585       3,369             9,954  
 
                       
 
    102,636       66,113             168,749  
 
                       
Operating income (loss) from continuing operations
    (32 )     9,886             9,854  
 
                       
 
                               
Other income (expense)
                               
Interest expense
    (8,617 )     (10,719 )     2,912       (16,424 )
Investment income (loss)
    3,609       (2,728 )     (2,912 )     (2,031 )
Foreign exchange gain (loss) on debt
    (9,560 )                 (9,560 )
Derivative financial instruments
          (8,215 )           (8,215 )
 
                       
Total other income (expense)
    (14,568 )     (21,662 )           (36,230 )
 
                       
Income (loss) before income taxes and minority interest from continuing operations
    (14,600 )     (11,776 )           (26,376 )
Income tax benefit (provision)
    5,173       740             5,913  
 
                       
Income (loss) before minority interest from continuing operations
    (9,427 )     (11,036 )           (20,463 )
Minority interest
          3,290             3,290  
 
                       
Net income (loss)
  (9,427 )   (7,746 )       (17,173 )
 
                       
                                 
    Three Months Ended September 30, 2007  
    Restricted     Unrestricted             Consolidated  
    Group     Subsidiaries     Eliminations     Group  
Revenues
  106,530     84,581         191,111  
 
                       
 
                               
Operating costs
    84,545       63,984             148,529  
Operating depreciation and amortization
    7,419       6,865             14,284  
Selling, general and administrative expenses
    3,610       3,231             6,841  
 
                       
 
    95,574       74,080             169,654  
 
                       
Operating income (loss) from continuing operations
    10,956       10,501             21,457  
 
                       
 
                               
Other income (expense)
                               
Interest expense
    (6,996 )     (11,240 )     937       (17,299 )
Investment income (loss)
    1,321       1,107       (937 )     1,491  
Foreign exchange gain (loss) on debt
    4,545       81             4,626  
Derivative financial instruments, net
          (5,696 )           (5,696 )
 
                       
Total other income (expense)
    (1,130 )     (15,748 )           (16,878 )
 
                       
Income (loss) before income taxes and minority interest from continuing operations
    9,826       (5,247 )           4,579  
Income tax benefit (provision)
    (783 )     (7,652 )           (6,869 )
 
                       
Income before minority interest from continuing operations
    9,043       2,405             11,448  
Minority interest
          (742 )           (742 )
 
                       
Net income (loss) from continuing operations
    9,043       1,663             10,706  
Net income (loss) from discontinued operations
    (10 )                 (10 )
 
                       
Net income (loss)
  9,033     1,663         10,696  
 
                       
FORM 10-Q
QUARTERLY REPORT — PAGE 19

 


Table of Contents

MERCER INTERNATIONAL INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands of Euros, except per share data)
Note 10.   Restricted Group Supplemental Disclosure (continued)
Combined Condensed Statements of Operations
                                 
    Nine Months Ended September 30, 2008  
    Restricted     Unrestricted             Consolidated  
    Group     Subsidiaries     Eliminations     Group  
Revenues
  301,400     226,889         528,289  
 
                       
 
                               
Operating costs
    254,312       172,793             427,105  
Operating depreciation and amortization
    21,528       20,140             41,668  
Selling, general and administrative expenses
    15,194       9,609             24,803  
(Sale) purchase of emission allowances
                       
 
                       
 
    291,034       202,542             493,576  
 
                       
Operating income (loss) from continuing operations
    10,366       24,347             34,713  
 
                       
 
                               
Other income (expense)
                               
Interest expense
    (19,769 )     (32,200 )     2,912       (49,057 )
Investment income (loss)
    4,972       (2,360 )     (2,912 )     (300 )
Foreign exchange gain (loss) on debt
    (3,181 )     (110 )           (3,291 )
Derivative financial instruments
          4,515             4,515  
 
                       
Total other income (expense)
    (17,978 )     (30,155 )           (48,133 )
 
                       
Income (loss) before income taxes and minority interest from continuing operations
    (7,612 )     (5,808 )           (13,420 )
Income tax benefit (provision)
    1,716       (4,766 )           (3,050 )
 
                       
Income (loss) before minority interest from continuing operations
    (5,896 )     (10,574 )           (16,470 )
Minority interest
          3,037             3,037  
 
                       
Net income (loss)
  (5,896 )   (7,537 )       (13,433 )
 
                       
                                 
    Nine Months Ended September 30, 2007  
    Restricted     Unrestricted             Consolidated  
    Group     Subsidiaries     Eliminations     Group  
Revenues
  310,770     226,475         537,245  
 
                       
 
                               
Operating costs
    248,292       178,539             426,831  
Operating depreciation and amortization
    21,080       20,923             42,003  
Selling, general and administrative expenses
    12,315       9,985             22,300  
(Sale) purchase of emission allowances
    (268 )     (498 )           (766 )
 
                       
 
    281,419       208,949             490,368  
 
                       
Operating income (loss) from continuing operations
    29,351       17,526             46,877  
 
                       
 
                               
Other income (expense)
                               
Interest expense
    (21,414 )     (35,472 )     2,778       (54,108 )
Investment income (loss)
    3,761       2,803       (2,778 )     3,786  
Foreign exchange gain (loss) on debt
    6,808       421             7,229  
Derivative financial instruments, net
          18,976             18,976  
 
                       
Total other income (expense)
    (10,845 )     (13,272 )           (24,117 )
 
                       
Income (loss) before income taxes and minority interest from continuing operations
    18,506       4,254             22,760  
Income tax benefit (provision)
    (4,933 )     (1,903 )           (6,836 )
 
                       
Income (loss) before minority interest from continuing operations
    13,573       2,351             15,924  
Minority interest
          (785 )           (785 )
 
                       
Net income (loss) from continuing operations
    13,573       1,566             15,139  
Net income (loss) from discontinued operations
    (198 )                 (198 )
 
                       
Net income (loss)
  13,375     1,566         14,941  
 
                       
FORM 10-Q
QUARTERLY REPORT — PAGE 20

 


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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 September 30, 2008, unless otherwise stated; (iv) all references to monetary amounts are to “Euros”, the lawful currency adopted by most members of the European Union, unless otherwise stated; (v) “” refers to Euros, “$” refers to U.S. dollars and C$ refers to Canadian dollars; and (vi) “ADMTs” refers to air-dried metric tonnes.
We operate three NBSK pulp mills through our wholly owned subsidiaries, Rosenthal and Celgar, and our 70.6% owned subsidiary, Stendal, which have a consolidated annual production capacity of approximately 1.4 million ADMTs.
The following discussion and analysis of our results of operations and financial condition for the three and nine months ended September 30, 2008 should be read in conjunction with our interim 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, 2007 filed with the SEC.
Results of Operations
Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007
Selected production, sales and exchange rate data for the three months ended September 30, 2008 and 2007 is as follows:
                 
    Three Months Ended September 30,  
    2008     2007  
Pulp Production (‘000 ADMTs)
    368.4       361.0  
 
           
Scheduled Production Downtime (‘000 ADMTs)
    9.0       8.0  
 
           
Pulp Sales (‘000 ADMTs)
    363.8       363.5  
 
           
Revenues (in millions)
  178.6     191.1  
 
           
NBSK pulp list prices in Europe ($/ADMT)
  $ 878     $ 810  
NBSK pulp list prices in Europe (/ADMT)
  585     589  
Average pulp sales realizations (/ADMT)(1)
  484     520  
Average Spot Currency Exchange Rates
               
/ $(2)
    0.6658       0.7268  
C$ / $(2)
    1.0416       1.0446  
C$ / (3)
    1.5620       1.4367  
 
(1)   List price less discounts and commissions.
 
(2)   Average Federal Reserve Bank of New York noon spot rate over the reporting period.
 
(3)   Average Bank of Canada noon spot rate over the reporting period.
Revenues for the three months ended September 30, 2008 decreased by 6.5% to 178.6 million from 191.1 million in the comparative quarter of 2007, due to the weaker U.S. dollar in the current quarter which more than offset higher pulp prices.
List prices for NBSK pulp in Europe were approximately 585 ($878) per ADMT in the third quarter of 2008 compared to approximately 589 ($810) in the third quarter of 2007, 586 ($880) in the first quarter of 2008 and 576 ($900) in the second quarter of 2008. List prices, which had been improving in 2008, started declining towards the latter part of the third quarter as a result of slowing global economies and, in particular, lower demand in China.
FORM 10-Q
QUARTERLY REPORT — PAGE 21

 


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Pulp sales volume remained largely unchanged at 363,775 ADMTs in the current quarter compared to 363,523 ADMTs in the comparative period of 2007.
Average pulp sales realizations decreased by 6.9% to 484 per ADMT in the third quarter of 2008 from 520 per ADMT in the third quarter of 2007 as higher pulp prices were more than offset by the continued weakness in the U.S. dollar during the current quarter.
Partially offsetting the recent declines in pulp prices has been the appreciation of the U.S. dollar versus the Euro and the Canadian dollar which commenced in the latter part of the third quarter and has continued into the fourth quarter. Specifically, since the end of the third quarter to date, the Euro and the Canadian dollar have decreased by approximately 8.1% and 8.5%, respectively, in value against the U.S. dollar. A stronger U.S. dollar is beneficial to us because, although NBSK pulp is primarily quoted in U.S. dollars, our production costs are principally incurred in Euros and Canadian dollars.
Pulp production increased marginally to 368,378 ADMTs in the current quarter from 360,986 ADMTs in the same period of 2007, as all of our mills performed generally well. In the third quarter of 2008, we had a total of 10 days scheduled maintenance downtime at our mills, compared to 9 days in the same period last year.
During the third quarter of 2008, our raw material inventories increased to 47.0 million from 30.8 million at the end of the prior quarter as we built up inventories in anticipation of a slower winter harvesting season. Our pulp inventories increased to 57.1 million in the third quarter of 2008 from 52.2 million at the end of the prior quarter. Pulp inventories at our Celgar mill increased as sales to China slowed considerably in the latter part of the third quarter as a result of the build-up of pulp stocks by Chinese buyers earlier this year. Pulp inventories at our Rosenthal and Stendal mills were generally consistent with the second quarter.
Costs and expenses in the third quarter of 2008 decreased marginally to 168.7 million from 169.7 million in the comparative quarter of 2007.
On average, fiber costs increased by approximately 2.6% in the third quarter of 2008 versus the same period in 2007. Our fiber costs in Germany decreased slightly in the current quarter from the comparative period of 2007 as the sustained production curtailments by German sawmills and large parts of the European board industry continue and demand for fiber remains generally low. Fiber costs at our Celgar mill increased in the current quarter from the prior quarter and the same period last year as a result of increased whole log chipping and higher freight costs incurred in the delivery of wood chips to the mill. Overall, we currently expect fiber prices in Germany in the fourth quarter and early part of 2009 to remain generally level with third quarter prices. Fiber costs at our Celgar mill are also expected to remain at current levels in the near term and to decrease as we move into 2009 as a result of fiber initiatives implemented at the mill including improvements in transportation logistics and woodroom efficiencies.
We recorded no contribution to income from the sale of emission allowances for the three months ended September 30, 2008 and 2007 as a result of weak markets and prices for the sale of emission allowances. In the third quarter of 2008, sales of surplus energy were approximately 7.2% higher than in the comparative quarter of 2007.
FORM 10-Q
QUARTERLY REPORT — PAGE 22

 


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Operating depreciation and amortization decreased marginally to 14.0 million from 14.3 million in the comparative quarter of 2007.
For the third quarter of 2008, operating income decreased to 9.9 million from 21.5 million in the comparative quarter of 2007, primarily due to lower sales realizations.
Interest expense in the third quarter of 2008 decreased to 16.4 million from 17.3 million in the year ago period, primarily due to lower levels of borrowing.
We recorded an unrealized loss of 8.2 million before minority interests on our interest rate derivatives during the third quarter of 2008. In the comparative quarter of 2007, we recorded an unrealized loss of 5.7 million before minority interests on our then outstanding interest rate derivatives.
In the third quarter of 2008, we recorded an unrealized loss of 9.6 million on our foreign currency denominated debt, compared to an unrealized gain of 4.6 million in the same period of 2007.
In the third quarter of 2008, the minority shareholder’s proportionate interest in the Stendal mill’s loss for the period was 3.3 million, compared to 0.7 million of income in the third quarter of 2007.
We reported a net loss from continuing operations for the third quarter of 2008 of 17.2 million, or 0.47 per basic and diluted share. In the third quarter of 2007, we reported net income from continuing operations of 10.7 million, or 0.30 per basic share and 0.26 per diluted share.
Operating EBITDA decreased to 24.0 million in the third quarter of 2008 from 35.8 million in the three months ended September 30, 2007.
Operating EBITDA is defined as operating income from continuing 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, 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 or income from operations as a measure of operational performance, nor as an alternative to net cash from operating activities as a measure of liquidity.
FORM 10-Q
QUARTERLY REPORT — PAGE 23

 


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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 operational 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 interim 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 EBITDA as a supplemental measure of our operational performance and relying primarily on our GAAP financial statements.
The following table provides a reconciliation of net income from continuing operations to Operating EBITDA for the periods indicated:
                 
    Three Months Ended  
    September 30,  
    2008     2007  
    (in thousands)  
Net income (loss) from continuing operations
  (17,173 )   10,706  
Minority interest
    (3,290 )     742  
Income taxes (benefits)
    (5,913 )     (6,869 )
Interest expense
    16,424       17,299  
Investment (income) loss
    2,031       (1,491 )
Unrealized foreign exchange loss (gain) on debt
    9,560       (4,626 )
Derivative financial instruments
    8,215       5,696  
 
           
Operating income from continuing operations
    9,854       21,457  
Add: Depreciation and amortization
    14,103       14,351  
 
           
Operating EBITDA
  23,957     35,808  
 
           
Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007
Selected production, sales and exchange rate data for the nine months ended September 30, 2008 and 2007 is as follows:
                 
    Nine Months Ended September 30,  
    2008     2007  
Pulp Production (‘000 ADMTs)
    1,086.1       1,034.6  
 
           
Scheduled Production Downtime (‘000 ADMTs)
    26.0       46.0  
 
           
Pulp Sales (‘000 ADMTs)
    1,059.2       1,029.7  
 
           
Revenues (in millions)
  528.3     537.2  
 
           
NBSK pulp list prices in Europe ($/ADMT)
  $ 886     $ 783  
NBSK pulp list prices in Europe (/ADMT)
  582     582  
Average pulp sales realizations (/ADMT)(1)
  493     517  
Average Spot Currency Exchange Rates
               
/ $(2)
    0.6572       0.7435  
C$ / $(2)
    1.0185       1.1048  
C$ / (3)
    1.5486       1.4844  
 
(1)   List price less discounts and commissions.
 
(2)   Average Federal Reserve Bank of New York noon spot rate over the reporting period.
 
(3)   Average Bank of Canada noon spot rate over the reporting period.
FORM 10-Q
QUARTERLY REPORT — PAGE 24

 


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Revenues for the nine months ended September 30, 2008 decreased to 528.3 million from 537.2 million in the comparative period of 2007, as higher sales volumes and pulp prices were more than offset by the weaker U.S. dollar versus the Euro in the current period.
List prices for NBSK pulp in Europe were approximately 582 ($886) per ADMT in the first nine months of 2008 compared to approximately 582 ($783) in the first nine months of 2007.
Pulp sales volume increased to 1,059,212 ADMTs in the first nine months of 2008 from 1,029,674 ADMTs in the first nine months of 2007.
Average pulp sales realizations were 493 per ADMT in the first nine months of 2008 compared to 517 per ADMT in the comparative period of 2007, primarily as a result of the weakness of the U.S. dollar versus the Euro during the period.
Pulp production in the first nine months of 2008 increased to 1,086,078 ADMTs from 1,034,592 ADMTs in the same period of 2007, as all of our mills performed generally well. In the first nine months of 2008, we had a total of 22 days scheduled maintenance downtime at our mills, compared to 33 days in the same period last year.
During the first nine months of 2008, our raw material inventories increased to 47.0 million from 38.0 million at the end of 2007. Our pulp inventories increased to 57.1 million in the third quarter of 2008 from 43.1 million at the end of 2007.
Costs and expenses in the first nine months of 2008 increased to 493.6 million from 490.4 million in the comparative period of 2007.
On average, fiber costs decreased by approximately 1.5% in the first nine months of 2008 versus the same period in 2007. Our fiber costs in Germany were approximately 3.3% lower compared to the same period last year as lower demand for fiber from the European board industry reduced pressure on pricing. At our Celgar mill fiber costs increased almost 12.6% from the third quarter of 2007 as the deterioration of the North American housing and lumber markets sharply reduced sawmilling activity and residual chip supply requiring Celgar to increase its levels of whole log chipping. Celgar’s fiber costs were also negatively affected by higher freight costs incurred in the delivery of wood chips to the mill.
We recorded no contribution to income from the sale of emission allowances for the nine months ended September 30, 2008 compared to 0.8 million in the same period last year as a result of weak markets and prices for the sale of emission allowances. In the first nine months of 2008, sales of surplus energy were approximately 9.8% higher than in the same period of 2007.
Operating depreciation and amortization decreased marginally to 41.7 million in the first nine months of 2008 from 42.0 in the same period last year.
For the first nine months of 2008, operating income decreased to 34.7 million from 46.9 million in the comparative period of 2007.
Interest expense in the first nine months of 2008 decreased to 49.1 million from 54.1 million in the year ago period, primarily due to a lower level of borrowing.
FORM 10-Q
QUARTERLY REPORT — PAGE 25

 


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We recorded an unrealized gain of 4.5 million before minority interests on our interest rate derivatives during the first nine months of 2008. In the comparative period of 2007, we recorded a gain of 19.0 million before minority interests on our then outstanding derivatives, which included a realized gain of 6.8 million from the settlement of currency swaps.
In the first nine months of 2008, we recorded a loss of 3.3 million on our foreign currency denominated debt, compared to a gain of 7.2 million in the comparative period of 2007.
In the first nine months of 2008, the minority shareholder’s proportionate interest in the Stendal mill’s loss for the period was 3.0 million, compared to 0.8 million of income in the same period of 2007.
We reported a net loss from continuing operations for the first nine months of 2008 of 13.4 million, or 0.37 per basic and diluted share. In the first nine months of 2007, we reported net income from continuing operations of 15.1 million, or 0.42 per basic share and 0.40 per diluted share.
Operating EBITDA was 76.6 million in the first nine months of 2008 from 89.1 million in the nine months ended September 30, 2007. 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 three months ended September 30, 2008 for additional information relating to Operating EBITDA.
The following table provides a reconciliation of net income from continuing operations to Operating EBITDA for the periods indicated:
                 
    Nine Months Ended  
    September 30,  
    2008     2007  
    (in thousands)  
Net income (loss) from continuing operations
  (13,433 )   15,139  
Minority interest
    (3,037 )     785  
Income taxes (benefits)
    3,050       6,836  
Interest expense
    49,057       54,108  
Investment (income) loss
    300       (3,786 )
Unrealized foreign exchange (gain) loss on debt
    3,291       (7,229 )
Derivative financial instruments
    (4,515 )     (18,976 )
 
           
Operating income from continuing operations
    34,713       46,877  
Add: Depreciation and amortization
    41,879       42,197  
 
           
Operating EBITDA
  76,592     89,074  
 
           
FORM 10-Q
QUARTERLY REPORT — PAGE 26

 


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Liquidity and Capital Resources
The following table is a summary of selected financial information for the periods indicated:
                 
    As at   As at
    September 30,   December 31,
    2008   2007
    (in thousands)
Financial Position
               
Cash and cash equivalents
  75,779     84,848  
Working capital
    173,132       168,743  
Property, plant and equipment
    904,653       933,258  
Total assets
    1,249,708       1,283,517  
Long-term liabilities
    872,743       885,339  
Shareholders’ equity
    252,096       276,662  
As at September 30, 2008 and December 31, 2007, our cash and cash equivalents were 75.8 million and 84.8 million, respectively. We also had 13.0 million of restricted cash in a debt service account related to the financing for the Stendal mill at the end of the third quarter of 2008 compared to 33.0 million at December 31, 2007. As at September 30, 2008, we had not drawn any amount under the 40.0 million Rosenthal revolving term credit facility and had drawn approximately C$35.2 million under the C$40.0 million Celgar revolving credit facility.
We expect to meet our interest and debt service obligations and the working and maintenance capital requirements for our operations, other than the Stendal mill, from cash flow from operations, cash on hand and the two revolving working capital facilities for the Rosenthal and Celgar mills.
The following summary of certain selected provisions of our credit facilities is not complete and these provisions, including definitions of certain terms, are qualified in their entirety by reference to the credit facilities and applicable amendments on file with the SEC.
The Celgar revolving working facility had an initial three-year term and matures in May 2009. It may be extended by our Celgar mill for successive one-year periods upon request and lender acceptance. The maximum amount available under the Celgar facility is C$40.0 million, subject to borrowing base limitations equal to 85% of eligible accounts receivable and a percentage of eligible inventory varying between 65% and 85%. The facility is secured by a first fixed charge on the Celgar mill’s working capital and is guaranteed by Mercer Inc. No security is granted upon the equipment, buildings or real property of the Celgar mill. Advances under the facility are available in Canadian and U.S. dollars. Rates for advances in Canadian and U.S. dollars are equal to a prime rate charged by a Canadian bank plus a margin of 0.50%. Advances are also available under Canadian dollar acceptances and U.S. currency LIBOR rates plus, in each case, a margin of 2.25%. The credit facility is subject to a number of positive and negative covenants customary for credit agreements of this nature including a covenant that, if the excess amount under the credit facility for the Celgar mill is less than C$8.0 million, then until it becomes equal to or greater than such amount, the Celgar mill must maintain a fixed charge coverage ratio of not less than 1.1:1.0 for each 12-month period.
The Rosenthal revolving working capital facility is in the aggregate amount of 40.0 million and matures in February 2010. There is no borrowing base requirement in this facility and it is secured by a first fixed charge on the working capital of the Rosenthal mill. No security is granted upon the equipment, buildings or real property of Rosenthal. Advances are available in Euros or U.S. dollars. Interest accrues based upon the form of advance at LIBOR or EURIBOR plus a margin of 1.55% plus certain other costs incurred by lenders. The agreement contains positive and negative covenants customary to facilities of this type. They include that for the Rosenthal mill the ratio of net debt to EBITDA must not exceed 3:1 in any 12-month period, there must be an interest ratio coverage of EBITDA to interest expense equal to or in excess of 1.4:1 for each six-month period and there must be a current ratio where current assets to current liabilities must equal or exceed 1.1:1.
FORM 10-Q
QUARTERLY REPORT — PAGE 27

 


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We currently expect to meet the capital requirements for the Stendal mill, including working capital, interest and principal service expenses through cash on hand, cash flow from operations and our 70% owned Stendal mill’s loan facility (the “Stendal Facility”). The Stendal Facility was designed as a “project loan facility” for the construction and operation of the Stendal mill. It is non-recourse to Mercer Inc. and our other operating subsidiaries. The Stendal Facility of our Stendal mill is our only credit facility with regularly scheduled principal payments, which are due semi-annually until its maturity in 2017. In 2009, the Stendal Facility provides for semi-annual principal payments of approximately 17.9 million and 18.7 million. In addition to operating cash flow, the Stendal mill also has approximately 13.0 million in its debt service reserve account to assist with scheduled payments. Additionally, under the Stendal Facility, the Stendal mill is permitted, at its option, to implement one six-month deferral of scheduled principal payments. As the Stendal Facility is the only credit facility which currently has scheduled principal payments, Stendal has had initial discussions with its lenders to provide for greater financial flexibility given the current distress and uncertainty facing global world markets.
Our expectations as to our liquidity are based upon current market conditions and, in particular, current and expected future pulp pricing and foreign exchange rates.
Operating Activities
Operating activities in the first nine months of 2008 provided cash of 6.5 million, compared to 3.1 million in the comparative period of 2007. A decrease in receivables provided cash of 7.7 million in the first nine months of 2008, compared to using cash of 19.3 million in the comparative period of 2007. An increase in inventories used cash of 27.4 million in the first nine months of 2008, compared to 31.1 in the same period of 2007.
Working capital is subject to cyclical operating needs, such as the timing of collections and sales and the payment of payables.
Investing Activities
Investing activities in the first nine months of 2008 provided cash of 10.1 million in large part due to a drawdown of funds in our debt service reserve account to repay principal and interest under the Stendal Facility. The repayment of notes receivable provided cash of 5.3 million and the sale of equipment provided cash of 1.9 million. In the nine months ended September 30, 2007 investing activities provided cash of 26.6 million primarily due to a drawdown of funds in our debt service reserve account under the Stendal facility.
In the first nine months of 2008, capital expenditures, including expenditures related to the Celgar energy project and woodroom upgrade as well as the renewal of a bleaching line at our Rosenthal mill, used cash of 17.1 million. In the same period last year, capital expenditures used 2.7 million which included approximately 9.1 million received in the third quarter of 2007 in connection with the settlement of the Stendal engineering, procurement and construction contract, which was recorded as a reduction of property, plant and equipment.
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Financing Activities
Financing activities used cash of 26.1 million in the nine months ended September 30, 2008, as we paid 34.0 million in scheduled repayments of indebtedness under the Stendal Facility in the first nine months of 2008. In the comparative period in 2007, financing activities used cash of 30.8 million primarily due to scheduled repayments under the Stendal Facility.
Other than commitments totaling approximately 13.5 million relating to the energy project at our Celgar mill which we entered into in the first nine months of 2008, and contracts totaling approximately 4.2 million to purchase equipment for Rosenthal’s bleach plant project, 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 nine months of 2008.
Capital Resources
In addition to our current revolving credit facilities for the Rosenthal and Celgar mills, 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) 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.
Foreign Currency
Our reporting currency is the Euro as the majority of our business transactions are denominated in Euros. However, we hold certain assets and liabilities in U.S. dollars and 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.
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In the nine months ended September 30, 2008, accumulated other comprehensive income decreased by 12.1 million which was primarily due to the foreign exchange translation.
Based upon the exchange rate at September 30, 2008, the U.S. dollar has increased by approximately 1.0% in value against the Euro since September 30, 2007. 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”. The Restricted Group is comprised of Mercer Inc., certain holding subsidiaries, and our Rosenthal and Celgar mills. The Restricted Group excludes 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 Restricted Group including, without limitation, a reconciliation to our consolidated results of operations, see Note 10 of our quarterly interim consolidated financial statements included herein.
Restricted Group Results — Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007
Revenues for the Restricted Group for the three months ended September 30, 2008 decreased to 102.6 million from 106.5 million in the comparative period of 2007, primarily due to the weaker U.S. dollar relative to the Euro which more than offset higher pulp prices.
List prices for NBSK pulp in Europe were approximately 585 ($878) per ADMT in the third quarter of 2008 and approximately 589 ($810) in the same period of 2007.
Pulp sales volume increased to 209,288 ADMTs in the third quarter of 2008 from 201,236 ADMTs in the comparative period of 2007.
Average pulp sales realizations for the Restricted Group were 489 per ADMT in the three months ended September 30, 2008, compared to 528 per ADMT in the comparative period of 2007, as higher pulp prices were more than offset by the weakness in the U.S. dollar during the period.
Pulp production for the Restricted Group increased to 205,628 ADMTs in the third quarter of 2008 from 202,301 ADMTs in the same period of 2007 as our Celgar and Rosenthal mills performed generally well. In the third quarter of 2008, we had a total of 10 days scheduled maintenance downtime at our Rosenthal mill, compared to 9 days in the same period last year.
Pulp inventories for the Restricted Group were higher at September 30, 2008, compared to the same time last year primarily as a result of higher inventories at our Celgar mill which resulted from slowing sales to China in the latter part of the third quarter as a result of the build up of pulp stocks by Chinese buyers earlier this year.
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Cost of sales and general, administrative and other expenses for the Restricted Group in the third quarter of 2008 increased to 102.6 million from 95.6 million in the comparative period of 2007.
Overall, fiber costs of the Restricted Group increased by approximately 8.4% in the third quarter of 2008 versus the same period of 2007. Fiber costs for our Rosenthal mill increased slightly in the third quarter of 2008 from the comparative period of 2007 due to higher prices for sawmill residuals which comprise a significant portion of fiber for the Rosenthal mill. At our Celgar mill fiber costs increased in the third quarter of 2008 as a result of increased whole log chipping and higher freight costs incurred in the delivery of wood chips to the mill.
The Restricted Group recorded no contribution to income from the sale of emission allowances by our Rosenthal mill for the three months ended September 30, 2008 and 2007 as a result of weak markets and prices for the sale of emission allowances. In the current period, sales of surplus energy were approximately 3.4% higher than in the same quarter of 2007.
Operating depreciation and amortization for the Restricted Group remained largely the same at 7.4 million in the third quarter of 2008 and the same period last year.
In the third quarter of 2008, the Restricted Group reported an operating loss of 0.1 million compared to operating income of 11.0 million in the third quarter of 2007, primarily due to lower sales realizations.
Interest expense for the Restricted Group in the third quarter of 2008 increased to 8.6 million from 7.0 million in the same quarter last year due to higher levels of borrowing.
In the third quarter of 2008, the Restricted Group recorded a loss on foreign currency denominated debt of 9.6 million, compared to a gain of 4.5 million in the comparative quarter of 2007.
The Restricted Group reported a net loss from continuing operations for the third quarter of 2008 of 9.4 million. In the third quarter of 2007, the Restricted Group had net income from continuing operations of 9.0 million.
Operating EBITDA for the Restricted Group was 7.4 million in the third quarter of 2008 compared to 18.4 million in the comparative quarter of 2007.
Operating EBITDA is defined as operating income (loss) from continuing operations plus depreciation and amortization and non-recurring capital asset impairment charges. 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 three months ended September 30, 2008 for additional information relating to such limitations and Operating EBITDA.
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The following table provides a reconciliation of net income from continuing operations to Operating EBITDA for the Restricted Group for the periods indicated:
                 
    Three Months Ended  
    September 30,  
    2008     2007  
    (in thousands)  
Restricted Group
               
Net income (loss) from continuing operations(1)
  (9,427 )   9,043  
Income taxes
    (5,173 )     783  
Interest expense
    8,617       6,996  
Investment (income) loss
    (3,609 )     (1,321 )
Unrealized foreign exchange (gain) loss on debt
    9,560       (4,545 )
 
           
Operating income (loss) from continuing operations
    (32 )     10,956  
Add: Depreciation and amortization
    7,403       7,486  
 
           
Operating EBITDA(1)
  7,371     18,442  
 
           
 
(1)   See Note 10 of the interim consolidated financial statements included elsewhere herein for a reconciliation to our consolidated results.
Restricted Group Results — Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007
Revenues for the Restricted Group for the nine months ended September 30, 2008 decreased to 301.4 million from 310.8 million in the comparative period of 2007, primarily as a result of the weak U.S. dollar versus the Euro.
List prices for NBSK pulp in Europe were approximately 582 ($886) per ADMT in the first nine months of 2008 and approximately 582 ($783) in the comparative period of 2007.
Pulp sales volume increased to 609,564 ADMTs in the first nine months of 2008 from 589,463 ADMTs in the comparative period of 2007.
Average pulp sales realizations for the Restricted Group were 493 per ADMT in the nine months ended September 30, 2008, compared to 526 per ADMT in the comparative period of 2007, primarily as a result of the weakness of the U.S. dollar versus the Euro during the period.
Pulp production for the Restricted Group increased to 610,338 ADMTs in the first nine months of 2008 from 593,060 ADMTs in the same period of 2007 as our Celgar and Rosenthal mills generally performed well. We had a total of 22 days scheduled maintenance downtime at our Celgar and Rosenthal mills in the nine months ended September 30, 2008 compared to 21 days in the same period last year.
Pulp inventories for the Restricted Group were higher in the first nine months of 2008, compared to the same period last year.
Cost of sales and general, administrative and other expenses for the Restricted Group in the first nine months of 2008 increased to 291.0 million from 281.4 million in the comparative period of 2007.
On average, fiber costs of the Restricted Group increased by approximately 0.6% in the first nine months of 2008 versus the same period of 2007. Fiber costs for our Rosenthal mill declined in the first nine months of 2008 from the comparative period of 2007 as lower demand for fiber from the European board industry reduced pressure on pricing in Germany.
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At our Celgar mill fiber costs were higher in the first nine months of 2008 compared to the same period of 2007 as the deterioration of the North American housing and lumber markets sharply reduced sawmilling activity and residual chip supply requiring Celgar to increase its levels of whole log chipping. Celgar’s fiber costs were also negatively affected by higher freight costs incurred in the delivery of wood chips to the mill.
The Restricted Group recorded no contribution to income from the sale of emission allowances by our Rosenthal mill for the nine months ended September 30, 2008 compared to 0.3 million in the same period last year as a result of weak markets and prices for the sale of emission allowances. In the current period, sales of surplus energy were approximately 4.4% higher than in the same period of 2007.
Operating depreciation and amortization for the Restricted Group increased marginally to 21.5 million in the current period from 21.1 million in the comparative period of 2007.
In the first nine months of 2008, the Restricted Group’s operating income decreased to 10.4 million from 29.4 million in the first nine months of 2007.
Interest expense for the Restricted Group in the first nine months of 2008 decreased to 19.8 million from 21.4 million in the same period last year, primarily as a result of lower levels of borrowing.
In the first nine months of 2008, the Restricted Group recorded a loss of 3.2 million on our foreign currency denominated debt, compared to a gain of 6.8 million in the comparative period of 2007.
The Restricted Group reported a net loss from continuing operations for the first nine months of 2008 of 5.9 million. In the first nine months of 2007, net income from continuing operations for the Restricted Group was 13.6 million.
Operating EBITDA for the Restricted Group was 32.1 million in the first nine months of 2008 compared to 50.6 million in the comparative period of 2007.
Operating EBITDA is defined as operating income (loss) from continuing operations plus depreciation and amortization and non-recurring capital asset impairment charges. 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 three months ended September 30, 2008 for additional information relating to such limitations and Operating EBITDA.
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The following table provides a reconciliation of net income from continuing operations to Operating EBITDA for the Restricted Group for the periods indicated:
                 
    Nine Months Ended  
    September 30,  
    2008     2007  
    (in thousands)  
Restricted Group
               
Net income (loss) from continuing operations(1)
  (5,896 )   13,573  
Income taxes (benefits)
    (1,716 )     4,933  
Interest expense
    19,769       21,414  
Investment (income) loss
    (4,972 )     (3,761 )
Unrealized foreign exchange (gain) loss on debt
    3,181       (6,808 )
 
           
Operating income (loss) from continuing operations
    10,366       29,351  
Add: Depreciation and amortization
    21,739       21,274  
 
           
Operating EBITDA(1)
  32,105     50,625  
 
           
 
(1)   See Note 10 of the interim consolidated 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
    September 30,   December 31,
    2008   2007
    (in thousands)
Restricted Group Financial Position(1)
               
Cash and cash equivalents
  61,689     59,371  
Working capital
    136,895       120,486  
Property, plant and equipment
    370,672       385,569  
Total assets
    641,845       627,854  
Long-term liabilities
    329,397       305,158  
Shareholders’ equity
    261,754       278,582  
 
(1)   See Note 10 of the interim consolidated financial statements included elsewhere herein for a reconciliation to our consolidated results.
At September 30, 2008, the Restricted Group had cash and cash equivalents of 61.7 million, compared to 59.4 million at December 31, 2007. At September 30, 2008, the Restricted Group had working capital of 136.9 million.
As at September 30, 2008, we had not drawn any amount under the Rosenthal revolving term credit facility and had drawn approximately C$35.2 million under the C$40.0 million Celgar revolving credit facility.
We expect the Restricted Group to meet its interest and debt service obligations and meet the working and maintenance capital requirements for its operations with cash flow from operations, cash on hand and the revolving working capital loan facilities for the Rosenthal and Celgar mills.
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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 both our significant and critical accounting policies, see our annual report on Form 10-K for the fiscal year ended December 31, 2007.
New Accounting Standards
See Note 1 to the Company’s interim consolidated financial statements included in Item 1.
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 fiscal year ended December 31, 2007. 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.
Cyclical Nature of Business
Revenues
The pulp 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. Pulp markets are highly competitive and are sensitive to cyclical changes in the global economy, industry capacity and foreign exchange rates, all of which can have a significant influence on selling prices and our earnings. The length and magnitude of industry cycles have varied over time but generally reflect changes in macro economic conditions and levels of industry capacity.
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Industry capacity can fluctuate as changing industry conditions can influence producers to idle production or permanently close machines or entire mills. In addition, to avoid substantial cash costs in idling or closing a mill, some producers will choose to operate at a loss, sometimes even a cash loss, which can prolong weak pricing environments due to oversupply. Oversupply of our products can also result from producers introducing new capacity in response to favorable pricing trends.
Demand for pulp has historically been determined by the level of economic growth and has been closely tied to overall business activity. Although pulp prices have improved commencing in the latter part of 2005 and through the first half of 2008, they fell in the third quarter of 2008. We cannot predict the impact of continued economic weakness in world markets or the impact of war, terrorist activity or other events on our markets.
Prices for pulp are driven by many factors outside our control, and we have little influence over the timing and extent of price changes, which are often volatile. Because market conditions beyond our control determine the price for pulp, such price for pulp may fall below our cash production costs, requiring us to either incur short-term losses on product sales or cease production at one or more of our manufacturing facilities. Therefore, our profitability depends on managing our cost structure, particularly raw materials which represent a significant component of our operating costs and can fluctuate based upon factors beyond our control. If the prices of our products decline, or if raw materials increase, or both, demand for our products may decline and our sales and profitability could be materially adversely affected.
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. Fiber costs are primarily affected by the supply of, and demand for, lumber which is highly cyclical in nature and can vary significantly by location. 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.
Currency
The majority of our sales are in products quoted in U.S. dollars while most of our operating costs and expenses, other than those of the Celgar mill, are incurred in Euros. In addition, all of the products sold by the Celgar mill are quoted in U.S. dollars and the Celgar mill costs are primarily incurred in Canadian dollars. Our results of operations and financial condition are reported in Euros. As a result, our revenues are adversely affected by a decrease in the value of the U.S. dollar relative to the Euro and to the Canadian dollar. Such shifts in currencies relative to the Euro and the Canadian dollar reduce our operating margins and the cash flow available to fund our operations and to service our debt. Conversely, an increase in the U.S. dollar versus the Euro and the Canadian dollar positively impacts our revenues by increasing our operating margins and cash flow.
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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 seek to manage these risks through internal risk management policies, as well as the use of derivatives. We use derivatives to reduce or limit our exposure to interest rate and 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.
During the first nine months of 2008, we recorded an unrealized gain of 4.5 million before minority interests on our outstanding interest rate derivatives compared to a realized and unrealized gain of 19.0 million in the comparative period of 2007.
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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.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are subject to routine litigation incidental to our business, including those described in our latest annual report on Form 10-K for the fiscal year ended December 31, 2007. 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
Other than inherent risks associated with the matters listed below, there have been no material changes to the factors disclosed in Item 1A. Risk Factors in our latest annual report on Form 10-K for the fiscal year ended December 31, 2007.
The Celgar green energy project is subject to risks inherent in large capital projects
The new energy project we have commenced at our Celgar mill to increase its production of “green energy” and optimize its power generation capacity is subject to customary risks and uncertainties inherent in large capital projects which could result in the energy project not completing on schedule or as budgeted. Delays to Celgar receiving any operating permits or any required amendments to such permits could result in construction delays, operational deficiencies or funding shortfalls. Furthermore, the Celgar mill could experience operating difficulties or delays during the start-up period when production of “green energy” is being ramped up. The Celgar mill may not achieve our planned power generation or cost projections.
The German Renewable Energy Resources Act is subject to governmental amendment
There can be no assurance that the amendments to Germany’s Renewable Energy Resources Act scheduled to take effect January 1, 2009 will be implemented in their current form. Additional and future amendments to the Act could adversely affect the eligibility of our Rosenthal and Stendal mills to participate in this statutory program and/or the tariffs paid thereunder. As a result we cannot predict with any certainty the amount of future sales of surplus energy we may be able to generate.
Our business is subject to a number of global economic risks
As widely reported, financial markets in the United States, Europe and Asia have been experiencing extreme disruption in recent months, including, among other things, extreme volatility in security prices, severely diminished liquidity and credit availability, rating downgrades of certain investments and declining valuations of others. Governments have taken unprecedented actions intended to address extreme market conditions that include severely restricted credit and declines in values of real estate and other asset classes.
The extreme disruption in financial markets can adversely affect our business in several ways. Principally, as pulp demand has historically been determined by the level of economic growth and business activity, financial market disruptions are expected to lead to slowdowns in world economies which generally result in lower demand and prices for our product. Additionally, restricted credit availability restrains our customers’ ability or willingness to purchase our products resulting in lower revenues. Restricted credit availability also can limit us in the way
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we operate our business, our level of inventories and the amount of capital expenditures we may undertake. Any of these changes can adversely affect our operations and our financial performance.
We are unable to predict the likely duration and severity of the current disruption in financial markets and adverse economic conditions on world economies and pulp markets.
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.
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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: November 4, 2008
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