POTLATCHDELTIC CORP - Quarter Report: 2010 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

For the quarterly period ended September 30, 2010

Or

For the transition period from                      to                     

Commission File Number 1-32729

POTLATCH CORPORATION

(Exact name of registrant as specified in its charter)

(509) 835-1500

(Registrant’s telephone number, including area code)

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

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

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

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

The number of shares of common stock of the registrant outstanding as of September 30, 2010 was 40,006,521.

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POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

Index to Form 10-Q

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Part I

ITEM 1.

Financial Statements

Potlatch Corporation and Consolidated Subsidiaries

Consolidated Condensed Statements of Operations and Comprehensive Income

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

Certain 2009 amounts have been reclassified to conform to the 2010 presentation.

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

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Potlatch Corporation and Consolidated Subsidiaries

Consolidated Condensed Balance Sheets

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

Certain 2009 amounts have been reclassified to conform to the 2010 presentation.

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

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Potlatch Corporation and Consolidated Subsidiaries

Consolidated Condensed Statements of Cash Flows

Unaudited (Dollars in thousands)

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

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Potlatch Corporation and Consolidated Subsidiaries

Notes to Consolidated Condensed Financial Statements

Unaudited (Dollars in thousands)

NOTE 1.

General

For purposes of this report, any reference to “Potlatch,” “the company,” “we,” “us,” and “our” means Potlatch Corporation and all of its wholly owned subsidiaries, except where the context indicates otherwise.

Potlatch is a real estate investment trust, or REIT, for federal income tax purposes. The REIT tax rules require that we derive most of our income, other than income generated by a taxable REIT subsidiary, from investments in real estate, which for us primarily consists of income from the sale of standing timber. Through our wholly owned taxable REIT subsidiary, which we refer to in this report as Potlatch TRS, we operate a real estate sales and development business and five manufacturing facilities that produce lumber and plywood.

The accompanying Consolidated Condensed Balance Sheets at September 30, 2010 and December 31, 2009, the Consolidated Condensed Statements of Operations and Comprehensive Income for the quarters and nine months ended September 30, 2010 and 2009, and the Consolidated Condensed Statements of Cash Flows for the nine months ended September 30, 2010 and 2009 have been prepared in conformity with accounting principles generally accepted in the United States of America. We believe that all adjustments necessary for a fair statement of the results of such interim periods have been included.

In December 2008, we completed the spin-off of Clearwater Paper Corporation, or Clearwater Paper, which owns and operates our former pulp-based manufacturing businesses, consisting of our former pulp and paperboard and consumer products segments, as well as our former wood products operations located in Lewiston, Idaho. In May 2008, our Prescott, Arkansas lumber mill permanently ceased operations due to poor market conditions. We sold our oriented strand board, or OSB, manufacturing facilities to Ainsworth Lumber Co. Ltd., or Ainsworth, in 2004. In 2006, Ainsworth filed a complaint against us, which we settled in April 2009. As a result, any expenses associated with Clearwater Paper, Prescott and the OSB settlement are classified within discontinued operations in the financial statements for the quarters and nine months ended September 30, 2010 and 2009.

The Patient Protection and Affordable Care Act, as amended by the Health Care and Reconciliation Act of 2010, was enacted in March 2010 and included a change in the deductibility of drug expenses reimbursed under the Medicare Part D retiree drug subsidy program beginning after 2012. As a result of this legislation, deferred taxes associated with our retiree health care liabilities based on prior law were required to be adjusted, resulting in a net charge to earnings in the first quarter of 2010 of approximately $3.0 million. In March 2010, we sold our Idaho particleboard manufacturing facility’s buildings and equipment. As a result of the sale, we recorded charges totaling $0.4 million, primarily related to severance benefits. During the quarter ended June 30, 2010, we sold the railroad we operated in Idaho resulting in a pre-tax loss of $1.8 million, which is recorded within cost of goods sold attributable to the Wood Products segment. During the quarter ended June 30, 2009, we recognized an income tax benefit resulting from the Federal tax credit allowed with respect to electricity produced from qualified energy resources and sold to an unrelated party. See Note 3 for additional information about this tax credit. All other adjustments were of a normal recurring nature.

This Quarterly Report on Form 10-Q should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2009, as filed with the Securities and Exchange Commission on February 18, 2010.

NOTE 2.

Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board, or FASB, issued authoritative guidance for fair value measurements, which requires additional disclosures and clarifications to existing disclosures. This authoritative guidance requires a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and also to describe the reasons for these transfers. This authoritative guidance also requires enhanced disclosure of activity in Level 3 fair value measurements. The new disclosures and clarifications of existing disclosures for Level 1 and Level 2 fair value measurements became effective for the first interim reporting period after December 15, 2009, and are therefore included in our 2010 quarterly Form 10-Q filings. Disclosures regarding activity within Level 3 fair value measurements become effective for the first interim reporting period after December 15, 2010. Refer to Note 12 for information and related disclosures regarding our fair value measurements.

In February 2010, the FASB issued Accounting Standards Update, or ASU, 2010-09. The update provides amendments to Accounting Standards Codification Subtopic 855-10 and states that an SEC filer is not required to disclose the date through which subsequent events have been evaluated. However, consistent with current GAAP, entities are required to evaluate subsequent events through the date that the financial statements are issued. This ASU was effective immediately and applied during preparation of the consolidated condensed financial statements.

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NOTE 3.

Income Taxes

As a REIT, if we meet certain requirements, we generally will not be subject to federal and state corporate income taxes on our ordinary and capital gains income from our real estate investments that we distribute to our shareholders. We will, however, be subject to corporate taxes on built-in gains (the excess of fair market value at January 1, 2006 over tax basis on that date) with respect to the REIT’s sale of any real property owned at such date within the first ten years following our conversion to a REIT except for sales occurring in 2011. The Small Business Jobs Act of 2010, enacted on September 27, 2010, modifies the built-in gains provisions to exempt sales of real properties by a REIT in 2011, if five years of the recognition period has elapsed before January 1, 2011. The built-in gains tax is eliminated or deferred if sale proceeds are reinvested in like-kind property in accordance with the like-kind exchange provisions of the Internal Revenue Code. The built-in gains tax is not applicable to the sale of timber pursuant to a stumpage sale agreement or timber deed.

We also sell REIT properties that result in gains that are not deferred in accordance with the like-kind exchange provisions of the Internal Revenue Code. For the quarters ended September 30, 2010 and 2009, we recorded income tax expense of $0.1 and $0.4 million, respectively, related to these sales. For the nine months ended September 30, 2010 and 2009, we recorded income tax expense of $0.4 million and $12.5 million, respectively, related to these sales.

We incur federal and state corporate income taxes on earnings from our real estate sales and development activities and the wood products manufacturing operations conducted by Potlatch TRS. For the quarter ended September 30, 2010, we recorded an income tax provision related to the continuing operations of Potlatch TRS of $1.6 million, which was due to pre-tax income in that entity. For the quarter ended September 30, 2009, we recorded an income tax benefit related to the continuing operations of Potlatch TRS of $5.2 million, which was due to pre-tax losses in that entity. For the nine months ended September 30, 2010, we recorded an income tax provision related to the continuing operations of Potlatch TRS of $5.1 million, which was due to pre-tax income in that entity. For the nine months ended September 30, 2009, we recorded an income tax benefit related to the continuing operations of Potlatch TRS of $17.1 million, which was due to pre-tax losses in that entity.

The Patient Protection and Affordable Care Act, as amended by the Health Care and Reconciliation Act of 2010, was enacted in March 2010 and included a change in the deductibility of drug expenses reimbursed under the Medicare Part D retiree drug subsidy program beginning after 2012. As a result of this legislation, deferred taxes associated with our retiree health care liabilities based on prior law were required to be adjusted, resulting in a net charge to earnings in the first quarter of 2010 of approximately $3.0 million. During the nine months ended September 30, 2010, we recorded income tax benefits related to continuing operations of Potlatch TRS of $0.3 million attributable to the Part D reimbursements received during the period that were non-taxable.

During the nine months ended September 30, 2009, we recognized an income tax benefit of $5.8 million, classified within continuing operations, attributable to the years 2005 through 2008, resulting from the federal tax credit allowed with respect to electricity produced from qualified energy resources and sold to an unrelated party. This tax credit expired at the end of 2009.

During the quarter and nine months ended September 30, 2009, we recognized an income tax benefit of $1.0 million, classified within continuing operations, resulting from adjustments to prior year state income tax returns.

We reviewed our tax positions at September 30, 2010, and determined that no uncertain tax positions were taken during the first nine months of 2010, and that no new information was available that would require derecognition of previously taken positions.

We reflect interest related to tax obligations and overpayments, as well as penalties, in our provision for income taxes. During the quarter and nine months ended September 30, 2010, we reflected less than $0.1 million in interest income net of penalties. During the quarter and nine months ended September 30, 2009, we reflected $0.3 million in interest income net of penalties. At September 30, 2010 and December 31, 2009, we had $1.0 million accrued as a receivable for interest with respect to open refunds.

NOTE 4.

Discontinued Operations

In December 2008, we completed the spin-off of Clearwater Paper, which owns and operates our former pulp-based manufacturing businesses, consisting of our former pulp and paperboard and consumer products segments, as well as our former wood products operations located in Lewiston, Idaho. In May 2008, our Prescott, Arkansas lumber mill permanently ceased operations due to poor market conditions. We are actively pursuing a sale of the assets associated

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with this facility. We sold our oriented strand board, or OSB, manufacturing facilities to Ainsworth Lumber Co. Ltd., or Ainsworth, in 2004. In 2006, Ainsworth filed a complaint against us, which we settled in April 2009. As a result, any expenses associated with Clearwater Paper, Prescott and the OSB settlement are classified within discontinued operations in the financial statements for the quarters and nine months ended September 30, 2010 and 2009.

NOTE 5.

Like-Kind Exchanges

In order to acquire and sell assets, primarily timberlands, in a tax efficient manner, we enter into like-kind exchange, or LKE, tax-deferred transactions. There are two main types of LKE transactions: forward transactions, in which property is sold and the proceeds are reinvested by acquiring similar property; and reverse transactions, in which property is acquired and similar property is subsequently sold by us. Both forward and reverse transactions must be completed within prescribed time periods under Internal Revenue Code section 1031.

We use a qualified intermediary to facilitate LKE transactions. Proceeds from forward transactions are held by the intermediary and are classified as restricted cash, within non-current other assets, because the funds must be reinvested in similar properties. If the acquisition of suitable LKE properties is not completed within 180 days of the sale of the company-owned property, the proceeds are distributed to us by the intermediary and are reclassified as available cash and applicable income taxes are determined. Proceeds from reverse transactions are not restricted because the funds are available upon demand; therefore, these proceeds are included in short-term investments. In the case of reverse transactions in which we have not yet completed LKE sales of company-owned land to match with property purchased on our behalf by the intermediary, the amount associated with the property purchased on our behalf but not yet matched with LKE sales is classified as a long-term asset and included in “Timber and timberlands, net” in our Consolidated Condensed Balance Sheets and as “Deposits on timberlands” in the investing activities section of our Consolidated Condensed Statements of Cash Flows. Amounts deposited with a third party towards the potential future purchase of property that are not matched with LKE sales are also included in “Timber and timberlands, net” in our Consolidated Condensed Balance Sheets and as “Deposits on timberlands” in our Consolidated Condensed Statements of Cash Flows.

At September 30, 2010, we had $0.3 million of proceeds from land sales deposited with a qualified LKE intermediary classified as restricted cash, within non-current other assets on our Consolidated Condensed Balance Sheets. At December 31, 2009, we had no proceeds from land sales deposited with a qualified LKE intermediary. These proceeds, when deposited with the qualified LKE intermediary, are included as non-cash adjustments to net earnings from continuing operations in the Consolidated Condensed Statements of Cash Flows.

NOTE 6.

Earnings per Common Share

The following table reconciles the number of common shares used in calculating basic and diluted earnings per share from continuing operations:

For the quarter ended September 30, 2010, 81,162 performance share awards and 750 restricted stock units were excluded from the computation of diluted earnings per share because their effect was anti-dilutive. For the quarter ended

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September 30, 2009, options to purchase 52,134 shares of common stock were excluded from the computation of diluted earnings per share because their effect was anti-dilutive. Options to purchase 85,391 shares of common stock were also excluded from the computation of diluted earnings per share for the quarter ended September 30, 2009, because the per-share exercise prices of the stock options were greater than the average market price of our common stock during the period.

For the nine months ended September 30, 2010, 81,162 performance share awards and 4,550 restricted stock units were excluded from the computation of diluted earnings per share because their effect was anti-dilutive. For the nine months ended September 30, 2009, options to purchase 105,547 shares of common stock were excluded from the computation of diluted earnings per share because their effect was anti-dilutive. Options to purchase 85,391 shares of common stock were also excluded from the computation of diluted earnings per share for the nine months ended September 30, 2009, because the per-share exercise prices of the stock options were greater than the average market price of our common stock during the period.

NOTE 7.

Equity-Based Compensation

At September 30, 2010, we had three stock incentive plans under which stock option, performance share, or restricted stock unit, or RSU, grants were outstanding. All of these plans have received shareholder approval. We were originally authorized to issue up to 1.7 million shares, 1.4 million shares and 1.6 million shares under our 1995 Stock Incentive Plan, 2000 Stock Incentive Plan and 2005 Stock Incentive Plan, respectively. At September 30, 2010, no shares were available for future use under the 1995 Stock Incentive Plan, while approximately 101,000 and 526,000 shares were authorized for future use under the 2000 and 2005 Stock Incentive Plans, respectively. We issue new shares of common stock to pay stock option exercises and to settle performance share and RSU awards.

During the quarter ended September 30, 2010, we recorded equity-based compensation expense of $0.9 million, of which $0.8 million related to performance shares and $0.1 million related to RSUs. During the quarter ended September 30, 2009, we recorded equity-based compensation expense of $1.0 million, of which $0.8 million related to performance shares and $0.2 million related to RSUs. During the nine months ended September 30, 2010 and 2009, we recorded equity-based compensation expense of $2.8 million, of which $2.4 million related to performance shares and $0.4 million related to RSUs. All outstanding stock options were fully vested prior to January 2006. The net income tax benefit associated with our equity-based compensation expense totaled $0.1 million and $0.5 million for the quarter and nine months ended September 30, 2009, respectively. There was no net income tax benefit associated with our equity-based compensation expense during 2010.

Our outside directors are granted an annual award of common stock units that is credited to an account established on behalf of each director. These accounts are then credited with additional common stock units equal in value to the distributions that are paid on the same amount of common stock. Upon separation from service as a director, the common stock units held by the director in his or her stock unit account will be converted to cash based upon the then market price of the common stock and paid to the director.

Our outside directors also can each elect to defer compensation in the form of common stock units. We record compensation expense or income during each reporting period based on the amount of compensation deferred during the period and the increase or decrease in the value of our common stock. For the quarter ended September 30, 2010 we recorded director deferred compensation income of less than $0.1 million. We recorded director deferred compensation expense of $0.5 million for the quarter ended September 30, 2009. We recorded director deferred compensation expense totaling $0.9 million and $0.5 million for the nine months ended September 30, 2010 and 2009, respectively.

For the nine months ended September 30, 2010 and 2009, there were no cash flows representing the realized tax benefit related to the excess of the deductible amount over the compensation cost recognized as a financing cash inflow in the Consolidated Condensed Statements of Cash Flows.

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STOCK OPTIONS

All outstanding stock options were granted with an exercise price equal to the market price on the date of grant, were fully exercisable after two years and expire not later than 10 years from the date of grant. No new stock options were granted in 2010 or 2009.

A summary of outstanding stock options and changes during the nine months ended September 30, 2010, is presented below:

There were no unvested stock options outstanding during the nine months ended September 30, 2010. The aggregate intrinsic value of stock options exercised during the nine months ended September 30, 2009 was $2.9 million.

The following table summarizes information about stock options outstanding at September 30, 2010:

Cash received from stock option exercises for the nine months ended September 30, 2010 and 2009 was $1.7 million and $0.5 million, respectively. There were no tax benefits realized for tax deductions from option exercises for the quarters and nine months ended September 30, 2010 and 2009.

PERFORMANCE SHARES

Performance share awards granted under the stock incentive plans have a three-year performance period and shares are issued at the end of the period if the performance measure is met. The performance measure is based on the percentile ranking of our total shareholder return relative to the total shareholder return performance of both a selected peer group of companies and a larger group of indexed companies over the three-year performance period. The number of shares actually issued, as a percentage of the amount subject to the performance share award, could range from 0% to 200%. Performance share awards granted under our stock incentive plans do not have voting rights unless and until shares are issued upon settlement. If shares are issued at the end of the three-year performance measurement period, the recipients will receive distribution equivalents in the form of additional shares at the time of payment equal to the distributions that would have been paid on the shares earned had the recipients owned the shares during the three-year period.

A Monte Carlo simulation method is used to estimate the stock prices of Potlatch and the selected peer group and index companies at the end of the three-year performance period. The expected volatility of each company’s stock price and covariance of returns among the peer group and index companies are key assumptions within the Monte Carlo simulation. Historical volatility over a term similar to the performance period is considered a reasonable proxy for forecasted volatility. Likewise, because the returns of Potlatch and the peer group and index companies are correlated, the covariance, a measure of how two variables tend to move together, is calculated over a historical term similar to the performance period and applied in the simulations. The simulations use the stock prices of Potlatch and the peer group and index companies as of the award date as a starting point. Multiple simulations are generated, resulting in share prices and total shareholder return values for Potlatch and the peer group and index companies. For each simulation, the total shareholder return of Potlatch is ranked against that of the peer group and index companies. The future value of the performance share unit is calculated based on a multiplier for the percentile ranking and then discounted to present value. The discount rate is the risk-free rate as of the award date for a term consistent with the performance period. Awards are also credited with dividend equivalents at the end of the performance period, and as a result, award values are not adjusted for dividends.

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The following table presents the key inputs used in calculating the fair value of the performance share awards in 2010 and 2009, and the resulting fair values:

A summary of outstanding performance share awards as of September 30, 2010, and changes during the nine months ended September 30, 2010 is presented below:

As of September 30, 2010, there was $4.4 million of unrecognized compensation cost related to non-vested performance share awards, which is expected to be recognized over a weighted average period of 1.4 years.

RESTRICTED STOCK UNITS

Our 2005 Stock Incentive Plan also allows for awards to be issued in the form of RSUs. During 2010 and 2009, certain officers and other select employees of the company were granted RSU awards that will accrue dividend equivalents based on distributions paid during the RSU vesting period. The dividend equivalents will be converted into additional RSUs that will vest in the same manner as the underlying RSUs to which they relate. The terms of the awards generally state that 20% of the RSUs will vest on each of the first and second anniversaries of the awards, with the remaining 60% vesting on the third anniversary.

A summary of the status of outstanding RSU awards as of September 30, 2010, and changes during the nine months ended September 30, 2010, is presented below:

For RSU awards granted during the period, the fair value of each share was determined on the date of grant using the grant date market price. The total fair value of RSU awards vested during the nine months ended September 30, 2010 was $0.3 million.

As of September 30, 2010, there was $0.7 million of total unrecognized compensation cost related to non-vested RSU awards, which is expected to be recognized over a weighted average period of 1.37 years.

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NOTE 8.

Inventories

Inventories at the balance sheet dates consist of:

NOTE 9.

Other Assets

Other assets at the balance sheet dates consist of:

The basis of real estate held for sale as of September 30, 2010 is primarily comprised of timberland in Wisconsin and Arkansas that was sold in October 2010.

Noncurrent investments primarily consist of company-owned life insurance stated at cash surrender value. Deferred charges primarily consist of deferred financing costs, which are being amortized over the life of the associated debt.

NOTE 10.

Pension Plans and Other Postretirement Employee Benefits

The following table details the components of net periodic cost (benefit) of our pension plans and other postretirement employee benefits, or OPEB, for the quarters and nine months ended September 30, 2010 and 2009:

Quarters ended September 30:

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Nine months ended September 30:

As reported in our 2009 Annual Report on Form 10-K, our company-sponsored pension plans were underfunded at December 31, 2009. We are not required to make contributions during 2010 as a result of carry-forward credits that we earned from discretionary contributions made in prior periods. We estimate cash payments will total approximately $1.7 million in 2010 to our non-qualified supplemental pension plan. As of September 30, 2010, $1.3 million of contributions had been made. Payments to be made in 2010 for OPEB obligations represent benefit costs incurred during the year by eligible participants.

NOTE 11.

Comprehensive Income

The components of comprehensive income for the quarters and nine months ended September 30, 2010 and 2009 were as follows:

Of the $0.7 million reported as other comprehensive income, net of tax, for the quarter ended September 30, 2010, $1.3 million and $(0.6) million related to our defined benefit pension plans and OPEB obligations, respectively. Of the $1.8 million reported as other comprehensive income, net of tax, for the quarter ended September 30, 2009, $0.5 million and $1.3 million related to our defined benefit pension plans and OPEB obligations, respectively.

Of the $7.7 million reported as other comprehensive income, net of tax, for the nine months ended September 30, 2010, $4.1 million and $3.6 million related to our defined benefit pension plans and OPEB obligations, respectively. Of the $3.8 million reported as other comprehensive income, net of tax, for the nine months ended September 30, 2009, $2.2 million and $1.6 million related to our defined benefit pension plans and OPEB obligations, respectively.

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NOTE 12.

Financial Instruments

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

We record all derivatives on our balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether we have elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk in a fair value hedge.

We formally document all relationships between hedging instruments and hedged items, as well as the risk-management objective and strategy for undertaking various hedge transactions.

On June 30, 2010, we entered into nine separate interest rate swap agreements with notional amounts totaling $68.25 million, each effective July 1, 2010, associated with our $22.5 million debentures and $45.75 million of our medium-term notes. The swaps converted interest payments with fixed rates ranging between 6.95% and 8.89% to a three-month LIBOR plus a spread between 4.738% and 7.8375%. The interest rate swaps terminate at various dates ranging from January 2011 to February 2018. Our risk management objective and strategy is to protect against the risk of adverse changes in fair value attributable to changes in the 3-month LIBOR swap rate, the designated benchmark interest rate being hedged, on $68.25 million of fixed-rate debt. All of the interest rate swaps qualify for and have been designated as fair value hedges under the “short-cut method” of FASB Accounting Standard Codification, or ASC, 815, Derivatives and Hedging. As such, the net changes in fair value of the derivatives and the net changes in fair value of the hedged items are each recorded within interest expense. As of September 30, 2010, we have a derivative asset within non-current other assets of $1.5 million and a $1.5 million cumulative increase to the carrying amount of our debt on our Consolidated Condensed Balance Sheets. For the quarter and nine months ended September 30, 2010, we recognized a total of $1.7 million and $1.5 million, respectively, of net changes in fair value of the derivatives and hedged items.

FAIR VALUE OF FINANCIAL INSTRUMENTS

Estimated fair values of our financial instruments are as follows:

A framework has been established for measuring fair value, which provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below.

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If the asset or liability has a specified (contractual) term, the Level 2 input must be observed for substantially the full term of the asset or liability.

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

For short-term investments, the carrying amount approximates fair value due to the short-term nature of the investments. The fair value of our long-term debt is estimated based upon the quoted market prices for the same or similar debt issues. For long-term debt for which there is no quoted market price, fair value is estimated based on average market prices for comparable liquid bonds. For both our derivative asset and associated adjustment to the hedged debt, the fair value is estimated based on the theoretical cost to cash settle the transactions on September 30, 2010, partially offset by the consideration of credit risk, or credit standing, of the counterparties to the transactions and the effect of any credit enhancements related to the transactions.

Significant transfers into and out of Level 1 occur on a routine basis based on our liquidity resources and requirements. Normal fluctuations occur due to items such as cash inflows from accounts receivable collections and cash outflows for items such as payrolls, accounts payable payments and quarterly dividend distributions. During the nine months ended September 30, 2010, the Level 1 balance also increased due to proceeds received from the Wisconsin and Arkansas land sale and improved operating results. Level 2 financial instruments consist of long-term debt, the derivative asset and associated adjustment to the hedged debt. As compared to December, 31, 2009, no significant transfers have occurred.

NOTE 13.

Commitments and Contingencies

In January 2007, the U.S. Environmental Protection Agency, or EPA, notified us that we are a potentially responsible party under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 and the Clean Water Act for clean-up of a site known as Avery Landing in northern Idaho. We own a portion of the land at the Avery Landing site, which we acquired in 1980 from the Milwaukee Railroad. The land we own at the site and adjacent properties were contaminated with petroleum as a result of the Milwaukee Railroad’s operations at the site and adjacent properties prior to 1980. We entered into a consent order with the EPA in August 2008 to conduct an Engineering Evaluation/Cost Analysis, or EE/CA, study to determine the best means of addressing the contamination at the site. In January 2010, we submitted our draft EE/CA report to the EPA outlining various alternatives for addressing the contamination at the entire site (including adjacent properties). The range of cost estimates for the various alternatives to address the contamination at the entire site is from $0.7 million to $8.2 million. In April 2010, we were notified by the EPA that they determined the EE/CA report submitted by us contained deficiencies. Accordingly, the EPA will now be completing the EE/CA report for the Avery Landing site and also producing the Biological Assessment and Cultural Resources Evaluation reports. We anticipate the EPA will issue the reports in late 2010. Currently we are under no legal obligation to implement any remedy selected by the EPA. We believe we have valid defenses available to limit our potential liability at the site. There is also the possibility of pursuing recovery from third parties as a means of further limiting our liability. As of September 30, 2010, we have accrued $0.7 million for this matter.

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NOTE 14.

Segment Information

NOTE 15.

Guarantor Subsidiaries

On November 3, 2009, Potlatch sold $150 million aggregate principal amount of 7.5% senior notes due on November 1, 2019. The notes are unconditionally guaranteed by certain of Potlatch’s subsidiaries. We filed a registration statement with the SEC, which was effective May 7, 2010, pursuant to which we offered to exchange the senior notes and related subsidiary guarantees for notes and subsidiary guarantees with substantially similar terms that are registered under the Securities Act. All of the original notes were tendered for the registered notes in June 2010.

In accordance with SEC rules, the registration of the notes does not result in a requirement to file periodically separate financial information with respect to an issuer, its guarantor subsidiaries and its non-guarantor subsidiaries where the parent entity has “no independent assets or operations,” the guarantees are full and unconditional and joint and several, and the non-guarantor subsidiaries are “minor,” all as defined by applicable SEC rules.

Separate financial information about Potlatch, Potlatch’s guarantor subsidiaries and its non-guarantor subsidiaries is not presented because Potlatch holds all of its assets and conducts all of its operations through its subsidiaries and has no independent assets or operations. Potlatch’s subsidiaries, other than the subsidiary guarantors, are minor in significance. The guarantees of our subsidiary guarantors are full and unconditional and joint and several. Except with respect to REIT tax rules, there are no significant restrictions on the ability of Potlatch or any of the subsidiary guarantors to obtain funds from any of our subsidiaries by dividend or loan. The tax rules with which we must comply to maintain our status as a REIT limit our ability to use dividends from Potlatch TRS to service our indebtedness. In particular, at least 75% of our gross income for each taxable year as a REIT must be derived from sales of our standing timber and other types of real estate income. No more than 25% of our gross income may consist of dividends from Potlatch TRS and other non-qualifying types of income. This requirement may limit our ability to receive dividends from Potlatch TRS and may impact our ability to service our indebtedness using cash flows from Potlatch TRS.

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ITEM 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

This report contains, in addition to historical information, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including without limitation, statements regarding future revenues, cash flows, the funding of our operations and debt service, the nature of our REIT income, dividend distributions, compliance with REIT tax rules, timber harvest levels, log prices, lumber prices, costs, manufacturing output, capital expenditures, the funding of our pension plans, tax refunds, FSC certification of our timberlands, future land sales and acquisitions, realization of deferred tax assets, and like-kind exchanges and tax consequences. Words such as “anticipate,” “expect,” “will,” “intend,” “plan,” “target,” “project,” “believe,” “seek,” “schedule,” “estimate,” “could,” “can,” “may,” and similar expressions are intended to identify such forward-looking statements. These forward-looking statements reflect our current views regarding future events based on estimates and assumptions, and are therefore subject to known and unknown risks and uncertainties and are not guarantees of future performance. Our actual results of operations could differ materially from those expressed or implied by forward-looking statements contained in this report. Important factors that could cause or contribute to such differences include those factors discussed in Item 1A of our Annual Report on Form 10-K, as well as the following:

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

OVERVIEW

We are a real estate investment trust, or REIT, with approximately 1.5 million acres of timberlands in Arkansas, Idaho, Minnesota and Wisconsin. Through wholly owned taxable subsidiaries, which we refer to in this report as Potlatch TRS, we operate a real estate sales and development business and five manufacturing facilities that produce lumber and plywood.

As of September 30, 2010, our business was organized into three segments:

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In August 2010, we sold approximately 29,800 acres of timberland in Wisconsin and 11,900 acres in Arkansas to RMK Timberland Group, or RMK, a timber investment management organization, for $28.7 million. In October 2010, we sold an additional 29,000 acres in Wisconsin and another 17,400 acres in Arkansas to RMK for approximately $36 million. The total Wisconsin sale includes all but approximately 1,200 acres of our land in Wisconsin, and those remaining Wisconsin properties are currently under contract to sell, or are expected to be sold within the next two to three years.

FACTORS INFLUENCING OUR RESULTS OF OPERATIONS AND CASH FLOWS

The operating results of our Resource, Real Estate and Wood Products business segments have been and will continue to be influenced by a variety of factors, including the cyclical nature of the forest products industry, changes in timber prices and in harvest levels from our timberlands, competition, timberland valuations, demand for our non-core timberland for higher and better use purposes, the efficiency and level of capacity utilization of our wood products manufacturing operations, changes in our principal expenses, such as log costs, asset dispositions or acquisitions, and other factors.

Fluctuating Timber Prices. Our results of operations and cash flows are materially affected by the fluctuating nature of timber prices. A variety of factors affect prices for timber, including factors affecting demand, such as changes in economic conditions, construction activity levels, interest rates, credit availability, population growth and weather conditions, as well as changes in timber supply and other factors. All of these factors can vary by region and by timber type, such as sawlogs or pulpwood logs. In the first nine months of 2010, average sawlog prices were approximately 14% and 5% higher in our Northern and Southern regions, respectively, compared to the same period in 2009. In the first nine months of 2010, average pulpwood prices were approximately 5% lower in our Northern region and 13% higher in our Southern region compared to the same period in 2009.

Timber prices are also affected by changes in timber availability at the local and national level. Our timberland ownership is currently concentrated in Arkansas, Idaho and Minnesota. In Arkansas and Minnesota, most timberlands are privately owned. Historically, increases in timber prices have often resulted in substantial increases in harvesting on private timberlands, including lands not previously made available for commercial timber operations, causing a short-term increase in supply that has tended to moderate price increases. Decreases in timber prices have often resulted in less harvesting activity, causing short-term decreases in supply that have tended to moderate price decreases. In Idaho, where a greater proportion of timberland is government owned, any substantial increase in timber harvesting from government-owned lands could significantly reduce timber prices, which would harm our results of operations. For more than twenty-five years, environmental concerns and other factors have limited timber sales by federal agencies, which historically had been major suppliers of timber to the United States forest products industry, particularly in the West. Any reversal of policy that substantially increases timber sales from government lands could have a material adverse effect on our results of operations and cash flows. On a local level, timber supplies can fluctuate depending upon factors such as changes in weather conditions and in the harvest strategies of local forest products industry participants, as well as occasionally high timber salvage efforts due to events such as storm damage, unusual pest infestations or fires.

Harvest Levels. Changes in harvest levels on our timberlands also may have a significant impact on our results of operations. Over the long term, we manage our timberlands on a sustainable yield basis to achieve a balance between timber growth and timber harvests. From time to time, however, we may choose, consistent with our environmental

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commitments, to harvest timber at levels above or below our estimate of sustainability for various reasons. In 2009, the overall harvest from our timberlands was 3.8 million tons. Based on our current projections that take into consideration such factors as market conditions, the ages of our timber stands and recent timberland acquisitions and sales, we expect the overall timber harvest from our lands in 2010 to be approximately 4.1 to 4.2 million tons, increasing to approximately 4.7 million tons annually over the next five to ten years, subject to adjustment depending upon market conditions. The sales of our Wisconsin acreage and the two tracts of timberlands in Arkansas reduced our annual expected harvest level from 5.1 million tons over the next five to ten years to the current projection of approximately 4.7 million tons. Our future timber harvest levels will continue to be affected by acquisitions of additional timberlands and sales of existing timberlands.

On a short-term basis, we may adjust our timber harvest levels in response to market conditions. For example, due to stronger sawlog prices, during the first nine months of 2010 our sawlog harvest volumes increased 33% in our Northern region and 18% in our Southern region over the same period in 2009. Decreased demand resulted in a 23% and 7% decrease in pulpwood harvested in the Northern and Southern regions, respectively, compared to the 2009 period. We also experience seasonally lower harvest activity during the winter and spring due to weather conditions. In addition, future timber harvest levels may be affected by changes in estimates of long-term sustainable yield because of genetic improvements and other silvicultural advances, natural disasters, fires and other hazards, regulatory constraints and other factors beyond our control.

Demand for and Timing of Real Estate Sales. A number of factors, including availability of credit, a slowing of real estate development, changes in population growth patterns and changes in demographics could reduce the demand for our timberland as a real estate asset. In addition, changes in the interpretation or enforcement of current laws, or the enactment of new laws, regarding the use and development of real estate or changes in the political composition of governmental bodies could lead to new or greater costs, delays and liabilities that could materially adversely affect our real estate business. The timing of real estate sales is a function of many factors, including the general state of the economy, demand in local real estate markets, the number of properties listed for sale, the seasonal nature of sales, the plans of adjacent landowners, and our expectations of future price appreciation. For example, our Real Estate segment revenues were $26.6 million higher in the third quarter of 2010 compared to the same period in 2009, primarily due to the non-strategic land sale of approximately 41,700 acres in Wisconsin and Arkansas for $28.7 million in August 2010. There was no comparable large real estate sale in the third quarter of 2009. In contrast, Real Estate segment revenues were $12.2 million higher in the first nine months of 2009 compared to the same period in 2010, primarily due to a large non-strategic land sale of approximately 24,500 acres in Arkansas for $43.3 million in January 2009. Delays in the completion of transactions or the termination of potential transactions may be beyond our control. These events could adversely affect our operating results.

Cyclical Wood Products Markets. The operating results of our wood products manufacturing operations are cyclical. Historical prices for our wood products have been volatile, and we, like other manufacturers in the forest products industry, have limited direct influence over the timing and extent of price changes for our products. The demand for our wood products is affected by the level of new residential construction activity and, to a lesser extent, home repair and remodeling activity, which are subject to fluctuations due to changes in economic conditions, interest rates, population growth, weather conditions and other factors.

The profitability of our Wood Products segment depends largely on our ability to operate our facilities efficiently and at or near full capacity. Our operating results can be adversely affected if market demand does not justify operating at these levels or if our operations are inefficient or suffer significant interruption for any reason.

The forest products industry in general and the wood products business in particular have been adversely affected since 2008 by the national decline in home building and the resulting weak demand and lower prices for wood products. In December 2009, we recorded a pre-tax asset impairment charge of $3.0 million related to our Idaho particleboard manufacturing assets. The fair value of the impaired assets was estimated based on expected future cash flows. In March 2010, we sold the particleboard manufacturing facility’s buildings and equipment, but not the underlying land. We entered into a lease agreement with the purchaser pursuant to which we will receive nominal lease revenues on the property for the next ten years. As a result of the sale, we recorded additional charges totaling $0.4 million, primarily related to severance benefits. These costs are reflected in the operating results of the Wood Products segment. Improving prices and demand for manufactured wood products in the first nine months of 2010 resulted in other mills in our operating regions restarting their operations, and as a result, supply has increased and demand and prices have fluctuated. Lumber prices increased 18% in the first nine months of 2010 compared to the same period in 2009, but prices decreased 2% in the third quarter of 2010 compared to the same quarter in 2009. We expect to see a gradual improvement in prices through the remainder of 2010.

One of the most significant expenses of our Wood Products segment is the cost of sawlogs and wood fiber needed to supply our manufacturing facilities. The cost of logs that supply our lumber mills has at times fluctuated greatly as a result of the factors discussed above affecting the price of our timber. Selling prices of our wood products have not always increased in response to log price increases, nor have log prices always decreased in conjunction with declining wood products prices. On occasion, the results of operations of our wood products business have been, and may in the future be, adversely affected if we are unable to pass cost increases through to our customers.

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