MERCER INTERNATIONAL INC - MERCS Quarterly Report (10-Q) ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ...

The following is an excerpt from a 10-Q SEC Filing, filed by MERCER INTERNATIONAL INC on 11/9/2004.

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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, "we", "our", "us", the "Company" or "Mercer" mean Mercer International Inc. and its subsidiaries; (ii) information is provided as of September 30, 2004, unless otherwise stated; (iii) all references to monetary amounts are to "Euros", the lawful currency adopted by most members of the European Union, unless otherwise stated; (iv) "" refers to Euros; and (v) a "tonne" is one metric ton or 2,204.6 pounds.

The following discussion and analysis of our results of operations and financial condition for the nine and three months ended September 30, 2004 should be read in conjunction with our consolidated financial statements and related notes included in this quarterly report, as well as our most recent annual report on Form 10-K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission (the "SEC"). Certain reclassifications have been made to the prior period financial statements to conform with the current period presentation.

Results of Operations

We operate in the pulp and paper business and our operations are located primarily in Germany. Our manufacturing facilities are comprised of: (a) a northern bleached softwood kraft ("NBSK") pulp mill operated by our wholly-owned subsidiary, Zellstoff-und Papierfabrik Rosenthal GmbH & Co., KG ("Rosenthal"), near Blankenstein, Germany, which has an annual production capacity of approximately 310,000 tonnes; (b) a newly constructed, state-of-the-art NBSK pulp mill, with a design production capacity of approximately 552,000 tonnes, near Stendal, Germany (the "Stendal project") built and being started up by our 63.6% owned subsidiary, Zellstoff Stendal GmbH ("Stendal"); and (c) two paper mills located at Heidenau and Fhrbrcke, Germany (the "paper mills"), which produce specialty papers and printing and writing papers and, based upon their current product mix, have an aggregate annual production capacity of approximately 70,000 tonnes.

The Stendal mill was completed substantially on its planned schedule and budget in the third quarter of 2004. Total investment costs in respect of the Stendal mill were approximately 1.0 billion, the majority of which was financed under a senior project finance facility (the "Stendal Loan Facility") in the amount of 828 million and arranged with Bayerische Hypo-und Vereinsbank AG. The Stendal mill is currently in the start-up phase and is undergoing extensive testing and evaluation. Effective September 18, 2004, we commenced expensing all of the costs, including interest, related to the Stendal mill. Prior to that date, most of the costs, including interest, relating to the Stendal mill were capitalized. Our results for the nine and three months ended September 30, 2004 include operating and interest costs of 9.8 million and 4.2 million, respectively, related to the Stendal mill. During such periods, we did not report any pulp sales revenues from Stendal. Some lower quality pulp produced at the Stendal mill prior to September 18, 2004 was sold, but the revenues therefrom were capitalized against testing costs in property, plant and equipment. See " - Stendal Project Status".

Our financial performance depends on a number of variables that impact sales and production costs. Sales and production results are influenced largely by the market price for products and raw materials, the mix of products produced and foreign currency exchange rates. Kraft pulp and paper markets are highly cyclical, with prices determined by supply and demand. Demand for kraft pulp and paper is influenced to a significant degree by global levels of economic activity and supply is driven by industry capacity and utilization rates. Our product mix is important because premium grades of kraft pulp and specialty papers generally achieve higher prices and profit margins.

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 pulplogs for pulp production, and waste paper and pulp for paper production. Fiber costs are primarily affected by the supply of, and demand for, lumber and pulp, which are both highly cyclical. Production costs also depend on the total volume of production. High operating rates and production efficiencies permit us to lower our average cost by spreading fixed costs over more units.

Global economic conditions, changes in production capacity and inventory levels are the primary factors affecting kraft pulp and paper prices. Historically kraft pulp and paper prices have been cyclical in nature. Kraft pulp prices declined from a high of approximately $710 per tonne in late 2000 to an average of approximately $460 per tonne in late 2001 and most of 2002 as the decline of North American and European economies caused a sharp reduction in paper demand and a build-up of producer inventories. The weakening of the U.S. dollar against the Euro and other major currencies and an increase in demand resulting from improving American and major European economies in 2003 resulted in list prices for kraft pulp in Europe increasing to approximately $560 per tonne in December 2003 despite relatively high inventory levels. List prices for kraft pulp in Europe continued to strengthen in 2004 due to the relatively weak U.S. dollar and improving world economies. List prices increased to approximately $640 per tonne in August 2004, before decreasing to approximately $605 per tonne in September 2004, primarily as a result of a build-up of producer inventories. There can be no assurance that prices will not continue to fall in ensuing months.

Our financial performance for any reporting period is also impacted by changes in the U.S. dollar to Euro exchange rate and in interest rates. Changes in currency rates affect our operating results because the price for our principal product, NBSK pulp, is generally based on a global industry benchmark that is priced in U.S. dollars, even though our sales are invoiced in Euros. Therefore, a weakening of the U.S. dollar against the Euro will generally reduce the amount of Euro revenues of our pulp operations. Most of our costs, including our debt obligations, are incurred in Euros. These do not fluctuate with the U.S. dollar to Euro exchange rate. Thus, a weakening of the U.S. dollar against the Euro tends to reduce our sales revenue, gross profit and income from operations.

Changes in interest rates can impact our operating results because the indebtedness we incurred under the credit facilities for establishing the Rosenthal and Stendal pulp mills provide for floating rates of interest.

Changes in currency exchange and interest rates also impact certain foreign currency and interest rate derivatives Rosenthal and Stendal use to partially protect against the effect of such changes. Gains or losses on such derivatives are included in our earnings, either as they are settled or as they are marked to market for each reporting period. See "Quantitative and Qualitative Disclosures about Market Risk".

Stendal, as required under its project financing, entered into variable-to-fixed rate interest swaps (the "Stendal Interest Rate Swaps") in August 2002 to fix the interest rate on approximately 612.6 million of indebtedness for the full term of the Stendal Loan Facility. Rosenthal has also entered into forward interest rate and interest cap contracts (the "Rosenthal Interest Rate Contracts" and, together with the Stendal Interest Rate Swaps, the "Interest Rate Contracts") in respect of a portion of its long-term indebtedness under its bank loan facility (the "Rosenthal Loan Facility").

In the nine months ended September 30, 2004, we recorded a net non-cash holding loss of 15.8 million before minority interests on the marked to market valuation of the Interest Rate Contracts versus a net loss of 22.8 million before minority interests thereon in the prior period of 2003. In the quarter ended September 30, 2004, we recorded a net non-cash holding loss of 14.1 million before minority interests on the marked to market valuation of the Interest Rate Contracts versus a net gain of 5.9 million before minority interests thereon in the prior period of 2003.

In March 2004, to protect against a weakening U.S. dollar, Rosenthal entered into two currency swaps in the aggregate principal amount of 184.5 million to convert all of its long-term indebtedness under the Rosenthal Loan Facility into U.S. dollars and a currency forward in the notional amount of 40.7 million (the "Rosenthal Currency Derivatives"). In the same month, Stendal entered into a currency swap in the principal amount of 306.3 million to convert approximately one-half of its indebtedness under the Stendal Loan Facility into U.S. dollars and a currency forward in the notional amount of 20.6 million (the "Stendal Currency Derivatives" and, together with the Rosenthal Currency Derivatives, the "Currency Derivatives"). Primarily as a result of a weakening of the U.S. dollar versus the Euro and changes in interest rates related to such currencies, in the nine and three months ended September 30, 2004, we recognized a net non-cash holding gain of approximately 14.7 million and 6.0 million, respectively, before minority interests on the Currency Derivatives. In the nine and three months ended September 30, 2003, we recognized a net gain of approximately 19.2 million and 3.8 million, respectively, before minority interests on the then outstanding currency derivatives of Rosenthal and Stendal. See "Quantitative and Qualitative Disclosures about Market Risk".

If the U.S. dollar continues to weaken versus the Euro, we could record further marked to market non-cash holding gains on the Currency Derivatives in future periods, although our pulp sales realizations would decrease. A strengthening of the U.S. dollar versus the Euro could result in our recording marked to market non-cash holding losses on the Currency Derivatives in future periods, although we would expect to achieve higher pulp sales realizations. Improving world economies resulted in an increase in interest rates in the first half of 2004. If world economies continue to strengthen, we would expect interest rates to continue to rise from their historically low levels. Higher interest rates could result in our recording marked to market non-cash holding gains on the Interest Rate Contracts in future periods, which may be offset in part by higher interest rates payable on Rosenthal's debt obligations. However, a fall in interest rates could result in our recording non-cash holding losses on the Interest Rate Contracts in future periods when they are marked to market. See "Quantitative and Qualitative Disclosures about Market Risk".

Nine Months Ended September 30, 2004 Compared to Nine Months Ended September 30, 2003

Selected sales data for the nine months ended September 30, 2004 and 2003 is as follows:

Nine Months Ended September 30,
2004 2003

(tonnes)
Sales Volume by Product Class
Pulp(1) 229,462 221,926 Papers
Specialty papers 28,144 30,420 Printing papers 19,357 16,568 Total papers 47,501 46,988 Total(1) 276,963 268,914
(in thousands Revenues by Product Class
Pulp(1) 103,743 92,418 Papers
Specialty papers 28,039 30,185 Printing papers 13,302 12,332 Total papers 41,341 42,517 Total(1) 145,084 134,935

º (1)
º Excluding intercompany sales volumes of 3,897 tonnes and 5,166 tonnes of pulp and intercompany net sales revenues of approximately 1.8 million and 2.2 million in the nine months ended September 30, 2004 and 2003, respectively.

Total revenues for the nine months ended September 30, 2004 increased to 153.9 million from 144.1 million in the comparative period of 2003, primarily because of higher pulp sales. Pulp and paper revenues were 145.1 million in the current period, versus 134.9 million in the comparative period of 2003.

Costs of pulp and paper sales in the nine months ended September 30, 2004 decreased to 131.4 million from 131.8 million in the comparative period of 2003, primarily as a result of lower pulp production costs at our Rosenthal mill.

In the current period, pulp sales increased to 103.7 million from 92.4 million in the same period a year ago as a result of higher prices and production from our Rosenthal mill. We did not report any revenues from the sale of pulp from the Stendal mill in the current period. List prices for NBSK pulp in Europe were approximately 519 ($635) per tonne in the third quarter of 2004, compared to approximately 444 ($550) per tonne in the third quarter of last year. The increase in NBSK pulp prices was partially offset by the weakness of the U.S. dollar versus the Euro in the current period. In the current period, pulp sales by volume were 229,462 tonnes, compared to 221,926 tonnes in the comparative period of 2003.

Pulp sales realizations were 452 per tonne on average in the current period, compared to 416 per tonne in the comparative period of 2003.

Transportation and other revenues for the pulp operations were 8.9 million in the period ended September 30, 2004, compared to 8.2 million in the comparative period of last year.

Cost of sales and general, administrative and other expenses for the pulp operations increased to 108.8 million in the nine months ended September 30, 2004 from 104.6 million in the comparative period of 2003, primarily as a result of the inclusion of 7.9 million of operating costs related to the Stendal mill.

On average, fiber costs for pulp production decreased by approximately 4.3% compared to the first nine months of last year.

Depreciation for the pulp operations was 15.0 million in the current period, versus 16.3 million in the year ago period. A change effective July 1, 2004 in our depreciation estimate in respect of our Rosenthal mill resulted in a decrease of 2.2 million in cost of sales and net loss, and a decrease in net loss per share of 0.13 for the nine months ended September 30, 2004.

For the nine months of 2004, our pulp operations generated operating income of 5.7 million, versus an operating loss of 1.8 million in the year ago period.

Paper sales in the current period were 41.3 million, compared with 42.5 million in the same period of last year. Sales of specialty papers in the nine months ended September 30, 2004 were 28.0 million versus 30.2 million in the comparative period of 2003, primarily as a result of a shift in the product
mix. For the current period, total paper sales volumes were 47,501 tonnes, versus 46,988 tonnes in the nine months ended September 30, 2003. On average, prices for specialty papers realized in the current period increased slightly, reflecting a shift in the product mix. Average prices for our printing papers decreased by approximately 7.7% reflecting generally weak demand.

Cost of sales and general, administrative and other expenses for the paper operations in the nine months ended September 30, 2004 increased to 52.2 million from 41.7 million in the comparative period of 2003, primarily as a result of a non-cash 6.0 impairment charge relating to our paper operations. On November 3, 2004, our management determined to record and our audit committee approved a non-cash impairment charge of 6.0 million to write-off the carrying value of our Fhrbrcke paper mill assets. Based upon its current product mix, the mill has an annual production capacity of approximately 35,000 tonnes and produces primarily printing and writing paper. We determined to take the impairment charge as the Fhrbrcke mill has generated weaker than expected returns over a period of time despite changes to its product mix. We do not expect the impairment charge in and of itself to result in future cash expenditures as we intend to continue to operate the Fhrbrcke mill.

Depreciation for the paper operations was 1.7 million in the current period, compared to 1.5 million in the same period last year.

For the nine months ended September 30, 2004, our paper operations generated an operating loss of 10.6 million, which included the non-cash impairment charge of 6.0 million, compared to operating income of 1.6 million in the same period of last year.

For the nine months ended September 30, 2004, consolidated general and administrative expenses increased to 21.2 million from 13.0 million in the year ago period, primarily as a result of the inclusion of operating costs of 7.9 million related to the Stendal mill.

In the current period, we reported a loss from operations of 7.6 million, compared to 2.5 million in the same period last year. Interest expense (excluding capitalized interest of 27.2 million relating to the Stendal pulp
mill) in the period ended September 30, 2004 increased to 9.6 million from 6.9 million a year ago, due to higher borrowings resulting primarily from our convertible note issue in October 2003 and the inclusion of interest expense of 1.9 million relating to the Stendal project after September 18, 2004.

In the period ended September 30, 2004, we recorded a net non-cash holding loss of 15.8 million before minority interests on the marked to market valuation of the Interest Rate Contracts versus a net loss of 22.8 million before minority interests thereon in the prior period of 2003. In addition, in the nine months ended September 30, 2004, we recorded a net non-cash holding gain of approximately 14.7 million before minority interests on the valuation of the Currency Derivatives as a result of the weakening of the U.S. dollar versus the Euro and changes in interest rates related to such currencies. In the prior period of 2003, we recorded a net gain of 19.2 million before minority interests on the then outstanding currency derivatives of Rosenthal and Stendal.

In the nine months ended September 30, 2004, minority interest, representing the two minority shareholders' proportionate interest in the Stendal project, was 3.9 million, compared to 8.5 million in the comparative period of 2003.

Our results for the prior period of 2003 included an adjustment of 5.5 million for the non-cash impact of other-than-temporary impairment losses on our available-for-sale securities.

We reported a net loss for the nine months ended September 30, 2004 of 12.6 million, or 0.73 per basic and diluted share, which reflected the non-cash 6.0 million impairment charge related to our paper operations, the inclusion of 9.8 million of operating and interest costs related to our Stendal mill and the net non-cash holding loss on the marked to market valuation of our derivative instruments. In the comparative period of 2003, we reported a net loss of 9.2 million, or 0.54 per basic and diluted share.

We generated "Operating EBITDA" of 15.6 million in the nine months ended September 30, 2004 and 2003, respectively. Operating EBITDA is defined as income
(loss) from operations plus depreciation and amortization and non-recurring capital asset impairment charges. Operating EBITDA is calculated by adding depreciation and amortization and non-recurring capital asset impairment charges of 23.2 million and 18.1 million to the loss from operations of 7.6 million and 2.5 million for the nine-month periods ended September 30, 2004 and 2003, respectively.

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

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

Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are: (i) Operating EBITDA does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments; (ii) Operating EBITDA does not reflect changes in, or cash requirements for, working capital needs; and
(iii) Operating EBITDA does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our outstanding debt. Because of these limitations, operating EBITDA should not be considered as a measure of liquidity or cash available to us to invest in the growth of our business. See the Statement of Cash Flows set out in our consolidated financial statements included herein. Because all companies do not calculate Operating EBITDA in the same manner, Operating EBITDA as calculated by us may differ from Operating EBITDA as calculated by other companies.

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

Nine Months Ended September 30,
2004 2003

(in thousands)
Net loss (12,604 ) (9,173 ) Minority interest (3,936 ) (8,499 ) Income taxes (37 ) 226 Interest expense 9,554 6,887 Investment income (1,679 ) (1,055 ) Derivative financial instruments 1,077 3,604 Impairment of investments - 5,511 Other - (20 ) Loss from operations (7,625 ) (2,519 ) Add: Depreciation and amortization 17,217 18,135 Impairment charge 6,000 - Operating EBITDA 15,592 15,616

Three Months Ended September 30, 2004 Compared to Three Months Ended September 30, 2003

Selected sales data for the three months ended September 30, 2004 and 2003 is as follows:

Three Months Ended September 30,
2004 2003

(tonnes)
Sales Volume by Product Class
Pulp(1) 73,128 73,747 Papers
Specialty papers 8,519 8,745 Printing papers 6,193 7,234 Total papers 14,712 15,979 Total(1) 87,840 89,726

(in thousands)
Revenues by Product Class
Pulp(1) 34,517 30,004 Papers
Specialty papers 8,597 8,610 Printing papers 4,202 5,047 Total papers 12,799 13,657 Total(1) 47,316 43,661

º (1)
º Excluding intercompany sales volumes of 1,348 tonnes and 1,555 tonnes of pulp and intercompany net sales revenues of approximately 0.6 million and 0.7 million in the three months ended September 30, 2004 and 2003, respectively.

Total revenues for the three months ended September 30, 2004 increased to 49.1 million from 45.8 million in the comparative period of 2003, primarily because of higher pulp sales. Pulp and paper revenues were 47.3 million in the third quarter of 2004, versus 43.7 million in the comparative period of 2003.

Costs of pulp and paper sales in the three months ended September 30, 2004 decreased to 39.8 million from 45.4 million in the comparative period of 2003, primarily as a result of lower pulp production costs at our Rosenthal mill.

For the three months ended September 30, 2004, pulp sales increased to 34.5 million from 30.0 million in the same period a year ago, primarily as a result of higher prices. We did not report any revenues from the sale of pulp from the Stendal mill in the current period. List prices for NBSK pulp in Europe were approximately 519 ($635) per tonne in the third quarter of 2004, approximately 535 ($645) per tonne in the second quarter of 2004 and approximately 444 ($550) per tonne in the third quarter of last year. The increase in NBSK pulp prices was partially offset by the weakness of the U.S. dollar versus the Euro in the current period. In the current quarter, pulp sales by volume were 73,128 tonnes, compared to 73,747 tonnes in the comparative period of 2003.

Pulp sales realizations were 472 per tonne on average in the current quarter, compared to 471 per tonne in the second quarter of 2004 and 407 per tonne in the three months ended September 30, 2003.

Transportation and other revenues for the pulp operations were 2.2 million in the three months ended September 30, 2004, compared to 2.0 million in the three months ended September 30, 2003.

Cost of sales and general, administrative and other expenses for the pulp operations were 33.4 million in the three months ended September 30, 2004 compared to 35.3 million in the comparative period of 2003, and included 2.5 million of operating costs related to the Stendal mill.

On average, fiber costs for pulp production decreased by approximately 4.6% compared to the third quarter of last year.

Depreciation for the pulp operations was 3.8 million in the current quarter, versus 5.5 million in the year ago period. A change in our depreciation estimate in respect of our Rosenthal mill resulted in a decrease of 2.2 million in cost of sales and net loss, and a decrease in net loss per share of 0.13 for the quarter ended September 30, 2004.

For the three months ended September 30, 2004, our pulp operations generated operating income of 4.0 million, versus an operating loss of 2.6 million in the year ago period.

Paper sales in the three months ended September 30, 2004 were 12.8 million, compared to 13.7 million in the same period of last year. Sales of specialty papers in the three months ended September 30, 2004 and 2003 were 8.6 million, respectively. For the current quarter, total paper sales volumes were 14,712 tonnes, versus 15,979 tonnes in the comparative period of last year. On average, prices for specialty papers realized in the current quarter increased by 2.5%, reflecting a shift in the product mix. Average prices for our printing papers decreased by approximately 2.8% reflecting generally weak demand.

Cost of sales and general, administrative and other expenses for the paper operations in the three months ended September 30, 2004 increased to 20.3 million from 14.9 million in the comparative quarter of 2003, primarily as a result of a non-cash 6.0 million impairment charge relating to our paper operations. Depreciation for the paper operations was 0.6 million in the three months ended September 30, 2004 and 2003, respectively.

For the three months ended September 30, 2004, our paper operations generated an operating loss of 7.6 million, which included the non-cash impairment charge of 6.0 million, compared to an operating loss of 1.1 million in the same period of last year.

For the three months ended September 30, 2004, consolidated general and administrative expenses increased to 7.3 million from 4.2 million in the year ago period, primarily as a result of the inclusion of operating costs of 2.5 million related to the Stendal mill.

In the three months ended September 30, 2004, we reported a loss from operations of 4.8 million, compared to a loss from operations of 5.1 million in the same period last year. Interest expense (excluding capitalized interest of 9.7 million relating to the Stendal pulp mill) in the three months ended September 30, 2004 increased to 4.2 million from 2.2 million a year ago, due to higher borrowings resulting primarily from our convertible note issue in October 2003 and the inclusion of interest expense of 1.7 million relating to the Stendal project after September 18, 2004.

In the three months ended September 30, 2004, the marked to market valuation of the Interest Rate Contracts resulted in a net non-cash holding loss of approximately 14.1 million before minority interests, versus a net gain of 5.9 million before minority interests on such Interest Rate Contracts in the prior period of 2003. In addition, in the three months ended September 30, 2004, we recorded a net non-cash holding gain of approximately 6.0 million before minority interests on the valuation of the Currency Derivatives as a result of a weakening of the U.S. dollar versus the Euro and changes in interest rates related to such currencies, versus a net gain of 3.8 million before minority interests on the then outstanding currency derivatives of Rosenthal and Stendal in the year ago period.

In the current quarter, minority interest, representing the two minority shareholders' proportionate interest in the Stendal project, was 6.7 million, compared to (1.9) million in the comparative period of 2003.

We reported a net loss for the three months ended September 30, 2004 of 9.9 million, or 0.57 per basic and diluted share, which reflected the non-cash 6.0 million impairment charge related to our paper operations, the inclusion of 4.2 million of operating and interest costs related to the Stendal mill and the net non-cash holding loss on the marked to market valuation of our derivative instruments. In the comparative period of 2003, we reported net income of 0.9 million, or 0.05 per basic and diluted share.

We generated Operating EBITDA of 5.3 million in the current quarter, compared to Operating EBITDA of 1.1 million in the comparative period of 2003. 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 nine months ended September 30, 2004 for additional information relating to Operating EBITDA.

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

Three Months Ended September 30,
2004 2003

(in thousands)
Net (loss) income (9,879 ) 876 Minority interest (6,726 ) 1,880 Income taxes (236 ) 28 Interest expense 4,200 2,236 Investment income (215 ) (416 ) Derivative financial instruments 8,105 (9,739 ) Other - (9 ) Income (loss) from operations (4,751 ) (5,144 ) Add: Depreciation and amortization 4,005 6,254 Impairment charge 6,000 - Operating EBITDA 5,254 1,110

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, 2004 2003

(in thousands)
Financial Position
Cash and cash equivalents 42,643 51,993 Working capital (122,474 )(1) (48,947 )(1) Property, plant and equipment 942,249 745,178 Total assets 1,192,727 935,905 Long-term liabilities 778,939 625,702 Shareholders' equity 121,595 132,855

º (1)
º We qualify for investment grants from the federal and state governments of Germany and had claim expenditures of 65.2 million and 82.1 million outstanding at September 30, 2004 and December 31, 2003, respectively. We expect to receive our currently outstanding claim expenditures in 2005. However, in accordance with our accounting policies, we do not record these grants until they are received.

At September 30, 2004, our cash and cash equivalents were 42.6 million, compared to 52.0 million at December 31, 2003. We also had 29.3 million of cash restricted to pay construction costs payable and 19.1 million of cash restricted in a debt service account, both related to the Stendal project. In addition, we had 28.5 million of cash restricted in a debt service account relating to the Rosenthal Loan Facility. At September 30, 2004, we had a working capital deficit of 122.5 million, primarily because we had Stendal construction costs payable of 161.0 million for which we had not yet drawn down under the Stendal Loan Facility and, under our accounting policies, we do not record certain government grants until they are received. The Stendal construction costs will be paid pursuant to the Stendal Loan Facility in the ordinary course. At September 30, 2004, we qualified for investment grants related to the Stendal mill totaling approximately 65.2 million from the federal and state governments of Germany, which we expect to receive in 2005. Approximately 61.2 million of these grants, when received, will be applied to repay the amounts drawn under the dedicated tranche of the Stendal Loan Facility. The grants are not reported in our income and reduce the cost basis of the assets purchased when they are received. We expect to qualify for additional investment grants totaling 23.3 million when such Stendal construction costs have been substantially paid.

We expect to continue to generate sufficient cash flow from operations to pay our interest and debt service expenses and meet the working and maintenance capital requirements for our current operations. We currently do not have any revolving credit facilities. From time to time, we have entered into project specific credit facilities to finance capital projects and expect to continue to do so, subject to availability. We expect to meet the capital requirements for the Stendal mill, including working capital and potential losses during start-up, through shareholder advances already made to Stendal, the Stendal Loan Facility, which includes a revolving line of credit for the mill, the receipt of government grants and cash flow from operations.

Operating Activities

Operating activities in the current period used cash of 1.2 million, compared to providing cash of 7.0 million in the comparative period of 2003. An increase in receivables related primarily to the start-up of the Stendal mill used cash of 2.1 million in the current period, compared to using cash of 8.1 million in the comparative period of 2003. Higher inventories due primarily to the build up of fiber and finished goods in connection with the start-up of the Stendal mill used cash of 35.8 million in the first nine months of 2004, compared to higher inventories using cash of 6.6 million in the first nine months of 2003. We expect that as the Stendal mill ramps up operations, inventory levels at the mill will decrease to more normalized levels. An increase in accounts payable and accrued expenses related primarily to the start-up of the Stendal mill provided cash of 26.3 million in the current period, compared to providing cash of 11.6 million in the comparative period of 2003.

Investing Activities

Investing activities in the nine months ended September 30, 2004 used cash of 211.8 million, primarily as a result of the acquisition of properties, net of investment grants, of which 206.9 million was attributable to the Stendal project, compared to using cash of 225.9 million in the nine months ended September 30, 2003, of which 145.9 million was attributable to the Stendal project. Sales of certain legacy available-for-sale securities provided cash of 1.2 million in the current period.

We qualify for investment grants related to the Stendal mill from the federal and state governments of Germany and had claim expenditures of 65.2 million outstanding as of September 30, 2004, which we expect to receive in 2005. We received investment grants totaling 74.7 million with respect to the Stendal project during the quarter ended September 30, 2004. In accordance with our accounting policies, we do not record these grants until they are received. These grants reduce the cost basis of the assets purchased with them.

Financing Activities

Financing activities provided cash of 203.6 million in the nine months ended September 30, 2004. A net increase in indebtedness, primarily related to the Stendal project, provided cash of 104.1 million. An increase in construction costs payable provided cash of 118.2 million in the current period. An increase in restricted cash used cash of 17.5 million in the current period. We made principal repayments of 20.1 million in connection with the Rosenthal Loan Facility in the nine months ended September 30, 2004. The balance outstanding under such facility at September 30, 2004, net of cash in a restricted debt service account, was 143.1 million. The issuance of shares in connection with the exercise of options provided cash of 0.6 million in the current period. Financing activities provided cash of 206.2 million in the first nine months of 2003, primarily as a result of an increase in construction costs payable relating to the Stendal project and an increase in indebtedness primarily in connection with the Stendal project.

Other than the agreements entered into by Stendal relating to the Stendal project, we had no material commitments to acquire assets or operating businesses at September 30, 2004. 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, borrowing against our assets, the sale of debt and/or equity securities and/or asset sales.

Stendal Project Status

The Stendal mill was completed substantially on its planned schedule and budget in the third quarter of 2004. The mill is currently in the start-up phase and is undergoing extensive testing and evaluation. The mill has all of its requisite permits in place to commence operations and has secured sufficient fiber supplies for the balance of 2004 and into the first quarter of 2005. At September 30, 2004, the mill had filled in excess of 77% of its overall staffing requirements. The balance of the hiring will occur in affiliated activities such as harvesting and transportation and will be completed through 2004 and 2005 as the mill ramps up operations.

The Stendal mill is currently being supervised by the contractor using Stendal's personnel to operate the mill. Stendal commenced the initial production of pulp in the third quarter of 2004. The initial pulp produced was off-grade pulp which was primarily sold into the recycled fiber, corrugated board and similar markets. The mill is currently producing "start-up quality" pulp. The prices realized on the sale of off-grade and start-up quality pulp are lower than the selling price for on-grade NBSK pulp. Under our current start-up plan, we expect Stendal to commence ramping up pulp production and quality so that the Stendal mill will be producing a significant proportion of saleable kraft pulp in the fourth quarter of 2004. Pursuant to our start up plan, we expect that the mill would be operating at approximately 80% of its design capacity by the end of 2004.

In conjunction with the start-up of the Stendal mill, we built up the fiber and finished goods inventory at the mill. We expect that the inventory levels at the Stendal mill will decrease to more normalized levels as the mill ramps up operations.

The mill is currently undergoing extensive testing and evaluation in connection with its mechanical completion and to also determine, following several months of start-up operations, whether certain performance requirements have been met, referred to as the "Acceptance Test". The Acceptance Test requires that the mill continuously produces pulp for a 72-hour period in compliance with specified operational, quality and environmental requirements. Following completion of such testing, if the requisite performance requirements are met, we are required to provide the contractor with an acceptance certificate. Once we deliver the acceptance certificate, we assume responsibility for the operation of the mill, subject to the contractor's warranty obligations.

Under the current start-up plan, we expect that the contractor will shut down the mill for approximately one week in the fourth quarter of 2004 for the completion of any adjustments, installations and the replacement of any equipment that may be required in order to fulfill its obligations under the construction contract. We also expect that, in the latter part of 2004, the Stendal mill will be shut down for a few days for fine tuning and cleaning so that the contractor may commence trials for the Acceptance Test.

Our planned start up of the Stendal mill is subject to risks commonly associated with the start up of large greenfield industrial projects which could result in the Stendal mill experiencing operating difficulties or delays in the start-up period and the Stendal mill may not achieve our planned production, timing, quality or cost projections. These risks include, without limitation, equipment failures or damage, errors or miscalculations in engineering, design specifications or equipment manufacturing, faulty construction or workmanship, defective equipment or installation, human error, industrial accidents, weather conditions, failure to comply with environmental and other permits, and complex integration of processes and equipment.

Foreign Currency

We hold certain assets and liabilities in U.S. dollars, Swiss francs and, to a lesser extent, in Canadian dollars. Accordingly, our consolidated financial results are subject to foreign currency exchange rate fluctuations.

We translate foreign denominated assets and liabilities into Euros at the rate of exchange on the balance sheet date. Unrealized gains or losses from these translations are recorded as shareholders' equity on the balance sheet and do not affect our net earnings.

In the nine months ended September 30, 2004, we reported a net 0.3 million foreign exchange translation loss and, as a result, the cumulative foreign exchange translation gain decreased to 5.7 million at September 30, 2004 from 6.0 million at December 31, 2003.

Based upon the exchange rate at September 30, 2004, the U.S. dollar decreased by approximately 6.2% in value against the Euro since September 30, 2003. See "Quantitative and Qualitative Disclosures about Market Risk".

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America 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, income taxes, and contingencies. Actual results could differ from these estimates.

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

For information about our significant accounting policies, see our annual report on Form 10-K for the year ended December 31, 2003. In addition, we had a change in our depreciation estimate relating to the Rosenthal mill during the current quarter. See Note 8 to our consolidated financial statements included herein.

Cautionary Statement Regarding Forward-Looking Information

The statements in this report that are not based on historical facts are called "forward-looking statements" within the meaning of the United States Private Securities Litigation Reform Act of 1995. These statements appear in a number of different places in this report and can be identified by words such as "estimates", "projects", "expects", "intends", "believes", "plans", or their negatives or other comparable words. Also look for discussions of strategy that involve risks and uncertainties. Forward-looking statements include statements regarding the outlook for our future operations, forecasts of future costs and expenditures, the evaluation of market conditions, the outcome of legal proceedings, the adequacy of reserves, or other business plans. You are cautioned that any such forward-looking statements are not guarantees and may involve risks and uncertainties. Our actual results may differ materially from those in the forward-looking statements due to risks facing us or due to actual facts differing from the assumptions underlying our estimates. Some of these risks and assumptions include those set forth in reports and other documents we have filed with or furnished to the SEC, including in our annual report on Form 10-K for the year ended December 31, 2003. 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

The pulp and paper business is cyclical in nature and markets for our principal products are characterized by periods of supply and demand imbalance, which in turn affects product prices. The markets for pulp and paper are highly competitive and are sensitive to cyclical changes in industry capacity and in the global economy, all of which can have a significant influence on selling prices and our earnings. Demand for pulp and paper products has historically been determined by the level of economic growth and has been closely tied to overall business activity. During two of the past three calendar years, list pulp prices have fallen significantly. Although pulp prices improved overall in 2003 and the first half of 2004, they fell in the third quarter of 2004. We cannot predict the impact of continued economic weakness in most world markets or the impact of war, terrorist activity or other events on our markets.

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 pulplogs for pulp production, and waste paper and pulp for paper production. Fiber costs are primarily affected by the supply of, and demand for, lumber and pulp, which are both highly cyclical in nature. 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.