UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

 

 

 

Commission File No.: 1333274

 

MERCER INTERNATIONAL INC.

Exact name of Registrant as specified in its charter

 

 

Suite 2840, 650 West Georgia Street, Vancouver, British Columbia, Canada, V6B 4N8

Address of Office

 

Registrant’s telephone number including area code: (604) 684-1099

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

 

Common Stock

Title of Class

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes     þ No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Act.  o Yes     þ No

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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

 

 

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

 

The aggregate market value of the Registrant’s voting and non-voting common equity held by non-affiliates of the Registrant as of June 30, 2007, the last business day of the Registrant’s most recently completed second fiscal quarter, based on the closing price of the voting stock on the NASDAQ Global Market on such date, was approximately $36,893,075.

 

As of February 21, 2008, the Registrant had 36,285,027 shares of common stock, $1.00 par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information that will be contained in the definitive proxy statement for the Registrant’s annual meeting to be held in 2008 is incorporated by reference into Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

EXCHANGE RATES

 

Our reporting currency and financial statements included in this report are in Euros, as a significant majority of our business transactions are originally denominated in Euros. We translate non-Euro denominated assets and liabilities at the rate of exchange on the balance sheet date. Revenues and expenses are translated at the average rate of exchange prevailing during the period.

 

The following table sets out exchange rates, based on the noon buying rates in New York City for cable transfers in foreign currencies as certified for customs purposes by the Federal Reserve Bank of New York (the “Noon Buying Rate”) for the conversion of Euros and Canadian dollars to U.S. dollars in effect at the end of the following periods, the average exchange rates during these periods (based on daily Noon Buying Rates) and the range of high and low exchange rates for these periods:

 

 

On February 21, 2008, the Noon Buying Rate for the conversion of Euros and Canadian dollars to U.S. dollars was €0.6751 per U.S. dollar and C$1.0083 per U.S. dollar.

 

In addition, certain financial information relating to our Celgar pulp mill, which we acquired in February 2005, included in this annual report is stated in Canadian dollars while we report our financial results in Euros. The following table sets out exchange rates, based on the noon rates as provided by the Bank of Canada, for the conversion of Canadian dollars to Euros in effect at the end of the following periods, the average exchange rates during these periods (based on daily noon rates) and the range of high and low exchange rates for these periods:

 

 

On February 21, 2008, the noon rate for the conversion of Canadian dollars to Euros was C$1.4940 per Euro.

 

 

In this document, please note the following:

 

 

 

General

 

Mercer Inc. is a Washington corporation and our shares of common stock are quoted and listed for trading on the NASDAQ Global Market (MERC) and the Toronto Stock Exchange (MRI.U). We converted our corporate form from a Washington business trust to a corporation effective March 1, 2006 without effecting any change in our business, management, accounting practices, assets or liabilities.

 

We operate in the pulp business and are the second largest producer of market northern bleached softwood kraft, or “NBSK”, pulp in the world. We are the sole kraft pulp producer, and the only producer of pulp for resale, known as “market pulp”, in Germany, which is the largest pulp import market in Europe. We also have significant sales to Asia, including China, which is the region with the fastest rate of growth in demand. Our operations are currently located in eastern Germany and western Canada. We currently employ approximately 1,076 people at our German operations, 396 people at our Celgar mill in western Canada and 18 people at our office in Vancouver, British Columbia, Canada. We operate three NBSK pulp mills with a consolidated annual production capacity of approximately 1.4 million ADMTs:

 

 

We have a global sales and marketing team that handles sales to over 140 customers. As a result of the close proximity of our mills to customers and our global platform, we can service our customers on a worldwide basis.

History and Development of Business

 

We originally invested in various real estate assets with the intention of becoming a real estate investment trust, but in 1985 changed our operational direction to acquiring controlling interests in operating companies. We acquired our initial pulp and paper operations in 1993.

 

In late 1999, we completed a major capital project which, among other things, converted the Rosenthal mill to the production of kraft pulp from sulphite pulp, increased its annual production capacity from approximately 160,000 ADMTs to approximately 280,000 ADMTs, reduced costs and improved efficiencies. The aggregate cost of this conversion project was approximately €361.0 million, of which approximately €102.0 million was financed through government grants. Subsequent minor capital investments and efficiency improvements have reduced emissions and energy costs and increased the Rosenthal mill’s annual production capacity to approximately 325,000 ADMTs.

 

In September 2004, we completed construction of the Stendal mill at an aggregate cost of approximately €1.0 billion. The Stendal mill is one of the largest NBSK pulp mills in Europe. The Stendal mill was financed through a combination of government grants totaling approximately €275 million, low-cost, long-term project debt which is largely severally guaranteed by the federal government and a state government in Germany, and equity contributions. We initially had a 63.6% ownership interest in Stendal and, in October 2006, increased our interest to 70.6% by acquiring a 7% minority interest therein for €8.1 million. We may in the future seek to acquire all of the remaining 29.4% minority interest in the Stendal mill.

 

The Stendal mill was constructed under a €716.0 million fixed-price turn-key engineering, procurement and construction, or “EPC”, contract between Stendal and the EPC contractor. Under the contract, the EPC contractor was responsible for all planning, design, engineering, procurement, construction and testing in connection with the build-out and start-up of the mill. Pursuant to the EPC contract, construction of the Stendal mill was completed substantially on its planned schedule and budget in September 2004. Such completion meant that the construction and installation of all equipment and works were essentially finished and final checks occurred so that continuous production from the mill could commence. The mill then underwent extensive testing and evaluation to determine whether certain performance requirements had been met. Although the tests were generally successful, the EPC contractor agreed in the first quarter of 2005 to implement certain remedial measures at the mill, including the installation of two additional digesters and related equipment, improvements to the non-condensable gas, or “NCG”, boiler and water treatment plant. These digesters enhanced the reliability and overall operating performance of the Stendal mill and, along with other measures, increased its annual production capacity to approximately 620,000 ADMTs. The two additional digesters had a capital cost of approximately €8.0 million, of which we paid €2.0 million and the balance was paid by the EPC contractor and certain suppliers.

 

Subsequently, each department of the mill was tested on a stand-alone basis for compliance with its design specifications. Based upon such testing, Stendal made a number of warranty claims. In September 2007, Stendal concluded a final settlement of substantially all outstanding matters with its contractors under the EPC contract while still maintaining existing warranties. Pursuant to the settlement, Stendal received a payment of approximately €11.0 million.

 

We, Stendal and its minority shareholder are parties to a shareholders’ agreement dated August 26, 2002, as amended, to govern our respective interests in Stendal. The agreement contains terms and conditions customary for these types of agreements, including restrictions on transfers of share capital and shareholder loans other than to affiliates, rights of first refusal on share and shareholder loan transfers, pre-emptive rights and piggyback rights on dispositions of our interest. The shareholders are not obligated to fund any further equity capital contributions to the project. The shareholders’ agreement provides that Stendal’s managing directors may be appointed by holders of a simple majority of its share capital. Further, shareholder decisions, other than those mandated by law or for the provision of financial assistance to a shareholder, are determined by a simple majority of Stendal’s share capital.

 

A significant portion of the capital investments at our German pulp mills, including the construction of the Stendal mill, were financed through government grants. Since 1999, our German pulp mills have benefited from an aggregate €383.0 million in government grants. These grants are not reported in our income. These grants reduce the cost basis of the assets purchased when the grants are received. See “— Capital Expenditures”.

In February 2005, we acquired the Celgar mill for $210.0 million, of which $170.0 million was paid in cash and $40.0 million was paid in our shares, plus $16.0 million for the defined working capital at the mill on closing. The Celgar mill was completely rebuilt in the early 1990s through a C$850.0 million modernization and expansion project, which transformed it into a low-cost producer.

 

In 2007, we completed a C$28.0 million capital project commenced in 2005 which improved efficiencies and reliability and, with other measures, increased the Celgar mill’s annual production capacity to 480,000 ADMTs.

 

We previously operated two paper mills in Germany that had an aggregate annual production capacity of approximately 70,000 ADMTs. We viewed these as non-core operations and divested them in 2006 and account for this business as discontinued operations. As a result, certain previously reported amounts and the financial statements and related notes herein have been reclassified to conform to the current presentation. In 2006, we also divested our equity interest in a non-consolidated specialty paper mill in Switzerland. These divestitures were effected so that we could focus on our core pulp business.

 

Organizational Chart

 

The following chart sets out our directly and indirectly owned principal operating subsidiaries, their jurisdictions of organization and their principal activities:

 

 

Our competitive strengths include the following:

 

 

 

Our corporate strategy is to create shareholder value by focusing on the expansion of our asset and earnings base. Key features of our strategy include:

 

 

General

 

Pulp is used in the production of paper, tissues and paper related products. Pulp is generally classified according to fiber type, the process used in its production and the degree to which it is bleached. Kraft pulp is produced through a sulphate chemical process in which lignin, the component of wood which binds individual fibers, is dissolved in a chemical reaction. Chemically prepared pulp allows the wood’s fiber to retain its length and flexibility, resulting in stronger paper products. Kraft pulp can be bleached to increase its brightness. Kraft pulp is noted for its strength, brightness and absorption properties and is used to produce a variety of products, including lightweight publication grades of paper, tissues and paper related products.

 

The market value of kraft pulp depends in part on the fiber used in the production process. There are two primary species of wood used as fiber: softwood and hardwood. Softwood species generally have long, flexible fibers which add strength to paper while fibers from species of hardwood contain shorter fibers which lend bulk and opacity. Generally, prices for softwood pulp are higher than for hardwood pulp. Currently, the kraft pulp market is roughly evenly split between softwood and hardwood grades. Most uses of market kraft pulp, including fine printing papers, coated and uncoated magazine papers and various tissue products, utilize a mix of softwood and hardwood grades to optimize production and product qualities. In recent years, production of hardwood pulp, based on fast growing plantation fiber primarily from Asia and South America, has increased much more rapidly than that of softwood grades that have longer growth cycles. As a result of the growth in supply and lower costs, kraft pulp customers in recent years have substituted some of the pulp content in their products to hardwood pulp. Counteracting customers’ increased proportionate usage of hardwood pulp has been the requirement for strength characteristics in finished goods. Paper and tissue makers focus on higher machine speeds and lower basis weights for publishing papers which also require the strength characteristics of softwood pulp. We believe that the ability of kraft pulp users to further substitute hardwood for softwood pulp is limited by such requirements.

 

NBSK pulp, which is a bleached kraft pulp manufactured using species of northern softwood, is considered a premium grade because of its strength. It generally obtains the highest price relative to other kraft pulps. Southern bleached softwood kraft pulp is kraft pulp manufactured using southern softwood species and does not possess the strength found in NBSK pulp. NBSK pulp is the sole product of our mills.

 

Kraft pulp can be made in different grades, with varying technical specifications, for different end uses. High-quality kraft pulp is valued for its reinforcing role in mechanical printing papers, while other grades of kraft pulp are used to produce lower priced grades of paper, including tissues and paper related products.

 

Markets

 

We believe that over 125 million ADMTs of kraft pulp are converted annually into printing and writing papers, tissues, cartonboards and other white grades of paper and paperboard around the world. Approximately 70% of this pulp is produced for internal purposes by integrated paper and paperboard manufacturers, and approximately 30% is produced for sale on the open market.

 

Although demand is cyclical, worldwide demand for kraft market pulp has grown at an average rate of approximately 3% annually over the last ten years. The growth rate for NBSK pulp reflects this continuing demand.

 

Western Europe accounts for approximately 35% of global market pulp demand with a growth rate of approximately 1% annually over the past ten years. Within Europe, Germany, with its large economy and sizable paper industry, has historically been the largest pulp market relying largely on imports from North America and Scandinavia.

 

Demand for market pulp in Asia has been growing at approximately 5% annually over the past 10 years and currently accounts for approximately 34% of global demand. This demand growth has primarily been driven by increasing per capita consumption. Demand for NBSK market pulp in China has grown at a rate of approximately 15% per year over the last ten years. China, which accounted for 4% of world market kraft pulp demand in 1996 now accounts for 14% of world demand. Canada is the largest exporter to this region.

We expect Europe and Asia to continue to be significant net importers of pulp in the foreseeable future. The markets for kraft pulp are cyclical in nature and demand for kraft pulp is related to global and regional levels of economic activity. A measure of demand for kraft pulp is the ratio obtained by dividing the worldwide demand of kraft pulp by the worldwide capacity for the production of kraft pulp, or the “demand/capacity ratio”. An increase in this ratio generally occurs when there is an increase in global and regional levels of economic activity. An increase in this ratio generally indicates greater demand as consumption increases, which generally results in rising kraft pulp prices, a build-up of inventories by buyers and a reduction by producers. As prices continue to rise, producers continue to run at higher operating rates. However, an adverse change in global and regional levels of economic activity generally negatively affects demand for kraft pulp, often leading to a high level of inventory build-up by buyers. Falling demand is precipitated by buyers generally reducing their purchases and relying on inventories of kraft pulp, and, in turn, many producers will run at lower operating rates by taking downtime to limit the build-up of their own inventories. The demand/capacity ratio was approximately 96% in 2006 and approximately 93% in 2005.

 

We do not believe there are any significant new NBSK pulp production capacity increases coming online in the next several years due in part to fiber supply constraints and high capital costs.

 

Competition

 

Pulp markets are large and highly competitive. Producers ranging from small independent manufacturers to large integrated companies produce pulp worldwide. Our pulp and customer services compete with similar products manufactured and distributed by others. Many factors influence our competitive position. These factors include price, service, quality and convenience of location. Some of our competitors are larger than we are in certain markets and have greater financial resources. These resources may afford those competitors more purchasing power, increased financial flexibility, more capital resources for expansion and improvement and enable them to compete more effectively.

 

Our key NBSK pulp competitors are principally located in northern Europe and Canada. In 2007, our largest competitors included Södra Cell International, Canfor Pulp Income Trust and Pope & Talbot, Inc.

 

NBSK Pulp Pricing

 

Global economic conditions, changes in production capacity, inventory levels, and currency exchange rates are the primary factors affecting NBSK pulp list prices. Prices are cyclical and the average annual European list prices for NBSK pulp since 1990 have ranged from a low of approximately $444 per ADMT in 1993 to a high of approximately $985 per ADMT in 1995.

 

In 2005, list prices for NBSK pulp started the year at approximately $625 per ADMT but declined primarily due to the strengthening of the U.S. dollar to $600 per ADMT in Europe at the end of the year. Pulp prices increased steadily in 2006 and 2007 primarily as a result of the closure of several pulp mills, particularly in North America, which reduced NBSK capacity by approximately 1.2 million ADMTs, better demand and the general weakness of the U.S. dollar against the Euro and the Canadian dollar. At the end of 2007, list prices for NBSK pulp in Europe had increased to $870 per ADMT.

 

A producer’s sales realizations will reflect customer discounts, commissions and other items and prices will continue to fluctuate in the future. While there are differences between NBSK list prices in Europe, North America and Asia, European prices are generally regarded as the global benchmark and pricing in other regions tends to follow European trends. The nature of the pricing structure in Asia is different in that, while quoted list prices tend to be lower than Europe, customer discounts and commissions tend to be lower resulting in net sales realizations that are generally similar to other markets.

The majority of market NBSK pulp is produced and sold by North American and Scandinavian, or “Norscan”, producers, while the price of NBSK pulp is generally quoted in U.S. dollars. As a result, NBSK pricing is affected by fluctuations in the currency exchange rates for the U.S. dollar versus the Canadian dollar and the Euro. NBSK pulp price increases over the last two years have in large part been offset by the weakening of the U.S. dollar.

 

The following chart sets out the changes in list prices for NBSK pulp in Europe and the value of the U.S. dollar to the Euro and the Canadian dollar for the periods indicated.

 

Price Delivered to N. Europe (C$ and € equivalent indexed to 2000)

 

 

Source: RISI, Federal Reserve Bank of New York and Bank of Canada

 

The Manufacturing Process

 

The following diagram provides a simplified description of the kraft pulp manufacturing process at our pulp mills:

 

 

In order to transform wood chips into kraft pulp, wood chips undergo a multi-step process involving the following principal stages: chip screening, digesting, pulp washing, screening, bleaching and drying.

 

In the initial processing stage, wood chips are screened to remove oversized chips and sawdust and are conveyed to a pressurized digester where they are heated and cooked with chemicals. This occurs in a continuous process at the Celgar and Rosenthal mills and in a batch process at the Stendal mill. This process softens and eventually dissolves the phenolic material called lignin that binds the fibers to each other in the wood.

 

Cooked pulp flows out of the digester and is washed and screened to remove most of the residual spent chemicals, called black liquor, and partially cooked wood chips. The pulp then undergoes a series of bleaching stages where the brightness of the pulp is gradually increased. Finally, the bleached pulp is sent to the pulp machine where it is dried to achieve a dryness level of more than 90%. The pulp is then ready to be baled for shipment to customers.

 

A significant feature of kraft pulping technology is the recovery system, whereby chemicals used in the cooking process are captured and extracted for re-use, which reduces chemical costs and improves environmental performance. During the cooking stage, dissolved organic wood materials and black liquor are extracted from the digester. After undergoing an evaporation process, black liquor is burned in a recovery boiler. The chemical compounds of the black liquor are collected from the recovery boiler and are reconstituted into cooking chemicals used in the digesting stage through additional processing in the recausticizing plant.

 

The heat produced by the recovery boiler is used to generate high-pressure steam. Additional steam is generated by a power boiler through the combustion of biomass consisting of bark and other wood residues from sawmills and our woodrooms and residue generated by the effluent treatment system. Additionally, during times of

upset, we may use natural gas to generate steam. The steam produced by the recovery and power boilers is used to power a turbogenerator to generate electricity, as well as to provide heat for the digesting and pulp drying processes.

 

We manufacture and sell NBSK pulp produced from wood chips and pulp logs.

 

The kraft pulp produced at the Rosenthal mill is a long-fibered softwood pulp produced by a sulphate cooking process and manufactured primarily from wood chips and pulp logs. A number of factors beyond economic supply and demand have an impact on the market for chemical pulp, including requirements for pulp bleached without any chlorine compounds or without the use of chlorine gas. The Rosenthal mill has the capability of producing both “totally chlorine free” and “elemental chlorine free” pulp. Totally chlorine free pulp is bleached to a high brightness using oxygen, ozone and hydrogen peroxide as bleaching agents, whereas elemental chlorine free pulp is produced by substituting chlorine dioxide for chlorine gas in the bleaching process. This substitution virtually eliminates complex chloro-organic compounds from mill effluent.

 

Kraft pulp is valued for its reinforcing role in mechanical printing papers and is sought after by producers of paper for the publishing industry, primarily for magazines and advertising materials. Kraft pulp produced for reinforcement fibers is considered the highest grade of kraft pulp and generally obtains the highest price. Through a focused technical and marketing effort, we have changed the mix of the kraft pulp that we produce at the Rosenthal mill to substantially increase our relative amount of reinforcement fibers from approximately 16% at the beginning of 2000 to approximately 59% at the end of 2007. The Rosenthal mill produces pulp for reinforcement fibers to the specifications of certain of our customers. We believe that a number of our customers consider us their supplier of choice. For more information about the facilities at the Rosenthal mill, see “Item 2 — Properties”.

 

The kraft pulp produced at the Stendal mill is of a slightly different grade than the pulp produced at the Rosenthal mill as the mix of softwood fiber used is slightly different. This results in a complementary product more suitable for different end uses. The Stendal mill is capable of producing both totally chlorine free and elemental chlorine free pulp. For more information about the facilities at the Stendal mill, see “Item 2 — Properties”.

 

The Celgar mill produces high quality kraft pulp that is made from a unique blend of slow growing/long-fiber western Canadian tree species. It is used in the manufacture of high-quality paper and tissue products. We believe the Celgar mill’s pulp is known for its excellent product characteristics, including tensile strength, wet strength and brightness. The Celgar mill is a long-established supplier to paper producers in Asia. For more information about the facilities at the Celgar mill, see “Item 2 — Properties”.

 

Our major costs of production are labor, fiber, energy and chemicals. Fiber comprised of wood chips and pulp logs is our most significant operating expense. Given the significance of fiber to our total operating expenses and our limited ability to control its costs, compared with our other operating costs, volatility in fiber costs can materially affect our margins.

 

Labor

 

Our labor costs tend to be generally steady, with small overall increases due to inflation in wages and health care costs. Over the last three years, we have been able to generally offset such increases by increasing our efficiencies and production and streamlining operations.

 

Fiber

 

Our mills are situated in regions which generally provide a relatively stable supply of fiber. The fiber consumed by our mills consist of wood chips produced by sawmills and pulp logs, which are cyclical in both price and supply. Wood chips are small pieces of wood used to make pulp and are a by-product of either wood residuals from sawmills or logs or pulp logs chipped especially for this purpose. Pulp logs consist of lower quality logs not used in the production of lumber.

Generally, the cost of wood chips and pulp logs are primarily affected by the supply and demand for lumber. Additionally, regional factors can also have a material effect on both the supply, demand and price for fiber.

 

In Germany, since 2006, the price and supply of wood chips has been affected by increasing demand from alternative or renewable energy producers, changes in supply resulting from weather conditions and government initiatives and a move to increase harvesting levels. High energy prices, along with initiatives by European governments to promote the use of wood as a carbon neutral energy, have increased demand for wood usage for energy production and for wood fiber. This non-traditional demand for fiber is expected to continue and has, and will continue to, put upward pressure on fiber prices.

 

Weather patterns have also had a significant effect on short-term fiber supply and pricing. Severe winter storms in central Europe, including Germany, in January 2007 resulted in significant damage to the forests. We believe the damage to forests in Germany was in excess of 25 million solid cubic meters of wood. As the damaged forests were harvested as rapidly as possible to preserve the value of the wood, its availability tempered and moderated fiber prices in the second half of 2007.

 

Effective July 1, 2007, the Russian government raised tariffs on the export of sawmill and pulp wood to 20% and has announced that it will be implementing additional increases to 25% in April 2008. Russia has also announced it will be seeking further increases in 2009. This is expected to reduce the export of Russian wood to Europe, in particular to Scandinavian producers who import a significant amount of their wood from Russia, and is expected to put upward pressure on pricing as such producers try to replace these volumes from other regions.

 

Offsetting some of the increases in demand for wood fiber have been initiatives in which we and other producers are participating to increase harvest levels in Germany, particularly from small private forest owners. We believe that Germany has the highest availability of softwood forests suitable for harvesting and manufacturing. Private ownership of such forests is approximately 50%. Many of these forest ownership stakes are very small and have been harvested at rates much lower than their rate of growth.

 

In British Columbia, in 2007, the supply of wood fiber was materially affected by the weakness in the U.S. housing market which resulted in a significant reduction in lumber production in the Province. On the fiber demand side, although it is not nearly as advanced as Europe, there is growing interest in British Columbia for renewable or “green” energy. These initiatives, which are likely to increase over time, are expected to create additional competition for fiber.

 

We believe we are the largest consumer of wood chips and pulp logs in Germany and often provide the best, long-term economic outlet for the sale of wood chips in eastern Germany. We coordinate the wood procurement activities for our German mills to reduce overall personnel and administrative costs, provide greater purchasing power and coordinate buying and trading activities. This coordination and integration of fiber flows also allows us to optimize transportation costs, and the species and fiber mix for both mills.

 

In 2007, the Rosenthal mill consumed approximately 1.8 million cubic meters of fiber. Approximately 63%, or approximately 1.1 million cubic meters, of such consumption was in the form of sawmill wood chips. The balance of approximately 37%, or approximately 0.7 million cubic meters, was in the form of pulp logs. The wood chips for the Rosenthal mill are sourced from approximately 21 sawmills located in the states of Bavaria, Saxony and Thüringia and are within a 150 kilometer radius of the Rosenthal mill. Within this radius, the Rosenthal mill is the largest consumer of wood chips. Given its location and size, the Rosenthal mill is often the best economic outlet for the sale of wood chips in the area. Approximately 95% of the fiber consumed by the Rosenthal mill is spruce and the remainder is pine. While fiber costs and supply are subject to cyclical changes largely in the sawmill industry, we expect that we will be able to continue to obtain an adequate supply of fiber on reasonably satisfactory terms for the Rosenthal mill due to its location and our long-term relationships with suppliers. We have not historically experienced any significant fiber supply interruptions at the Rosenthal mill.

 

Wood chips for the Rosenthal mill are normally sourced from sawmills under one year or quarterly supply contracts with fixed volumes, which provide for price adjustments. More than 85% of our chip supply is sourced from suppliers with which we have a long-standing relationship. We generally enter into annual contracts with such suppliers. Pulp logs are sourced from the state forest agencies in Thüringia, Saxony and Bavaria on a contract basis and partly from private holders on the same basis as wood chips. Like the wood chip supply arrangements, these

contracts tend to be of less than one-year terms with quarterly adjustments for market pricing. We organize the harvesting of pulp logs sourced from the state agencies in Thüringia, Saxony and Bavaria after discussions with the agencies regarding the quantities of pulp logs that we require.

 

In 2007, the Stendal mill consumed approximately 3.0 million cubic meters of fiber. Approximately 30% of such fiber was in the form of sawmill wood chips and approximately 70% in the form of pulp logs. The core wood supply region for the Stendal mill includes most of the northern part of Germany within an approximate 300 kilometer radius of the mill. We also purchase wood chips from southwestern and southern Germany. The fiber base in the wood supply area for the Stendal mill consisted of approximately 40% pine and 60% spruce and other species in 2007. The Stendal mill has sufficient chipping capacity to fully operate solely using pulp logs, if required. We source wood chips from sawmills within an approximate 300 kilometer radius of the Stendal mill. We source pulp logs partly from private forest holders and partly from state forest agencies in Thüringia, Saxony-Anhalt, Mecklenburg-Western Pomerania, Saxony, Lower Saxony, North Rhine-Westphalia, Hesse and Brandenburg.

 

Stendal has its own wood procurement division to handle its fiber requirements. This division focuses on three principal activities, being wood procurement and sales, harvesting and transportation. The procurement and sales main activity is to procure the required wood chip and pulp log assortments for the mill’s annual production. In conjunction with this activity, it may also procure higher quality sawlogs, either through harvesting or through purchases that it can sell or trade with others for wood chips in order to optimize the mill’s fiber mix. The harvesting activities in 2008 will focus on acquiring up to approximately 500,000 cubic meters per annum of harvestable timber, of which approximately 65% is expected to be pulp logs and the balance likely to be higher quality logs that could be sold or traded to third parties for wood chips. We currently expect that approximately 65% of this volume may be harvested directly by us and the other 35% would be contracted out to third parties.

 

In 2007, the Celgar mill consumed approximately 2.6 million cubic meters of fiber. Approximately 90% of such fiber was in the form of sawmill wood chips and the remaining 10% came from pulp logs processed through its woodroom. The source of fiber at the mill is characterized by a mixture of species (whitewoods and cedar) and the mill sources fiber from a number of Canadian and U.S. suppliers.

 

The Celgar mill has long and short-term chip supply agreements with over 30 different suppliers from Canada and the U.S., representing over 90% of its total annual fiber requirements. The woodroom supplies the remaining chips to meet the Celgar mill’s fiber requirements. Chips are purchased in Canada and the U.S. in accordance with chip purchase agreements. Generally, pricing is reviewed and adjusted periodically to reflect market prices. The majority of the agreements are for periods ranging between two and five years. Several of the longer-term contracts are so-called “evergreen” agreements, where the contract remains in effect until one of the parties elects to terminate. Termination requires a minimum of two, and in some cases, five years’ written notice. Certain non-evergreen long-term agreements provide for renewal negotiations prior to expiry.

 

The Celgar mill has contracts with two sawmills owned by the same parent, Pope & Talbot, Inc., that, in 2007, supplied approximately 20% of its annual fiber requirements. One of these sawmills is directly adjacent to the Celgar mill. In the fourth quarter of 2007, Pope & Talbot sought and obtained creditor protection in Canada and the U.S.. As part of such creditor protection, in December 2007, Pope & Talbot announced the sale of the two sawmills to another sawmilling company, subject to customary conditions. The sale is expected to close in the first half of 2008. We cannot currently predict the new purchaser’s plans for the two sawmills, including if there will be temporary or permanent closures and the effect the sale will have on our supply and cost of fiber from this source. Should operations at these sawmills be curtailed for an extended period of time or permanently, or if our fiber supply arrangements are materially altered, fiber costs and supply for our Celgar mill could be adversely impacted. However, given the proximity of the Celgar mill to these two sawmills, there is a logistical advantage to their supplying chips to the Celgar mill.

 

In 2007, as a result of the cyclical decline in sawmill chip availability resulting from lower lumber production in British Columbia and the weakness in the U.S. currency, the Celgar mill increased its U.S. purchases of fiber, diversified its suppliers and increased its production of chips from pulp logs processed through its woodroom by 25% compared to 2006. The woodroom at our Celgar mill can process approximately 33% of the mill’s chip requirements, and alternative offsite chipping plants have been sourced. With the continuing weakness in the U.S. housing market, we currently expect to increase the amount of pulp log chipping at our Celgar mill in 2008.

To secure the volume of pulp logs required by the woodroom, the Celgar mill has entered into annual pulp log supply agreements with a number of different suppliers, many of whom are also contract chip suppliers to the mill. All of the pulp log agreements can be terminated by either party for any reason, upon seven days’ written notice.

 

Energy

 

Steam and electrical power are the primary forms of energy used in pulp production. Processed steam is produced in boilers using mostly renewable fuels. Our mills produce all of our steam requirements and generally generate excess energy which we sell to third party utilities. In 2007, we sold 430,437 megawatt hours of excess energy. Sales of excess energy are recorded as a reduction to production costs. These sales of surplus energy have allowed us to continually reduce our energy production costs over the last three years.

 

Our energy is primarily generated from renewable carbon neutral sources, such as wood waste. As a result, our German mills have benefited from the sales of emission allowances. In Europe, green energy receives a premium price compared to carbon-based energy. This recognition is also expected to develop in North America. We are pursuing a number of initiatives, including working with government to have the energy produced at our pulp mills recognized as “green” energy so that we may improve price realizations from surplus energy sales.

 

The following table sets out our electricity generation and surplus energy sales for the last three years:

 

Mercer Electricity Generation and Exports

 

 

Chemicals

 

Our pulp mills use certain chemicals which are generally available from several suppliers and sourcing is primarily based upon pricing and location. Although chemical prices have risen slightly over the last three years, we have been able to reduce our costs through improved efficiencies and capital expenditures.

 

Cash production costs per tonne for our pulp mills are as follows:

 

 

 

 

The distribution of our pulp sales revenues by geographic area are set out in the following table for the periods indicated:

 

 

 

 

The following charts illustrate the geographic distribution of our revenues for the periods indicated:

 

 

 

Our global sales and marketing group has been responsible for conducting all sales and marketing of the pulp produced at our three pulp mills since 2005. This has resulted in reduced agents’ commissions and fees, increased contract sales and improved pulp sales realizations. About 19 employees are currently engaged full time in such activities. We coordinate and integrate the sales and marketing activities of our German mills to realize on a number of synergies between them. These include reduced overall administrative and personnel costs and coordinated selling, marketing and transportation activities. We also coordinate sales from the Celgar mill with our German mills on a global basis, thereby providing our larger customers with seamless service across all major geographies. In marketing our pulp, we seek to establish long-term relationships by providing a competitively priced, high quality, consistent product and excellent service. In accordance with customary practice, we do not have long-term sales contracts with our customers. Instead, we maintain long-standing relationships with our customers pursuant to which we periodically reach agreements on specific volumes and prices.

 

Our pulp sales are on customary industry terms. At December 31, 2007, we had no material payment delinquencies. In 2007, 2006 and 2005, no single customer accounted for more than 10% of our pulp sales. Our pulp sales are not dependent upon the activities of any single customer.

 

Our German mills are currently the only market kraft pulp producers in Germany, which is the largest import market for kraft pulp in Europe. We therefore have a competitive transportation cost advantage compared to Norscan pulp producers when shipping to customers in Europe. Due to the location of our German mills, we are able to deliver pulp to many of our customers primarily by truck. Most trucks that deliver goods into eastern Germany generally do not also haul goods out of the region as eastern Germany is primarily an importer of goods. We are therefore able to obtain relatively low back haul freight rates for the delivery of our products to many of our customers. Since many of our customers are located within a 500 kilometer radius of our German mills, we can generally supply pulp to customers of these mills faster than our competitors because of the short distances between the mills and our customers.

 

The Celgar mill’s pulp production is transported to customers by rail, truck and ocean carrier using strategically located third party warehouses to ensure timely delivery. The majority of Celgar’s pulp for overseas markets is initially delivered primarily by rail to the port of Vancouver for shipment overseas by ocean carrier. As a western Canada based pulp mill, the Celgar mill is well positioned to service Asian customers. The majority of the Celgar mill’s pulp for domestic markets is shipped by rail to third party warehouses in the U.S. or directly to the customer.

 

In 2007, we continued with our capital investment programs designed to increase production capacity, improve efficiency and reduce effluent discharges and emissions at our manufacturing facilities. The improvements made at

our mills over the past five years have reduced operating costs and increased the competitive position of our facilities.

 

Total capital expenditures at the Rosenthal mill in 2007, 2006 and 2005 were €5.2 million, €13.4 million and €7.1 million, respectively. Capital investments at the Rosenthal mill in 2007 related mainly to the installation of a new white liquor tank, and additional capacity to store sawmill chips and roundwood to better buffer against the market fluctuations of our raw materials. We estimate capital expenditures at the Rosenthal mill to be approximately €5.0 million for 2008 relating primarily to a dust filter for the lime kiln, final work on the new white liquor tank, noise reduction for the cooling towers and other smaller projects relating to maintaining the quality and efficiency of the mill. In addition, we will initiate a washer project that, among other things, is expected to offset three years of wastewater fees that would otherwise be payable. The aggregate value of the project is approximately €10 million but, after giving effect to government grants and offsetting wastewater fees, we estimate our net costs to be approximately €2.1 million.

 

Total capital expenditures at the Stendal mill in 2007, 2006 and 2005 were €4.9 million, €2.5 million and €8.3 million, respectively. Capital investments at the Stendal mill in 2007 related mainly to digester capacity increases. We estimate capital expenditures for the Stendal mill for 2008 to be approximately €10.0 million relating primarily to fiber handling optimization projects and equipment to increase the efficiency and capacity of the mill’s black liquor production. The black liquor project is expected to increase the mill’s ability to produce steam and energy. Stendal’s 2008 capital expenditures include approximately €6.0 million of reliability improvements identified and funded from the €11.0 million Stendal received upon the settlement of the EPC contract in September 2007.

 

Certain of our capital investment programs in Germany were partially financed through government grants made available by German federal and state governments. Under legislation adopted by the federal and certain state governments of Germany, government grants are provided to qualifying businesses operating in eastern Germany to finance capital investments. The grants are made to encourage investment and job creation. Currently, grants are available for up to 15% of the cost of qualified investments. Previously, the government grants were available for up to 35% of the cost of qualified investments such as for the construction of our Stendal pulp mill. These grants with 35% of cost level required that at least one permanent job be created for each €500,000 of capital investment eligible for such grants and that such jobs be maintained for a period of five years from the completion of the capital investment project. Generally, government grants are not repayable by a recipient unless it fails to complete the proposed capital investment or, if applicable, fails to create or maintain the requisite amount of jobs. In the case of such failure, the government is entitled to revoke the grants and seek repayment unless such failure resulted from material unforeseen market developments beyond the control of the recipient, wherein the government may refrain from reclaiming previous grants. Pursuant to such legislation in effect at the time, the Stendal mill received approximately €275 million of government grants. We believe that we are in compliance in all material respects with all of the terms and conditions governing the government grants we have received in Germany.

 

The following table sets out for the periods indicated the effect of these government grants on the recorded value of such assets in our consolidated balance sheets:

 

 

Qualifying capital investments at industrial facilities in Germany to reduce effluent discharges offset wastewater fees that would otherwise be required to be paid. For more information about our environmental capital expenditures, see “— Environmental”.

Total capital expenditures at the Celgar mill in 2007, 2006 and 2005 were €7.9 million, €16.0 million and €5.3 million, respectively. In 2007, we completed the C$28.0 million capital improvement project at the Celgar mill that commenced in 2005. The objective of this project was to reduce operating costs, increase production capacity and enhance the operating efficiency and reliability of the mill. The major components of the capital project consisted of the installation of two new compact wash presses and the expansion of one of the pulp machine dryers at an aggregate cost of approximately C$28.0 million. We estimate capital expenditures for the Celgar mill for 2008 to be approximately €5.7 million which is primarily related to reliability initiatives and environmental improvement projects.

 

Our operations are subject to a wide range of environmental laws and regulations, dealing primarily with water, air and land pollution control. We devote significant management and financial resources to comply with all applicable environmental laws and regulations. Our total capital expenditures on environmental projects at our mills were approximately €0.2 million in 2007 (2006 — €2.0 million) and are expected to be approximately €1.6 million in 2008.

 

We believe we have obtained all required environmental permits, authorizations and approvals for our operations. We believe our operations are currently in substantial compliance with the requirements of all applicable environmental laws and regulations and our respective operating permits.

 

Under German state environmental rules relating to effluent discharges, industrial users are required to pay wastewater fees based upon the amount of their effluent discharge. These rules also provide that an industrial user which undertakes environmental capital expenditures and lowers certain effluent discharges to prescribed levels may offset the amount of these expenditures against the wastewater fees that they would otherwise be required to pay. We estimate that the aggregate wastewater fees we saved in 2007 as a result of environmental capital expenditures and initiatives to reduce allowable emissions and discharges at our Stendal pulp mill were approximately €4.1 million. In 2006, the Stendal and Rosenthal mills saved aggregate wastewater fees of approximately €7.7 million. We expect that capital investment programs and other environmental initiatives at our German mills will mostly offset the wastewater fees that may be payable for 2008 and 2009 and will ensure that our operations continue in substantial compliance with prescribed standards.

 

Beginning in 2005, our German operations became subject to the European Union Emissions Trading Scheme pursuant to which our German mills were granted emission allowances. Emission allowances are granted based upon production volumes and the types of fuels consumed by manufacturing facilities in Germany. Excess allowances, which are the result of variations in production volumes and the overall consumption of fuels, are available for sale.

 

Environmental compliance is a priority for our operations. To ensure compliance with environmental laws and regulations, we regularly monitor emissions at our mills and periodically perform environmental audits of operational sites and procedures both with our internal personnel and outside consultants. These audits identify opportunities for improvement and allow us to take proactive measures at the mills as considered appropriate.

 

The Rosenthal mill has a relatively modern biological wastewater treatment and oxygen bleaching facility. We have significantly reduced our levels of adsorbable organic halogen discharge at the Rosenthal mill and we believe the Rosenthal mill’s adsorbable organic halogen and chemical oxygen demand discharges are in compliance with the standards currently mandated by the German government. In 2003 we completed a strategic capital project to reconstruct the landfill at the Rosenthal mill so that it will be useable for an additional 15 years.

 

The Stendal mill, which commenced operations in September 2004, has been in substantial compliance with applicable environmental laws, regulations and permits, but experienced certain minor exceedances during its ramp-up stage which is typical for a mill in this phase of its operations. Management believes that, as the Stendal mill is a state-of-the-art facility, it will operate in compliance with the applicable environmental requirements.

 

The Celgar mill has a number of permits regulating air and effluent emissions. In March 2007, its air permit was amended to include a single limit for SO₂ from the mill. The mill has been in substantial compliance with this limit. Air permit compliance issues are achieving substantial compliance with particulate emissions from the power boiler, smelt dissolving tank and the recovery boiler. The budget for 2008 includes modifications to the electrostatic

precipitator on the recovery boiler. Upgrade plans to the power boiler have been proposed for 2009. Odor control remains a priority in 2008. Spill pond dredging is necessary to remove a considerable stockpile of solids that is responsible for generating odor. This odor will at times cause compliance issues with the air permit. Dredging of this spill pond is scheduled for the first quarter of 2008.

 

The Celgar mill operates two landfills, a newly commissioned site and an older site. The Celgar mill intends to decommission the old landfill and is developing a closure plan and reviewing such plan with the Ministry of Environment, or “MOE”. However, the MOE, in conjunction with the provincial pulp and paper industry, is in the process of developing a standard for landfill closures. In addition, the portion of the landfill owned by an adjacent sawmill continues to be active. Accordingly, the mill has not been able to move forward with the closure. We currently believe we may receive regulatory approval for such closure plan in 2008 and commence closure activities thereafter. We currently estimate the cost of closing the landfill at approximately €1.5 million but since the closure program for the old landfill has not been finalized or approved, there can be no assurance that the decommissioning of the old landfill will not exceed such cost estimate.

 

Future regulations or permits may place lower limits on allowable types of emissions, including air, water, waste and hazardous materials, and may increase the financial consequences of maintaining compliance with environmental laws and regulations or conducting remediation. Our ongoing monitoring and policies have enabled us to develop and implement effective measures to maintain emissions in substantial compliance with environmental laws and regulations to date in a cost-effective manner. However, there can be no assurances that this will be the case in the future.

 

We currently employ or hold positions for approximately 1,490 people. We have approximately 1,076 employees working in our German pulp operations, including our transportation subsidiaries. In addition, there are approximately 18 people working at the office we maintain in Vancouver, British Columbia, Canada. The Celgar mill currently employs approximately 396 people in its operations, the vast majority of which are unionized.

 

Rosenthal is bound by collective agreements negotiated with Industriegewerkschaft Bergbau Chemie, Energie, or “IGBCE”, a national union that represents pulp and paper workers. During the second quarter of 2007, Rosenthal concluded a new labor contract with IGBCE which represents the majority of its employees. The agreement lengthened the work week to standard industry practice which indirectly lowered wage costs by about 4% and was largely offset by a 3% wage increase in the second half of 2008. The new labor contract is set to expire at the end of 2008.

 

Stendal and its subsidiaries employ approximately 612 people. Pursuant to the government grants and financing arranged in connection with the Stendal mill, we have agreed with German state authorities to maintain this number of jobs until September 2010. Stendal has not yet entered into any collective agreements with IGBCE, although it may do so in the future.

 

We consider the relationships with our employees to be good. We have implemented profit sharing plans, training programs and early retirement schemes for the benefit of our German employees. Although no assurances can be provided, we have not had any significant work stoppages at any of our German operations and we would therefore expect to enter into labor agreements with our pulp workers in Germany without any significant work stoppages at our German mills.

 

A five-year collective agreement with our union hourly workers at the Celgar mill is scheduled to expire on April 30, 2008. Generally, in British Columbia, the union representing hourly pulp mill workers seeks to settle a pattern agreement with a designated employer. Other than for local issues, this pattern agreement is usually then adopted by all pulp mill producers in the province. However, due to changing conditions in the industry, employers are moving towards customized agreements for specific mills. Although we consider our relationship with our Celgar hourly employees to be good, we can provide no assurance that a new collective agreement will be settled for the Celgar mill without significant work stoppages or disruptions.

 

The following summaries of certain material provisions of: (i) our senior notes; (ii) our convertible notes; (iii) the Stendal Loan Facility; (iv) the Rosenthal Loan Facility; and (v) the Celgar Working Capital Facility, as such terms are referred to below, are not complete and these provisions, including definitions of certain terms, are qualified by reference to the applicable documents and the applicable amendments to such documents on file with the Securities and Exchange Commission, or “SEC”.

 

Senior Notes

 

In conjunction with the acquisition of the Celgar mill and the repayment of Rosenthal’s then project loan facility, in February 2005, we issued $310.0 million in principal amount of senior notes. The senior notes bear interest at the rate of 9.25% per annum and mature on February 15, 2013. Interest on such notes is payable in arrears on February 15 and August 15 of each year the notes are outstanding. The notes are our senior unsecured obligations and, accordingly, will rank junior in right of payment to all existing and future secured indebtedness and all indebtedness and liabilities of our subsidiaries, equal in right of payment with all existing and future unsecured senior indebtedness and senior in right of payment to the 8.5% convertible senior subordinated notes due 2010 and any future subordinated indebtedness. We may redeem the notes on or after February 15, 2009, in whole or in part, at the applicable redemption prices plus accrued and unpaid interest, if any, to the redemption date. In certain circumstances, we may also redeem up to 35% of the aggregate principal amount of the notes at a redemption price of 109.35% of the principal amount, plus accrued and unpaid interest, if any, to the redemption date with the net cash proceeds of certain equity offerings. The notes were issued under an indenture which, among other things, restricts our ability and the ability of our restricted subsidiaries under the indenture to: (i) incur additional indebtedness or issue preferred stock; (ii) pay dividends or make other distributions to our stockholders; (iii) purchase or redeem capital stock or subordinated indebtedness (unless there is no default and such purchase or redemption involves our convertible notes and the daily closing sale price per share of our common stock on the Nasdaq Global Market for a period of at least ten consecutive trading days exceeds 120% of the then applicable conversion price of such convertible notes); (iv) make investments; (v) create liens and enter into sale and lease back transactions; (vi) incur restrictions on the ability of our restricted subsidiaries to pay dividends or make other payments to us; (vii) sell assets; (viii) consolidate or merge with or into other companies or transfer all or substantially all of our assets; and (ix) engage in transactions with affiliates. These limitations are subject to other important qualifications and exceptions.

 

In order to take into account the nature of the non-recourse “project financing” of the loan facility for our Stendal mill and to enhance our financing flexibility the indenture governing our senior notes provides for a “restricted group” and an “unrestricted group”. The terms of the indenture are applicable to the restricted group and generally not applicable to the unrestricted group. Currently the restricted group is comprised of Mercer Inc., certain holding subsidiaries, and the Rosenthal and the Celgar mills. The restricted group excludes our Stendal mill. The working capital facilities at our Rosenthal and Celgar mills and our convertible and senior notes are obligations of the restricted group. The loan facility for our Stendal mill is an obligation of our unrestricted group.

 

Convertible Notes

 

In October 2003, we issued $82.5 million in aggregate principal amount of 8.5% convertible senior subordinated notes due 2010, referred to as the “convertible notes”. In December 2006, we purchased and cancelled an aggregate of approximately $15.2 million principal amount of such notes in exchange for approximately 2.2 million shares of our common stock.

 

We pay interest semi-annually on the convertible notes on April 15 and October 15 of each year, beginning on April 15, 2004. The convertible notes mature on October 15, 2010. The convertible notes are redeemable on and after October 15, 2008, at any time in whole or in part, at our option on not less than 20 and not more than 60 days’ prior notice at a redemption price equal to 100% of the principal amount thereof plus accrued and unpaid interest, if any, to, but not including, the date of redemption, subject to the restrictions in the indenture governing the notes.

 

The convertible notes are convertible, at the option of the holder, unless previously redeemed, at any time on or prior to maturity into our common shares at a conversion price of $7.75 per share, which is equal to a conversion rate of approximately 129 shares per $1,000 principal amount of convertible notes, subject to adjustment.

Holders of the convertible notes have the right to require us to purchase all or any part of the convertible notes 30 business days after the occurrence of a change of control with respect to us at a purchase price equal to the principal amount thereof plus accrued and unpaid interest, if any, to the date of purchase.

 

The convertible notes are unsecured obligations of Mercer Inc. and are subordinated in right of payment to existing and future senior indebtedness (including our 9.25% senior notes described below) and are effectively subordinated to all of the indebtedness and liabilities of our subsidiaries. The indenture governing the convertible notes limits the incurrence by us, but not our subsidiaries, of senior indebtedness.

 

Stendal Loan Facility

 

In August 2002, we entered into a senior project finance facility, referred to as the “Stendal Loan Facility”, arranged by Bayerische Hypo-und Vereinsbank AG, or “HVB”, pursuant to a project finance loan agreement, referred to as the “Project Finance Loan Agreement”, entered into between Stendal and HVB. The Stendal Loan Facility was initially established in the aggregate amount of €828.0 million and is divided into tranches which cover, among other things, project construction and development costs, financing and start-up costs and working capital, as well as the financing of a debt service reserve account, approved cost overruns and a revolving loan facility that covered time lags for receipt of grant funding and value-added tax refunds in the amount of €160.0 million, which has been repaid. Other than the revolving working capital tranche, no further advances are currently available under the Stendal Loan Facility.

 

Pursuant to the Project Finance Loan Agreement, interest on the credit facilities was to accrue at variable rates between Euribor plus 0.60% and Euribor plus 1.55% per year. The Project Finance Loan Agreement provides for facilities to allow us to manage our risk exposure to interest rate risk, currency risk and pulp price risk by way of interest rate swaps, Euro and U.S. dollar swaps and pulp hedging transactions, subject to certain controls, including certain maximum notional and at-risk amounts. Pursuant to the terms of the Project Finance Loan Agreement, in 2002 Stendal entered into interest rate swap agreements in respect of borrowings under the Stendal Loan Facility to fix most of the interest costs under the Stendal Loan Facility at a rate of 3.795% per year until April 2004 and 5.28% commencing May 2004, plus margin, until final payment in October 2017. For more information, see “Item 7A — Quantitative and Qualitative Disclosures about Market Risk”.

 

Pursuant to the terms of the Stendal Loan Facility, Stendal reduced the aggregate advances outstanding to €565.1 million at the end of 2007 from a maximum original amount of €638.0 million. The tranches are generally repayable in installments and mature between the fifth and 15th anniversary of the first advance under the Stendal Loan Facility for project construction. Subject to various conditions, including a minimum debt service coverage test, Stendal may make distributions, in the form of interest and capital payments on shareholder debt or dividends on equity invested, to its shareholders, including us.

 

The tranches under the Stendal Loan Facility for project construction and development costs, financing costs, start-up costs and working capital are severally guaranteed by German federal and state governments in respect of an aggregate of 80% of the principal amount of these tranches, but the tranche under the Stendal Loan Facility for financing and start-up costs, working capital and certain of the project construction and development costs benefiting from these guarantees will be reduced semi-annually by 12.5% per year beginning on the first repayment date following the fourth anniversary of the first advance under the Stendal Loan Facility for each of these costs. Under the guarantees, the German federal and state governments that provide the guarantees are responsible for the performance of our payment obligations for the guaranteed amounts. As our Stendal Project Facility is guaranteed up to 80% pursuant to such governmental guarantees, this facility benefits from lower interest costs and other credit terms than would otherwise be available.

 

The Stendal Loan Facility is secured by all of the assets of Stendal.

 

In connection with the Stendal Loan Facility, we entered into a shareholders’ undertaking agreement, referred to as the “Undertaking”, dated August 26, 2002, as amended, with RWE AG and HVB in order to finance the shareholders’ contribution to the Stendal mill. Pursuant to the terms of the Undertaking, on the Stendal financing closing date the shareholders of Stendal, on a pro rata basis, subscribed for €15.0 million of share capital of Stendal and advanced to it €55.0 million in subordinated loans. In addition, on a pro rata basis, the shareholders of Stendal

advanced to it €30.0 million of stand-by equity to, among other things, cover approved cost overruns, fund the equity reserve account and partially fund the debt service reserve account under the Stendal Loan Facility. On the closing of the Stendal Loan Facility, we provided HVB with a cash deposit for our pro rata portion of such equity reserve account. Our total funding commitment under the Undertaking was €63.5 million, all of which was effected in August 2002. In 2006, when we acquired an additional 7% minority interest in Stendal, we also acquired the holder’s pro rata interest in the outstanding shareholder loans and standby equity of Stendal. Pursuant to the Undertaking, we have agreed, for as long as Stendal has any liability under the Stendal Loan Facility to HVB, to retain control over at least 51% of the voting shares of Stendal. We have no further capital commitments with relation to the Stendal mill.

 

Rosenthal Loan Facility

 

In February 2005, we established a revolving working capital facility for the Rosenthal mill, referred to as the “Rosenthal Loan Facility”, to replace its prior project financing facility. The €40.0 million revolving working capital facility for the Rosenthal mill, arranged by HVB, consists of a revolving credit facility which may be utilized by way of cash advances or advances by way of letter of credit or bank guarantees. The facility matures in February 2010. The interest payable on cash advances is LIBOR or EURIBOR plus 1.55%, plus certain other costs incurred by the lenders in connection with the facility. Each cash advance is to be repaid on the last day of the respective interest period and in full on the termination date and each advance by way of a letter of credit or bank guarantee shall be repaid on the applicable expiry date of such letter of credit or bank guarantee. An interest period for cash advances shall be three, six or 12 months or any other period as Rosenthal and the lenders may determine. There is also a 0.35% per annum commitment fee on the unused and uncancelled amount of the revolving facility which is payable quarterly in arrears. This facility is secured by a first fixed charge on the inventories, receivables and accounts of Rosenthal. It also provides Rosenthal with a hedging facility relating to the hedging of the interest, currency and pulp prices as they affect Rosenthal pursuant to a strategy agreed to by Rosenthal and HVB from time to time.

 

Celgar Working Capital Facility

 

In May 2006, we established a C$40.0 million working capital facility for our Celgar mill, referred to as the “Celgar Working Capital Facility”, to replace an existing facility. This facility consists of a three-year revolving working capital credit facility maturing in May 2009. The borrower under the facility is Zellstoff Celgar Limited Partnership, which is our wholly owned subsidiary that owns the Celgar mill. Availability of drawdowns under the facility is subject to a borrowing base limit that is based upon the Celgar mill’s eligible accounts receivable and inventory levels from time to time. The revolving facility is available by way of: (i) Canadian and U.S. denominated advances which bear interest at a designated prime rate plus 0.50% for Canadian advances and at a designated base rate plus 0.50% per annum for U.S. advances; (ii) banker’s acceptance equivalent loans which bear interest at the applicable Canadian dollar bankers’ acceptance rate plus 2.25% per annum; and/or (iii) LIBOR advances which bear interest at the applicable LIBOR plus 2.25% per annum. The facility incorporates two sub lines, a $2.0 million letter of credit sub line and a $3.0 million foreign exchange contract sub line. Under these sub lines the lender will provide letters of credit guarantees and foreign exchange contract guarantees up to a maximum of $2.0 million and $3.0 million, respectively, subject, in each case, to the facility limit and payment of applicable fees. The borrower is also required to pay a 0.25% per annum standby fee monthly in arrears on any unutilized portion of the revolving facility. This facility is secured by, among other things, a first fixed charge on the current assets of the borrower.

 

In August 2006, we divested our equity interest in the Heidenau paper mill and Landqart AG for cash proceeds of €5.0 million and a secured note of €5.0 million. In November 2006, we sold substantially all of the assets comprising the Fährbrücke paper mill. We recorded an aggregate net loss of €6.0 million on the disposal of these assets which included an accrual of €1.9 million for net costs expected in connection with funding and other commitments related to the Fährbrücke sale.

 

We make available free of charge on or through our website at www.mercerint.com annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and all amendments to these reports, as soon as reasonably practicable after we file these materials with the SEC. The public may read and copy any material we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may also obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site at www.sec.gov that also contains our current and periodic reports, including our proxy and information statements.

 

 

This annual report on Form 10-K contains forward looking statements. Statements that are not historical or current facts, including statements about our expectations, anticipated financial results, projected capital expenditures and future business prospects, are forward looking statements. You can identify these statements by our use of words such as “may”, “will”, “expect”, “believe”, “should”, “plan”, “anticipate” and other similar expressions. You can find examples of these statements throughout this annual report, including the description of business in “Item 1. Business” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations”. We cannot guarantee that our actual results will be consistent with the forward looking statements we make in this annual report. You should review carefully the risk factors listed below, as well as those factors listed in other documents we file with the SEC. You are cautioned not to place undue reliance on forward looking statements. We note that additional risks not presently known to us or that we may currently deem immaterial may also impair our business and operations. Unless required by applicable law, we do not assume an obligation to update any forward looking statement.

 

Our business is highly cyclical in nature.

 

The pulp business is cyclical in nature and markets for our principal products are characterized by periods of supply and demand imbalance, which in turn affects product prices. Pulp markets are highly competitive and are sensitive to cyclical changes in the global economy, industry capacity and foreign exchange rates, all of which can have a significant influence on selling prices and our earnings. The length and magnitude of industry cycles have varied over time but generally reflect changes in macro economic conditions and levels of industry capacity.

 

Industry capacity can fluctuate as changing industry conditions can influence producers to idle production or permanently close machines or entire mills. In addition, to avoid substantial cash costs in idling or closing a mill, some producers will choose to operate at a loss, sometimes even a cash loss, which can prolong weak pricing environments due to oversupply. Oversupply of our products can also result from producers introducing new capacity in response to favorable pricing trends.

 

Demand for pulp has historically been determined by the level of economic growth and has been closely tied to overall business activity. Although pulp prices have improved over the last two years, we cannot predict the impact of future economic weakness in certain world markets or the impact of war, terrorist activity or other events on our markets.

 

Prices for pulp are driven by many factors outside our control, and we have little influence over the timing and extent of price changes, which are often volatile. Because market conditions beyond our control determine the price for pulp, such price may fall below our cash production costs, requiring us to either incur short-term losses on product sales or cease production at one or more of our manufacturing facilities. Therefore, our profitability depends on managing our cost structure, particularly raw materials which represent a significant component of our operating costs and can fluctuate based upon factors beyond our control. If the prices of our products decline, or if raw materials increase, or both, demand for our products may decline and our sales and profitability could be materially adversely affected.

 

Our production costs are influenced by the availability and cost of raw materials, energy and labor, and our plant efficiencies and productivity. Our main raw material is fiber in the form of wood chips and pulp logs. Fiber costs are primarily affected by the supply of, and demand for, lumber which is highly cyclical in nature and can vary

significantly by location. Production costs also depend on the total volume of production. Lower operating rates and production efficiencies during periods of cyclically low demand result in higher average production costs and lower margins.

 

Cyclical fluctuations in the price and supply of our raw materials could adversely affect our business.

 

Wood chips and pulp logs comprise the fiber used by our pulp mills. Such fiber is cyclical in terms of both price and supply. The cost of wood chips and pulp logs is primarily affected by the supply and demand for lumber. Demand for these raw materials is generally determined by the volume of pulp and paper products produced globally and regionally. Recently, continued high energy prices, a focus on “green” or renewable energy and governmental initiatives have led to an increase in renewable energy projects in Europe, including Germany. Demand for wood residuals from such energy producers has put upward pressure on prices for wood residuals such as wood chips in Germany and its neighboring countries. This has resulted in higher fiber costs for our German pulp mills and such trend could continue to put further upward pressure on wood chip prices. Similarly, North American energy producers are exploring the viability of renewable energy initiatives which could increase the demand for sawmill residual fiber, including chips. The cyclical nature of pricing for these raw materials represents a potential risk to our profit margins if pulp producers are unable to pass along price increases to their customers.

 

We do not own any timberlands or have any long-term governmental timber concessions nor do we have any long-term fiber contracts at our German operations. Raw materials are available from a number of suppliers and we have not historically experienced material supply interruptions or substantial sustained price increases, however our requirements have increased and may continue to increase as we increase capacity through capital projects or other efficiency measures at our mills. As a result, we may not be able to purchase sufficient quantities of these raw materials to meet our production requirements at prices acceptable to us during times of tight supply. In addition, the quality of fiber we receive could be reduced as a result of industrial disputes, material curtailments or shut-down of operations by suppliers, government orders and legislation, weather conditions, acts of god and other events beyond our control. An insufficient supply of fiber or reduction in the quality of fiber we receive would materially adversely affect our business, financial condition, results of operations and cash flow. In addition to the supply of wood fiber, we are dependent on the supply of certain chemicals and other inputs used in our production facilities. Any disruption in the supply of these chemicals or other inputs could affect our ability to meet customer demand in a timely manner and could harm our reputation. Any material increase in the cost of these chemicals or other inputs could have a material adverse effect on our business, results of operations, financial condition and cash flows.

 

Our level of indebtedness could negatively impact our financial condition and results of operations.

 

As of December 31, 2007, we had approximately €849.9 million of indebtedness outstanding, of which €565.1 million is project debt of Stendal. We may also incur additional indebtedness in the future. Our high debt levels may have important consequences for us, including, but not limited to the following:

 

 

Our ability to repay or refinance our indebtedness will depend on our future financial and operating performance. Our performance, in turn, will be subject to prevailing economic and competitive conditions, as well as financial, business, legislative, regulatory, industry and other factors, many of which are beyond our control. Our ability to meet our future debt service and other obligations, in particular the Stendal project debt, may depend

in significant part on the success of the Stendal mill and the extent to which we can implement successfully our business and growth strategy. We cannot assure you that we will be able to implement our strategy fully or that the anticipated results of our strategy will be realized.

 

We operate in highly competitive markets.

 

We sell our pulp globally, with a large percentage sold in Europe, North America and Asia. The markets for pulp are highly competitive. A number of other global companies compete in each of these markets and no company holds a dominant position. For pulp, many companies produce products that are largely standardized. As a result, the primary basis for competition in our markets has been price. Many of our competitors have greater resources and lower leverage than we do and may be able to adapt more quickly to industry or market changes or devote greater resources to the sale of products than we can. There can be no assurance that we will continue to be competitive in the future. The global pulp market has historically been characterized by considerable swings in prices which have and will result in variability in our earnings. Prices are typically denominated in U.S. dollars.

 

We are exposed to currency exchange rate and interest rate fluctuations.

 

In 2007, the majority of our sales were in products quoted in U.S. dollars while most of our operating costs and expenses, other than those of the Celgar mill, were incurred in Euros. In addition, all of the products sold by the Celgar mill are quoted in U.S. dollars and the Celgar mill costs are primarily incurred in Canadian dollars. Our results of operations and financial condition are reported in Euros. As a result, our revenues have been adversely affected by the decrease in the value of the U.S. dollar relative to the Euro and to the Canadian dollar. Such shifts in currencies relative to the Euro and the Canadian dollar reduce our operating margins and the cash flow available to fund our operations and to service our debt. This could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

In 2002, Stendal entered into variable-to-fixed interest rate swaps to fix interest payments under the Stendal mill financing facility, which has kept Stendal from benefiting from the general decline in interest rates that ensued. These derivatives are marked to market at the end of each reporting period and all unrealized gains and losses are recognized in earnings for the relevant reporting periods.

 

Increases in our capital expenditures or maintenance costs could have a material adverse effect on our cash flow and our ability to satisfy our debt obligations.

 

Our business is capital intensive. Our annual capital expenditures may vary due to fluctuations in requirements for maintenance, business capital, expansion and as a result of changes to environmental regulations that require capital expenditures to bring our operations into compliance with such regulations. In addition, our senior management and board of directors may approve projects in the future that will require significant capital expenditures. Increased capital expenditures could have a material adverse effect on our cash flow and our ability to satisfy our debt obligations. Further, while we regularly perform maintenance on our manufacturing equipment, key pieces of equipment in our various production processes may still need to be repaired or replaced. If we do not have sufficient funds or such repairs or replacements are delayed, the costs of repairing or replacing such equipment and the associated downtime of the affected production line could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

We use derivatives to manage certain risk which has caused significant fluctuations in our operating results.

 

A significant amount of our sales revenue is based on pulp sales quoted in U.S. dollars while our reporting currency is Euros and our costs are predominantly in Euros and in Canadian dollars. From time to time, we use foreign currency derivative instruments primarily to try to manage against depreciation of the U.S. dollar against the Euro.

 

We also use derivative instruments to limit our exposure to interest rate fluctuations. Concurrently with entering into the Stendal financing, Stendal entered into variable-to-fixed rate interest swaps for the full term of the Stendal Facility to manage its interest rate risk exposure with respect to the full principal amount of this facility.

We record unrealized gains or losses on our derivative instruments when they are marked to market at the end of each reporting period and realized gains or losses on them when they are settled. These unrealized and realized gains and losses can materially impact our operating results for any reporting period. For example, our operating results for 2007 included realized and unrealized net gains of €20.4 million on our currency and interest rate derivatives. Our operating results for 2006 included realized and unrealized net gains of €105.8 million on currency and interest rate derivatives.

 

If any of the variety of instruments and strategies we utilize are not effective, we may incur losses which may have a materially adverse effect on our business, financial condition, results of operations and cash flow. Further, we may in the future use derivative instruments to manage pulp price risks. The purpose of our derivative activity may also be considered speculative in nature; we do not use these instruments with respect to any pre-set percentage of revenues or other formula, but either to augment our potential gains or reduce our potential losses depending on our perception of future economic events and developments.

 

We are subject to extensive environmental regulation and we could have environmental liabilities at our facilities.

 

Our operations are subject to numerous environmental laws as well as permits, guidelines and policies. These laws, permits, guidelines and policies govern, among other things:

 

 

In addition, as a result of our operations, we may be subject to remediation, clean up or other administrative orders or amendments to our operating permits, and we may be involved from time to time in administrative and judicial proceedings or inquiries. Future orders, proceedings or inquiries could have a material adverse effect on our business, financial condition and results of operations. Environmental laws and land use laws and regulations are constantly changing. New regulations or the increased enforcement of existing laws could have a material adverse effect on our business and financial condition. In addition, compliance with regulatory requirements is expensive, at times requiring the replacement, enhancement or modification of equipment, facilities or operations. There can be no assurance that we will be able to maintain our profitability by offsetting any increased costs of complying with future regulatory requirements.

 

We are subject to liability for environmental damage at the facilities that we own or operate, including damage to neighboring landowners, residents or employees, particularly as a result of the contamination of soil, groundwater or surface water and especially drinking water. The costs of such liabilities can be substantial. Our potential liability may include damages resulting from conditions existing before we purchased or operated these facilities. We may also be subject to liability for any offsite environmental contamination caused by pollutants or hazardous substances that we or our predecessors arranged to transport, treat or dispose of at other locations. In addition, we may be held legally responsible for liabilities as a successor owner of businesses that we acquire or have acquired. Except for Stendal, our facilities have been operating for decades and we have not done invasive testing to determine whether or to what extent environmental contamination exists. As a result, these businesses may have liabilities for conditions that we discover or that become apparent, including liabilities arising from non-compliance with environmental laws by prior owners. Because of the limited availability of insurance coverage for

environmental liability, any substantial liability for environmental damage could materially adversely affect our results of operations and financial condition.

 

Enactment of new environmental laws or regulations or changes in existing laws or regulations might require significant capital expenditures. We may be unable to generate sufficient funds or access other sources of capital to fund unforeseen environmental liabilities or expenditures.

 

We are subject to risks related to our employees.

 

The majority of our employees are unionized. In the future we may enter into a collective agreement with our pulp workers at the Stendal mill. The collective agreements relating to hourly workers at both our Rosenthal and Celgar mills expire in 2008. Although we have not experienced any work stoppages in the past, there can be no assurance that we will be able to negotiate acceptable collective agreements or other satisfactory arrangements with our employees upon the expiration of our collective agreements or in conjunction with the establishment of a new agreement or arrangement with our pulp workers at the Stendal mill. This could result in a strike or work stoppage by the affected workers. The registration or renewal of the collective agreements or the outcome of our wage negotiations could result in higher wages or benefits paid to union members. Accordingly, we could experience a significant disruption of our operations or higher on-going labor costs, which could have a material adverse effect on our business, financial condition, results of operations and cash flow.

 

We rely on German federal and state government grants and guarantees.

 

We currently benefit from a subsidized capital expenditure program and lower cost of financing as a result of German federal and state government grants and guarantees at our Stendal mill. Should either the German federal or state governments be prohibited from honoring legislative grants and guarantees at Stendal, or should we be required to repay any such legislative grants, this may have a material adverse effect on our business, financial condition, results of operations and cash flow.

 

The sale of emission allowances is relatively new and volatile and subject to governmental amendment.

 

Commencing in 2005, our German operations became subject to the European Emissions Trading Scheme. Over the last three years, we have benefited from the sales of emission allowances. The market for emission allowances is relatively new and volatile. Further, the allocation of emission allowances, which is currently based upon production volumes and the types of fuels consumed by manufacturing facilities in Germany, is subject to governmental review and potential changes in 2008. Additionally, we expect that, over time, the amount of emission allowances granted to manufacturing facilities in Germany will be reduced although we cannot predict the timing or the amount of any such reduction. As a result, we cannot predict with any certainty either the amount of future sales of emission allowances or the amount of emission allowances we may be granted.

 

We are dependent on key personnel.

 

Our future success depends, to a large extent, on the efforts and abilities of our executive and senior mill operating officers. Such officers are industry professionals many of whom have operated through multiple business cycles. Our officers play an integral role in, among other things:

 

 

The loss of one or more of our officers could make us less competitive in these areas which could materially adversely affect our business, financial condition, results of operations and cash flows. We do not maintain any key person life insurance for any of our executive or senior mill operating officers.

We may experience material disruptions to our production.

 

A material disruption at one of our manufacturing facilities could prevent us from meeting customer demand, reduce our sales and/or negatively impact our results of operations. Any of our pulp manufacturing facilities could cease operations unexpectedly due to a number of events, including:

 

 

Any such downtime or facility damage could prevent us from meeting customer demand for our products and/or require us to make unplanned capital expenditures. If any of our facilities were to incur significant downtime, our ability to meet our production capacity targets and satisfy customer requirements would be impaired and could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our insurance coverage may not be adequate.

 

We have obtained insurance coverage that we believe would ordinarily be maintained by an operator of facilities similar to our pulp mills. Our insurance is subject to various limits and exclusions. Damage or destruction to our facilities could result in claims that are excluded by, or exceed the limits of, our insurance coverage.

 

We rely on third parties for transportation services.

 

Our business primarily relies upon third parties for the transportation of pulp to our customers, as well as for the delivery of our raw materials to our mills. Our pulp and raw materials are principally transported by truck, barge, rail and sea-going vessels, all of which are highly regulated. Increases in transportation rates can also materially adversely affect our results of operations.

 

Further, if our transportation providers fail to deliver our pulp in a timely manner, it could negatively impact our customer relationships and we may be unable to sell it at full value. If our transportation providers fail to deliver our raw materials in a timely fashion, we may be unable to manufacture pulp in response to customer orders. Also, if any of our transportation providers were to cease operations, we may be unable to replace them at a reasonable cost. The occurrence of any of the foregoing events could materially adversely affect our results of operations.

 

Washington State law and our Articles of Incorporation may have anti-takeover effects which will make an acquisition of our Company by another company more difficult.

 

We are subject to the provisions of the Revised Code of Washington, Chapter 23B.19, which prohibits a Washington corporation, including our Company, from engaging in any business combination with an “acquiring person” for a period of five years after the date of the transaction in which the person became an acquiring person, unless the business combination is approved in a prescribed manner. A business combination includes mergers, asset sales as well as certain transactions resulting in a financial benefit to the acquiring person. Subject to certain exceptions, an “acquiring person” is a person who, together with affiliates and associates, owns, or within five years did own, 10% or more of the corporation’s voting stock. We may in the future adopt certain measures that may have the effect of delaying, deferring or preventing a change in control of our Company. Under Washington State law, we

have the ability to adopt certain of these measures, including, without limitation, a shareholder rights plan, without any further vote or action by the holders of our shares. These measures may have anti-takeover effects, which may delay, defer or prevent a takeover attempt that a holder of our shares might consider in its best interest.

 

 

None.

 

 

We lease offices in Seattle, Washington, Vancouver, British Columbia, and in Berlin, Germany. We own the Rosenthal and Celgar mills and the underlying property. The Stendal mill is situated on property owned by Stendal, our 70.6% owned subsidiary.

 

The Rosenthal mill is situated on a 220 acre site near the town of Blankenstein in the state of Thüringia, approximately 300 kilometers south of the Stendal mill. The Saale river flows through the site of the mill. In late 1999, we completed a major capital project which converted the Rosenthal mill to the production of kraft pulp. It is a single line mill with a current annual production capacity of approximately 325,000 ADMTs of kraft pulp. The mill is self-sufficient in steam and electrical power. Some excess electrical power which is constantly generated is sold to the regional power grid. The facilities at the mill include:

 

 

The Stendal mill is situated on a 200 acre site owned by Stendal that is part of a larger 1,250 acre industrial park near the town of Stendal in the state of Saxony-Anhalt, approximately 300 kilometers north of the Rosenthal mill and 130 kilometers from the city of Berlin. The mill is adjacent to the Elbe river and has access to harbor facilities for water transportation. The mill is a single line mill with a current annual design production capacity of approximately 620,000 ADMTs of kraft pulp. The Stendal mill is self-sufficient in steam and electrical power. Some excess electrical power which is constantly being generated is sold to the regional power grid. The facilities at the mill include:

 

 

 

The Celgar mill is situated on a 400 acre site near the city of Castlegar, British Columbia. The mill is located on the south bank of the Columbia River, approximately 600 kilometers east of the port city of Vancouver, British Columbia, and approximately 32 kilometers north of the Canada-U.S. border. The city of Seattle, Washington is approximately 650 kilometers southwest of Castlegar. It is a single line mill with a current annual production capacity of approximately 480,000 ADMTs of NBSK pulp. Internal power generating capacity could, with certain capital improvements, enable the Celgar mill to be self-sufficient in electrical power and at times to sell surplus electricity. The facilities at the Celgar mill include:

 

 

At the end of 2007, substantially all of the assets relating to the Stendal mill were pledged to secure the Stendal Loan Facility. The working capital loan facilities established for the Rosenthal and Celgar mills are secured by first charges against the inventories and receivables at the respective mills.

 

The following table sets out our pulp production capacity and actual production sales volumes and revenues by mill for the periods indicated:

 

 

 

 

In October 2005, our wholly owned subsidiary, Zellstoff Celgar Limited, received a re-assessment for real property transfer tax payable in British Columbia, Canada, in the amount of approximately €3.3 million (C$4.7 million) in connection with the transfer of the land where the Celgar mill is situated. We are contesting the assessment and the amount, if any, that may be payable in connection therewith is not yet determinable.

 

As our Stendal mill is located in eastern Germany, it received approximately €275 million of government grants, which are applied to reduce the cost basis of the assets acquired with such grants. Under European Union

rules, the Commission of the European Communities, referred to as the “Commission”, was formally notified in March 2002 by Germany of plans to provide support to the Stendal mill through grants and guarantees. The Commission considered these plans and, on June 19, 2002, decided not to raise any objection against such support being provided by the German federal and state governments in respect of the Stendal mill. In its decision, the Commission was not called upon to determine whether the governmental aid schemes, on which the support is based, were acceptable, but was limited to a determination as to whether a reduction of the pre-approved aid level for investment in the German state of Saxony-Anhalt under the previously approved schemes was required under European Union law in the case of the Stendal mill. In coming to its decision, the Commission generally has a wide margin of discretion in its assessment of facts and data. Under European Union law, member states, competitors or trade associations directly affected by a decision of the Commission may appeal such decision within a period of two months and 24 days after publication of the Commission decision. On December 23, 2002, Kronoply GmbH and Kronotex GmbH & Co., two related manufacturers of, among other things, oriented strand board, or “OSB”, and medium-density fiber boards, or “MDF”, boards that do not compete with the Stendal mill by selling pulp or paper, filed an appeal with the Court of First Instance of the European Communities (Luxembourg), referred to as the “Court”, against the Commission decision of June 19, 2002. Generally, to be successful, an appeal must show that the Commission failed to comply with procedural requirements or committed a manifest error in assessing facts and data in adopting its decision.

 

In late 2004, the Court in an unrelated case determined that the Commission committed a procedural error in determining the amount of state aid that could be granted by Germany to a recipient in a different business. The Court found the Commission erred when reviewing the effect of state aid on competition by only considering capacity utilization and not also considering product demand trends prior to providing its approval. As a result, in that case the Court set aside the Commission approval and remanded the matter back to the Commission to redetermine. The Court’s decision is being appealed by the aid recipient and the government of Germany. If such appeal is unsuccessful, the Commission will have to redetermine the matter in such unrelated case based upon its mandated criteria and may come to the same determination as before. The procedure followed by the Commission in this remanded decision was similar to that it used in determining not to reduce the amount of state aid available to the Stendal mill.

 

Although no assurance can be provided, we continue to believe that the appellant does not have any standing to bring the appeal as it is not a competitor of Stendal and, in any event, that the appeal is without merit. Further, the procedural error found by the Court in the remanded case was not raised in the Stendal appeal and we do not believe the Court should permit the appellant to amend its appeal at this stage.

 

Subject to the Court’s schedule, we believe a hearing, in which the Court would consider both the standing of the applicant and the merits of the appeal is likely to occur in the course of 2008. In the event the appellant was then successful both on the issue of standing and as regards the merits and such decision was upheld on appeal, the issue of whether the amount of state aid granted to the Stendal mill should be reduced would be remanded back to the Commission for reconsideration. Although we cannot assure you as to the outcome of any such redetermination, we believe that, given the Commission’s criteria and the factual circumstances related to the Stendal mill including demand trends in the pulp business, there would be no basis for the Commission to reduce the level of state aid. If the Commission determined to reduce the level of state aid available to the Stendal mill and such decision was upheld on appeal, Stendal would be required to repay a portion of the previously received state aid back to the German government. While we do not expect an adverse outcome, litigation is inherently uncertain and there can be no assurance of the final outcome.

 

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

 

 

Not applicable.

 

 

(a) Market Information.  Our shares are quoted for trading on the NASDAQ Global Market under the symbol “MERC” and listed in U.S. dollars on the Toronto Stock Exchange under the symbol “MRI.U”. The following table sets forth the high and low sales prices of our shares on the NASDAQ Global Market for each quarter in the two year period ended December 31, 2007, and for the period ended February 21, 2008:

 

 

(b) Shareholder Information.  As at February 21, 2008, there were approximately 462 holders of record of our shares and a total of 36,285,027 shares were outstanding.

 

(c) Dividend Information.  The declaration and payment of dividends is at the discretion of our board of directors. Our board of directors has not declared or paid any dividends on our shares in the past two years and does not anticipate declaring or paying dividends in the foreseeable future.

 

(d) Equity Compensation Plans.  The following table sets forth information as at December 31, 2007 regarding: (i) our 1992 amended and restated stock option plan under which options to acquire an aggregate of 3,600,000 of our shares may be granted; and (ii) our 2004 Stock Incentive Plan pursuant to which 1,000,000 of our shares may be issued pursuant to options, stock appreciation rights and restricted shares:

 

 

 

 

(e) Private Placements.  In February 2005, pursuant to the acquisition of the Celgar mill, we issued 4,210,526 of our shares at a price of $9.50 per share to the vendor of the Celgar mill for gross proceeds of $40.0 million in reliance on Regulation S under the Securities Act of 1933, as amended, referred to as the “Securities Act”. In connection with the issuance of these shares, we filed a shelf registration statement on Form S-3 with the SEC in 2005 to register these shares for resale. The shelf registration statement was withdrawn in February 2007.

 

In December 2006, we purchased and cancelled an aggregate of $15,245,000 principal amount of our convertible notes in exchange for 2,201,035 shares of our common stock. The shares were issued pursuant to Section 3(a)(9) of the Securities Act of 1933, as amended.

 

The following table sets forth selected historical financial and operating data as at and for the periods indicated. The following selected financial data is qualified in its entirety by, and should be read in conjunction with, our consolidated financial statements and related notes contained in this annual report and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations”. The following selected financial data:

 

 

 

 

 

The following discussion and analysis of our financial condition and results of operations as at and for the three years ended December 31, 2007 is based upon and should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this annual report. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations reflects:

 

 

We operate in the pulp business and our operations are located in Germany and western Canada. Our pulp mills are comprised of: (a) an NBSK pulp mill operated by our wholly-owned subsidiary, Rosenthal, near Blankenstein, Germany, which has a current annual production capacity of approximately 325,000 ADMTs; (b) a state-of-the-art NBSK pulp mill, with a current production capacity of approximately 620,000 ADMTs per year, near Stendal, Germany owned and operated by our 70.6% owned subsidiary, Stendal; and (c) the Celgar NBSK pulp mill operated by our wholly-owned subsidiary, Celgar, with a current annual production capacity of approximately 480,000 ADMTs located near Castlegar, British Columbia, Canada.

 

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 markets are highly cyclical, with prices determined by supply and demand. Demand for kraft pulp 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 NBSK pulp 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 pulp logs. Wood chip and pulp log 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 prices. Historically, kraft pulp prices have been cyclical in nature. The average European list prices for NBSK pulp between 2000 and 2007 ranged from a low of $477 per ADMT in 2002 to a high of $870 per ADMT in 2007.

 

List prices for NBSK pulp weakened in 2005 primarily due to the strengthening of the U.S. dollar and were approximately $600 per ADMT in Europe in December 2005. Pulp prices increased steadily in 2006 primarily as a result of the closure of several pulp mills, particularly in North America, which reduced NBSK pulp capacity by approximately 1.2 million ADMTs, better demand and the general weakness of the U.S. dollar. At the end of 2007, list prices for NBSK pulp in Europe had increased to approximately $870 per ADMT.

 

A producer’s sales realizations will reflect customer discounts, commissions and other items and NBSK pulp prices will continue to fluctuate in the future.

Our financial performance for any reporting period is also impacted by changes in the U.S. dollar to Euro and Canadian dollar 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 quoted in U.S. dollars, even though a significant portion of the sales from our German mills is invoiced in Euros. Therefore, a weakening of the U.S. dollar against the Euro and the Canadian dollar will generally reduce the amount of revenues of our pulp operations. Most of our operating costs at our German mills, including our debt obligations under the Stendal Loan Facility and Rosenthal Loan Facility, are incurred in Euros. Most of our operating costs at the Celgar mill, including under its working capital facility, are in Canadian dollars. These costs do not fluctuate with the U.S. dollar to Euro or Canadian dollar exchange rates. Thus, a weakening of the U.S. dollar against the Euro and the Canadian dollar tends to reduce our sales revenue, gross profit and income from operations. From time to time, we seek to mitigate the effect of such weakening against the Euro through foreign currency derivatives we put into place from time to time to protect against such currency movements.

 

Changes in interest rates can impact our operating results because the credit facilities established for our pulp mills provide for floating rates of interest.

 

Changes in currency exchange and interest rates also impact certain foreign currency and interest rate derivatives used by Stendal and Rosenthal from time to time 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 “Item 7A — Quantitative and Qualitative Disclosures about Market Risk”.

 

In 2005, Stendal entered into currency swaps in the aggregate principal amount of €612.6 million to convert all of its long-term indebtedness under the Stendal Loan Facility from Euros into U.S. dollars, as well as certain currency forwards, such swaps and forwards being collectively referred to as the “Currency Derivatives”. In 2007, we recorded a net realized gain of €6.8 million before minority interests on the settlement of such swaps and a net unrealized non-cash loss of €5.9 million before minority interests on the balance of the Currency Derivatives. In 2006, we recorded a net realized loss of €3.5 million before minority interests on the settlement of such swaps and a net unrealized non-cash gain of €72.1 million before minority interests on the Currency Derivatives. In 2005, we recorded a net realized loss of €2.2 million before minority interests on the Currency Derivatives that were settled and a net unrealized non-cash holding loss of €66.1 million before minority interests in respect of the Currency Derivatives.

 

Stendal, as required under its project financing, entered into variable-to-fixed rate interest swaps, referred to as the “Stendal Interest Rate Contracts”, in August 2002 to fix the interest rate on approximately €612.6 million of indebtedness for the full term of the Stendal Loan Facility.

 

In 2007 and 2006, we recorded net unrealized non-cash holding gains of €19.5 million and €37.3 million, respectively, before minority interests on the marked to market valuation of the Stendal Interest Rate Contracts. These gains resulted primarily from improving world economies and increases in long-term European interest rates. In 2005, we recorded a net unrealized non-cash holding loss of €3.2 million before minority interests on the Stendal Interest Rate Contracts. Slowing world economies and a fall in interest rates could result in our recording non-cash holding losses on the Stendal Interest Rate Contracts in future periods when they are marked to market.

Selected production, sales and exchange rate data for each of our last three years is as follows:

 

 

 

 

In the year ended December 31, 2007, revenues increased by approximately 13% to €704.4 million from €624.0 million in 2006, primarily due to higher prices which were partially offset by an 8% and 5% weakening of the U.S. dollar versus the Euro and the Canadian dollar, respectively. Pulp prices increased steadily in 2007 primarily as a result of stronger demand and the weakening of the U.S. dollar. List prices for NBSK pulp in Europe were approximately $800 (€584) per ADMT in 2007, compared to approximately $680 (€542) per ADMT in 2006. At the end of 2007, list prices increased to approximately $870 (€596) per ADMT in Europe and $760 (€520) per ADMT in Asia, depending upon the country of delivery. At December 31, 2007, Norscan producers’ inventories for softwood kraft declined to 27 days supply, compared to 25 days at the end of 2006.

 

Average pulp sales realizations increased to €516 per ADMT in 2007 from €465 per ADMT in 2006.

 

Operating costs and selling, general, administrative and other expenses increased to €634.8 million in the year ended December 31, 2007 from €531.5 million in 2006, primarily as a result of increased fiber costs and higher sales volume. In 2006, we benefited from, and costs were reduced by, a reversal of an accrual for wastewater fees of €13.0 million.

 

Weak markets for emission allowances in 2007 resulted in the contribution to income from such sales decreasing to €4.6 million, compared to €15.6 million in 2006. Partially offsetting this was a 9% increase in sales of surplus energy in 2007 compared to 2006.

 

Overall, in 2007, fiber costs increased by approximately 29% compared to 2006 as a result of both a supply imbalance and increased demand. In Germany, the supply imbalance resulted from low harvesting levels in late 2005 and 2006 which were not made up during the course of the year. Increased demand in Germany resulted from higher consumption of wood residuals by renewable energy suppliers. A strong European lumber market at the beginning of 2007 provided some marginal price relief in the middle of the year. Fiber costs at our Celgar mill were also higher in the current period compared to the comparative period of 2006 due to reduced North American sawmill activity as a result of weakness in U.S. housing construction. Fiber costs at our Celgar mill were relatively stable over the last half of 2007, due to supply optimization and the currency impact on the mill’s U.S. sourced fiber. Overall, continued weakness in lumber markets may put upward pressure on prices in the first half of 2008.

 

Operating depreciation and amortization increased marginally to €56.4 million in 2007 from €55.8 million in 2006.

 

For the year ended December 31, 2007, operating income decreased to €69.6 million from €92.5 million in the prior year as higher pulp prices, productivity and energy sales were more than offset by higher fiber costs, the weakening of the U.S. dollar and the reduction in sales of emission allowances.

Interest expense in 2007 decreased by 22% to €71.4 million from €91.9 million in 2006 primarily due to a lower level of borrowing by Stendal as it repaid €33.9 million in principal, the settlement of the cross-currency swaps in the first quarter of 2007 and the inclusion in 2006 of €2.1 million of interest expense related to our repurchase of convertible notes.

 

Stendal previously entered into the Stendal Interest Rate Contracts to fix the interest rate on its outstanding bank indebtedness and we also entered into the Currency Derivatives. Due primarily to the increase in long-term European interest rates, we recorded an unrealized gain of €20.4 million before minority interests on our outstanding derivatives in 2007, compared to an unrealized net gain of €105.8 million before minority interests on our outstanding derivatives in 2006 which included a realized loss of €3.5 million from the settlement of currency forwards.

 

A portion of our long-term debt is denominated and repayable in foreign currencies, principally U.S. dollars. In 2007, we recorded an unrealized gain of €11.0 million on our foreign currency denominated debt as a result of the weakening of the U.S. dollar during the period, compared to an unrealized gain of €15.2 million thereon in 2006.

 

In 2007 we decreased our provision for deferred income tax by approximately €48.7 million, primarily due to lower unrealized gains on our derivative instruments.

 

In 2007, minority interest, representing the minority shareholder’s proportionate interest in the Stendal mill, was €1.3 million, compared to €1.1 million in 2006.

 

We reported net income for 2007 of €22.4 million, or €0.62 per basic and €0.58 per diluted share, which included an aggregate net gain of €31.3 million on our outstanding derivatives and a foreign exchange gain on our long-term debt. In 2006, we reported net income of €69.2 million, or €2.08 per basic and €1.72 per diluted share, which reflected a net unrealized gain of €121.1 million on our outstanding derivatives and a foreign exchange gain on our debt.

 

In 2007, net income including discontinued operations was €22.2 million, or €0.61 per basic and €0.58 per diluted share. In 2006, net income including discontinued operations was €63.2 million, or €1.90 per basic and €1.58 per diluted share.

 

In 2007, “Operating EBITDA” decreased to €126.2 million from €148.3 million in 2006. Operating EBITDA is defined as operating income (loss) from continuing 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 €56.7 million and €55.8 million to the operating income from continuing operations of €69.6 million and €92.5 million for the years ended December 31, 2007 and 2006, 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 that Operating EBITDA does not reflect: (i) our cash expenditures, or future requirements, for capital expenditures or contractual commitments; (ii) changes in, or cash requirements for, working capital needs; (iii) the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our outstanding debt; (iv) minority

interests on our Stendal NBSK pulp mill operations; (v) the impact of realized or marked to market changes in our derivative positions, which can be substantial; and (vi) Operating EBITDA does not reflect the impact of impairment charges against our investments or assets. Because of these limitations, Operating EBITDA should only be considered as a supplemental performance measure and should not be considered as a measure of liquidity or cash available to us to invest in the growth of our business. See the Statement of Cash Flows set out in our consolidated financial statements included herein. Because all companies do not calculate Operating EBITDA in the same manner, Operating EBITDA as calculated by us may differ from Operating EBITDA or EBITDA as calculated by other companies. We compensate for these limitations by using Operating EBITDA as a supplemental measure of our performance and relying primarily on our GAAP financial statements.

 

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

 

 

In the year ended December 31, 2006, revenues increased by approximately 38% to €624.0 million from €452.4 million in 2005, primarily as a result of higher pulp prices and higher sales volumes at our Stendal and Celgar mills. Pulp prices increased steadily in 2006 primarily as a result of the closure of several pulp mills, particularly in North America, which reduced NBSK capacity by approximately 1.2 million ADMTs, better demand and the general weakness of the U.S. dollar against the Euro and the Canadian dollar. List prices for NBSK pulp in Europe were approximately $680 (€542) per ADMT in 2006, compared to approximately $610 (€490) per ADMT in 2005. At the end of 2006, list prices increased to approximately $730 (€553) per ADMT in Europe and between $700 (€530) and $730 (€553) per ADMT in Asia, depending upon the country of delivery. At December 31, 2006, Norscan producers’ inventories for softwood kraft were at 24 days supply, compared to 30 days at the end of 2005.

 

Average pulp sales realizations increased to €465 per ADMT on average in 2006 from €407 per ADMT in 2005, primarily as a result of higher pulp prices.

 

Operating costs and selling, general, administrative and other expenses increased to €531.5 million in the year ended December 31, 2006 from €433.8 million in 2005, primarily as a result of higher sales volume, partially offset by a reversal of accruals for wastewater fees of €13.0 million. In 2006, German environmental authorities confirmed that certain initiatives and capital expenditures undertaken by us qualified to offset such fees.

 

Beginning in 2005, our German operations became subject to the European Union Emissions Trading Scheme, pursuant to which our German mills have been granted emission allowances. We recorded a contribution to income from the sale of emission allowances of €15.6 million and €17.3 million in 2006 and 2005, respectively.

 

On average, our fiber costs for our German mills increased by approximately 12% compared to 2005 as a result of both a supply imbalance and increased demand. The supply imbalance resulted primarily from low harvest levels during the severe winter conditions in late 2005 and early 2006 in central Europe. Such low harvest levels were not made up over the course of the year. The increase in demand resulted from demand for wood residuals from alternative or renewable energy producers. These factors contributed to upward pressure on fiber prices in the latter

half of 2006 and for fiber deliveries into the start of 2007. Severe winter storms in central Europe in January 2007 reportedly caused the downfall of over 40 million cubic meters of wood. This wood will need to be harvested and processed in a timely manner and we expect this to increase the fiber supply to our German mills and to temper and moderate fiber prices in the second half of 2007. In 2006, fiber costs for our Celgar mill increased by approximately 10% over the prior year, primarily because of fluctuations in regional wood chip availability caused by slumping North American lumber markets.

 

Operating depreciation and amortization for the pulp operations increased to €55.8 million in the current period, from €50.9 million in 2005, primarily as a result of the inclusion of a full year of depreciation at our Celgar mill.

 

For the year ended December 31, 2006, operating income increased almost fourfold to €92.5 million from €18.7 million in the prior year, primarily as a result of overall higher pulp prices and sales volumes and improved productivity at our Stendal and Celgar mills.

 

Interest expense in the year ended December 31, 2006 increased to €91.9 million from €86.3 million a year ago because of the inclusion of a full year’s interest on our senior notes issued in February 2005 and €2.1 million of interest expense recorded on the repurchase of approximately $15.2 million principal amount of our convertible notes.

 

In 2006, due to the strengthening of the Euro versus the U.S. dollar, we recorded a net unrealized non-cash holding gain of €72.1 million before minority interests upon the marked to market valuation of our outstanding Currency Derivatives. In 2006, we also recorded a net realized loss of €3.5 million before minority interests in respect of Currency Derivatives that we settled during the period. In 2005, due to the strengthening of the U.S. dollar versus the Euro, we recorded a net unrealized non-cash holding loss of €66.1 million before minority interests upon the marked to market valuation of outstanding Currency Derivatives. In 2005, we also recorded a net realized loss of €2.2 million before minority interests in respect of such derivatives that were settled during the period.

 

In 2006, as a result of an increase in long-term European interest rates, we also recorded an unrealized non-cash holding gain of €37.3 million before minority interests on the marked to market valuation of the Stendal Interest Rate Contracts. In 2005, we recorded an unrealized non-cash loss on the Stendal Interest Rate Contracts of €3.2 million and a realized loss of €0.3 million upon the settlement of the Rosenthal forward interest rate and interest cap contracts, or the “Rosenthal Interest Rate Contracts”, in respect of a portion of its long-term indebtedness under its previous project loan facility. We also recorded an unrealized non-cash foreign exchange gain on our long-term debt of €15.2 million in 2006 due to the strengthening of the Euro versus the U.S. dollar, compared to an unrealized loss of €4.2 million thereon in 2005.

 

In the year ended December 31, 2006, minority interest, representing the minority shareholder’s proportionate interest in the Stendal mill, was €1.1 million, compared to €17.7 million in 2005. In 2005, we recorded an adjustment of €1.7 million for the non-cash impact of other-than-temporary impairment losses on our available-for-sale securities and a loan.

 

We reported net income for 2006 of €69.2 million, or €2.08 per basic and €1.72 per diluted share, which reflected higher pulp prices and generally stronger pulp markets and the net gains on our currency and interest rate derivatives of €68.6 million and €37.3 million. In 2005, we reported a net loss of €112.1 million, or €3.59 per basic and diluted share, which reflected generally weak pulp markets, the realized and unrealized net losses on our currency and interest rate derivatives of €71.8 million, interest expense relating to our Stendal mill of €56.8 million, the unrealized non-cash foreign exchange loss on our long-term debt of €4.2 million and the non-cash impairment charge of €1.7 million relating to investments, partially offset by a non-cash benefit for income taxes of €13.1 million.

 

In 2006, net income including discontinued operations was €63.2 million, or €1.90 per basic and €1.58 per diluted share. In 2005, the net loss including discontinued operations was €117.1 million, or €3.75 per basic and diluted share.

 

In 2006, Operating EBITDA increased to €148.3 million from €69.8 million in 2005. Operating EBITDA is defined as operating income (loss) from continuing 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 €55.8 million and €51.2 million to the operating income from continuing operations of €92.5 million and €18.7 million for the years ended December 31, 2006 and 2005, respectively.

 

Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of our results for the year ended December 31, 2007 for additional information relating to such limitations and Operating EBITDA.

 

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

 

 

Our earnings are sensitive to, among other things, fluctuations in:

 

NBSK Pulp Price.  NBSK pulp is a global commodity that is priced in U.S. dollars, whose markets are highly competitive and cyclical in nature. As a result, our earnings are sensitive to NBSK pulp price changes. Based upon our 2007 sales volume (and assuming all other factors remained constant), each $10.00 per tonne change in NBSK pulp prices yields a change in Operating EBITDA of approximately €10.0 million.

 

Foreign Exchange.  As NBSK pulp is principally quoted in U.S. dollars, the amount of revenues we generate fluctuates with changes in the value of the U.S. dollar to the Euro. Based upon our 2007 revenues, each €0.01 change in the value of the U.S. dollar yields a change in annual gross sales revenue of approximately €10.0 million.

 

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

 

 

 

 

At December 31, 2007, our cash and cash equivalents were €84.8 million, compared to €69.4 million at the end of 2006. We also had €33.0 million of cash restricted in a debt service account related to the financing for the Stendal mill, compared to €57.0 million as at the end of 2006.

 

We expect to meet our interest and debt service expenses and the working and maintenance capital requirements for our operations from cash flow from operations, cash on hand and the revolving working capital loan facilities for our mills.

 

We operate in a cyclical industry and our operating cash flows vary accordingly. Our principal operating cash expenditures are for labor, fiber, chemicals and debt service.

 

Operating activities in 2007 provided cash of €19.1 million, compared to €49.2 million in 2006. An increase in receivables due primarily to higher pulp sales used cash of €11.9 million in 2007, compared to €7.4 million in 2006. An increase in inventories used cash of €38.7 million in 2007, primarily due to the build up of fiber supply at our three mills, compared to a reduction in inventories providing cash of €7.4 million in 2006. An increase in accounts payable and accrued expenses provided cash of €3.3 million in 2007, compared to a reduction thereof using cash of €9.3 million in 2006.

 

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

 

Investing activities in 2007 provided cash of €25.0 million, primarily due to a drawdown of €24.0 million from our debt service reserve account under the Stendal Loan Facility to repay principal. The repayment of notes receivable provided cash of €5.0 million. Investing activities in 2006 used cash of €62.2 million, primarily related to the purchase of property, plant and equipment at our pulp mills of €32.9 million and a build up in our Stendal mill’s debt service reserve account of €25.4 million.

 

We expect capital expenditures in 2008 to total approximately €20.8 million. This level of capital expenditures could increase or decrease as a result of a number of factors, including our financial results and future economic conditions. Our planned capital spending in 2008 will be for efficiency and quality improvement projects, replacement projects and ongoing environmental compliance.

 

Financing activities used cash of €30.7 million in 2007 primarily due to the principal repayments of the Stendal Loan Facility of €33.9 million, of which €24.0 million was funded from the restricted cash Stendal debt service account and the repayment of capital lease obligations of €5.6 million. In 2006, financing activities provided cash of €1.0 million primarily due to the receipt of the last outstanding government grants related to the Stendal mill of €9.1 million which were offset by the net repayment of debt of €9.8 million and the repayment of capital lease obligations of €4.1 million.

 

As at December 31, 2007, we had drawn down none of the €40.0 million revolving term credit facility relating to the Rosenthal mill and C$22.0 million under the C$40.0 million revolving credit facility relating to the Celgar mill.

 

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

 

Our discontinued operations consist of two paper mills in Germany that had an aggregate annual production capacity of approximately 70,000 ADMTs. Since we viewed these paper mills as non-core operations, we successfully divested them in 2006 and now account for them as discontinued operations.

 

The following represents the results of our discontinued operations for the periods indicated:

 

 

The following represents the statement of cash flows of our discontinued operations for the periods indicated:

 

 

See Note 18, Discontinued Operations, of the consolidated financial statements and related notes contained in this annual report for additional information relating to the discontinued operations.

 

The following table sets out our contractual obligations and commitments as at December 31, 2007 in connection with our long-term liabilities.

 

 

 

In addition to our current revolving credit facilities for the Rosenthal and Celgar mills, we may seek to raise future funding in the debt markets if our indenture relating to our 9.25% senior notes permits, and subject to compliance with the terms thereunder. The indenture governing the senior notes provides that, in order for Mercer Inc. and its restricted subsidiaries (as defined in the indenture and which excludes the Stendal mill and, up to December 31, 2006, our discontinued operations) to enter into certain types of transactions, including the incurrence of additional indebtedness, the making of restricted payments and the completion of mergers and consolidations (other than, in each case, those specifically permitted by our senior note indenture), we must meet a minimum ratio of Indenture EBITDA to Fixed Charges, as defined in the senior note indenture, of 2.0 to 1.0 on a pro forma basis for the most recently ended four full fiscal quarters.

 

For a description of our senior notes and credit facilities, see “Item 1 — Business — Description of Certain Indebtedness”.

 

Our reporting currency is the Euro as a majority of our business transactions are denominated in Euros. However, we hold certain assets and liabilities in U.S. dollars and Canadian dollars. Accordingly, our consolidated financial results are subject to foreign currency exchange rate fluctuations.

 

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

 

In the year ended December 31, 2007, we reported a net €29.2 million foreign exchange translation income and, as a result, the cumulative foreign exchange translation gain reported within comprehensive income increased to €41.1 million at December 31, 2007 from €11.9 million at December 31, 2006.

 

Based upon the exchange rate at December 31, 2007, the U.S. dollar has decreased by approximately 11% in value against the Euro since December 31, 2006. See “Item 7A — Quantitative and Qualitative Disclosures about Market Risk”.

 

The indenture governing our 9.25% senior notes requires that we also provide a discussion in annual and quarterly reports we file with the SEC under Management’s Discussion and Analysis of Financial Condition and Results of Operations of the results of operations and financial condition of Mercer Inc. and our restricted subsidiaries under the indenture, referred to as the “Restricted Group”. The Restricted Group is comprised of Mercer Inc., certain holding subsidiaries, Rosenthal and the Celgar mill. The Restricted Group excludes our Stendal mill and, up to December 31, 2006, our discontinued operations.

 

The following is a discussion of the results of operations and financial condition of the Restricted Group. For further information regarding the Restricted Group including, without limitation, a reconciliation to our consolidated results of operations, see Note 20 of our annual financial statements included herein.

 

Revenues for the Restricted Group in 2007 increased to €401.3 million from €361.0 million in 2006, primarily because of higher prices and sales volumes. Average pulp sales realizations for the Restricted Group increased to €524 per ADMT on average in the year ended December 31, 2007 from €472 per ADMT in 2006. The increase in pulp prices was partially offset by the weakening of the U.S. dollar which decreased in value by approximately 8% and 5% against the Euro and the Canadian dollar, respectively, during the period.

 

Operating costs and selling, general, administrative and other expenses for the Restricted Group in 2007 increased to €364.6 million from €326.6 million in the comparative period of 2006, primarily as a result of increased fiber costs and higher sales volume.

Operating depreciation and amortization for the Restricted Group in 2007 increased marginally to €28.7 million from €27.8 million in 2006.

 

During 2007, we took an aggregate of 21 days scheduled annual maintenance downtime at our Rosenthal and Celgar mills. During 2006, our Rosenthal and Celgar mills took approximately 34 days of scheduled maintenance and strategic capital expenditure downtime, during which Rosenthal completed the installation of a new brownstock washer.

 

During the scheduled maintenance downtime at Celgar, we implemented the final phase of our Blue Goose capital project consisting of the dryer capacity expansion. These changes have shown improvements in production capacity and operational efficiencies, as evidenced by Celgar achieving daily, monthly and quarterly production records during the year.

 

The markets and prices for emission allowances continue to be weak, and as a result our contribution to income from the sale of such emission allowances by our Rosenthal pulp mill in 2007 was €1.6 million, compared to €4.9 million in 2006.

 

Overall, fiber costs of the Restricted Group increased by approximately 33% in 2007 versus the same period of 2006 as a result of both a supply imbalance and increased demand. In Germany, the supply imbalance resulted from low harvesting levels in late 2005 and 2006 which were not made up during the course of the year. Increased demand in Germany resulted from higher consumption of wood residuals by renewable energy suppliers. A strong European lumber market at the beginning of 2007 provided some price relief in the middle of the year. Overall, we currently expect fiber prices to be generally level for the balance of the year but continued weakness in lumber markets may put upward pressure on prices in early 2008.

 

In 2007, income from operations of the Restricted Group increased to €36.7 million from €34.4 million last year, primarily as a result of higher pulp prices, partially offset by higher fiber prices and a weakening U.S. dollar.

 

Interest expense for the Restricted Group in 2007 decreased to €28.5 million from €34.4 million a year ago as a result of lower borrowings and the inclusion in 2006 of €2.1 million of interest expense recorded on the repurchase of convertible notes.

 

The Restricted Group did not have any currency derivatives outstanding during 2006 that materially affected its results. In 2007, the Restricted Group recorded an unrealized non-cash foreign exchange gain on debt and distributions of €10.6 million, compared to €15.2 million in 2006.

 

The net income for the Restricted Group for the year ended December 31, 2007 was €17.7 million, which reflected improved markets and an unrealized non-cash foreign exchange gain on debt of €10.6 million. In 2006, the Restricted Group reported net income of €9.4 million, which reflected improved markets and an unrealized non-cash foreign exchange gain on debt of €15.2 million.

 

The Restricted Group generated “Operating EBITDA” of €65.6 million and €62.2 million in the years ended December 31, 2007 and 2006, respectively. Operating EBITDA is defined as operating income (loss) from continuing operations plus depreciation and amortization and non-recurring capital asset impairment charges. Operating EBITDA for the Restricted Group is calculated by adding depreciation and amortization and non-recurring capital asset impairment charges of €28.9 million and €27.8 million to the income from operations of €36.7 million and €34.4 million for the years ended December 31, 2007 and 2006, respectively.

 

Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of our results for the year ended December 31, 2007 for additional information relating to such limitations and Operating EBITDA.

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

 

 

 

 

Total revenues for the Restricted Group for the year ended December 31, 2006 increased to €361.0 million from €276.4 million in the comparative period of 2005, primarily because of higher pulp sales and the inclusion of a full year of sales for the Celgar mill. Average pulp sales realizations for the Restricted Group increased to €472 per ADMT on average in the year ended December 31, 2006 from €413 per ADMT in 2005, primarily as a result of higher sales prices.

 

Operating costs and selling, general, administrative and other expenses for the Restricted Group in the year ended December 31, 2006 increased to €326.6 million from €265.7 million in the comparative period of 2005, primarily as a result of higher sales volumes.

 

Depreciation for the Restricted Group was €27.8 million in the current period, versus €23.9 million in 2005, primarily as a result of the inclusion of a full year of depreciation for the Celgar mill.

 

In the year ended December 31, 2006, income from operations of the Restricted Group increased to €34.4 million from €10.7 million last year, primarily as a result of higher prices and improved results at our Celgar mill. Interest expense for the Restricted Group in 2006 increased to €34.4 million from €32.4 million a year ago, primarily due to the inclusion of a full year’s interest on outstanding senior notes issued in February 2005 and €2.1 million of interest expense recorded on the repurchase of approximately $15.2 million principal amount of our convertible notes.

 

In 2005, the Restricted Group recorded a non-cash impairment charge of €1.7 million related to a legacy investment in a venture company.

 

In 2005, the Restricted Group had a marginal unrealized non-cash holding loss on the marked to market valuation of the interest rate derivatives related to the Rosenthal mill. The Restricted Group did not have any currency derivatives outstanding during 2006 that materially affected its results. In addition, the Restricted Group recorded an unrealized non-cash foreign exchange gain on debt of €15.2 million in 2006.

 

The net income for the Restricted Group for the year ended December 31, 2006 was €9.4 million, which reflected improved markets and an unrealized non-cash foreign exchange gain on debt of €15.2 million. In 2005, the Restricted Group reported a net loss of €25.2 million, which reflected generally weak markets, higher interest expense of €32.4 million, the unrealized non-cash foreign exchange loss on debt of €4.2 million and the non-cash impairment charge of €1.7 million on investments.

 

The Restricted Group generated “Operating EBITDA” of €62.2 million and €34.6 million in the years ended December 31, 2006 and 2005, respectively. Operating EBITDA is defined as operating income (loss) from continuing operations plus depreciation and amortization and non-recurring capital asset impairment charges.

Operating EBITDA for the Restricted Group is calculated by adding depreciation and amortization and non-recurring capital asset impairment charges of €27.8 million and €23.8 million to the income from operations of €34.4 million and €10.7 million for the years ended December 31, 2006 and 2005, respectively.

 

Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of our results for the year ended December 31, 2007 for additional information relating to such limitations and Operating EBITDA.

 

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

 

 

 

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

 

 

 

 

At December 31, 2007, the Restricted Group had cash and cash equivalents of €59.4 million, compared to €39.1 million at the end of 2006. At December 31, 2007, the Restricted Group had working capital of €120.5 million.

 

We expect the Restricted Group to meet its interest and debt service expenses and meet the working and maintenance capital requirements for its current operations from cash flow from operations, cash on hand and two working capital facilities for the Rosenthal and Celgar mills in the amounts of €40.0 million and C$40.0 million, respectively.

 

The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect both the amount and the timing of recording of assets, liabilities, revenues and expenses in the consolidated financial statements and accompanying note disclosures. 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.

 

Our significant accounting policies are disclosed in Note 1 to our audited annual consolidated financial statements included in Part IV of this annual report. While all of the significant accounting policies are important to the consolidated financial statements, some of these policies may be viewed as having a high degree of judgment. On an ongoing basis using currently available information, management reviews its estimates, including those related to accounting for pensions and post-retirement benefits, provisions for bad debt and doubtful accounts, derivative instruments, impairment of long-lived assets, deferred taxes and environmental conservation and legal liabilities. Actual estimates could differ from these estimates.

 

The following accounting policies require management’s most difficult, subjective and complex judgments, and are subject to a fair degree of measurement uncertainty.

 

Derivative Instruments.  We adopted Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, effective January 1, 2001. Derivative instruments are measured at fair value and reported in the balance sheet as assets or liabilities. Accounting for gains or losses depends on the intended use of the derivative instruments. Gains or losses on derivative instruments which are not designated hedges for accounting purposes are recognized in earnings in the period of the change in fair value. Gains or losses on derivative instruments formally designated as hedges are recognized in either earnings or other comprehensive income.

 

In 2007, we reported a net unrealized non-cash holding gain of €19.5 million before minority interests in respect of the Stendal Interest Rate Contracts. We also recognized a net gain of €0.9 million in respect of the Currency Derivatives.

 

Impairment of Long-Lived Assets.  We periodically evaluate long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In performing the review of recoverability, we estimate future cash flows expected to result from the use of the asset and its eventual disposition. The estimates of future cash flows, based on reasonable and supportable assumptions and projections, require management to make subjective judgments. In addition, the time periods for estimating future cash flows is often lengthy, which increases the sensitivity of the assumptions made. Depending on the assumptions and estimates used, the estimated future cash flows projected in the evaluation of long-lived assets can vary within a wide range of outcomes. Our management considers the likelihood of possible outcomes in determining the best estimate of future cash flows. If actual results are not consistent with the assumptions and judgments used in estimating future cash flows and asset fair values, actual impairment losses could vary materially, either positively or negatively, from estimated impairment losses.

 

No impairment losses were recorded in 2007.

 

Deferred Taxes.  We currently have deferred tax assets which are comprised primarily of tax loss carryforwards and deductible temporary differences, both of which will reduce taxable income in the future. The amounts recorded for deferred tax are based upon various judgments, assumptions and estimates. We assess the realization of these deferred tax assets on a periodic basis to determine whether a valuation allowance is required. We determine whether it is more likely than not that all or a portion of the deferred tax assets will be realized, based on currently available information, including, but not limited to, the following:

 

 

 

If we believe that it is more likely than not that some of these deferred tax assets will not be realized, based on currently available information, an income tax valuation allowance is recorded against these deferred tax assets. As at December 31, 2007, we had €17.6 million in deferred tax assets and €18.6 million in deferred tax liabilities, resulting in a net deferred tax liability of €1.0 million. Our tax assets are net of a €73.2 million valuation allowance. For the year ended December 31, 2007, our review concluded that it was appropriate to reduce the valuation allowance against loss carryforwards by approximately €15.0 million primarily as a result of a legislated tax rate reduction in Germany after considering expected future earnings.

 

If market conditions improve or tax planning opportunities arise in the future, we will reduce our valuation allowances, resulting in future tax benefits. If market conditions deteriorate in the future, we will increase our valuation allowances, resulting in future tax expenses. Any change in tax laws, particularly in Germany, will change the valuation allowances in future periods.

 

In December 2007, the Financial Accounting Standards Board, or “FASB”, issued Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements, or “FAS 160”. FAS 160 establishes accounting and reporting standards for entities that have equity investments that are not attributable directly to the parent, called noncontrolling interests or minority interests. Specifically, FAS 160 states where and how to report noncontrolling interests in the consolidated statements of financial position and operations, how to account for changes in noncontrolling interests and provides disclosure requirements. The provisions of FAS 160 are effective for us beginning January 1, 2009. We are currently evaluating the impact that the adoption of this statement will have on our consolidated financial position, results of operations and disclosures.

 

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141(R), Business Combinations, or “FAS 141(R)”. FAS 141(R) establishes how an entity accounts for the identifiable assets acquired, liabilities assumed, and any noncontrolling interests acquired, how to account for goodwill acquired and determines what disclosures are required as part of a business combination. FAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, early adoption is prohibited. We are currently evaluating the impact that the adoption of this statement will have on our consolidated financial position, results of operations and disclosures.

 

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, or “FAS 157”. FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. It is applicable whenever another standard requires or permits assets or liabilities to be measured at fair value, but it does not expand the use of fair value to any new circumstances. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. On February 12, 2008, the FASB Staff issued for comment FASB Staff Position FAS 157-2, or “FSP 157-2”, which defers the effective date of FAS 157 for all nonfinancial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. FSP 157-2 defers the effective date of FAS 157 to fiscal years beginning after November 15, 2008 for items within the scope of FSP 157-2. We are in the process of determining the impact, if any, the adoption of FAS 157 will have on its consolidated financial position or results of operations.

 

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or “FAS 159”. FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value, with the objective of improving financial reporting by mitigating volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The provisions of FAS 159 are effective for our year ending December 31, 2008. We are currently evaluating the impact, if any, that the adoption of this statement will have on our consolidated financial position, results of operations and disclosures.

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109, or “FIN 48”. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes, and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, we recognized no adjustment in the net liability for unrecognized tax benefits.

 

For additional discussion of new accounting standards see Note 1 to our annual audited consolidated financial statements included elsewhere in this annual report.

 

Statements in this annual report that are not reported financial results or other historical information are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. These statements use forward-looking terminology, are based on present information we have related to our existing business circumstances and various assumptions we make and involve a number of risks and uncertainties, any of which could cause actual results to differ materially from these forward-looking statements. We caution you that, unless required by applicable law, we do not assume any obligation to update forward-looking statements based on unanticipated events or changed expectations. Factors that could cause actual results to differ materially include, but are not limited to those set forth under “Item 1A — Risk Factors”.

 

We do not believe that inflation has had a material impact on revenues or income during 2007.

 

We are exposed to market risks from changes in interest rates and foreign currency exchange rates, particularly the exchange rates between the Euro and the U.S. dollar and, since 2005, the Canadian dollar versus the U.S. dollar and the Euro. Changes in these rates may affect our results of operations and financial condition and, consequently, our fair value. We seek to manage these risks through internal risk management policies as well as the use of derivatives. We use derivatives to reduce or limit our exposure to interest rate and currency risks. We may in the future use derivatives to reduce or limit our exposure to fluctuations in pulp prices. We also use derivatives to reduce our potential losses or to augment our potential gains, depending on our management’s perception of future economic events and developments. These types of derivatives are generally highly speculative in nature. They are also very volatile as they are highly leveraged given that margin requirements are relatively low in proportion to notional amounts.

 

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

 

Derivatives

 

Derivatives are contracts between two parties where payments between the parties are dependent upon movements in the price of an underlying asset, index or financial rate. Examples of derivatives include swaps, options and forward rate agreements. The notional amount of the derivatives is the contract amount used as a reference point to calculate the payments to be exchanged between the two parties and the notional amount itself is not generally exchanged by the parties.

 

The principal derivatives we use are foreign exchange derivatives and interest rate derivatives.

 

Foreign exchange derivatives include currency swaps which involve the exchange of fixed payments in one currency for the receipt of fixed payments in another currency. Such cross currency swaps involve the exchange of both interest and principal amounts in two different currencies. They also include foreign exchange forwards which are contractual obligations in which two counterparties agree to exchange one currency for another at a specified price for settlement at a pre-determined future date. Forward contracts are effectively tailor-made agreements that are transacted between counterparties in the over-the-counter market.

 

Interest rate derivatives include interest rate forwards (forward rate agreements) which are contractual obligations to buy or sell an interest-rate-sensitive financial instrument on a future date at a specified price. Forward contracts are effectively tailor-made agreements that are transacted between different counterparties in the over-the-counter market. They also include interest rate swaps which are over-the-counter contracts in which two counterparties exchange interest payments based upon rates applied to a notional amount.

 

We use foreign exchange derivatives to convert some of our costs (including currency swaps relating to our long-term indebtedness) from Euros to U.S. dollars as our principal product is priced in U.S. dollars. We have also converted some of our costs to U.S. dollars by issuing long-term U.S. dollar denominated debt in the form of our 8.5% convertible subordinated notes and $310 million 9.25% senior notes issued in February 2005. The proceeds of the 9.25% senior notes were used in part to repay a project loan facility for our Rosenthal mill, referred to as the “Project Facility”. We use interest rate derivatives to fix the rate of interest on indebtedness, including under the Stendal Loan Facility and, prior to its repayment in February 2005, the Project Facility.

 

All of the derivatives we entered into were either pursuant to the Project Facility, which was repaid and discharged in February 2005, or the Stendal Loan Facility. Each of these loan facilities provided facilities for foreign exchange derivatives, interest rate derivatives and commodities derivatives, subject to prescribed controls, including maximum notional and at-risk amounts. The Stendal Loan Facility is secured by substantially all of the assets of the Stendal mill and has the benefit of certain German governmental guarantees. Prior to its discharge in 2005, the Project Facility was secured by substantially all of the mill’s assets and also had the benefit of certain

German governmental grants. Neither of these credit facilities had any separate margin requirements when derivatives are entered into pursuant to their terms and are subsequently marked to market. The revolving working capital credit facility we established in February 2005 for the Rosenthal mill allows us to enter into derivative instruments to manage risks relating to its operations.

 

We record unrealized gains and losses on our outstanding derivatives when they are marked to market at the end of each reporting period and realized gains or losses on them when they are settled. We determine market valuations based primarily upon valuations provided by our counterparties.

 

In March 2004, Rosenthal entered into currency derivatives which included two currency swaps in the aggregate principal amount of €184.5 million that mature in September 2008 and September 2013, respectively. As NBSK pulp prices are quoted in U.S. dollars and the majority of our business transactions are denominated in Euros, Rosenthal had entered into the currency swaps to reduce the effects of exchange rate fluctuations between the U.S. dollar and the Euro on notional amounts outstanding under its project loan facility. Under these currency swaps, Rosenthal effectively paid the principal and interest in U.S. dollars and at U.S. dollar borrowing rates. The Rosenthal currency derivatives also included a currency forward in the notional amount of €40.7 million which matured in March 2005 that was entered into to reduce or limit Rosenthal’s exposure to currency risks.

 

In August 2002, Stendal entered into the Stendal Interest Rate Contracts in connection with its long-term indebtedness relating to the Stendal mill to fix the interest rate under the Stendal Loan Facility at the then low level, relative to its historical trend and projected variable interest rate. These contracts were entered into under a specific credit line under the Stendal Loan Facility and are subject to prescribed controls, including certain maximum amounts for notional and at-risk amounts. Under the Stendal Interest Rate Contracts, Stendal pays a fixed rate and receives a floating rate with the interest payments being calculated on a notional amount. The interest rates payable under the Stendal Loan Facility were swapped into fixed rates based on the Eur-Euribor rate for the repayment periods of the tranches under the Stendal Loan Facility. Stendal effectively converted the Stendal Loan Facility from a variable interest rate loan into a fixed interest rate loan, thereby reducing interest rate uncertainty.

 

In March 2004, Stendal also entered into currency derivatives which are comprised of a currency swap in the principal amount of €306.3 million which matures in April 2011 and a currency forward contract for the notional amount of €20.6 million maturing in March 2005 to reduce or limit its exposure to currency risks and to augment its potential gains or reduce its potential losses.

 

In December 2004, we settled all of our then outstanding currency derivatives due to the substantial weakening of the U.S. dollar versus the Euro in 2004 and realized a gain of €44.5 million thereon. In February 2005, we settled the Rosenthal Interest Rate Contracts in connection with the repayment and discharge of the Project Facility and realized a loss of €0.3 million thereon.

 

In the first quarter of 2005, Stendal entered into foreign currency derivatives in order to swap approximately three-quarters of its long-term indebtedness outstanding under the Stendal Loan Facility into U.S. dollars as follows: (i) approximately €306.3 million in principal amount was swapped into U.S. dollars at a rate of 1.2960 with a maturity in October 2017, and (ii) approximately €153.2 million in principal amount was swapped into U.S. dollars at a rate of 1.2990 with a maturity in October 2017. In the second quarter of 2005, Stendal swapped the balance of its long-term indebtedness under the Stendal Loan Facility, being approximately €153.2 million in principal amount, into U.S. dollars at a rate of 1.2799 with a maturity in October 2017. All of these currency swaps were entered into by Stendal to reduce the effects of exchange rate fluctuations between the U.S. dollar and the Euro on notional amounts under the Stendal Loan Facility.

 

During the first quarter of 2005, Stendal entered into a $50.0 million currency forward contract at a rate of 1.3108 which matured in February 2006 and a $25.0 million currency forward at a rate of 1.3080 which matured in September 2005. During the second quarter of 2005, Stendal entered into a $25.0 million currency forward contract at a rate of 1.2357 which also matured in September 2005. In the third quarter of 2005, Stendal entered into a $13.9 million currency forward at a rate of 1.2048 which matured in October 2005. These currency derivatives were entered into by Stendal to reduce or limit its exposure to currency risks.

We are exposed to very modest credit related risks in the event of non-performance by counterparties to derivative contracts. However, we do not expect that the counterparties, which are major financial institutions, will fail to meet their obligations.

 

The following table and the notes thereto sets forth the maturity date, the notional amount, the recognized gain or loss and the strike and swap rates for derivatives that were in effect during 2006 and 2007:

 

 

 

 

Interest Rate Risk

 

Fluctuations in interest rates may affect the fair value of fixed interest rate financial instruments which are sensitive to such fluctuations. A decrease in interest rates may increase the fair value of such fixed interest rate financial instrument assets and an increase in interest rates may decrease the fair value of such fixed interest rate financial instrument liabilities, thereby increasing our fair value. An increase in interest rates may decrease the fair value of such fixed interest rate financial instrument assets and a decrease in interest rates may increase the fair value of such fixed interest rate financial instrument liabilities, thereby decreasing our fair value. We seek to manage our interest rate risks through the use of interest rate derivatives. For a discussion of our interest rate derivatives including maturities, notional amounts, gains or losses and swap rates, see “Derivatives” in this Item 7A.

The following tables provide information about our exposure to interest rate fluctuations for the carrying amount of financial instruments sensitive to such fluctuations as at December 31, 2007, and expected cash flows from these instruments: