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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20459

FORM 10-Q

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

For the quarterly period ended March 31, 2005 or

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934


Commission File Number 333-31931


NORTH ATLANTIC TRADING COMPANY, INC.
------------------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)


DELAWARE 13-3961898
-------- ----------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

257 Park Avenue South, New York, New York 10010-7304
----------------------------------------- ----------
(Address of Principal Executive Offices) (Zip Code)

(212) 253-8185
--------------
(Registrant's Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X].

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 10 shares of common stock, $.01
par value, as of May 12, 2005.


PART I
FINANCIAL INFORMATION

Item 1. Financial Statements

NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands except share data)
(unaudited)




March 31, December 31,
2005 2004
---- ----

Current assets:
Cash $ 426 $ 2,346
Accounts receivable, net 7,404 7,839
Inventories 37,342 37,959
Other current assets 3,786 5,861
-------------- -------------

Total current assets 48,958 54,005

Property, plant and equipment, net 11,280 10,771

Deferred financing costs 8,880 9,407

Goodwill 128,697 128,697

Other intangible assets, net 10,182 10,293

Other assets 16,481 15,526
-------------- -------------

Total assets $ 224,478 $ 228,699
============== =============

Current liabilities:
Accounts payable $ 3,486 $ 7,005
Accrued expenses 5,421 4,642
Accrued interest expense 1,696 6,274
Revolving credit facility 21,900 14,500
-------------- -------------

Total current liabilities 32,503 32,421

Senior notes and long-term debt 200,000 200,000
Postretirement benefits 6,026 6,061
Pension benefits and other long-term liabilities 4,095 4,013
-------------- -------------

Total liabilities 242,624 242,495
-------------- -------------

Stockholder's Equity:
Common stock, voting, $.01 par value authorized shares,
10; issued and outstanding shares, 10 - -
Additional paid-in capital 64,095 64,095
Advance to parent (1,931) (1,961)
Loans to stockholders for stock purchase (100) (99)
Accumulated other comprehensive income (loss) (1,351) (1,351)
Accumulated deficit (78,859) (74,480)
-------------- -------------

Total stockholders' equity (deficit) (18,146) (13,796)
-------------- -------------

Total liabilities and stockholders' deficit $ 224,478 $ 228,699
============== =============

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

2

NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands except per share amounts)
(unaudited)



Three months Three months
Ended Ended
March 31, 2005 March 31, 2004
------------------ ------------------


Net sales $ 27,347 $ 22,105

Cost of sales 13,154 12,252
------------------ ------------------

Gross profit 14,193 9,853

Selling, general and administrative expenses 10,435 11,439
Restructuring charges 1,896 -
------------------ ------------------

Operating income (loss) 1,862 (1,586)

Interest expense and financing costs, net 5,471 7,410
Other expense (income) 770 88
------------------ ------------------

Income (loss) before income tax expense (benefit) (4,379) (9,084)

Income tax expense (benefit) - (3,452)
------------------ ------------------

Net income (loss) (4,379) (5,632)

Preferred stock dividends - (1,613)
------------------ ------------------

Net income (loss) applicable to common shares $ (4,379) $ (7,245)
================== ==================


Basic and Diluted earnings per common share:
Net income (loss) $ (437,900.00) $ (24.08)

Preferred stock dividends - (6.90)
------------------ ------------------

Net income (loss) applicable to common shares $ (437,900.00) $ (30.98)
================== ==================

Weighted average common shares outstanding:
Basic .01 233.9
Diluted .01 233.9



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


3

NORTH ATLANTIC TRADING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)



Three months Three months
Ended Ended
March 31, 2005 March 31, 2004
----------------- -----------------

Cash flows from operating activities:
Net income (loss) $ (4,379) $ (5,632)
Adjustments to reconcile net income (loss)
to net cash provided by (used in) operating activities:
Depreciation 217 212
Amortization of other intangible assets 111 110
Amortization of deferred financing costs 527 687
Deferred income taxes - (3,634)
Changes in operating assets and liabilities:
Accounts receivable, net 435 4,930
Inventories 617 (4,582)
Other current assets 2,075 1,052
Other assets (955) 33
Accounts payable (3,519) (2,311)
Accrued expenses and other (3,799) 6,535
Accrued pension liabilities 82 (548)
Accrued postretirement liabilities (35) 416
----------------- -----------------

Net cash provided by (used in) operating activities (8,623) (2,732)
----------------- -----------------

Cash flows from investing activities:
Capital expenditures (726) (182)
Restricted Cash - (160,162)
Purchase of Stoker, Inc. (net of cash acquired $1,672) - (38)
----------------- -----------------

Net cash provided by (used in) investing activities (726) (160,382)
----------------- -----------------

Cash flows from financing activities:
Capital contribution from parent - 53,751
Proceeds from revolving credit facility 7,400 14,100
Proceeds from issuance of new senior notes - 200,000
Payment of financing costs - (5,628)
Payments on notes payable - (30,686)
Redemption of preferred stock - (65,080)
Preferred stock cash dividends - (1,613)
Advance to parent 30 2,406
Loans to stockholders for stock purchases (1) -
----------------- -----------------

Net cash provided by (used in) financing activities 7,429 167,250
----------------- -----------------

Net increase (decrease) in cash (1,920) 4,136

Cash, beginning of period 2,346 304
----------------- -----------------

Cash, end of period $ 426 $ 4,440
================= =================



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


4

North Atlantic Trading Company, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements

1. ORGANIZATION

These condensed consolidated financial statements should be read in conjunction
with the financial statements and related notes thereto included in North
Atlantic Trading Company, Inc.'s (the "Company") Annual Report on Form 10-K, as
amended, for the year ended December 31, 2004.

The accompanying condensed consolidated financial statements are presented in
accordance with the requirements of Form 10-Q and, accordingly, do not include
all the disclosures normally required by generally accepted accounting
principles. The condensed consolidated financial statements have been prepared
in accordance with the Company's customary accounting practices and have not
been audited. In the opinion of management, all adjustments necessary to fairly
present the results of operations for the reported interim periods have been
recorded and were of a normal and recurring nature. The year-end balance sheet
data was derived from audited financial statements, but does not include all
disclosures required by generally accepted accounting principles.

On February 9, 2004, the Company consummated a holding company reorganization
whereby North Atlantic Holding Company, Inc., a Delaware corporation (the
"Parent"), became the parent company of the Company. The holding company
reorganization was effected pursuant to an Agreement and Plan of Merger (the
"Merger Agreement"), dated February 9, 2004, among the Company, the Parent and
NATC Merger Sub, Inc., a Delaware corporation and a direct wholly-owned
subsidiary of the Parent ("Merger Sub").

Pursuant to the Merger Agreement, (i) Merger Sub was merged with and into the
Company (the "Merger"), with the Company as the surviving corporation; (ii) the
Company became a wholly-owned subsidiary of the Parent; (iii) each of the
539,235 issued and outstanding shares of voting common stock of the Company, par
value $0.01 per share, was converted into the right to receive one share of
common stock of the Parent, par value $0.01 per share ("NAHC Common Stock");
(iv) each issued and outstanding share of common stock of Merger Sub was
converted into one issued and outstanding share of common stock of the Company,
par value $0.01 per share (the "Company Common Stock"); and (v) all of the
issued and outstanding shares of NAHC Common Stock held by the Company were
cancelled.

Immediately after the Merger, (i) 539,235 shares of NAHC Common Stock were
issued and outstanding; and (ii) ten (10) shares of the Company Common Stock
were issued and outstanding.

Subsequently, Parent issued 49,523 shares of NAHC Common Stock upon the exercise
of certain warrants pursuant to a Warrant Agreement (the "Warrant Agreement"),
dated June 25, 1997, between Parent (as assignee to the Company's rights and
obligations under the Warrant Agreement) and The Bank of New York, as warrant
agent (as successor to the United States Trust Company of New York). As of March
31, 2005, (i) 591,343 shares of NAHC Common Stock were issued and 589,176 were
outstanding; and (ii) ten (10) shares of Company Common Stock were issued and
outstanding.


5

2. RECAPITALIZATION AND REORGANIZATION:

On February 9, 2004, the Company consummated its general corporate
reorganization in which the Company became a wholly-owned subsidiary to the
Parent. On February 17, 2004, the Company consummated the refinancing of its
existing debt and preferred stock and the Parent issued senior discount notes in
conjunction with the refinancing. The refinancing consisted principally of (1)
the offering and sale of $200.0 million principal amount of 9 1/4% senior notes
due 2012 by the Company (the "New Senior Notes"), (2) the entering into an
amended and restated loan agreement (the "New Credit Agreement") that provided a
$50.0 million senior secured revolving credit facility (the "Senior Revolving
Credit Facility") to the Company and (3) the concurrent offering and sale of
$97.0 million aggregate principal amount at maturity of 12 1/4% senior discount
notes due 2014 of the Parent (the "Parent Notes"). Both the New Senior Notes and
the Parent Notes were offered pursuant to Rule l44A and Regulation S under the
Securities Act of 1933, as amended.

Concurrently with the closing of the refinancing, the Company also called for
the redemption of all its outstanding 11% senior notes due 2004 (the "Old Senior
Notes"), in accordance with the terms of the indenture governing such notes, at
the applicable redemption price of 100.0% of the principal amount of $155.0
million, plus interest accrued to the redemption date of April 2, 2004.

The proceeds from the offering of the New Senior Notes, along with borrowings
under the Senior Revolving Credit Facility (see Notes 6 and 7) and the proceeds
from the concurrent offering of the Parent Notes were used to (1) repay $36.6
million in outstanding borrowings under the existing senior credit facility (the
"Old Senior Credit Facility"), including borrowings used to finance the cash
purchase price for the acquisition of Stoker, Inc., (2) redeem the Old Senior
Notes, (3) redeem the Company's existing 12% senior exchange payment-in-kind
preferred stock on March 18, 2004, (4) pay a $4.9 million pro rata distribution
to stockholders of Parent and make a distribution to certain holders of warrants
of Parent, (5) make $2.1 million in incentive payments to certain key employees
and outside directors, and (6) pay fees and expenses of $12.8 million incurred
in connection with the offerings.

The New Credit Agreement contains customary events of default, including payment
defaults, breach of representations and warranties, covenant defaults,
cross-acceleration, cross-defaults to certain other indebtedness, certain events
of bankruptcy and insolvency, the occurrence of a change in control and judgment
defaults.

As of December 31, 2004 the Company would have failed to meet its original
required minimum fixed charge coverage ratio covenant for the period then ended
due to its operating results in 2004. This would have represented an event of
default under the terms of the New Credit Agreement. This covenant, however, was
eliminated pursuant to the March 30, 2005 amendment to the New Credit Agreement.
On January 19, 2005, the New Credit Agreement was amended to reduce the
revolving credit facility to $35.0 million.

The March 30, 2005 amendment to the New Credit Agreement modified the fixed
charge coverage ratio covenant, which now applies only to quarters ending June
30, 2005 and thereafter, and the minimum consolidated adjusted EBITDA covenant,
which now applies only to quarters ending from June 30, 2004 through March 31,
2005. The fixed charge coverage ratio definition was also amended to include any
future cash equity contributions to the Company. In addition, the amendment
changed the New Credit Agreement maturity date from February 28, 2007 to January
31, 2006.


6

3. RESTRUCTURING:

In January 2005, the Company engaged the management consulting firm of Alvarez
and Marsal, LLC ("A&M") to identify the potential for performance improvement
opportunities and to provide for the services of Douglas P. Rosefsky as Chief
Financial Officer.

For the three months ended March 31, 2005, total restructuring charges amounted
to approximately $1.9 million, including, but not limited to, severance and
separation expenses and A&M fees.

In April 2005, the Company appointed Douglas P. Rosefsky (formally Chief
Financial Officer) as President and Chief Executive Officer, Thomas F. Helms,
Jr. (formally Chairman of the Board of Directors, President and Chief Executive
Officer) as Chairman of the Board of Directors, and Brian C. Harriss as Chief
Financial Officer.

4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

REVENUE RECOGNITION: The Company recognizes revenues and the related costs upon
transfer of title and risk of loss to the customer.

SHIPPING COSTS: The Company records shipping costs incurred as a component of
selling, general and administrative expenses. Shipping costs incurred were $1.1
million and $0.8 million for the three months ended March 31, 2005 and 2004,
respectively.

MASTER SETTLEMENT AGREEMENT ESCROW ACCOUNT: Pursuant to the Master Settlement
Agreement (the "MSA") entered into in November 1998 by most states (represented
by their attorneys general acting through the National Association of Attorneys
General) and subsequent states' statutes, a "cigarette manufacturer" (which is
defined to include a manufacturer of make-your-own cigarette tobacco) has the
option of either becoming a signatory to the MSA or opening, funding, and
maintaining an escrow account to have funds available for certain potential
tobacco-related liabilities, with sub-accounts on behalf of each settling state.
The Company has chosen to open and fund an escrow account as its method of
compliance. It is the Company's policy to record amounts on deposit in the
escrow account for prior years, as well as cash-on-hand to fund its projected
deposit based on its monthly sales for the current year, as an Other non-current
asset. Each year's obligation is required to be deposited in the escrow account
by April 15 of the following year. During April 2005, approximately $3.4 million
relating to 2004 sales was deposited. As of March 31, 2005 and December 31,
2004, the Company has recorded approximately $14.2 million and $13.2 million,
respectively, in Other assets. For the three months ended March 31, 2005,
approximately $1.0 million relating to 2005 sales was recorded in Other assets.

COMPREHENSIVE INCOME: The Company's Comprehensive income for the three months
ended March 31, 2005 and 2004 is equal to the Company's Net income (loss) for
the respective periods

7

5. INVENTORIES

Inventories are stated at the lower of cost or market. Cost is determined on the
last-in, first-out ("LIFO") method for approximately 97% of the inventories.
Leaf tobacco is presented in current assets in accordance with standard industry
practice, notwithstanding the fact that such tobaccos are carried longer than
one year for the purpose of curing.

For the three months ended March 31, 2005, inventory quantities were reduced.
This reduction resulted in a liquidation of LIFO inventory quantities carried at
higher costs prevailing in prior years as compared with the cost of 2004
purchases, the effect of which increased cost of goods sold and decreased net
income by approximately $0.4 million.

The components of inventories are as follows (in thousands):





3/31/05 12/31/04
-------------- -------------
Raw materials and work in process $ 4,139 $ 4,246
Leaf tobacco 7,631 7,878
Finished goods - loose leaf tobacco 3,458 3,069
Finished goods - MYO products 8,121 8,539
Other 2,153 2,163
-------------- -------------

25,502 25,895
LIFO reserve 11,840 12,064
-------------- -------------
$ 37,342 $ 37,959
============== =============


6. NEW SENIOR NOTES

The new senior notes amounted to $200 million as of March 31, 2005 and December
31, 2004.

On February 17, 2004, the Company consummated the refinancing of its existing
debt and preferred stock. The refinancing consisted principally of (1) the
offering and sale of the New Senior Notes, (2) entering into the Senior
Revolving Credit Facility, (3) the concurrent sale of the Parent Notes and (4)
the repayment of $30.7 million in debt relating principally to the acquisition
of Stoker, Inc.

The New Senior Notes are senior unsecured obligations of the Company and will
mature on March 1, 2012. The New Senior Notes bear interest at the rate of 9
1/4% per annum, payable semiannually on March 1 and September 1 of each year,
commencing on September 1, 2004. Each of the Company's existing subsidiaries
jointly and severally guarantees the New Senior Notes on a senior unsecured
basis. Each of the Company's future subsidiaries (other than those designated
unrestricted subsidiaries) will jointly and severally guarantee the New Senior
Notes on a senior unsecured basis. The Company is not required to make mandatory
redemptions or sinking fund payments prior to the maturity of the New Senior
Notes.

On and after March 1, 2008, the New Senior Notes will be redeemable, at the
Company's option, subject to meeting certain requirements in the New Credit
Agreement, in whole at any time or in part from time to time, upon not less than
30 nor more than 60 days prior notice at the following redemption prices


8

(expressed in percentages of principal amount), if redeemed during the 12-month
period commencing March 1 of the years set forth below, plus accrued and unpaid
interest to the redemption date (subject to the right of holders of record on
the relevant record date to receive interest due on the relevant interest
payment date):


YEAR REDEMPTION PRICE
---- ----------------

2008 104.625%
2009 102.313%
2010 and thereafter 100.000%

In addition, prior to March 1, 2008, the Company may redeem the New Senior
Notes, subject to meeting certain requirements in the New Credit Agreement, at
its option, in whole at any time or in part from time to time, upon not less
than 30 nor more than 60 days prior notice at a redemption price equal to 100%
of the principal amount of the New Senior Notes redeemed plus a "make-whole"
premium based on U.S. Treasury rates as of, and accrued and unpaid interest to,
the applicable redemption date.

Further, at any time prior to March 1, 2007, the Company may, at its option,
subject to meeting certain requirements in the New Credit Agreement, redeem up
to 35% of the aggregate principal amount of the New Senior Notes with the net
cash proceeds of one or more equity offerings by Parent or the Company, subject
to certain conditions, at a redemption price equal to 109.250% of the principal
amount thereof, plus accrued and unpaid interest thereon, if any, to the date of
redemption; provided, however, that after any such redemption at least 65% of
the aggregate principal amount of the New Senior Notes remains outstanding. In
order to affect the foregoing redemption with the proceeds of any equity
offering, the Company shall make such redemption not more than 60 days after the
consummation of any such equity offering.

Concurrently with the offering of the New Senior Notes, Parent issued $97.0
million aggregate amount at maturity of the Parent Notes. Proceeds of
approximately $53.8 million from this issuance were used to make a capital
contribution to the Company. The Parent Notes are Parent's senior obligations
and are unsecured. The Parent Notes are not guaranteed by the Company or any of
its subsidiaries and are structurally subordinated to all of the Company's and
its subsidiaries' obligations, including the New Senior Notes and the Senior
Revolving Credit Facility. Parent is not required to make mandatory redemptions
or sinking fund payments prior to the maturity of the Parent Notes.

Parent is dependent on the Company's cash flows to service its debt. The amount
of cash interest to be paid by the Parent during the next five years is as
follows: $0 in each of 2005, 2006, 2007 and March 1, 2008; $5,941 payable on
September 1, 2008 and $5,941 payable on each of March 1 and September 1
thereafter until maturity.

The advance to Parent of approximately $1.9 million at March 31, 2005, relates
principally to the assumption of certain obligations, including warrants and
stock options referred to above, net of deferred financing costs transferred to
Parent.


9

7. SENIOR REVOLVING CREDIT FACILITY

In connection with the refinancing, the Company also amended and restated its
Old Senior Credit Facility, resulting in a new $50.0 million (reducing to $40.0
million in August 2005) Senior Revolving Credit Facility with Bank One, N.A., as
agent (the "Agent Bank"), and LaSalle Bank, National Association. The New Credit
Agreement governing the new Senior Revolving Credit Facility includes a letter
of credit sublimit of $25.0 million and matures three years from the closing
date. The Company intends to use the Senior Revolving Credit Facility for
working capital and general corporate purposes. On January 19, 2005, the New
Credit Agreement was amended to reduce the Senior Revolving Credit Facility to
$35.0 million. As of March 31, 2005 and December 31, 2004, the Company had
borrowed $21.9 million and $14.5 million, respectively, under the Senior
Revolving Credit Facility.

Indebtedness under the New Credit Agreement is guaranteed by each of the
Company's current and future direct and indirect subsidiaries, and is secured by
a first perfected lien on substantially all of the Company's and the Company's
direct and indirect subsidiaries' current and future assets and property. The
collateral includes a pledge by the Parent of its equity interest in the Company
and a first priority lien on all equity interests and intercompany notes held by
the Company and each of its subsidiaries.

Each advance under the New Credit Agreement will bear interest at variable rates
based, at the Company's option, on either the prime rate plus 1% or LIBOR plus
3%. The New Credit Agreement provides for voluntary prepayment, subject to
certain exceptions, of loans. In addition, without the prior written consent of
the Agent Bank, the Company will not allow a Change in Control (as defined in
the New Credit Agreement), the sale of any material part of its assets and the
assets of its subsidiaries on a consolidated basis or, subject to certain
exceptions, the issuance of equity or debt. As of March 31, 2005, the weighted
average interest rate on borrowings under the New Credit Agreement was
approximately 5.7%.

Under the New Credit Agreement, the Company is required to pay the lenders an
annual commitment fee in variable amounts ranging from 0.50% to 0.65% of the
difference between the commitment amount and the average usage of the facility,
payable on a quarterly basis. The Company is also required to pay to the lenders
letter of credit fees equal to 3.00% per annum multiplied by the maximum amount
available from time to time to be drawn under such letters of credit issued
under the New Credit Agreement and to the lenders issuing letters of credit a
fronting fee of 0.125% per annum multiplied by the aggregate face amount of
letters of credit outstanding during a fiscal quarter plus other customary
administrative, amendment, payment and negotiation charges in connection with
such letters of credit.

The New Credit Agreement required the Company and its subsidiaries to meet
certain financial tests, including a minimum fixed charge coverage ratio and a
minimum consolidated adjusted earnings before interest, taxes, dividends and
amortization ("EBITDA"). The New Credit Agreement also contains covenants which,
among other things, limit the incurrence of additional indebtedness, dividends,
transactions with affiliates, asset sales, acquisitions, mergers, prepayments of
other indebtedness, liens and encumbrances and other matters customarily
restricted in such agreements. In addition, the New Credit Agreement requires
that certain members of executive management remain active in the day-to-day
operation and management of the Company and its subsidiaries during the term of
the facility.


10

The New Credit Agreement contains customary events of default, including payment
defaults, breach of representations and warranties, covenant defaults,
cross-acceleration, cross-defaults to certain other indebtedness, certain events
of bankruptcy and insolvency, the occurrence of a Change in Control and judgment
defaults.

On March 30, 2005, the New Credit Agreement was amended to modify the fixed
charge coverage ratio covenant, which now applies only to quarters ending June
30, 2005 and thereafter, and the minimum consolidated adjusted EBITDA covenant,
which now applies only to quarters ending from June 30, 2004 through March 31,
2005. The fixed charge coverage ratio definition was also amended to include any
future cash equity contributions to the Company. In addition, the amendment
changed the New Credit Agreement maturity date from February 28, 2007 to January
31, 2006.

The Company was in full compliance with all provisions of the New Credit
Agreement as of March 31, 2005.

Looking forward, due to the lower than anticipated operating performance of the
Company's core business and increased net expenses resulting from the Company's
developmental activities relating to Zig-Zag Premium Cigarettes, the Company
currently anticipates that it will not likely meet the fixed charge coverage
ratio test contained in the New Credit Agreement for the rolling four quarter
periods ending June 30, 2005 and thereafter without the contribution of
additional equity into the Company. In the event that such covenant is breached,
the Company would be in default under the New Credit Agreement, pursuant to
which the lenders would have all rights and remedies available to them at that
time, including the right to accelerate payment of all obligations thereunder.
Such acceleration would trigger an event of-default under the indentures
governing the New Senior Notes and the Parent Notes, allowing an acceleration of
the obligations thereunder. In the case of both the New Senior Notes and the
Parent Notes, the trustee or the holders of at least 25% in principal amount at
maturity of such notes would have the right, following an event of default, to
declare the obligations thereunder, including accrued and unpaid interest, to be
due and payable immediately. In the event of an acceleration of its obligations
under either the New Credit Agreement or New Senior Notes, the Company would not
be able to satisfy its obligations and would likely be required to seek
protection from its creditors under applicable laws. No adjustments have been
recorded relating to any balance sheet classification of the New Senior Notes.
Although there can be no assurance, the Company believes that it will be able to
successfully negotiate new senior secured financing on reasonably acceptable
terms, refinance out the existing lenders and avoid a default under the New
Credit Agreement, as amended.


8. PROVISION FOR INCOME TAXES

The Company has determined that at March 31, 2005, its ability to realize future
benefits of net deferred tax assets does not meet the "more likely than not"
criteria in SFAS No. 109, "Accounting for Income Taxes"; therefore, a valuation
allowance continues to be recorded.


11

9. PENSION AND POSTRETIREMENT BENEFIT PLANS

The components of Net Periodic Benefit Cost for the three months ended March 31
are as follows (in thousands):



PENSION BENEFITS OTHER BENEFITS
-------------------------------- ---------------------------------
2005 2004 2005 2004
--------------- ------------- --------------- --------------

Service cost $ 11 $ 56 $ 40 $ 241
Interest cost 194 185 37 226
Expected return of plan assets (126) (212) - -
Curtailment gain - (264) - -
Amortization of net (gain) loss 25 28 17 102
--------------- ------------- --------------- --------------
Net periodic pension cost $ 104 $ (207) $ 94 $ 569
=============== ============= =============== ==============


The Company has a defined benefit pension plan covering substantially all of its
hourly employees. Benefits for the hourly employees' plan are based on a stated
benefit per year of service, reduced by amounts earned in a previous plan.

Effective June 30, 2004 and July 31, 2004, the Company froze the defined benefit
retirement plan for the respective hourly employees of its three collective
bargaining units.

Effective September 30, 2004, the Company terminated its postretirement benefit
plan for its salaried employees. Accordingly, the Company recognized a reduction
in the postretirement benefit plan liability of $3,811. The Company expects to
contribute approximately $500 to its postretirement plan in 2005 for the payment
of benefits. Plan contributions and benefits have amounted to $131 for the three
months ended March 31, 2005. Based upon the above decision, management believes
that any future contributions will not be material.


10. RECONCILIATION OF INCOME (LOSS) PER COMMON SHARE
(DOLLARS AND SHARES IN THOUSANDS, EXCEPT PER SHARE AMOUNTS):





THREE MONTHS ENDED MARCH 31, 2005
- ---------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
-------------- ---------------- ----------------

Basic and Diluted:
Net loss (4,379)
--------------

Net income applicable to common shares $ (4,379) .01 $ (437,900.00)
============== ================ ================


12




THREE MONTHS ENDED MARCH 31, 2004
- ---------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
-------------- --------------- ---------------

Basic and Diluted:
Net loss $ (5,632)
Less: preferred stock dividends (1,613)
--------------

Net income applicable to common shares $ (7,245) 233.9 $ (30.98)
============== =============== ===============


On February 9, 2004, in connection with the Merger, all the common shares of the
Company were cancelled. Immediately after the Merger, ten (10) shares of the
Company's common stock, par value $0.01 per share, were issued and outstanding.


11. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued SFAS No. 123R (Revised 2004), "Accounting for
Stock Based Compensation" ("SFAS No. 123R"). SFAS No. 123R establishes standards
for the accounting for transactions in which an entity exchanges its equity
instruments for goods or services. It also addresses transactions in which an
entity incurs liabilities in exchange for goods or services that are based on
the fair value of the entity's equity instruments or that may be settled by the
issuance of those equity instruments. SFAS No. 123R eliminates the alternative
to use APB 25's intrinsic value method of accounting that was provided in SFAS
No. 123 as originally issued. SFAS No. 123R requires entities to recognize the
cost of employee services received in exchange for awards of equity instruments
based on the grant-date fair value of those awards (with limited exceptions).
That cost will be recognized over the period during which an employee is
required to provide service in exchange for the award or the vesting period. No
compensation cost is recognized for equity instruments for which employees do
not render the requisite service. A public entity will initially measure the
cost of liability based service awards based on their current fair value; the
fair value of those awards will be remeasured subsequently at each reporting
date through the settlement date. Changes in fair value during the requisite
service period will be recognized as compensation cost over that period. The
provisions of SFAS No. 123R shall become effective for the Company in the first
quarter of 2006 and will apply to all awards granted after June 30, 2005 and to
awards modified, repurchased, or cancelled after that date. The Company is
evaluating SFAS No. 123R and believes it will not have a material effect on
financial results of operations.

In November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an amendment
of ARB No. 43, Chapter 4," to clarify the accounting for abnormal amounts of
idle facility expense, freight, handling costs, and wasted material (spoilage).
SFAS No. 151 requires that items be recognized as current-period charges
regardless of whether they meet the criterion of "so abnormal" that was
previously stated in ARB No. 43, Chapter 4. In addition, SFAS No. 151 requires
that allocation of fixed production overheads to the costs of conversion be
based on the normal capacity of the production facilities. The provisions of
this statement shall be effective for inventory costs incurred during fiscal
years beginning after June 15, 2005. The Company does not expect SFAS No. 151 to
have a material impact on the Company's financial condition or results of
operations.


13

In December 2004, the FASB issued two FASB Staff Positions ("FSP") regarding the
accounting implications of the American Jobs Creation Act of 2004 (the "Act").
The Act provides a deduction for income from qualified domestic production
activities, which will be phased in from 2005 through 2010. In return, the Act
also provides for a two-year phase-out of the existing extra-territorial income
exclusion ("ETI") for foreign sales. Under the guidance in FSP No. FAS 109-1,
"Application of FASB Statement 109, `Accounting for Income Taxes,' to the Tax
Deduction on Qualified Production Activities Provided by the American Jobs
Creation Act of 2004," the deduction will be treated as a "special deduction" as
described in FASB Statement No. 109. As such, the special deduction has no
effect on deferred tax assets and liabilities existing at the enactment date.
FSP No. FAS 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings
Repatriation Provision within the American Jobs Creation Act of 2004," was
effective for the first quarter of 2005 and had no material impact on the
Company's Condensed Consolidated Financial Statements.

In December 2003, the Medicare Prescription Drug, Improvement and Modernization
Act of 2003 (the "Act"), which introduces a Medicare prescription drug benefit,
as well as a federal subsidy to sponsors of retiree health care benefit plans
that provide a benefit that is at least actuarially equivalent to the Medicare
benefit, was enacted. In May 2004, the FASB issued Financial Staff Position No.
106-2, "Accounting and Disclosure Requirements Related to the Medicare
Prescription Drug, Improvement and Modernization Act of 2003" ("FSP 106-2") to
discuss certain accounting and disclosure issues raised by the Act. In January
2005, the Centers for Medicare and Medicaid Services released the final
regulations implementing the Medicare Prescription Drug, Improvement, and
Modernization Act of 2003. FSP No. 106-2 provides guidance to employers that
have determined that prescription drug benefits available under their retiree
health care benefit plans are at least actuarially equivalent to Medicare Part
D. The Company's postretirement healthcare plans provide for prescription drug
benefits for certain participants. Due to the limited number of participants in
the Company's Hourly postretirement healthcare plans that are affected by the
Act, the adoption of FSP No. 106-2 did not have a material impact on the
Company's financials.


12. CONTINGENCIES

LITIGATION WITH REPUBLIC TOBACCO

On July 15, 1998, North Atlantic Operating Company, Inc. ("NAOC") and National
Tobacco Company, L.P. ("NTC"), which are subsidiaries of the Company, filed a
complaint (the "Kentucky Complaint") against Republic Tobacco, Inc. and its
affiliates ("Republic Tobacco") in Federal District Court for the Western
District of Kentucky. Republic Tobacco imports and sells Roll-Your-Own ("RYO")
premium cigarette papers under the brand names JOB and TOP as well as other
brand names. The Kentucky Complaint alleges, inter alia, that Republic Tobacco's
use of exclusivity agreements, rebates, incentive programs, buy-backs and other
activities related to the sale of premium cigarette papers in the southeastern
United States violate federal and state antitrust and unfair competition laws
and that Republic Tobacco defaced and directed others to deface NAOC's point of
purchase vendor displays for premium cigarette papers by covering up the ZIG-ZAG
brand name and advertising material with advertisements for Republic Tobacco's
RYO cigarette paper brands. The Kentucky Complaint alleges that these activities
constitute unfair competition under federal and state laws.


14

On June 30, 1998, Republic Tobacco filed a complaint against the Company, NAOC
and NTC in the U.S. District Court of the Northern District of Illinois (the
"Illinois Complaint") and served it on the Company after the institution of the
Kentucky action. In the Illinois Complaint, Republic Tobacco seeks declaratory
relief with respect to the Company's claims. In addition, the Illinois Complaint
alleges that certain actions taken by the Company to inform its customers of its
claims against Republic Tobacco constitute tortuous interference with customer
relationships, false advertising, violations of Uniform Deceptive Trade
Practices and Consumer Fraud Acts, defamation and unfair competition. In
addition, although not included in its original complaint but in its amended
complaint, Republic Tobacco alleged that the Company has unlawfully monopolized
and attempted to monopolize the market on a national and regional basis for
premium cigarette papers. Republic sought unspecified compensatory damages,
injunctive relief and attorneys fees and costs.

On October 20, 2000, Republic Tobacco filed a motion to dismiss, stay, or
transfer the Kentucky Complaint to the Illinois Court. On December 19, 2000, the
Court denied Republic Tobacco's motion, holding that it was premature. The Court
noted also that it had communicated with the Court in Illinois and that it had
concluded that Republic Tobacco may not be entitled to any preference on forum
selection, which would ordinarily be given because it was first to file. The
Kentucky complaint is still on file.

Prior to the completion of discovery, the Court dismissed Republic Tobacco's
antitrust claims against the Company. After discovery was completed in 2001,
both parties moved for summary judgment on the others claims. In April 2002, the
District Court for the Northern District of Illinois decided the summary
judgment motions by dismissing all claims of both the Company and Republic
Tobacco and its affiliates, except for Republic Tobacco's claim of defamation
per se against the Company, on which it granted summary judgment on liability in
favor of Republic Tobacco, and a Lanham Act false advertising claim, based on
the same facts as the defamation claim, for equitable relief. In February 2003,
the District Court granted Republic's motion for summary judgment on the
Company's counterclaim that Republic tortuously interfered with the Company's
business relationships and economic advantage. The only claim that remained to
be tried was Republic's Lanham Act claim and damages on the defamation claim on
which the Court previously ruled that Republic could only obtain equitable
relief if successful.

On July 8, 2003, following a four-day trial, an Illinois jury returned a verdict
in favor of Republic on the defamation claims of $8.4 million in general damages
and $10.2 million in punitive damages, for a total damage award of $18.6
million. The Company recorded an $18.8 million charge during the second quarter
2003 relating to this transaction. The Company filed post-trial motions for a
new trial and, in the alternative, for a reduction of the awards. On August 1,
2003, the Company posted a judgment bond in the amount of $18.8 million with the
U.S. District Court. This was accomplished by obtaining a $19.0 million senior
secured term loan pursuant to a July 31, 2003 amendment to the Company's
existing credit facility. On November 20, 2003, the court ruled that the awards
were excessive and reduced the awards by approximately 60%, with the award of
compensatory damages being reduced to $3.36 million and the award of punitive
damages being reduced to $4.08 million, for a total of $7.44 million. On
December 18, 2003, Republic accepted these reduced awards. The Company reversed
$11.16 million during the fourth quarter 2003 due to this court ruling.


15

On January 8, 2004, the Company appealed the final judgment, including the
finding of liability in this case as well as the amount of the award. On January
22, 2004, Republic filed a general notice of cross appeal and argued in its
appellate briefs that the judgment should be affirmed and also asserted, in its
cross-appeal, that the original judgment should be reinstated despite its
acceptance of the District Court's order reducing the judgment amount.

On September 1, 2004, the Court of Appeals issued its ruling affirming the
finding of liability against the Company for defamation, but reducing the amount
of the damage award to $3.0 million. The Court of Appeals also affirmed the
dismissal of the Company's antitrust claim against Republic and the dismissal of
Republic's motion to re-instate the original jury award of $18.8 million. As a
result of these rulings, in October 2004 the Company received approximately $4.5
million relating to the cash bond it had posted with the Court in 2003. This
amount was included in Other income during the third quarter of 2004.

The Company has also applied to the Court of Appeals for an order awarding the
Company approximately $1.0 million for the difference in the expense of the
original bond of $18.8 million and the subsequent reduced bond of $7.0 million,
on the one hand, and the lesser expense the Company would have incurred to bond
the final $3.0 million judgment, on the other hand. On November 30, 2004, the
Court of Appeals ruled that the application for costs should be directed to the
District Court. On December 17, 2004, the Company filed this motion with the
District Court. That motion has been fully briefed and the parties are waiting
for the Court to rule.

LITIGATION RELATED TO COUNTERFEITING

Texas Infringing Products Litigation. In Bollore, S.A. v. Import Warehouse,
Inc., Civ. No. 3-99-CV-1196-R (N.D. Texas), Bollore, the Company's Licensor of
ZIG-ZAG brand premium cigarette papers, obtained a sealed order allowing it to
conduct a seizure of infringing and counterfeit ZIG-ZAG products in the United
States. On June 7, 1999, seizures of products occurred in Michigan and Texas.
Subsequently, all named defendants have been enjoined from buying and selling
such infringing or counterfeit goods. Bollore and the Company negotiated
settlements with all defendants. These defendants included Import Warehouse,
Ravi Bhatia, Tarek Makki and Adham Makki. Those settlements included a consent
injunction against distribution of infringing or counterfeit goods.

On May 18, 2001, the Company, in conjunction with Bollore and law enforcement
authorities conducted raids on the businesses and homes of certain defendants
previously enjoined (including Tarek Makki and Adham Makki) from selling
infringing or counterfeit ZIG-ZAG brand products in the Bollore S.A. v. Import
Warehouse litigation. Evidence was uncovered that showed that these defendants
and certain other individuals were key participants in importing and
distributing counterfeit ZIG-ZAG premium cigarette papers. After a two day
hearing in the U.S. District Court for the Northern District of Texas, on May
30, 2001, the Court held the previously enjoined defendants in contempt of
court, and enjoined the additional new defendants, including Ali Makki, from
selling infringing or counterfeit ZIG-ZAG premium cigarette papers.

The Company entered into a settlement with the defendants, the principal terms
of which included a cash payment, an agreed permanent injunction, the withdrawal
of the defendants' appeal of the civil contempt order, an agreed judgment of
$11.0 million from the civil contempt order and an agreement to forbear from
enforcing that $11.0 million money judgment until such time in the future that
the defendants violate the terms of the permanent injunction. Two of the
defendants, Tarek Makki and Adham Makki, also agreed to provide complete
information concerning the counterfeiting conspiracy as well as information on
other parties engaged in the purchase and distribution of infringing ZIG-ZAG
premium cigarette papers.


16

On February 17, 2004, the Company and Bollore filed a motion in the U.S.
District Court for the Northern District of Texas, which had issued the original
injunctions against the infringing defendants, seeking, with respect to
respondents Adham Makki, Tarek Makki and Ali Makki, to have the $11.0 million
judgment released from the forbearance agreement and to have the named
respondents held in contempt of court. The motion alleged that the three
respondents had trafficked in counterfeit ZIG-ZAG cigarette papers after the
execution of the settlement, citing evidence that all three had been charged in
the United States District Court for the Eastern District of Michigan with
criminal violations of the United States counterfeiting laws by trafficking in
counterfeit ZIG-ZAG cigarette papers, which trafficking occurred after the
settlement agreement.

On April 13, 2004, the Court entered an order (the "Contempt 2 Order"), finding
Ali Mackie, Tarek Makki, Adham Mackie and their companies Best Price Wholesale
(the "Makki Defendants") and Harmony Brands LLC in civil contempt, freezing all
of their assets, releasing the July 12, 2002 Final Judgment of $11.0 million
from the forbearance agreement as to the Makki Defendants, and again referring
the matter to the United States Attorney for Criminal Prosecution. Subsequent to
the entry of the Contempt 2 Order, the Company settled with defendant Harmony
Brands and its members for the amount of $750,000 and the entry of a permanent
injunction. The Company is seeking to execute on the outstanding $11.0 million
judgment against the remaining Makki Defendants and those efforts are currently
underway.

Pursuant to the U.S. Distribution Agreement and a related agreement between
Bollore and the Company, any collections on the judgments issued in the Bollore
v. Import Warehouse case are to be divided evenly between Bollore and the
Company after the payment of all expenses.

On February 7, 2002, Bollore, NAOC and the Company filed a motion with the
District Court in the Texas action seeking to hold Ravi Bhatia and Import
Warehouse Inc. in contempt of court for violating the terms of the consent order
and injunction entered against those defendants. The Company alleges that Mr.
Bhatia and Import Warehouse sold counterfeit goods to at least three different
companies over an extended period of time. On June 27, 2003, the Court found
Import Warehouse and Mr. Bhatia in contempt of court for violating an existing
injunction barring those parties from distributing infringing ZIG-ZAG cigarette
paper products. The Court requested that the Company and Bollore (the Company's
co-plaintiff in the case) file a submission detailing the damages incurred. The
Company and Bollore filed their submission on July 25, 2003 which reported and
requested damages of $2.4 million.

On July 1, 2004, the Court issued an Order awarding approximately $2.5 million
in damages to the Company for the damages incurred by the Company as a result of
the Import Warehouse Defendants' civil contempt. On July 15, 2004, the Court
entered a Final Judgment in that amount for which defendants Import Warehouse,
Inc. and Ravi Bhatia are jointly and severally liable. After the Company and
Bollore commenced collection proceedings, Import Warehouse paid the Company and
Bollore an amount equal to the entire judgment plus the expenses incurred in
collection. Accordingly, approximately $1.2 million has been recorded in Other
income during the third quarter of 2004. The Import Warehouse Defendants filed a
notice of appeal on July 24, 2004. No briefing schedule has been established.


17

LITIGATION RELATED TO ALLEGED PERSONAL INJURY

West Virginia Complaints. Trial of the West Virginia complaints against the
smokeless tobacco defendants has been postponed indefinitely, as described
below. On October 6, 1998 NTC was served with a summons and complaint on behalf
of 65 individual plaintiffs in an action in the Circuit Court of Kanawha County,
West Virginia, entitled Kelly Allen, et al. v. Philip Morris Incorporated, et
al. (Civil Action Nos. 98-C-240l). On November 13, 1998, NTC was served with a
second summons and complaint on behalf of 18 plaintiffs in an action in the
Circuit Court of Kanawha County, West Virginia, entitled Billie J. Akers, et al.
v. Philip Morris Incorporated et al. (Civil Action Nos. 98-C-2696 to 98-C-2713).
The complaints are identical in most material respects. In the Allen case, the
plaintiffs have specified the defendant companies for each of the 65 cases. NTC
is named in only one action. One Akers plaintiff alleged use of an NTC product,
alleging lung cancer.

On September 14, 2000, NTC was served with a summons and complaint on behalf of
539 separate plaintiffs filed in Circuit Court of Ohio County, West Virginia,
entitled Linda Adams, et al. v. Philip Morris Inc., et al. (Civil Action Nos.
00-C-373 to 00-C-911). Only one of these plaintiffs alleged use of a product
currently manufactured by NTC. The time period during which this plaintiff
allegedly used the product has not yet been specified. Thus, it is not yet known
whether NTC is a proper defendant in this case.

On September 19, 2000, NTC was served with a second summons and complaint on
behalf of 561 separate plaintiffs filed in Circuit Court of Ohio County, West
Virginia, entitled Ronald Accord, et al. v. Philip Morris Inc., et al. (Civil
Action Nos. 00-C-923 to 00-C-1483). A total of five of these plaintiffs alleged
use of a product currently manufactured by NTC. One of these plaintiffs does not
specify the time period during which the product was allegedly used. Another
alleges use that covers, in part, a period when NTC did not manufacture the
product. On motion by cigarette company defendants, this claim was dismissed on
February 11, 2004, for failure to follow the case management order. Of the
remaining three, one alleges consumption of a competitor's chewing tobacco from
1966 to 2000 and NTC's Beech-Nut chewing tobacco from 1998 to 2000; another
alleges a twenty-four year smoking history ending in 1995 and consumption of
Beech-Nut chewing tobacco from 1990 to 1995; and the last alleges a thirty-five
year smoking history ending in 2000, and consumption of NTC's Durango Ice
chewing tobacco from 1990 to 2000 (although Durango Ice did not come onto the
market until 1999).

In November 2001, NTC was served with an additional four separate summons and
complaints in actions filed in the Circuit Court of Ohio County, West Virginia.
The actions are entitled Donald Nice v. Philip Morris Incorporated, et al.
(Civil Action No. 01-C-479), Korene S. Lantz v. Philip Morris Incorporated, et
al. (Civil Action No. 01-C-480), Ralph A. Prochaska, et al. v. Philip Morris,
Inc., et al. (Civil Action No. 01-C-481), and Franklin Scott, et al. v. Philip
Morris, Inc., et al., (Civil Action No. 01-C-482).

All of the West Virginia smokeless tobacco actions have been consolidated before
the West Virginia Mass Litigation Panel for discovery and trial of certain
issues. Trial of these matters was planned in two phases. In the initial phase,
a trial was to be held to determine whether tobacco products, including all
forms of smokeless tobacco, cigarettes, cigars and pipe and roll-your-own
tobacco, can cause certain specified diseases or conditions. In the second
phase, individual plaintiffs would attempt to prove that they were in fact
injured by tobacco products. Fact and expert discovery in these cases has
closed, however, in the cigarette cases the Court has allowed additional
discovery.


18

The claims against NTC in the various consolidated West Virginia actions include
negligence, strict liability, fraud in differing forms, conspiracy, breach of
warranty and violations of the West Virginia consumer protection and antitrust
acts. The complaints in the West Virginia cases request unspecified compensatory
and punitive damages.

The manufacturers of smokeless tobacco products (as well as the manufacturers of
cigarettes) moved to sever the claims against the smokeless tobacco manufacturer
defendants from the claims against the cigarette manufacturer defendants. That
motion was granted and the trial date on the smokeless tobacco claims has now
been postponed indefinitely.

The trial court has now vacated the initial trial plan in its entirety because
of concerns that its provisions violated the dictates of the United States
Supreme Court's decision in State Farm Mutual Automobile Insurance Company v.
Campbell, 538 U.S. 408 (2003). A new trial plan has not yet been implemented
with regard to the consolidated claims against the cigarette manufacturer
defendants. The West Virginia Supreme Court has accepted review of the case
management order and briefing by the parties was commenced. The claims against
the smokeless tobacco manufacturer defendants remain severed and indefinitely
stayed.

Minnesota Complaint. On September 24, 1999, NTC was served with a complaint in a
case entitled Tuttle v. Lorillard Tobacco Company, et al. (Case No. C2-99-7105),
brought in Minnesota. The other manufacturing defendants are Lorillard and The
Pinkerton Tobacco Company. The Complaint alleges that plaintiff's decedent was
injured as a result of using NTC's (and, prior to the formation of NTC,
Lorillard's) Beech-Nut brand and Pinkerton's Red Man brand of loose-leaf chewing
tobacco. Plaintiff asserts theories of liability, breach of warranty, fraud, and
variations on fraud and misrepresentation. Plaintiff specifically requests in
its complaint an amount of damages in excess of fifty thousand dollars ($50,000)
along with costs, disbursements and attorneys' fees, and ". . . an order
prohibiting defendants from disseminating in Minnesota further misleading
advertising and making further untrue, deceptive and/misleading statements about
the health effects and/or addictive nature of smokeless tobacco products. . . ."
After discovery, summary judgment motions were filed on behalf of all
defendants. On March 3, 2003, the Court granted defendants' motions, dismissing
all claims against all defendants and the Court has since denied the plaintiff's
motion for reconsideration. Plaintiff has appealed the dismissal. Briefing has
been completed. Oral argument before the Court of Appeals was held on February
11, 2004. On July 30, 2004, the Court of Appeals affirmed the dismissal of all
of the claims.

In addition to the above described legal proceedings, the Company is subject to
other litigation in the ordinary course of its business. The Company does not
believe that any of these other proceedings will have a material adverse effect
on the results of operations, financial position or cash flows of the Company.
For a description of regulatory matters and related industry litigation to which
the Company is a party, see Part I, Item 1. "Business--Regulation" in the
Company's Annual Report on Form 10-K, as amended, for the year ended December
31, 2004.


19

OTHER EMPLOYMENT MATTERS

The Company may, from time to time, have claims from and make settlements with
former officers or employees.

David I. Brunson, the former President, Chief Financial Officer and Treasurer of
the Company, resigned from the Company effective January 19, 2005, at which time
his employment agreement with the Company (the "Brunson Employment Agreement")
was effectively terminated. Pursuant to the Brunson Employment Agreement, the
Company is required to make certain severance payments to Mr. Brunson, including
$425,000, which was paid within ten business days after January 19, 2005, and an
additional $425,000 payable within the next 12 months. In addition, Mr. Brunson
may become entitled to a bonus payment of up to $725,000 relating to synergies
achieved in the integration of the business of Stoker, Inc. that was acquired by
the Company in 2003. Pursuant to the Brunson Employment Agreement, after the
last severance payment is made, Mr. Brunson will have an option to require the
Company to repurchase all or a portion of his shares of Parent at their fair
market value. The Company will not be obligated to repurchase these shares if,
upon or after the payment, it would be in default under any instrument,
agreement or law by which it is bound; in this case, the repurchase may be
deferred until it can be completed without such default. Similarly, the Company
has an option to repurchase Mr. Brunson's shares at their fair market value. In
the event the Company and Mr. Brunson are unable to agree upon the fair market
value of these shares, an independent investment banking firm will be selected
to determine such fair market value, in accordance with the procedure provided
for by the Brunson Employment Agreement. If neither Mr. Brunson nor the Company
exercise their respective options by the earliest of the fifth anniversary of
the termination of Mr. Brunson's employment or the date on which the Company
refinances, or uses proceeds derived from refinancing, certain of its
obligations, the Company will be required to repurchase Mr. Brunson's shares on
such date unless Mr. Brunson waives his right to require the Company to purchase
his shares. Any liability is deemed, at this time, not to be material to the
Company's Condensed Consolidated Financial Statements.

During the first quarter of 2005, the Company recorded approximately $1.1
million relating to the resignation of Mr. Brunson. Any options or shares of
restricted stock granted to Mr. Brunson vested in full as of the date of such
resignation.

As part of the A&M agreement, as amended in April 2005, the Company will pay a
cash incentive fee to A&M upon the closing of the refinancing of the Company's
existing revolving credit facility equal to 0.5% of the total commitment amount
of the refinancing (reduced by $50,000 per month for the period from April 11,
2005 to the date of such refinancing). A&M is also entitled to a fee based on
improvement in the Company's financial performance as measured against the
Company's 2005 Business Plan, to be paid upon the termination of the engagement.
One portion of the fee will be a specified percentage of the sustainable
annualized EBITDAR improvement, as defined, and the other portion of the fee
will be an amount to be determined by the Board of Directors of the Company in
their reasonable judgment for significant and sustainable improvement in working
capital investment and management, in each case as measured against the
Company's 2005 Business Plan. As of March 31, 2005, no related liability or
expense has been recorded.


20

13. SEGMENT INFORMATION

In accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information," the Company has three reportable segments. The
smokeless tobacco segment manufactures smokeless tobacco products which are
distributed primarily through wholesale and food distributors in the United
States. The make-your-own segment imports and distributes premium cigarette
papers and contract manufactures and distributes cigarette tobaccos and related
products primarily through wholesale distributors in the United States. The
premium cigarette segment distributes contract manufactured cigarettes through
wholesale distributors in the United States.

The accounting policies of these segments are the same as those of the Company.
Segment data includes a charge allocating all corporate costs to each operating
segment. Other includes the assets of the Company not assigned to segments and
Eliminations includes the elimination of intercompany accounts between segments.
The Company evaluates the performance of its segments and allocates resources to
them based on earnings before interest, taxes, depreciation, amortization,
certain non-cash charges, other income and expenses and restructuring charges
("Adjusted EBITDAR").

The table below presents financial information about reported segments for the
three months ended March 31, 2005 and 2004, respectively (in thousands):




THREE MONTHS ENDED: SMOKELESS YOUR MANUFACTURED
MARCH 31, 2005 TOBACCO OWN CIGARETTES OTHER ELIMINATIONS TOTAL
- ------------------------- -------------- ------------ -------------- ---------- -------------- -------------

Net sales $ 9,835 $ 16,139 $ 180 $ 1,193 $ - $ 27,347
Operating income 574 4,112 (985) (1,839) - 1,862
Adjusted EBITDAR 1,131 4,126 (956) 127 - 4,428
Assets 58,292 278,642 2,775 33,893 (149,124) 224,478

MARCH 31, 2004
- -------------------------

Net sales $ 11,240 $ 9,560 $ 16 $ 1,289 $ - $ 22,105
Operating income 1,665 (1,732) (1,395) (124) - (1,586)
Adjusted EBITDAR 4,406 (1,623) (1,373) (57) - 1,353
Assets 72,706 274,287 2,982 12,826 53,672 416,473




21

The table set forth below is a reconciliation of the Company's Net income (loss)
to Adjusted EBITDAR for the three months ended March 31, 2005 and 2004,
respectively (in thousands):



FOR THE THREE MONTHS ENDED:
MARCH 31
---------------------------
2005 2004
------------ ------------


Net income (loss) $ (4,379) $ (5,632)
Interest expense, net and amortization
of deferred financing fees 5,471 7,410
Income tax expense (benefit) - (3,452)
Depreciation 217 212
Other expense 770 88
LIFO adjustment 225 225
Stock option compensation expense 30 100
Postretirement/pension expense 198 295
Restructuring charges 1,896 -
Incentive payments in conjunction with reorganization - 2,107
------------ ------------

Adjusted EBITDAR $ 4,428 $ 1,353
============ ============



ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations

The Company, a wholly-owned subsidiary of Parent, competes, in three distinct
markets: (1) the smokeless tobacco market; (2) the Make-Your-Own ("MYO")
cigarette market; and (3) the premium manufactured cigarette market. The
smokeless tobacco market includes the loose leaf chewing tobacco sector. The MYO
cigarette market is comprised of the MYO premium cigarette papers sector and the
MYO cigarette tobaccos and related products sector. The Company's subsidiaries
manufacture and market loose leaf chewing tobacco, import and distribute MYO
premium cigarette papers, contract manufacture and market MYO cigarette tobaccos
and related products, and contract manufacture and market premium manufactured
cigarettes. To date, the Company's premium manufactured cigarette segment
continues in its development phase and net sales of this segment have not been
significant.


RESULTS OF OPERATIONS

COMPARISON OF THREE MONTHS ENDED MARCH 31, 2005 AND 2004

Net Sales. Net sales for the three months ended March 31, 2005 were $27.3
million, an increase of $5.2 million or 23.5% from the corresponding period of
the prior year.

Net sales of the smokeless tobacco segment for the current period decreased $1.4
million or 12.5% from the corresponding period of the prior year. The volume of
the Company's brands declined 14.1% in net cases due to promotional activity
during the first quarter of 2004 as compared to limited promotional activity
during the first quarter of 2005, coupled with a continuing decline in the
segment.


22

Net sales of the Company's MYO segment increased $6.6 million or 68.8% in
comparison to the corresponding period of the prior year. Within the MYO
segment, premium cigarette paper sales increased $6.2 million or 155.0% from the
corresponding period of the prior year due to the timing in significant
promotional activities occurring in the fourth quarter of 2003 resulting in
weakened sales during the first quarter of 2004. The MYO cigarette tobaccos and
related product sales increased $0.4 million or 7.1% in comparison to the
corresponding period of the prior year. The aggregate volume in net cases
increased 15.8% reflecting higher sales of lower price product.

Gross Profit. Gross profit for the three months ended March 31, 2005 totaled
$14.2 million, an increase of $4.3 million or 43.4% from the corresponding
period of the prior year.

Gross profit of the smokeless tobacco segment decreased $0.5 million or 10.0%
from the corresponding period of the prior year. Gross margin for this segment
increased to 45.9% of net sales for the current period from 44.2% in the
corresponding period of the prior year due to several factors, including lower
manufacturing costs per case.

Gross profit of the MYO segment for the current period increased $4.5 million or
100.0% in comparison to the corresponding period of the prior year. The gross
margin of the MYO segment increased to 55.6% of net sales for the current period
in comparison to 46.9% for the corresponding period of the prior year. This
increase in gross margin was due principally to product mix resulting from
increased sales of its premium cigarette papers.

Selling, General, and Administrative Expenses. Selling, general, and
administrative expenses for the three months ended March 31, 2005 were $10.4
million, a decrease of $1.0 million or 8.8% in comparison to the corresponding
period of the prior year. Of this decrease, $2.1 million relates to management
incentive payments incurred in conjunction with the refinancing in February
2004, offset by increased legal and professional fees of $0.6 million, freight
of $0.4 million and other of $0.1 million.

Interest Expense and Amortization of Financing Costs. Interest expense and
amortization of financing costs decreased $1.9 million or 26.2% to $5.5 million
for the three months ended March 31, 2005 as compared to the corresponding
period of the prior year. This decrease was due principally to the write off of
old deferred financing costs during the first quarter of 2004, relating to the
recapitalization and reorganization consummated in February 2004, as more fully
described in Note 2 to the Condensed Consolidated Financial Statements contained
herein, partially offset by increased interest expense during the first quarter
of 2005 due to higher average outstanding indebtedness also resulting from the
recapitalization and reorganization consummated in February 2004.

Other Income (Expense). Other expense was $0.8 million for the three months
ended March 31, 2005 as compared to an expense of $0.1 million during the
corresponding period of the prior year. This increase relates principally to
higher litigation and related expenses associated with counterfeiting activity.

Restructuring Charges. For the three months ended March 31, 2005, total
restructuring charges amounted to approximately $1.9 million, including, but not
limited to, severance and separation expenses and A&M fees. The Company
anticipates incurring additional expenses relating to the restructuring during
2005.

Income Tax Benefit (Expense). The Company has determined that at March 31, 2005,
its ability to realize future benefits of net deferred tax assets does not meet
the "more likely than not" criteria in SFAS No. 109, "Accounting for Income
Taxes". Therefore, no income tax benefit for the three months ended March 31,
2005 was recorded, compared to a benefit of $3.5 million for the corresponding
period of the prior year. As of March 31, 2005, a valuation allowance continues
to be recorded. The effective income tax rate for the three months ended March
31, 2004 was 38.0%.

Net Income (Loss). Due to the factors described above, net loss for the three
months ended March 31, 2005 was $4.4 million compared to $5.6 million for the
corresponding period of the prior year.


23

LIQUIDITY AND CAPITAL RESOURCES

At March 31, 2005, working capital was $16.5 million compared to $21.6 million
at December 31, 2004. This decrease was the result of decreased other current
assets of $2.1 million, decreased inventory of $0.6 million, decreased accounts
receivable of $0.4 million, a lower cash balance of $1.9 million, an increase in
the revolving credit facility of $7.4 million offset by decreased accrued
liabilities of $3.8 million and decreased accounts payable of $3.5 million.

For the three months ended March 31, 2005, net cash used in operating activities
was $8.6 million compared with $2.7 million in the corresponding period of the
prior year. The change was due primarily to the payment of interest relating to
the New Senior Notes partially offset by a decrease in accounts receivable.

For the three months ended March 31, 2005, net cash used in investing activities
was $0.7 million compared with $160.4 million in the corresponding period of the
prior year. The change was due primarily to the restricted cash used to pay off
the Old Senior Notes in April 2004, relating to the refinancing in February
2004.

For the three months ended March 31, 2005, net cash provided by financing
activities was $7.4 million compared with $167.3 million in the corresponding
period of the prior year. The change was due primarily to the refinancing in
February 2004.

As more fully discussed below (under "Senior Revolving Credit Facility/New
Credit Agreement") and in Note 7 to the Condensed Consolidated Financial
Statements contained in Item 1 of this report the Company anticipates that it
will not likely meet its fixed charge coverage ratio covenant under the New
Credit Agreement for the rolling four quarter periods ending June 30, 2005 and
thereafter without the contribution of additional equity into the Company.

The Company expects to be able to fund its seasonal working capital requirements
through its operating cash flows and, if needed, bank borrowings under the
Senior Revolving Credit Facility and, if necessary and subject to the Company's
ability to refinance, borrowings under the facility provided by such
refinancing. As of March 31, 2005, the Company had additional availability of
$13.1 million under the revolving credit portion of its New Credit Agreement.

For the three months ending March 31, 2005, capital expenditures totaled
approximately $0.7 million. The Company believes that its capital expenditure
requirements for 2005 will be approximately $3.0-5.0 million due to the Stoker
integration, purchasing of certain manufacturing equipment and the continuing
investment in data and related systems.

The Company believes that it will be able to fund its capital expenditure
requirements from operating cash flows and, if needed, bank borrowings under the
Senior Revolving Credit Facility and, if necessary and subject to the Company's
ability to refinance, borrowings under the facility provided by such
refinancing.


24

SENIOR REVOLVING CREDIT FACILITY / NEW CREDIT AGREEMENT
- -------------------------------------------------------

The New Credit Agreement required the Company and its subsidiaries to meet
certain financial tests, including a four-quarter rolling minimum fixed charge
coverage ratio for the quarters ending June 30, 2005 and thereafter.

Looking forward, due to the lower than anticipated operating performance of the
Company's core business and increased net expenses resulting from the Company's
developmental activities relating to Zig-Zag Premium Cigarettes, the Company
currently anticipates that it will not likely meet the fixed charge coverage
ratio test contained in the New Credit Agreement for the rolling four quarter
periods ending June 30, 2005 and thereafter without the contribution of
additional equity into the Company. In the event that such covenant is breached,
the Company would be in default under the New Credit Agreement, pursuant to
which the lenders would have all rights and remedies available to them at that
time, including the right to accelerate payment of all obligations thereunder.
Such acceleration would trigger an event of-default under the indentures
governing the New Senior Notes and the Parent Notes, allowing an acceleration of
the obligations thereunder. In the case of both the New Senior Notes and the
Parent Notes, the trustee or the holders of at least 25% in principal amount at
maturity of such notes would have the right, following an event of default, to
declare the obligations thereunder, including accrued and unpaid interest, to be
due and payable immediately. In the event of an acceleration of its obligations
under either the New Credit Agreement or New Senior Notes, the Company would not
be able to satisfy its obligations and would likely be required to seek
protection from its creditors under applicable laws. No adjustments have been
recorded relating to any balance sheet classification of the New Senior Notes.
Although there can be no assurance, the Company believes that it will be able to
successfully negotiate new senior secured financing on reasonably acceptable
terms, refinance out the existing lenders and avoid a default under the New
Credit Agreement, as amended.

For a general description of the New Credit Agreement and the Senior Revolving
Credit Facility, as well as the Parent Notes and the New Senior Notes, see Notes
6 and 7 to the Condensed Consolidated Financial Statements included herein,
which information is incorporated herein by reference.


CONTRACTUAL OBLIGATIONS
- -----------------------

Certain contractual obligations are summarized in our Annual Report on Form
10-K, as amended, for the year ended December 31, 2004 under the heading
"Contractual Obligations" in "Management's Discussion and Analysis of Financial
Condition and Results of Operations." As of March 31, 2005, there had been no
material changes outside the ordinary course of our business in such contractual
obligations from December 31, 2004.


25

FORWARD-LOOKING STATEMENTS

The Company cautions the reader that certain statements in the Management's
Discussion and Analysis of Financial Condition and Results of Operations section
as well as elsewhere in this Form 10-Q are "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are not guarantees of future performance. They
involve risks, uncertainties and other important factors, including the risks
discussed below. The Company's actual future results, performance or achievement
of results may differ materially from any such results, performance or
achievement implied by these statements. Among the factors that could affect the
Company's actual results and could cause results to differ from those
anticipated in the forward-looking statements contained herein is the Company's
ability to comply with certain New Credit Agreement financial covenants, extend
the maturity date of the New Credit Agreement or obtain alternative financing,
and its ability to implement its business strategy successfully, which may be
dependent on business, financial, and other factors beyond the Company's
control, including, among others, federal, state and/or local regulations and
taxes, competitive pressures, prevailing changes in consumer preferences,
consumer acceptance of new product introductions and other marketing
initiatives, market acceptance of the Company's current distribution programs,
access to sufficient quantities of raw material or inventory to meet any sudden
increase in demand, disruption to historical wholesale ordering patterns,
product liability litigation and any disruption in access to capital necessary
to achieve the Company's business strategy.

The Company cautions the reader not to put undue reliance on any forward-looking
statements. In addition, the Company does not have any intention or obligation
to update the forward-looking statements in this document. The Company claims
the protection of the safe harbor for forward-looking statements contained in
Section 21E of the Securities Exchange Act of 1934.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

There have not been any significant changes with respect to quantitative and
qualitative disclosures about market risk from what was previously disclosed in
the Company's Form 10-K, as amended, for the year ended December 31, 2004.

ITEM 4. CONTROLS AND PROCEDURES.

The Company's management, with the participation of the Company's principal
executive and principal financial officers, has evaluated the effectiveness of
the Company's disclosure controls and procedures (as defined in Rules 13a-15(e)
and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the
"Exchange Act")) as of March 31, 2005. Based on their evaluation, the Company's
principal executive and principal financial officers concluded that the
Company's disclosure controls and procedures were effective as of March 31,
2005.


26

There has been no change in the Company's internal control over financial
reporting (as defined in Rules 13a-15(f) and 15-d-15(f) under the Exchange Act)
that occurred during the Company's fiscal quarter ended March 31, 2005, that has
materially affected, or is reasonably likely to materially affect, the Company's
internal control over financial reporting.



PART II
OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS
-----------------

Reference is made to the information contained in Note 12 to the Condensed
Consolidated Financial Statements included herein, which information is
incorporated herein by reference.




ITEM 6. EXHIBITS
--------

10.1 Employment Agreement, dated March 10, 2005, between North
Atlantic Trading Company, Inc. and Brian Harriss (supersedes
the Employment Agreement, dated March 10, 2005, between
North Atlantic Trading Company, Inc. and Brian Harriss,
attached as Exhibit 10.1 to the Company's Current Report on
Form 8-K filed with the U.S. Securities and Exchange
Commission on April 14, 2005).

31.1 Certification by the Chief Executive Officer pursuant to
rule 13-14(a) or 15d-14(a) of the Securities Exchange Act of
1934, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.

31.2 Certification by the Chief Financial Officer pursuant to
rule 13-14(a) or 15d-14(a) of the Securities Exchange Act of
1934, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.

* The Certifications by the Chief Executive Officer and Chief
Financial Officer pursuant to 18 U.S.C. ss. 1350, as adopted
by Section 906 of the Sarbanes-Oxley Act of 2002, are no
longer included because the registrant is no longer required
to file reports pursuant to Section 15(d) of the Securities
Exchange Act of 1934.




27

SIGNATURES


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

NORTH ATLANTIC TRADING COMPANY, INC.


Date: May 16, 2005 /s/ Douglas P. Rosefsky
---------------------------------
Douglas P. Rosefsky
Chief Executive Officer

/s/ Brian C. Harriss
---------------------------------
Brian C. Harriss
Chief Financial Officer








28

EXHIBIT INDEX

No. Description

10.1 Employment Agreement, dated March 10, 2005, between North Atlantic
Trading Company, Inc. and Brian Harriss (supersedes the Employment
Agreement, dated March 10, 2005, between North Atlantic Trading
Company, Inc. and Brian Harriss, attached as Exhibit 10.1 to the
Company's Current Report on Form 8-K filed with the U.S. Securities
and Exchange Commission on April 14, 2005).

31.1 Certification by the Chief Executive Officer pursuant to rule 13-14(a)
or 15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification by the Chief Financial Officer pursuant to rule 13-14(a)
or 15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.

* The Certifications by the Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. ss. 1350, as adopted by Section 906 of
the Sarbanes-Oxley Act of 2002, are no longer included because the
registrant is no longer required to file reports pursuant to Section
15(d) of the Securities Exchange Act of 1934.




29