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EX-23 - Verso Paper Holdings LLCv176998_ex23.htm
EX-12 - Verso Paper Holdings LLCv176998_ex12.htm
EX-31.2 - Verso Paper Holdings LLCv176998_ex31-2.htm
EX-32.1 - Verso Paper Holdings LLCv176998_ex32-1.htm
EX-31.1 - Verso Paper Holdings LLCv176998_ex31-1.htm
EX-32.2 - Verso Paper Holdings LLCv176998_ex32-2.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 
FORM 10-K
 
(Mark One)
 
þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2009
 
or
 
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________ to _____________

Commission file number:  333-142283
 
Verso Paper Holdings LLC
 (Exact name of registrant as specified in its charter)

Delaware
  
56-2597634
(State or other jurisdiction of incorporation or organization)
  
(I.R.S. Employer Identification Number)
     
6775 Lenox Center Court, Suite 400
     
Memphis, Tennessee 38115-4436
  
(901) 369-4100
(Address of principal executive offices) (Zip Code)
  
(Registrant’s telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Act: None
 
Securities registered pursuant to Section 12(g) of the Act: None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No þ 
 
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 ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405) 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):
 
Large accelerated filer ¨
  
 Accelerated filer ¨
 Non-accelerated filer þ
 (Do not check if a smaller reporting company)
Smaller reporting company ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.)  Yes ¨ No þ
 
DOCUMENTS INCORPORATED BY REFERENCE: None

The registrant meets the conditions set forth in General Instruction I(1)(a) and (b) of Form 10-K and is therefore filing this Form 10-K with the reduced disclosure format permitted by General Instruction I(2). 

 
 

 

Table of Contents

     
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Forward-Looking Statements
 
In this annual report, all statements that are not purely historical facts are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  Forward-looking statements may be identified by the words “believe,” “expect,” “anticipate,” “project,” “plan,” “estimate,” “intend,” and similar expressions.  Forward-looking statements are based on currently available business, economic, financial, and other information and reflect management’s current beliefs, expectations, and views with respect to future developments and their potential effects on Verso.  Actual results could vary materially depending on risks and uncertainties that may affect Verso and its business.  For a discussion of such risks and uncertainties, please refer to “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of this annual report and to Verso’s other filings with the Securities and Exchange Commission.  Verso assumes no obligation to update any forward-looking statement made in this annual report to reflect subsequent events or circumstances or actual outcomes.
 
Market and Industry Information
 
Market data and other statistical information used throughout this annual report are based on independent industry publications, government publications, reports by market research firms, or other published independent sources. Some data are also based on our good-faith estimates which are derived from our review of internal surveys, as well as the independent sources listed above.  Although we believe these sources are reliable, we have not independently verified the information.  Industry prices for coated paper provided in this annual report are, unless otherwise expressly noted, derived from Resource Information Systems, Inc., or “RISI, Inc.” data.  “North American” data included in this annual report that has been derived from RISI, Inc. only includes data from the United States and Canada.  Any reference to (i) grade No. 3, grade No. 4 and grade No. 5 coated paper relates to 60 lb. basis weight, 50 lb. basis weight and 34 lb. basis weight, respectively, (ii) lightweight coated groundwood paper refers to groundwood paper grades that are a 36 lb. basis weight or less, and (iii) ultra-lightweight coated groundwood paper refers to groundwood paper grades that are a 30 lb. basis weight or less.  The RISI, Inc. data included in this annual report has been derived from the following RISI, Inc. publications: RISI World Graphic Paper Forecast, December 2009 and RISI Paper Trader: A Monthly Monitor of the North American Graphic Paper Market, December 2009.

 
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Unless otherwise noted, the terms “Verso,” “Verso Paper,” “Company,” “we,” “us,” “our,” and “Successor” refer collectively to Verso Paper Holdings LLC, a Delaware limited liability company, and its subsidiaries, and references to the “Predecessor” refer to the Coated and Supercalendered Papers Division of International Paper Company, or “International Paper.”
 
Background
 
We began operations on August 1, 2006, when we acquired the assets and certain liabilities comprising the business of the Coated and Supercalendered Papers Division of International Paper.  We were formed by affiliates of Apollo Management, L.P., or “Apollo,” for the purpose of consummating the acquisition from International Paper, or the “Acquisition.”  Verso Paper Corp., of which we are an indirect, wholly-owned subsidiary, went public on May 14, 2008, with an initial public offering, or “IPO," of 14 million shares of common stock which generated $152.2 million in net proceeds.
 
Our principal executive offices are located at 6775 Lenox Center Court, Suite 400, Memphis, Tennessee 38115-4436.  Our telephone number is (901) 369-4100.  Our web site address is www.versopaper.com.  Information on our web site is not considered part of this annual report.
 
Overview
 
We are a leading North American supplier of coated papers to catalog and magazine publishers.  The coating process adds a smooth uniform layer in the paper, which results in superior color and print definition.  As a result, coated paper is used primarily in media and marketing applications, including catalogs, magazines, and commercial printing applications, such as high-end advertising brochures, annual reports, and direct mail advertising.
 
We are one of North America’s largest producers of coated groundwood paper, which is used primarily for catalogs and magazines.  We are also a low cost producer of coated freesheet paper, which is used primarily for annual reports, brochures, and magazine covers.  In addition, we have a strategic presence in supercalendered paper, which is primarily used for retail inserts, and specialty papers.  We also produce and sell market kraft pulp, which is used to manufacture printing and writing paper grades and tissue products.
 
We operate 11 paper machines at four mills located in Maine, Michigan, and Minnesota.  The mills have a combined annual production capacity of 1,406,000 tons of coated paper, 215,000 tons of supercalendered paper, 131,000 tons of ultra-lightweight specialty and uncoated papers, and 838,000 tons of kraft pulp.
 
We sell and market our products to approximately 100 customers which comprise approximately 670 end-user accounts.  We have long-standing relationships with many leading magazine and catalog publishers, commercial printers, specialty retail merchandisers, and paper merchants.  Our relationships with our ten largest coated paper customers average more than 20 years.  We reach our end-users through several distribution channels, including direct sales, commercial printers, paper merchants, and brokers.

 
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Our net sales (in millions) by product line in 2009 are illustrated below:
 
 
Industry
 
Based on 2009 sales, the size of the global coated paper industry is estimated to be approximately $41 billion, or 44 million tons of coated paper shipments, including approximately $8 billion, or 9 million tons of coated paper shipments, in North America.  Coated paper is used primarily in media and marketing applications, including catalogs, magazines, and commercial printing applications, which include high-end advertising brochures, annual reports and direct mail advertising.  Demand is generally driven by North American advertising and print media trends, which in turn have historically been correlated with growth in Gross Domestic Product, or “GDP.”

In North America, coated papers are classified by brightness and fall into five grades, labeled No. 1 to No. 5, with No. 1 having the highest brightness level and No. 5 having the lowest brightness level.  Papers graded No. 1, No. 2, and No. 3 are typically coated freesheet grades. No. 4 and No. 5 papers are predominantly groundwood containing grades.  Coated groundwood grades are the preferred grades for catalogs and magazines, while coated freesheet is more commonly used in commercial print applications.

Products
 
We manufacture three main grades of paper: coated groundwood paper, coated freesheet paper, and supercalendered paper.  These paper grades are differentiated primarily by their respective brightness, weight, print quality, bulk, opacity, and strength.  We also produce Northern Bleached Hardwood Kraft, or “NBHK,” pulp.  The following table sets forth our principal products by 2009 tons sold and as a percentage of our 2009 net sales:
 
(tons in thousands, dollars in millions)
 
Tons Sold
   
Net Sales
 
Product:
 
Kts
   
%
   
$
   
%
 
Coated groundwood paper
    792       46     $ 681       50  
Coated freesheet paper
    491       28       428       31  
Supercalendered paper
    122       7       89       7  
Pulp
    252       15       105       8  
Other
    68       4       58       4  
Total
    1,725       100     $ 1,361       100  

 
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As a result of our scale and technological capabilities, we are able to offer our customers a broad product offering, from ultra-lightweight coated groundwood to heavyweight coated freesheet and supercalendered papers.  Our customers have the opportunity to sole-source all of their coated paper needs from us while optimizing their choice of paper products.  As our customers’ preferences change, they can switch paper grades to meet their desired balance between cost and performance attributes while maintaining their relationship with us.
 
We are also one of the largest rotogravure lightweight coated paper manufacturers in North America.  Rotogravure printing is a technique for transferring ink onto coated papers, which typically results in a sharper image with truer colors and less ink trapping than in other printing processes but generally requires a smaller and higher-quality paper. Additionally, we are the only manufacturer in North America with the technological expertise to supply both rotogravure coated groundwood and coated freesheet.
 
Coated groundwood paper.  Coated groundwood paper includes a fiber component produced through a mechanical pulping process.  The use of such fiber results in a bulkier and more opaque paper that is better suited for applications where lighter weights and/or higher stiffness are required, such as catalogs and magazines.  In addition to mechanical pulp, coated groundwood paper typically includes a kraft pulp component to improve brightness and print quality.
 
Coated freesheet paper.  Coated freesheet paper is made from bleached kraft pulp, which is produced using a chemical process to break apart wood fibers and dissolve impurities such as lignin.  The use of kraft pulp results in a bright, heavier-weight paper with excellent print qualities, which is well-suited for high-end commercial applications and premium magazines.  Coated freesheet contains primarily kraft pulp, with less than 10% mechanical pulp in its composition.
 
Supercalendered paper.  Supercalendered paper consists of groundwood fibers and a very high filler content but does not receive a separate surface coating.  Instead, the paper is passed through a supercalendering process in which alternating steel and filled rolls “iron” the paper, giving it a gloss and smoothness that makes it resemble coated paper.  Supercalendered papers are primarily used for retail inserts, due to their relatively low price point.
 
Pulp. We produce and sell NBHK pulp. NBHK pulp is produced through the chemical kraft process using hardwoods. Hardwoods typically have shorter length fibers than softwoods and are used to smooth paper. Kraft describes pulp produced using a chemical process, whereby wood chips are combined with chemicals and steam to separate the wood fibers. The fibers are then washed and pressure screened to remove the chemicals and lignin which originally held the fibers together. Finally, the pulp is bleached to the necessary whiteness and brightness. Kraft pulp is used in applications where brighter and whiter paper is required.
 
Other products.  We also offer recycled paper to help meet specific customer requirements.  Additionally, we offer customized product solutions for strategic accounts by producing paper grades with customer-specified weight, brightness and pulp mix characteristics, providing customers with cost benefits and/or brand differentiation.  Finally, we have recently expanded our offerings to include ultra-lightweight uncoated printing papers and ultra-lightweight coated and uncoated flexible packaging papers.
 
Manufacturing
 
We operate 11 paper machines at four mills located in Maine, Michigan, and Minnesota.  We believe our coated paper mills are among the most efficient and lowest cost coated paper mills in the world based on the cash cost of delivery to Chicago. We attribute our manufacturing efficiency, in part, to the significant historical investments made in our mills. Our mills have a combined annual production capacity of 1,406,000 tons of coated paper, 215,000 tons of supercalendered paper, 131,000 tons of ultra-lightweight specialty and uncoated papers, and 838,000 tons of kraft pulp.  Of the pulp that we produce, we consume approximately 565,000 tons internally and sell the rest.  Our facilities are strategically located within close proximity to major publication printing customers, which affords us the ability to more quickly and cost-effectively deliver our products.  The facilities also benefit from convenient and cost-effective access to northern softwood fiber, which is required for the production of lightweight and ultra-lightweight coated papers.

 
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The following table sets forth the locations of our mills, the products they produce, and other key operating information:
 
             
Production
 
       
Paper
   
Capacity
 
Mill/Location
 
Product/Paper Grades
 
Machines
   
(in tons)
 
Jay (Androscoggin), ME
 
Lightweight Coated Groundwood
    2       366,000  
   
Lightweight Coated Freesheet
    1       148,000  
    
Specialty/Uncoated
            50,000  
    
Pulp
            403,000  
Bucksport, ME
 
Lightweight and Ultra-Lightweight Coated
               
    
   Groundwood and High Bulk Specialty
               
    
   Coated Groundwood
    3       425,000  
    
Specialty/Uncoated
    1       61,000  
Quinnesec, MI
 
Coated Freesheet
    1       382,000  
    
Specialty/Uncoated
            20,000  
    
Pulp
            435,000  
Sartell, MN
 
Lightweight and Ultra-Lightweight Coated
               
    
   Groundwood
    1       85,000  
    
Supercalendered
    2       215,000  
 
The basic raw material of the papermaking process is wood pulp.  The first stage of papermaking involves converting wood logs to pulp through either a mechanical or chemical process.  Before logs can be processed into pulp, they are passed through a debarking drum to remove the bark.  Once separated, the bark is burned as fuel in bark boilers. The wood logs are composed of small cellulose fibers which are bound together by a glue-like substance called lignin.  The cellulose fibers are then separated from each other through either a mechanical or a kraft pulping process.
 
After the pulping phase, the fiber furnish is run onto the forming fabric of the paper machine.  On the forming fabric, the fibers become interlaced, forming a mat of paper, and much of the water is extracted.  The paper web then goes through a pressing and drying process to extract the remaining water.  After drying, the web receives a uniform layer of coating that makes the paper smooth and provides uniform ink absorption.  After coating, the paper goes through a calendering process that provides a smooth finish by ironing the sheet between multiple soft nips that consist of alternating hard (steel) and soft (cotton or synthetic) rolls.  At the dry end, the paper is wound onto spools to form a machine reel and then rewound and split into smaller rolls on a winder.  Finally, the paper is wrapped, labeled, and shipped.
 
Catalog and magazine publishers with longer print runs tend to purchase paper in roll form for use in web printing, a process of printing from a reel of paper as opposed to individual sheets of paper, in order to minimize costs.  In contrast, commercial printers typically buy large quantities of sheeted paper in order to satisfy the short-run printing requirements of their customers.  We believe that sheeted paper is a less attractive product as it requires additional processing, bigger inventory stocks, a larger sales and marketing team and a different channel strategy.  For this reason, we have pursued a deliberate strategy of configuring our manufacturing facilities to produce all web-based papers, which are shipped in roll form and have developed relationships with third-party converters to address any sheeted paper needs of our key customers.

 
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We utilize a manufacturing excellence program, called R-GAP, to take advantage of the financial opportunities that exist between the current or historical performance of our mills and the best performance possible given usual and normal constraints (i.e., configuration, geographical and capital constraints).  Our continuous improvement process is designed to lower our cost position and enhance operating efficiency through reduced consumption of energy and material inputs, reduced spending on indirect costs and improved productivity.  The program utilizes benchmarking data to identify improvement initiatives and establish performance targets.  Detailed action plans are used to monitor the execution of these initiatives and calculate the amount saved.  We also use multi-variable testing, lean manufacturing, center of excellence teams, source-of-loss initiatives and best practice sharing to constantly improve our manufacturing processes and products.  Since 2001, three of our four facilities have participated in OSHA’s Voluntary Protection Program which recognizes outstanding safety programs and performance.
 
Raw Materials and Suppliers
 
Our key cost inputs in the papermaking process are wood fiber, market kraft pulp, chemicals, and energy.
 
Wood Fiber.  We source our wood fiber from a broad group of timberland and sawmill owners located in our regions as well as from our 27,000-acre hybrid poplar woodlands located near Alexandria, Minnesota.
 
Kraft Pulp.  Overall, we have the capacity to produce 838,000 tons of kraft pulp, consisting of 403,000 tons of pulp at the Androscoggin mill and 435,000 tons of pulp at the Quinnesec mill, of which a total of approximately 565,000 tons are consumed internally.  We supplement our internal production of kraft pulp with purchases from third parties.  In 2009, these purchases were approximately 81,000 tons of pulp.  We purchase the pulp requirements from a variety of suppliers and are not dependent on any single supplier to satisfy our pulp needs.
 
Chemicals.  Chemicals utilized in the manufacturing of coated papers include latex, starch, calcium carbonate, and titanium dioxide.  We purchase these chemicals from a variety of suppliers and are not dependent on any single supplier to satisfy our chemical needs.
 
Energy.  We produce a large portion of our energy requirements, historically producing approximately 50% of our energy needs for our coated paper mills from sources such as waste wood and paper, hydroelectric facilities, chemicals from our pulping process, our own steam recovery boilers, and internal energy cogeneration facilities.  Our external energy purchases vary across each one of our mills and include fuel oil, natural gas, coal, and electricity. While our internal energy production capacity and ability to switch between certain energy sources mitigates the volatility of our overall energy expenditures, we expect prices for energy to remain volatile for the foreseeable future. We utilize derivative contracts as part of our risk management strategy to manage our exposure to market fluctuations in energy prices.
 
Sales, Marketing, and Distribution
 
We reach our end-users through several sales channels.  These include selling directly to end-users, through brokers, merchants, and printers.  We sell and market products to approximately 100 customers, which comprise approximately 670 end-user accounts.
 
Sales to End-Users.  In 2009, we sold approximately 41% of our paper products directly to end-users, most of which are catalog and magazine publishers.  These customers are typically large, sophisticated buyers who have the scale, resources, and expertise to procure paper directly from manufacturers.  Customers for our pulp products are mostly other paper manufacturers.
 
Sales to Brokers and Merchants.  Our largest indirect paper sales by volume are through brokers and merchants who resell the paper to end-users.  In 2009, our total sales to brokers and merchants represented approximately 47% of our total sales.  Brokers typically act as an intermediary between paper manufacturers and smaller end-users who do not have the scale or resources to cost effectively procure paper directly from manufacturers.  The majority of the paper sold to brokers is resold to catalog publishers.  We work closely with brokers to achieve share targets in the catalog, magazine, and insert end-user segments through collaborative selling.

 
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Merchants are similar to brokers in that they act as an intermediary between the manufacturer and the end-user. However, merchants generally take physical delivery of the product and keep inventory on hand.  Merchants tend to deal with smaller end-users that lack the scale to warrant direct delivery from the manufacturer.  Coated freesheet comprises the majority of our sales to merchants.  In most cases, because they are relatively small, the ultimate end-users of paper sold through merchants are generally regional or local catalog or magazine publishers.
 
Sales to Printers.  In 2009, our total sales to printers represented approximately 12% of our total sales.  The majority of our sales were to two of the four largest publication printers in the United States.  Printers also effectively act as an intermediary between manufacturers and end-users in that they directly source paper for printing/converting and then resell it to their customers as a finished product.
 
The majority of our products are delivered directly from our manufacturing facilities to the printer, regardless of the sales channel.  In order to serve the grade No. 3 coated freesheet segment, we maintain a network of distribution centers located in the West, Midwest, South, and Northeast close to our customer base to provide quick delivery.  The majority of our pulp products are delivered to our customers’ paper mills.
 
Our sales force is organized around our sales channels.  We maintain an active dialogue with all of our major customers and track product performance and demand across grades.  We have a team of sales representatives and marketing professionals organized into three major sales groups that correspond with our sales channels: direct sales support; support to brokers and merchants; and printer support.
 
The majority of our products are sold under contracts with our customers.  Contracted sales are more prevalent for coated groundwood paper, as opposed to coated freesheet paper, which is more often sold without a contract.  Our contracts generally specify the volumes to be sold to the customer over the contract term, as well as the pricing parameters for those sales.  Most of our contracts are negotiated on an annual basis, with only a few having terms extending beyond one year.  Typically, our contracts provide for quarterly price adjustments based on market price movements.  The large portion of contracted sales allows us to plan our production runs well in advance, optimizing production over our integrated mill system and thereby reducing costs and increasing overall efficiency.
 
Part of our strategy is to continually reduce the cost to serve our customer base through e-commerce initiatives which allow for simplified ordering, tracking, and invoicing.  In 2009, orders totaling $344.5 million, or approximately 28% of our total paper sales, were placed through our online ordering platforms.  We are focused on further developing our technology platform and e-commerce capabilities.  To this end, we operate Nextier Solutions, an Internet-based system that allows for collaborative production planning, order placement, and inventory management throughout the supply chain.  Participants use the system to maximize supply chain efficiencies, improve communication, and reduce operating costs, and they pay us subscription and transaction fees for system usage.
 
Customers
 
We serve the catalog, magazine, insert, and commercial printing markets and have developed long-standing relationships with the premier North American retailers and catalog and magazine publishers.  The length of our relationships with our top ten customers averages more than 20 years. International Paper and its divisions and subsidiaries (including xpedx and Central Lewmar LLC) accounted for approximately 10% of our net sales in 2009.  Other key customers include leading magazine publishers such as Condé Nast Publications, Inc., Hearst Corporation, National Geographic Society, and Time Inc.; leading catalog producers such as Avon Products, Inc. and Sears Holding Corporation; leading commercial printers such as Quad/Graphics, Inc., and RR Donnelley & Sons Company; and leading paper merchants and brokers, such as A.T. Clayton & Co., Unisource Worldwide, Inc., and Clifford Paper, Inc.

 
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Our net sales, excluding pulp sales, by end-user segment in 2009, are illustrated below (dollars in millions):
 

Research and Development
 
The primary function of our research and development efforts is to work with customers in developing and modifying products to accommodate their evolving needs and to identify cost-saving opportunities within our operations.
 
Examples of our research and development efforts implemented over the past several years include:
 
·
high-bulk offset and rotogravure coated groundwood;
 
·
lightweight grade No. 4 coated groundwood;
 
·
ultra-lightweight grade No. 5 coated groundwood;
 
·
rotogravure coated freesheet; and
 
·
innovative and performance driven products for the flexible packaging, label, and specialty printing markets.
 
Intellectual Property
 
We have several patents and patent applications in the United States and various foreign countries.  These patents and patent applications generally relate to various paper manufacturing methods and equipment which may become commercially viable in the future.  We also have trademarks for our names, Verso® and Verso Paper®, as well as for  our products such as Influence®, Velocity®, Liberty®, Advocate®, and Clarity™.  In addition to the intellectual property that we own, we license a significant portion of the intellectual property used in our business on a perpetual, royalty-free, non-exclusive basis from International Paper.

 
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Competition
 
Our business is highly competitive.  A significant number of North American competitors produce coated and supercalendered papers, and several overseas manufacturers, principally from Europe, export to North America.  We compete based on a number of factors, including:
 
·
price;
 
·
product availability;
 
·
product quality;
 
·
breadth of product offerings;
 
·
timeliness of product delivery; and
 
·
customer service.
 
Foreign competition in North America is also affected by the exchange rate of the U.S. dollar relative to other currencies, especially the euro, market prices in North America and other markets, worldwide supply and demand, and the cost of ocean-going freight.
 
While our product offering is broad in terms of grades produced (from supercalendered and ultra-lightweight coated groundwood offerings to heavier-weight coated freesheet products), we are focused on producing coated groundwood and coated freesheet in roll form.  This strategy is driven by our alignment with catalog and magazine end-users which tend to purchase paper in roll form for use in long runs of web printing in order to minimize costs. Our principal competitors include NewPage Corporation, Abitibi Bowater Inc., UPM-Kymmene Corporation, and Sappi Limited, all of which have North American operations.  UPM and Sappi are headquartered overseas and also have overseas manufacturing facilities.

Employees
 
As of December 31, 2009, we had approximately 2,800 employees, of whom approximately 35% are unionized and approximately 75% are hourly employees.  Employees at two of our four mills are represented by labor unions under a total of three collective bargaining agreements which expire in 2011.  We have not experienced any work stoppages during the past several years.  We believe that we have good relations with our employees.
 
Environmental and Other Governmental Regulations
 
We are subject to federal, state, and local environmental, health and safety laws and regulations, including the federal Water Pollution Control Act of 1972, or “Clean Water Act,” the federal Clean Air Act, the federal Resource Conservation and Recovery Act, the Comprehensive Environmental Response, Compensation and Liability Act of 1980, or “CERCLA,” the federal Occupational Health and Safety Act, and analogous state and local laws.  Our operations also are subject to two regional regimes designed to address climate change, the Regional Greenhouse Gas Initiative in the northeastern United States and the Midwestern Greenhouse Gas Reduction Accord, and in the future we may be subject to additional federal, state, local or supranational legislation related to climate change.  Among our activities subject to environmental regulation are the emissions of air pollutants, discharges of wastewater and stormwater, operation of dams, storage, treatment, and disposal of materials and waste, and remediation of soil, surface water, and ground water contamination.  Many environmental laws and regulations provide for substantial fines or penalties and criminal sanctions for any failure to comply.  In addition, failure to comply with these laws and regulations could result in the interruption of our operations and, in some cases, facility shutdowns.

 
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Certain of these environmental laws, such as CERCLA and analogous state laws, provide for strict, and under certain circumstances, joint and several liability for investigation and remediation of the release of hazardous substances into the environment, including soil and groundwater.  These laws may apply to properties presently or formerly owned or operated by an entity or its predecessors, as well as to conditions at properties at which wastes attributable to an entity or its predecessors were disposed.  Under these environmental laws, a current or previous owner or operator of real property, and parties that generate or transport hazardous substances that are disposed of at real property, may be held liable for the cost to investigate or clean up such real property and for related damages to natural resources.  We handle and dispose of wastes arising from our mill operations, including disposal at on-site landfills. We are required to maintain financial assurance for the expected cost of landfill closure and post-closure care.  We may be subject to liability, including liability for investigation and cleanup costs, if contamination is discovered at one of our paper mills or another location where we have disposed of, or arranged for the disposal of, wastes.  We could be subject to potentially significant liabilities under, or fines or penalties for any failure to comply with, any environmental rule or regulation.
 
Compliance with environmental laws and regulations is a significant factor in our business.  We have made, and will continue to make, significant expenditures to comply with these requirements.  We incurred environmental capital expenditures of $2.6 million in 2009, $9.7 million in 2008, and $3.4 million in 2007, and we expect to incur additional environmental capital expenditures of approximately $6 million in 2010.  We anticipate that environmental compliance will continue to require increased capital expenditures and operating expenses over time as environmental laws or regulations, or interpretations thereof, change or the nature of our operations require us to make significant additional capital expenditures.
 
Permits are required for the operation of our mills and related facilities.  The permits are subject to renewal, modification, and revocation.  We and others have the right to challenge our permit conditions through administrative and legal appeals and review processes.  Governmental authorities have the power to enforce compliance with the permits, and violators are subject to civil and criminal penalties, including fines, injunctions or both.  Other parties also may have the right to pursue legal actions to enforce compliance with the permits.
 
Available Information
 
Our web site is located at www.versopaper.com.  We make available free of charge through this web site our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed with or furnished to the Securities and Exchange Commission, or “SEC,” pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after they are electronically filed with or furnished to the SEC.

 
11

 

 
Our business is subject to various risks.  Set forth below are certain of the more important risks that we face and that could cause our actual results to differ materially from our historical results.  These risks are not the only ones that we face.  Our business also could be affected by additional risks that are presently unknown to us or that we currently believe are immaterial to our business.

We have limited ability to pass through increases in our costs to our customers.  Increases in our costs or decreases in coated or supercalendered paper prices could have a material adverse effect on our business, financial condition, and results of operations.

Our earnings are sensitive to price changes in coated or supercalendered paper.  Fluctuations in paper prices (and coated paper prices in particular) historically have had a direct effect on our net income (loss) and Earnings Before Interest, Taxes, Depreciation and Amortization, or “EBITDA,”  for several reasons:

 
·
Market prices for paper products are a function of supply and demand, factors over which we have limited control.  We therefore have limited ability to control the pricing of our products.  Market prices of grade No. 3, 60 lb. basis weight paper, which is an industry benchmark for coated freesheet paper pricing, have fluctuated since 2000 from a high of $1,100 per ton to a low of $705 per ton.  In addition, market prices of grade No. 5, 34 lb. basis weight paper, which is an industry benchmark for coated groundwood paper pricing, have fluctuated between a high of $1,120 per ton to a low of $795 per ton over the same period.  Our average coated paper prices declined in 2009 and while we expect average prices in 2010 to remain below 2009 levels, the rate of decline in paper prices has slowed and we expect modest price increases in 2010. Because market conditions determine the price for our paper products, the price for our products could fall below our cash production costs.
 
 
·
Market prices for paper products typically are not directly affected by raw material costs or other costs of sales, and consequently we have limited ability to pass through increases in our costs to our customers absent increases in the market price. In addition, a significant portion of our sales are pursuant to contracts that limit price increases. Thus, even though our costs may increase, we may not have the ability to increase the prices for our products, or the prices for our products may decline.
 
 
·
The manufacturing of coated paper is highly capital-intensive and a large portion of our operating costs are fixed.  Additionally, paper machines are large, complex machines that operate more efficiently when operated continuously.  Consequently, both we and our competitors typically continue to run our machines whenever marginal sales exceed the marginal costs, adversely impacting prices at times of lower demand.
 
Therefore, our ability to achieve acceptable margins is principally dependent on (1) managing our cost structure, (2)  managing changes in raw materials prices, which represent a large component of our operating costs and fluctuate based upon factors beyond our control, and (3) general conditions in the paper market.  If the prices of our products decline, or if our raw material costs increase, it could have a material adverse effect on our business, financial condition, and results of operations.

12

 
The paper industry is cyclical and North American demand for certain paper products tends to decline during a weak U.S. economy.  Fluctuations in supply and demand for our products could have a material adverse effect on our business, financial condition, and results of operations.

The paper industry is a commodity market to a significant extent and is subject to cyclical market pressures.  North American demand for coated and supercalendered paper products tends to decline during a weak U.S. economy. Accordingly, general economic conditions and demand for magazines and catalogs may have a material adverse impact on the demand for our products, which may result in a material adverse effect on our business, financial condition, and results of operations.  In addition, currency fluctuations can have a significant impact on the supply of coated paper products in North America.  If the U.S. dollar strengthens, imports may increase, which would cause the supply of paper products available in the North American market to increase.  Foreign overcapacity also could result in an increase in the supply of paper products available in the North American market.  An increased supply of paper available in North America could put downward pressure on prices and/or cause us to lose sales to competitors, either of which could have a material adverse effect on our business, financial condition, and results of operations.
 
Recent global market and economic conditions have been challenging with tight credit conditions and a slowdown in economic growth in most major economies.  While there are some indications the economy and credit markets are improving, economic conditions are expected to remain difficult in 2010.  Continued concerns about the systemic impact of potential long-term and wide-spread recession, energy costs, geopolitical issues, the availability and cost of credit, and the global housing and mortgage markets have contributed to increased market volatility and diminished expectations for the U.S. economy.  These factors have led to a decrease in spending by businesses and consumers alike which has disproportionately impacted the magazine industry, and a corresponding decrease in demand for our products.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Selected Factors that Affect Our Operating Results.”  In addition to the cyclical downturns that our industry regularly experiences and is currently experiencing, demand may suffer from secular declines as the result of changes in general business conditions that impact the use of catalogues and magazines.  At times of weakening demand, such as the current economic climate, it is difficult to determine whether reduced demand for our products is the result of cyclical macroeconomic factors or instead the result of structural changes in the marketplace.  Continued turbulence in the U.S. and international markets and economies and prolonged declines in business and consumer spending may further adversely affect our business, financial condition, and results of operations.
 
Our substantial leverage could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under these notes and our other indebtedness.
 
We have been highly leveraged since the consummation of the Acquisition.  As of December 31, 2009, our total indebtedness was $1,118.3 million, net of $24.0 million of unamortized discounts.  The total amount of payments we will need to make on our outstanding long-term indebtedness for each of the next three fiscal years is equal to $111.6 million, $111.6 million, and $110.8 million, respectively (assuming the current prevailing interest rates on our outstanding floating rate indebtedness remain the same).

Our high degree of leverage could have important consequences, including:
 
·
increasing our vulnerability to general adverse economic and industry conditions;
 
·
requiring us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, research and development efforts, and other general corporate purposes;
 
·
increasing our vulnerability to, and limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;
 
·
exposing us to the risk of increased interest rates as borrowings under our senior secured credit facilities and our second priority senior secured floating rate notes are subject to variable rates of interest;
 
·
placing us at a competitive disadvantage compared to our competitors that have less debt; and
 
·
limiting our ability to borrow additional funds.

 
13

 
 
We may be able to incur substantial additional indebtedness in the future because the terms of the indentures governing our outstanding notes and our senior secured credit facilities do not fully prohibit us or our subsidiaries from doing so.  If new indebtedness is added to our and our subsidiaries’ current debt levels, the related risks that we and they now face could intensify.
 
Our operations require substantial ongoing capital expenditures, and we may not have adequate capital resources to fund all of our required capital expenditures.
 
Our business is capital intensive, and we incur capital expenditures on an ongoing basis to maintain our equipment and comply with environmental laws, as well as to enhance the efficiency of our operations.  Our total capital expenditures were $34 million in 2009, including approximately $20 million for maintenance and environmental capital expenditures.  We expect to spend approximately $77 million on capital expenditures during 2010, with approximately $6 million expected to be reimbursed through a Recovery Act grant for the deployment of waste energy recovery technologies.  Included in the total for 2010 is approximately $41 million for maintenance and environmental capital expenditures.  We anticipate that our available cash resources and cash generated from operations will be sufficient to fund our operating needs and capital expenditures for at least the next year.  We may also dispose of certain of our non-core assets in order to obtain additional liquidity.  However, if we require additional funds to fund our capital expenditures, we may not be able to obtain them on favorable terms, or at all.  If we cannot maintain or upgrade our facilities and equipment as we require or as necessary to ensure environmental compliance, it could have a material adverse effect on our business, financial condition and results of operations.
 
We will require a significant amount of cash to service our indebtedness and make planned capital expenditures. Our ability to generate cash or refinance our indebtedness depends on many factors beyond our control.
 
Our ability to make payments on, and to refinance, our indebtedness and to fund planned capital expenditures and research and development efforts will depend on our ability to generate cash flow in the future and our ability to borrow under credit facilities to the extent of available borrowings. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.  If adverse regional and national economic conditions persist, worsen, or fail to improve significantly, we could experience decreased revenues from our operations attributable to decreases in wholesale and consumer spending levels and could fail to generate sufficient cash to fund our liquidity needs or fail to satisfy the restrictive covenants and borrowing limitations which we are subject to under our indebtedness. Additionally, until December 31, 2009, the United States government provided an excise tax credit to taxpayers for the use of alternative fuel mixtures.  As a result of our use of an alternative fuel mixture containing “black liquor,” a byproduct of pulp production, at our Androscoggin and Quinnesec mills, we recognized $238.9 million of alternative fuel mixture tax credits in the year ended December 31, 2009, including approximately $10 million for claims pending at December 31, 2009.  The amount recognized in fiscal 2009 includes amounts received for claims for use of the alternative fuel mixture from September 2008 through December 2009.  The tax credit, as it relates to liquid fuels derived from biomass, expired on December 31, 2009.  Therefore, we will not recognize any proceeds from this tax credit in future periods.
 
Based on our current and expected level of operations, we believe our cash flow from operations, available cash and available borrowings under our senior secured credit facilities, will be adequate to meet our future liquidity needs for at least the next year.  We cannot assure you, however, that our business (taking into account the expiration of the tax credit discussed above) will generate sufficient cash flow from operations or that future borrowings will be available to us under our senior secured credit facilities or otherwise in an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. We may explore additional steps to raise liquidity including potential dispositions of non-core assets. We may need to refinance all or a portion of our indebtedness on or before the maturity thereof. We cannot assure you that we will be able to refinance any of our indebtedness on commercially reasonable terms or at all. If we cannot service our indebtedness, we may have to take actions such as selling assets, seeking additional equity or reducing or delaying capital expenditures, strategic acquisitions, investments and alliances. We cannot assure you that any such actions, if necessary, could be effected on commercially reasonable terms or at all.

 
14

 
 
Restrictive covenants in the indentures governing our notes and our revolving credit agreement may restrict our ability to pursue our business strategies.
 
The indentures governing our notes and our revolving credit agreement limit our ability, among other things, to:
 
·
incur additional indebtedness;
 
·
pay dividends or make other distributions or repurchase or redeem our stock;
 
·
prepay, redeem or repurchase certain of our indebtedness;
 
·
make investments;
 
·
sell assets, including capital stock of restricted subsidiaries;
 
·
enter into agreements restricting our subsidiaries’ ability to pay dividends;
 
·
consolidate, merge, sell or otherwise dispose of all or substantially all of our assets;
 
·
enter into transactions with our affiliates; and
 
·
incur liens.
 
A breach of any of these restrictive covenants could result in a default under the indentures governing our notes and our revolving credit agreement. If a default occurs, the holders of the notes and the lenders under our revolving credit facility may elect to declare all borrowings or notes outstanding, together with accrued interest and other fees, to be immediately due and payable. The lenders under our revolving credit facility would also have the right in these circumstances to terminate any commitments they have to provide further borrowings. If we are unable to repay our indebtedness when due or declared due, the lenders under our revolving credit facility and our other secured indebtedness (including our notes) will also have the right to proceed against the collateral, including our available cash, granted to them to secure the indebtedness. If the indebtedness under our revolving credit facility, the notes and our other secured indebtedness were to be accelerated, we cannot assure you that our assets would be sufficient to repay in full our secured indebtedness, including the notes, and we could be forced into bankruptcy or liquidation.

Lenders under our revolving credit facility may not fund their commitments.
 
Lehman Commercial Paper, Inc., or “Lehman,” which filed for bankruptcy in October 2008 is one of the lenders under our revolving credit facility, with a commitment of $15.8 million of the $200 million available under the facility.  On October 10, 2008, we requested funding in the amount of $100 million under the revolving credit facility, and Lehman failed to fund $7.9 million, the entire portion of its commitment with respect to that borrowing request.  Under the credit agreement governing our revolving credit facility, if a lender's commitment is not honored, that portion of the lender's commitment under the revolving credit facility will be unavailable to the extent that the lender's commitment is not replaced by a new commitment from an alternate lender.
 
Lenders under our revolving credit facility are well-diversified, totaling 14 lenders at December 31, 2009.  We currently anticipate that these lenders, other than Lehman, will participate in future requests for funding.  However, there can be no assurance that further deterioration in the credit markets and overall economy will not affect the ability of our lenders to meet their funding commitments.  Additionally, our lenders have the ability to transfer their commitments to other institutions, and the risk that committed funds may not be available under distressed market conditions could be exacerbated to the extent that consolidation of the commitments under our facilities or among its lenders were to occur.

 
15

 
 
We received notices of examination from the Internal Revenue Service regarding two claims for the alternative fuel mixture tax credit for our mills.
 
We believe that our Androscoggin and Quinnesec mills have been eligible to receive the federal alternative fuel mixture tax credit since September 2008. In May 2009, we received separate notices from the Internal Revenue Service informing us that they would be auditing the fourth quarter 2008 Quinnesec claim and the March 2009 Androscoggin claim. Both audits are currently in progress with no findings as of this date.  Although we routinely receive notices of examination by taxing authorities, there can be no assurance that further steps will not be taken by the Internal Revenue Service as a result of the examination of these claims.

Litigation could be costly and harmful to our business.
 
We are involved from time to time in claims and legal proceedings relating to contractual, employment, environmental, intellectual property and other matters incidental to the conduct of our business.  We do not believe that any currently pending claim or legal proceeding is likely to result in an unfavorable outcome that would have a material adverse effect on our financial condition or results of operations.  Nonetheless, claims and legal proceedings could result in unfavorable outcomes that could have a material adverse effect on our financial condition and results of operations.

We have a limited operating history as a separate company.  Accordingly, our Predecessor’s combined historical financial data may not be representative of our results as a separate company.
 
We operated as a division of International Paper prior to August 1, 2006, when we acquired the business of the Coated and Supercalendered Papers Division from International Paper.  Therefore, we have a limited operating history as a separate company.  Our business strategy as an independent entity may not be successful on a long-term basis.  Although International Paper generally no longer sells coated or supercalendered paper, we cannot assure you that our customers will continue to do business with us on the same terms as when we were a division of International Paper or at all.  We may not be able to grow our business as planned and may not remain a profitable business.  In addition, the historical combined financial data included in this annual report may not necessarily reflect what our results of operations, financial condition, and cash flows would have been had we been a separate independent entity pursuing our own strategies during the periods presented.  Our limited operating history as a separate entity makes evaluating our business and our future financial prospects difficult.  As a result, our business, financial condition, and results of operations may differ materially from our expectations based on the historical financial data contained in this annual report.
 
Our cost structure following our separation from International Paper is not comparable to the cost structure that we experienced in prior periods.  Our management has limited experience managing our business as a separate company with a significant amount of indebtedness.  We cannot assure you that our cost structure in future periods will be consistent with our current expectations or will permit us to operate our business profitably.
 
The markets in which we operate are highly competitive.
 
Our business is highly competitive.  Competition is based largely on price.  We compete with foreign producers, some of which are lower cost producers than we are or are subsidized by governments.  We also face competition from numerous North American coated and supercalendered paper manufacturers.  Some of our competitors have advantages over us, including lower raw material and labor costs and fewer environmental and governmental regulations to comply with than we do.  Furthermore, some of our competitors have greater financial and other resources than we do or may be better positioned than we are to compete for certain opportunities.

 
16

 
 
Our non-U.S. competitors may develop a competitive advantage over us and other U.S. producers if the U.S. dollar strengthens in comparison to the home currency of those competitors or ocean shipping rates decrease.  If the U.S. dollar strengthens, if shipping rates decrease, or if overseas supply exceeds demand, imports may increase, which would cause the supply of coated paper products available in the North American market to increase.  An increased supply of coated paper could cause us to lower our prices or lose sales to competitors, either of which could have a material adverse effect on our business, financial condition, and results of operations.
 
In addition, the following factors will affect our ability to compete:
 
·
product availability;
 
·
the quality of our products;
 
·
our breadth of product offerings;
 
·
our ability to maintain plant efficiencies and to achieve high operating rates;
 
·
manufacturing costs per ton;
 
·
customer service and our ability to distribute our products on time; and
 
·
the availability and/or cost of wood fiber, market pulp, chemicals, energy and other raw materials, and labor.
 
If we are unable to obtain energy or raw materials at favorable prices, or at all, it could have a material adverse effect on our business, financial condition, and results of operations.
 
We purchase wood fiber, market pulp, chemicals, energy, and other raw materials from third parties.  We may experience shortages of energy supplies or raw materials or be forced to seek alternative sources of supply.  If we are forced to seek alternative sources of supply, we may not be able to do so on terms as favorable as our current terms or at all.  In addition, the prices for energy and many of our raw materials, especially petroleum-based chemicals, have recently been volatile and are expected to remain volatile for the foreseeable future.  Chemical suppliers that use petroleum-based products in the manufacture of their chemicals may, due to a supply shortage and cost increase, ration the amount of chemicals available to us and/or we may not be able to obtain the chemicals we need to operate our business at favorable prices, if at all.  In addition, certain specialty chemicals that we purchase are available only from a small number of suppliers.  If any of these suppliers were to cease operations or cease doing business with us, we may be unable to obtain such chemicals at favorable prices, if at all.
 
The supply of energy or raw materials may be adversely affected by, among other things, hurricanes and other natural disasters or an outbreak or escalation of hostilities between the United States and any foreign power and, in particular, events in the Middle East.  For example, wood fiber is a commodity and prices historically have been cyclical.  The primary source for wood fiber is timber.  Environmental litigation and regulatory developments have caused, and may cause in the future, significant reductions in the amount of timber available for commercial harvest in Canada and the United States.  In addition, future domestic or foreign legislation, litigation advanced by aboriginal groups, litigation concerning the use of timberlands, the protection of endangered species, the promotion of forest biodiversity, and the response to and prevention of wildfires and campaigns or other measures by environmental activists also could affect timber supplies.  The availability of harvested timber may further be limited by factors such as fire and fire prevention, insect infestation, disease, ice and wind storms, droughts, floods, and other natural and man-made causes.  Additionally, due to increased fuel costs, suppliers, distributors, and freight carriers have charged fuel surcharges, which have increased our costs.  Any significant shortage or significant increase in our energy or raw material costs in circumstances where we cannot raise the price of our products due to market conditions could have a material adverse effect on our business, financial condition, and results of operations.  Any disruption in the supply of energy or raw materials also could affect our ability to meet customer demand in a timely manner and could harm our reputation.  Furthermore, we may be required to post letters of credit or other financial assurance obligations with certain of our energy and other suppliers, which could limit our financial flexibility.

 
17

 
 
Currency fluctuations may adversely affect our business, financial condition, and results of operations.
 
We compete with producers in North America and abroad.  Changes in the relative strength or weakness of the U.S. dollar may affect international trade flows of coated paper products.  A stronger U.S. dollar may attract imports from foreign producers, increase supply in the United States, and have a downward effect on prices, while a weaker U.S. dollar may encourage U.S. exports.  Variations in the exchange rates between the U.S. dollar and other currencies, particularly the Canadian dollar and the euro, may significantly affect our competitive position, including by making it more attractive for foreign producers to restart previously shut-down paper mills or by increasing production capacity in North America or Europe.
 
We are involved in continuous manufacturing processes with a high degree of fixed costs.  Any interruption in the operations of our manufacturing facilities may affect our operating performance.
 
We seek to run our paper machines on a nearly continuous basis for maximum efficiency.  Any downtime at any of our paper mills, including as a result of or in connection with planned maintenance and capital expenditure projects, results in unabsorbed fixed costs that negatively affect our results of operations for the period in which we experience the downtime.  Due to the extreme operating conditions inherent in some of our manufacturing processes, we may incur unplanned business interruptions from time to time and, as a result, we may not generate sufficient cash flow to satisfy our operational needs.  In addition, many of the geographic areas where our production is located and where we conduct our business may be affected by natural disasters, including snow storms, forest fires, and flooding.  Such natural disasters could cause our mills to stop running, which could have a material adverse effect on our business, financial condition, and results of operations.  Furthermore, during periods of weak demand for paper products, such as the current market, we have experienced and may in the future experience market-related downtime, which could have a material adverse effect on our financial condition and results of operations.
 
We depend on a small number of customers for a significant portion of our business.
 
Our largest customer, International Paper and its divisions and subsidiaries (including xpedx and Central Lewmar LLC), accounted for approximately 10% of our net sales in 2009.  In 2009, our ten largest customers (including International Paper) accounted for approximately 50% of our net sales, while our ten largest end-users accounted for approximately 27% of our net sales.  The loss of, or reduction in orders from, any of these customers or other customers could have a material adverse effect on our business, financial condition, and results of operations, as could significant customer disputes regarding shipments, price, quality or other matters.
 
We may not realize certain productivity enhancements or improvements in costs.
 
As part of our business strategy, we are in the process of identifying opportunities to improve profitability by reducing costs and enhancing productivity.  For example, through our continuous process improvement program, we have implemented focused programs to optimize material and energy sourcing and usage, reduce repair costs and control overhead.  We will continue to utilize the process improvement program to drive further cost reductions and operating improvements in our mill system, and have targeted additional profitability enhancements in the next twelve months. Any cost savings or productivity enhancements that we realize from such efforts may differ materially from our estimates.  In addition, any cost savings or productivity enhancements that we realize may be offset, in whole or in part, by reductions in pricing or volume, or through increases in other expenses, including raw material, energy or personnel. We cannot assure you that these initiatives will be completed as anticipated or that the benefits we expect will be achieved on a timely basis or at all.

 
18

 
 
Rising postal costs could weaken demand for our paper products.
 
A significant portion of paper is used in magazines, catalogs, and other promotional mailings.  Many of these materials are distributed through the mail.  Future increases in the cost of postage could reduce the frequency of mailings, reduce the number of pages in magazine and advertising materials and/or cause catalog and magazine publishers to use alternate methods to distribute their materials.  Any of the foregoing could decrease the demand for our products, which could have a material adverse effect on our business, financial condition, and results of operations.
 
Our business may suffer if we do not retain our senior management.
 
We depend on our senior management.  The loss of services of members of our senior management team could adversely affect our business until suitable replacements can be found.  There may be a limited number of persons with the requisite skills to serve in these positions and we may be unable to locate or employ qualified personnel on acceptable terms.  In addition, our future success requires us to continue to attract and retain competent personnel.
 
A large percentage of our employees are unionized.  Wage increases or work stoppages by our unionized employees may have a material adverse effect on our business, financial condition, and results of operations.
 
As of December 31, 2009, approximately 35%, of our employees were represented by labor unions under three collective bargaining agreements at two of our mills, which expire in 2011.  We may become subject to material cost increases or additional work rules imposed by agreements with labor unions.  This could increase expenses in absolute terms and/or as a percentage of net sales.  In addition, although we believe we have good relations with our employees, work stoppages or other labor disturbances may occur in the future.  Any of these factors could negatively affect our business, financial condition, and results of operations.
 
We depend on third parties for certain transportation services.
 
We rely primarily on third parties for transportation of our products to our customers and transportation of our raw materials to us, in particular, by truck and train.  If any third-party transportation provider fails to deliver our products in a timely manner, we may be unable to sell them at full value.  Similarly, if any transportation provider fails to deliver raw materials to us in a timely manner, we may be unable to manufacture our products on a timely basis.  Shipments of products and raw materials may be delayed due to weather conditions, strikes or other events.  Any failure of a third-party transportation provider to deliver raw materials or products in a timely manner could harm our reputation, negatively impact our customer relationships and have a material adverse effect on our business, financial condition, and results of operations.  In addition, our ability to deliver our products on a timely basis could be adversely affected by the lack of adequate availability of transportation services, especially rail capacity, whether because of work stoppages or otherwise.  Furthermore, increases in the cost of our transportation services, including as a result of rising fuel costs, could have a material adverse effect on our business, financial condition, and results of operations.
 
19

 
We are subject to various environmental, health and safety laws and regulations that could impose substantial costs or other liabilities upon us and may have a material adverse effect on our business, financial condition, and results of operations.

We are subject to a wide range of federal, state, and local general and industry-specific environmental, health and safety laws and regulations, including those relating to air emissions (including greenhouse gases), wastewater discharges, solid and hazardous waste management and disposal and site remediation.  Compliance with these laws and regulations, and permits issued thereunder, is a significant factor in our business.  We have made, and will continue to make, significant expenditures to comply with these requirements and our permits.  In addition, we handle and dispose of wastes arising from our mill operations and operate a number of on-site landfills to handle that waste.  We maintain financial assurance for the projected cost of closure and post-closure care for these landfill operations.  We could be subject to potentially significant fines, penalties, criminal sanctions, plant shutdowns or interruptions in operations for any failure to comply with applicable environmental, health and safety laws, regulations, and permits.  Moreover, under certain environmental laws, a current or previous owner or operator of real property, and parties that generate or transport hazardous substances that are disposed of at real property, may be held liable for the full cost to investigate or clean up such real property and for related damages to natural resources.  We may be subject to liability, including liability for investigation and cleanup costs, if contamination is discovered at one of our current or former paper mills, other properties or other locations where we have disposed of, or arranged for the disposal of, wastes.  The 2006 acquisition agreement with International Paper contains an environmental indemnity, subject to certain limitations, for former properties and former off-site shipments related to the business during the time it was owned by International Paper, as well as certain other limited environmental liabilities.  There can be no assurance that International Paper will perform under any of its environmental indemnity obligations, and its failure to do so could have a material adverse effect on our financial condition and results of operations.  We also could be subject to claims brought pursuant to applicable laws, rules or regulations for property damage or personal injury resulting from the environmental impact of our operations, including due to human exposure to hazardous substances.  Increasingly stringent or new environmental requirements, more aggressive enforcement actions or policies, the discovery of unknown conditions or the bringing of future claims may cause our expenditures for environmental matters to increase, and we may incur material costs associated with these matters.
 
A recent decision of the United States Supreme Court held that greenhouse gases are subject to regulation under the Clean Air Act.  The Environmental Protection Agency, or “EPA,” has subsequently issued regulations applicable to us which require monitoring of greenhouse gas emissions, and we are in compliance with those regulations.  The EPA may, in the future, issue additional regulations which require installation of greenhouse gas emission controls, acquisition of emission credits as to such emissions and/or other measures which may have a material effect on our operations.  The United States Congress is also considering legislation which would similarly provide for regulation of greenhouse gas emissions. It is also possible that we could become subject to other federal, state, local or supranational legislation related to climate change and greenhouse gas controls.  We do not expect that we would be disproportionately affected by these measures as compared to similarly situated operators in the United States.

 
20

 

 
Not applicable.
 
 
Our corporate headquarters are located in Memphis, Tennessee.  We own four mills located in Maine, Michigan, and Minnesota at which we operate 11 paper machines.  We also own five hydroelectric dams, of which four provide hydroelectric power to our Androscoggin mill and the fifth services our Sartell mill.  In addition, we own 15 and lease four woodyards for the purpose of storage and loading of forest products and lease a number of sales offices.
 
Our headquarters and material facilities as of December 31, 2009, are shown in the following table:
 
Location
 
Use
 
Owned/Leased
Memphis, TN
 
corporate headquarters
 
 leased
Jay (Androscoggin), ME
 
paper mill/kraft pulp mill
 
 owned
Bucksport, ME
 
paper mill
 
 owned
Quinnesec, MI
 
paper mill/kraft pulp mill
 
 owned
Sartell, MN
 
paper mill
 
 owned
West Chester, OH
 
sales, distribution, and customer service
 
 leased
 
 
In October 2009, Thilmany, LLC (together with its parent company, Packaging Dynamics Corporation) served us with a lawsuit filed in circuit court in Outagamie County, Wisconsin. Thilmany alleges in the lawsuit that the alternative fuel mixture tax credits that we have received from the operation of the Androscoggin mill have had the effect of reducing our costs associated with operating the Androscoggin mill and producing the pulp that we use to manufacture paper products for Thilmany on paper machine no. 5 under a long-term supply agreement. Thilmany seeks unspecified damages for our alleged breach of contract for failing to provide Thilmany with a prorated share of the purported cost savings attributable to the tax credits and a declaration that Thilmany is entitled to a prorated share of any such future costs savings attributable to our use of alternative fuel mixtures at the Androscoggin mill.  In November 2009, we filed responsive pleadings with the court in which we denied Thilmany’s claims and requested that Packaging Dynamics Corporation be dismissed from the lawsuit.

We are involved in legal proceedings incidental to the conduct of our business. We do not believe that any liability that may result from these proceedings will have a material adverse effect on our financial statements.

 
Not applicable.

 
21

 

 
 
Not applicable.
 
 
The following table presents our selected financial data as of and for the periods presented.  The following information is only a summary and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and their related notes, and the other financial information, included elsewhere in this annual report.
 
The selected historical financial data for the seven months ended July 31, 2006, and as of and for the year ended December 31, 2005, have been derived from the audited combined financial statements of the Coated and Supercalendered Papers Division of International Paper, or the “Predecessor.”  The selected historical financial data as of and for the years ended December 31, 2009, 2008, and 2007, and as of and for the five months ended December 31, 2006, have been derived from the audited consolidated (2009, 2008, and 2007) and combined (2006) financial statements of Verso Paper Holdings., or the “Successor.”  The audited consolidated financial statements of the Successor as of and for the years ended December 31, 2009, 2008, and 2007, are included elsewhere in this annual report.

 
22

 
 
   
Successor Consolidated
   
Predecessor Combined
 
                     
Five
   
Seven
       
                     
Months
   
Months
       
               
Ended
   
Ended
   
Year Ended
 
   
Year Ended December 31,
   
December 31,
   
July 31,
   
December 31,
 
(Dollars and tons in millions)
 
2009
   
2008
   
2007
   
2006
   
2006
   
2005
 
Statement of Operations Data:
                                   
Net sales
  $ 1,360.9     $ 1,766.8     $ 1,628.8     $ 706.8     $ 904.4     $ 1,603.8  
Costs and expenses:
                                               
Cost of products sold - (exclusive of depreciation, amortization, and depletion)
    1,242.7       1,462.3       1,403.2       589.3       771.6       1,338.2  
Depreciation, amortization, and depletion
    132.7       134.4       123.1       48.3       72.7       129.4  
Selling, general, and administrative expenses
    61.7       79.4       52.0       14.0       34.3       65.6  
Restructuring and other charges
    1.0       27.4       19.4       10.1       (0.3 )     10.4  
Operating income (loss)
    (77.2 )     63.3       31.1       45.1       26.1       60.2  
Interest income
    (0.2 )     (0.8 )     (1.5 )     (1.8 )     -       -  
Interest expense
    116.1       103.2       113.9       48.7       8.4       14.8  
Other income, net
    (273.8 )     -       -       -       -       -  
Income (loss) before income taxes
    80.7       (39.1 )     (81.3 )     (1.8 )     17.7       45.4  
Provision for income taxes
    -       -       -       -       7.0       17.9  
Net income (loss)
  $ 80.7     $ (39.1 )   $ (81.3 )   $ (1.8 )   $ 10.7     $ 27.5  
                                                 
Statement of Cash Flows Data:
                                               
Cash provided by operating activities
  $ 180.1     $ 74.9     $ 38.8     $ 128.8     $ 39.3     $ 116.8  
Cash used in investing activities
    (34.1 )     (80.3 )     (67.8 )     (1,391.8 )     (27.6 )     (53.0 )
Cash (used in) provided by financing activities
    (115.8 )     66.4       (24.9 )     1,375.4       (11.6 )     (63.8 )
                                                 
Other Financial and Operating Data:
                                               
EBITDA (1)
  $ 329.3     $ 197.7     $ 154.2     $ 93.4     $ 98.8     $ 189.6  
Capital expenditures
    (34.2 )     (80.4 )     (69.6 )     (27.5 )     (27.7 )     (53.1 )
Total tons sold
    1,724.5       1,952.7       2,096.3       866.4       1,145.0       2,024.9  
 
                                               
Balance Sheet Data:
                                               
Working capital (2)
  $ 210.4     $ 156.3     $ 95.6     $ 154.0             $ 87.8  
Property, plant, and equipment, net
    1,022.6       1,115.7       1,159.9       1,212.0               1,287.0  
Total assets
    1,560.3       1,614.1       1,577.0       1,692.4               1,534.1  
Total debt
    1,118.3       1,245.7       1,156.4       1,159.3               301.2  
Total member's equity
    198.0       91.7       174.9       279.7               1,040.0  

(1) EBITDA consists of earnings before interest, taxes, depreciation, and amortization. EBITDA is a measure commonly used in our industry and we present EBITDA to enhance your understanding of our operating performance. We use EBITDA as one criterion for evaluating our performance relative to that of our peers. We believe that EBITDA is an operating performance measure, and not a liquidity measure, that provides investors and analysts with a measure of operating results unaffected by differences in capital structures, capital investment cycles and ages of related assets among otherwise comparable companies. However, EBITDA is not a measurement of financial performance under U.S. GAAP, and our EBITDA may not be comparable to similarly titled measures of other companies. You should not consider our EBITDA as an alternative to operating or net income, determined in accordance with U.S. GAAP, as an indicator of our operating performance, or as an alternative to cash flows from operating activities, determined in accordance with U.S. GAAP, as an indicator of our cash flows or as a measure of liquidity.
 
(2) Working capital is defined as current assets net of current liabilities, excluding the current portion of long-term debt and the Predecessor's accounts payable to International Paper.

 
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The following table reconciles net income (loss) to EBITDA for the periods presented:
 
   
Successor Consolidated
   
Predecessor Combined
 
                     
Five
   
Seven
       
                     
Months
   
Months
       
               
Ended
   
Ended
   
Year Ended
 
   
Year Ended December 31,
   
December 31,
   
July 31,
 
December 31,
 
(In millions of U.S. dollars)
 
2009
   
2008
   
2007
   
2006
   
2006
   
2005
 
Reconciliation of net income (loss) to EBITDA:
                                   
Net income (loss)
  $ 80.7     $ (39.1 )   $ (81.3 )   $ (1.8 )   $ 10.7     $ 27.5  
Provision (benefit) for income taxes
    -       -       -       -       7.0       17.9  
Interest expense, net
    115.9       102.4       112.4       46.9       8.4       14.8  
Depreciation, amortization, and depletion
    132.7       134.4       123.1       48.3       72.7       129.4  
EBITDA
  $ 329.3     $ 197.7     $ 154.2     $ 93.4     $ 98.8     $ 189.6  
 
 
The following discussion and analysis of our financial condition and results of operations includes statements regarding the industry outlook and our expectations regarding the performance of our business.  These non-historical statements in the discussion and analysis are forward-looking statements.  These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors.”  Our actual results may differ materially from those contained in or implied by any forward-looking statements.  The discussion and analysis should be read together with “Risk Factors” and the financial statements and their related notes included elsewhere in this annual report.
 
Overview
 
We are a leading North American supplier of coated papers to catalog and magazine publishers.  Coated paper is used primarily in media and marketing applications, including catalogs, magazines, and commercial printing applications, such as high-end advertising brochures, annual reports, and direct mail advertising.  We are one of North America’s largest producers of coated groundwood paper which is used primarily for catalogs and magazines.  We are also a low cost producer of coated freesheet paper which is used primarily for annual reports, brochures, and magazine covers.  In addition, we have a growing presence in supercalendered paper which is primarily used for retail inserts, but also increasingly for catalogs and magazines.  We also produce and sell market kraft pulp which is used to manufacture printing and writing paper grades and tissue products.  We have recently expanded our product line of specialty papers by introducing new specialty papers for applications in flexible packaging.
 
Background
 
We began operations on August 1, 2006, when we acquired the assets and certain liabilities of the business of International Paper.  We were formed by affiliates of Apollo for the purpose of consummating the Acquisition from International Paper.  Verso Paper Corp., of which we are an indirect, wholly-owned subsidiary, went public on May 14, 2008, with an IPO of 14 million shares of common stock, which generated $152.2 million in net proceeds.
 
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Selected Factors Affecting Operating Results
 
Net Sales
 
Our sales, which we report net of rebates, allowances, and discounts, are a function of the number of tons of paper that we sell and the price at which we sell our paper.  The coated paper industry is cyclical, which results in changes in both volume and price.  Paper prices historically have been a function of macro-economic factors which influence supply and demand.  Price has historically been substantially more variable than volume and can change significantly over relatively short time periods.  Paper prices declined in late 2006 and early 2007, which we believe was due to high customer and producer inventories and cautious purchasing by customers in advance of a scheduled postal rate increase.  Beginning in mid-2007, prices began to rebound following announcements by several of our North American competitors of permanent closures of approximately 1 million tons of annual production capacity (approximately 9% of North American coated paper capacity).  These market conditions continued into early 2008 with a series of announced price increases by suppliers of coated paper. Meanwhile, customers were rebuilding their paper inventories after a significant depletion in the second half of 2007.  In the second half of 2008, we saw a significant weakening in demand as general economic conditions began to worsen.  This weakened demand, coupled with the inventory build, put downward pressure on prices in late 2008 and into 2009, and has caused us, and most coated paper producers, to curtail production to match supply with demand.  Coated prices continue to remain under pressure compared to the peak levels reached in the second half of 2008; however, improved demand combined with market downtime, announced closures, and movements to other grades serve to balance supply with demand.

We are primarily focused on serving two end-user segments: catalogs and magazines.  In 2009, we believe we had a leading market share for the catalog and magazine segments of coated papers.  Coated paper demand is primarily driven by advertising and print media usage.  Advertising spending and magazine and catalog circulation tend to correlate with changes in the GDP of the United States – they rise with a strong economy and contract with a weak economy.
 
The majority of our products are sold under contracts with our customers.  Contracted sales are more prevalent for coated groundwood paper, as opposed to coated freesheet paper, which is more often sold without a contract.  Our contracts generally specify the volumes to be sold to the customer over the contract term, as well as the pricing parameters for those sales.  Most of our contracts are negotiated on an annual basis, with only a few having terms extending beyond one year.  Typically, our contracts provide for quarterly price adjustments based on market price movements.  The large portion of contracted sales allows us to plan our production runs well in advance, optimizing production over our integrated mill system and thereby reducing costs and increasing overall efficiency.
 
We reach our end-users through several channels, including printers, brokers, paper merchants, and direct sales to end-users.  We sell and market our products to approximately 100 customers which comprise approximately 670 end-user accounts.  In 2009, International Paper and its divisions and subsidiaries (including xpedx and Central Lewmar LLC) accounted for approximately 10% of our total net sales.
 
Our historical results include specialty papers that we manufacture for Thilmany, LLC, or “Thilmany,” on paper machine no. 5 at the Androscoggin mill.  Under a long-term supply agreement entered into in 2005 in connection with International Paper’s sale of its Industrial Papers business to Thilmany, these products are sold to Thilmany at a variable charge for the paper purchased and a fixed charge for the availability of the machine.  The amounts included in our net sales for the specialty papers sold to Thilmany totaled $39.0 million, $42.4 million, and $37.6 million in 2009, 2008, and 2007, respectively.

Cost of Products Sold
 
The principal components of our cost of sales are chemicals, wood, energy, labor, maintenance, and depreciation, amortization, and depletion.  Costs for commodities, including chemicals, wood, and energy, are the most variable component of our cost of sales because their prices can fluctuate substantially, sometimes within a relatively short period of time.  In addition, our aggregate commodity purchases fluctuate based on the volume of paper that we produce.
 
Chemicals.  Chemicals utilized in the manufacturing of coated papers include latex, starch, calcium carbonate, and titanium dioxide.  We purchase these chemicals from a variety of suppliers and are not dependent on any single supplier to satisfy our chemical needs.  In the near term, we expect the rate of inflation for our total chemical costs to be lower than that experienced over the last two years.  However, we expect imbalances in supply and demand will drive higher prices for certain chemicals.
 
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Wood.  Our costs to purchase wood are affected directly by market costs of wood in our regional markets and indirectly by the effect of higher fuel costs on logging and transportation of timber to our facilities.  While we have in place fiber supply agreements that ensure a substantial portion of our wood requirements, purchases under these agreements are typically at market rates.  As we have begun to utilize wood harvested from our 27,000-acre hybrid poplar woodlands located near Alexandria, Minnesota, our ongoing wood costs should be positively impacted.

Energy.  We produce a large portion of our energy requirements, historically producing approximately 50% of our energy needs for our coated paper mills from sources such as waste wood and paper, hydroelectric facilities, chemicals from our pulping process, our own steam recovery boilers, and internal energy cogeneration facilities.  Our external energy purchases vary across each of our mills and include fuel oil, natural gas, coal, and electricity.  While our internal energy production capacity mitigates the volatility of our overall energy expenditures, we expect prices for energy to remain volatile for the foreseeable future and our energy costs to increase in a high energy cost environment.  As prices fluctuate, we have some ability to switch between certain energy sources in order to minimize costs.  We utilize derivative contracts as part of our risk management strategy to manage our exposure to market fluctuations in energy prices.
 
Labor.  Labor costs include wages, salary, and benefit expenses attributable to our mill personnel.  Mill employees at a non-managerial level are compensated on an hourly basis.  Management employees at our mills are compensated on a salaried basis.  Wages, salary, and benefit expenses included in cost of sales do not vary significantly over the short term.  In addition, we have not experienced significant labor shortages.
 
Maintenance.  Maintenance expense includes day-to-day maintenance, equipment repairs, and larger maintenance projects, such as paper machine shutdowns for periodic maintenance.  Day-to-day maintenance expenses have not varied significantly from year-to-year.  Larger maintenance projects and equipment expenses can produce year-to-year fluctuations in our maintenance expenses.  In conjunction with our periodic maintenance shutdowns, we have incidental incremental costs that are primarily comprised of unabsorbed fixed costs from lower production volumes and other incremental costs for purchased materials and energy that would otherwise be produced as part of the normal operation of our mills.
 
Depreciation, Amortization, and Depletion.  Depreciation, amortization, and depletion expense represents the periodic charge to earnings through which the cost of tangible assets, intangible assets, and natural resources are recognized over the asset’s life.  Capital investments can increase our asset bases and produce year-to-year fluctuations in expense.
 
Selling, General, and Administrative Expenses
 
The principal components of our selling, general, and administrative expenses are wages, salaries, and benefits for our office personnel at our headquarters and our sales force, travel and entertainment expenses, advertising expenses, expenses relating to certain information technology systems, and research and development expenses.  In addition, we previously paid an annual management fee to Apollo under a management agreement pursuant to which Apollo provided us with certain financial and strategic advisory services and consulting services.  Upon the consummation of the IPO, Apollo terminated the annual fee arrangement under the management agreement.
 
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Critical Accounting Policies

Our accounting policies are fundamental to understanding management’s discussion and analysis of financial condition and results of operations.  Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America and follow general practices within the industry in which we operate.  The preparation of the financial statements requires management to make certain judgments and assumptions in determining accounting estimates.  Accounting estimates are considered critical if the estimate requires management to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and different estimates reasonably could have been used in the current period, or changes in the accounting estimate are reasonably likely to occur from period to period, that would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations.

Management believes the following critical accounting policies are both important to the portrayal of our financial condition and results of operations and require subjective or complex judgments.  These judgments about critical accounting estimates are based on information available to us as of the date of the financial statements.  

Accounting standards whose application may have a significant effect on the reported results of operations and financial position, and that can require judgments by management that affect their application, include the following: Financial Accounting Standards Board, or “FASB,” Accounting Standards Codification, or “ASC,” 450, Contingencies, FASB ASC 360, Property, Plant, and Equipment, FASB ASC 350, Intangibles – Goodwill and Other, and FASB ASC 715, Compensation – Retirement Benefits.

Impairment of long-lived assets and goodwill.  Long-lived assets are reviewed for impairment upon the occurrence of events or changes in circumstances that indicate that the carrying value of the assets may not be recoverable, as measured by comparing their net book value to the estimated undiscounted future cash flows generated by their use.

Goodwill and other intangible assets are accounted for in accordance with FASB ASC 350.  Intangible assets primarily consist of trademarks, customer-related intangible assets and patents obtained through business acquisitions.  Impairment is the condition that exists when the carrying amount of these assets exceed their implied fair value.  An impairment evaluation of the carrying amount of goodwill and other intangible assets with indefinite lives is conducted annually or more frequently if events or changes in circumstances indicate that an asset might be impaired.  The Company has identified the following trademarks as intangible assets with an indefinite life: Influence®, Liberty®, and Advocate®.  Goodwill is evaluated at the reporting unit level and has been allocated to the “Coated” segment.  The valuation as of October 1, 2009, of goodwill and trademarks assigned indefinite lives, indicated no impairment.

The evaluation for impairment is performed by comparing the carrying amount of these assets to their estimated fair value.  If impairment is indicated, then an impairment charge is recorded to reduce the asset to its estimated fair value.  The estimated fair value is generally determined on the basis of discounted future cash flows.  Management believes the accounting estimates associated with determining fair value as part of the impairment test is a critical accounting estimate because estimates and assumptions are made about the Company’s future performance and cash flows.  While management uses the best information available to estimate future performance and cash flows, future adjustments to management’s projections may be necessary if economic conditions differ substantially from the assumptions used in making the estimates.
 
Pension Benefit Obligations. We offer various pension plans to employees.  The calculation of the obligations and related expenses under these plans requires the use of actuarial valuation methods and assumptions, including the expected long-term rate of return on plan assets, discount rates, projected future compensation increases, health care cost trend rates and mortality rates.  Actuarial valuations and assumptions used in the determination of future values of plan assets and liabilities are subject to management judgment and may differ significantly if different assumptions are used.
 
27

 
Contingent liabilities. A liability is contingent if the outcome or amount is not presently known, but may become known in the future as a result of the occurrence of some uncertain future event. We estimate our contingent liabilities based on management’s estimates about the probability of outcomes and their ability to estimate the range of exposure. Accounting standards require that a liability be recorded if management determines that it is probable that a loss has occurred and the loss can be reasonably estimated. In addition, it must be probable that the loss will be confirmed by some future event. As part of the estimation process, management is required to make assumptions about matters that are by their nature highly uncertain.

The assessment of contingent liabilities, including legal contingencies, asset retirement obligations and environmental costs and obligations, involves the use of critical estimates, assumptions and judgments. Management’s estimates are based on their belief that future events will validate the current assumptions regarding the ultimate outcome of these exposures. However, there can be no assurance that future events will not differ from management’s assessments.

Recent Accounting Developments

Fair Value Measurements and Disclosures — In January 2010, the FASB issued Accounting Standards Update, or “ASU,” 2010-06, Fair Value Measurements and Disclosures (Topic 820) – Improving Disclosures about Fair Value Measurements, which provides additional guidance relating to fair value measurement disclosures. Specifically, companies will be required to separately disclose significant transfers into and out of Level 1 and Level 2 measurements in the fair value hierarchy and the reasons for those transfers. For Level 3 fair value measurements, the new guidance requires a gross presentation of activities within the Level 3 roll forward. Additionally, the FASB also clarified existing fair value measurement disclosure requirements relating to the level of disaggregation, inputs, and valuation techniques. This ASU is effective for interim or annual reporting periods beginning after December 15, 2009, except for the detailed Level 3 disclosures, which are effective for interim or annual reporting periods beginning after December 15, 2010. Since ASU 2010-06 only affects disclosure requirements, the adoption of these provisions will have no impact on our financial condition, results of operations, or cash flows.
 
Other new accounting pronouncements issued but not effective until after December 31, 2009, are not expected to have a significant effect on the Company’s financial condition, results of operations, or cash flows.
 
Financial Overview

The economic downturn has presented a significant challenge for manufacturers of coated paper as reduced spending on advertising and the overall weak retail market significantly impacted our customers, especially magazine and catalog publishers, resulting in unprecedented declines in demand for coated papers in the first half of 2009. Coated paper demand strengthened during the second half of 2009, and shipments were significantly improved in the fourth quarter of 2009 compared to the fourth quarter of 2008, and were down only slightly from the seasonally strong third quarter of 2009. On a quarterly basis, year over year demand has increased as mill and end-user inventories have moved to the lowest level in over five years. However, coated paper prices remained under pressure from the peak levels reached in the second half of 2008. Improved demand combined with market downtime and movements to other grades serve to balance supply with demand.

Net sales for the fourth quarter of 2009 increased 1.4% as sales volume increased 22.9% compared to last year’s fourth quarter, reflecting an increase in demand, which includes the effects of lower customer inventory levels. The average sales price fell 17.5% from the fourth quarter of 2008, and fell 1.7% sequentially from the third quarter of 2009. Additionally, new product initiatives increased net sales by $10.5 million in the fourth quarter of 2009 as compared to the same period in 2008, reflecting the development of new paper product offerings for our customers.
 
In response to market conditions, we continue to assess and implement, as appropriate, various expense reduction initiatives. Our company-wide cost reduction program produced approximately $62 million of savings during 2009 and is expected to yield an additional $50 million in cost reductions. Management expects to achieve most of these savings in 2010. Included in this program are material usage reductions, energy usage reductions, labor cost savings, chemical substitution, selling, general, and administrative expense reductions, and workforce planning improvements.
 
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Also included in the results for 2009 are $238.9 million in pre-tax net benefits from alternative fuel mixture tax credits provided by the U.S. government for our use of black liquor in alternative fuel mixtures and $31.3 million in pre-tax net gains from the early retirement of debt. The impact of these tax credits is excluded from our calculation of Adjusted EBITDA. The tax credit, as it relates to liquid fuels derived from biomass, expired on December 31, 2009. Therefore, we will not recognize any proceeds from this tax credit in future periods.
 
Results of Operations
 
The following table sets forth certain consolidated financial information for the years ended December 31, 2009, 2008 and 2007. Cost of sales in the following table and discussion includes the cost of products sold and depreciation, amortization and depletion. The following table and discussion should be read in conjunction with the information contained in our consolidated financial statements and the related notes included elsewhere in this annual report.
 
   
Year Ended December 31,
 
(In thousands of U.S. dollars)
 
2009
   
2008
   
2007
 
Net sales
  $ 1,360,854     $ 1,766,813     $ 1,628,753  
Costs and expenses:
                       
Cost of products sold - exclusive of
                       
depreciation, amortization, and depletion
    1,242,743       1,462,333       1,403,144  
Depreciation, amortization, and depletion
    132,682       134,344       123,139  
Selling, general, and administrative expenses
    61,655       79,441       52,007  
Restructuring and other charges
    979       27,416       19,395  
Operating income (loss)
    (77,205 )     63,279       31,068  
Interest income
    (241 )     (770 )     (1,544 )
Interest expense
    116,130       103,200       113,881  
Other income, net
    (273,796 )     -       -  
Net income (loss)
  $ 80,702     $ (39,151 )   $ (81,269 )
 
2009 Compared to 2008

Net Sales. Net sales for 2009 decreased 23.0% to $1,360.9 million from $1,766.8 million as total sales volume decreased 11.7% compared to last year, primarily reflecting lower demand for coated papers in a difficult economic environment and lower sales prices.  The average sales price per ton for all of our products fell 12.8% in 2009 due to the weak demand.

Net sales for our coated and supercalendered papers segment decreased 23.9% to $1,198.8 million in 2009 from $1,575.0 million in 2008.  The decrease reflects a 14.7% decrease in paper sales volume and a 10.8% decrease in average paper sales price per ton for 2009 compared to 2008.

Net sales for our market pulp segment decreased 28.6% to $104.5 million in 2009 from $146.4 million in 2008.  This decline was due to a 27.9% decrease in average sales price per ton combined with a 1.0% decrease in sales volume compared to 2008.

29

 
Net sales for our other segment increased 26.9% to $57.6 million in 2009 from $45.4 million in 2008.  New product offerings contributed to the improvement as sales volume increased 31.7% in 2009.  This was partially offset by a 3.6% decrease in average sales price per ton compared to 2008.
 
Cost of sales. Cost of sales, including depreciation, amortization, and depletion, decreased 13.9% to $1,375.4 million in 2009 from $1,596.7 million in 2008, primarily reflecting the decline in sales volume and the effects of our expense reduction initiatives.  Our gross margin, excluding depreciation, amortization, and depletion, was 8.7% for 2009, compared to 17.2% for 2008.  This compression in the margin reflects lower average sales prices in 2009 and $74.9 million of unabsorbed costs resulting from approximately 340,000 tons of market downtime taken in 2009 compared to $15.8 million of unabsorbed costs resulting from approximately 75,000 tons of market downtime taken in 2008, as we curtailed production in response to weak demand for coated papers.  Depreciation, amortization, and depletion expense was $132.7 million for 2009, compared to $134.4 million for 2008.

Selling, general, and administrative. Selling, general, and administrative expenses were $61.7 million in 2009, compared to $79.4 million in 2008, reflecting the absence of expenses associated with our IPO and the effect of our expense reduction initiatives.

Interest expense.  Interest expense was $116.1 million in 2009, compared to $103.2 million in 2008.  Included in 2008 interest expense is $5.0 million from a prepayment penalty and the write-off of debt issuance costs resulting from the partial repayment of our senior unsecured term loan with a portion of the IPO proceeds.  Interest expense for 2009 includes $111.3 million of cash interest expense on our outstanding indebtedness and $4.8 million of non-cash interest expense, including amortization of deferred debt issuance costs.  The increase in interest expense was primarily related to higher interest rates on outstanding debt in 2009.

Other income. Other income was $273.8 million in 2009 and includes $238.9 million in net benefits from alternative fuel mixture tax credits provided by the U.S. government for our use of black liquor in alternative fuel mixtures and $31.3 million in net gains related to the early retirement of debt.

Restructuring and other charges. Restructuring and other charges in 2009, were $1.0 million compared to $27.4 million in 2008.  Restructuring and other charges are comprised of transition and other costs (i.e., technology migration costs, consulting and legal fees, and other one-time costs), including those associated with the Acquisition.  Subsequent to the Acquisition, we entered into a management agreement with Apollo relating to the provision of certain financial and strategic advisory services and consulting services.  Upon consummation of the IPO, Apollo terminated the annual fee arrangement under the management agreement for a one-time fee of $23.1 million in 2008.
 
2008 Compared to 2007
 
Net Sales.  Net sales grew 8.5% to $1,766.8 million in 2008 from $1,628.8 million in 2007.  The growth was the result of a 16.5% increase in the average sales price per ton for all of our products in 2008.  This increase was partially offset by a 6.8% decrease in total sales volume, reflecting lower coated paper demand in a difficult economic environment.

Net sales for our coated and supercalendered papers segment were $1,575.0 million in 2008, compared to $1,443.2 million in 2007, an increase of 9.1%.  The improvement reflects a 17.2% increase in average paper sales price which was partially offset by a 6.9% decrease in paper sales volume compared to 2007.
 
Net sales for our hardwood market pulp segment were relatively stable at $146.4 million in 2008, compared to $148.0 million in 2007.  This result reflected a 9.3% decrease in pulp sales volume which was largely offset by a 9.1% increase in average pulp sales price.
 
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Net sales for our other segment increased 20.7% to $45.4 million in 2008 from $37.6 million in  2007.  This increase reflects an 11.4% increase in average sales price combined with an 8.4% increase in sales volume compared to 2007.

Cost of sales.  Cost of sales, including depreciation and amortization, was $1,596.7 million in 2008 compared to $1,526.3 million in 2007, an increase of 4.6% which was primarily driven by higher input costs.  Our gross margin, excluding depreciation and amortization, was 17.2% for 2008 compared to 13.9% for 2007, reflecting the higher average sales price in 2008.  Depreciation and amortization expense was $134.4 million in 2008 compared to $123.1 million in 2007.

Selling, general, and administrative expenses.  Selling, general, and administrative expenses were $79.4 million in 2008 compared to $52.0 million in 2007.  Included in selling, general, and administrative expenses for 2008 is a one-time charge of $10.8 million due to the accelerated vesting of the Legacy Class C Units of Verso Paper Management LP in connection with the IPO.

Interest expense.  Interest expense was $103.2 million in 2008 compared to $113.9 million in 2007.  The net decrease in interest expense was due to lower interest rates on floating rate debt compared to 2007.  Interest expense for 2008 includes $99.2 million of cash interest expense on our outstanding indebtedness and $4.0 million of non-cash interest expense, including amortization of deferred debt issuance costs.

Restructuring and other charges.  Restructuring and other charges were $27.4 million in 2008 compared to $19.4 million in 2007.  Restructuring and other charges are comprised of transition and other costs associated with the Acquisition, including costs of a transition service agreement with International Paper, technology migration costs, consulting and legal fees, and other one-time costs related to becoming a stand-alone business.  Subsequent to the Acquisition, we entered into a management agreement with Apollo relating to the provision of certain financial and strategic advisory services and consulting services.  Upon consummation of the IPO, Apollo terminated the annual fee arrangement under the management agreement for a one-time payment of $23.1 million, which is included in the charges for 2008.  The charges in 2007 included $5.6 million of transition service agreement costs and $2.8 million of charges under the management agreement.  As of September 30, 2007, we substantially discontinued the use of services under the transition service agreement.
 
Seasonality
 
We are exposed to fluctuations in quarterly net sales volumes and expenses due to seasonal factors.  These seasonal factors are common in the coated paper industry.  Typically, the first two quarters are our slowest quarters due to lower demand for coated paper during this period.  Our third quarter is generally our strongest quarter, reflecting an increase in printing related to end-of-year magazines, increased end-of-year direct mailings, and holiday season catalogs.  Our working capital and accounts receivable generally peak in the third quarter, while inventory generally peaks in the second quarter in anticipation of the third quarter season.  We expect our seasonality trends to continue for the foreseeable future.
 
Liquidity and Capital Resources
 
We rely primarily upon cash flow from operations and borrowings under our revolving credit facility to finance operations, capital expenditures and fluctuations in debt service requirements.  We believe that our ability to manage cash flow and working capital levels, particularly inventory and accounts payable, will allow us to meet our current and future obligations, pay scheduled principal and interest payments, and provide funds for working capital, capital expenditures and other needs of the business for at least the next twelve months.  However, given the uncertainty of the current economic environment, no assurance can be given that we will be able to generate sufficient cash flows from operations or that future borrowings will be available under our revolving credit facility in an amount sufficient to fund our liquidity needs.  As of December 31, 2009, $152.1 million was available for future borrowing under our revolving credit facility.  As we focus on managing our expenses and cash flows, we continue to assess and implement, as appropriate, various earnings and expense reduction initiatives. Management has developed a company-wide cost reduction program which produced approximately $62 million of savings during 2009 and is expected to yield an additional $50 million in cost reductions.  We may also dispose of certain of our non-core assets in order to obtain additional liquidity.

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Net cash flows from operating activities.  Net cash provided by operating activities increased to $180.1 million in 2009 compared to $74.9 million in 2008 and $38.8 million in 2007.  The increase from 2008 to 2009 was primarily due to improved results with $80.7 million net income in 2009 compared a net loss of $39.2 million in 2008. Net income in 2009 includes $238.9 million in net benefits from alternative fuel mixture tax credits provided by the U.S. government for our use of black liquor in alternative fuel mixtures and $31.3 million in non-cash gains on the early retirement of debt.  The tax credit, as it relates to liquid fuels derived from biomass, expired on December 31, 2009.  Therefore, we will not recognize any proceeds from this tax credit in future periods.  Partially offsetting this net positive impact on cash flows was the negative effect of changes in working capital in 2009, which included declines in accrued liabilities and accounts payable, primarily due to lower input costs, and an increase in accounts receivable, reflecting the recent improvement in sales and the $10 million accrual for alternative fuel mixture tax credits earned, while inventory balances decreased.  The increase in net cash provided by operating activities in 2008 as compared to 2007 was primarily due to improved performance, with a net loss of $39.2 million in 2008 compared to a net loss of $81.3 million in 2007.

Net cash flows from investing activities.  In 2009, 2008, and 2007, we used $34.1 million, $80.3 million, and $67.8 million, respectively, of net cash in investing activities primarily for investments in capital expenditures.  Management significantly reduced annual capital expenditures in 2009 in response to the uncertain economic environment.  The majority of these capital expenditures were realized during the first half of the year while the mills were experiencing significant market downtime.
 
Net cash flows from financing activities.  In 2009 we used net cash of $115.8 million on financing activities, reflecting principal payments and debt repurchases of $296.6 million on long-term debt and $92.1 million in net payments on our revolving credit facility, partially offset by $288.6 million in proceeds from the issuance of $325.0 million in senior secured notes net of discount, underwriting fees, and issuance costs.  Additionally, $12.5 million was contributed to Verso Paper Finance Holdings One LLC, or “Verso Finance One,” parent company of Verso Finance, in order to accommodate additional repurchases of debt.  In 2008, our financing activities provided $66.4 million of net cash, which reflected $92.1 million in borrowings under our revolving credit facility, $2.8 million in scheduled principal payments made on the senior secured term loan, and $22.8 million in distributions paid to Verso Paper Finance Holdings LLC, or “Verso Finance,” our indirect parent company, to fund interest and other obligations.  This compares to $24.9 million of net cash used during 2007, which was comprised of $2.8 million in scheduled principal payments on the senior secured term loan and $22.1 million in distributions to Verso Finance.
 
Indebtedness.  As of December 31, 2009, our aggregate indebtedness was $1,118.3 million, net of $24.0 million of unamortized discounts.
 
On December 31, 2009, we had a credit facility and outstanding debt securities consisting of:
 
 
·
$200 million revolving credit facility maturing in 2012, under which no amounts were outstanding, $32.1 million in letters of credit were issued, and $152.1 million was available for future borrowing.  Our availability under our revolving credit facility has been reduced by $15.8 million as a result of the bankruptcy filing of Lehman Commercial Paper, Inc., “Lehman.”  As a result of Lehman’s inability to fulfill its obligation under the revolving credit facility, we do not expect that Lehman will fund its pro rata share of any future borrowing requests.
 
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·
$325 million aggregate principal amount of 11½% senior secured fixed rate notes due  2014;
 
 
·
$337 million aggregate principal amount of 9⅛% second priority senior secured fixed rate notes due 2014;
 
 
·
$180 million aggregate principal amount of second priority senior secured floating rate notes due 2014; and
 
 
·
$300 million aggregate principal amount of 11⅜% senior subordinated fixed rate notes due 2016.
 
The revolving credit facility bears interest at a rate equal to LIBOR plus 3.00% and/or Prime plus 2.00%.  We are required to pay a commitment fee to the lenders under the revolving credit facility in respect of unutilized commitments at a rate equal to 0.50% per annum and customary letter of credit and agency fees.  The revolving credit facility is secured by first priority security interests in, and mortgages on, substantially all of our tangible and intangible assets and those of each of our direct and indirect subsidiaries.  It is also secured by first priority pledges of all the equity interests owned by us in our subsidiaries.  The obligations under the revolving credit facility are unconditionally guaranteed by Verso Paper Finance Holdings LLC, or “Verso Finance,” and, subject to certain exceptions, each of its direct and indirect subsidiaries.  On June 3, 2009, the credit agreement was amended and restated to provide for the issuance of the senior secured notes due July 1, 2014 (see below).  The amendment also, among other things, increased the applicable margin for the interest rate on borrowings under the revolving credit facility to 3.0% for Eurodollar loans and 2.0% for base rate loans and eliminated the requirement to maintain a net first-lien secured debt to Adjusted EBITDA ratio, providing us with additional business flexibility.  The revolving credit facility is secured on a ratable and pari passu basis with the senior secured notes due 2014.

On June 11, 2009, we issued $325.0 million aggregate principal amount of 11.5% senior secured notes due July 1, 2014.  These fixed-rate notes pay interest semi-annually.  The notes are secured by substantially all of our property and assets and those of each of our direct and indirect subsidiaries.  The notes are secured on a ratable and pari passu basis with the revolving credit facility.  The net proceeds, after deducting the discount, underwriting fees, and issuance costs, were $288.6 million, which funds were used to repay in full $252.9 million outstanding on our first priority term loan and to temporarily reduce the debt outstanding under the revolving credit facility by $35.0 million.  The write-off of unamortized debt issuance costs related to the term loan resulted in a loss of $5.9 million.  On January 12, 2010, we issued an additional $25.0 million aggregate principal amount of the 11.5% senior secured notes under the existing indenture.  These notes will be treated as a single series with and have the same terms as the notes issued under the indenture in June 2009.  The net proceeds including premium, after deducting underwriting fees and before deducting offering expenses, were $27.0 million.  We intend to use the net proceeds for capital expenditures and other general corporate purposes.

During 2009, we repurchased and retired $12.9 million of our second priority senior secured fixed-rate notes due on August 1, 2014, for a total purchase price of $7.9 million, which resulted in gains of $4.7 million, net of the write-off of unamortized debt issuance costs.  During 2009, we also repurchased and retired $69.8 million of our second priority senior secured floating-rate notes due on August 1, 2014, for a total purchase price of $35.1 million, which resulted in gains of $33.0 million, net of the write-off of unamortized debt issuance costs.  In addition, we de-designated the interest rate swap hedging interest payments on these notes and recognized losses of $0.3 million on the interest rate swap.  The second priority senior secured fixed rate notes have a fixed interest rate of 9.125% and pay interest semiannually.  The second priority senior secured floating rate notes bear interest at a rate equal to LIBOR plus 3.75% and pay interest quarterly.  At December 31, 2009, the interest rate was 4.03%.  The original principal amount of the senior subordinated notes was outstanding at December 31, 2009.  These senior subordinated notes have a fixed interest rate of 11.375% and pay interest semi-annually.  The second priority senior secured fixed rate and floating rate notes have the benefit of a second priority security interest in the collateral securing our senior secured credit facility, while the subordinated notes are unsecured.

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We may elect to retire our outstanding debt in open market purchases, privately negotiated transactions, or otherwise.  These repurchases may be funded through available cash from operations and borrowings from our credit facilities.  Such repurchases are dependent on prevailing market conditions, our liquidity requirements, contractual restrictions, and other factors.

Covenant Compliance

The credit agreement and the indentures governing our notes contain affirmative covenants as well as restrictive covenants which limit our ability to, among other things, incur additional indebtedness; pay dividends or make other distributions; repurchase or redeem our stock; make investments; sell assets, including capital stock of restricted subsidiaries; enter into agreements restricting our subsidiaries’ ability to pay dividends; consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; enter into transactions with our affiliates; and incur liens.  These covenants can result in limiting our long-term growth prospects by hindering our ability to incur future indebtedness or grow through acquisitions.  At December 31, 2009, we were in compliance with the covenants in our debt agreements.
 
Effect of Inflation
 
While inflationary increases in certain input costs, such as for energy, wood fiber, and chemicals, have an impact on our operating results, changes in general inflation have had minimal impact on our operating results in the last three years.  Sales prices and volumes are more strongly influenced by supply and demand factors in specific markets and by exchange rate fluctuations than by inflationary factors.  We cannot assure you, however, that we will not be affected by general inflation in the future.  
 
Contractual Obligations
 
The following table reflects our contractual obligations and commercial commitments as of December 31, 2009. Commercial commitments include lines of credit, guarantees, and other potential cash outflows resulting from a contingent event that requires our performance pursuant to a funding commitment.
 
   
Payments due by period
 
         
Less than
               
More than
 
(in millions of U.S. dollars)
 
Total
   
1 year
   
1-3 years
   
3-5 years
   
5 years
 
Long-term debt (1)
  $ 1,714.9     $ 111.6     $ 222.3     $ 1,027.0     $ 354.0  
Operating leases
    16.2       5.2       6.3       2.2       2.5  
Purchase obligations (2)
    747.1       130.5       175.1       174.2       267.3  
Other long-term liabilities (3)
    34.4       1.7       0.8       4.1       27.8  
Total
  $ 2,512.6     $ 249.0     $ 404.5     $ 1,207.5     $ 651.6  

(1)
Long-term debt includes principal payments, commitment fees, and interest payable. A portion of interest expense is at a variable rate and has been calculated using current LIBOR. Actual payments could vary.
(2)
Purchase obligations include unconditional purchase obligations for power purchase agreements (gas and electricity), machine clothing, and other commitments for advertising, raw materials, or storeroom inventory.
(3) 
Other long-term liabilities reflected above represent the gross amount of asset retirement obligations.
 
 
We are exposed to market risk from fluctuations in our paper prices, interest rates, energy prices, and commodity prices for our inputs.

 
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Paper Prices
 
Our sales, which we report net of rebates, allowances, and discounts, are a function of the number of tons of paper that we sell and the price at which we sell our paper.  The coated paper industry is cyclical, which results in changes in both volume and price.  Paper prices historically have been a function of macro-economic factors, which influence supply and demand.  Price has historically been substantially more variable than volume and can change significantly over relatively short time periods.

We are primarily focused on serving two end-user segments: catalogs and magazines.  Coated paper demand is primarily driven by advertising and print media usage.  Advertising spending and magazine and catalog circulation tend to correlate with GDP in the United States - they rise with a strong economy and contract with a weak economy.

The majority of our products are sold under contracts with our customers; however, coated freesheet paper is sold without a contract more often then coated groundwood paper.  Our contracts generally specify the volumes to be sold to the customer over the contract term, as well as the pricing parameters for those sales.  Most of our contracts are negotiated on an annual basis, with only a few having terms extending beyond one year.  Typically, our contracts provide for quarterly price adjustments based on market price movements.  The large portion of contracted sales allows us to plan our production runs well in advance, optimizing production over our integrated mill system and thereby reducing costs and increasing overall efficiency.

We reach our end-users through several channels, including printers, brokers, paper merchants and direct sales to end-users.  We sell and market our products to approximately 100 customers.  In 2009, International Paper and its divisions and subsidiaries (including xpedx and Central Lewmar LLC) accounted for approximately 10% of our total net sales.

Interest Rates

We issued fixed- and floating-rate debt to finance the Acquisition in order to manage our variability to cash flows from interest rates.  Borrowings under our revolving credit facility and our floating rate notes accrue interest at variable rates, but there were no amounts outstanding under our revolving credit facility at December 31, 2009.  A 100 basis point increase in quoted interest rates on our debt balances outstanding as of December 31, 2009, under our floating-rate notes would increase our annual interest expense by $1.8 million.  While we may enter into agreements limiting our exposure to higher interest rates, any such agreements may not offer complete protection from this risk.

Derivatives

In the normal course of business, we utilize derivatives contracts as part of our risk management strategy to manage our exposure to market fluctuations in energy prices and interest rates.  These instruments are subject to credit and market risks in excess of the amount recorded on the balance sheet in accordance with generally accepted accounting principles.  Controls and monitoring procedures for these instruments have been established and are routinely reevaluated.  We have an Energy Risk Management Policy which was adopted by our board of directors and is monitored by an Energy Risk Management Committee composed of our senior management.  In addition, we have an Interest Rate Risk Committee which was formed to monitor our Interest Rate Risk Management Policy.  Credit risk represents the potential loss that may occur because a party to a transaction fails to perform according to the terms of the contract.  The measure of credit exposure is the replacement cost of contracts with a positive fair value.  We manage credit risk by entering into financial instrument transactions only through approved counterparties.  Market risk represents the potential loss due to the decrease in the value of a financial instrument caused primarily by changes in commodity prices or interest rates.  We manage market risk by establishing and monitoring limits on the types and degree of risk that may be undertaken.

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We do not hedge the entire exposure of our operations from commodity price volatility for a variety of reasons.  To the extent that we do not hedge against commodity price volatility, our results of operations may be affected either favorably or unfavorably by a shift in the future price curve.  As of December 31, 2009, we had net unrealized losses of $1.6 million on open commodity contracts with maturities of one to fifteen months.  These derivative instruments involve the exchange of net cash settlements, based on changes in the price of the underlying commodity index compared to the fixed price offering, at specified intervals without the exchange of any underlying principal.  A 10% decrease in commodity prices would have a negative impact of approximately $3.2 million on the fair value of such instruments.  This quantification of exposure to market risk does not take into account the offsetting impact of changes in prices on anticipated future energy purchases.

We entered into a $250 million notional value receive-variable, pay-fixed interest rate swap in connection with our outstanding floating rate notes that mature in 2014.  We are hedging the cash flow exposure on our quarterly variable-rate interest payments due to changes in the benchmark interest rate (three-month LIBOR).  As of December 31, 2009, the fair value of this swap was an unrealized loss of $1.6 million.  This swap expired on February 1, 2010.  

Commodity Prices

We are subject to changes in our cost of sales caused by movements underlying commodity prices.  The principal components of our cost of sales are chemicals, wood, energy, labor, maintenance, and depreciation, amortization, and depletion.  Costs for commodities, including chemicals, wood, and energy, are the most variable component of our cost of sales because their prices can fluctuate substantially, sometimes within a relatively short period of time.  In addition, our aggregate commodity purchases fluctuate based on the volume of paper that we produce.

Chemicals.  Chemicals utilized in the manufacturing of coated papers include latex, starch, calcium carbonate, and titanium dioxide.  We purchase these chemicals from a variety of suppliers and are not dependent on any single supplier to satisfy our chemical needs.  In the near term, we expect the rate of inflation for our total chemical costs to be lower than that experienced over the last two years.  However, we expect imbalances in supply and demand will drive higher prices for certain chemicals such as starch and sodium chlorate.

Wood.  Our costs to purchase wood are affected directly by market costs of wood in our regional markets and indirectly by the effect of higher fuel costs on logging and transportation of timber to our facilities.  While we have in place fiber supply agreements that ensure a substantial portion of our wood requirements, purchases under these agreements are typically at market rates. As we have begun to utilize wood harvested from our 27,000-acre hybrid poplar woodlands located near Alexandria, Minnesota, our ongoing wood costs should be positively impacted.

Energy.  We produce a large portion of our energy requirements, historically producing approximately 50% of our energy needs for our coated paper mills from sources such as waste wood and paper, hydroelectric facilities, chemicals from our pulping process, our own steam recovery boilers, and internal energy cogeneration facilities.  Our external energy purchases vary across each of our mills and include fuel oil, natural gas, coal, and electricity.  While our internal energy production capacity mitigates the volatility of our overall energy expenditures, we expect prices for energy to remain volatile for the foreseeable future and our energy costs to increase in a high energy cost environment.  As prices fluctuate, we have some ability to switch between certain energy sources in order to minimize costs.  We utilize derivatives contracts as part of our risk management strategy to manage our exposure to market fluctuations in energy prices.
 
Off-Balance Sheet Arrangements
 
None.

 
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Verso Paper Holdings LLC

Consolidated Financial Statements
For the Years Ended December 31, 2009, 2008, and 2007

Index to Financial Statements
 

 
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Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2009, based upon the guidelines established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our internal control over financial reporting includes policies and procedures that provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America.

Based on the results of our evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2009. We reviewed the results of management’s assessment with our Audit Committee.
 
The effectiveness of our internal control over financial reporting as of December 31, 2009, has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their attestation report which appears below.

 
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To the Board of Directors and Members of Verso Paper Holdings LLC:

We have audited the accompanying consolidated balance sheets of Verso Paper Holdings LLC, (the “Company”), a wholly-owned subsidiary of Verso Paper Finance Holdings LLC, as of December 31, 2009 and 2008, and the related consolidated statements of operations, changes in member’s equity, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 2, 2010 expressed an unqualified opinion on the Company’s internal control over financial reporting.

/s/ Deloitte & Touche LLP

Memphis, Tennessee
March 2, 2010

 
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REPORT OF DELOITTE & TOUCHE LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM, ON INTERNAL CONTROL OVER FINANCIAL REPORTING
 
To the Board of Directors and Members of Verso Paper Holdings LLC:
 
We have audited the internal control over financial reporting of Verso Paper Holdings LLC (the "Company"), a wholly-owned subsidiary of Verso Paper Finance Holdings LLC, as of December 31, 2009, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control Over Financial Reporting.  Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.  Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides a reasonable basis for our opinion.
 
A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
 
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis.  Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 
40

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2009 of the Company and our report dated March 2, 2010 expressed an unqualified opinion on those financial statements.

/s/ Deloitte & Touche LLP

Memphis, Tennessee
March 2, 2010

 
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CONSOLIDATED BALANCE SHEETS

   
December 31,
 
(In thousands of U.S. dollars)
 
2009
   
2008
 
ASSETS
           
Current Assets:
           
Cash and cash equivalents
  $ 149,762     $ 119,520  
Accounts receivable - net
    104,289       83,045  
Inventories
    162,401       195,934  
Prepaid expenses and other assets
    10,385       2,512  
Total Current Assets
    426,837       401,011  
Property, plant, and equipment - net
    1,022,622       1,115,657  
Reforestation
    13,357       770  
Intangibles and other assets - net
    86,896       86,083  
Goodwill
    10,551       10,551  
Total Assets
  $ 1,560,263     $ 1,614,072  
LIABILITIES AND MEMBER'S EQUITY
               
Current Liabilities:
               
Accounts payable
  $ 100,995     $ 122,041  
Accrued liabilities
    115,425       122,649  
Current maturities of long-term debt
    -       2,850  
Total Current Liabilities
    216,420       247,540  
Long-term debt
    1,118,273       1,242,821  
Other liabilities
    27,577       32,007  
Total Liabilities
    1,362,270       1,522,368  
Commitments and contingencies (Note 16)
    -       -  
Member's Equity
               
Paid-in-capital
    317,023       301,110  
Retained deficit
    (105,461 )     (167,135 )
Accumulated other comprehensive loss
    (13,569 )     (42,271 )
Total Member's Equity
    197,993       91,704  
Total Liabilities and Member's Equity
  $ 1,560,263     $ 1,614,072  
                 
Included in the balance sheet line items above are related-party balances as follows:
               
Accounts receivable
  $ 7,785     $ 8,312  
Accounts payable
    498       4,135  

See notes to consolidated financial statements.

 
42

 

 
CONSOLIDATED STATEMENTS OF OPERATIONS

   
Year Ended December 31,
 
(In thousands of U.S. dollars)
 
2009
   
2008
   
2007
 
Net sales
  $ 1,360,854     $ 1,766,813     $ 1,628,753  
                         
Costs and expenses:
                       
Cost of products sold - (exclusive of  depreciation, amortization, and depletion)
    1,242,743       1,462,333       1,403,144  
Depreciation, amortization, and depletion
    132,682       134,344       123,139  
Selling, general, and administrative expenses
    61,655       79,441       52,007  
Restructuring and other charges
    979       27,416       19,395  
Operating income (loss)
    (77,205 )     63,279       31,068  
Interest income
    (241 )     (770 )     (1,544 )
Interest expense
    116,130       103,200       113,881  
Other income, net
    (273,796 )     -       -  
Net income (loss)
  $ 80,702     $ (39,151 )   $ (81,269 )
                         
Included in the financial statement line items above are related-party transactions as follows (Notes 14 and 15):
                       
Net sales
  $ 138,760     $ 165,799     $ 191,358  
Purchases included in cost of products sold
    4,625       7,159       11,722  
Restructuring and other charges
    -       23,281       8,399  

See notes to consolidated financial statements.

 
43

 

 
CONSOLIDATED STATEMENTS OF CHANGES IN MEMBER'S EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007
               
Accumulated
       
               
Other
   
Total
 
   
Paid-in-
   
Retained
   
Comprehensive
   
Member's
 
(In thousands of U.S. dollars)
 
Capital
   
Deficit
   
Income (Loss)
   
Equity
 
Balance - December 31, 2006
  $ 289,286     $ (1,832 )   $ (7,741 )   $ 279,713  
Cash distributions
    -       (22,087 )     -       (22,087 )
Net loss
    -       (81,269 )     -       (81,269 )
Other comprehensive income (loss):
                               
Net unrealized losses on derivatives
    -       -       (2,095 )     (2,095 )
Defined benefit pension plan:
                               
Pension liability adjustment
    -       -       (819 )     (819 )
Prior service cost amortization
    -       -       785       785  
Total other comprehensive loss
    -       -       (2,129 )     (2,129 )
Comprehensive loss
    -       (81,269 )     (2,129 )     (83,398 )
Equity award expense
    625       -       -       625  
Balance - December 31, 2007
    289,911       (105,188 )     (9,870 )     174,853  
Cash distributions
    -       (22,796 )     -       (22,796 )
Net loss
    -       (39,151 )     -       (39,151 )
Other comprehensive income (loss):
                               
Net unrealized losses on derivatives, net of $1.9 million of net gains reclassified into net loss
    -       -       (27,571 )     (27,571 )
Defined benefit pension plan:
                               
Pension liability adjustment
    -       -       (5,701 )     (5,701 )
Prior service cost amortization
    -       -       871       871  
Total other comprehensive loss
    -       -       (32,401 )     (32,401 )
Comprehensive loss
    -       (39,151 )     (32,401 )     (71,552 )
Equity award expense
    11,199       -       -       11,199  
Balance - December 31, 2008
    301,110       (167,135 )     (42,271 )     91,704  
Parent company contributions
    15,281       (3,569 )     -       11,712  
Cash distributions
    -       (15,459 )     -       (15,459 )
Net income
    -       80,702       -       80,702  
Other comprehensive income:
                               
Net unrealized losses on derivatives, net of $40.2 million of net losses reclassified into net income
    -       -       27,773       27,773  
Defined benefit pension plan:
                               
Pension liability adjustment
    -       -       (413 )     (413 )
Amortization of net loss and prior service cost
    -       -       1,342       1,342  
Total other comprehensive income
    -       -       28,702       28,702  
Comprehensive income
    -       80,702       28,702       109,404  
Equity award expense
    632       -       -       632  
Ending Balance - December 31, 2009
  $ 317,023     $ (105,461 )   $ (13,569 )   $ 197,993  

See notes to consolidated financial statements.

 
44

 

 
CONSOLIDATED STATEMENTS OF CASH FLOWS

   
Year Ended December 31,
 
(In thousands of U.S. dollars)
 
2009
   
2008
   
2007
 
Cash Flows From Operating Activities:
                 
Net income (loss)
  $ 80,702     $ (39,151 )   $ (81,269 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
                       
Depreciation, amortization, and depletion
    132,682       134,344       123,139  
Amortization of debt issuance costs
    5,264       5,427       5,425  
Accretion of discount on long-term debt
    2,081       -       -  
Gain on retirement of debt
    (31,266 )     -       -  
Loss on disposal of fixed assets
    533       722       942  
Equity award expense