UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[ X ]                            QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018

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 No.: 000-51826

MERCER INTERNATIONAL INC.

(Exact name of Registrant as specified in its charter)

 

Washington		47-0956945
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

Suite 1120, 700 West Pender Street, Vancouver, British Columbia, Canada, V6C 1G8

(Address of office)

(604) 684-1099

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).    YES ☒      NO ☐

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

 

Large Accelerated Filer    ☒		Accelerated Filer    ☐		Non-Accelerated Filer    ☐		Smaller Reporting Company     ☐

 

Emerging Growth Company     ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.     ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ☐    NO ☒

The Registrant had 65,201,661 shares of common stock outstanding as at October 24, 2018.

 

 

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

MERCER INTERNATIONAL INC.

INTERIM CONSOLIDATED FINANCIAL STATEMENTS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2018

(Unaudited)

 

FORM 10-Q

QUARTERLY REPORT - PAGE 2

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MERCER INTERNATIONAL INC.

INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands of U.S. dollars, except per share data)

 

		Three Months Ended September 30								Nine Months Ended September 30
		2018				2017				2018				2017
Revenues		$	331,058			$	305,498			$	1,045,493			$	831,459
Costs and expenses
Operating costs, excluding depreciation and amortization			230,009				228,941				755,428				632,071
Operating depreciation and amortization			23,197				22,568				69,312				62,205
Selling, general and administrative expenses			14,506				12,327				43,883				35,312
Operating income			63,346				41,662				176,870				101,871
Other income (expenses)
Interest expense			(11,729	)			(13,513	)			(35,972	)			(40,712	)
Loss on settlement of debt (Note 4(a))			—				—				(21,515	)			(10,696	)
Legal cost award (Note 11(c))			—				—				(6,951	)			—
Other income (expenses)			(259	)			(374	)			(628	)			199
Total other expenses			(11,988	)			(13,887	)			(65,066	)			(51,209	)
Income before provision for income taxes			51,358				27,775				111,804				50,662
Provision for income taxes			(10,182	)			(6,632	)			(28,224	)			(21,897	)
Net income		$	41,176			$	21,143			$	83,580			$	28,765
Net income per common share
Basic		$	0.63			$	0.33			$	1.28			$	0.44
Diluted		$	0.63			$	0.32			$	1.27			$	0.44
Dividends declared per common share		$	0.125			$	0.115			$	0.375			$	0.345

INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands of U.S. dollars)

 

		Three Months Ended September 30,								Nine Months Ended September 30
		2018				2017				2018				2017
Net income		$	41,176			$	21,143			$	83,580			$	28,765
Other comprehensive income (loss), net of taxes(1)
Foreign currency translation adjustment			(1,981	)			37,957				(41,503	)			107,597
Change in unrecognized losses and prior service costs related to defined benefit pension plan			(574	)			302				(1,302	)			904
Change in unrealized gains/losses on marketable securities			(1	)			53				26				58
Other comprehensive income (loss), net of taxes(1)			(2,556	)			38,312				(42,779	)			108,559
Total comprehensive income		$	38,620			$	59,455			$	40,801			$	137,324

(1)	Balances are net of tax effects of $nil in all periods.

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

 

FORM 10-Q

QUARTERLY REPORT - PAGE 3

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MERCER INTERNATIONAL INC.

INTERIM CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

		September 30,				December 31,
		2018				2017
ASSETS
Current assets
Cash and cash equivalents		$	242,185			$	143,299
Restricted cash to redeem senior notes (Note 4(a))			—				317,439
Accounts receivable			193,648				206,027
Inventories			229,784				176,601
Prepaid expenses and other			12,417				8,973
Total current assets			678,034				852,339
Property, plant and equipment, net			834,347				844,848
Intangible and other assets			24,274				26,147
Deferred income tax			4,641				1,376
Total assets		$	1,541,296			$	1,724,710
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Accounts payable and other		$	173,784			$	133,557
Pension and other post-retirement benefit obligations			955				985
Senior notes to be redeemed with restricted cash (Note 4(a))			—				295,924
Total current liabilities			174,739				430,466
Debt			696,519				662,997
Pension and other post-retirement benefit obligations			22,705				21,156
Capital leases and other			36,239				27,464
Deferred income tax			41,152				31,961
Total liabilities			971,354				1,174,044
Shareholders’ equity
Common shares $1 par value; 200,000,000 authorized; 65,202,000 issued and outstanding (2017 – 65,017,000)			65,171				64,974
Additional paid-in capital			341,420				338,695
Retained earnings			265,131				205,998
Accumulated other comprehensive loss			(101,780	)			(59,001	)
Total shareholders’ equity			569,942				550,666
Total liabilities and shareholders’ equity		$	1,541,296			$	1,724,710
Commitments and contingencies (Note 11)
Subsequent events (Note 8 and Note 12)

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

 

FORM 10-Q

QUARTERLY REPORT - PAGE 4

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MERCER INTERNATIONAL INC.

INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands of U.S. dollars)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
Cash flows from (used in) operating activities
Net income		$	41,176			$	21,143			$	83,580			$	28,765
Adjustments to reconcile net income to cash flows from operating activities
Depreciation and amortization			23,310				22,673				69,643				62,519
Deferred income tax provision			1,314				4,184				7,330				12,589
Loss on settlement of debt			—				—				21,515				10,696
Defined benefit pension plan and other post-retirement benefit plan expense			423				549				1,294				1,615
Stock compensation expense			970				774				2,922				1,525
Other			884				783				3,015				1,308
Defined benefit pension plan and other post-retirement benefit plan contributions			(19	)			(458	)			(124	)			(1,309	)
Changes in working capital
Accounts receivable			(150	)			1,584				8,193				(42,130	)
Inventories			(41,084	)			(14,043	)			(60,127	)			(9,912	)
Accounts payable and accrued expenses			(10,803	)			(1,906	)			44,130				41,929
Other			(5,252	)			(1,496	)			(8,480	)			(4,338	)
Net cash from (used in) operating activities			10,769				33,787				172,891				103,257
Cash flows from (used in) investing activities
Purchase of property, plant and equipment			(26,744	)			(14,342	)			(71,583	)			(42,249	)
Purchase of intangible assets			(163	)			(394	)			(483	)			(799	)
Acquisition of Friesau Facility			—				—				—				(61,627	)
Other			211				(381	)			278				(304	)
Net cash from (used in) investing activities			(26,696	)			(15,117	)			(71,788	)			(104,979	)
Cash flows from (used in) financing activities
Redemption of senior notes			—				—				(317,439	)			(234,945	)
Proceeds from issuance of senior notes			—				—				—				250,000
Proceeds from (repayment of) revolving credit facilities, net			(3,443	)			—				34,293				26,525
Dividend payments			(8,150	)			(7,477	)			(24,424	)			(22,389	)
Payment of interest rate derivative liability			—				—				—				(3,789	)
Payment of debt issuance costs			—				—				(1,390	)			(6,132	)
Other			(944	)			(389	)			(2,563	)			569
Net cash from (used in) financing activities			(12,537	)			(7,866	)			(311,523	)			9,839
Effect of exchange rate changes on cash, cash equivalents and restricted cash			1,167				3,895				(8,133	)			10,329
Net increase (decrease) in cash, cash equivalents and restricted cash			(27,297	)			14,699				(218,553	)			18,446
Cash, cash equivalents and restricted cash, beginning of period			269,482				144,643				460,738				140,896
Cash, cash equivalents and restricted cash, end of period		$	242,185			$	159,342			$	242,185			$	159,342
Supplemental cash flow disclosure
Cash paid for interest		$	19,591			$	8,430			$	35,287			$	29,311
Cash paid for income taxes		$	2,192			$	2,797			$	6,412			$	8,001
Supplemental schedule of non-cash investing and financing activities
Leased production equipment		$	—			$	4			$	12,126			$	143

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

 

FORM 10-Q

QUARTERLY REPORT - PAGE 5

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

Note 1. The Company and Summary of Significant Accounting Policies

Nature of Operations and Basis of Presentation

The Interim Consolidated Financial Statements contained herein include the accounts of Mercer International Inc. (“Mercer Inc.”) and all of its subsidiaries (collectively the “Company”). The Company’s shares of common stock are quoted and listed for trading on the NASDAQ Global Market.

The Interim Consolidated Financial Statements have been prepared by the Company pursuant to the rules and regulations of the United States Securities and Exchange Commission (the “SEC”). The year-end Consolidated Balance Sheet data was derived from audited financial statements. The footnote disclosure included herein has been prepared in accordance with accounting principles generally accepted for interim financial statements in the United States (“GAAP”). The unaudited Interim Consolidated Financial Statements should be read together with the audited Consolidated Financial Statements and accompanying notes included in the Company’s latest Annual Report on Form 10-K for the fiscal year ended December 31, 2017. In the opinion of the Company, the unaudited Interim Consolidated Financial Statements contained herein contain all adjustments necessary for a fair statement of the results of the interim periods included. The results for the periods included herein may not be indicative of the results for the entire year.

In these Interim Consolidated Financial Statements, unless otherwise indicated, all amounts are expressed in United States dollars (“U.S. dollars” or “$”). The symbol “€” refers to euros and the symbol “C$” refers to Canadian dollars.

Use of Estimates

Preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Significant management judgment is required in determining the accounting for, among other things, pension and other post-retirement benefit obligations, deferred income taxes (valuation allowance and permanent reinvestment), depreciation and amortization, future cash flows associated with impairment testing for long-lived assets, the allocation of the purchase price in a business combination to the assets acquired and liabilities assumed, legal liabilities and contingencies. Actual results could differ materially from these estimates, and changes in these estimates are recorded when known.

New Accounting Pronouncements

Accounting Pronouncements Implemented

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2014-09 (“ASU 2014-09”), Revenue Recognition – Revenue from Contracts with Customers that requires companies to recognize revenue when a customer obtains control rather than when companies have transferred substantially all risks and rewards of a good or service. Additionally, the update provides presentation and disclosure requirements which are more detailed in regards to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The Company adopted ASU 2014-09 as at January 1, 2018 using the modified retrospective method. This update does not change the timing of when the Company recognizes revenue as the majority of the Company’s revenue arises from contracts with customers in which the sale of goods is the main performance obligation. The Company’s revised revenue recognition disclosure has been included in the Significant Accounting Policies and the Business Segment Information Note.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 6

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 1. The Company and Summary of Significant Accounting Policies (continued)

 

In March 2017, the FASB issued Accounting Standards Update 2017-07 (“ASU 2017-07”), Improving the Presentation of Net Periodic Pension Cost and Net Periodic Post-Retirement Benefit Cost which requires that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations. The Company adopted ASU 2017-07 as at January 1, 2018. For the three and nine month periods ended September 30, 2018, $282 and $864 of the net benefit cost, respectively, has been recorded in other income (expenses) in the Interim Consolidated Statement of Operations. For the three and nine month periods ended September 30, 2017, $373 and $1,109, respectively, has been reclassified from operating costs, excluding depreciation and amortization to other income (expenses) in the Interim Consolidated Statement of Operations.

In January 2018, the FASB released guidance on the accounting for tax on the global intangible low-taxed income (“GILTI”) provisions of the Tax Cuts and Jobs Act (the “Act”). The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. The Company has elected to treat any potential GILTI inclusions as a period cost.

Accounting Pronouncements Not Yet Implemented

In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (“ASU 2016-02”) which requires lessees to recognize virtually all of their leases on the balance sheet, by recording a right-of-use asset and liability. In July 2018 the FASB issued Accounting Standards Update 2018-10, Codification Improvements to Topic 842, Leases as well as Accounting Standards Update 2018-11, Leases: Targeted Improvements which further affect the guidance of ASU 2016-02. These updates are effective for financial statements issued for fiscal years beginning after December 15, 2018, with early adoption permitted at the beginning of an interim or annual reporting period. The Company will adopt these updates on January 1, 2019. Currently, the Company believes these updates will not have a material impact on its consolidated financial statements.

In February 2018, the FASB issued Accounting Standards Update 2018-02, Income Statement - Reporting Comprehensive Income which allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Act. This update is effective for fiscal years beginning after December 15, 2018, and should be applied either in the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corporate income tax rate in the Act is recognized. The Company believes this update will not have an impact on its consolidated financial statements.

In June 2018, the FASB issued Accounting Standards Update 2018-07, Compensation - Stock Compensation - Improvements to Nonemployee Share-Based Payment Accounting which both clarifies and modifies accounting requirements relating to nonemployee share based payment transactions. The Company believes this update will not have an impact on its consolidated financial statements.

In August 2018, the FASB issued Accounting Standards Update 2018-13, Fair Value Measurement (“ASU 2018-13”) which both modifies and clarifies the disclosure requirements for fair value measurement. This update is effective for financial statements issued for fiscal years beginning after December 15, 2019, with early adoption permitted. The Company is currently assessing the impact the adoption of ASU 2018-13 will have on its consolidated financial statements.

In August 2018, the FASB issued Accounting Standards Update 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (“ASU 2018-14”) which both modifies and clarifies certain disclosure requirements for defined benefit pension and post-retirement plans. This update is effective for financial statements issued for fiscal years beginning after December 15, 2020, with early adoption permitted. The Company is currently assessing the impact the adoption of ASU 2018-14 will have on its consolidated financial statements.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 7

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 1. The Company and Summary of Significant Accounting Policies (continued)

 

Significant Accounting Policies

Revenue Recognition

The Company recognizes revenue when obligations under the terms of a contract with its customer are satisfied; generally this occurs with the transfer of control of the products sold. Transfer of control to the customer is based on the standardized shipping terms in the contract as this determines when the Company has the right to payment, the customer has legal title to the asset and the customer has the risks of ownership. Payment terms are defined in the contract and payment is typically due within three months after control has transferred to the customer. The contracts do not have a significant financing component.

The Company has elected to exclude value added, sales and other taxes it collects concurrent with revenue-producing activities from revenues.

The Company may arrange shipping and handling activities as part of the sale of its products. The Company has elected to account for shipping and handling activities that occur after the customer has obtained control of the product as a fulfillment cost rather than as an additional promised service.

The following is a description of the principal activities from which the Company generates its revenues. For a breakdown of revenues by product and geographic location see the Business Segment Information Note.

Pulp and Lumber Revenues

For European sales sent by truck or train from the mills directly to the customer, the contracted sales terms are such that control transfers once the truck or train leaves the mill. For orders sent by ocean freighter, the contract terms state that control transfers at the time the product passes the ships rail. For North American sales shipped by truck or train, the contracts state that control transfers once the truck or train has arrived at the customer’s specified location.

The transaction price is included in the sales contract and is net of customer discounts, rebates and other selling concessions.

The Company’s pulp sales are to tissue and paper producers and the Company’s lumber sales are to manufacturers and retailers. The Company’s sales to Europe and North America are direct to the customer. The Company’s pulp sales to overseas customers are primarily through third party sales agents and the Company’s lumber sales to overseas customers are either direct to the customer or through third party sales agents.

By-Product Revenues

Energy sales are to utility companies in Canada and Germany. Sales of energy are recognized as the electricity is consumed by the customer and is based on contractual usage rates and meter readings that measure electricity consumption.

Chemicals and wood residuals are sold into the European market direct to the customer and have shipping terms where control transfers once the chemicals or wood residuals are loaded onto the truck at the mill.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 8

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 2. Inventories

 

		September 30,				December 31,
		2018				2017
Raw materials		$	98,623			$	49,137
Finished goods			63,054				58,364
Spare parts and other			68,107				69,100
		$	229,784			$	176,601

Note 3. Accounts Payable and Other

 

		September 30,				December 31,
		2018				2017
Trade payables		$	46,529			$	36,151
Accrued expenses			81,502				67,528
Interest payable			9,025				10,093
Income tax payable			14,864				4,324
Legal cost award payable (Note 11(c))			6,951				—
Dividends payable			8,150				8,126
Other			6,763				7,335
		$	173,784			$	133,557

Note 4. Debt

 

		September 30,				December 31,
		2018				2017
2022 Senior Notes, principal amount, $100,000 (a)		$	98,849			$	394,565
2024 Senior Notes, principal amount, $250,000 (a)			245,965				245,398
2026 Senior Notes, principal amount, $300,000 (a)			294,395				293,773
Revolving credit facilities
€75.0 million (b)			—				—
C$40.0 million (c)			—				—
€70.0 million (d)			42,252				25,185
€5.0 million (e)			—				—
€25.0 million (f)			15,058				—
		$	696,519			$	958,921

As at September 30, 2018, the maturities of the principal portion of debt are as follows:

 

2018		$	—
2019			—
2020			15,058
2021			—
2022			142,252
Thereafter			550,000
		$	707,310

 

FORM 10-Q

QUARTERLY REPORT - PAGE 9

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 4. Debt (continued)

 

Certain of the Company’s debt instruments were issued under agreements which, among other things, may limit its ability and the ability of its subsidiaries to make certain payments, including dividends. These limitations are subject to specific exceptions. As at September 30, 2018, the Company is in compliance with the terms of its debt agreements.

 

(a)

On December 20, 2017, the Company issued $300,000 in aggregate principal amount of 5.50% senior notes which mature on January 15, 2026 (“2026 Senior Notes”). The 2026 Senior Notes were issued at a price of 100.00% of their principal amount. The net proceeds of the offering were $293,795, after deducting the underwriter’s discount and offering expenses.

In January 2018, the Company used the net proceeds, together with cash on hand, to redeem $300,000 in aggregate principal amount of 2022 Senior Notes (herein defined below). In connection with this redemption the Company recorded a loss on settlement of debt of $21,515 in the Interim Consolidated Statement of Operations. As at December 31, 2017, the total cash used to redeem the 2022 Senior Notes was classified as restricted cash and the carrying value of the 2022 Senior Notes was classified as a current liability in the Consolidated Balance Sheet.

On February 3, 2017, the Company issued $225,000 in aggregate principal amount of 6.50% senior notes which mature on February 1, 2024 (“2024 Senior Notes”) and on March 16, 2017, the Company issued an additional $25,000 in aggregate principal amount of its 2024 Senior Notes. The 2024 Senior Notes were issued at a price of 100.00% of their principal amount. The net proceeds of the offerings were $244,711, after deducting the underwriter’s discount and offering expenses. The net proceeds from the 2024 Senior Notes, together with cash on hand, were used to redeem $227,000 of remaining aggregate principal amount of outstanding senior notes due 2019, to finance the acquisition of a German sawmill and bio-mass power plant near Friesau Germany (the “Friesau Facility”) and for general working capital purposes. In connection with the redemption the Company recorded a loss on settlement of debt of $10,696 in the Interim Consolidated Statement of Operations.

On November 26, 2014, the Company issued $400,000 in aggregate principal amount of 7.75% senior notes which mature on December 1, 2022 (“2022 Senior Notes” and collectively with the 2024 Senior Notes and 2026 Senior Notes, the “Senior Notes”).

The Senior Notes are general unsecured senior obligations of the Company. They rank equal in right of payment with all existing and future unsecured senior indebtedness of the Company and are senior in right of payment to any current or future subordinated indebtedness of the Company. The Senior Notes are effectively junior in right of payment to all existing and future secured indebtedness, to the extent of the assets securing such indebtedness, and all indebtedness and liabilities of the Company’s subsidiaries.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 10

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 4. Debt (continued)

 

The Company may redeem all or a part of the 2026 Senior Notes, upon not less than 10 days’ or more than 60 days’ notice, at the redemption prices (expressed as percentages of principal amount) discussed below, plus accrued and unpaid interest to (but not including) the applicable redemption date. The Company may redeem all or a part of the 2024 Senior Notes or 2022 Senior Notes, upon not less than 30 days’ or more than 60 days’ notice, at the redemption prices (expressed as percentages of principal amount) discussed below, plus accrued and unpaid interest to (but not including) the applicable redemption date. The 2026 Senior Notes redemption prices are equal to 102.750% for the twelve month period beginning on January 15, 2021, 101.375% for the twelve month period beginning on January 15, 2022, and 100.000% beginning on January 15, 2023 and at any time thereafter. The 2024 Senior Notes redemption prices are equal to 103.250% for the twelve month period beginning on February 1, 2020, 101.625% for the twelve month period beginning on February 1, 2021, and 100.000% beginning on February 1, 2022 and at any time thereafter. The 2022 Senior Notes redemption prices are equal to 105.813% for the twelve month period beginning on December 1, 2017, 103.875% for the twelve month period beginning on December 1, 2018, 101.938% for the twelve month period beginning on December 1, 2019, and 100.000% beginning on December 1, 2020 and at any time thereafter.

 

(b)

A €75.0 million revolving credit facility at the Stendal mill that matures in October 2019. Borrowings under the facility are collateralized by the mill’s inventory and accounts receivable and bear interest at Euribor plus 3.50%. As at September 30, 2018, approximately €0.1 million ($151) of this facility was supporting bank guarantees leaving approximately €74.9 million ($86,669) available.

 

(c)

A C$40.0 million revolving credit facility at the Celgar mill that matures in July 2023. Borrowings under the facility are collateralized by the mill’s inventory, accounts receivable, general intangibles and capital assets and are restricted by a borrowing base calculated on the mill’s inventory and accounts receivable. When the borrowing capacity is less than 25% of the total facility the Canadian dollar denominated amounts bear interest at bankers acceptance plus 1.50% or Canadian prime and the U.S. dollar denominated amounts bear interest at LIBOR plus 1.50% or U.S. base. When the borrowing capacity is greater than or equal to 25% of the total facility, the respective bankers acceptance or LIBOR margins are reduced by 0.25% and the Canadian Prime or U.S. base margins are reduced by 0.125%. As at September 30, 2018, approximately C$1.7 million ($1,312) was supporting letters of credit and approximately C$38.3 million ($29,587) was available.

 

(d)

A €70.0 million joint revolving credit facility that matures in April 2022. The Rosenthal mill has full access to the available amount under the facility and the Company’s wholly owned subsidiary, Mercer Timber Products GmbH has access to a maximum of €45.0 million. Borrowings under the facility are collateralized by the borrowers’ inventory and accounts receivable and bear interest at Euribor plus 2.95%. As at September 30, 2018, approximately €36.5 million ($42,252) of this facility was drawn and accruing interest at a rate of 2.95% and approximately €11.4 million ($13,210) of this facility was supporting bank guarantees leaving approximately €22.1 million ($25,570) available.

 

(e)

A €5.0 million revolving credit facility at the Rosenthal mill that matures in December 2018. Borrowings under this facility bear interest at the rate of the three-month Euribor plus 2.50% and are secured by certain land at the Rosenthal mill. As at September 30, 2018 approximately €2.6 million ($2,954) of this facility was supporting bank guarantees leaving approximately €2.4 million ($2,834) available.

 

(f)

A €25.0 million revolving credit facility for the Company’s wholly owned German subsidiary, Mercer Holz GmbH (“Mercer Holz”), that matures in February 2020. Borrowings under this facility bear interest at Euribor plus 3.30% and are secured by Mercer Holz’s inventory and accounts receivable. As at September 30, 2018, approximately €13.0 million ($15,058) of this facility was drawn and accruing interest at a rate of 3.30% and approximately €0.3 million ($370) of this facility was supporting bank guarantees leaving approximately €11.7 million ($13,512) available.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 11

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 5. Pension and Other Post-Retirement Benefit Obligations

Defined Benefit Plans

Included in pension and other post-retirement benefit obligations are amounts related to the Company’s Celgar and Rosenthal mills. The largest component of these obligations is with respect to the Celgar mill which maintains a defined benefit pension plan and other post-retirement benefit plans for certain employees (the “Celgar Defined Benefit Plans”).

Pension benefits are based on employees’ earnings and years of service. The Celgar Defined Benefit Plans are funded by contributions from the Company based on actuarial estimates and statutory requirements.

The components of the net benefit costs relating to the Celgar Defined Benefit Plans for the three and nine month periods ended September 30, 2018 and 2017 were as follows:

 

		Three Months Ended September 30,
		2018								2017
		Pension				Other Post-     Retirement     Benefits				Pension				Other Post-     Retirement     Benefits
Service cost		$	26			$	115			$	25			$	151
Interest cost			312				175				346				245
Expected return on plan assets			(380	)			—				(520	)			—
Amortization of unrecognized items			226				(51	)			265				37
Net benefit costs		$	184			$	239			$	116			$	433
		Nine Months Ended September 30,
		2018								2017
		Pension				Other Post- Retirement Benefits				Pension				Other Post- Retirement Benefits
Service cost		$	78			$	352			$	71			$	435
Interest cost			952				535				998				706
Expected return on plan assets			(1,157	)			—				(1,499	)			—
Amortization of unrecognized items			690				(156	)			792				112
Net benefit costs		$	563			$	731			$	362			$	1,253

Defined Contribution Plan

Effective December 31, 2008, the Celgar Defined Benefit Plans were closed to new members. In addition, the defined benefit service accrual ceased on December 31, 2008, and members began to receive pension benefits, at a fixed contractual rate, under a new defined contribution plan effective January 1, 2009. During the three and nine month periods ended September 30, 2018, the Company made contributions of $215 and $650, respectively (2017 – $213 and $672), to this plan.

Multiemployer Plan

The Company participates in a multiemployer plan for the hourly-paid employees at the Celgar mill. The contributions to the plan are determined based on a percentage of pensionable earnings pursuant to a collective bargaining agreement. The Company has no current or future contribution obligations in excess of the contractual contributions. During the three and nine month periods ended September 30, 2018, the Company made contributions of $529 and $1,674, respectively (2017 – $493 and $1,539), to this plan.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 12

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 6. Income Taxes

The income tax provision attributable to income before provision for income taxes in the Interim Consolidated Statements of Operations differs from the amounts computed by applying the U.S. federal statutory income tax rate of 21% (2017 - 35%) for the three and nine month periods ended September 30, 2018 and 2017 as a result of the following:

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
U.S. federal statutory rate			21%				35%				21%				35%
U.S. federal statutory rate on income before provision for income taxes		$	(10,785	)		$	(9,722	)		$	(23,479	)		$	(17,732	)
Tax differential on foreign income			(4,265	)			2,701				(11,493	)			5,668
Effect of foreign earnings			(19,983	)			—				(28,440	)			—
Change in undistributed earnings			—				(450	)			—				(5,915	)
Valuation allowance			23,492				(1,823	)			45,510				(11,177	)
Tax benefit of partnership structure			965				1,246				3,242				3,692
Non-taxable foreign subsidies			716				608				2,204				1,717
True-up of prior year taxes			109				(169	)			(14,384	)			(279	)
Foreign exchange on valuation allowance			(30	)			1,241				(704	)			2,404
Foreign exchange on settlement of debt			—				—				—				550
Other			(401	)			(264	)			(680	)			(825	)
		$	(10,182	)		$	(6,632	)		$	(28,224	)		$	(21,897	)
Comprised of:
Current income tax provision		$	(8,868	)		$	(2,448	)		$	(20,894	)		$	(9,308	)
Deferred income tax provision			(1,314	)			(4,184	)			(7,330	)			(12,589	)
		$	(10,182	)		$	(6,632	)		$	(28,224	)		$	(21,897	)

The Act enacted on December 22, 2017 resulted in substantial changes including reducing the U.S. federal corporate income tax rate from 35% to 21% and requiring companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred. The Company applied the guidance in Staff Accounting Bulletin No. 118 and at December 31, 2017 calculated its best estimate of the impact of the Act in its year end income tax provision. Subsequent to the completion and filing of the 2017 tax return in the third quarter of 2018 it was determined that no significant measurement period adjustments to the provisional estimates recorded at December 31, 2017 were necessary.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 13

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 7. Net Income Per Common Share

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
Net income
Basic and diluted		$	41,176			$	21,143			$	83,580			$	28,765
Net income per common share
Basic		$	0.63			$	0.33			$	1.28			$	0.44
Diluted		$	0.63			$	0.32			$	1.27			$	0.44
Weighted average number of common shares outstanding:
Basic(1)			65,170,531				64,973,653				65,120,976				64,896,511
Effect of dilutive shares:
Performance Share Units (“PSUs”)			639,998				412,995				550,983				429,801
Restricted shares			7,510				7,268				20,328				17,447
Diluted			65,818,039				65,393,916				65,692,287				65,343,759

(1)	For the three and nine month periods ended September 30, 2018, the basic weighted average number of common shares outstanding excludes 31,130 restricted shares which have been issued, but have not vested as at September 30, 2018 (2017 – 43,635 restricted shares).

The calculation of diluted net income per common share does not assume the exercise of any instruments that would have an anti-dilutive effect on net income per common share. There were no anti-dilutive instruments for the three and nine month periods ended September 30, 2018 and 2017.

Note 8. Shareholders’ Equity

Dividends

During the nine month period ended September 30, 2018, the Company’s Board of Directors declared the following quarterly dividends:

 

Date Declared		Dividend Per Common Share				Amount
February 15, 2018		$	0.125			$	8,147
May 3, 2018			0.125				8,150
July 26, 2018			0.125				8,150
		$	0.375			$	24,447

In October 2018, the Company’s Board of Directors declared a quarterly dividend of $0.125 per common share. Payment of the dividend will be made on December 20, 2018 to all shareholders of record on December 13, 2018. Future dividends are subject to approval by the Board of Directors and may be adjusted as business and industry conditions warrant.

Stock Based Compensation

In June 2010, the Company adopted a stock incentive plan which provides for options, restricted stock rights, restricted shares, performance shares, PSUs and stock appreciation rights to be awarded to employees, consultants and non-employee directors. During the nine month period ended September 30, 2018, there were no issued and outstanding options, restricted stock rights, performance shares or stock appreciation rights. As at September 30, 2018, after factoring in all allocated shares, there remain approximately 2.8 million common shares available for grant.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 14

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 8. Shareholders’ Equity (continued)

 

PSUs

PSUs comprise rights to receive common shares at a future date that are contingent on the Company and the grantee achieving certain performance objectives. The performance objective period is generally three years. For the three and nine month periods ended September 30, 2018, the Company recognized an expense of $840 and $2,534, respectively related to PSUs (2017 – $646 and $1,201).

The following table summarizes PSU activity during the period:

 

		Number of PSUs
Outstanding as at January 1, 2018			1,867,158
Granted			652,548
Vested and issued			(153,243	)
Forfeited			(330,455	)
Outstanding as at September 30, 2018			2,036,008

Restricted Shares

Restricted shares generally vest at the end of one year. Expense recognized for the three and nine month periods ended September 30, 2018 was $130 and $388 (2017 – $128 and $324). As at September 30, 2018, the total remaining unrecognized compensation cost related to restricted shares amounted to approximately $347 which will be amortized over the remaining vesting periods.

The following table summarizes restricted share activity during the period:

 

		Number of Restricted Shares
Outstanding as at January 1, 2018			43,635
Granted			31,130
Vested			(43,635	)
Outstanding as at September 30, 2018			31,130

Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive loss are as follows:

 

		Foreign Currency Translation       Adjustment				Defined Benefit Pension and Other Post- Retirement Benefit Items				Unrealized Gains / Losses on Marketable Securities				Total
Balance as at January 1, 2018		$	(50,083	)		$	(8,900	)		$	(18	)		$	(59,001	)
Other comprehensive income (loss) before reclassifications			(41,503	)			(1,836	)			26				(43,313	)
Amounts reclassified from accumulated other comprehensive loss			—				534				—				534
Other comprehensive income (loss)			(41,503	)			(1,302	)			26				(42,779	)
Balance as at September 30, 2018		$	(91,586	)		$	(10,202	)		$	8			$	(101,780	)

 

FORM 10-Q

QUARTERLY REPORT - PAGE 15

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 9. Business Segment Information

The Company is managed based on the primary products it manufactures: pulp and wood products. Accordingly, the Company’s three pulp mills are aggregated into the pulp business segment and the Friesau Facility from its acquisition date of April 12, 2017 is a separate reportable business segment, wood products.

None of the income or loss items following operating income in the Company’s Interim Consolidated Statement of Operations are allocated to the segments, since those items are reviewed separately by management.

The following tables shows information by reportable business segments for the three and nine month periods ended September 30, 2018 and 2017:

 

Three Months Ended September 30, 2018		Pulp				Wood Products				Corporate and Other				Consolidated
Revenues from external customers		$	292,969			$	38,089			$	—			$	331,058
Operating income (loss)		$	68,794			$	(1,770	)		$	(3,678	)		$	63,346
Depreciation and amortization		$	20,802			$	2,395			$	113			$	23,310
Revenues by major products
Pulp		$	274,970			$	—			$	—			$	274,970
Lumber			—				34,270				—				34,270
Energy and chemicals			17,999				1,978				—				19,977
Wood residuals			—				1,841				—				1,841
Total revenues		$	292,969			$	38,089			$	—			$	331,058
Revenues by geographical markets
U.S.		$	7,148			$	10,857			$	—			$	18,005
Germany			132,233				14,771				—				147,004
China			44,981				—				—				44,981
Other countries			108,607				12,461				—				121,068
Total revenues		$	292,969			$	38,089			$	—			$	331,058
Three Months Ended September 30, 2017		Pulp				Wood Products				Corporate and Other				Consolidated
Revenues from external customers		$	272,358			$	33,140			$	—			$	305,498
Operating income (loss)		$	40,982			$	2,983			$	(2,303	)		$	41,662
Depreciation and amortization		$	21,149			$	1,419			$	105			$	22,673
Revenues by major products
Pulp		$	247,314			$	—			$	—			$	247,314
Lumber			—				27,851				—				27,851
Energy and chemicals			25,044				3,116				—				28,160
Wood residuals			—				2,173				—				2,173
Total revenues		$	272,358			$	33,140			$	—			$	305,498
Revenues by geographical markets
U.S.		$	12,276			$	3,458			$	—			$	15,734
Germany			112,267				18,676				—				130,943
China			60,604				—				—				60,604
Other countries			87,211				11,006				—				98,217
Total revenues		$	272,358			$	33,140			$	—			$	305,498

 

FORM 10-Q

QUARTERLY REPORT - PAGE 16

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 9. Business Segment Information (continued)

 

Nine Months Ended September 30, 2018		Pulp				Wood Products				Corporate and Other				Consolidated
Revenues from external customers		$	898,836			$	146,657			$	—			$	1,045,493
Operating income (loss)		$	179,824			$	5,534			$	(8,488	)		$	176,870
Depreciation and amortization		$	63,452			$	5,860			$	331			$	69,643
Total assets		$	1,343,035			$	133,215			$	65,046			$	1,541,296
Revenues by major products
Pulp		$	845,460			$	—			$	—			$	845,460
Lumber			—				131,429				—				131,429
Energy and chemicals			53,376				8,014				—				61,390
Wood residuals			—				7,214				—				7,214
Total revenues		$	898,836			$	146,657			$	—			$	1,045,493
Revenues by geographical markets
U.S.		$	18,451			$	42,511			$	—			$	60,962
Germany			373,176				58,631				—				431,807
China			204,818				—				—				204,818
Other countries			302,391				45,515				—				347,906
Total revenues		$	898,836			$	146,657			$	—			$	1,045,493
Nine Months Ended September 30, 2017		Pulp				Wood Products				Corporate and Other				Consolidated
Revenues from external customers		$	781,028			$	50,431			$	—			$	831,459
Operating income (loss)		$	104,411			$	3,064			$	(5,604	)		$	101,871
Depreciation and amortization		$	59,652			$	2,553			$	314			$	62,519
Revenues by major products
Pulp		$	712,810			$	—			$	—			$	712,810
Lumber			—				41,444				—				41,444
Energy and chemicals			68,218				5,761				—				73,979
Wood residuals			—				3,226				—				3,226
Total revenues		$	781,028			$	50,431			$	—			$	831,459
Revenues by geographical markets
U.S.		$	23,394			$	3,458			$	—			$	26,852
Germany			313,730				30,312				—				344,042
China			194,280				—				—				194,280
Other countries			249,624				16,661				—				266,285
Total revenues		$	781,028			$	50,431			$	—			$	831,459

Revenues between segments are accounted for at prices that approximate fair value. These include revenues from the sale of residual fiber from the wood products segment to the pulp segment for use in the pulp production process and from the sale of residual fuel from the pulp segment to the wood products segment for use in energy production. For the three and nine month periods ended September 30, 2018, the pulp segment sold $163 and $1,073, respectively of residual fuel to the wood products segment (2017 - $1,056 and $1,056) and the wood products segment sold $3,764 and $13,809, respectively of residual fiber to the pulp segment (2017 - $5,753 and $8,739).

As at December 31, 2017, the Company had total assets of $1,253,545 in the pulp segment, $116,320 in the wood products segment and $354,845 in corporate and other.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 17

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 10. Financial Instruments and Fair Value Measurement

Due to their short-term maturity, the carrying amounts of cash and cash equivalents, restricted cash, accounts receivable and accounts payable and other approximates their fair value.

The fair value of the senior notes classified as Level 2 was determined using quoted prices in a dealer market, or using recent market transactions.

The following tables present a summary of the Company’s outstanding financial instruments and their estimated fair values under the fair value hierarchy:

 

		Fair value measurements as at September 30, 2018 using:
Description		Level 1				Level 2				Level 3				Total
Revolving credit facilities		$	—			$	57,310			$	—			$	57,310
Senior notes			—				653,656				—				653,656
		$	—			$	710,966			$	—			$	710,966
		Fair value measurements as at December 31, 2017 using:
Description		Level 1				Level 2				Level 3				Total
Revolving credit facilities		$	—			$	25,185			$	—			$	25,185
Senior notes			—				989,125				—				989,125
		$	—			$	1,014,310			$	—			$	1,014,310

Credit Risk

The Company’s credit risk is primarily attributable to cash held in bank accounts and accounts receivable. The Company maintains cash balances in foreign financial institutions in excess of insured limits. The Company limits its credit exposure on cash held in bank accounts by periodically investing cash in excess of short-term operating requirements and debt obligations in low risk government bonds, or similar debt instruments. The Company’s credit risk associated with the sale of pulp, lumber and other wood residuals is managed through setting credit limits, the purchase of credit insurance and for certain customers a letter of credit is received prior to shipping the product. Concentrations of credit risk on the sale of pulp, lumber and other wood residuals are with customers and agents based primarily in Germany, China and Italy.

The carrying amount of cash and cash equivalents of $242,185 and accounts receivable of $193,648 recorded in the Interim Consolidated Balance Sheet, net of any allowances for losses, represents the Company’s maximum exposure to credit risk.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 18

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 11. Commitments and Contingencies

 

(a)

The Company is involved in legal actions and claims arising in the ordinary course of business. While the outcome of any legal actions and claims cannot be predicted with certainty, it is the opinion of management that the outcome of any such claims which are pending or threatened, either individually or on a combined basis, will not have a material adverse effect on the consolidated financial condition, results of operations or liquidity of the Company.

 

(b)

The Company is subject to regulations that require the handling and disposal of asbestos in a prescribed manner if a property undergoes a major renovation or demolition. Otherwise, the Company is not required to remove asbestos from its facilities. Generally asbestos is found on steam and condensate piping systems as well as certain cladding on buildings and in building insulation throughout older facilities. The Company’s obligation for the proper removal and disposal of asbestos products from the Company’s mills is a conditional asset retirement obligation. As a result of the longevity of the Company’s mills, due in part to the maintenance procedures and the fact that the Company does not have plans for major changes that require the removal of asbestos, the timing of the asbestos removal is indeterminate. As a result, the Company is currently unable to reasonably estimate the fair value of its asbestos removal and disposal obligation. The Company will recognize a liability in the period in which sufficient information is available to reasonably estimate its fair value.

 

(c)

In March 2018, the Company announced it had received the decision of the tribunal in respect of its previously initiated claim in January 2012 against the Government of Canada under the North American Free Trade Agreement (“NAFTA”). The basis of the claim was that the Celgar mill had received discriminatory treatment regarding its ability to purchase and sell energy compared to other pulp mills and entities that generate and sell electricity within the Province of British Columbia. The tribunal ruled that there was no violation of NAFTA and as is customary in these matters, the tribunal awarded costs to the Government of Canada of approximately $6,951.

Note 12. Subsequent Events

Santanol Group (“Santanol”)

On October 18, 2018, the Company acquired Santanol for approximately $33,000 cash. Santanol owns and leases existing Indian sandalwood plantations and a processing extraction plant in Australia. The acquisition presents the opportunity to expand the Company’s operations to include plantation harvesting as well as production of solid wood chemical extractives. The Company is in the process of evaluating the business combination accounting considerations, including the initial purchase price allocation.

Daishowa-Marubeni International Ltd. (“DMI”)

On October 3, 2018, the Company announced that it has entered into an agreement (the “Purchase Agreement”) to acquire all of the issued and outstanding shares of DMI for consideration of $359,200 cash, which includes a minimum working capital of $85,700 (the “Transaction”). The acquisition would result in 100% ownership of a bleached kraft pulp mill in Peace River, Alberta as well as 50% joint venture interest in a bleached kraft pulp mill in Quesnel, British Columbia. The acquisition would expand the Company’s presence in Asia and add northern bleached hardwood kraft to its product mix. The acquisition is subject to certain customary closing conditions. The Company currently expects the acquisition to close in the fourth quarter of 2018.

Pursuant to the Purchase Agreement, the completion of the Transaction is subject to customary closing conditions, including the receipt of requisite regulatory anti-trust approvals. The Company and the vendors may each terminate the agreement if closing of the Transaction does not occur as of the date that is within 120 days of the Purchase Agreement unless such date is extended in certain circumstances as provided in the Purchase Agreement.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 19

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MERCER INTERNATIONAL INC.

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(In thousands of U.S. dollars, except share and per share data)

 

Note 12. Subsequent Events (continued)

 

In connection with entering into the Purchase Agreement, on October 3, 2018, the Company accepted and entered into a Commitment Letter by and among the Company, Credit Suisse Loan Funding LLC and Credit Suisse AG (the “Commitment Letter”) dated September 30, 2018, pursuant to which Credit Suisse AG has agreed to provide the Company with a senior unsecured bridge facility in the principal amount of up to $350,000 in order to finance the purchase price under the Transaction. The facility is anticipated to be replaced or refinanced by the Company as provided in the Commitment Letter.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 20

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NON-GAAP FINANCIAL MEASURES

This quarterly report on Form 10-Q contains “non-GAAP financial measures”, that is, financial measures that either exclude or include amounts that are not excluded or included in the most directly comparable measure calculated and presented in accordance with the generally accepted accounting principles in the United States, referred to as “GAAP”. Specifically, we make use of the non-GAAP measure “Operating EBITDA”.

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

Operating EBITDA does not reflect the impact of a number of items that affect our net income (loss), including financing costs and the effect of derivative instruments. Operating EBITDA is not a measure of financial performance under GAAP, and should not be considered as an alternative to net income (loss) or income (loss) from operations as a measure of performance, or as an alternative to net cash from operating activities as a measure of liquidity. Operating EBITDA is an internal measure and therefore may not be comparable to other companies.

Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are that Operating EBITDA does not reflect: (i) our cash expenditures, or future requirements, for capital expenditures or contractual commitments; (ii) changes in, or cash requirements for, working capital needs; (iii) the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our outstanding debt; (iv) the impact of realized or marked to market changes in our derivative positions, which can be substantial; and (v) the impact of impairment charges against our investments or assets. Because of these limitations, Operating EBITDA should only be considered as a supplemental performance measure and should not be considered as a measure of liquidity or cash available to us to invest in the growth of our business. Because all companies do not calculate Operating EBITDA in the same manner, Operating EBITDA as calculated by us may differ from Operating EBITDA or EBITDA as calculated by other companies. We compensate for these limitations by using Operating EBITDA as a supplemental measure of our performance and by relying primarily on our GAAP financial statements.

 

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In this document: (i) unless the context otherwise requires, references to “we”, “our”, “us”, the “Company” or “Mercer” mean Mercer International Inc. and its subsidiaries; (ii) references to “Mercer Inc.” mean the Company excluding its subsidiaries; (iii) information is provided as of September 30, 2018, unless otherwise stated; (iv) our reporting currency is dollars and references to “€” mean euros and “C$” mean Canadian dollars; (v) “ADMTs” refers to air-dried metric tonnes; (vi) “MW” refers to megawatts and “MWh” refers to megawatt hours; (vii) “Mfbm” refers to thousand board feet of lumber and “MMfbm” mean million board feet of lumber; and (viii) our lumber metrics are converted from cubic meters to Mfbm using a conversion ratio of 1.6 cubic meters to 1 Mfbm, which is the ratio commonly used in the industry.

Due to rounding, numbers presented throughout this report may not add up precisely to totals we provide and percentages may not precisely reflect the absolute figure.

The following discussion and analysis of our results of operations and financial condition for the three and nine months ended September 30, 2018 should be read in conjunction with our interim consolidated financial statements and related notes included in this quarterly report, as well as our most recent annual report on Form 10-K for the fiscal year ended December 31, 2017 filed with the Securities and Exchange Commission, referred to as the “SEC”.

Results of Operations

General

We have two reportable operating segments, being the pulp business and, since April 2017, the wood products business.

Each segment offers primarily different products and requires different manufacturing processes, technology and sales and marketing.

Current Market Environment

In the third quarter of 2018, pulp prices in Europe and North America increased compared to prior quarter of 2018 due to continued steady demand. Pulp prices in China modestly declined compared to prior quarter of 2018 due to a weakening local Chinese currency and customer downtime.

Overall, our average pulp sales realizations were approximately 4% higher in the third quarter of 2018 compared to the prior quarter of 2018.

At the end of the current quarter, list prices in Europe, China and North America were approximately $1,230, $885 and $1,390 per ADMT, respectively.

Currently, the NBSK pulp market is generally balanced with world producer inventories at about 33 days’ supply. Looking forward, we believe the new pulp production capacity that has or is coming online will not materially adversely impact the market in the near term as a result of continued steady demand growth and expected supply limitations.

 

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In the fourth quarter of 2018, we have three days of scheduled maintenance downtime (which will reduce production by approximately 5,700 ADMTs) at our Stendal mill.

In the third quarter of 2018, European and U.S. lumber markets weakened with prices declining from multi-year highs. European lumber pricing declined due to an increase in beetle and storm damaged wood entering the market at lower prices. U.S. lumber pricing declined primarily due to increased supply as a response to record pricing, high customer inventory levels and a slower summer housing market. We currently expect lumber prices in the fourth quarter to stabilize at third quarter pricing levels.

 

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Summary Financial Highlights

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
		(in thousands, other than per share amounts)
Pulp segment revenues		$	292,969			$	272,358			$	898,836			$	781,028
Wood products segment revenues			38,089				33,140				146,657				50,431
Total revenues		$	331,058			$	305,498			$	1,045,493			$	831,459
Pulp segment operating income		$	68,794			$	40,982(	1)		$	179,824			$	104,411(	1)
Wood products segment operating income (loss)			(1,770)				2,983				5,534				3,064
Corporate and other operating loss			(3,678)				(2,303)				(8,488)				(5,604)
Total operating income		$	63,346			$	41,662			$	176,870			$	101,871
Pulp segment depreciation and amortization		$	20,802			$	21,149			$	63,452			$	59,652
Wood products segment depreciation and amortization			2,395				1,419				5,860				2,553
Corporate and other depreciation and amortization			113				105				331				314
Total depreciation and amortization		$	23,310			$	22,673			$	69,643			$	62,519
Operating EBITDA(2)		$	86,656			$	64,335(	1)		$	246,513			$	164,390(	1)
Loss on settlement of debt		$	-			$	-			$	21,515(	3)		$	10,696(	4)
Legal cost award		$	-			$	-			$	6,951			$	-
Provision for income taxes		$	10,182			$	6,632			$	28,224			$	21,897
Net income		$	41,176			$	21,143			$	83,580			$	28,765
Net income per common share
Basic		$	0.63			$	0.33			$	1.28			$	0.44
Diluted		$	0.63			$	0.32			$	1.27			$	0.44
Common shares outstanding at period end			65,202				65,017				65,202				65,017

 

(1)	Adjusted as a result of our adoption of Accounting Standards Update 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Post-Retirement Benefit Cost, in the current year. See Note 1 to our Interim Consolidated Financial Statements.

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

 

 

(3)	Redemption of 7.75% senior notes due 2022, referred to as the “2022 Senior Notes”.

(4)	Redemption of 7.00% senior notes due 2019, referred to as the “2019 Senior Notes”.

 

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Selected Production, Sales and Other Data

 

		Three Months Ended September 30,												Nine Months Ended September 30,
Pulp Segment		2018				2017								2018				2017
Pulp production (‘000 ADMTs)			363.5				388.1								1,037.7				1,124.5
Annual maintenance downtime (‘000 ADMTs)			14.4				10.2								69.9				42.7
Annual maintenance downtime (days)			14				10								51				32
Pulp sales (‘000 ADMTs)			319.9				383.8								1,025.2				1,147.7
Average NBSK pulp list prices in Europe ($/ADMT)(1)			1,230				903								1,176				869
Average NBSK pulp list prices in China ($/ADMT)(1)			887				670								902				662
Average NBSK pulp list prices in North America ($/ADMT)(1)			1,377				1,110								1,307				1,079
Average pulp sales realizations ($/ADMT)(2)			852				638								817				615
Energy production (‘000 MWh)			388.0				497.5								1,120.7				1,418.5
Energy sales (‘000 MWh)			141.0				224.8								401.3				620.9
Average energy sales realizations ($/MWh)			105				97								105				92
Wood Products Segment
Lumber production (MMfbm)			79.5				109.6								294.8				177.1
Lumber sales (MMfbm)			83.8				74.2								312.0				115.7
Average lumber sales realizations ($/Mfbm)			409				375								421				358
Energy production (‘000 MWh)			16.4				24.5								62.5				48.5
Energy sales (‘000 MWh)			16.4				24.5								62.5				48.5
Average energy sales realizations ($/MWh)			121				127								128				119
Average Spot Currency Exchange Rates
$ / €(3)			1.1629				1.1755								1.1945				1.1146
$ / C$(3)			0.7651				0.7984								0.7767				0.7659

 

(1)	Source: RISI pricing report.

(2)	Sales realizations after customer discounts, rebates and other selling concessions. Incorporates the effect of pulp price variations occurring between the order and shipment dates.

(3)	Average Federal Reserve Bank of New York Noon Buying Rates over the reporting period.

Consolidated - Three Months Ended September 30, 2018 Compared to Three Months Ended September 30, 2017

Total revenues for the three months ended September 30, 2018 increased by approximately 8% to $331.1 million from $305.5 million in the same quarter of 2017 primarily due to a 34% increase in pulp sales realizations partially offset by lower pulp sales volumes.

Costs and expenses in the current quarter were generally flat at $267.7 million compared to $263.8 million in the third quarter of 2017 as higher maintenance and per unit fiber costs were mostly offset by the impact of lower pulp sales volumes.

In the third quarter of 2018, operating depreciation and amortization increased to $23.2 million from $22.6 million in the same quarter of 2017 primarily due to capital improvements at our Friesau Facility.

Selling, general and administrative expenses increased to $14.5 million in the third quarter of 2018 from $12.3 million in the same quarter of 2017 primarily due to increased spending on business development activities.

 

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In the third quarter of 2018, our operating income increased by approximately 52% to $63.3 million from $41.7 million in the same quarter of 2017 as higher pulp and lumber sales realizations more than offset lower pulp and energy sales volumes and higher maintenance and per unit fiber costs.

Interest expense in the current quarter decreased to $11.7 million from $13.5 million in the same quarter of 2017 primarily as a result of a lower average interest rate on our outstanding senior notes.

During the third quarter of 2018, income tax expense increased to $10.2 million from $6.6 million in the same quarter of 2017 due to higher taxable income for our German pulp mills.

For the third quarter of 2018, our net income increased to $41.2 million, or $0.63 per share, from $21.1 million, or $0.33 per basic share and $0.32 per diluted share, in the same quarter of 2017.

In the third quarter of 2018, Operating EBITDA increased by approximately 35% to $86.7 million from $64.3 million in the same quarter of 2017 as higher pulp and lumber sales realizations more than offset lower pulp and energy sales volumes and higher maintenance and per unit fiber costs.

Operating Results by Business Segment

None of the income or loss items following operating income in our Interim Consolidated Statement of Operations are allocated to our segments, since those items are reviewed separately by management.

Pulp Segment - Three Months Ended September 30, 2018 Compared to Three Months Ended September 30, 2017

Selected Financial Information

 

		Three Months Ended September 30,
		2018				2017
		(in thousands)
Pulp revenues		$	274,970			$	247,314
Energy and chemical revenues		$	17,999			$	25,044
Depreciation and amortization		$	20,802			$	21,149
Operating income		$	68,794			$	40,982

Pulp revenues in the third quarter of 2018 increased by approximately 11% to $275.0 million from $247.3 million in the same quarter of 2017 due to higher sales realizations partially offset by lower sales volumes.

Energy and chemical revenues decreased by approximately 28% to $18.0 million in the third quarter of 2018 from $25.0 million in the same quarter of 2017 primarily due to maintenance work on one turbine at each of our Stendal and Celgar mills and the maintenance downtime at the Rosenthal mill. The turbine at the Stendal mill was taken offline for a scheduled major maintenance in April and did not resume service until late July 2018. The turbine at the Celgar mill was taken offline to complete maintenance work identified during the prior quarter maintenance shut and did not resume service until late August 2018.

 

FORM 10-Q

QUARTERLY REPORT - PAGE 26

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Pulp production decreased by approximately 6% to 363,543 ADMTs in the current quarter from 388,102 ADMTs in the same quarter of 2017. In the current quarter of 2018, we had 14 days (approximately 14,400 ADMTs) of annual maintenance downtime at our Rosenthal mill. In the third quarter of 2017, we had 10 days (approximately 10,200 ADMTs) of annual maintenance downtime at our Rosenthal mill. The Celgar and Stendal mills each had lower production in the current quarter due to minor maintenance issues.

We estimate that annual maintenance downtime in the current quarter adversely impacted our operating income by approximately $10.8 million, comprised of approximately $7.1 million in direct out-of-pocket expenses and the balance in reduced production. Many of our competitors that report their financial results using International Financial Reporting Standards (“IFRS”) capitalize their direct costs of maintenance downtime.

Pulp sales volumes decreased by approximately 17% to 319,850 ADMTs in the current quarter from 383,795 ADMTs in the same quarter of 2017 primarily due to the timing of shipments to China and lower production.

In the current quarter of 2018 list prices for NBSK pulp increased from the same quarter of 2017 largely as a result of overall steady demand. Average list prices for NBSK pulp in Europe were approximately $1,230 per ADMT in the third quarter of 2018 compared to approximately $903 per ADMT in the same quarter of 2017. Average list prices for NBSK pulp in China and North America were approximately $887 per ADMT and $1,377 per ADMT, respectively, in the current quarter compared to approximately $670 per ADMT and $1,110 per ADMT, respectively, in the same quarter of 2017. NBSK pulp prices are cyclical and are at or near record highs.

Average pulp sales realizations increased by approximately 34% to $852 per ADMT in the third quarter of 2018 from approximately $638 per ADMT in the same quarter of 2017 due to higher list prices.

As a result of the effect of a stronger dollar on our euro and Canadian dollar denominated costs and expenses and our dollar denominated cash and receivables held at our operations, we recorded a positive impact of approximately $9.1 million due to foreign exchange.

Costs and expenses for our pulp segment in the current quarter decreased by approximately 3% to $224.3 million from $232.4 million in the third quarter of 2017 primarily due to the impact of lower sales volumes mostly offset by higher maintenance and per unit fiber costs.

In the third quarter of 2018, pulp segment depreciation and amortization decreased to $20.8 million from $21.1 million in the same quarter of 2017 primarily due the positive impact of a stronger dollar on our euro and Canadian dollar denominated depreciation expense.

On average, in the current quarter overall per unit fiber costs increased by approximately 15% from the same quarter of 2017, primarily as a result of strong demand. In the current quarter, per unit fiber costs for our German mills were approximately 12% higher due to strong demand for imported wood from Scandinavian pulp mills. In the current quarter, per unit fiber costs for our Celgar mill were 24% higher due to a decrease in pulp log availability as sawmills continued to focus harvesting activities on building sawlog inventory and demand from coastal pulp mills in Celgar’s fiber procurement area. We currently expect modestly lower per unit fiber costs in the

 

FORM 10-Q

QUARTERLY REPORT - PAGE 27

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fourth quarter of 2018 as a result of improved harvesting conditions and the availability of storm damaged wood in Germany.

Transportation costs for our pulp segment decreased by approximately 19% to $15.8 million in the current quarter from $19.4 million in the same quarter of 2017 primarily due to lower sales volumes.

In the third quarter of 2018, pulp segment operating income increased by approximately 68% to $68.8 million from $41.0 million in the same quarter of 2017 as higher pulp sales realizations more than offset lower sales volumes and higher maintenance and per unit fiber costs.

Wood Products Segment - Three Months Ended September 30, 2018 Compared to Three Months Ended September 30, 2017

Selected Financial Information

 

		Three Months Ended September 30,
		2018				2017
		(in thousands)
Lumber revenues		$	34,270			$	27,851
Energy revenues		$	1,978			$	3,116
Wood residual revenues		$	1,841			$	2,173
Depreciation and amortization		$	2,395			$	1,419
Operating income (loss)		$	(1,770	)		$	2,983

In the third quarter of 2018 lumber revenues increased by approximately 23% to $34.3 million from $27.9 million due to higher sales volume and higher sales realizations. In the current quarter approximately 25% of sales volumes were in the U.S. market and substantially all remaining sales were in Europe.    

Energy and wood residual revenues decreased by approximately 28% to $3.8 million in the third quarter of 2018 from $5.3 million in the same quarter of 2017 due to lower sales volumes as a result of lower lumber production.

Production decreased by approximately 27% to 79.5 MMfbm of lumber in the current quarter from 109.6 MMfbm in the same quarter of 2017 primarily due to planned downtime to upgrade our large saw line and install an auto-grader in the existing planer mill. These capital investments are designed to increase production and improve efficiencies.

Average lumber sales realizations increased by approximately 9% to $409 per Mfbm in the third quarter of 2018 from approximately $375 per Mfbm in the same quarter of 2017 primarily due to increased sales to the U.S. where we realized higher sale prices.    

Fiber costs are approximately 80% of our cash production costs. In the current quarter per unit fiber costs increased by approximately 4% from the same quarter of 2017 primarily as a result of continued strong fiber demand. We currently expect modestly lower per unit fiber costs in the fourth quarter of 2018 as a result of improved harvesting conditions and the availability of storm damaged wood.

 

FORM 10-Q

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In the third quarter of 2018, wood products segment depreciation and amortization increased to $2.4 million from $1.4 million in the same quarter of 2017 primarily due to capital improvements at the mill.

Transportation costs for our wood products segment increased by approximately 59% to $4.6 million in the current quarter from $2.9 million in the same quarter of 2017 primarily due to higher sales to the U.S.

In the third quarter of 2018, our wood products segment had an operating loss of $1.8 million compared to operating income of $3.0 million in the same quarter of 2017 primarily due to higher maintenance costs, lower production due to downtime taken for capital projects and higher per unit fiber costs.

Consolidated - Nine Months Ended September 30, 2018 Compared to Nine Months Ended September 30, 2017

Total revenues for the nine months ended September 30, 2018 increased by approximately 26% to $1,045.5 million from $831.5 million in the same period of 2017 primarily due to a 33% increase in pulp sales realizations and the inclusion of an additional $96.2 million of wood products segment revenues partially offset by lower pulp sales volumes.

Costs and expenses in the nine months ended September 30, 2018 increased by approximately 19% to $868.6 million from $729.6 million in the same period of 2017 primarily due to additional costs and expenses from our wood products segment and higher maintenance and per unit fiber costs partially offset by lower pulp sales volumes.

In the nine months ended September 30, 2018 operating depreciation and amortization increased to $69.3 million from $62.2 million in the same period of 2017 primarily due to the negative impact of a weaker dollar on our euro denominated depreciation expense and the inclusion of depreciation for the wood products segment for the full period.

Selling, general and administrative expenses increased to $43.9 million in the nine months ended September 30, 2018 from $35.3 million in the same period of 2017 primarily due to the inclusion of our wood products segment for the full period, increased business development activities and the negative impact of a weaker dollar.

In the nine months ended September 30, 2018 operating income increased by approximately 74% to $176.9 million from $101.9 million in the same period of 2017 as higher pulp and lumber sales realizations more than offset lower pulp and energy sales volumes, higher maintenance and per unit fiber costs and the negative impact of a weaker dollar on our euro denominated costs and expenses.

In December 2017, we issued $300.0 million of 5.50% senior notes due 2026, referred to as the “2026 Senior Notes” and, on January 5, 2018, we utilized the proceeds, together with cash on hand, to redeem $300.0 million of our 2022 Senior Notes at a cost, including premium, of $317.4 million and recorded a loss on such redemption of $21.5 million (being $0.33 per share).

 

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Interest expense in the nine months ended September 30, 2018 decreased to $36.0 million from $40.7 million in the same period of 2017 primarily as a result of a lower average interest rate on our outstanding senior notes.

In the nine months ended September 30, 2018, we recognized an expense of $7.0 million, or $0.11 per share, in connection with the legal cost award made by the tribunal in our claim against the Government of Canada under the North American Free Trade Agreement, referred to as “NAFTA”.

During the nine months ended September 30, 2018 income tax expense increased to $28.2 million from $21.9 million in the same period of 2017 due to higher taxable income for our German pulp mills.

For the nine months ended September 30, 2018, after giving effect to costs of $28.5 million, or $0.44 per basic and $0.43 per diluted share, for the redemption of senior notes and the NAFTA legal cost award, our net income was $83.6 million or $1.28 per basic and $1.27 per diluted share. In the same period of 2017, we had net income of $28.8 million or $0.44 per share after giving effect to costs of $10.7 million for the redemption of senior notes in the same period of 2017.

In the nine months ended September 30, 2018, Operating EBITDA increased by approximately 50% to $246.5 million from $164.4 million in the same period of 2017 as higher pulp and lumber sales realizations more than offset lower pulp and energy sales volumes, higher maintenance and per unit fiber costs and the negative impact of a weaker dollar on our euro denominated costs and expenses.

Pulp Segment – Nine Months Ended September 30, 2018 Compared to Nine Months Ended September 30, 2017

Selected Financial Information

 

		Nine Months Ended September 30,
		2018				2017
		(in thousands)
Pulp revenues		$	845,460			$	712,810
Energy and chemical revenues		$	53,376			$	68,218
Depreciation and amortization		$	63,452			$	59,652
Operating income		$	179,824			$	104,411

Pulp revenues in the nine months ended September 30, 2018 increased by approximately 19% to $845.5 million from $712.8 million in the same period of 2017 due to higher sales realizations partially offset by lower sales volumes.

Energy and chemical revenues decreased by approximately 22% to $53.4 million in the nine months ended September 30, 2018 from $68.2 million in the same period of 2017 due to lower pulp production and maintenance work on one turbine at each of our Stendal and Celgar mills. The turbine at the Stendal mill was taken offline for a scheduled major maintenance in April 2018 and did not resume service until late July 2018. The turbine at the Celgar mill was taken offline

 

FORM 10-Q

QUARTERLY REPORT - PAGE 30

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to complete maintenance work identified during the second quarter shut and did not resume service until late August 2018.

Pulp production decreased by approximately 8% to 1,037,697 ADMTs in the nine months ended September 30, 2018 from 1,124,532 ADMTs in the same period of 2017. In the nine months ended September 30, 2018 we had annual maintenance downtime of 51 days (approximately 69,900 ADMTs) compared to 32 days (approximately 42,700 ADMTs) in the same period of 2017.

We estimate that annual maintenance downtime in the nine months ended September 30, 2018 adversely impacted our operating income by approximately $69.9 million, comprised of approximately $43.7 million in direct out-of-pocket expenses and the balance in reduced production. Many of our competitors that report their financial results using IFRS capitalize their direct costs of maintenance downtime.

Pulp sales volumes decreased by approximately 11% to 1,025,232 ADMTs in the nine months ended September 30, 2018 compared to 1,147,691 ADMTs in the same period of 2017 primarily due to lower production.

In the nine months ended September 30, 2018, list prices for NBSK pulp increased from the same period of 2017, largely as a result of continued steady demand. Average list prices for NBSK pulp in Europe were approximately $1,176 per ADMT in the nine months ended September 30, 2018, compared to approximately $869 per ADMT in the same period of 2017. Average list prices for NBSK pulp in China and North America were approximately $902 per ADMT and $1,307 per ADMT, respectively, in the nine months ended September 30, 2018, compared to approximately $662 per ADMT and $1,079 per ADMT, respectively, in the same period of 2017.

Average pulp sales realizations increased by approximately 33% to $817 per ADMT in the nine months ended September 30, 2018 from approximately $615 per ADMT in the same period of 2017 due to higher list prices.

In the nine months ended September 30, 2018, the dollar was weaker against the euro by about 7% which increased the dollar cost of our euro denominated costs and expenses and contributed to a negative foreign exchange impact on operating income of approximately $9.9 million when compared to the same period of the prior year.

Costs and expenses in the nine months ended September 30, 2018 increased by approximately 6% to $720.1 million from $677.7 million in the same period of 2017 primarily due to higher maintenance and per unit fiber costs and the negative impact of a weaker dollar on our euro denominated costs and expenses partially offset by lower sales volumes.

In the nine months ended September 30, 2018, depreciation and amortization increased to $63.5 million from $59.7 million in the same period of 2017 primarily due the negative impact of a weaker dollar on our euro denominated depreciation expense.

On average, in the nine months ended September 30, 2018 overall per unit fiber costs increased by approximately 20% from the same period of 2017 primarily as a result of increased demand from Scandinavian pulp mills in our European fiber procurement areas and demand from coastal pulp mills in Celgar’s fiber basket. Harvesting activities in both Germany and British Columbia

 

FORM 10-Q

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were impacted by short-term interruptions resulting from unseasonably wet winter conditions. Additionally, in British Columbia, there was lower pulp log availability as sawmills focused harvesting activities on rebuilding low sawlog inventories. We currently expect modestly lower per unit fiber costs in the fourth quarter of 2018 as a result of improved harvesting conditions and the availability of storm damaged wood in Germany.

Transportation costs for our pulp segment decreased by approximately 7% to $53.2 million in the nine months ended September 30, 2018 from $56.9 million in the same period of 2017 primarily due to lower sales volume.

In the nine months ended September 30, 2018 pulp segment operating income increased by approximately 72% to $179.8 million from $104.4 million in the same period of 2017 primarily due to higher pulp sales realizations partially offset by lower sales volumes, higher maintenance and per unit fiber costs and the negative impact of a weaker dollar relative to the euro.

Wood Products Segment - Nine Months Ended September 30, 2018 Compared to Nine Months Ended September 30, 2017

Selected Financial Information

 

		Nine Months Ended September 30,
		2018				2017
		(in thousands)
Lumber revenues		$	131,429			$	41,444
Energy revenues		$	8,014			$	5,761
Wood residual revenues		$	7,214			$	3,226
Depreciation and amortization		$	5,860			$	2,553
Operating income		$	5,534			$	3,064

We entered into the wood products business on April 12, 2017.

In the nine months ended September 30, 2018, lumber revenues were $131.4 million, of which approximately 25% of sales volumes were in the U.S. market and substantially all remaining sales were in Europe. European and U.S. lumber markets were generally strong with prices steady and near multi-year highs during the nine months ended September 30, 2018.

In the nine months ended September 30, 2018, lumber production increased to 294.8 MMfbm from 177.1 MMfbm in the same period of 2017.

In the nine months ended September 30, 2018, lumber sales volumes increased to 312.0 MMfbm from 115.7 MMfbm in the same period of 2017.

In the nine months ended September 30, 2018, average lumber sales realizations increased by approximately 18% to $421 per Mfbm from $358 per Mfbm in the same period of 2017.

In the nine months ended September 30, 2018, energy and other by-product revenues increased to $15.2 million from $9.0 million in the same period of 2017.

 

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Our fiber costs were approximately 80% of our cash production costs. Unseasonably wet winter weather conditions in Germany resulted in lower harvesting activities and high fiber costs in the nine months ended September 30, 2018 compared to the same period of 2017. We currently expect modestly lower per unit fiber costs in the fourth quarter of 2018 as a result of improved harvesting conditions and the availability of storm damaged wood.

In the nine months ended September 30, 2018 depreciation and amortization for our wood products segment increased to $5.9 million from $2.6 million in the same period of 2017 as a result of inclusion for the full period of 2018 and capital projects.

In the nine months ended September 30, 2018, our wood products segment operating income increased to $5.5 million from $3.1 million in the same period of 2017.

Liquidity and Capital Resources

Summary of Cash Flows

 

		Nine Months Ended September 30,
		2018				2017
		(in thousands)
Net cash from operating activities		$	172,891			$	103,257
Net cash used in investing activities			(71,788	)			(104,979	)
Net cash from financing activities			5,916	(1)			9,839
Effect of exchange rate changes on cash, cash equivalents and restricted cash			(8,133	)			10,329
Net increase in cash, cash equivalents and restricted cash		$	98,886			$	18,446

 

(1)	Excludes restricted cash of $317.4 million held to redeem $300.0 million of 2022 Senior Notes on January 5, 2018.

Cash Flows from Operating Activities. We operate in a cyclical industry and our operating cash flows vary accordingly. Our principal operating cash expenditures are for labor, fiber, chemicals and debt service. Working capital levels fluctuate throughout the year and are affected by maintenance downtime, changing sales patterns, seasonality and the timing of receivables and sales and the payment of payables and expenses.

Cash provided by operating activities was $172.9 million in the nine months ended September 30, 2018 compared to $103.3 million in the same period of 2017. An increase in accounts payable and accrued expenses provided cash of $44.1 million, including the legal cost award in our NAFTA claim, in the nine months ended September 30, 2018 compared to $41.9 million in the same period of 2017. An overall increase in inventories used cash of $60.1 million in the nine months ended September 30, 2018 compared to $9.9 million in the same period of 2017. A decrease in accounts receivable provided cash of $8.2 million in the nine months ended September 30, 2018 compared to an increase in accounts receivable using cash of $42.1 million in the same period of 2017.

Cash Flows from Investing Activities. Investing activities in the nine months ended September 30, 2018 used cash of $71.8 million primarily related to capital expenditures. In the current period of 2018, capital expenditures included large maintenance projects at our pulp mills, improvements to the digester at our Celgar mill, other capital improvements at our German pulp mills and upgrades to our planer mill and large saw line and the replacement of mobile

 

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equipment at our Friesau Facility. In the same period of 2017, investing activities used cash of $105.0 million, primarily related to the acquisition of our Friesau Facility for $61.6 million and capital expenditures of $42.2 million. In the nine months ended September 30, 2017, capital expenditures primarily related to a rail car acceptance system for logs and additional land for raw material storage at our Rosenthal mill, a pre-bleach press system upgrade and large maintenance projects at our Celgar mill and various other smaller projects.

Cash Flows from Financing Activities. In the nine months ended September 30, 2018, financing activities used cash of $311.5 million primarily in connection with the redemption of the 2022 Senior Notes, which used cash of $317.4 million. In the nine months ended September 30, 2018, advances of $34.3 million on our revolving credit facilities were primarily used to finance capital projects at the Friesau Facility and wood procurement activities. In the nine months ended September 30, 2018, we paid dividends of $24.4 million and $1.4 million of debt issuance costs related to the 2026 Senior Notes. In the same period of 2017, financing activities provided cash of $9.8 million, including an aggregate of $250.0 million from the issuance of our 6.50% senior notes due 2024, referred to as the “2024 Senior Notes”, which was primarily used to redeem our 2019 Senior Notes at a cost of $234.9 million. In the nine months ended September 30, 2017, debt issuance costs primarily for the 2024 Senior Notes used cash of $6.1 million, dividend payments used cash of $22.4 million and a scheduled payment in respect of our interest rate derivative used cash of $3.8 million. In the nine months ended September 30, 2017, we also drew $26.5 million on our €70.0 million revolving credit facility to partially finance the acquisition of the Friesau Facility and the build in working capital associated with its ramp up of operations.

Balance Sheet Data

The following table is a summary of selected financial information as at the dates indicated:

 

		September 30,				December 31,
		2018				2017
		(in thousands)
Financial Position
Cash and cash equivalents		$	242,185			$	143,299	(1)
Working capital		$	503,295			$	421,873
Total assets		$	1,541,296			$	1,407,271	(1)
Long-term liabilities		$	796,615			$	743,578
Total equity		$	569,942			$	550,666

 

(1)	Excludes restricted cash of $317.4 million held to redeem $300.0 million of 2022 Senior Notes on January 5, 2018.

As a result of the strengthening of the dollar versus the euro and Canadian dollar as at September 30, 2018, we recorded a net non-cash decrease in the carrying value of our net assets, consisting primarily of our fixed assets denominated in euros and Canadian dollars. This non-cash decrease of approximately $41.5 million does not affect our net income, Operating EBITDA or cash flows but is reflected in our other comprehensive loss and as a decrease to our total equity.

Sources and Uses of Funds

Our principal sources of funds are cash flows from operations and cash and cash equivalents on hand. Our principal operating uses of funds consist of operating expenses, capital expenditures and semi-annual interest payments on our outstanding senior notes.

 

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The following table sets out our total capital expenditures and interest expense for the periods indicated:

 

		Nine Months Ended September 30,
		2018				2017
		(in thousands)
Capital expenditures		$	71,583			$	42,249
Cash paid for interest expense(1)		$	35,287			$	29,311
Interest expense(2)		$	35,972			$	40,712

 

(1)	Amounts differ from interest expense which includes non-cash items. See supplemental disclosure of cash flow information from our Interim Consolidated Statement of Cash Flows included in this report.

(2)

Interest on our 2022 Senior Notes is paid semi-annually in June and December of each year. In January 2018, we redeemed $300.0 million of our 2022 Senior Notes. Interest on our 2024 Senior Notes is paid semi-annually in February and August of each year and interest on our 2026 Senior Notes is paid semi-annually in January and July of each year, commencing July 2018.

In the nine months ended September 30, 2018, we expended $24.4 million to pay quarterly dividends of $0.125 per common share.

As at September 30, 2018, our cash and cash equivalents increased to $242.2 million from $143.3 million at the end of 2017. As at September 30, 2018, we had approximately $158.2 million available under our revolving credit facilities.

On October 3, 2018, we entered into a share purchase agreement (the “Purchase Agreement”) to acquire all of the issued and outstanding shares of Daishowa-Marubeni International Ltd. (“DMI”) in consideration for a purchase price of $359.2 million, which includes minimum working capital of $85.7 million, and is subject to certain customary adjustments (the “Transaction”).

DMI owns 100% of a bleached kraft pulp mill in Peace River, Alberta and a 50% interest in the Cariboo Pulp and Paper Company joint venture, which operates a bleached kraft pulp mill in Quesnel, British Columbia.

We and the vendors have each made customary representations, warranties and covenants under the Purchase Agreement, including the covenant of the vendors to operate the business of DMI in the ordinary course, consistent with past practice, until closing of the Transaction. Pursuant to the Purchase Agreement, the completion of the Transaction is subject to customary closing conditions, including the receipt of requisite regulatory anti-trust approvals. We and the vendors may each terminate the agreement if closing of the Transaction does not occur as of the date that is within 120 days of the Purchase Agreement unless such date is extended in certain circumstances as provided in the Purchase Agreement.

We currently expect that closing of the Transaction will occur in the fourth quarter of 2018.

The foregoing description of the Purchase Agreement does not purport to be complete and is subject to, and qualified in its entirety by reference to, the full text of the Purchase Agreement.

In connection with entering into the Purchase Agreement, on October 3, 2018, we accepted and entered into a Commitment Letter by and among us, Credit Suisse Loan Funding LLC and Credit Suisse AG (the “Commitment Letter”) dated September 30, 2018, pursuant to which Credit Suisse AG has agreed to provide us with a senior unsecured bridge facility in the principal

 

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amount of up to $350.0 million in order to finance the purchase price under the Transaction. The facility is anticipated to be replaced or refinanced by us as provided in the Commitment Letter.

In October 2018, we acquired all of the Santanol Group for approximately $33.0 million. The Santanol Group owns and leases existing Indian sandalwood plantations and a processing extraction plant in Australia.

Based upon the current level of operations and our current expectations for future periods in light of the current economic environment, and in particular, current and expected pulp and lumber pricing and foreign exchange rates, we believe that cash flow from operations and available cash, together with available borrowings under our revolving credit facilities, will be adequate to finance the capital requirements for our business including the payment of our quarterly dividend during the next 12 months.

In the future we may make acquisitions of businesses or assets or commitments to additional capital projects. To achieve the long-term goals of expanding our assets and earnings, including through acquisitions, capital resources will be required. Depending on the size of a transaction, the capital resources that will be required can be substantial. The necessary resources will be generated from cash flow from operations, cash on hand, borrowing against our assets or the issuance of securities.

Debt Covenants

Certain of our long-term obligations contain various financial tests and covenants customary to these types of arrangements. See our annual report on Form 10-K for the fiscal year ended December 31, 2017.

As at September 30, 2018, we were in full compliance with all of the covenants of our indebtedness.

Off-Balance Sheet Arrangements

At September 30, 2018, we did not have any off-balance sheet arrangements (as defined in Item 303(a)(4)(ii) of Regulation S-K).

Contractual Obligations and Commitments

Other than as aforesaid with respect to the agreement to acquire DMI and the committed financing in respect thereof, there were no material changes outside the ordinary course to any of our material contractual obligations during the nine months ended September 30, 2018.

Foreign Currency

As a majority of our assets, liabilities and expenditures are held or denominated in euros or Canadian dollars, our consolidated financial results are subject to foreign currency exchange rate fluctuations.

We translate foreign denominated assets and liabilities into dollars at the rate of exchange on the balance sheet date. Equity accounts are translated using historical exchange rates. Unrealized gains

 

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or losses from these translations are recorded in other comprehensive loss and do not affect our net earnings.

As a result of the strengthening of the dollar versus the euro and Canadian dollar as at September 30, 2018, we recorded a net non-cash decrease of $41.5 million in the carrying value of our net assets, consisting primarily of our fixed assets denominated in euros and Canadian dollars. As a result, our accumulated other comprehensive loss increased to $101.8 million.

Based upon the exchange rate as at September 30, 2018, the dollar has strengthened by approximately 3% against the euro and the Canadian dollar since December 31, 2017. See “Quantitative and Qualitative Disclosures about Market Risk”.

Credit Rating

We and our senior notes are rated by Moody’s Investors Service, Inc., referred to as “Moody’s”. On October 24, 2018, Moody’s upgraded its current rating on our senior notes to Ba3 from B1 and upgraded our corporate rating to Ba2 from Ba3, maintaining its outlook as “stable”.

Factors that may affect our credit rating include changes in our operating performance and liquidity. Credit rating downgrades can adversely impact, among other things, future borrowing costs and access to capital markets.

Credit ratings are not recommendations to buy, sell or hold securities and may be subject to revision or withdrawal by the assigning rating organization. Each rating should be evaluated independently of any other rating.

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect both the amount and the timing of the recording of assets, liabilities, revenues, and expenses in the consolidated financial statements and accompanying note disclosures. Our management routinely makes judgments and estimates about the effects of matters that are inherently uncertain. As the number of variables and assumptions affecting the probable future resolution of the uncertainties increases, these judgments become even more subjective and complex.

Our significant accounting policies are disclosed in Note 1 to our audited annual financial statements included in our annual report on Form 10-K for the fiscal year ended December 31, 2017. While all of the significant accounting policies are important to the consolidated financial statements, some of these policies may be viewed as having a high degree of judgment. On an ongoing basis using currently available information, management reviews its estimates, including those related to accounting for, among other things, pension and other post-retirement benefit obligations, deferred income taxes (valuation allowance and permanent reinvestment), depreciation and amortization, future cash flows associated with impairment testing for long-lived assets, the allocation of the purchase price in a business combination to the assets acquired and liabilities assumed, legal liabilities and contingencies. Actual results could differ materially from these estimates, and changes in these estimates are recorded when known.

We have identified certain accounting policies that are the most important to the portrayal of our current financial condition and results of operations.

For information about both our significant and critical accounting policies, see our annual report on Form 10-K for the fiscal year ended December 31, 2017.

Cautionary Statement Regarding Forward-Looking Information

The statements in this report that are not reported financial results or other historical information are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, as amended.

Generally, forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, or words of similar meaning, or future or

 

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conditional verbs, such as “will”, “should”, “could”, or “may”, although not all forward-looking statements contain these identifying words. Forward-looking statements are based on expectations, forecasts and assumptions by our management and involve a number of risks, uncertainties and other factors, many of which are beyond our control, that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. These factors include, but are not limited to, the following:

 

●

our business is highly cyclical in nature;

 

●

a weakening of the global economy, including capital and credit markets, could adversely affect our business and financial results and have a material adverse effect on our liquidity and capital resources;

 

●

our level of indebtedness could negatively impact our financial condition, results of operations and liquidity;

 

●

cyclical fluctuations in the price and supply of our raw materials, particularly fiber, could adversely affect our business;

 

●

we face intense competition in our markets;

 

●

we are exposed to currency exchange rate fluctuations;

 

●

we are subject to extensive environmental regulation and we could incur substantial costs as a result of compliance with, violations of or liabilities under applicable environmental laws and regulations;

 

●

our proposed acquisition of DMI may result in additional risks and uncertainties in our business;

 

●

any failure to successfully integrate DMI with our business may adversely affect our results of operations;

 

●

the operations of DMI are subject to their own risks, which we may not be able to manage successfully;

 

●

our business is subject to risks associated with climate change and social and government responses thereto;

 

●

our operations require substantial capital and we may be unable to maintain adequate capital resources to provide for such capital requirements;

 

●

our acquisition of the Friesau Facility and other future acquisitions may result in additional risks and uncertainties in our business;

 

●

fluctuations in prices and demand for lumber could adversely affect our business;

 

●

adverse housing market conditions may increase the credit risk from customers of our Friesau Facility;

 

●

our Friesau Facility’s lumber products are vulnerable to declines in demand due to competing technologies or materials;

 

●

changes in credit ratings issued by nationally recognized statistical rating organizations could adversely affect our cost of financing and have an adverse effect on the market price of our securities;

 

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●

we rely on government grants and participate in German statutory energy programs;

 

●

we are subject to risks related to our employees;

 

●

we are dependent on key personnel;

 

●

we may experience material disruptions to our production;

 

●

if our long-lived assets become impaired, we may be required to record non-cash impairment charges that could have a material impact on our results of operations;

 

●

we may incur losses as a result of unforeseen or catastrophic events, including the emergence of a pandemic, terrorist attacks or natural disasters;

 

●

our insurance coverage may not be adequate;

 

●

we rely on third parties for transportation services;

 

●

we periodically use derivatives to manage certain risks which has caused significant fluctuations in our operating results;

 

●

failures or security breaches of our information technology systems could disrupt our operations and negatively impact our business;

 

●

the price of our common stock may be volatile;

 

●

a small number of our shareholders could significantly influence our business;

 

●

our international sales and operations are subject to applicable laws relating to trade, export controls and foreign corrupt practices, the violation of which could adversely affect our operations;

 

●

we are exposed to interest rate fluctuations; and

 

●

political uncertainty, the rise of populist political parties and an increase in trade protectionism could have a material adverse effect on global macro-economic activities and trade and adversely affect our business, results of operations and financial condition.

Given these uncertainties, you should not place undue reliance on our forward-looking statements. The forgoing review of important factors is not exhaustive or necessarily in order of importance and should be read in conjunction with the risks and assumptions including those set forth in reports and other documents we have filed with or furnished to the SEC, including in our annual report on Form 10-K for the fiscal year ended December 31, 2017. We advise you that these cautionary remarks expressly qualify in their entirety all forward-looking statements attributable to us or persons acting on our behalf. Unless required by law, we do not assume any obligation to update forward-looking statements based on unanticipated events or changed expectations. However, you should carefully review the reports and other documents we file from time to time with the SEC.

 

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Cyclical Nature of Business

Revenues

The pulp and lumber businesses are highly cyclical in nature and markets are characterized by periods of supply and demand imbalance, which in turn can materially affect prices. Pulp and lumber markets are sensitive to cyclical changes in the global economy, industry capacity and foreign exchange rates, all of which can have a significant influence on selling prices and our operating results. The length and magnitude of industry cycles have varied over time but generally reflect changes in macro-economic conditions and levels of industry capacity. Pulp and lumber are commodities that are generally available from other producers. Because commodity products have few distinguishing qualities from producer to producer, competition is generally based upon price, which is generally determined by supply relative to demand.

Industry capacity can fluctuate as changing industry conditions can influence producers to idle production capacity or permanently close mills. In addition, to avoid substantial cash costs in idling or closing a mill, some producers will choose to operate at a loss, sometimes even a cash loss, which can prolong weak pricing environments due to oversupply. Oversupply of our products can also result from producers introducing new capacity in response to favorable pricing trends. Certain integrated pulp and paper producers have the ability to discontinue paper production by idling their paper machines and selling their NBSK pulp production on the market, if market conditions, prices and trends warrant such actions.

Demand for each of pulp and lumber has historically been determined primarily by general global macro-economic conditions and has been closely tied to overall business activity. NBSK pulp prices have been and are likely to continue to be volatile and can fluctuate widely over time. Between 2008 and 2018, European list prices for NBSK pulp have fluctuated between a low of approximately $575 per ADMT in 2009 to a high of $1,230 per ADMT in 2018.

Our mills and operations voluntarily subject themselves to third-party certification as to compliance with internationally recognized, sustainable management standards because end use paper and lumber customers have shown an increased interest in understanding the origin of products they purchase. Demand for our products could be adversely affected if we, or our suppliers, are unable to achieve compliance, or are perceived by the public as failing to comply, with these standards or if our customers require compliance with alternate standards for which our operations are not certified.

A producer’s actual sales price realizations are list prices net of customer discounts, rebates and other selling concessions. Over the last three years, these have increased as producers compete for customers and sales.

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

 

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prices of our products decline, or if prices for our raw materials increase, or both, our results of operations and cash flows could be materially adversely affected.

Costs

Our production costs are influenced by the availability and cost of raw materials, energy and labor, and our plant efficiencies and productivity. Our main raw material is fiber in the form of wood chips, pulp logs and sawlogs. Wood chip, pulp log and sawlog costs are primarily affected by the supply of, and demand for, lumber and pulp, which are both highly cyclical. Higher fiber prices could affect producer profit margins if they are unable to pass along price increases to pulp and lumber customers or purchasers of surplus energy.

Currency

We have manufacturing operations in Germany and Canada. Most of the operating costs and expenses of our German mills are incurred in euros and those of our Celgar mill in Canadian dollars. However, the majority of our sales are in products quoted in dollars. Our results of operations and financial condition are reported in dollars. As a result, our costs generally benefit from a strengthening dollar but are adversely affected by a decrease in the value of the dollar relative to the euro and to the Canadian dollar. Such declines in the dollar relative to the euro and the Canadian dollar reduce our operating margins and the cash flow available to fund our operations and to service our debt. This could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

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ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risks from changes in interest rates and foreign currency exchange rates, particularly the exchange rates between the dollar and the euro and Canadian dollar. Changes in these rates may affect our results of operations and financial condition and, consequently, our fair value. We seek to manage these risks through internal risk management policies as well as the periodic use of derivatives.

For additional information, please refer to Part II, Item 7A. Quantitative and Qualitative Disclosures about Market Risk included in our annual report on Form 10-K for the fiscal year ended December 31, 2017.

 

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ITEM 4.

CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, referred to as the “Exchange Act”), as of the end of the period covered by this report. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. Based on such evaluation, our principal executive officer and principal financial officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act.

It should be noted that any system of controls is based in part upon certain assumptions designed to obtain reasonable (and not absolute) assurance as to its effectiveness and there can be no assurance that any design will succeed in achieving its stated goals.

Changes in Internal Controls

There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

ITEM 1.

LEGAL PROCEEDINGS

We are subject to routine litigation incidental to our business, including that which is described in our latest annual report on Form 10-K for the fiscal year ended December 31, 2017. We do not believe that the outcome of such litigation will have a material adverse effect on our business or financial condition.

 

ITEM 1A.

RISK FACTORS

There have been no material changes to the factors disclosed in Item 1A. Risk Factors in our annual report on Form 10-K for the fiscal year ended December 31, 2017, other than the addition of the risk factors in item (i), (ii), (iii) and (iv) below and the update in item (v) below:

 

(i)	Our proposed acquisition (the “Acquisition”) of DMI may result in additional risks and uncertainties in our business.

In order to grow our business, in October 2018, we entered into a share purchase agreement (the “Purchase Agreement”) to acquire all of the issued and outstanding shares of DMI for a purchase price of $359.2 million, which includes minimum working capital of $85.7 million and is subject to certain customary closing conditions. We currently expect the Acquisition to complete in the fourth quarter of 2018.

Although we performed diligence on DMI, in light of the circumstances of the Acquisition, an unavoidable level of risk remains regarding the actual condition of such business. We may not have ascertained the value or understood or identified all of the amount of the potential liabilities of DMI and its operations until we assume operating control of the assets and operations of DMI. Any such unascertained liabilities could individually or in the aggregate be material and materially adversely affect our operating results.

Furthermore, the costs of integrating acquired businesses (including potential restructuring charges associated with acquisitions, as well as other acquisition costs, such as financing and professional fees) could significantly impact our operating results. Acquisitions also frequently result in recording of goodwill and other intangible assets, which are subject to potential impairments in the future that could have a material adverse effect on our operating results.

 

(ii)	Any failure to successfully integrate DMI with our business may adversely affect our results of operations.

Our future performance will depend in part on whether we can integrate DMI with our operations in an effective and efficient manner. The acquisition of DMI is larger than the other acquisitions we have made. Integrating DMI with our operations will be a complex, time consuming and potentially expensive process and will be subject to various risks including:

 

●

diversion of management’s attention from our ongoing business;

 

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●

difficulty integrating the operations, including financial and accounting functions, sales and marketing procedures, technology and other corporate administrative functions of the combined operations;

 

●

increased operating costs;

 

●

exposure to substantial unanticipated liabilities;

 

●

difficulty in realizing projected synergies, efficiencies and cost savings;

 

●

difficulty maintaining relationships with present and potential customers, distributors and suppliers of DMI due to uncertainties regarding service, production quality and prices; and

 

●

problems retaining key employees of DMI.

While we believe that there are a number of opportunities to reduce operating costs, increase production and improve the financial results of DMI, we cannot fully evaluate the feasibility of our plans until we control DMI. We may not be able to achieve our planned synergies or effect operating improvements, cost reductions, capacity increases or improved price realizations in our expected time periods, if at all. In addition, some of the improvements that we hope to achieve depend upon capital expenditure projects that we plan to implement at the DMI mills. Such capital projects may not be completed in our expected time periods, if at all, may not achieve the results that we have estimated or may have a cost substantially in excess of our planned amounts.

All of the pulp produced by the DMI mills is currently sold by a third party agent which is a shareholder of DMI. We intend to take over a majority of its sales functions directly over time. Our internal sales staff and third party agents may not be able to sell such pulp production on terms as favorable as those achieved by the existing agent.

We expect to incur material costs in connection with the Acquisition, including the necessary financing therefor, related transactions and integration costs. In connection with the Acquisition, we have arranged committed debt financing of up to $350 million. Such financing, including any replacement therefor, will materially increase both our level of indebtedness and interest expense.

The actual costs we incur may substantially exceed our estimates and unanticipated expenses associated with such integration may arise. Furthermore, we may not be aware of all of the risks associated with the Acquisition and we may not have identified adverse information concerning the businesses we are acquiring. If the benefits of the Acquisition do not exceed all such costs, our financial results will be materially adversely affected.

We cannot guarantee that we will successfully integrate DMI with our operations. If we are unable to address any of these risks, our results of operations and financial condition could be materially adversely affected and the operations of DMI may not achieve the results or otherwise perform as expected.

 

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(iii)

The operations of DMI are subject to their own risks, which we may not be able to manage successfully.

The financial results of DMI are subject to many of the same factors that affect our financial condition and results of operations, including the cyclical nature of the pulp business, exposure to interest rate and currency exchange rate fluctuations, exposure to liability for environmental damage, the competitive nature of our markets and regulatory, legislative and judicial developments. The financial results of DMI could be materially adversely affected as a result of any of these or other related factors, which could have a material adverse effect on our results of operations and financial condition on a consolidated basis.

 

(iv)	Political uncertainty, the rise of populist political parties and an increase in trade protectionism could have a material adverse effect on global macro-economic activities and trade and adversely affect our business, results of operations and financial condition.

The current rise of populist political parties, economic nationalist sentiments and trade protectionism has led to increasing political uncertainty and unpredictability throughout the world. In 2016, the United Kingdom held a referendum at which the electorate voted to leave the Council of the European Union (the “EU”). It is unclear whether any other EU member states will hold such referendums, but such referendums could result in one or more other countries leaving the EU or in major reforms being made to the EU. The current U.S. presidential administration has imposed tariffs on various goods from various countries, including China and announced intentions to impose further more significant tariffs. These potential developments, market perceptions concerning these and related issues and the attendant regulatory uncertainty regarding, for example, the posture of governments with respect to international trade, could have a material adverse effect on global trade and economic growth which, in turn can adversely affect our business, results of operation and financial condition.

The rise of populist political parties in some countries and the dominance of single-party political power in other countries may also lead to increased trade barriers, trade protectionism and restrictions on trade. Increased trade protectionism could materially adversely affect our business. If the current continuing global recovery is undermined by downside risks and there is a prolonged economic downturn, governments, especially populist governments, may turn to trade barriers to protect their domestic industries against imports, thereby depressing demand. Changes in U.S. trade policy, such as the announcement of unilateral tariffs on imported products, have already triggered retaliatory actions from affected countries, resulting in “trade wars” that could have a material adverse effect on global trade and economic growth.

Protectionist developments, or the perception they may occur, may have a material adverse effect on global economic conditions, and may significantly reduce global trade. Increasing trade protectionism in the markets could increase the risks associated with exporting goods to such markets. These developments could have a material adverse effect on our business, results of operations and financial condition.

 

(v)	We rely on government grants and participate in German statutory energy programs.

Our German mills, including our pulp mills, sell surplus green energy at fixed prices or “tariffs” pursuant to the Renewable Energy Act.

 

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In 2014, in response to an investigation by the European Commission into whether portions of the Renewable Energy Act constituted unpermitted state aid, the German government amended the same, which amendments permitted our German mills to continue to sell green energy into the market at stipulated prices or “tariffs” and were exempted, as “existing installations”, from certain surcharges on the consumption of energy that they generate, or “auto-generation”.

The German government further amended the Renewable Energy Act effective January 1, 2017, so that funding for renewable energy is to be allocated through an auction system, primarily to create a competitive bidding process for new installations of wind, solar and biomass energy. Our Friesau Facility’s tariff expires in 2029. However, the amendments provide that existing pulp mills, including our German pulp mills, are ineligible for such auction process and instead will have their tariffs renewed upon expiry of their initial 20-year terms for a further 10-year period, based upon the price received in the last year prior to renewal regressing at a rate of 8% per annum. Our Rosenthal mill’s initial 20-year tariff expires on December 31, 2019 and our Stendal mill’s initial 20-year tariff expires on December 31, 2024. Such 10-year extensions for such pulp mills have been notified by the German government to the European Commission for review for compliance with applicable state aid rules. We have been advised by German governmental authorities that such extensions may not be permitted under EU rules. As a result, we cannot currently predict whether such promulgated amendments to the Renewable Energy Act will become effective. If they do not become effective, we cannot predict what further resulting amendments the German government may put into effect and their effect on our German mills’ sale or consumption of energy after the expiry of their current terms of December 31, 2019 for Rosenthal and December 31, 2024 for Stendal.

Our costs of energy for our pulp operations in Germany could increase in the event that the auto-generation surcharge exemption is removed or reduced in the future. Additionally, if the stipulated tariffs for energy sold by our German mills are reduced in the future or sales are on an auction or market basis, we cannot provide assurances that our energy sales in Germany will be as profitable. Any of the foregoing situations or any combination of them could have a material adverse effect on our results of operations.

 

ITEM 2.

UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

 

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None.

 

ITEM 4.

MINE SAFETY DISCLOSURES

None.

 

ITEM 5.

OTHER INFORMATION

None.

 

FORM 10-Q

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ITEM 6.

EXHIBITS

 

Exhibit No.		Description
31.1		Section 302 Certification of Chief Executive Officer
31.2		Section 302 Certification of Chief Financial Officer
32.1*		Section 906 Certification of Chief Executive Officer
32.2*		Section 906 Certification of Chief Financial Officer
101		The following financial statements from the Company’s Form 10-Q for the fiscal period ended September 30, 2018, formatted in XBRL: (i) Interim Consolidated Statements of Operations; (ii) Interim Consolidated Statements of Comprehensive Income; (iii) Interim Consolidated Balance Sheets; (iv) Interim Consolidated Statements of Cash Flows; and (v) Notes to Interim Consolidated Financial Statements.

 

* In accordance with Release No. 33-8212 of the SEC, these Certifications: (i) are “furnished” to the SEC and are not “filed” for the purposes of liability under the Securities Exchange Act of 1934, as amended; and (ii) are not to be subject to automatic incorporation by reference into any of the Company’s registration statements filed under the Securities Act of 1933, as amended, for the purposes of liability thereunder or any offering memorandum, unless the Company specifically incorporates them by reference therein.

 

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SIGNATURES

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

 

Date: October 25, 2018

 

FORM 10-Q

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