Annual Report For the Fiscal Year Ended December 31, 2003
Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K/A

AMENDMENT NO. 2

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

 

For the Fiscal Year Ended

  Commission File

December 31, 2003

  Number 1-5313

 

LOGO

 

Potlatch Corporation

 

A Delaware Corporation

  (IRS Employer Identification
    Number 82-0156045)

 

601 West Riverside Ave., Suite 1100

Spokane, Washington 99201

Telephone (509) 835-1500

 

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

 

Title of each class    Name of each exchange
on which registered

Common Stock

   New York Stock Exchange

($1 par value)

   Pacific Exchange
     Chicago Stock Exchange

 

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

Title of each class

 

None  

 

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    ü       No      

 

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

 

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

 

The aggregate market value of the voting stock held by non-affiliates of the registrant at June 30, 2003, was approximately $695.9 million, based on the closing price of $25.75, as reported on the New York Stock Exchange Composite Transactions.

 

The number of shares of common stock outstanding as of January 31, 2004: 28,956,554 shares of Common Stock, par value of $1 per share.

 

Documents Incorporated by Reference

 

Portions of the definitive proxy statement for the 2004 annual meeting of stockholders are incorporated by reference in Part III hereof.


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Introductory Note

 

On March 12, 2004, Potlatch Corporation filed its Annual Report on Form 10-K for its fiscal year ended December 31, 2003 (the 2003 Form 10-K). On December 6, 2004, Potlatch Corporation filed an amendment to the 2003 Form 10-K (the 2003 Form 10-K/A). Although the certifications required by Section 302 and Section 906 of the Sarbanes-Oxley Act of 2002 (the Section 302 and 906 Certifications) were included with the 2003 Form 10-K on the date it was originally filed, such certifications were inadvertently omitted from the amended 2003 Form 10-K/A. The Company hereby files this second amendment to the 2003 Form 10-K to include the Section 302 and Section 906 Certifications. No other information previously disclosed in the 2003 Form 10-K/A is being modified by this second amendment.

 

POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

Index to 2003 Form 10-K/A-2

 

          Page
Number


PART I     

ITEM 1.

   Business    2-8

ITEM 2.

   Properties    8-9

ITEM 3.

   Legal Proceedings    9

ITEM 4.

   Submission of Matters to a Vote of Security Holders    9

Executive Officers of the Registrant

   9-10
PART II     

ITEM 5.

   Market for Registrant’s Common Equity and Related Stockholder Matters    11

ITEM 6.

   Selected Financial Data    11

ITEM 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    11

ITEM 7A.

   Quantitative and Qualitative Disclosures About Market Risk    11

ITEM 8.

   Financial Statements and Supplementary Data    11

ITEM 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    12

ITEM 9A.

   Controls and Procedures    12
PART III     

ITEM 10.

   Directors and Executive Officers of the Registrant    13

ITEM 11.

   Executive Compensation    13

ITEM 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    13-14

ITEM 13.

   Certain Relationships and Related Transactions    14

ITEM 14.

   Principal Accounting Fees and Services    14
PART IV     

ITEM 15.

   Exhibits, Financial Statement Schedules and Reports on Form 8-K    15

SIGNATURES

   16-17

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES

   18

EXHIBIT INDEX

   75-78


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PART I

 

ITEM 1.    BUSINESS

 

General

 

Potlatch Corporation (herein referred to as the “company,” “us,” “we,” and “our”), incorporated in 1903, is a vertically integrated and diversified forest products company. We own and manage approximately 1.5 million acres of timberlands and operate 15 manufacturing facilities. Our timberlands and all of our manufacturing facilities are located within the continental United States, primarily in Arkansas, Idaho and Minnesota. We are engaged principally in growing and harvesting timber and converting wood fiber into two broad product lines: (a) commodity and specialty wood products; and (b) bleached pulp products. Our business is organized into four operating segments: Resource; Wood Products; Pulp and Paperboard; and Consumer Products.

 

Information relating to the amounts of net sales, operating income (loss) and identifiable assets attributable to each of our operating segments for 2001-2003 is included in Note 15 to the financial statements on pages 60-62 of this report.

 

Interested parties may access our periodic and current reports filed with the Securities and Exchange Commission, at no charge, by visiting our website: www.potlatchcorp.com. In the menu choose: Corporate Governance, then choose: SEC Filings. Information on our website is not part of this report.

 

Cautionary Statement Regarding Forward-Looking Information

 

This report contains, in addition to historical information, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including without limitation, statements regarding future revenues, costs, manufacturing output, capital expenditures and timber supply issues. These forward-looking statements reflect management’s current views regarding future events based on estimates and assumptions, and are therefore subject to known and unknown risks and uncertainties and are not guarantees of future performance. Our actual results of operations could differ materially from those expressed or implied by forward-looking statements contained in this report. Factors that could cause or contribute to such differences include, but are not limited to, changes in the United States and international economies; changes in exchange rates between the U.S. dollar and other currencies; changes in the level of construction activity; changes in worldwide demand for our products; changes in worldwide production and production capacity in the forest products industry; competitive pricing pressures for our products; unanticipated manufacturing disruptions; changes in general and industry-specific environmental laws and regulations; unforeseen environmental liabilities or expenditures; weather conditions; and changes in raw material, energy and other costs. Other potential factors that could affect our financial position or results of operations include, but are not limited to, our ability to extend or replace our current bank credit facility. Forward-looking statements contained in this report present management’s views only as of the date of this report. Except as required under applicable law, we do not intend to issue updates concerning any future revisions of management’s views to reflect events or circumstances occurring after the date of this report.

 

Raw Materials

 

The principal raw material used by our manufacturing operations is wood fiber, which is obtained from our own timberlands and purchased on the open market. During 2003, we harvested approximately 783,000 tons of sawtimber from our Arkansas timberlands and purchased an additional 1,330,000 tons. Of the 2,113,000 tons of sawtimber harvested and purchased, we sold 390,000 tons

 

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to third parties during the year. We also harvested 603,000 tons of pulpwood from our Arkansas timberlands and purchased an additional 944,000 tons. We sold 492,000 tons of the harvested and purchased pulpwood to third parties. In 2003 we harvested approximately 1,214,000 tons of sawtimber from our Idaho timberlands and purchased an additional 414,000 tons. From these amounts we sold 488,000 tons to third parties. We also harvested 245,000 tons of pulpwood from our timberlands in Idaho and purchased 54,000 tons. Of the 299,000 tons of pulpwood harvested and purchased, we sold 59,000 tons to third parties. We harvested from our Minnesota timberlands in 2003 approximately 366,000 tons of both sawtimber and logs used in the manufacture of oriented strand board (OSB). We also purchased an additional 2,312,000 tons of sawtimber and OSB logs and, from the total of 2,678,000 tons, sold 266,000 tons to third parties. We harvested 17,000 tons of pulpwood from our Minnesota timberlands, purchased 7,000 tons and sold all 24,000 tons to third parties.

 

In 2003, 500,022 tons of the total 5,061,000 tons of purchased sawtimber, OSB logs and pulpwood were acquired directly from timberlands owned by federal, state and local governments. Wood fiber acquisitions from these sources occur in market transactions at current market prices. We generally do not maintain long-term supply contracts for a significant volume of timber.

 

Our Resource segment supplies fiber from our timberlands, as well as some purchased fiber, to our manufacturing facilities. In addition, each of our manufacturing segments procures fiber directly from third parties for use in their respective operations. Our Wood Products segment purchases a portion of its sawtimber and OSB log needs; our Pulp and Paperboard segment purchases a substantial amount of wood chips and sawdust from third parties for use in the production of pulp; and the Consumer Products segment purchases several varieties of pulp, used in manufacturing tissue products in addition to pulp provided by our Pulp and Paperboard segment.

 

Timber from our lands, together with outside purchases, is presently adequate to support our manufacturing operations. For more than a decade, the timber supply from federal lands has been increasingly curtailed, largely due to environmental pressures that are expected to continue for the foreseeable future. This trend has had a favorable effect on earnings, but the long-term effect of this trend on earnings cannot be predicted.

 

The volume and value of timber that can be harvested from our lands may be affected by natural disasters such as fire, insect infestation, disease, ice storms, wind storms, floods and other weather conditions and causes. We assume substantially all risk of loss from fire and other hazards on the standing timber we own, as do most owners of timber tracts in the United States.

 

Resource Segment

 

The Resource segment manages our 1.5 million acres of timberlands located in Arkansas, Idaho and Minnesota, and a 17,000 acre hybrid poplar plantation in Oregon. The timberlands include a wide diversity of softwood and hardwood species. In Arkansas we own approximately 478,000 acres of timberlands. Primary species on these lands include southern yellow pine, red oak, white oak and other hardwoods. We own approximately 668,000 acres of timberlands in the northern portion of the state of Idaho. Primary species on these lands include grand fir, inland red cedar, Douglas fir, ponderosa pine, western larch, Engelmann spruce and western white pine. We own approximately 326,000 acres of timberlands in Minnesota, comprised primarily of aspen and red pine.

 

The segment sells wood fiber to our manufacturing facilities at market prices, as well as to third parties. We believe this maximizes our timber value and motivates management of our manufacturing segments to optimize operating efficiencies and identify profitable markets in which to compete. The Resource segment also provides some fiber procurement services to our manufacturing facilities and uses its expertise for regional timber and log acquisitions and sales.

 

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In addition to sales to our manufacturing facilities, which accounted for 62% of the segment’s net sales in 2003, the Resource segment sells wood fiber to a variety of paper and forest products companies situated within economically viable transportation distance of our timberlands. These customers range in size from small operators to multinational corporations. The segment competes with owners of timberlands that operate in areas adjacent to or near our timberlands, ranging from private owners of small tracts of land to some of the largest timberland companies in the United States. The segment competes principally on the basis of log quality, customer service and price.

 

The segment also sells land in the normal course of business, the majority of which is comprised of small parcels of timberland. We have intensified our efforts to manage our timberlands, which include sales of non-strategic land. Non-strategic land sales occur because the parcels do not fit our strategic plan or the parcels may be more valuable to others. As part of our strategic plan for timber, we also purchase new parcels.

 

We own 17,000 acres of agricultural land located in northeastern Oregon, which is being developed for the production of hybrid poplar. In 2001, these development efforts were re-directed from the production of an alternate source of wood chips for pulping, with a harvest rotation of seven years, to the production of high-quality solid wood logs, with a harvest rotation of approximately 11 years. Stable production of high quality logs is expected to begin in 2006. We intend to sell hardwood sawlogs from the plantation for conversion into plywood and lumber for furniture manufacturing and other non-structural uses. Our success in the project will depend upon our ability to market hybrid poplar as a cost-competitive, viable alternative to other regional hardwood species, mainly red alder, which are currently used to supply the raw material needs for these activities. The supply of available red alder is declining due to increased environmental restrictions in riparian areas throughout the Pacific Northwest. We believe our operation in Oregon and the positive characteristics of hybrid poplar logs produced there will enable us to compete effectively with producers of other hardwood species.

 

The amount of timber harvested in any year from company-owned lands varies according to the requirements of sustainable forest management. By continually improving silvicultural techniques and other forest management practices, we have been able to increase the volume of wood fiber produced per acre from our timberlands. Due to a low cost basis, on average, the cost of timber from company-owned land is substantially below the cost of timber obtained on the open market. Our overall results of operations are favorably affected to the extent we can supply wood fiber from our own timberlands, due to its low cost basis relative to wood fiber purchased on the open market. Our annual harvest plans and requirements of our manufacturing facilities influence the volume harvested from our own lands. We manage long-term harvest levels on our timberlands in a manner that assures sustainable yields consistent with the Sustainable Forestry Initiative® (SFI) Program. The SFI Program was initially developed by the American Forest & Paper Association (AF&PA) to establish principles and objectives for program participants committed to sustainable forestry and to provide measures by which the public can monitor and evaluate this commitment. The SFI Program is currently managed by an independent board (The Sustainable Forestry Board) whose members include representatives of the forest products industry as well as representatives of diversified stakeholders. As a member of AF&PA and a participant in the SFI Program, we have implemented the principles of the SFI Program: sustainable forestry, responsible practices, forest health and productivity, and protection of special sites. During 2002, an independent third party certified that management practices on our timberlands in Arkansas, Idaho and Minnesota met the requirements for SFI certification, as well as the International Organization on Standardization (ISO) 14001 standard for environmental management systems. In 2003, our management practices on all 1.5 million acres of timberlands were re-certified under these programs. Our Boardman, Oregon, hybrid poplar plantation was certified as “well managed” in 2001 under the Forest Stewardship Council® (FSC) standards, and was also certified under the ISO standard in 2003. The SFI and ISO certifications should aid us in marketing our products to customers who require that products they purchase for resale have such certification.

 

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In 2003, the Idaho region elected to be the sole industry participant in a certification system comparison project conducted by the Pinchot Institute, initiated to understand and document similarities and differences between the SFI and FSC standards of performance, the two primary North American programs. Participation required that our Idaho timberlands undergo third party audits under both programs. Results of the audits and comparisons will be made public and reported by the Pinchot Institute during the first half of 2004.

 

In late 2002, we reached agreement with the Trust for Public Lands to establish working-forest conservation easements to be held by the Idaho Department of Lands on up to 600,000 acres of our Idaho timberlands in phases over a period of years. The first phase was completed in the third quarter of 2003, covering over 2,700 acres. The next phase, comprising approximately 25,000 acres, is expected to be completed by September 2004. We expect that additional conservation easements will be developed and established in phases over the next several years. The easements require us to accept certain restrictions on the use of the property over which the easements are granted, such as a prohibition on converting land to residential or commercial uses. The easement terms permit the continued use of the land as a working, managed forest. Our compensation for accepting restrictions is based upon a fair-market appraisal of the rights foregone. In 2003 we recognized approximately $0.5 million in Idaho easement revenues. In December 2003, we announced another agreement with the Trust for Public Land to pursue conservation easements in the Brainerd Lakes region of Minnesota. The first phase of that agreement will involve easements on 4,700 acres of land to be held by the Minnesota Department of Natural Resources. Similar easements are being considered on other portions of our Minnesota timberlands and on our Arkansas timberlands.

 

Wood Products Segment

 

The Wood Products segment manufactures and markets oriented strand board (OSB), lumber, plywood and particleboard. These products are sold through our sales offices primarily to wholesalers for nationwide distribution.

 

To produce these solid wood products, we own and operate ten manufacturing facilities in Arkansas, Idaho and Minnesota. A description of these facilities is included under Item 2 of this report.

 

The forest products industry is highly competitive, and we compete with both smaller and substantially larger forest products companies as well as companies that manufacture substitutes for wood and wood fiber products. Although we are a relatively large OSB manufacturer, we believe we make less than ten percent of the OSB manufactured in the United States and less than seven percent of the OSB manufactured in North America. Our share of the market for lumber, plywood and particleboard is not significant compared to the total United States market for these products. We believe that competitiveness in this industry is largely based on individual mill efficiency and on the availability of competitively priced resources on a facility-by-facility basis, rather than the number of mills operated. This is due to the fact that it is generally not economical to transfer wood between or among facilities, which would permit a greater degree of specialization and operating efficiencies. Instead, each facility must utilize the raw materials that are available to it in a relatively limited geographic area. For these reasons, we believe we are able to compete effectively with companies that have a larger number of mills. In addition, we are developing and marketing a series of specialty OSB products designed to provide a radiant heat barrier, moisture resistance, insect resistance or fungal resistance. Initial market acceptance has been positive and we believe these value-added products will become a significant portion of our total OSB sales. We also have a number of other specialty products under development. We compete based on product quality, customer service and price.

 

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Pulp and Paperboard Segment

 

The Pulp and Paperboard segment produces and markets bleached paperboard and bleached pulp. A description of the facilities used to produce these products is included under Item 2 of this report.

 

As a result of management changes effective in January 2003, the former Pulp and Paper segment was split into two separate business segments, the Pulp and Paperboard segment and the Consumer Products segment. Beginning in the first quarter of 2003, results for these two segments were reported separately, with prior year amounts reclassified for comparative purposes.

 

We are a major producer of bleached paperboard in the United States, where we compete with at least six other domestic pulp and paperboard producers. We believe we are the third largest domestic producer of bleached paperboard, with approximately 10% of the available capacity. The business is capital intensive, which leads to high fixed costs. As a result, production generally continues as long as selling prices cover variable costs. As part of our ongoing effort to increase manufacturing efficiency and lower costs, we have allocated production of various paperboard products between our two facilities.

 

Bleached paperboard is a product used in the high-end segment of the packaging industry due to its strength, brightness and favorable printing and graphic surface features. Our bleached paperboard is processed by our customers into a variety of end products, including packaging for liquids and other food products, pharmaceuticals, toiletries and other consumable goods as well as paper cups and paper plates.

 

We also produce and sell bleached softwood market pulp, which is used as the basis for many paper products. We do not consider ourselves among the larger manufacturers of softwood market pulp in the United States.

 

We utilize various methods of sale and distribution for our paperboard and softwood pulp. In general, we sell paperboard to packaging converters domestically through sales offices located throughout the United States. The majority of our international paperboard sales are made in Japan, Korea, China and other Southeast Asian countries through sales representative offices. The majority of softwood market pulp sales are generally made through agents. Our principal methods of competing are product quality, customer service and price.

 

Consumer Products Segment

 

The Consumer Products segment produces and markets household tissue products. A description of the facilities used to produce these products is included under Item 2 of this report. During 2002 we began construction of a new 102-inch trim through-air-dried tissue machine next to our existing tissue converting facility in Las Vegas, Nevada. The machine began production in early 2004.

 

During 2003 our tissue products were manufactured on three machines at our Lewiston, Idaho, facility and then converted into packaged tissue products at three converting facilities in Lewiston, Las Vegas, and Benton Harbor, Michigan. Approximately 70% of the pulp we used to make our tissue products was obtained from our Lewiston pulp mill. The remaining portion was purchased on the open market and consisted primarily of hardwood pulp, which enhances the quality of certain grades of tissue.

 

We are a leading North American producer of private label household tissue products, and we produce most of the private label tissue products sold in grocery stores in the western U.S. We compete with at least three companies that are much larger than Potlatch who sell national brand

 

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tissue products, as well as commercial, industrial and private label products. We also compete with smaller companies who sell regional brand products, commercial, industrial and private label products. Our household tissue products (facial and bathroom tissues, paper towels and napkins) are packaged to order for retail chains, wholesalers and cooperative buying organizations throughout the United States and to a lesser extent Canada. These products are sold to consumers under our customers’ own brand names. We sell a majority of our tissue products to three national grocery store chains. We do not have long-term supply contracts with any of these national chains and the loss of one or more of these customers could potentially have a material adverse effect upon the operating results of the segment.

 

We sell tissue products to major retail outlets through brokers. Our principal methods of competing are product quality, customer service and price.

 

Discontinued Operations

 

On March 18, 2002, we announced that we had signed a definitive agreement with a domestic subsidiary of Sappi Limited for the sale of our Cloquet, Minnesota, pulp and printing papers facilities and certain associated assets for $485.5 million in cash, after closing adjustments. The sale was completed in May 2002. In conjunction with the sale, we closed our Brainerd, Minnesota, printing papers mill and exited the coated printing papers business. As a result, we recorded an after-tax charge of $149.8 million in the first quarter of 2002. The charge represented estimated costs associated with the write-down of the carrying value of the assets involved in the sale and the closure of the Brainerd facility, as well as other costs associated with our exit of the coated paper business. In December 2002, we recorded an additional after-tax charge of $14.6 million to adjust employee severance costs, the carrying value of the remaining Brainerd assets and other exit costs. We sold the Brainerd facility in February 2003 for $4.44 million in cash. In December 2003, we recorded an after-tax charge of $1.6 million for a continuing contractual obligation related to the Brainerd facility. Our exit from the printing papers business reflects a strategic realignment to focus on our natural resources, wood products and consumer tissue businesses, which we believe have the greatest potential for growth.

 

On June 3, 2002, we announced that we would close our Bradley hardwood sawmill in Warren, Arkansas, and exit the hardwood lumber business. An after-tax charge of $5.7 million was recorded for estimated asset write-down and closure costs. We sold the facility in August 2002. In December 2002, we reversed $1.6 million of the after-tax charge to reflect the actual costs incurred for the closure and sale.

 

Environment

 

Information regarding environmental matters is included under Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations on pages 35-36 of this report.

 

Employees

 

As of December 31, 2003, we had approximately 4,300 full time employees. The workforce consisted of approximately 1,000 salaried, 3,300 hourly and 100 temporary or part-time employees. As of December 31, 2003, approximately 54% of the workforce was covered under collective bargaining agreements.

 

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Hourly union labor contracts expiring in 2004 are set forth below.

 

Contract
Expiration
Date


    

Location


  

Union


  

Approximate

Number of

Hourly
Employees


May 31      Wood Products Division &
Resource Management Division
Lewiston, Idaho
   International Association of Machinists & Aerospace Workers    310
May 31      Idaho Pulp & Paperboard Division
No. 4 Power Boiler
Lewiston, Idaho
   International Association of Machinists & Aerospace Workers    50
June 30      Nursery Operations
Lewiston, Idaho
   Paper, Allied-Industrial, Chemical and Energy Workers International Union    10
October 14      Wood Products Division
Grand Rapids, Minnesota
   Paper, Allied-Industrial, Chemical and Energy Workers International Union    130

 

ITEM 2.    PROPERTIES

 

For information regarding our timberlands, see the discussion under the heading “Resource Segment” on pages 3-5 of this report. Our principal manufacturing facilities at December 31, 2003, which are all owned by us except as noted, together with their respective 2003 annual capacities and production, are as follows:

 

    

Capacity(A)


   Production(A)

Wood Products

         

Oriented Strand Board Mills(B):

         

Bemidji, Minnesota

   535,000 msf    529,000 msf

Cook, Minnesota

   440,000 msf    436,000 msf

Grand Rapids, Minnesota

   375,000 msf    372,000 msf

Sawmills:

         

Prescott, Arkansas

   225,000 mbf    222,000 mbf

Warren, Arkansas

   225,000 mbf    219,000 mbf

Lewiston, Idaho

   170,000 mbf    168,000 mbf

St. Maries, Idaho

   105,000 mbf    104,000 mbf

Bemidji, Minnesota

   95,000 mbf    94,000 mbf

Plywood Mill(B):

         

St. Maries, Idaho

   145,000 msf    141,000 msf

Particleboard Mill(C):

         

Post Falls, Idaho

   71,000 msf    71,000 msf

Pulp and Paperboard

         

Pulp Mills:

         

Cypress Bend, Arkansas

   270,000 tons    268,000 tons

Lewiston, Idaho

   530,000 tons    522,000 tons

Bleached Paperboard Mills:

         

Cypress Bend, Arkansas

   290,000 tons    289,000 tons

Lewiston, Idaho

   390,000 tons    371,000 tons

Consumer Products

         

Tissue Mills:

         

Lewiston, Idaho

   180,000 tons    176,000 tons

Las Vegas, Nevada(D)

   30,000 tons    — tons

Tissue Converting Facilities:

         

Lewiston, Idaho

   115,000 tons    112,000 tons

Benton Harbor, Michigan(E)

   10,000 tons    5,000 tons

Las Vegas, Nevada

   55,000 tons    46,000 tons

 

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(A)   msf stands for thousand square feet; mbf stands for thousand board feet.
(B)    3/8 inch panel thickness basis.
(C)    3/4 inch panel thickness basis.
(D)   Commenced operations in 2004. Capacity shown is rated capacity.
(E)   Operated as a leased facility. Lease expires in May 2005.

 

ITEM 3.    LEGAL PROCEEDINGS

 

In late January 2004, we voluntarily reported to the Minnesota Pollution Control Agency (MPCA) a potential air permit violation at our oriented strand board facility in Bemidji, Minnesota, relating to the non-operation of equipment used to control nitrous oxide emissions from a wood-fired boiler for a period of approximately 29 months. Corrective action has been taken, and we are cooperating with the MPCA in its investigation. As the investigation is ongoing, we have not been advised as to what action the MPCA may take. Because we discovered the violation, took corrective action and voluntarily reported it to the MPCA, we do not believe any potential penalty will be material.

 

Taking into consideration the possible consequences of the above described matter, we believe there is no pending or threatened litigation that would have a material adverse effect on our financial position, operations or liquidity.

 

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2003.

 

EXECUTIVE OFFICERS OF THE REGISTRANT

 

Information as of March 1, 2004, and for the past five years concerning the executive officers of the company is as follows:

 

L. Pendleton Siegel (age 61), first elected an officer in 1983, has served as Chairman of the Board and Chief Executive Officer since May 1999. From May 1994 to May 1999, he was President and Chief Operating Officer. Mr. Siegel was elected a director of the company effective November 1997. He is a member of the Finance Committee of the Board of Directors.

 

Richard L. Paulson (age 62), first elected an officer in 1992, has served as President and Chief Operating Officer since May 1999. From May 1996 through April 1999, he was Vice President, Minnesota Pulp and Paper Division. Mr. Paulson will retire from the company on March 31, 2004.

 

Richard K. Kelly (age 56), first elected an officer in 1999, has served as Vice President, Wood Products Division, since July 1999. From May 1999 to July 1999, he was Vice President, Western Wood Products Division. From April 1993 to May 1999, he was an appointed officer and served as Vice President, Western Wood Products Division.

 

Craig H. Nelson (age 47), first elected an officer in 1996, has served as Vice President, Consumer Products Division since January 2003. From May 2000 through December 2002 he was Vice President, Consumer Products and Paperboard Division. From May 1996 through May 2000, he was Vice President, Consumer Products Division.

 

John R. Olson (age 55), first elected an officer in 1999, has served as Vice President, Resource Management Division, since May 1999. From August 1998 through May 1999 he was an appointed officer serving as Vice President, Resource Management Division.

 

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Harry D. Seamans (age 50), first elected an officer in 2003, has served as Vice President, Pulp and Paperboard Division, since January 2003. From March 2000 through December 2002, he was Arkansas Pulp and Paperboard Mill Manager. From January 1993 through February 2000, he was an appointed officer serving as Vice President, Arkansas Pulp and Paperboard Division.

 

Gerald L. Zuehlke (age 55), first elected an officer in 1994, has served as Vice President, Finance, Chief Financial Officer and Treasurer since June 2000. From June 1994 to June 2000, he was Treasurer.

 

NOTE:   The aforementioned officers of the company are elected to hold office until the officer’s successor has been duly elected and has qualified or until the earlier of the officer’s death, resignation, retirement or removal by the board.

 

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PART II

 

ITEM  5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

The company’s common stock is traded on the New York, Chicago and Pacific Stock Exchanges. The quarterly and yearly high and low sales price per share of our common stock, as reported in the New York Stock Exchange Composite Transactions for 2003 and 2002 were as follows:

 

     2003

   2002

Quarter


   High

   Low

   High

   Low

1st

   $ 25.10    $ 18.75    $ 34.44    $ 27.85

2nd

     26.10      20.00      36.13      32.32

3rd

     31.90      25.35      33.69      28.35

4th

     35.95      29.90      29.88      23.88

Year

     35.95      18.75      36.13      23.88

 

In general, all holders of Potlatch common stock who own shares 48 consecutive calendar months or longer (“long-term holders”) are entitled to exercise four votes per share of stock so held, while stockholders who are not long-term holders are entitled to one vote per share. All stockholders are entitled to only one vote per share on matters arising under certain provisions of the company’s charter. There were approximately 1,800 common stockholders of record at December 31, 2003.

 

The board of directors annually reviews and approves the dividend policy. The board considers a variety of factors in determining whether to pay a dividend and the dividend rate, including, among other things, conditions in the forest products industry and the economy generally, dividend pay rates in the forest products industry, our operating results and cash flows, anticipated capital expenditures and compliance with the terms of any debt instrument that limit the payment of dividends on our common stock. The quarterly dividend rate is subject to change from time to time based on the board’s business judgment with respect to these and other relevant factors. Quarterly dividend payments per common share for 2003 and 2002 were:

 

Quarter


   2003

   2002

1st

   $ .15    $ .15

2nd

     .15      .15

3rd

     .15      .15

4th

     .15      .15
    

  

     $ .60    $ .60
    

  

 

ITEMS  6, 7, 7A and 8

 

The information called for by Items 6, 7, 7A and 8, inclusive, of Part II of this form is contained in the following sections of this report at the pages indicated below:

 

         Page
Number


ITEM 6

  Selected Financial Data    19

ITEM 7

  Management’s Discussion and Analysis of Financial Condition and Results of Operations    19-37

ITEM 7A

  Quantitative and Qualitative Disclosures About Market Risk    37-38

ITEM 8

  Financial Statements and Supplementary Data    39-74

 

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ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.

 

ITEM 9A.    CONTROLS AND PROCEDURES

 

Potlatch maintains “disclosure controls and procedures,” as such term is defined in Rule 13a-14(c) under the Securities and Exchange Act of 1934 (the Exchange Act), that are designed to ensure that information required to be disclosed by Potlatch in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to Potlatch’s management, including its Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating Potlatch’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, Potlatch’s management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

 

Subject to the limitations noted above, our management, with the participation of our CEO and CFO, has evaluated the effectiveness of the design and operation of Potlatch’s disclosure controls and procedures as of the end of the fiscal year covered by the annual report on this Form 10-K. Based on that evaluation, the CEO and CFO have concluded that Potlatch’s disclosure controls and procedures were effective to meet the objective for which they were designed.

 

There were no changes in Potlatch’s internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonable likely to materially affect, Potlatch’s internal control over financial reporting.

 

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PART III

 

ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

 

Information regarding the directors of our company is set forth under the heading “Board of Directors” on pages 7-8 of our definitive proxy statement, dated April 5, 2004, for the 2004 annual meeting of stockholders (the “2004 Proxy Statement”), which information is incorporated herein by reference. Information concerning Executive Officers is included in Part I of this report following Item 4. Information regarding reporting compliance with Section 16(a) for directors, officers or other parties is set forth under the heading “Section 16(a) Beneficial Ownership Reporting Compliance” on page 21 of the 2004 Proxy Statement and is incorporated herein by reference.

 

We have adopted a Corporate Conduct and Ethics Code that applies to all directors, officers and employees. You can find our Corporate Conduct and Ethics Code on our website by going to the following address: www.potlatchcorp.com, clicking on Corporate Governance, and then clicking on the link for Corporate Conduct and Ethics Code. We will post any amendments, as well as any waivers that are required to be disclosed by the rules of either the Securities and Exchange Commission or the New York Stock Exchange, on our website.

 

Our board of directors has adopted Corporate Governance Guidelines and charters for the board of directors’ Audit Committee, Executive Compensation and Personnel Policies Committee, and Nominating and Corporate Governance Committee. You can find these documents on our website by going to the following address: www.potlatchcorp.com, clicking on Corporate Governance, and then clicking on the appropriate link.

 

You can also obtain a printed copy of any of the materials referred to above by contacting us at the following address:

 

Potlatch Corporation

Attention: Mac Ryerse, Corporate Secretary

601 West Riverside Ave., Suite 1100

Spokane, Washington 99201

Telephone: (509) 835-1500

 

The Audit Committee of our board of directors is an “audit committee” for purposes of Section 3(a)(58) of the Securities Exchange Act of 1934. As of December 31, 2003, the members of that committee were: Boh A. Dickey (Chair), Jerome C. Knoll, and Gregory L. Quesnel. The board of directors has determined that Mr. Dickey is an “audit committee financial expert” and that he and all of our Audit Committee members are “independent” as defined under the applicable rules and regulations of the Securities and Exchange Commission.

 

ITEM 11.    EXECUTIVE COMPENSATION

 

Information set forth under the heading “Compensation of the Named Executive Officers” on pages 16-19 of the 2004 Proxy Statement is incorporated herein by reference.

 

ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

Information regarding any person or group known by us to be the beneficial owner of more than five percent of our common stock as well as the security ownership of management set forth under the heading “Stock Ownership” on pages 9-10 of the 2004 Proxy Statement is incorporated herein by reference.

 

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The following table provides certain information as of December 31, 2003, with respect to our equity compensation plans:

 

Plan category


   Number of
securities
to be issued
upon
exercise of
outstanding
options (1)


   Weighted
average
exercise
price of
outstanding
options


   Number of
securities
remaining
available for
future
issuance
under equity
compensation
plans


Equity compensation plans approved by security holders

   2,804,975    $ 36.19    569,042

Equity compensation plans not approved by security holders

   —        —      —  
    
  

  

Total

   2,804,975    $ 36.19    569,042
    
  

  

(1)   Includes 88,155 performance shares granted in December 2003, which amount includes the maximum number of shares that could be awarded under the grant, but does not include future dividend equivalents. Performance shares are not included in the weighted average exercise price calculation.

 

ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

Not applicable.

 

ITEM 14.    PRINCIPAL ACCOUNTING FEES AND SERVICES

 

Information set forth under the heading “Fees Paid to Independent Auditor in 2003 and 2002” on page 21 of the 2004 Proxy Statement is incorporated herein by reference.

 

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Table of Contents

PART IV

 

ITEM 15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

 

Consolidated Financial Statements

 

Our consolidated financial statements are listed in the Index to Consolidated Financial Statements and Schedules on page 18 of this Form 10-K.

 

Financial Statement Schedules

 

Our financial statement schedules are listed in the Index to Consolidated Financial Statements and Schedules on page 18 of this Form 10-K.

 

Reports on Form 8-K

 

A current report on Form 8-K was filed on October 24, 2003. Under Item 5, Other Events, we announced the election of Ruth Ann M. Gillis to our Board of Directors, effective November 1, 2003.

 

A current report on Form 8-K was filed on November 10, 2003. Under Item 5, Other Events, we reported the details of remarks made by company officials at an industry analysts meeting that day.

 

A current report on Form 8-K was filed on December 19, 2003. Under Item 5, Other Events, we announced the election of William L. Driscoll to our Board of Directors, effective January 1, 2004.

 

A current report on Form 8-K was filed on December 29, 2003. Under Item 5, Other Events, we disclosed that Richard L. Paulson, our President and Chief Operating Officer, will retire at the end of March 2004. We had previously disclosed that Mr. Paulson planned to retire at the end of 2003.

 

Exhibits

 

Exhibits are listed in the Exhibit Index on pages 75-78 of this Form 10-K.

 

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Table of Contents

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

POTLATCH CORPORATION

(Registrant)

By:

 

/s/    L. PENDLETON SIEGEL        


   

L. Pendleton Siegel

Chairman of the Board and
Chief Executive Officer

Date: January 18, 2005

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on January 18, 2005, by the following persons on behalf of the company in the capacities indicated.

 

By


 

/s/    L. PENDLETON SIEGEL        


L. Pendleton Siegel

  

Director and Chairman of the Board and Chief Executive Officer (Principal Executive Officer)

   

By


 

/s/    GERALD L. ZUEHLKE        


Gerald L. Zuehlke

  

Vice President, Finance
and Chief Financial Officer (Principal Financial Officer)

   

By


 

/s/    TERRY L. CARTER        


Terry L. Carter

  

Controller (Principal
Accounting Officer)

   

 

*


Boh A. Dickey

  

Director

   

 

*


Ruth Ann M. Gillis

  

Director

   

 

*


Jerome C. Knoll

  

Director

   

 

*


Lawrence S. Peiros

  

Director

   

 

16


Table of Contents

 

*


Michael T. Riordan

  

Director

   

 

*


Judith M. Runstad

  

Director

   

 

*


Dr. William T. Weyerhaeuser

  

Director

   

 

*By

 

/s/    MALCOLM A. RYERSE        


   

Malcolm A. Ryerse

(Attorney-in-fact)

 

17


Table of Contents

POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

Index to Consolidated Financial Statements and Schedules

 

The following documents are filed as part of this report:

 

     Page
Number


Selected Financial Data

   19

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   19-37

Consolidated Financial Statements:

    

Consolidated Statements of Operations and Comprehensive Income for the years ended December 31, 2003, 2002 and 2001

   39

Consolidated Balance Sheets at December 31, 2003 and 2002

   40

Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001

   41

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2003, 2002 and 2001

   42

Summary of Principal Accounting Policies

   43-46

Notes to Consolidated Financial Statements

   47-72

Independent Auditors’ Report

   73

Schedules:

    

II.    Valuation and Qualifying Accounts

   74

 

All other schedules are omitted because they are not required, not applicable or the required information is given in the consolidated financial statements.

 

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Table of Contents

Potlatch Corporation and Consolidated Subsidiaries

 

Selected Financial Data

(Dollars in thousands — except per-share amounts)

 

     2003

   2002

    2001

    2000

    1999

Net sales

   $ 1,506,634    $ 1,293,546     $ 1,278,864     $ 1,295,810     $ 1,347,533

Earnings (loss) from continuing operations

     53,221      (50,933 )     (56,566 )     (33,393 )     52,210

Net earnings (loss)

     50,727      (234,381 )     (79,445 )     (33,214 )     40,947

Net cash provided by (used for) operations

     163,402      (38,619 )     25,530       78,899       199,541

Working capital

     160,802      102,693       612,384       745,052       780,003

Current ratio

     1.9 to 1      1.4 to 1       2.1 to 1       2.7 to 1       3.1 to 1

Long-term debt (including current portion)

   $ 618,785    $ 638,252     $ 1,150,125     $ 801,874     $ 712,121

Stockholders’ equity

     470,851      430,791       707,304       813,236       921,039

Long-term debt to stockholders’ equity ratio

     1.3 to 1      1.5 to 1       1.6 to 1       .99 to 1       .77 to 1

Capital expenditures

   $ 79,686    $ 51,614     $ 42,679     $ 142,812     $ 65,277

Total assets

     1,597,377      1,624,817       2,488,439       2,542,445       2,446,500

Basic net earnings (loss) from continuing operations per common share

   $ 1.85    $ (1.79 )   $ (2.00 )   $ (1.17 )   $ 1.80

Basic net earnings (loss) per common share

     1.77      (8.23 )     (2.81 )     (1.16 )     1.41

Average common shares outstanding (in thousands)

     28,706      28,462       28,282       28,523       28,947

Diluted net earnings (loss) from continuing operations per common share

   $ 1.85    $ (1.79 )   $ (2.00 )   $ (1.17 )   $ 1.80

Diluted net earnings (loss) per common share

     1.77      (8.23 )     (2.81 )     (1.16 )     1.41

Average common shares outstanding, assuming dilution (in thousands)

     28,718      28,462       28,282       28,523       28,967

Cash dividends per common share

   $ .60    $ .60     $ 1.17     $ 1.74     $ 1.74
    

  


 


 


 

Certain amounts for 1999-2002 have been reclassified to conform to the 2003 presentation.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

We are a vertically integrated and diversified forest products company. We own approximately 1.5 million acres of timberland and operate 15 manufacturing facilities, located primarily in Arkansas, Idaho and Minnesota. Our business is organized into four segments:

 

    The Resource segment manages our timberlands, which supply logs, wood chips, pulpwood and other wood fiber to our manufacturing segments, as well as to third parties. Intersegment sales are based on prevailing market prices for wood fiber. In 2003, Resource segment net sales were $252.6 million, representing approximately 15% of our net sales, before elimination of intersegment sales. Intersegment sales were $157.2 million in 2003.

 

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Table of Contents
    The Wood Products segment manufactures oriented strand board (OSB), lumber, plywood and particleboard at ten mills located in Arkansas, Idaho and Minnesota. These products are largely commodity products, which are sold to wholesalers primarily for use in home building and other construction activity. Wood Products segment net sales were $683.1 million in 2003, representing approximately 40% of our net sales, before elimination of intersegment sales. Intersegment sales were $11.7 million in 2003.

 

    The Pulp and Paperboard segment manufactures bleached paperboard used in packaging and bleached softwood market pulp. The Pulp and Paperboard segment operates two pulp mills and two paperboard mills located in Arkansas and Idaho. Pulp and Paperboard segment net sales were $482.0 million in 2003, representing approximately 28% of our net sales, before elimination of intersegment sales. Intersegment sales were $43.0 million in 2003.

 

    The Consumer Products segment manufactures tissue products primarily sold on a private label basis by major grocery store chains. In 2003 the Consumer Products segment operated one tissue mill and three tissue converting facilities located in Idaho, Michigan and Nevada. The segment began operating a newly constructed tissue machine in Las Vegas in 2004. Consumer Products segment net sales were $300.9 million in 2003, representing approximately 17% of our net sales, before elimination of intersegment sales. Intersegment sales were $0.1 million in 2003.

 

As a result of management changes effective in January 2003, the former Pulp and Paper segment was split into two separate business segments, the Consumer Products segment and the Pulp and Paperboard segment. Because the restructuring of the former Pulp and Paper segment into the Pulp and Paperboard segment and the Consumer Products segment was the result of changes in management structure and did not affect the day-to-day operations of the facilities included in the business segments, there was no effect on our results of operations, liquidity and sources and uses of capital resources as a result of this change. Segment data for 2002 and 2001 related to the two segments has been reclassified to be comparative with 2003 data.

 

In May 2002, we exited our Printing Papers segment, which produced primarily high-grade coated printing papers and bleached hardwood market pulp. We sold our Cloquet, Minnesota, pulp and printing papers facilities and certain associated assets to a domestic subsidiary of Sappi Limited for $485.5 million in cash, after closing adjustments. We closed our Brainerd, Minnesota, printing papers mill at the same time. That facility was sold in February 2003 for $4.44 million in cash. The sale of the printing papers business reflects a strategic realignment to focus on our natural resources, wood products and consumer tissue businesses, which we believe have the greatest potential for growth.

 

In June 2002, we announced that we would close our Bradley hardwood mill in Warren, Arkansas, and exit the hardwood lumber business. We sold the facility in August 2002.

 

Our consolidated financial statements and this discussion reflect the classification of the Printing Papers segment and the Bradley hardwood mill as discontinued operations for all periods presented. Our discontinued operations generated operating losses of $1.3 million, $24.5 million and $37.5 million for the years ended December 31, 2003, 2002 and 2001, respectively. Cash flows generated by discontinued operations (without consideration of sale proceeds) totaled $(.8) million, $3.4 million and $42.9 million for the years ended December 31, 2003, 2002 and 2001, respectively. The majority of the proceeds from the sale of the discontinued operations were used to retire over $400 million of debt. The retirement of this debt has decreased our interest expense in subsequent years and improved the measurement of financial maintenance covenants contained in our bank credit facility.

 

Certifications with respect to this annual report on Form 10-K by our Chief Executive Officer and Chief Financial Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002, are included as exhibits to this report. Certifications as required by Section 906 of the Sarbanes-Oxley Act are furnished as exhibits to this report.

 

20


Table of Contents

Factors Influencing Our Results of Operations

 

Our operating results have been and will continue to be influenced by a variety of factors, including the cyclical nature of the forest products industry, competition, the efficiency and level of capacity utilization of our manufacturing operations, changes in our principal expenses, such as wood fiber and energy costs, changes in the production capacity of our manufacturing operations as a result of major capital spending projects, asset dispositions or acquisitions and other factors.

 

Our operating results generally reflect the cyclical pattern of the forest products industry. Historical prices for our products have been volatile, and we, like other manufacturers in the forest products industry, have limited direct influence over the timing and extent of price changes for our products. Product pricing is significantly affected by the relationship between supply and demand. Product supply is influenced primarily by fluctuations in available manufacturing capacity. Demand is affected by the state of the economy in general and a variety of other factors. The demand for our timber resources and wood products is affected by the level of new residential construction activity and, to a lesser extent, home repair and remodeling activity, which are subject to fluctuations due to changes in economic conditions, interest rates, population growth, weather conditions and other factors. The demand for most of our pulp and paperboard products is primarily affected by the general state of the global economy, and the economies in North America and east Asia in particular. The demand for our tissue products is primarily affected by the state of the United States economy.

 

The markets for our products are highly competitive and companies that have substantially greater financial resources than we do compete with us in each of our markets. Logs and other fiber from our timberlands, as well as our wood products, are subject to competition from timberland owners and wood products manufacturers in North America and to a lesser extent in South America, Europe, Australia and New Zealand. Our pulp-based products, other than tissue products, are globally-traded commodity products. Because our competitors in these segments are located throughout the world, variations in exchange rates between the U.S. dollar and other currencies can significantly affect our competitive position compared to our international competitors. As it is generally not profitable to sell tissue products overseas due to high transportation costs, currency exchange rates do not have a major effect on our ability to compete in our tissue business.

 

Tariffs, quotas or trade agreements can also affect the markets for our products, particularly our wood products. In 2002, the United States imposed duties on imported lumber from Canada in response to a dispute over the stumpage policies of some provincial governments. The two countries are currently in negotiations to resolve the dispute, and any resulting agreement could have a significant effect on lumber markets in the United States.

 

In addition, our industry is capital intensive, which leads to high fixed costs and generally results in continued production as long as prices are sufficient to cover variable costs. These conditions have contributed to substantial price competition, particularly during periods of reduced demand. Some of our competitors are currently lower-cost producers in some of the businesses in which we operate, and accordingly these competitors may be less adversely affected than we are by price decreases. During the fourth quarter of 2001, downtime was taken at most of the Wood Products segment facilities as well as the paperboard facility in Lewiston, Idaho, due to our inability to cover our variable costs. The fixed costs incurred at these facilities during the downtime were expensed as period costs. For all other periods presented, no downtime was taken for market related conditions.

 

Energy has become one of our most volatile operating expenses over the past several years. Substantial price increases commenced in late 2000 and continued in the first half of 2001, before moderating in the second half of 2001. These price increases were substantial and contributed to the net losses we incurred during these periods. Energy prices returned to more normal historical levels in

 

21


Table of Contents

2002, which had a favorable effect on our results compared to 2001. Energy costs rose overall in 2003, but the effects varied among our operating regions; from modest increases at our facilities in Idaho to a significant increase at our pulp and paperboard facility in Arkansas. In periods of high energy prices, market conditions may prevent us from passing higher energy costs on to our customers through price increases and therefore could adversely affect our operating results. We have taken steps through conservation and electrical production to reduce our exposure to the volatile spot market for energy. Our energy costs in future periods will depend principally on our ability to continue to produce internally a substantial portion of our electricity needs and on changes in market prices for natural gas. From time to time we have entered into derivative financial instruments as a hedge against potential increases in the cost of natural gas. We entered into several such contracts in the third quarter of 2003, covering a portion of our expected natural gas purchases from November 2003 through March 2004.

 

Another significant expense is the cost of wood fiber needed to supply our manufacturing facilities. The percentage of our wood fiber requirements supplied by our timberlands will fluctuate based on a variety of factors, including changes in our timber harvest levels, changes in our manufacturing capacity and changes in the amount of timber sales to third parties. The cost of various types of wood fiber that we purchase in the market has at times fluctuated greatly because of economic or industry conditions. Selling prices of our products have not always increased in response to wood fiber price increases nor have wood fiber prices always decreased in conjunction with declining product prices. On occasion, our results of operations have been and may in the future be adversely affected if we are unable to pass cost increases through to our customers.

 

The disparity between cost of fee timber harvested and the cost of timber purchased is caused by the fact that the capitalized costs to establish the fee timber were expended many years ago. The initial stand establishment costs remain as a capitalized asset until the timber reaches maturity (becomes merchantable), which typically ranges from 30 to 60 years. On-going forest management costs include recurring items necessary to the ownership and administration of timber producing property and are expensed as incurred. The cost of purchased timber is significantly higher due to the fact that the timber being purchased from third parties is mature and is sold by them at the current market price.

 

The cost of timber harvested in 2003, as noted in Footnote No. 5, decreased $1.4 million. Also disclosed in the footnote is the fact that cost of timber harvested increased $1.7 million in 2002 from 2001. Because timber growing is a long-term business, the variation between these amounts is not unusual. Such variances are caused by factors that we have discussed in the preceding paragraphs. The tons of timber purchased have increased progressively in each of the three years presented in the statements of operations. In addition, our harvested tons as well as the tons sold have increased progressively in each of the years presented. Harvested tons as a percentage of total harvested and purchased tons for each year was 37%, 37% and 40% for 2003, 2002 and 2001, respectively. The tons sold for each of the years presented compared to total harvested and purchased tons was 18%, 10% and 8%, respectively.

 

Finally, changes in our manufacturing capacity, primarily as a result of capital spending programs or asset dispositions, have significantly affected our results of operations in recent periods. In January 2001, we completed a modernization and expansion of our OSB mill in Cook, Minnesota, which resulted in an increase in annual production capacity from 250 million square feet to 440 million square feet. In May 2002, we sold a majority of our Printing Papers segment assets to a domestic subsidiary of Sappi Limited and exited the printing papers business. In August 2002, we sold a hardwood sawmill in Arkansas. We are currently in the process of bringing a newly constructed tissue machine in Las Vegas, Nevada, up to full operating production, which we anticipate will produce 30,000 tons a year. Each of these changes has affected or will affect our levels of net sales and expenses, as well as the

 

22


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comparability of our operating results from period to period. Additionally, the profitability of our manufacturing segments depends largely on our ability to operate our manufacturing facilities efficiently and at or near full capacity. Our operating results would be adversely affected if market demand does not justify operating at these levels or if our operations are inefficient or suffer significant interruption for any reason.

 

Critical Accounting Policies

 

Our principal accounting policies are discussed on pages 43-46 of this Form 10-K. The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported financial position and operating results of the company. Management believes the accounting policies discussed below represent the most complex, difficult and subjective judgments it makes in this regard.

 

Long-lived assets.    Due to the capital-intensive nature of our industry, a significant portion of our total assets are invested in our manufacturing facilities. Also, the cyclical patterns of our businesses cause cash flows to fluctuate by varying degrees from period to period. As a result, long-lived assets are a material component of our financial position with the potential for material change in valuation if assets are determined to be impaired. We account for impairment of long-lived assets in accordance with Financial Accounting Standards Board (FASB) Statement No. 144. The statement requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, as measured by its undiscounted estimated future cash flows. We use our operational budgets to estimate future cash flows. Budgets are inherently uncertain estimates of future performance due to the fact that all inputs (revenues, costs, capital spending) are subject to frequent change for many different reasons, as previously described in “Factors Affecting Our Results of Operations.” Because of the number of variables involved, the interrelationship between the variables and the long-term nature of the impairment measurement, sensitivity analysis of individual variables is not practical. Budget estimates are adjusted periodically to reflect changing business conditions and operations are reviewed, as appropriate, for impairment using the most current data available. To date, this process has not resulted in an impairment charge for any of our assets.

 

Timber and timberlands.    Timber and timberlands are recorded at cost, net of fee timber harvested. Expenditures for reforestation, including all costs related to stand establishment, such as site preparation, costs of seeds or seedlings and tree planting, are capitalized. Expenditures for forest management, consisting of regularly recurring items necessary to the ownership and administration of our timber and timberlands, are accounted for as current operating expense. Our cost of timber harvested is determined based on costs capitalized and the related current estimated recoverable timber volume. Recoverable volume does not include anticipated future growth, nor are anticipated future costs considered.

 

There are currently no authoritative accounting rules relating to costs to be capitalized in timber and timberlands. We have used relevant portions of current accounting rules, industry practices and our judgment in determining costs to be capitalized or expensed. Alternate interpretations and judgments could significantly affect the amounts capitalized. Additionally, models and observations used to estimate the current recoverable timber volume on our lands are subject to judgments that could significantly affect volume estimates. For example, harvest cycles can vary by geographic region and by species of timber, weather patterns can affect harvest cycles, environmental regulations and restrictions may limit the company’s ability to harvest certain timberlands, changes in harvest plans may occur, or scientific advancement in seedlings and timber growing technology may affect future harvests. Different assumptions for either the cost or volume estimates, or both, could have a

 

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significant effect upon amounts reported in our statements of operations and financial condition. Because of the number of variables involved and the interrelationship between the variables, sensitivity analysis of individual variables is not practical.

 

Restructuring charges and discontinued operations.    In 2001 and 2002 we recorded charges for the reduction of the hourly workforce at a manufacturing site and a reduction of our salaried workforce, respectively. In May 2002 we completed the sale of a majority of the assets of our Printing Papers segment and closed a printing papers facility in Brainerd, Minnesota, which was subsequently sold in 2003. In July 2002 we closed a hardwood lumber mill in Warren, Arkansas. The mill was sold in August 2002. In January 2004, we recorded a charge for a workforce reduction in our Consumer Products segment. These events required us to record estimates of liabilities for employee benefits, environmental clean-up and other costs at the time of the event. In making these judgments, we considered contractual obligations, legal liabilities, and possible incremental costs incurred as a result of restructuring plans to determine the liability. Our estimated liabilities could differ materially from actual costs incurred, with resulting adjustments to future period earnings for any differences, although no material adjustments to our original estimates have occurred for the events described above.

 

Environmental liabilities.    We record accruals for estimated environmental liabilities in accordance with FASB Statement No. 5, “Accounting for Commitments and Contingencies.” These estimates reflect assumptions and judgments as to the probable nature, magnitude and timing of required investigation, remediation and monitoring activities. In making these estimates, we consider, among other things, the activities we have conducted at any particular site, information obtained through consultation with applicable regulatory authorities and third-parties, and our historical experience at other sites that are judged to be comparable. We must also consider the likelihood of changes in governmental regulations, advancements in environmental technologies, and changing legal standards regarding liability. Due to the numerous uncertainties and variables associated with these assumptions and judgments, and changes in governmental regulations and environmental technologies, our accruals are subject to substantial uncertainties and our actual costs could be materially more or less than the estimated amounts.

 

Pension and postretirement benefits.    The determination of pension plan expense and the requirements for funding our pension plans are based on a number of actuarial assumptions. Two critical assumptions are the discount rate applied to pension plan obligations and the rate of return on plan assets. For other postretirement employee benefit (OPEB) plans, which provide certain health care and life insurance benefits to qualified retired employees, critical assumptions in determining OPEB expense are the discount rate applied to benefit obligations and the assumed health care cost trend rates used in the calculation of benefit obligations.

 

Note 12 to the consolidated financial statements on pages 54-58 includes information for the three years ending December 31, 2003, on the components of pension and OPEB expense, the underlying actuarial assumptions used to calculate periodic expense, as well as the funded status for our pension and OPEB plans as of December 31, 2003 and 2002.

 

The discount rate used in the determination of pension benefit obligations and pension expense is based on high-quality fixed income investment interest rates. At December 31, 2003, we calculated obligations using a 6.25% discount rate. The discount rates used at December 31, 2002 and 2001 were 6.75% and 7.25%, respectively. To determine the expected long-term rate of return on pension assets, we employ a process that analyzes historical long-term returns for various investment categories, as measured by appropriate indexes. These indexes are weighted based upon the extent to which plan assets are invested in the particular categories in arriving at our determination of a composite expected return. The assumed long-term rate of return on pension plan assets used for 2003-2001 was 9.5%.

 

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An increase in the discount rate or the expected return on plan assets, all other assumptions remaining the same, would reduce pension plan expense, and conversely, a decrease in either of these measures would increase plan expense. Total periodic pension plan income in 2003 was $13.3 million. As an indication of the sensitivity that pension expense has to the discount rate assumption, a 25 basis point change in the discount rate would affect plan expense by approximately $1.1 million. A 25 basis point change in the assumption for expected return on plan assets would affect plan expense by approximately $1.5 million. The actual rates on plan assets may vary significantly from the assumption used because of unanticipated changes in financial markets.

 

We estimate contributions to our pension plan will total approximately $1.2 million in 2004.

 

For our OPEB plans, expense for 2003 was $23.4 million. The discount rate used to calculate OPEB obligations was also 6.25% at December 31, 2003, and 6.75% and 7.25% at December 31, 2002 and 2001, respectively. The assumed health care cost trend rate used to calculate OPEB obligations and expense at December 31, 2003, was an 8% increase over the previous year, declining 1 percent annually to a long-term ultimate rate increase assumption of 6% for 2005 and thereafter.

 

As an indication of the sensitivity that OPEB expense has to the discount rate assumption, a 25 basis point change in the discount rate would affect plan expense by approximately $0.8 million. A 1% change in the assumption for health care cost trend rates would have affected 2003 plan expense by approximately $2.2-$2.6 million and the total postretirement obligation by approximately $27.0-$31.7 million, as reported in Note 12 on page 56. The actual rates of health care cost increases may vary significantly from the assumption used because of unanticipated changes in health care costs.

 

Periodic pension and OPEB expense are included in “Materials, labor and other operating expenses” and “Selling, general and administrative expenses” in the statements of operations. The expense is allocated to all business segments. Depending upon the funded status of the different plans, either a long-term asset or long-term liability is recorded for plans with overfunding or underfunding, respectively. Any unfunded accumulated pension benefit obligation in excess of recorded liabilities is accounted for in “Accumulated other comprehensive income”. See Note 12 on pages 54-58 for related balance sheet effects at December 31, 2003 and 2002.

 

Results of Operations

 

At December 31, 2003, our business was organized into four reporting segments: Resource, Wood Products, Pulp and Paperboard, and Consumer Products. Sales or transfers between segments are recorded as intersegment sales based on prevailing market prices. Because of the role of the Resource segment in supplying our manufacturing segments with wood fiber, intersegment sales represent a significant portion of the Resource segment’s total net sales. Beginning in the third quarter of 2002, our Wood Products and Pulp and Paperboard operating segments transitioned to a fiber procurement system where a portion of third party fiber purchases are made directly by each of these segments, rather than from the Resource segment. The change in the fiber procurement system has significantly decreased intersegment sales for the Resource segment and decreased fiber purchases by the Resource segment from third parties. Intersegment sales represent a substantially smaller percentage of net sales for our other segments.

 

In the period-to-period discussion of our results of operations below, when we discuss our consolidated net sales, contributions by each of the segments to our net sales are reported after elimination of intersegment sales. In the “Discussion of Business Segments” sections below, each segment’s net sales are set forth before elimination of intersegment sales.

 

As a result of our decisions to sell our Printing Papers segment assets and to close the Bradley hardwood sawmill, those operations have been classified as “discontinued operations” and “assets held for sale” in the financial statements. The discussion below addresses our continuing businesses.

 

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In addition, revenues and expenses associated with land sales have been reclassified, for periods prior to the second quarter of 2003, in our Statements of Operations and Comprehensive Income. Revenues from land sales are included in net sales and the associated expense is included in materials, labor and other operating expenses. Revenues and expenses from land sales are attributable to the Resource segment. The change in presentation reflects the Resource segment’s ongoing commitment to actively manage timberland assets, which includes land sales for higher and better use, in the normal course of business.

 

Certain 2002 and 2001 period amounts presented below have been conformed to 2003 classifications.

 

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

 

Net sales of $1.51 billion for the year ended December 31, 2003, increased 16% compared to net sales of $1.29 billion recorded for the year ended December 31, 2002. Increases in net sales for the Wood Products, Pulp and Paperboard and Resource segments of $174.7 million, $30.5 million and $22.7 million, respectively, more than offset a decline in Consumer Products net sales of $14.8 million. Increased shipments and higher sales prices for oriented strand board in the Wood Products segment and increased paperboard shipments in the Pulp and Paperboard segment were largely responsible for the increase in net sales for these segments. The Resource segment net sales were higher due to increased land sales. A decrease in sales prices resulted in lower net sales for the Consumer Products segment.

 

Expenses for depreciation, amortization and cost of fee timber harvested were $104.9 million for the year ended December 31, 2003, a decrease of $10.6 million from the prior year total of $115.5 million. For the year ended December 31, 2003, the major components constituting the decrease in depreciation, amortization and the cost of fee timber harvested were permit timber harvest expenses, which were $4.4 million lower in Minnesota than in the prior year, and depreciation expense, which was $1.7 million lower in the Pulp and Paperboard segment and $1.5 million lower in the Wood Products segment than in the prior year.

 

For the year ended December 31, 2003, materials, labor and other operating expenses rose to $1.21 billion from $1.10 billion in 2002. The higher costs were due primarily to increased shipments of oriented strand board, lumber and paperboard.

 

Selling, general and administrative expenses were $80.3 million for the year ended December 31, 2003, a slight increase from 2002’s expense of $79.6 million, due principally to a small increase in selling expense.

 

The following items were included in the “Restructuring charges” line in the Statements of Operations:

 

    In 2002, we recorded a $9.0 million pre-tax charge for costs associated with the elimination of 106 salaried production and administrative positions. As of December 31, 2002, 82 employees had been terminated, three had assumed other positions within the company as a result of job openings and 21 were scheduled for termination in the first half of 2003. We recorded $3.8 million against the accrued liability associated with the charge at December 31, 2002.

 

   

In the first quarter of 2003, we recorded additional charges totaling $0.2 million for costs related to terminated employees whose service had been retained beyond the initial 60-day period following the announced job eliminations in 2002. In December 2003 we recorded a $0.7 million credit, reflecting final cost determinations for pension and medical benefits. As of December 31, 2003, 100 employees had been terminated, four had assumed other positions

 

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within the company as a result of job openings and two individuals have been retained until mid-2004. As of December 31, 2003, all costs except immaterial amounts related to the retained individuals, associated with the salaried workforce reduction had been incurred.

 

Interest expense, net of capitalized interest, was $48.2 million for the year ended December 31, 2003, substantially less compared to the $59.9 million charged against income in 2002. The decrease reflected the lower amount of average debt outstanding during 2003 compared to 2002, as well as an increase of $2.6 million in the amount of interest capitalized from major construction projects in 2003 versus 2002. Capitalized interest increased in 2003 due to the construction of a new tissue machine in Las Vegas, Nevada. It is our policy to calculate and capitalize interest on capital projects with a construction period exceeding 12 months, based upon management’s discretion in consideration of the requirements of SFAS No. 34, “Capitalization of Interest Costs.” These factors were partially offset by increased interest expense of approximately $2.8 million on our $100 million credit sensitive debentures, due to the lowering of our debt ratings in January 2003.

 

In 2003, we incurred one-time, pre-tax costs of $0.2 million for the early retirement of $3.1 million of outstanding debt. During 2002, we incurred one-time, pre-tax costs of $15.4 million related to our early retirement of over $380 million of outstanding debt.

 

Interest income for the year ended December 31, 2003, was $14.1 million, compared to $1.9 million recorded in 2002. The increase was primarily due to the receipt of $13.2 million of interest income in conjunction with a settlement with the Internal Revenue Service for tax years 1989 through 1994.

 

For the year ended December 31, 2003, we recorded an income tax provision of $27.3 million on income from continuing operations, based on an estimated effective tax rate of 34%. During the third quarter of 2003 we revised our estimated tax rate from 39% to 34% as a result of applying anticipated tax credits to our income tax provision. For the year ended December 31, 2002, we recorded an income tax benefit of $32.6 million, reflecting our net loss from continuing operations before taxes, based on an estimated effective tax rate of 39%.

 

Our earnings from continuing operations for the year ended December 31, 2003, were $53.2 million, compared to our net loss from continuing operations of $50.9 million for the year ended December 31, 2002.

 

We incurred a pre-tax loss on our discontinued operations of $4.1 million in 2003, compared to a pre-tax loss of $300.7 million in 2002. Discontinued operations include our former Printing Papers segment and a hardwood sawmill. The 2003 loss represents costs we incurred related to maintaining the Brainerd facility before its sale in February 2003, an additional loss on the sale and recognition of a continuing contractual obligation relating to the Brainerd facility. Included in the 2002 amount was $276.2 million for loss on disposition of these properties and $24.5 million in operational losses.

 

Our net earnings, including discontinued operations, for 2003 were $50.7 million, compared to a net loss of $234.4 million in 2002.

 

Items recorded in “Other comprehensive loss, net of tax” for 2003 include a $0.4 million, after-tax increase to our minimum pension liability partially offset by cash flow hedge derivative gains of $0.1 million, after tax, related to our natural gas hedging activities. The increase to the minimum pension liability is the result of a change in the discount rate from 6.75% to 6.25%, partially offset by market increases in our pension assets. In 2002 we recorded a minimum pension liability increase totaling $33.2 million, after-tax, as a result of market declines in our pension assets and a reduction in the discount rate from 7.25% to 6.75%.

 

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Discussion of business segments

 

See Note 15, Segment Information, on pages 60-62 for tabular presentation of sales, operating income (loss), depreciation and amortization, assets and capital expenditures attributable to our business segments.

 

The Resource segment reported operating income of $65.5 million for the year ended December 31, 2003, slightly higher than the $62.6 million reported in 2002. Higher income from land sales in 2003 offset lower earnings from wood fiber sales. In 2003, income from land sales was 38% of the Resource segment operating income due primarily to the sale of 15,300 acres of non-strategic hardwood timberland in Arkansas. This sale of a large parcel was historically unusual as most sales consist of small parcels of less than 100 acres each. The sale occurred because the buyer placed greater value on the large parcel of hardwood timberland than we did, as it was no longer strategic for future use in our business in view of the fact that we had previously sold our hardwood lumber mill in Arkansas and exited the hardwood lumber business. In 2002 and 2001, income from land sales was 11% and 7%, respectively, of the Resource segment operating income. These two years are more representative of the percentage of income from land sales for the segment as land sale revenue amounts can and usually do vary between reporting periods, sometimes significantly as was the case in 2003. The period-to-period fluctuations are due to the unique characteristics of each transaction such as location, size, accessibility, parcel attributes and the value to certain buyers. The sale of timberland is just one aspect of managing our timber and timberland assets to maximize shareholder value within this segment. Segment net sales decreased to $252.6 million in 2003, compared to $411.8 million in 2002. The decrease in net sales was due to decreased wood fiber sales to our Wood Products and Pulp and Paperboard operating segments in Arkansas, Idaho and Minnesota. In the third quarter of 2002, these operating segments began the transition to a fiber procurement system where portions of third party fiber purchases are made directly by each segment. The changes in the fiber procurement system have resulted in lower intersegment sales for the Resource segment and, consequently, lower wood fiber purchases by the Resource segment from third parties. Intersegment sales declined $181.9 million in 2003 compared to 2002. Increased land sales partially offset the decline in wood fiber sales. Land sales revenue totaled $26.5 million in 2003 compared to $7.3 million in 2002. Expenses for the Resource segment were $187.1 million in 2003, significantly lower than the $349.3 million recorded in 2002, due to reduced outside wood purchases by the Resource segment.

 

The Wood Products segment’s operating income of $97.6 million for the year ended December 31, 2003, was a significant improvement over the operating loss of $27.0 million incurred in 2002. Net sales for the segment were $683.1 million, compared to $509.2 million reported in 2002. Low interest rates during 2003 helped to sustain a high level of new home construction, and by mid-year panel inventory levels and, to a lesser extent, dimension lumber began to recover from their oversupplied position, with a corresponding rise in sales prices. The effect was particularly favorable for oriented strand board. OSB net sales increased 68% in 2003, to $314.2 million, largely due to a 61% increase in 2003 versus 2002 average sales prices. Sales prices peaked at record high levels early in the fourth quarter and declined towards year end. Shipments of OSB were 4% higher in 2003 due to production efficiencies at our three facilities in Minnesota. The upturn in OSB markets also aided the markets for certain grades of plywood. Our plywood facility in Idaho adjusted its product mix and temporarily operated some additional shifts during the year to take advantage of market conditions. The resulting added production allowed a 27% increase in shipments, and, combined with increased sales prices, accounted for plywood net sales of $46.4 million, compared to $34.9 million in 2002. Lumber net sales increased to $279.2 million in 2003, compared to $249.8 million in 2002, due to a 17% increase in shipments that was partially offset by a 5% decline in sales prices. The increase in shipments was due to higher production at our lumber mills, largely as a result of adding a shift at each of our Arkansas facilities. Particleboard shipments increased 14% in 2003, due to the absence of market-related downtime taken in 2002. Net sales of particleboard were $15.2 million in 2003, compared to

 

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$14.1 million in 2002. Expenses were $585.5 million for the segment in 2003, compared to $536.2 million in 2002. Higher product shipments and resin costs were primarily responsible for the increase.

 

The Pulp and Paperboard segment incurred an operating loss of $15.1 million in 2003, versus a loss of $42.8 million in 2002. Segment net sales increased to $482.0 million for 2003, compared to $443.6 million in 2002. Paperboard net sales were $420.8 million in 2003, compared to $395.1 million in 2002. Paperboard shipments increased 9% compared to 2002, more than offsetting a 2% decline in sales prices. Pulp sales (including intersegment sales) were higher in 2003, rising to $61.2 million, compared to $48.5 million for 2002. The increase in pulp and paperboard sales was due to higher production at our Lewiston, Idaho, facility, which allowed increased pulp shipments internally and increased paperboard and pulp shipments to external customers. Pulp sales prices to external customers increased 12% in 2003. Segment expenses for 2003 totaled $497.1 million, compared to $486.4 million in 2002. The increase reflects greater volumes of product shipments in 2003 compared to 2002, as well as higher energy and wood fiber costs at our McGehee, Arkansas, facility. However, increased paperboard and pulp production at the Lewiston facility has resulted in lower unit production costs compared to 2002.

 

The Consumer Products segment reported operating income of $1.3 million in 2003, significantly less than the $42.8 million earned in 2002. Very competitive markets during the year resulted in a 5% decline in net sales, to $300.9 million, compared to $315.7 million in 2002. The effect of a sales price decline of 7% for 2003 was only partially offset by a 2% increase in product shipments. Segment expenses were $299.6 million in 2003, compared to $272.9 million in 2002. Higher per unit costs due to downtime taken on some converting lines during the year to reduce finished goods inventory levels, higher pulp costs, higher selling and administration costs in anticipation of the start-up of the new tissue machine in Las Vegas, and increased product shipments contributed to the increase in expenses.

 

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

 

Net sales of $1.29 billion for the year ended December 31, 2002, were slightly higher compared to net sales of $1.28 billion recorded for the year ended December 31, 2001. Increases in Resource and Wood Product segment net sales in 2002 of $30.3 million and $11.8 million, respectively, were partially offset by decreases in net sales for the Pulp and Paperboard segment of $25.4 million and $2.0 million for the Consumer Products segment. In 2002 Resource sales were greater due to increased sales to external customers, while Wood Products net sales increased as a result of an increase in OSB shipments. The decrease in net sales for Pulp and Paperboard was primarily due to lower sales prices for paperboard. In the Consumer Products segment, the effect of lower sales prices for tissue products was partially offset by higher product shipments in 2002.

 

Expenses for depreciation, amortization and cost of fee timber harvested were $115.5 million for the year ended December 31, 2002, an increase of $.5 million from the prior year amount of $115.0 million.

 

For the year ended December 31, 2002, materials, labor and other operating expenses were $1.10 billion, compared to $1.10 billion in 2001. Repair and maintenance expense and wood fiber costs were higher in 2002, but were offset by lower energy costs.

 

Selling, general and administrative expenses totaled $79.6 million for the year ended December 31, 2002, compared to 2001’s expense of $82.8 million. The change was primarily due to bad debt expense incurred in 2001 as a result of a $2.2 million charge related to the insolvency of a pulp broker. In 2002, we expensed the remaining balance due from the pulp broker, totaling $.8 million, after it was determined that collection was not reasonably likely to occur. In addition, bank fees were lower in 2002 versus 2001.

 

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The following three charges were included in the “Restructuring charges” line in the Statements of Operations:

 

    In 2002 we recorded a $9.0 million pre-tax charge for costs associated with the elimination of 106 salaried production and administrative positions. We recorded an additional $.2 million during the first half of 2003 for costs related to terminated employees whose services have been retained beyond the initial 60-day period following the announced job elimination, as required by Statement of Financial Accounting Standards (SFAS) No. 146. As of December 31, 2002, 82 employees had been terminated, three had assumed other positions within the company as a result of job openings, and 21 were scheduled for termination at a later date.

 

    In March 2001, we recorded a $4.2 million pre-tax charge associated with a workforce reduction plan at our pulp, paperboard and consumer products operations in Idaho. In September 2001, an additional $0.4 million pre-tax charge was recorded as a result of final cost determinations for pension and medical benefits. The plan permanently reduced the workforce by 124 hourly production and maintenance positions. As of December 31, 2001, all material costs associated with the plan had been incurred.

 

    In December 2001, we reversed $1.8 million of an $18.5 million pre-tax charge, taken in September 2000, for costs associated with the closure of a plywood mill. Our initial estimate of the cost to close the mill included expected costs for some aspects of maintenance and demolition that were not incurred.

 

Interest expense was $59.9 million for the year ended December 31, 2002, substantially less than the $77.9 million charged against income in 2001. The decrease reflected our net reduction of over $470 million of debt during 2002.

 

We incurred one-time, pre-tax costs of $15.4 million during 2002 related to our early retirement of over $380 million of outstanding debt. These costs included cash fees and premiums of $10.6 million and the non-cash write-off of related debt financing costs totaling $4.8 million.

 

Interest income for 2002 totaled $1.9 million, slightly less than the $2.6 million recorded in 2001.

 

For the year ended December 31, 2002, we recorded an income tax benefit of $32.6 million, reflecting our net loss from continuing operations before taxes, based on an estimated effective tax rate of 39%. For the year ended December 31, 2001, we recorded an income tax benefit of $36.2 million, also reflecting an estimated effective tax rate of 39%.

 

We recorded a net loss from continuing operations of $50.9 million for the year ended December 31, 2002, compared to a net loss from continuing operations of $56.6 million for the year ended December 31, 2001.

 

We incurred a pre-tax loss on our discontinued operations of $300.7 million in 2002. The discontinued operations included our former Printing Papers segment and a hardwood sawmill. Included in the amount was $276.2 million for loss on the disposition of these properties and $24.5 million from operational losses. In 2001 these operations incurred pre-tax losses of $37.5 million.

 

Our net loss for 2002 was $234.4 million, compared to a net loss of $79.4 million in 2001. The unfavorable comparison was due to recognition of the substantial charge for our discontinued operations.

 

In December 2002, as a result of market declines in our pension assets in the second half of 2002 and a reduction in the discount rate from 7.25% to 6.75%, we recorded in “Other comprehensive loss, net of tax” an adjustment for a minimum pension liability totaling $33.2 million, after tax.

 

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Discussion of business segments

 

The Resource segment reported operating income of $62.6 million for the year ended December 31, 2002, up from $55.3 million reported in 2001. Segment net sales were $411.8 million, compared to $410.1 million in 2001. Increased sales prices and higher sales volumes to third parties in Idaho, Minnesota and Arkansas in 2002, as well as slightly higher land sales, were largely offset by a decrease in internal net sales. Resource segment expenses decreased 2% to $349.3 million in 2002, compared to $354.8 million in 2001. Decreased purchases of residual fiber reduced costs but were partially offset by increased logging costs.

 

The Wood Products segment incurred an operating loss of $27.0 million for the year ended December 31, 2002, compared to an operating loss of $26.6 million incurred in 2001. Market conditions were difficult for our wood products due to the industry’s oversupply position, which persisted throughout 2002, despite a positive new home construction environment. Foreign imports continued to affect pricing during all of 2002, even after imposition of a U.S. duty on Canadian products beginning in May. Net sales for the segment were $509.2 million, slightly higher compared to $502.3 million reported in 2001. Net sales of oriented strand board increased 12% in 2002, to $187.3 million, due to a 13% increase in shipments. A small decrease in lumber shipments, combined with slightly lower sales prices, resulted in a net sales decrease to $249.8 million from $251.9 million in 2001. Net sales of plywood decreased 14% to $34.9 million. Plywood shipments were down 17%, due in large part to lower production in 2002 compared to 2001. Production was higher in 2001 due to extra shifts above the normal operating schedule at our St. Maries, Idaho, mill. Net sales of particleboard were $14.1 million, compared to $15.8 million in 2001. Expenses were $536.2 million for the segment in 2002, compared to $528.9 million in 2001. Higher wood fiber costs were partially offset by small declines in energy and labor costs. Wood fiber costs were higher due in large part to the full year’s operation of the Cook, Minnesota, oriented strand board mill. The mill was shut down for a portion of the first quarter of 2001 to complete a modernization and expansion project.

 

The Pulp and Paperboard segment incurred an operating loss of $42.8 million in 2002, compared to a loss of $56.0 million in 2001. Segment net sales decreased to $443.6 million for 2002, compared to $464.7 million in 2001. The decrease was due to lower sales prices and shipments for paperboard. Paperboard net sales declined 6% to $395.1 million from $420.6 million in 2001 due to a 5% decrease in sales prices and a 1% decline in shipments. The markets for paperboard reflected the difficult general economic conditions in 2002, as well as increased competition from international producers of paperboard. A $4.4 million increase in pulp net sales, due to a 12% increase in shipments, partially offset the decrease in paperboard net sales. Segment expenses were $486.4 million in 2002, compared to $520.7 million in 2001. Energy expense was significantly lower in 2002 but was partially offset by higher repair and maintenance expense and wood fiber costs. Repair and maintenance expense was higher due to a scheduled major maintenance shutdown at the Cypress Bend, Arkansas, pulp and paperboard mill and some equipment improvements at the Lewiston, Idaho, pulp and paperboard mill. Included in expenses for 2001 was an $11.1 million charge related to a lawsuit against a vendor and bad debt expense of $2.2 million related to the insolvency of a pulp broker.

 

The Consumer Products segment reported operating income of $42.8 million in 2002, slightly higher than 2001’s operating income of $41.6 million. Sales prices for consumer tissue products were down 3%, resulting in a decline in 2002 net sales to $315.7 million from $317.7 million in 2001. Segment expenses were $272.9 million in 2002, compared to $276.2 million in 2001. Lower energy expense in 2002 was primarily responsible for the favorable comparison.

 

Liquidity and Capital Resources

 

At December 31, 2003, our financial position included long-term debt of $618.8 million, including current installments on long-term debt of $0.5 million. Long-term debt at December 31, 2003 (including current installments) declined $19.5 million from the December 2002 balance due to normal

 

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payments on maturing debt of $15.5 million and the early retirement of $4.0 million of long-term debt. The majority of the repayments on maturing debt were made using $15.0 million placed in an interest-bearing escrow account in September 2002 that was restricted to the repayment of $15 million of our medium-term notes, which matured on April 4, 2003. Early retirements of long-term debt consisted of a bond associated with our Brainerd facility totaling $0.9 million and medium-term notes of $3.1 million. The Brainerd bond was called as a result of the sale of the facility in February 2003, and the medium-term notes (whose maturity date was 2018) were repurchased on the open market. Stockholders’ equity increased $40.1 million, largely due to net earnings of $50.7 million for 2003 and treasury stock issuances of $6.9 million, partially offset by dividend payments of $17.2 million. The ratio of long-term debt (including current installments) to stockholders’ equity was 1.31 to 1 at December 31, 2003, compared to 1.48 to 1 at December 31, 2002.

 

Scheduled payments due on long-term debt during each of the five years subsequent to December 31, 2003, are as follows:

 

     (Dollars in thousands)

2004

   $ 507

2005

     1,508

2006

     2,758

2007

     6,559

2008

     609

 

Working capital totaled $160.8 million at December 31, 2003, an increase of $58.1 million from December 31, 2002. The significant changes in the components of working capital are as follows:

 

    Restricted cash declined $15.1 million due to its use for the repayment of medium term notes, which matured in April 2003.

 

    Short-term investments increased $38.1 million. We invested positive cash flow from increased operating earnings not immediately needed for operations or capital expenditures into short-term bank instruments. The increase also reflects our investment in Euro, which will be used to pay the remaining balance due to the supplier of our tissue machine in Las Vegas.

 

    Receivables declined $14.6 million as a result of the receipt of an income tax settlement from the Internal Revenue Service totaling approximately $22.3 million. Increased sales and the corresponding increase in customer receivables partially offset the effect of the tax settlement receipt.

 

    Prepaid expenses declined $20.7 million largely as a result of a $10.4 million reduction in our current deferred tax asset and a reimbursement for a deposit on production equipment of approximately $10.0 million.

 

    During 2003 we repaid $40.0 million of notes payable outstanding at December 31, 2002, under our bank credit facility.

 

    Current installments on long-term debt declined $15.1 million. We made $15.5 million of scheduled debt payments, which were partially offset by approximately $0.5 million of debt scheduled for payment in 2004.

 

    Accounts payable and accrued liabilities declined $22.2 million, largely due to accrued taxes declining $9.4 million and declines in reserves for insurance, property taxes and employee benefits.

 

Net cash provided by operations in 2003 totaled $163.4 million, compared with cash used for operations of $38.6 million in 2002 and cash provided by operations of $25.5 million in 2001. Net earnings from continuing operations, versus a net loss in 2002, combined with cash generated from

 

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working capital changes were largely responsible for the favorable comparison in 2003. The net earnings were generally due to significantly higher sales, lower interest expense and higher interest income, as previously discussed. In 2003 we contributed $19.5 million to our two qualified hourly defined benefit pension plans, representing the maximum contribution allowed for tax deduction purposes. The contribution should eliminate the requirement for any material contributions to the plans for the next two years, in the absence of a significant drop in our discount rate assumption. An increase in cash used for working capital items in 2002 accounted for a majority of the unfavorable comparison to 2001.

 

Net cash used for investing was $111.9 million in 2003, while net cash provided by investing was $46.5 million in 2002 and net cash used for investing was $175.9 million in 2001. In 2003 we used $79.7 million for capital spending and $38.1 million to increase our short-term investments. These activities were partially offset by the use of $15.1 million of restricted cash to repay debt. A significant portion of 2003 capital spending was used for construction of a new tissue machine in North Las Vegas, Nevada. Total spending on this project was $44.4 million during the year. The balance of capital spending in 2003 was focused on forest resources and various small projects designed to improve product quality and manufacturing efficiency. Cash provided by investing in 2002 was largely from the use of restricted cash and the liquidation of short-term investments. The funds were used to repay long-term debt. Capital spending of $51.6 million in 2002 was modestly higher than the $42.7 million spent in 2001. In September 2002, we announced plans to spend $66 million to construct a new tissue machine in Las Vegas, Nevada. Of that amount, $19.2 million was spent on the project in 2002. The balance of capital spending in 2002 focused on routine general replacement, safety, forest resource and environmental projects.

 

At December 31, 2003, our authorized capital spending budget, including $11.4 million carried over from prior years, totaled $68.2 million. We expect to spend $67.7 million of this amount in 2004. Spending in 2004 will consist of the completion of the new tissue machine in Las Vegas as well as various routine general replacement and forest resource projects. Spending on projects may be delayed due to the acquisition of environmental permits, acquisition of equipment, engineering, weather and other factors.

 

Net cash used for financing totaled $56.9 million in 2003, compared to cash used for financing of $495.3 million in 2002 and cash provided by financing of $104.3 million in 2001. The majority of cash used for financing in 2003 was to repay borrowings under our bank credit facility totaling $40.0 million and to retire long-term debt in the amount of $19.5 million. Cash was also used to pay dividends of $17.2 million. The majority of cash used for financing in 2002 was for the retirement of $511.9 million of long-term debt. During 2002 we used restricted cash to repay our $100 million 6.25% Debentures, and we retired other debt using proceeds from asset sales. Notes payable increased $40.0 million in 2002, partially offsetting cash used for debt payments.

 

Cash generated from discontinued operations in 2003 totaled $3.6 million, which is the net result of the sale of the Brainerd facility in February for $4.44 million. Cash from discontinued operations in 2002 totaled $488.9 million, most of which was cash received from the sale of our Printing Papers segment assets and the sale of our hardwood sawmill in Arkansas. In connection with the sale of our Printing Papers segment assets in May 2002, we were required under the terms of our bank credit facility to use the proceeds to repay $198.5 million under the term loan portion of our bank credit facility, and all outstanding debt under our revolving credit line at the date of sale, totaling $33.2 million. We also used a portion of the proceeds to retire approximately $164.9 million of additional debt.

 

Our current bank credit facility, which expires June 28, 2004, is comprised of a revolving line of credit of up to $150.0 million, including a $70.0 million subfacility for letters of credit, usage of which reduces availability under the revolving line of credit. Our obligations under the bank credit facility are

 

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secured by our accounts receivable and inventory. As of December 31, 2003, there were no borrowings outstanding under the revolving line of credit; however, approximately $14.7 million of the revolving line of credit was used to support outstanding letters of credit. Prior to the expiration of our current bank credit facility, we expect to either extend the current credit facility or enter into a new credit facility.

 

Both the agreement governing our bank credit facility and the indenture governing our $250 million 10% senior subordinated notes contain certain covenants that, among other things, restrict our ability and our subsidiaries’ ability to create liens, merge or consolidate, dispose of assets, incur indebtedness and guarantees, pay dividends, repurchase or redeem capital stock and indebtedness, make certain investments or acquisitions, enter into certain transactions with affiliates, make capital expenditures, or change the nature of our business. The bank credit facility also contains financial maintenance covenants establishing a maximum funded indebtedness to capitalization ratio, a minimum consolidated net worth requirement, and a minimum interest coverage ratio. Events of default under the bank credit facility and the indenture include, but are not limited to, payment defaults, covenant defaults, breaches of representations and warranties, cross defaults to certain other material agreements and indebtedness, bankruptcy and other insolvency events, material adverse judgments, actual or asserted invalidity of security interests or loan documentation, and certain change of control events involving our company. As of December 31, 2003, we were in compliance with the covenants of our bank credit facility and the $250 million 10% senior subordinated notes.

 

We believe that our cash, cash flows from operations and available borrowings under our current bank credit facility (including our anticipated extension or replacement of the bank credit facility) will be sufficient to fund our operations, capital expenditures and debt service obligations for the next twelve months. We cannot assure, however, that our business will generate sufficient cash flow from operations or that we will be able to extend or replace our current bank credit facility, or that we will be in compliance with the financial covenants in our bank credit facility so that future borrowings thereunder will be available to us. Thus, our ability to fund our operations will be dependent upon our future financial performance, which will be affected by general economic, competitive and other factors, including those discussed above under “Factors Influencing Our Results of Operations,” many of which are beyond our control.

 

On January 30, 2003, Standard & Poor’s Ratings Services (S&P) announced that it had lowered our senior unsecured debt rating to BB+ and affirmed our senior secured bank loan rating at BBB-. The ratings downgrade by S&P caused the interest rate on our $100 million Credit Sensitive Debentures to increase from 9.425% to 12.5%, effective January 30, 2003. Also during the first quarter of 2003, Fitch, Inc. downgraded our senior unsecured debt to BB+ with a negative outlook and affirmed our senior secured bank loan rating at BBB-. Moody’s Investors Service Inc.’s rating of our debt remains unchanged at Baa3 with a negative outlook.

 

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The following table summarizes our contractual obligations as of December 31, 2003. Portions of the amounts shown are reflected in our consolidated financial statements and accompanying footnotes, as required by generally accepted accounting principles. See the footnotes following the table for information regarding the amounts presented and for references to appropriate financial statement footnotes, which include a detailed discussion of the item.

 

     Payments due by period

     Total

   1 Year

   2-3 Years

   4-5 Years

   Over 5
Years


     (Dollars in thousands)

Long-term debt(1)

   $ 618,785    $ 507    $ 4,266    $ 7,168    $ 606,844

Operating leases(2)

     87,907      12,391      21,524      16,779      37,213

Purchase obligations

     144,355      110,994      24,850      8,416      95

Other long-term obligations(3)

     266,514      21,858      46,541      74,801      123,314
    

  

  

  

  

Total

   $ 1,117,561    $ 145,750    $ 97,181    $ 107,164    $ 767,466
    

  

  

  

  


(1)   See Note 8, Debt, in the notes to financial statements.
(2)   See Note 13, Commitments and Contingencies, in the notes to financial statements.
(3)   Payments on qualified pension plans are based on estimated minimum required contributions for years 1-5. Payments on postretirement benefit plans are based on expected future benefit payments as disclosed in Note 12 to the financial statements for years 1-5.

 

Since December 1999, we have been authorized under a stock repurchase program to repurchase up to two million shares of our common stock. Under the plan, purchases of common stock may be made from time to time through open market and privately negotiated transactions at prices deemed appropriate by management. Through December 31, 2001, a total of 910,900 shares had been acquired under the stock repurchase program. No shares were acquired in 2002 or 2003, and we do not expect to repurchase additional common stock in the near future.

 

It is our practice to periodically review strategic and operational alternatives to improve our operating results and financial position. In this regard, we consider and plan to continue to consider, among other things, adjustments to our capital expenditures and overall spending, the restructuring of our operations to achieve greater efficiencies, and the disposition of assets that may have greater value to others. There can be no assurance that we will be successful in implementing any new strategic or operational initiatives or, if implemented, that they will have the effect of improving our operating results and financial position.

 

Off-Balance Sheet Arrangements

 

We currently are not a party to off-balance sheet arrangements that would require disclosure under this section.

 

Environment

 

We are subject to extensive federal and state environmental regulations at our operating facilities and timberlands, particularly with respect to air emissions, wastewater discharges, solid and hazardous waste management, site remediation, forestry operations and endangered species. We endeavor to comply with all environmental regulations and regularly monitor our activities for such compliance. Compliance with environmental regulations is a significant factor in our business and requires capital expenditures as well as additional operating costs. Capital expenditures specifically designated for environmental compliance totaled approximately $0.4 million during 2003 and are budgeted to be approximately $4.8 million in 2004.

 

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As previously discussed in Item I, Business, our timberlands in Idaho, Arkansas and Minnesota are certified by third parties to be in compliance with the Sustainable Forestry Initiative (SFI) Program and the International Organization on Standardization (ISO) 14001 standard for environmental management systems. Participation in the SFI and ISO programs is voluntary, can require operating processes which are more stringent than existing federal or state requirements, and can increase our operating costs to maintain certification. Such operating costs have not had a material adverse effect on our competitive position, nor do we expect that they will in the future.

 

In early 1998 the Environmental Protection Agency (EPA) published the “Cluster Rule” regulations specifically applicable to the pulp and paper industry. These extensive regulations govern both air and water emissions. During 2001, we completed modifications to process equipment and operating procedures to comply with Phase I of the regulations. Phase II of the regulations relates to control of high volume, low concentration emissions at kraft pulp mills, and our compliance efforts are scheduled to be completed in 2006 at an expected cost of approximately $6 million. We do not expect that such compliance costs will have a material adverse effect on our competitive position.

 

Our pulp mill at Lewiston, Idaho, discharges treated mill effluent into the nearby Snake River. Federal law requires that we comply with provisions of a National Pollution Discharge Elimination System (NPDES) permit. As allowed by federal regulations, we are operating under an NPDES permit that expired in 1997, but which continues to be in force until the effective date of a new NPDES permit. The EPA published a revised draft NPDES permit in June 2003, which among other matters requires a significant reduction in biochemical oxygen demand over the five year period of the new permit and also requires within two years of the effective date of the new permit a reduction in the temperature of the effluent during the months of July, August and September each year. Meeting these requirements would require modifications of operating practices that will increase operating costs. Physical modifications to the effluent system over the next several years may be required at a cost of up to $5 million. We do not expect that such compliance costs will have a material adverse effect on our competitive position.

 

The EPA is currently developing additional Maximum Achievable Control Technology (MACT) standards, which will affect wood products panel facilities. The effective date of these standards is expected to be in early 2004, with compliance required by early 2007. We have studied the proposed MACT standards for power boiler operations and for wood products operations, and estimate the capital expenditures necessary for compliance will be approximately $11 million. We do not expect such compliance costs to have a material adverse effect on our competitive position.

 

We believe that our facilities are currently in substantial compliance with applicable environmental laws and regulations. We cannot assure, however, that situations that may give rise to material environmental liabilities will not be discovered or that the enactment of new environmental laws or regulations or changes in existing laws or regulations will not require significant expenditures by us. In that regard, in late January 2004, we voluntarily reported to the Minnesota Pollution Control Agency (MPCA) a potential air permit violation at our oriented strand board facility in Bemidji, Minnesota, relating to the non-operation of equipment used to control nitrous oxide emissions from a wood-fired boiler for a period of approximately 29 months. Corrective action has been taken, and we are cooperating with the MPCA in its investigation. As the investigation is ongoing, we have not been advised as to what action the MPCA may take.

 

Taking into consideration the possible consequences of the above described matter, we believe there is no pending or threatened litigation that would have a material adverse effect on our financial position, operations or liquidity.

 

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Income Taxes

 

Our effective tax rate for 2003 was 34%, compared to 39% for 2002 and 2001. The effective rate for 2003 differs from the one used for 2002 and 2001 as a result of applying anticipated tax credits to our tax provision.

 

Subsequent Event

 

In late January 2004, we implemented a plan to reduce the hourly and salaried workforces at our Consumer Products manufacturing facilities in Lewiston and Las Vegas. A total of 8 salaried and 60 hourly positions were eliminated. Costs for the workforce reduction, consisting of severance benefits, are expected to be approximately $1.0 million to $1.5 million and will be incurred during the first quarter of 2004.

 

Quantitative and Qualitative Disclosures About Market Risks

 

Our exposure to market risks on financial instruments includes interest rate risk on our bank credit facility and long-term debt, credit rate risk on our credit sensitive debentures, foreign currency exchange rates that affect the value of our investment in Euro and commodity price risk on collars we use to hedge a portion of our short-term natural gas purchases.

 

As of December 31, 2003, we had no borrowings outstanding under our bank credit facility. The interest rates applied to borrowings under the bank credit facility are adjusted often and therefore react quickly to any movement in the general trend of market interest rates. We do not attempt to mitigate the effects of short-term interest rate fluctuations on our bank credit facility borrowings through the use of derivative financial instruments.

 

All of our long-term debt is fixed-rate and therefore changes in market interest rates do not expose us to interest rate risk for these financial instruments. However, in August 2003 we entered into a fixed-to-variable interest rate swap to hedge a portion of our 10% senior subordinated debentures. The swap was designated as a fair value hedge and calls for the company to pay a variable interest amount, determined semi-annually in arrears and equal to LIBOR plus 4.80%, and receive a fixed-rate payment from a financial institution, calculated on $165.0 million of our 10% senior subordinated debentures. The terms of the swap allow us to assume there is no ineffectiveness in the hedge. A previous swap, with essentially the same terms, was terminated in June 2003. We have received cash settlements totaling $20.0 million for the previous swap, representing the value of the swap at the time of termination as well as for a repricing of the swap in August 2002. The cash received will be accreted to earnings until the 10% senior subordinated debentures are retired.

 

We currently have $100 million of credit sensitive debentures outstanding which pay interest to the debt holder based upon our credit ratings as established by Standard & Poor’s Ratings Services (S&P) or Moody’s Investors Services, Inc. The following table denotes the interest rate applicable based on various credit ratings:

 

Ratings


   

Moody’s


   S&P

  Applicable Rate(%)

Aaa

   AAA     8.825

Aa1 - Aa3

   AA+-AA-     8.925

A1 - Baa2

   A+- BBB     9.125

Baa3

   BBB-     9.425

Ba1

   BB+   12.500

Ba2

   BB   13.000

Ba3

   BB-   13.500

B1 or lower

   B+ or lower   14.000

 

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On January 30, 2003, S&P announced that it had lowered our senior unsecured debt rating to BB+ from BBB -. The ratings downgrade caused the interest rate on our credit sensitive debentures to increase from 9.425% to 12.5%, effective January 30, 2003.

 

In the first half of 2003 we entered into forward purchase contracts to acquire Euro, with the settlement of these forward contracts timed to coincide with our required Euro payments to the supplier of our new tissue machine under construction in North Las Vegas, Nevada. As of December 31, 2003, we had no forward purchase contracts outstanding, however, we held 3.9 million Euro to be used to pay the remainder of the amount due to the supplier upon completion of the project. The Euro are valued on our Balance Sheet at the exchange rate quoted at December 31, 2003.

 

During the third quarter of 2003, we entered into several derivative financial instruments designated as cash flow hedges for a portion of our expected natural gas purchases during November 2003 through March 2004. The financial instruments are in the form of collars, with a ceiling of $6.35 per mmBtu and floors ranging from $4.44 to $5.30 per mmBtu, indexed to the NYMEX, Rocky Mountain and Canadian Border indices. The collars apply to 13,200 mmBtu of natural gas purchased per day for the five-month period beginning November 1, which represents approximately 60% of our expected daily usage during that period. As designated cash flow hedges, changes in the fair value of the financial instruments are recognized in “Other comprehensive loss, net of tax” to the extent the hedges are deemed effective, until the hedged item is recognized in the statement of operations.

 

Quantitative Information About Market Risks

 

     Expected Maturity Date

    Thereafter

    Total

 
     2004

    2005

    2006

    2007

    2008

     
     (Dollars in thousands)  

Long-term debt:

                                                        

Fixed rate

   $ 507     $ 1,508     $ 2,758     $ 6,559     $ 609     $ 606,844     $ 618,785  

Average interest rate

     6.0 %     6.2 %     6.4 %     6.1 %     6.8 %     8.0 %     8.0 %

Fair value at 12/31/03

                                                   $ 651,905  

Interest rate swap:

                                                        

Fixed to variable

     —         —         —         —         —       $ 165,000     $ 165,000  

Average pay rate

                                     6-month LIBOR in arrears + 4.8%  

Average receive rate

                                             10.0 %     10.0 %

Fair value at 12/31/03

                                                   $ 2,386  
                                   Maturity-2004

    Fair Value

 

Natural gas futures contracts:

                                                        

Puts

                                                   $ 7  

Contract volume (mmbtu)

                                             1,027,600          

Weighted average price (mmbtu)

                                           $ 4.82          

Calls

                                                   $ 105  

Contract volume (mmbtu)

                                             1,027,600          

Weighted average price (mmbtu)

                                           $ 6.35          

 

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POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

(Dollars in thousands — except per-share amounts)

 

     For the years ended December 31

 
     2003

    2002

    2001

 

Net sales

   $ 1,506,634     $ 1,293,546     $ 1,278,864  
    


 


 


Costs and expenses:

                        

Depreciation, amortization and cost of fee timber harvested

     104,859       115,469       115,033  

Materials, labor and other operating expenses

     1,207,086       1,099,690       1,095,686  

Selling, general and administrative expenses

     80,280       79,618       82,842  

Restructuring charges (Note 16)

     (476 )     8,963       2,750  
    


 


 


       1,391,749       1,303,740       1,296,311  
    


 


 


Earnings (loss) from operations

     114,885       (10,194 )     (17,447 )

Interest expense, net of capitalized interest of $2,907 ($300 in 2002 and $1,032 in 2001)

     (48,172 )     (59,882 )     (77,853 )

Debt retirement costs

     (248 )     (15,360 )     —    

Interest income

     14,090       1,939       2,569  
    


 


 


Earnings (loss) before taxes

     80,555       (83,497 )     (92,731 )

Provision (benefit) for taxes (Note 7)

     27,334       (32,564 )     (36,165 )
    


 


 


Earnings (loss) from continuing operations

     53,221       (50,933 )     (56,566 )

Discontinued operations (Note 17):

                        

Loss from discontinued operations (including loss on disposal of $2,745, $276,218 and $0)

     (4,089 )     (300,734 )     (37,507 )

Income tax benefit

     (1,595 )     (117,286 )     (14,628 )
    


 


 


Net earnings (loss)

   $ 50,727     $ (234,381 )   $ (79,445 )
    


 


 


Other comprehensive loss, net of tax:

                        

Cash flow hedges:

                        

Net derivative gains, net of income tax provision of $44, $0 and $0

     68       —         —    

Minimum pension liability adjustment, net of income tax benefit of $239, $21,231 and $0

     (374 )     (33,207 )     —    
    


 


 


Comprehensive income (loss)

   $ 50,421     $ (267,588 )   $ (79,445 )
    


 


 


Net earnings (loss) per common share from continuing operations:

                        

Basic

   $ 1.85     $ (1.79 )   $ (2.00 )

Diluted

     1.85       (1.79 )     (2.00 )

Net earnings (loss) per common share:

                        

Basic

     1.77       (8.23 )     (2.81 )

Diluted

     1.77       (8.23 )     (2.81 )
    


 


 


 

Certain amounts for 2002 and 2001 have been reclassified to conform to the 2003 presentation.

 

The accompanying notes and summary of principal accounting policies are

an integral part of these financial statements.

 

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POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands — except per-share amounts)

 

     At December 31

 
     2003

    2002

 

ASSETS


            

Current assets:

                

Cash (Note 11)

   $ 7,190     $ 8,973  

Restricted cash (Notes 1, 8 and 11)

     —         15,069  

Short-term investments (Note 11)

     40,091       2,000  

Receivables, net of allowance for doubtful accounts of $1,285 ($1,624 in 2002) (Notes 2 and 8)

     105,345       119,964  

Inventories (Notes 3 and 8)

     159,678       159,798  

Prepaid expenses (Note 7)

     18,315       39,005  

Assets held for sale (Note 17)

     —         5,000  
    


 


Total current assets

     330,619       349,809  
    


 


Land, other than timberlands

     8,831       8,750  

Plant and equipment, at cost less accumulated depreciation of $1,334,918 ($1,260,487 in 2002) (Note 4)

     740,342       758,168  

Timber, timberlands and related logging facilities, net (Note 5)

     398,899       396,426  

Other assets (Note 6)

     118,686       111,664  
    


 


     $ 1,597,377     $ 1,624,817  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY


            

Current liabilities:

                

Notes payable (Notes 8 and 11)

   $ —       $ 40,000  

Current installments on long-term debt (Notes 8 and 11)

     507       15,607  

Accounts payable and accrued liabilities (Note 9)

     169,310       191,497  

Liabilities related to assets held for sale (Note 17)

     —         12  
    


 


Total current liabilities

     169,817       247,116  
    


 


Long-term debt (Notes 8 and 11)

     618,278       622,645  

Other long-term obligations (Note 10)

     266,514       267,611  

Deferred taxes (Note 7)

     71,917       56,654  

Stockholders’ equity:

                

Preferred stock, Authorized 4,000,000 shares

     —         —    

Common stock, $1 par value Authorized 40,000,000 shares, issued 32,721,980 shares

     32,722       32,722  

Additional paid-in capital

     130,996       131,065  

Retained earnings

     443,202       409,692  

Accumulated other comprehensive loss:

                

Minimum pension liability adjustment

     (33,581 )     (33,207 )

Cash flow hedges

     68       —    

Common shares in treasury 3,881,217 (4,143,329 in 2002)

     (102,556 )     (109,481 )
    


 


Total stockholders’ equity

     470,851       430,791  
    


 


     $ 1,597,377     $ 1,624,817  
    


 


 

Certain amounts for 2002 have been reclassified to conform to the 2003 presentation.

 

The accompanying notes and summary of principal accounting policies are an integral part of these financial statements.

 

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POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 

     For the years ended December 31

 
     2003

    2002

    2001

 

CASH FLOWS FROM CONTINUING OPERATIONS

                        

Net earnings (loss)

   $ 50,727     $ (234,381 )   $ (79,445 )

Adjustments to reconcile net earnings (loss) to net operating cash flows:

                        

Loss from discontinued operations

     820       14,955       22,879  

Loss on disposal of discontinued operations

     60       229,023       —    

Depreciation, amortization and cost of fee timber harvested

     104,859       115,469       115,033  

Debt retirement costs

     248       15,360       —    

Deferred taxes

     15,503       (132,725 )     (83,351 )

Employee benefit plans

     1,514       3,295       (2,365 )

Decrease in receivables

     14,619       (1,333 )     27,499  

Decrease (increase) in inventories

     120       (52,085 )     19,077  

Decrease (increase) in prepaid expenses

     20,690       (7,731 )     29,879  

Increase (decrease) in accounts payable and accrued liabilities

     (26,297 )     11,534       (22,211 )

Funding of qualified pension plans

     (19,461 )     —         (1,465 )
    


 


 


Net cash provided by (used for) operations

     163,402       (38,619 )     25,530  
    


 


 


CASH FLOWS FROM INVESTING

                        

Decrease (increase) in restricted cash

     15,069       83,131       (98,200 )

Decrease (increase) in short-term investments

     (38,091 )     28,500       (30,500 )

Additions to plant and equipment, and to land other than timberlands

     (64,991 )     (36,956 )     (29,063 )

Additions to timber, timberlands and related logging facilities

     (14,695 )     (14,658 )     (13,616 )

Disposition of plant and properties

     709       2,099       15,695  

Other, net

     (9,927 )     (15,629 )     (20,244 )
    


 


 


Net cash provided by (used for) investing

     (111,926 )     46,487       (175,928 )
    


 


 


CASH FLOWS FROM FINANCING

                        

Change in book overdrafts

     4,610       (9,952 )     (2,366 )

Increase (decrease) in notes payable

     (40,000 )     40,000       (188,943 )

Proceeds from long-term debt

     —         —         450,000  

Retirement of long-term debt

     (19,467 )     (511,873 )     (101,749 )

Premiums and fees on debt retirement

     (248 )     (10,584 )     —    

Long-term debt issuance fees

     —         —         (15,553 )

Issuance of treasury stock

     6,799       8,146       6,620  

Purchase of treasury stock

     —         —         (10,453 )

Dividends on common stock

     (17,217 )     (17,071 )     (33,108 )

Other, net

     8,656       6,054       (112 )
    


 


 


Net cash provided by (used for) financing

     (56,867 )     (495,280 )     104,336  
    


 


 


Cash from continuing operations

     (5,391 )     (487,412 )     (46,062 )

Cash from discontinued operations

     3,608       488,910       42,880  
    


 


 


Increase (decrease) in cash

     (1,783 )     1,498       (3,182 )

Balance at beginning of year

     8,973       7,475       10,657  
    


 


 


Balance at end of year

   $ 7,190     $ 8,973     $ 7,475  
    


 


 


 

Net interest paid (net of amounts capitalized) in 2003, 2002 and 2001 was $46.2 million, $65.1 million and $66.1 million, respectively. Net income tax payments (refunds) in 2003, 2002 and 2001 were $(13.1) million, $(16.0) million and $.3 million, respectively.

 

Certain amounts for 2002 and 2001 have been reclassified to conform to the 2003 presentation.

 

The accompanying notes and summary of principal accounting policies are

an integral part of these financial statements.

 

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POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(Dollars in thousands — except per-share amounts)

 

    Common Stock Issued

  Additional
Paid-In
Capital


   

Retained

Earnings


   

Accumulated

Other
Comprehensive

Loss


    Treasury Stock

    Total
Stockholders’
Equity


 
    Shares

  Amount

        Shares

    Amount

   

Balance, December 31, 2000

  32,721,980   $ 32,722   $ 128,984     $ 773,697     $ —       4,375,546     $ (122,167 )   $ 813,236  

Exercise of stock options and stock awards

  —       —       5       —         —       (750 )     19       24  

Shares purchased at cost*

  —       —       —         —         —       250,000       —         —    

Issuance of treasury stock

  —       —       989       —         —       (214,268 )     5,608       6,597  

Net loss

  —       —       —         (79,445 )     —       —         —         (79,445 )

Common dividends, $1.17 per share

  —       —       —         (33,108 )     —       —         —         (33,108 )
   
 

 


 


 


 

 


 


Balance, December 31, 2001

  32,721,980   $ 32,722   $ 129,978     $ 661,144     $ —       4,410,528     $ (116,540 )   $ 707,304  

Exercise of stock options and stock awards

  —       —       141       —         —       (25,050 )     662       803  

Issuance of treasury stock

  —       —       946       —         —       (242,149 )     6,397       7,343  

Net loss

  —       —       —         (234,381 )     —       —         —         (234,381 )

Minimum pension liability adjustment

  —       —       —         —         (33,207 )   —         —         (33,207 )

Common dividends, $.60 per share

  —       —       —         (17,071 )     —       —         —         (17,071 )
   
 

 


 


 


 

 


 


Balance, December 31, 2002

  32,721,980   $ 32,722   $ 131,065     $ 409,692     $ (33,207 )   4,143,329     $ (109,481 )   $ 430,791  

Exercise of stock options and stock awards

  —       —       47       —         —       (49,925 )     1,319       1,366  

Issuance of treasury stock

  —       —       (173 )     —         —       (212,187 )     5,606       5,433  

Performance share awards

  —       —       57       —         —       —         —         57  

Net earnings

  —       —       —         50,727       —       —         —         50,727  

Cash flow hedges

  —       —       —         —         68     —         —         68  

Minimum pension liability adjustment

  —       —       —         —         (374 )   —         —         (374 )

Common dividends, $.60 per share

  —       —       —         (17,217 )     —       —         —         (17,217 )
   
 

 


 


 


 

 


 


Balance, December 31, 2003

  32,721,980   $ 32,722   $ 130,996     $ 443,202     $ (33,513 )   3,881,217     $ (102,556 )   $ 470,851  
   
 

 


 


 


 

 


 



*   Represents shares purchased pursuant to previously issued put option contracts. The cost of the shares ($10,453) was recorded in treasury stock at the time the put option contract was issued.

 

The accompanying notes and summary of principal accounting policies are

an integral part of these financial statements.

 

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POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

SUMMARY OF PRINCIPAL ACCOUNTING POLICIES

 

Consolidation

 

The financial statements include the accounts of Potlatch Corporation and its subsidiaries after elimination of significant intercompany transactions and accounts. There are no significant unconsolidated subsidiaries.

 

Potlatch Corporation is an integrated forest products company with substantial timber resources. We are engaged principally in the growing and harvesting of timber and the manufacture and sale of wood products and pulp and paper products. Our timberlands and all of our manufacturing facilities are located within the continental United States. The primary market for our products is the United States, although we sell a significant amount of paperboard to countries in the Pacific Rim.

 

Certain amounts for 2002 and 2001 have been reclassified in the financial statements and notes to conform to the 2003 presentation.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions.

 

Earnings (Loss) Per Common Share

 

Earnings (loss) per common share are computed by dividing net earnings (loss) by the weighted average number of common shares outstanding in accordance with SFAS No. 128, “Earnings Per Share.” The following table reconciles the number of common shares used in the basic and diluted earnings per share calculations:

 

     2003

   2002

   2001

Basic average common shares outstanding

   28,706,323    28,461,817    28,281,785

Incremental shares due to:

              

Common stock options

   12,105    —      —  
    
  
  

Diluted average common shares outstanding

   28,718,428    28,461,817    28,281,785
    
  
  

 

Incremental shares due to common stock options of 17,042 for the year ended December 31, 2002, and common stock options of 2,162 and put options of 34,147 for the year ended December 31, 2001, were not included in the diluted average common shares outstanding totals for 2002 and 2001 due to their antidilutive effect as a result of our net losses for those years. Stock options to purchase 2,327,470, 1,981,907 and 2,508,375 shares of common stock for 2003, 2002 and 2001, respectively, were not included in the computation of diluted earnings per share because the exercise prices of the stock options were greater than the average market price of the common shares.

 

Stock Based Compensation

 

We currently have three stock incentive plans, the 1989, 1995 and 2000 plans, under which options or performance shares are outstanding. We apply the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25 and related Interpretations in accounting for our stock based

 

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compensation. No compensation cost is recognized for options granted under the plans when the exercise price is equal to market value at the grant date. For performance share awards, which were first granted in December 2003, compensation expense is recorded ratably over the performance period based upon the market value of our stock and the likelihood that performance measurements will be met. Compensation expense related to performance shares was less than $0.1 million in 2003.

 

Had stock based compensation costs been determined based on the fair value at the grant dates as prescribed by SFAS No. 123, our net earnings (loss) and earnings (loss) per share would have been the pro forma amounts indicated below:

 

     2003

    2002

    2001

 
    

(Dollars in thousands —

except per-share amounts)

 

Net earnings (loss), as reported

   $ 50,727     $ (234,381 )   $ (79,445 )

Add: stock based compensation expense recorded under APB No. 25, net of tax

     35       —         —    

Deduct: stock based compensation determined under SFAS No. 123, net of tax

     (1,964 )     (1,912 )     (1,993 )
    


 


 


Pro forma net earnings (loss)

   $ 48,798     $ (236,293 )   $ (81,438 )
    


 


 


Basic and diluted earnings (loss) per share, as reported

   $ 1.77     $ (8.23 )   $ (2.81 )

Pro forma basic and diluted earnings (loss) per share

     1.70       (8.30 )     (2.88 )
    


 


 


 

Inventories

 

Inventories are stated at the lower of cost or market. The last-in, first-out method is used to determine cost of logs, lumber, plywood, particleboard and chips. The average cost method is used to determine cost of all other inventories.

 

Properties

 

Property, plant and equipment are valued at cost less accumulated depreciation. Depreciation of buildings, equipment and other depreciable assets is determined using the straight-line method of depreciation. Estimated useful lives range from 30 to 40 years for buildings and structures and 2 to 25 years for equipment.

 

Timber, timberlands and related logging facilities are valued at cost, net of the cost of fee timber harvested and depreciation and amortization of the related logging facilities. For fee timber the capitalized cost includes costs related to stand establishment, such as site preparation, including all costs of preparing the land for planting, cost of seeds or seedlings, whether purchased or company produced, tree planting, including labor, materials, depreciation of company-owned equipment and the cost of contract services. Upon completion of planting activities and field inspection to assure the planting operation was successful, a plantation will be considered “established.” Subsequent expenditures made to maintain the integrity or enhance the growth of an established plantation or stand are expensed. Post establishment expenses include release spray treatments, pest control activities, thinning operations and fertilization. Expenditures for forest management consist of regularly recurring items necessary to ownership and administration of timber producing property and are accounted for as current operating expenses such as fire protection, property taxes and insurance, silviculture costs incurred subsequent to stand establishment, cruising (physical inventory), property maintenance and salaries, supplies, travel, record-keeping and other normal recurring administrative personnel costs. Timberland purchased on the open market is capitalized and the cost is allocated to the relative values of the component items as appraised, such as timberland, merchantable

 

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sawtimber, merchantable pulpwood, reproduction (young growth not merchantable), logging roads and other woods improvements. The capitalized cost includes purchase price, title search and title recording, transfer taxes and fees, cruise of timber, appraisals and running of boundary lines.

 

The aggregate volume of current standing timber inventory is updated at least annually to reflect increases in merchantable timber due to reclassification of young growth stands to merchantable timber stands, the annual growth rates of merchantable timber and the acquisition of additional merchantable timber, and to reflect decreases due to timber harvests and land sales. Reproduction accounts are reviewed annually, and dollars and volumes are transferred from reproduction accounts to merchantable timber accounts on a reasonable and consistent basis. Volumes and the related accumulated costs are tracked and as the timber is harvested the cost per thousand board feet is amortized to the cost of fee timber harvested. Total standing volume is estimated on an annual basis using inventory data and a forest growth projection model. Inventory is estimated from cruises of the timber tracts, which are completed on all of our timberlands on roughly a 10-year cycle. Since the individual cruises collect field data at different times for specific sites, the growth-model projects standing inventory from the cruise date to a common reporting date. Average annual growth rates for the inventory have historically been in the range of 2%-3%.

 

Logging roads and related facilities on land not owned by us are amortized as the related timber is removed. Logging roads and related facilities on our land are presumed to become a part of our road system unless it is known at the time of construction that the road will be abandoned. Therefore, the base cost of the road, such as the clearing, grading, and ditching, is not amortized and remains a capitalized item until abandonment or other disposition, while other portions of the initial cost, such as bridges, culverts and gravel surfacing are depreciated over their useful lives, which range from 10 to 20 years. When it is known at the time of construction or purchase that a road will be abandoned after a given event has occurred, the total cost is amortized in the same manner as for roads on non-owned land.

 

Major improvements and replacements of property are capitalized. Maintenance, repairs, and minor improvements and replacements are expensed. Upon retirement or other disposition of property, applicable cost and accumulated depreciation or amortization are removed from the accounts. Any gains or losses are included in earnings.

 

Long-Lived Assets

 

We account for impairment of long-lived assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The Statement requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Assets to be disposed of are reported at the lower of carrying amount or fair value less cost to sell.

 

Income Taxes

 

The provision for taxes on income is based on earnings or loss reported in the financial statements. Deferred income taxes are recorded under the asset and liability method for the temporary differences between reported earnings and taxable income using current tax laws and rates.

 

Environment

 

As part of our corporate policy, we have an ongoing process to monitor, report on and comply with environmental requirements. Based on this ongoing process, accruals for environmental liabilities are established in accordance with SFAS No. 5. We estimate our environmental liabilities based on

 

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various assumptions and judgments, the specific nature of which varies in light of the particular facts and circumstances surrounding each environmental liability. These estimates typically reflect assumptions and judgments as to the probable nature, magnitude and timing of required investigation, remediation and monitoring activities and the probable cost of these activities, and in some cases reflect assumptions and judgments as to the obligation or willingness and ability of third parties to bear a proportionate or allocated share of the cost of these activities. Due to the numerous uncertainties and variables associated with these assumptions and judgments, and the effects of changes in governmental regulation and environmental technologies, both the precision and reliability of the resulting estimates of the related liabilities are subject to substantial uncertainties. We regularly monitor our estimated exposure to environmental liabilities and, as additional information becomes known, our estimates may change significantly. Our estimates of our environmental liabilities do not reflect potential future recoveries from insurance carriers except to the extent that recovery may from time to time be deemed probable as a result of a carrier’s agreement to payment terms. In those instances in which our estimated exposure reflects actual or anticipated cost-sharing arrangements with third parties, we do not believe that we will be exposed to additional material liability as a result of non-performance by such third parties. Currently, we are not aware of any material environmental liabilities and have accrued for only specific environmental remediation costs that we have determined are probable and reasonably estimable.

 

Revenue Recognition

 

We recognize revenue from product sales to our customers when title and risk of loss pass to the customer, which generally occurs upon shipment. In the case of export sales, title may not pass until the product reaches a foreign port. For land sales, we recognize revenue when title to the land passes to the buyer at closing and collection of proceeds is assured.

 

Recent Accounting Pronouncements

 

We adopted SFAS No. 143, “Accounting for Asset Retirement Obligations,” effective January 1, 2003. The Statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred, with the associated asset retirement costs capitalized as part of the carrying amount of the long-lived asset. Adoption of this Statement did not have a material effect on our financial condition or results of operations.

 

We adopted FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” effective January 1, 2003 and as subsequently amended. The Interpretation requires that an enterprise’s consolidated financial statements include entities in which the enterprise has a controlling financial interest. Adoption of the Interpretation did not have a material effect on our financial condition or results of operations.

 

In May 2003, the FASB issued and we adopted SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” The Statement requires certain financial instruments to be classified as liabilities, rather than equity, in a statement of financial condition. We currently do not have outstanding any financial instruments that fall under the scope of SFAS No. 150.

 

In December 2003, the FASB issued a revision of SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” The revised statement is effective for financial statements with fiscal years ending after December 15, 2003. It requires disclosures in addition to those contained in the original Statement No. 132 about assets, obligations, cash flows and the net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans. The information contained in Note 12, Savings, Pension and Other Postretirement Benefit Plans, on pages 54-58, incorporates the additional disclosure items required by the revised Statement No. 132.

 

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POTLATCH CORPORATION AND CONSOLIDATED SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1.    Restricted Cash

 

In September 2002, we placed $15.0 million into an interest-bearing escrow account under the terms of an amendment to our credit agreement. The escrow account’s use was restricted to the repayment of $15 million of our medium-term notes, which matured on April 4, 2003.

 

Note 2.    Receivables, net

 

The receivables balance at December 31, 2002, included approximately $22.3 million for settlements reached with the Internal Revenue Service for the years 1989 through 1994. The settlements were received in June 2003. Of the amount received, $12.5 million was classified as interest income.

 

Note 3.    Inventories

 

     2003

   2002

     (Dollars in thousands)

Logs, pulpwood, chips and sawdust

   $ 25,156    $ 25,212

Lumber and other manufactured wood products

     20,008      14,954

Pulp, paper and converted paper products

     71,410      79,690

Materials and supplies

     43,104      39,942
    

  

     $ 159,678    $ 159,798
    

  

Valued at lower of cost or market:

             

Last-in, first-out basis

   $ 40,056    $ 36,125

Average cost basis

     119,622      123,673
    

  

     $ 159,678    $ 159,798
    

  

 

If the last-in, first-out inventory had been priced at lower of current average cost or market, the values would have been approximately $27.3 million higher at December 31, 2003, and $22.4 million higher at December 31, 2002. In 2003 and 2002, reductions in quantities of LIFO inventories valued at lower costs prevailing in prior years had the effect of increasing earnings, net of income taxes, by approximately $0.5 million ($.02 per common share) and $3.2 million ($.11 per common share), respectively.

 

Note 4.    Plant and Equipment

 

     2003

   2002

     (Dollars in thousands)

Land improvements

   $ 75,128    $ 74,661

Buildings and structures

     278,256      277,369

Machinery and equipment

     1,646,265      1,637,864

Construction in progress

     75,611      28,761
    

  

     $ 2,075,260    $ 2,018,655
    

  

 

Depreciation charged against income amounted to $80.8 million in 2003 ($84.5 million in 2002 and $85.1 million in 2001).

 

At December 31, 2003, our authorized capital spending budget, including $11.4 million carried over from prior years, totaled $68.2 million. We expect to spend $67.7 million of this amount in 2004.

 

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Note 5.    Timber, Timberlands and Related Logging Facilities

 

     2003

   2002

     (Dollars in thousands)

Timber and timberlands

   $ 349,740    $ 347,853

Related logging facilities

     49,159      48,573
    

  

     $ 398,899    $ 396,426
    

  

 

The cost of timber harvested from company-owned lands amounted to $9.2 million in 2003 ($10.6 million in 2002 and $8.9 million in 2001). The cost of permit timber harvested from non-company owned lands amounted to $8.8 million in 2003 ($15.8 million in 2002 and $14.8 million in 2001). Amortization of logging roads and related facilities amounted to $2.3 million in 2003 ($2.0 million in 2002 and $2.4 million in 2001).

 

Note 6.    Other Assets

 

     2003

   2002

     (Dollars in thousands)

Pension assets

   $ 91,779    $ 81,582

Other

     26,907      30,082
    

  

     $ 118,686    $ 111,664
    

  

 

Note 7.    Taxes on Income

 

The provision (benefit) for taxes on income is comprised of the following:

 

     2003

   2002

    2001

 
     (Dollars in thousands)  

Current

   $ 358    $ 535     $ 438  

Deferred

     25,425      (150,385 )     (51,231 )
    

  


 


Provision (benefit) for taxes on income

   $ 25,783    $ (149,850 )   $ (50,793 )
    

  


 


 

The provision (benefit) for taxes on income differs from the amount computed by applying the statutory federal income tax rate of 35 percent to earnings before taxes on income due to the following:

 

     2003

    2002

    2001

 
     (Dollars in thousands)  

Computed “expected” tax expense (benefit)

   $ 26,802     $ (134,481 )   $ (45,583 )

State and local taxes, net of federal income tax benefits

     2,987       (14,985 )     (5,079 )

Research tax credits

     (4,000 )     —         —    

All other items

     (6 )     (384 )     (131 )
    


 


 


Provision (benefit) for taxes on income

   $ 25,783     $ (149,850 )   $ (50,793 )
    


 


 


Effective tax rate

     33.7 %     39.0 %     39.0 %
    


 


 


 

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The tax effects of significant temporary differences creating deferred tax assets and liabilities at December 31 were:

 

     2003

    2002

 
     (Dollars in thousands)  

Deferred Tax Assets:

                

Employee benefits

   $ 12,864     $ 19,108  

Postretirement benefits

     75,310       68,794  

Alternative minimum tax

     43,868       43,867  

Net operating losses

     59,713       71,565  

Tax credits

     12,644       8,428  

Discontinued operations

     1,323       26,663  

Other

     5,266       8,486  
    


 


Total deferred tax assets

     210,988       246,911  

Valuation allowance

     (6,565 )     (6,614 )
    


 


Deferred tax assets, net of valuation allowance

   $ 204,423     $ 240,297  
    


 


Deferred Tax Liabilities:

                

Plant and equipment

   $ (187,018 )   $ (214,677 )

Timber, timberlands and related logging facilities

     (57,644 )     (53,341 )

Pensions

     (16,847 )     (3,709 )
    


 


Total deferred tax liabilities

     (261,509 )     (271,727 )
    


 


Net deferred tax liabilities

   $ (57,086 )   $ (31,430 )
    


 


Net deferred tax liabilities consist of:

                

Current deferred tax assets(1)

   $ 14,831     $ 25,224  
    


 


Noncurrent deferred tax assets

     189,592       215,073  

Noncurrent deferred tax liabilities

     (261,509 )     (271,727 )
    


 


Net noncurrent deferred tax liabilities

     (71,917 )     (56,654 )
    


 


Net deferred tax liabilities

   $ (57,086 )   $ (31,430 )
    


 



(1)   Included in “Prepaid expenses” in the Balance Sheets.

 

A valuation allowance has been recognized for certain state tax credit carryforwards due to uncertainty of sufficient taxable income prior to expiration of available carryover periods.

 

As of December 31, 2003 and 2002, we had $153.1 million and $183.5 million, respectively, of net operating loss carryforwards available for use against taxable earnings in the next 17 to 18 years.

 

Our federal income tax returns have been examined, and we have reached final settlement, for all tax years through 1994. The years 1995 through 2001 are currently under examination. In the opinion of management, adequate provision had been made at December 31, 2003, for income taxes that might be due as a result of these audits, and any resulting assessments will have no material effect on our consolidated earnings.

 

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Note 8.    Debt

 

     2003

   2002

     (Dollars in thousands)

Revenue bonds fixed-rate 5.9% to 7.75% due 2003 through 2026

   $ 170,265    $ 171,628

Debentures 6.95% due 2015

     22,471      22,469

Credit sensitive debentures 9.125% due 2009

     100,000      100,000

Medium-term notes fixed-rate 8.27% to 9.46% due 2006 through 2022

     75,950      94,050

Senior subordinated notes 10% due 2011

     250,000      250,000

Other notes

     99      105
    

  

       618,785      638,252

Less current installments on long-term debt

     507      15,607
    

  

Long-term debt

   $ 618,278    $ 622,645
    

  

 

As a result of the Brainerd facility’s sale in February 2003, we retired early $0.9 million of associated revenue bonds.

 

We repaid $15.0 million of our medium-term notes, which became due April 4, 2003, using the funds contained in an interest-bearing escrow account that were restricted to such use. In the fourth quarter of 2003, we retired $3.1 million of medium-term notes (which were due in 2018) through repurchase on the open market.

 

The interest rate payable on the 9.125% credit sensitive debentures is subject to adjustment in accordance with the table below if certain changes in the debt rating of the debentures occur. On January 30, 2003, S&P lowered its rating on our senior debt to BB+, causing the interest rate to increase from 9.425% to 12.5% effective that date.

 

Ratings


   Applicable Rate(%)

Moody’s


           S&P        

  

Aaa

   AAA    8.825

Aa1 – Aa3

   AA+ – AA–    8.925

A1 – Baa2

   A+ – BBB    9.125

Baa3

   BBB–    9.425

Ba1

   BB+    12.500

Ba2

   BB    13.000

Ba3

   BB–    13.500

B1 or lower

   B+ or lower    14.000

 

Our current bank credit facility, which expires June 28, 2004, is comprised of a revolving line of credit of up to $150.0 million, including a $70.0 million subfacility for letters of credit, usage of which reduces availability under the revolving line of credit. Our obligations under the bank credit facility are secured by our accounts receivable and inventory. As of December 31, 2003, there were no borrowings outstanding under the revolving line of credit; however, approximately $14.7 million of the revolving line of credit was used to support outstanding letters of credit. At December 31, 2002, we had borrowed $40.0 million under the revolving line of credit, that was classified as “Notes payable” in the Balance Sheets. Prior to the expiration of our current bank credit facility, we expect to either extend the current credit facility or enter into a new credit facility.

 

Our 10% senior subordinated notes due 2011 are unsecured and are subordinated to our senior notes and our bank credit facility.

 

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Both the agreement governing our bank credit facility and the indenture governing our $250 million 10% senior subordinated notes contain certain covenants that, among other things, restrict our ability and our subsidiaries’ ability to create liens, merge or consolidate, dispose of assets, incur indebtedness and guarantees, pay dividends, repurchase or redeem capital stock and indebtedness, make certain investments or acquisitions, enter into certain transactions with affiliates, make capital expenditures, or change the nature of our business. The bank credit facility also contains financial maintenance covenants establishing a maximum funded indebtedness to capitalization ratio, a minimum consolidated net worth requirement, and a minimum interest coverage ratio. Events of default under the bank credit facility and the indenture include, but are not limited to, payment defaults, covenant defaults, breaches of representations and warranties, cross defaults to certain other material agreements and indebtedness, bankruptcy and other insolvency events, material adverse judgments, actual or asserted invalidity of security interests or loan documentation, and certain change of control events involving our company. As of December 31, 2003, we were in compliance with the covenants of our bank credit facility and the $250 million 10% senior subordinated notes.

 

Payments due on long-term debt during each of the five years subsequent to December 31, 2003, are as follows:

 

     (Dollars in thousands)

2004

   $ 507

2005

     1,508

2006

     2,758

2007

     6,559

2008

     609

 

Note 9.    Accounts Payable and Accrued Liabilities

 

     2003

   2002

     (Dollars in thousands)

Trade accounts payable

   $ 42,428    $ 44,371

Accrued wages, salaries and employee benefits

     42,555      51,015

Accrued taxes other than taxes on income

     11,842      11,066

Accrued interest

     18,074      17,050

Accrued taxes on income

     3,709      13,059

Book overdrafts

     20,640      16,030

Accrued restructuring, mill closure and divestiture charges

     3,541      8,659

Other

     26,521      30,247
    

  

     $ 169,310    $ 191,497
    

  

 

Note 10.    Other Long-Term Obligations

 

     2003

   2002

     (Dollars in thousands)

Postretirement benefits

   $ 193,103    $ 176,394

Pension and related liabilities

     46,572      69,747

Other

     26,839      21,470
    

  

     $ 266,514    $ 267,611
    

  

 

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Note 11.    Financial Instruments

 

Estimated fair values of our financial instruments are as follows:

 

     2003

   2002

     Carrying
Amount


   Fair
Value


   Carrying
Amount


   Fair
Value


     (Dollars in thousands)

Cash, restricted cash and short-term investments

   $ 47,169    $ 47,169    $ 26,042    $ 26,042

Natural gas collars

     112      112      —        —  

Interest rate swap

     2,386      2,386      6,446      6,446

Current notes payable

     —        —        40,000      40,000

Long-term debt

     618,785      651,905      638,252      659,818
    

  

  

  

 

For short-term investments and current notes payable, the carrying amount approximates fair value. The carrying amount and fair value of our interest rate swap and natural gas collars are based on current termination values. The fair value of our long-term debt is estimated based upon the quoted market prices for the same or similar debt issues. The amount of long-term debt for which there is no quoted market price is immaterial and the carrying amount approximates fair value.

 

We use derivative financial instruments from time to time as a tool to help us manage our exposure to certain market risks. We enter into derivative financial instruments as hedges against our exposure to market risks only if we believe there is a high probability that changes in the value of the hedging instrument will offset corresponding changes in the underlying exposure. Relationships between hedging instruments and hedged items are formally documented, as well as our risk management objectives and strategies for entering into the transactions. Designated cash flow hedges are linked to forecasted transactions. We also periodically assess whether the derivative financial instruments are effective in offsetting changes in cash flows or the fair value of the hedged items. If a hedge ceases to be highly effective, hedge accounting will be discontinued and derivative instrument gains and losses will be recognized in earnings. We do not enter into derivative contracts for speculative purposes, whether or not we utilize hedge accounting treatment for a specific transaction. The following describes our activities in this area during 2003.

 

In December 2001, we entered into a fixed-to-variable interest rate swap to hedge a portion of our 10% senior subordinated debentures. The swap was designated a fair value hedge and called for the company to pay a variable interest amount, based on LIBOR rates, and receive a fixed-rate payment from a financial institution, calculated on $165.0 million of our 10% senior subordinated debentures. In June 2003, we terminated the swap. The cash received upon termination of the swap, together with earlier amounts received for an August 2002 repricing, totaled $20.0 million and will be accreted to earnings until the 10% senior subordinated debentures are retired. In August 2003, we entered into another fixed-to-variable interest rate swap for the same portion of our 10% senior subordinated debentures with essentially the same terms as the swap that was terminated in June 2003. The variable interest rate we pay is determined semi-annually in arrears and will be equal to LIBOR plus 4.80%. The terms of the interest rate swap allow us to assume there is no ineffectiveness in the hedge, and therefore, no amount representing ineffectiveness is recognized in earnings during the period.

 

During the third quarter of 2003, we entered into several derivative financial instruments designated as cash flow hedges for a portion of our expected natural gas purchases during November 2003 through March 2004. The financial instruments are in the form of collars, with a ceiling of $6.35 per mmBtu and floors ranging from $4.44 to $5.30 per mmBtu, indexed to the NYMEX, Rocky Mountain and Canadian Border indices. The collars apply to 13,200 mmBtu of natural gas purchased

 

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per day for the five-month period beginning November 1, which represents approximately 60% of our expected daily usage during that period. As designated cash flow hedges, changes in the fair value of the financial instruments are recognized in “Other comprehensive loss,” to the extent the hedges are deemed effective, until the hedged item is recognized in the statement of operations. The terms of the instruments allow us to conclude there is no ineffectiveness and therefore, no amount representing ineffectiveness is recognized in earnings. The reclassification of gains or losses reported in “Other comprehensive income” to earnings occurs when the related inventory is classified as a cost of sales. At December 31, 2003, the balance in “Accumulated Other Comprehensive Income” of $112,000 relating to cash flow hedges is expected to be reclassified into earnings in the first half of 2004.

 

In the first half of 2003 we entered into forward purchase contracts to acquire Euro, with the settlement of these forward contracts timed to coincide with our required Euro payments to the supplier of our new tissue machine under construction in North Las Vegas, Nevada. As of December 31, 2003, we had no forward purchase contracts outstanding; however, we held 3.9 million Euro to be used to pay the remainder of the amount due to the supplier upon completion of the project. The Euro are valued on our Balance Sheet at the exchange rate quoted at December 31, 2003.

 

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Note 12.    Savings, Pension and Other Postretirement Benefit Plans

 

Substantially all of our employees are eligible to participate in 401(k) savings plans and are covered by noncontributory defined benefit pension plans. These include both company-sponsored and multi-employer plans. In 2003, 2002 and 2001 we made matching 401(k) contributions on behalf of employees of $5.4 million, $7.3 million and $8.9 million, respectively. We also provide benefits under company-sponsored defined benefit retiree health care and life insurance plans, which cover certain salaried and hourly employees. Most of the retiree health care plans require retiree contributions and contain other cost sharing features. The retiree life insurance plans are primarily noncontributory.

 

We use a December 31 measurement date for our benefit plans. The change in benefit obligation, change in plan assets, funded status and related balance sheet amounts for company-sponsored benefit plans are as follows:

 

     Pension Benefit Plans

    Other Postretirement
Benefit Plans


 
     2003

    2002

    2003

    2002

 
     (Dollars in thousands)  

Benefit obligation at beginning of year

   $ 525,107     $ 527,039     $ 242,413     $ 219,129  

Service cost

     9,060       10,605       2,507       3,723  

Interest cost

     34,067       36,979       17,006       16,205  

Plan amendments

     750       2,560       (7,684 )     —    

Actuarial losses

     35,569       16,619       44,136       37,084  

Curtailments

     —         —         —         (18,272 )

Mergers, sales and closures

     (1,285 )     (30,603 )     —         —    

Benefits paid

     (40,536 )     (38,092 )     (17,414 )     (15,456 )
    


 


 


 


Benefit obligation at end of year

     562,732       525,107       280,964       242,413  
    


 


 


 


Fair value of plan assets at beginning of year

     471,390       615,269       9,813       22,198  

Actual return on plan assets

     104,206       (67,821 )     834       (3,909 )

Employer contribution

     20,680       1,215       —         —    

Mergers, sales and closures

     —         (39,181 )     —         —    

Benefits paid

     (40,536 )     (38,092 )     (10,645 )     (8,476 )
    


 


 


 


Fair value of plan assets at end of year

     555,740       471,390       2       9,813  
    


 


 


 


Funded status

     (6,992 )     (53,717 )     (280,962 )     (232,600 )

Unrecognized prior service cost (benefit)

     15,359       16,411       (14,695 )     (8,614 )

Unrecognized net loss

     97,562       109,399       102,554       64,820  

Unrecognized net transition asset

     —         (37 )     —         —    
    


 


 


 


Prepaid (accrued) benefit cost

   $ 105,929     $ 72,056     $ (193,103 )   $ (176,394 )
    


 


 


 


Amounts recognized in the consolidated balance sheets:

                                

Prepaid benefit cost

   $ 122,701     $ 88,609     $ —       $ —    

Accrued benefit cost

     (87,061 )     (87,188 )     (193,103 )     (176,394 )

Intangible assets

     15,238       16,197       —         —    

Accumulated other comprehensive loss

     55,051       54,438       —         —    
    


 


 


 


Net amount recognized

   $ 105,929     $ 72,056     $ (193,103 )   $ (176,394 )
    


 


 


 


 

The accumulated benefit obligation for all defined benefit pension plans was $540.8 million and $506.6 million at December 31, 2003, and 2002, respectively.

 

In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) was signed into law. The Act introduces a drug benefit under Medicare Part D, as well as a

 

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federal subsidy to sponsors of retiree health care benefit plans that provide an equivalent benefit. Neither the accumulated benefit obligation nor the net periodic benefit cost presented in this footnote reflect the effects of the Act on our postretirement benefit plans. Specific authoritative guidance on accounting for the proposed subsidy is pending and once issued could require us (as sponsor) to change previously reported information. We have no current plans to amend our postretirement benefit plans as a result of the Act.

 

Information as of December 31 for pension plans with accumulated benefit obligations in excess of plan assets were as follows:

 

     2003

   2002

     (Dollars in thousands)

Projected benefit obligation

   $ 279,680    $ 262,405

Accumulated benefit obligation

     278,562      259,117

Fair value of plan assets

     237,660      196,540

 

Net periodic costs (benefit) were:

 

     Pension Benefit Plans

   

Other Postretirement

Benefit Plans


 
     2003

    2002

    2001

    2003

    2002

    2001

 
     (Dollars in thousands)  

Service cost

   $ 9,060     $ 10,605     $ 13,178     $ 2,507     $ 3,723     $ 3,243  

Interest cost

     34,067       36,979       35,754       17,006       16,205       12,942  

Expected return on plan assets

     (57,940 )     (62,686 )     (60,453 )     (416 )     (1,620 )     (2,847 )

Amortization of prior service cost

     1,747       2,296       3,356       (1,618 )     (820 )     (833 )

Recognized actuarial loss (gain)

     (174 )     (5,037 )     (5,378 )     5,905       2,790       —    

Recognized net initial asset

     (37 )     (37 )     (45 )     —         —         —    
    


 


 


 


 


 


Net periodic cost (benefit)

   $ (13,277 )   $ (17,880 )   $ (13,588 )   $ 23,384     $ 20,278     $ 12,505  
    


 


 


 


 


 


 

The pension benefits presented above exclude a charge of $0.1 million for a salaried workforce reduction in 2002 and a charge of $2.7 million in 2001 for an hourly workforce reduction program, which are included in “Restructuring charges” in the Statements of Operations. The postretirement costs presented above exclude $1.8 million for the salaried workforce reduction in 2002 and $0.5 million in 2001 for the hourly workforce reduction program, which are included in “Restructuring charges” in the Statements of Operations.

 

The pension benefits for 2002 presented above also do not reflect a cost of $11.0 million related to the sale of Printing Papers segment assets and subsequent closure of a printing papers facility, as well as $0.2 million for the sale of a lumber mill. Postretirement costs of $0.2 million and $0.2 million, respectively, as a result of these events are also excluded from the 2002 costs presented above. The combined costs of $11.6 million are included in “Loss from discontinued operations.”

 

As of December 31, 2003, $70.3 million of minimum pension liabilities for underfunded plans were included in other long-term liabilities, with corresponding intangible assets of $15.2 million and accumulated other comprehensive loss of $33.6 million, which is net of deferred taxes of $21.5 million. As of December 31, 2002, $70.6 million of minimum pension liabilities were included in other long-term liabilities, with corresponding intangible assets of $16.2 million and accumulated other comprehensive loss of $33.2 million, which is net of deferred taxes of $21.2 million. As of December 31, 2001, minimum pension liabilities totaled $2.2 million, with a corresponding intangible asset of the same amount.

 

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Weighted average assumptions used to determine the benefit obligation as of December 31 were:

 

     Pension Benefit Plans

    Other Postretirement
Benefit Plans


 
     2003

    2002

    2001

    2003

    2002

    2001

 

Discount rate

   6.25 %   6.75 %   7.25 %   6.25 %   6.75 %   7.25 %

Expected return on plan assets

   9.50     9.50     9.50     9.00     9.00     9.00  

Rate of salaried compensation increase

   4.00     4.00     5.00     —       —       —    

 

Weighted average assumptions used to determine the net periodic cost (benefit) for the years ended December 31 were:

 

     Pension Benefit Plans

   

Other Postretirement

Benefit Plans


 
     2003

    2002

    2001

    2003

    2002

    2001

 

Discount rate

   6.75 %   7.25 %   7.25 %   6.75 %   7.25 %   7.25 %

Expected return on plan assets

   9.50     9.50     9.50     9.00     9.00     9.00  

Rate of salaried compensation increase

   4.00     5.00     5.00     —       —       —    

 

The expected return on plan assets assumption is based upon an analysis of historical long-term returns for various investment categories as measured by appropriate indexes. These indexes are weighted based upon the extent to which plan assets are invested in the particular categories in arriving at our determination of a composite expected return. Over the past 25 years our actual average annual return on pension plan assets has been 12.0%.

 

The health care cost trend rate assumption used in determining the accumulated postretirement benefit obligation is 8.00% for 2003. The rate is assumed to decrease one percent annually to 6.00% in 2005 and remain at that level thereafter. This assumption has a significant effect on the amounts reported. A one percentage point change in the health care cost trend rates would have the following effects:

 

     1% Increase

   1% Decrease

 
     (Dollars in thousands)  

Effect on total of service and interest cost components

   $ 2,594    $ (2,165 )

Effect on postretirement benefit obligation

     31,749      (26,973 )

 

The weighted average asset allocations at December 31 by asset category are as follows:

 

     Pension Benefit Plans

      

Other Postretirement

Benefit Plans


 

Asset category


   2003

       2002

       2003

       2002

 

Domestic equity securities

   63 %      57 %      —   %      100 %

Global equity securities

   10        9        —          —    

Debt securities

   25        30        —          —    

Other

   2        4        100        —    
    

    

    

    

Total

   100 %      100 %      100 %      100 %
    

    

    

    

 

We utilize formal investment policy guidelines for our company-sponsored pension plans. These guidelines are approved by the board of directors and are periodically reviewed, as the board of directors has ultimate fiduciary responsibility for pension plan assets. The board of directors has delegated its authority to management to insure that the investment policy and guidelines are adhered to and the investment objectives are met.

 

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The general policy states that plan assets will be invested to seek the greatest return consistent with the fiduciary character of the pension funds and to allow the plans to meet the need for timely pension benefit payments. The specific investment guidelines stipulate that adequate liquidity will be maintained for meeting expected benefit payments by reviewing, on a timely basis, contribution and benefit payment levels and appropriately revising long-term and short-term asset allocations. Management will take reasonable and prudent steps to preserve the value of pension fund assets and to avoid the risk of large losses. Major steps taken to provide this protection include:

 

    Assets will be diversified among various asset classes, such as domestic equities, global equities, fixed income, convertible securities, venture capital and liquid reserves. The long-term asset allocation ranges are as follows:

 

Domestic and global equities

   50% - 80%

Fixed income and convertible securities

   15% - 40%

Venture Capital

   00% - 05%

Liquid reserves

   00% - 10%

 

The ranges are more heavily weighted toward equities since the liabilities of the pension plans are long-term in nature and equities have proven to significantly outperform other asset classes over long periods of time. Periodic reviews of allocations within these ranges are made to determine what adjustments should be made based on changing economic and market conditions and specific liquidity requirements.

 

    Assets will be managed by professional investment managers and may be invested in separately managed accounts or commingled funds. Assets will be diversified by selecting different investment managers for each asset class and by limiting assets under each manager to no more than 25% of the total pension fund.

 

    Assets, other than venture capital, will not be invested in securities rated below BBB- by S&P or Baa3 by Moody’s.

 

    Assets will not be invested in Potlatch stock.

 

The investment guidelines also require that the individual investment managers will be expected to achieve a reasonable rate of return over a market cycle. Emphasis will be placed on long-term performance versus short-term market aberrations. Factors to be considered in determining reasonable rates of return include performance achieved by a diverse cross section of other investment managers, performance of commonly used benchmarks (e.g., S&P 500 Index, Shearson Lehman Government/Corporate Intermediate Index, Morgan Stanley World Index, Merrill Lynch Investment Grade Convertibles Index, Consumer Price Index), actuarial assumptions for return on plan investments and specific performance guidelines given to individual investment managers.

 

During 2003, eight active investment managers managed approximately 97% of the pension funds, each of whom played a specific role in the management of these assets. The remaining 3% of the pension funds consisted of a dedicated bond portfolio managed by a fixed income manager and liquid reserves held by the plan trustee. Plan assets were diversified among the various asset classes within the allocation ranges approved by the board of directors.

 

We estimate contributions to defined benefit pension plans will total $1.2 million in 2004. We do not anticipate funding our postretirement benefit plans in 2004 except to pay benefit costs as incurred during the year by plan participants.

 

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Estimated future benefit payments, which reflect expected future service, are as follows for the years indicated:

 

     Pension Benefit Plans

   Other Postretirement
Benefit Plans


     (Dollars in thousands)

2004

   $ 41,290    $ 18,900

2005

     40,675      19,400

2006

     40,289      19,800

2007

     39,968      20,300

2008

     40,020      20,500

2009-2013

     203,605      110,800

 

Hourly employees at two of our manufacturing facilities participate in multi-employer defined benefit pension plans, the Paper, Allied-Industrial, Chemical and Energy Workers International Union (PACE) Pension Fund and the International Association of Machinist & Aerospace Workers (IAMA) National Pension Fund, to which we make contributions. We also make contributions to a trust fund established to provide retiree medical benefits for a portion of these employees, which is managed by PACE. Company contributions to these plans in 2003, 2002 and 2001 amounted to $7.7 million, $6.4 million and $6.1 million, respectively.

 

Note 13.    Commitments and Contingencies

 

We have operating leases covering office, warehouse and distribution space, equipment and vehicles expiring at various dates through 2019. As leases expire, it can be expected that, in the normal course of business, certain leases will be renewed or replaced.

 

As of December 31, 2003, the future minimum rental payments required under our operating leases are as follows:

 

     (Dollars in thousands)

2004

   $ 12,391

2005

     11,408

2006

     10,116

2007

     8,547

2008

     8,232

2009 and later years

     37,213
    

Total

   $ 87,907
    

 

Total rent expense was $9.0 million, $5.3 million and $4.3 million for the years ended December 31, 2003, 2002 and 2001, respectively.

 

In late January 2004, we voluntarily reported to the Minnesota Pollution Control Agency (MPCA) a potential air permit violation at our oriented strand board facility in Bemidji, Minnesota, relating to the non-operation of equipment used to control nitrous oxide emissions from a wood-fired boiler for a period of approximately 29 months. Corrective action has been taken, and we are cooperating with the MPCA in its investigation. As the investigation is ongoing, we have not been advised as to what action the MPCA may take. Because we discovered the violation, took corrective action and voluntarily reported it to the MPCA, we do not believe any potential penalty will be material.

 

Taking into consideration the possible consequences of the above described matter, we believe there is no pending or threatened litigation that would have a material adverse effect on our financial position, operations or liquidity.

 

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Note 14.    Stock Compensation Plans

 

We currently have three fixed stock option plans under which options are issued and outstanding. All of these plans have received shareholder approval. Options are granted with an exercise price equal to market value at the grant date and prior to 1995 may have included a stock appreciation right. Options are fully exercisable after two years and expire not later than 10 years from the date of grant. We were originally authorized to issue up to 1.5 million shares, 1.7 million shares and 1.4 million shares under our 1989 Stock Incentive Plan, 1995 Stock Incentive Plan and 2000 Stock Incentive Plan, respectively. At December 31, 2003, no shares were available for future use under the 1989 Stock Incentive Plan, while approximately 1,000 shares and 568,000 shares were authorized for future use under the 1995 and 2000 Stock Incentive Plans, respectively.

 

A summary of the status of outstanding stock options as of December 31, 2003, 2002 and 2001 and changes during those years is presented below:

 

    2003

  2002

  2001

Options


  Shares

    Weighted Avg.
Exercise Price


  Shares

    Weighted Avg.
Exercise Price


  Shares

    Weighted Avg.
Exercise Price


Outstanding at January 1

    2,836,357     $ 36.67     2,993,000     $ 38.63     2,664,025     $ 40.41

Granted

    150,070       33.18     378,300       24.87     488,275       28.69

Shares exercised

    (49,925 )     27.37     (25,050 )     32.06     (750 )     32.63

SARs exercised

    —         —       —         —       (4,050 )     32.63

Canceled or expired

    (219,682 )     42.32     (509,893 )     39.67     (154,500 )     38.08
   


 

 


 

 


 

Outstanding at December 31

    2,716,820       36.19     2,836,357       36.67     2,993,000       38.63
   


 

 


 

 


 

Options exercisable

    2,385,000       37.25     2,263,594       39.33     2,287,312       41.38

Options outstanding which include a stock appreciation right

    41,700             78,600             120,350        

Shares reserved for future grants

    569,042             793,963             834,145        

Fair value of options granted during the year

  $ 11.72           $ 7.20           $ 10.02        

 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 2003, 2002 and 2001, respectively: dividend yield of 1.73, 2.41 and 2.09 percent; stock volatility of .2737, .2538 and .275; risk free rate of return of 4.36, 4.17 and 5.28 percent; and expected term of 10 years for all grants.

 

The following table summarizes information about stock options outstanding at December 31, 2003:

 

     Options Outstanding

   Options Exercisable

Range of Exercise Prices


   Number
Outstanding
at 12/31/03


   Weighted Avg.
Remaining
Contractual Life


   Weighted Avg.
Exercise Price


   Number
Exercisable
at 12/31/03


   Weighted Avg.
Exercise Price


$23.88 to $29.32

   706,000    8.49 years    $ 26.81    523,250    $ 27.48

$32.06 to $37.75

   941,720    5.79 years      34.68    792,650      34.96

$41.25 to $48.25

   1,069,100    3.92 years      43.72    1,069,100      43.72
    
              
      

$23.88 to $48.25

   2,716,820    5.76 years      36.19    2,385,000      37.25
    
              
      

 

Options may also be issued in the form of restricted stock and other share-based awards. In December 2003, 59,270 shares of stock were granted under a performance-based award program. This program replaced a portion of the stock options normally granted. The performance shares have a three-year performance period and will be issued at the end of the period if the performance measure is met. The performance measure is a comparison of the percentile ranking of our total shareholder return compared to the total shareholder return performance of a selected peer group of forest

 

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product companies. The number of shares actually issued could range from 0%-150% of the amount initially granted. Shares granted under the program may not be voted until issued. A dividend equivalent will be calculated based upon shares earned and paid out as additional shares. In accordance with APB No. 25, we will recognize compensation expense over the performance period equal to the market value of our stock times the number of shares expected to be issued. Compensation expense in 2003 related to these performance shares was less than $0.1 million.

 

Note 15.    Segment Information

 

As of December 31, 2003, our operations were divided into four reporting segments: Resource, Wood Products, Pulp and Paperboard, and Consumer Products, based upon similarities in product lines, manufacturing processes, marketing and management of our businesses. The Resource segment manages our timberland base, provides wood fiber to the manufacturing segments and sells wood fiber to third parties. The Wood Products segment produces oriented strand board, lumber, plywood and particleboard. The Pulp and Paperboard segment produces paperboard and pulp. The Consumer Products segment produces consumer tissue products. Prior to 2003, the Pulp and Paperboard segment and the Consumer Products segment were combined into one reporting segment. Prior year results for these two segments have been reclassified for comparative purposes.

 

We exited our Printing Papers segment in May 2002 when a majority of the segment’s assets were sold to a domestic subsidiary of Sappi Limited. We also closed and sold a hardwood sawmill during the third quarter of 2002. Amounts presented for 2002 and 2001 in the tables below have been adjusted for these discontinued operations.

 

The reporting segments follow the same accounting policies used for our consolidated financial statements, as described in the summary of significant accounting policies, with the exception of the valuation of inventories. All segment inventories are reported using the average cost method and the LIFO reserve is recorded at the corporate level. Management evaluates a segment’s performance based upon profit or loss from operations before income taxes. Intersegment sales or transfers are recorded based on prevailing market prices.

 

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Following is a tabulation of business segment information for each of the past three years. Corporate information is included to reconcile segment data to the consolidated financial statements.

 

     2003

    2002

    2001

 
     (Dollars in thousands)  

Segment Sales:

                        

Resource

   $ 252,614     $ 411,833     $ 410,089  
    


 


 


Wood products:

                        

Oriented strand board

     314,197       187,293       167,182  

Lumber

     279,192       249,790       251,891  

Plywood

     46,402       34,915       40,529  

Particleboard

     15,230       14,083       15,833  

Other

     28,063       23,077       26,858  
    


 


 


       683,084       509,158       502,293  
    


 


 


Pulp and paperboard:

                        

Paperboard

     420,805       395,085       420,588  

Pulp

     61,239       48,483       44,092  
    


 


 


       482,044       443,568       464,680  
    


 


 


Consumer products:

                        

Tissue

     300,896       315,708       317,743  
    


 


 


       1,718,638       1,680,267       1,694,805  

Elimination of intersegment sales

     (212,004 )     (386,721 )     (415,941 )
    


 


 


Total consolidated net sales

   $ 1,506,634     $ 1,293,546     $ 1,278,864  
    


 


 


Intersegment Sales or Transfers(1):

                        

Resource

   $ 157,233     $ 339,169     $ 367,737  

Wood products

     11,715       12,489       17,450  

Pulp and paperboard

     42,971       34,975       30,666  

Consumer products

     85       88       88  
    


 


 


Total

   $ 212,004     $ 386,721     $ 415,941  
    


 


 


Operating Income (Loss):

                        

Resource

   $ 65,511     $ 62,554     $ 55,337  

Wood products

     97,623       (27,031 )     (26,562 )

Pulp and paperboard

     (15,104 )     (42,821 )     (56,045 )

Consumer products

     1,266       42,806       41,572  

Eliminations and adjustments

     (181 )     (3,389 )     2,058  
    


 


 


       149,115       32,119       16,360  

Corporate Items:

                        

Administration expense

     (34,706 )     (33,341 )     (33,686 )

Interest expense

     (48,172 )     (59,882 )     (77,853 )

Interest income

     14,090       1,930       2,448  

Restructuring charge

     476       (8,963 )     —    

Debt reduction charge

     (248 )     (15,360 )     —    
    


 


 


Consolidated income (loss) before taxes on income

   $ 80,555     $ (83,497 )   $ (92,731 )
    


 


 


Depreciation, Amortization and Cost of Fee Timber Harvested:

                        

Resource

   $ 20,917     $ 28,791     $ 26,527  

Wood products

     29,049       30,591       30,530  

Pulp and paperboard

     38,171       39,866       40,875  

Consumer products

     12,585       13,028       12,870  
    


 


 


       100,722       112,276       110,802  

Corporate

     4,137       3,193       4,231  
    


 


 


Total

   $ 104,859     $ 115,469     $ 115,033  
    


 


 


Assets:

                        

Resource

   $ 438,495     $ 432,036     $ 434,293  

Wood products

     339,477       353,693       357,581  

Pulp and paperboard

     418,706       446,362       462,450  

Consumer products

     245,581       231,387       201,459  
    


 


 


       1,442,259       1,463,478       1,455,783  

Assets held for sale

     —         5,000       772,033  

Corporate

     155,118       156,339       260,623  
    


 


 


Total consolidated assets

   $ 1,597,377     $ 1,624,817     $ 2,488,439  
    


 


 


Capital Expenditures:

                        

Resource

   $ 15,519     $ 15,346     $ 14,132  

Wood products

     10,895       8,520       14,572  

Pulp and paperboard

     5,193       3,972       11,778  

Consumer products

     47,881       23,446       2,120  
    


 


 


       79,488       51,284       42,602  

Corporate

     198       330       77  
    


 


 


Total

   $ 79,686     $ 51,614     $ 42,679  
    


 


 


 

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(1)   Intersegment sales for 2001-2003, which were based on prevailing market prices, consisted primarily of logs, chips, pulp logs and other fiber sales by our Resource segment to the Wood Products, Printing Papers and Pulp and Paperboard segments.

 

All of our manufacturing facilities and all other assets are located within the continental United States. However, we sell and ship products to many foreign countries. Geographic information regarding our net sales is summarized as follows:

 

     2003

   2002

   2001

     (Dollars in thousands)

United States

   $ 1,399,971    $ 1,197,154    $ 1,193,939

Japan

     48,666      48,224      33,771

Australia

     6,498      4,881      4,378

Canada

     12,997      9,090      8,731

China

     14,711      12,303      9,327

Italy

     7,013      6,543      7,450

Korea

     9,842      11,210      13,501

Other foreign countries

     6,936      4,141      7,767
    

  

  

Total consolidated net sales

   $ 1,506,634    $ 1,293,546    $ 1,278,864
    

  

  

 

Note 16.    Restructuring Charges

 

The following is a description of the charges included in the “Restructuring charges” line in the Statements of Operations.

 

In the first quarter of 2003, we recorded charges totaling $0.2 million for costs related to terminated employees whose service had been retained beyond the initial 60-day period following the announced elimination of 106 salaried positions in 2002. In December 2003 we recorded a $0.7 million credit, reflecting final cost determinations for pension and medical benefits. As of December 31, 2003, 100 employees had been terminated, four had assumed other positions within the company as a result of job openings and two individuals have been retained until mid-2004. All costs, except immaterial amounts related to the retained individuals, had been incurred by December 31, 2003.

 

In 2002, we recorded a $9.0 million pre-tax charge for costs associated with the elimination of 106 salaried production and administrative positions. As of December 31, 2002, 82 employees had been terminated, three had assumed other positions within the company as a result of job openings, and 21 were scheduled for termination in the first half of 2003. We recorded $3.8 million against the accrued liability associated with the charge at December 31, 2002.

 

In March 2001, we recorded a $4.2 million pre-tax charge associated with a workforce reduction plan at our pulp, paperboard and consumer products operations in Idaho. In September 2001, an additional $0.4 million pre-tax charge was recorded as a result of final cost determinations for pension and medical benefits. The plan permanently reduced the workforce by 124 hourly production and maintenance positions. As of December 31, 2001, all material costs associated with the plan, had been incurred.

 

In December 2001, we reversed $1.8 million of an $18.5 million pre-tax charge, taken in September 2000, for costs associated with the closure of a plywood mill. Our initial estimate of the cost to close the mill included expected costs for some aspects of maintenance and demolition that were not incurred.

 

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Note 17.    Discontinued Operations

 

On March 18, 2002, we announced that we had signed a definitive agreement with a domestic subsidiary of Sappi Limited for the sale of our Cloquet, Minnesota, pulp and printing papers facilities and certain associated assets for $485.5 million in cash, after closing adjustments. The sale was completed in May 2002. As a result of the transaction, we recorded an after-tax charge of $149.8 million in the first quarter of 2002. The charge represented estimated costs associated with the write-down of the carrying value of the assets involved in the sale and closure of the Brainerd facility, as well as other costs associated with exiting the coated paper business. In December 2002, we recorded an additional after-tax charge of $14.6 million to adjust employee severance costs, the carrying value of the remaining Brainerd assets and other exit costs. The charges and 2002 operating losses of $13.9 million, after-tax, are presented as discontinued operations in the Statements of Operations, as required by SFAS No. 144.

 

In conjunction with the sale, we closed our Brainerd printing papers mill. The facility was sold on February 28, 2003, for $4.44 million in cash. The loss on discontinued operations for 2003 of $2.5 million, after-tax, includes costs for maintaining the facility before its sale, an additional loss on the sale and recognition of a continuing contractual obligation.

 

On June 3, 2002, we announced that we would close our Bradley hardwood mill in Warren, Arkansas. We sold the facility in August 2002. An initial after-tax charge of $5.7 million was recorded for estimated asset write-down and closure costs. In December 2002, we reversed $1.6 million of the initial charge, after tax, to reflect actual costs incurred for the closure and sale. The net charge and 2002 operating losses of $1.0 million, after tax, are also presented as discontinued operations in the Statements of Operations, as required by SFAS No. 144.

 

The assets and liabilities of the Printing Papers segment and the Bradley lumber mill are presented in the Balance Sheets under the captions “Assets held for sale” and “Liabilities related to assets held for sale.” The carrying amounts of the major classes of these assets and liabilities at December 31 were as follows:

 

         2003    

       2002    

     (Dollars in thousands)

Assets:

             

Cash

   $ —      $ —  

Receivables, net

     —        —  

Inventories

     —        —  

Land, other than timberlands

     —        108

Plant and equipment, net

     —        4,892

Other assets

     —        —  
    

  

Total assets held for sale

   $ —      $ 5,000
    

  

Liabilities:

             

Accounts payable and accrued liabilities

   $ —      $ 12
    

  

 

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Note 18.    Financial Results by Quarter (Unaudited)

 

    Three Months Ended

 
    March 31

    June 30

    September 30

    December 31

 
    2003

    2002

    2003

    2002

    2003

  2002

    2003

    2002

 
    (Dollars in thousands — except per-share amounts)  

Net sales

  $ 334,802     $ 318,675     $ 368,094     $ 336,273     $ 400,259   $ 326,544     $ 403,479     $ 312,054  
   


 


 


 


 

 


 


 


Costs and expenses:

                                                             

Depreciation, amortization and cost of fee timber harvested

    26,859       30,484       25,202       27,244       25,779     29,067       27,019       28,674  

Materials, labor and other operating expenses

    292,344       273,452       311,915       278,895       308,469     272,100       294,358       275,243  

Selling, general and administrative expenses

    17,252       21,091       20,239       19,850       20,359     19,930       22,430       18,747  

Restructuring charges

    227       —         —         —         —       —         (703 )     8,963  
   


 


 


 


 

 


 


 


      336,682       325,027       357,356       325,989       354,607     321,097       343,104       331,627  
   


 


 


 


 

 


 


 


Earnings (loss) from operations

  $ (1,880 )   $ (6,352 )   $ 10,738     $ 10,284     $ 45,652   $ 5,447     $ 60,375     $ (19,573 )
   


 


 


 


 

 


 


 


Loss from discontinued operations, net of tax

  $ (674 )   $ (152,443 )   $ (173 )   $ (13,532 )   $ —     $ (2,051 )   $ (1,647 )   $ (15,422 )
   


 


 


 


 

 


 


 


Net earnings (loss)

  $ (9,565 )   $ (167,381 )   $ 6,649     $ (20,089 )   $ 22,156   $ (12,433 )   $ 31,487     $ (34,478 )
   


 


 


 


 

 


 


 


Net earnings (loss) per common share from continuing operations:

                                                             

Basic

  $ (.31 )   $ (.53 )   $ .24     $ (.23 )   $ .77   $ (.36 )   $ 1.15     $ (.67 )

Diluted

    (.31 )     (.53 )     .24       (.23 )     .77     (.36 )     1.15       (.67 )

Net earnings (loss) per common share:

                                                             

Basic

    (.33 )     (5.90 )     .23       (.70 )     .77     (.43 )     1.10       (1.20 )

Diluted

    (.33 )     (5.90 )     .23       (.70 )     .77     (.43 )     1.10       (1.20 )
   


 


 


 


 

 


 


 


 

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Note 19.    Subsidiary Guarantors

 

A portion of our outstanding debt is unconditionally guaranteed, on a joint and several basis, by four of our subsidiaries, which are also guarantors, on an unconditional, joint and several basis, of the obligations under our current credit facilities.

 

Consolidating statements of operations and comprehensive income for the years ended December 31, 2003, 2002, and 2001 are as follows:

 

     For the year ended December 31, 2003

 
     Parent
Company


    Subsidiary
Guarantors


   Eliminations

    Consolidated

 
     (Dollars in thousands)  

Net sales

   $ 1,506,634     $ 1,124    $ (1,124 )   $ 1,506,634  
    


 

  


 


Costs and expenses:

                               

Depreciation, amortization and cost of fee timber harvested

     104,761       98      —         104,859  

Materials, labor and other operating expenses

     1,208,006       204      (1,124 )     1,207,086  

Selling, general and administrative expenses

     79,867       413      —         80,280  

Restructuring charges

     (476 )     —        —         (476 )
    


 

  


 


       1,392,158       715      (1,124 )     1,391,749  
    


 

  


 


Earnings from operations

     114,476       409      —         114,885  

Interest expense

     (48,172 )     —        —         (48,172 )

Debt retirement costs

     (248 )     —        —         (248 )

Interest income

     14,090       —        —         14,090  
    


 

  


 


Earnings before taxes and equity in net income of consolidated subsidiaries

     80,146       409      —         80,555  

Equity in net income of consolidated subsidiaries

     271       —        (271 )     —    

Provision for taxes

     27,196       138      —         27,334  
    


 

  


 


Earnings from continuing operations

     53,221       271      (271 )     53,221  

Discontinued operations:

                               

Loss from discontinued operations

     (4,089 )     —        —         (4,089 )

Income tax benefit