Mercer International
MERC
#9697
Rank
$69.99 M
Marketcap
$1.04
Share price
-4.13%
Change (1 day)
-79.31%
Change (1 year)

Mercer International - 10-Q quarterly report FY


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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
   
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
OR
   
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission File No.: 000-51826
MERCER INTERNATIONAL INC.
(Exact name of Registrant as specified in its charter)
   
Washington 47-0956945
(State or other jurisdiction
of incorporation or organization)
 (I.R.S. Employer
Identification No.)
Suite 2840, 650 West Georgia Street, Vancouver, British Columbia, Canada, V6B 4N8
(Address of office)
(604) 684-1099
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES þ       NO o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer o            Accelerated Filer þ            Non-Accelerated Filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES o       NO þ
The Registrant had 33,179,140 shares of common stock outstanding as at August 8, 2006.
 
 

 


 

PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
MERCER INTERNATIONAL INC.
CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR THE SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)

FORM 10-Q
QUARTERLY REPORT - PAGE 2


 

MERCER INTERNATIONAL INC.
CONSOLIDATED CONDENSED BALANCE SHEETS
As at June 30, 2006 and December 31, 2005
(Unaudited)
(Euros in thousands)
         
  June 30,  December 31, 
  2006  2005 
ASSETS
        
Current Assets
        
Cash and cash equivalents
 73,079  83,547 
Cash restricted
  5,892   7,039 
Receivables
  87,020   74,315 
Inventories
  69,544   81,147 
Prepaid expenses and other
  6,240   5,474 
 
      
Total current assets
  241,775   251,522 
 
      
Long-Term Assets
        
Cash restricted
  66,537   24,573 
Property, plant and equipment
  1,008,319   1,024,662 
Investments
  7,695   6,314 
Deferred note issuance and other costs
  7,674   8,364 
Deferred income tax
  38,798   78,381 
 
      
 
  1,129,023   1,142,294 
 
      
Total assets
 1,370,798  1,393,816 
 
      
LIABILITIES
        
Current Liabilities
        
Accounts payable and accrued expenses
 109,113  112,726 
Debt, current portion
  75,375   27,601 
 
      
Total current liabilities
  184,488   140,327 
 
      
Long-Term Liabilities
        
Debt, less current portion
  898,379   922,619 
Unrealized foreign exchange rate derivative loss
  11,735   61,979 
Unrealized interest rate derivative losses
  42,320   78,646 
Pension and other post-retirement benefit obligations
  16,541   17,113 
Capital leases and other
  9,980   9,945 
Deferred income tax
  17,428   14,444 
 
      
 
  996,383   1,104,746 
 
      
Total liabilities
  1,180,871   1,245,073 
 
      
Minority Interest
      
SHAREHOLDERS’ EQUITY
        
Common shares
  181,655   181,586 
Additional paid-in capital, stock options
  87   14 
Deficit
  (12,961)  (47,970)
Accumulated other comprehensive income
  21,146   15,113 
 
      
Total shareholders’ equity
  189,927   148,743 
 
      
 
Total liabilities and shareholders’ equity
 1,370,798  1,393,816 
 
      
The accompanying notes are an integral part of these financial statements.

FORM 10-Q
QUARTERLY REPORT - PAGE 3


 

MERCER INTERNATIONAL INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For Six Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands, except for per share data)
         
  2006  2005 
Revenues
 325,769  227,502 
 
        
Costs and expenses:
        
Cost of sales
  298,045   210,167 
 
      
 
  27,724   17,335 
General and administrative expenses
  (18,591)  (15,316)
Sale of emission allowances
  13,246   6,288 
 
      
Income from operations
  22,379   8,307 
 
      
 
        
Other income (expense)
        
Interest expense
  (46,037)  (41,463)
Investment income
  3,011   981 
Unrealized foreign exchange gain (loss) on debt
  12,173   (7,509)
Realized loss on derivative instruments
  (5,219)  (295)
Unrealized gain (loss) on derivative instruments
  90,724   (73,015)
Impairment of investments
     (1,645)
 
      
Total other income (expense)
  54,652   (122,946)
 
      
 
        
Income (loss) before income taxes and minority interest
  77,031   (114,639)
Income tax (provision) benefit
  (42,920)  21,412 
 
      
Income (loss) before minority interest
  34,111   (93,227)
Minority interest
  898   11,409 
 
      
Net income (loss)
 35,009  (81,818)
 
        
(Deficit) retained earnings, beginning of period
  (47,970)  69,176 
 
      
Deficit, end of period
 (12,961) (12,642)
 
      
 
        
Income (loss) per share
        
Basic
 1.06  (2.80)
 
      
Diluted
 0.86  (2.80)
 
      
The accompanying notes are an integral part of these financial statements.

FORM 10-Q
QUARTERLY REPORT - PAGE 4


 

MERCER INTERNATIONAL INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For Three Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands, except for per share data)
         
  2006  2005 
Revenues
 166,705  129,609 
 
        
Costs and expenses:
        
Cost of sales
  153,706   119,178 
 
      
 
  12,999   10,431 
General and administrative expenses
  (9,733)  (7,518)
Sale of emission allowances
  7,608   6,288 
 
      
Income from operations
  10,874   9,201 
 
      
 
        
Other income (expense)
        
Interest expense
  (23,112)  (22,200)
Investment income
  1,267   806 
Unrealized foreign exchange gain (loss) on debt
  6,060   (9,806)
Realized loss on derivative instruments
  (1,657)   
Unrealized gain (loss) on derivative instruments
  46,347   (69,451)
 
      
Total other income (expense)
  28,905   (100,651)
 
      
 
        
Income (loss) before income taxes and minority interest
  39,779   (91,450)
Income tax (provision) benefit
  (21,807)  24,447 
 
      
Income (loss) before minority interest
  17,972   (67,003)
Minority interest
  449   4,852 
 
      
Net income (loss)
 18,421  (62,151)
 
        
(Deficit) retained earnings, beginning of period
  (31,382)  49,509 
 
      
Deficit, end of period
 (12,961) (12,642)
 
      
 
        
Income (loss) per share
        
Basic
 0.56  (1.88)
 
      
Diluted
 0.45  (1.88)
 
      
The accompanying notes are an integral part of these financial statements.

FORM 10-Q
QUARTERLY REPORT - PAGE 5


 

MERCER INTERNATIONAL INC.
CONSOLIDATED CONDENSED STATEMENTS OF
COMPREHENSIVE INCOME (LOSS)
For Six Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands)
         
  2006  2005 
Net income (loss)
 35,009  (81,818)
 
      
 
        
Other comprehensive gain:
        
Foreign currency translation adjustment
  5,360   1,118 
Pension plan additional minimum liability
  (17)   
Unrealized gains on securities
        
Unrealized holding gains arising during the period
  690   305 
 
      
 
        
Other comprehensive gain
  6,033   1,423 
 
      
 
        
Total comprehensive income (loss)
 41,042  (80,395)
 
      
The accompanying notes are an integral part of these financial statements.

FORM 10-Q
QUARTERLY REPORT - PAGE 6


 

MERCER INTERNATIONAL INC.
CONSOLIDATED CONDENSED STATEMENTS OF
COMPREHENSIVE INCOME (LOSS)
For Three Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands)
         
  2006  2005 
Net income (loss)
 18,421  (62,151)
 
      
 
        
Other comprehensive gain:
        
Foreign currency translation adjustment
  8,345   1,750 
Pension plan additional minimum liability
  2    
Unrealized gains on securities
        
Unrealized holding gains arising during the period
  569    
 
      
 
        
Other comprehensive gain
  8,916   1,750 
 
      
 
        
Total comprehensive income (loss)
 27,337  (60,401)
 
      
The accompanying notes are an integral part of these financial statements.

FORM 10-Q
QUARTERLY REPORT - PAGE 7


 

MERCER INTERNATIONAL INC.
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For Six Months Ended June 30, 2006 and 2005
(Unaudited)
(Euros in thousands)
         
  2006  2005 
Cash Flows from (used in) Operating Activities:
        
Net income (loss)
 35,009  (81,818)
Adjustments to reconcile net income (loss) to cash flows from operating activities
        
Unrealized (gains) losses on derivatives
  (85,505)  73,015 
Depreciation and amortization
  29,082   25,299 
Unrealized foreign exchange (gain) loss on debt
  (12,173)  7,509 
Impairment of investments and securities
     1,645 
Minority interest
  (898)  (11,409)
Deferred income taxes
  42,567   (21,638)
Stock compensation expense
  207   72 
Other
  (490)  125 
 
        
Changes in current assets and liabilities
        
Receivables
  (13,486)  (20,742)
Inventories
  10,670   (16,757)
Accounts payable and accrued expenses
  (3,347)  41,319 
Other
  (252)  (1,853)
 
      
Net cash from (used in) operating activities
  1,384   (5,233)
 
      
 
        
Cash Flows used in Investing Activities:
        
Cash restricted
  (40,817)  35,808 
Purchase of property, plant and equipment
  (15,439)  (8,493)
Acquisition of Celgar pulp mill
     (146,608)
 
      
Net cash used in investing activities
  (56,256)  (119,293)
 
      
 
        
Cash Flows from Financing Activities:
        
Decrease in construction costs payable
  (212)  (31,346)
Proceeds from borrowings of notes payable and debt
  48,634   325,195 
Repayment of notes payable and debt
  (375)  (183,691)
Proceeds from investment grants
     342 
Repayment of capital lease obligations
  (2,431)  (1,907)
Issuance of shares of common stock
  69   66,645 
 
      
Net cash from financing activities
  45,685   175,238 
 
      
 
        
Effect of exchange rate changes on cash and cash equivalents
  (1,281)  5,594 
 
      
Net (decrease) increase in cash and cash equivalents
  (10,468)  56,306 
Cash and cash equivalents, beginning of period
  83,547   49,568 
 
      
Cash and cash equivalents, end of period
 73,079  105,874 
 
      
The accompanying notes are an integral part of these financial statements.

FORM 10-Q
QUARTERLY REPORT - PAGE 8


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED June 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 1. Basis of Presentation
Effective March 1, 2006, the Company was converted from a business trust organized under the laws of the State of Washington to a corporation organized under the laws of the State of Washington. The conversion was effected through the merger of Mercer Inc. with and into an indirect wholly owned Delaware subsidiary company followed by a merger with a direct wholly owned Washington subsidiary company. The conversion effected a change in the Company’s legal form, but did not result in any change in its business, management, fiscal year, accounting practices, assets or liabilities (except to the extent of legal and other costs of effecting the conversion and maintaining ongoing corporate status) or location of its principal executive offices and facilities. The Company continues to operate under the name “Mercer International Inc.” following consummation of the conversion and continues to be engaged in the same business that it was engaged in prior to the conversion and its shares of common stock are quoted and listed for trading on the NASDAQ National Market and the Toronto Stock Exchange, respectively.
The interim period consolidated financial statements contained herein include the accounts of Mercer International Inc. (“Mercer Inc.”) and its wholly-owned and majority-owned subsidiaries (collectively, the “Company”).
The interim period consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such SEC rules and regulations. The interim period consolidated financial statements should be read together with the audited consolidated financial statements and accompanying notes included in the Company’s latest annual report on Form 10-K for the fiscal year ended December 31, 2005. In the opinion of the Company, the unaudited consolidated financial statements contained herein contain all adjustments necessary to present a fair statement of the results of the interim periods presented. The results for the periods presented herein may not be indicative of the results for the entire year.

FORM 10-Q
QUARTERLY REPORT - PAGE 9


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 2. Stock-Based Compensation
The Company adopted Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment, on January 1, 2006. This statement requires the Company to recognize the cost of employee services received in exchange for the Company’s equity instruments. Under SFAS No. 123R, the Company is required to record compensation expense over an award’s vesting period based on the award’s fair value at the date of grant. The Company has elected to adopt SFAS No. 123R on a modified prospective basis; accordingly, the financial statements for periods prior to January 1, 2006 will not include compensation cost calculated under the fair value method.
Prior to January 1, 2006, the Company applied Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees, and, therefore, recorded the intrinsic value of stock-based compensation as expense and applied the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation prior to January 1, 2006.
     
  Six Months Ended 
  June 30, 2005 
Net Loss
    
As reported
 (81,818)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of any related tax effects
  (21)
 
   
Pro forma
 (81,839)
 
   
Basic and Diluted Loss Per Share
    
As reported
 (2.80)
 
   
Pro forma
 (2.80)
 
   
     
  Three Months Ended 
  June 30, 2005 
Net Loss
    
As reported
 (62,151)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of any related tax effects
  (11)
 
   
Pro forma
 (62,162)
 
   
Basic and Diluted Loss Per Share
    
As reported
 (1.88)
 
   
Pro forma
 (1.88)
 
   
The fair value of each option granted is estimated on the grant date using the Black-Scholes model. During the six month period ended June 30, 2006 and 2005, no options were granted, exercised or cancelled.

FORM 10-Q
QUARTERLY REPORT - PAGE 10


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 2. Stock-Based Compensation (cont’d)
Summarized information about stock options outstanding and exercisable at June 30, 2006 is as follows:
                             
Outstanding Options  Exercisable Options 
              Weighted           
              Average  Weighted      Weighted 
Exercise        Remaining  Average      Average 
Price Range    Number  Contractual Life  Exercise price  Number  Exercise Price 
(In U.S. Dollars)        (Years)  (In U.S. Dollars)      (In U.S. Dollars) 
$5.65 - 6.375  
 
  920,000   4.00  $6.30   886,666  $6.32 
     8.50  
 
  135,000   1.00   8.50   135,000   8.50 
     7.30  
 
  30,000   9.00   7.30   10,000   7.30 
     7.92  
 
  100,000   9.25   7.92   33,333   7.92 
        
 
                
        
 
  1,185,000      $6.71   1,064,999  $6.66 
As at June 30, 2006, the total remaining unrecognized compensation cost related to non-vested stock options amounted to 218, which will be amortized over their remaining vesting period.
During the six-month period ended June 30, 2006, there was no change in the number of non-vested options.
Restricted Stock
The fair value of restricted stock is determined based upon the number of shares granted and the quoted price of the Company’s stock on the date of grant. Restricted stock generally vests over two years. Expense is recognized on a straight-line basis over the vesting period. Expense recognized for the six months ended June 30, 2006 and 2005 was 207 and 72, respectively.
As at June 30, 2006, the total remaining unrecognized compensation cost related to restricted stock amounted to 240, which will be amortized over their remaining vesting period.
During the six month period ended June 30, 2006, there were restricted stock awards of an aggregate of 10,000 of our common shares to independent directors.

FORM 10-Q
QUARTERLY REPORT - PAGE 11


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 3. Income (Loss) Per Share
Basic income (loss) per share is computed by dividing income (loss) available to common shareholders by the weighted average number of shares outstanding during a period. Diluted income (loss) per share takes into consideration shares outstanding (computed under basic earnings (loss) per share) and potentially dilutive shares. The following table sets out the computation of basic income (loss) per share for the six and three months ended June 30, 2006 and 2005, respectively:
                 
  Six Months Ended June 30,  Three Months Ended June 30, 
  2006  2005  2006  2005 
Income (loss) from continuing operations – basic
 35,009  (81,818) 18,421  (62,151)
Interest on convertible notes, net of tax
  2,767      1,441    
 
            
Income (loss) from continuing operations – diluted
 37,776  (81,818) 19,862  (62,151)
 
            
Weighted average number of common shares outstanding:
                
Basic
  33,169,637   29,270,388   33,170,129   33,055,103 
Effect of dilutive shares:
                
Stock options and awards
  274,686      292,002    
Convertible notes
  10,645,161      10,645,161    
 
            
Diluted
  44,089,484   29,270,388   44,107,292   33,055,103 
 
            
Income (loss) from continuing operations per share:
                
Basic
 1.06  (2.80) 0.56  (1.88)
 
            
Diluted
 0.86  (2.80) 0.45  (1.88)
 
            
The calculation of diluted income (loss) per share for the comparative 2005 period does not assume the exercise of stock options and awards or the conversion of convertible notes that would have an anti-dilutive effect on earnings per share. Stock options and awards excluded from the calculation of diluted income (loss) per share because they are anti-dilutive represented 253,969 for the six months ended June 30, 2005. Convertible notes excluded from the calculation of diluted income (loss) per share because they are anti-dilutive represented 10,645,161 for the six months ended June 30, 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 12


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 4. Acquisition of the Celgar Mill and Related Financings
Acquisition
On February 14, 2005, the Company completed its acquisition of the Celgar NBSK pulp mill. The aggregate consideration for the acquisition was 177,422, which included 142,940 in cash, acquisition related expenditures of 3,668 and 30,814 was paid in common shares of the Company. The results of the Celgar mill are included in the consolidated statement of operations since the acquisition date.
The allocation of the purchase price is summarized below.
     
Purchase price:
    
Cash (including defined working capital)
 142,940 
Equity – common shares
  30,814 
Acquisition costs
  3,668 
 
   
 
 177,422 
 
   
 
    
Net assets acquired:
    
Receivables
 32 
Inventories
  19,969 
Prepaids and other assets
  616 
Property, plant and equipment
  175,096 
Accrued expenses and other liabilities
  (4,103)
Pension plan and post-retirement benefits obligations
  (14,188)
 
   
 
 177,422 
 
   
In October 2005, our wholly owned subsidiary, Zellstoff Celgar Limited, received a re-assessment for real property transfer tax payable in British Columbia, Canada, in the amount of approximately 3.5 million in connection with the transfer of the land where the Celgar mill is situated. The Company is contesting the assessment and the amount, if any, that may be payable in connection therewith is not yet determinable. Any additional amount paid in connection with the re-assessment will increase the cost basis of the assets acquired.

FORM 10-Q
QUARTERLY REPORT - PAGE 13


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 5. Business Segment Information
The Company operates in two reportable business segments: pulp and paper. The segments are managed separately because each business requires different production and marketing strategies. The results of the Celgar mill presented below are from the date of its acquisition on February 14, 2005.
Summarized financial information concerning the segments is shown in the following table:
                             
                      Corporate,    
  Rosenthal  Celgar  Stendal  Total      Other and  Consolidated 
  Pulp  Pulp  Pulp  Pulp  Paper  Eliminations  Total 
Six Months Ended June 30, 2006
                            
Sales to external customers
 68,941  100,811  122,510  292,262  33,507    325,769 
Intersegment net sales
  (152)  23   4,688   4,559   108   (4,667)   
 
                     
 
  68,789   100,834   127,198   296,821   33,615   (4,667)  325,769 
 
                     
Operating costs
  49,453   98,702   95,571   243,726   29,971   (4,434)  269,263 
Operating depreciation and amortization
  7,750   6,291   14,129   28,170   456   156   28,782 
General and administrative
  3,592   4,939   5,940   14,471   2,276   1,844   18,591 
(Sale) purchase of emission allowances
  (3,651)     (9,595)  (13,246)        (13,246)
 
                     
 
  57,144   109,932   106,045   273,121   32,703   (2,434)  303,390 
 
                     
Income (loss) from operations
  11,645   (9,098)  21,153   23,700   912   (2,233)  22,379 
Interest expense
                          (46,037)
Investment income
                          3,011 
Derivative financial instruments, net
                          85,505 
Unrealized foreign exchange gain on debt
                          12,173 
 
                           
Income before income taxes and minority interest
                         77,031 
 
                           
Segment assets
 332,485  237,175  746,557  1,316,217  22,020  32,561  1,370,798 
 
                     
                             
                      Corporate,    
  Rosenthal  Celgar(1)  Stendal  Total      Other and  Consolidated 
  Pulp  Pulp  Pulp  Pulp  Paper  Eliminations  Total 
Six Months Ended June 30, 2005
                            
Sales to external customers
 65,936  48,480  81,606  196,022  31,480    227,502 
Intersegment net sales
        3,340   3,340      (3,340)   
 
                     
 
  65,936   48,480   84,946   199,362   31,480   (3,340)  227,502 
 
                     
Operating costs
  47,405   40,554   71,546   159,505   29,601   (3,822)  185,284 
Operating depreciation and amortization
  6,630   4,097   13,454   24,181   379   323   24,883 
General and administrative
  3,810   2,837   1,677   8,324   2,562   4,430   15,316 
(Sale) purchase of emission allowances
  (2,135)     (4,153)  (6,288)        (6,288)
 
                     
 
  55,710   47,488   82,524   185,722   32,542   931   219,195 
 
                     
Income (loss) from operations
  10,226   992   2,422   13,640   (1,062)  (4,271)  8,307 
Interest expense
                          (41,463)
Investment income
                          981 
Derivative financial instruments, net
                          (73,310)
Unrealized foreign exchange loss on debt
                          (7,509)
Impairment of investments
                          (1,645)
 
                           
Loss before income taxes and minority interest
                         (114,639)
 
                           
Segment assets
 347,935  244,361  906,244  1,498,540  24,294  15,995  1,538,829 
 
                     
 
(1) The results of the Celgar pulp mill are from the date of its acquisition on February 14, 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 14


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 5. Business Segment Information (cont’d)
                             
                      Corporate,    
  Rosenthal  Celgar  Stendal  Total      Other and  Consolidated 
  Pulp  Pulp  Pulp  Pulp  Paper  Eliminations  Total 
Three Months Ended June 30, 2006
                            
Sales to external customers
 34,269  54,514  61,811  150,594  16,111    166,705 
Intersegment net sales
  (194)  23   2,373   2,202   108   (2,310)   
 
                     
 
  34,075   54,537   64,184   152,796   16,219   (2,310)  166,705 
 
                     
Operating costs
  25,466   53,137   47,446   126,049   14,453   (1,664)  138,838 
Operating depreciation and amortization
  4,213   3,277   7,070   14,560   230   78   14,868 
General and administrative
  2,265   2,815   3,183   8,263   1,135   335   9,733 
(Sale) purchase of emission allowances
  (1,884)     (5,724)  (7,608)        (7,608)
 
                     
 
  30,060   59,229   51,975   141,264   15,818   (1,251)  155,831 
 
                     
Income (loss) from operations
  4,015   (4,692)  12,209   11,532   401   (1,059)  10,874 
Interest expense
                          (23,112)
Investment income
                          1,267 
Derivative financial instruments, net
                          44,690 
Unrealized foreign exchange gain on debt
                          6,060 
 
                           
Income before income taxes and minority interest
                         39,779 
 
                           
                             
                      Corporate,    
  Rosenthal  Celgar  Stendal  Total      Other and  Consolidated 
  Pulp  Pulp  Pulp  Pulp  Paper  Eliminations  Total 
Three Months Ended June 30, 2005
                            
Sales to external customers
 31,840  40,864  40,808  113,512  16,097    129,609 
Intersegment net sales
        1,786   1,786      (1,786)   
 
                     
 
  31,840   40,864   42,594   115,298   16,097   (1,786)  129,609 
 
                     
Operating costs
  22,217   35,419   34,411   92,047   15,370   (2,135)  105,282 
Operating depreciation and amortization
  3,362   3,274   6,773   13,409   198   289   13,896 
General and administrative
  1,909   1,162   702   3,773   1,326   2,419   7,518 
(Sale) purchase of emission allowances
  (2,135)     (4,153)  (6,288)        (6,288)
 
                     
 
  25,353   39,855   37,733   102,941   16,894   573   120,408 
 
                     
Income (loss) from operations
  6,487   1,009   4,861   12,357   (797)  (2,359)  9,201 
Interest expense
                          (22,200)
Investment income
                          806 
Derivative financial instruments, net
                          (69,451)
Unrealized foreign exchange loss on debt
                          (9,806)
 
                           
Loss before income taxes and minority interest
                         (91,450)
 
                           

FORM 10-Q
QUARTERLY REPORT - PAGE 15


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 6. Inventories
         
  June 30, 2006  December 31, 2005 
Raw materials
 44,277  42,649 
Finished goods
  25,267   38,498 
 
      
 
 69,544  81,147 
 
      
Note 7. Pension and Other Post-Retirement Benefit Obligations
Included in pension and other post-retirement benefit obligations are amounts related to our Celgar and German pulp mills.
The Celgar mill maintains defined benefit pension and post-retirement benefit plans for certain employees. Pension benefits are based on employees’ earnings and years of service. The pension plans are funded by contributions from the Company based on management’s best estimates. Pension contributions for the six month period ended June 30, 2006 and the period from acquisition to June 30, 2005 totaled 908 and 369, respectively.
                 
  Six Months Ended June 30, 
  2006  2005 
  Pension  Post-Retirement  Pension  Post-Retirement 
  Benefits  Benefits  Benefits  Benefits 
Service cost
 448  227  245  107 
Interest cost
  706   382   481   234 
Expected return on plan assets
  (786)     (471)   
Recognized net loss
     50       
 
            
Net periodic benefit cost
 368  659  255  341 
 
            
                 
  Three Months Ended June 30, 
  2006  2005 
  Pension  Post-Retirement  Pension  Post-Retirement 
  Benefits  Benefits  Benefits  Benefits 
Service cost
 222  112  161  58 
Interest cost
  350   190   323   146 
Expected return on plan assets
  (389)     (321)   
Recognized net loss
     25       
 
            
Net periodic benefit cost
 183  327  163  204 
 
            

FORM 10-Q
QUARTERLY REPORT - PAGE 16


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 8. Derivatives Transactions
         
  Six Months Ended June 30, 
  2006  2005 
Realized loss on derivative financial instruments
 (5,219) (295)
 
      
 
Unrealized net gain (loss) on interest rate derivatives
  36,326   (20,475)
Unrealized net gain (loss) on foreign exchange derivatives
  54,398   (52,540)
 
      
Unrealized gain (loss) on derivative financial instruments
 90,724  (73,015)
 
      
         
  Three Months Ended June 30, 
  2006  2005 
Realized loss on derivative financial instruments
 (1,657)  
 
      
 
Unrealized net gain (loss) on interest rate derivatives
  12,820   (20,819)
Unrealized net gain (loss) on foreign exchange derivatives
  33,527   (48,632)
 
      
Unrealized gain (loss) on derivative financial instruments
 46,347  (69,451)
 
      

FORM 10-Q
QUARTERLY REPORT - PAGE 17


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 9. Restricted Group Supplemental Disclosure
The terms of the indenture governing our 9.25% senior unsecured notes requires that we provide the results of operations and financial condition of Mercer Inc. and our restricted subsidiaries under the indenture, collectively referred to as the “Restricted Group”. From February 14, 2005, the Restricted Group includes Mercer Inc., certain holding subsidiaries, Rosenthal and the Celgar mill. The Restricted Group excludes our paper operations and the Stendal mill.
Combined Condensed Balance Sheet
                 
  June 30, 2006 
  Restricted  Unrestricted      Consolidated 
  Group  Subsidiaries  Eliminations  Group 
ASSETS
                
Current assets
                
Cash and cash equivalents
 37,018  36,061    73,079 
Cash restricted
     5,892      5,892 
Receivables
  47,468   39,552      87,020 
Inventories
  36,653   32,891      69,544 
Prepaid expenses and other
  3,620   2,620      6,240 
 
            
Total current assets
  124,759   117,016      241,775 
Cash restricted
     66,537      66,537 
Property, plant and equipment
  400,046   608,273      1,008,319 
Other
  10,048   5,321      15,369 
Deferred income tax
  18,149   20,649      38,798 
Due from unrestricted group
  49,302      (49,302)   
 
            
Total assets
 602,304  817,796  (49,302) 1,370,798 
 
            
 
                
LIABILITIES
                
Current liabilities
                
Accounts payable and accrued expenses
 43,851  65,262    109,113 
Debt, current portion
     75,375      75,375 
 
            
Total current liabilities
  43,851   140,637      184,488 
Debt, less current portion
  322,732   575,647      898,379 
Due to restricted group
     49,302   (49,302)   
Unrealized derivative loss
     54,055      54,055 
Other
  21,160   5,361      26,521 
Deferred income tax
  2,379   15,049      17,428 
 
            
Total liabilities
  390,122   840,051   (49,302)  1,180,871 
 
            
SHAREHOLDERS’ EQUITY
                
Total shareholders’ equity (deficit)
  212,182   (22,255)(1)     189,927 
 
            
Total liabilities and shareholders’ equity
 602,304  817,796  (49,302) 1,370,798 
 
            
 
(1) Shareholders’ equity does not include government grants received or receivable related to the Stendal mill. Shareholders’ equity is impacted by the unrealized non-cash marked to market valuation losses on derivative financial instruments.

FORM 10-Q
QUARTERLY REPORT - PAGE 18


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 9. Restricted Group Supplemental Disclosure (cont’d)
Combined Condensed Balance Sheet
                 
  December 31, 2005 
  Restricted  Unrestricted      Consolidated 
  Group  Subsidiaries  Eliminations  Group 
ASSETS
                
Current
                
Cash and cash equivalents
 48,790  34,757   83,547 
Cash restricted
     7,039      7,039 
Receivables
  41,349   32,966      74,315 
Inventories
  47,100   34,047      81,147 
Prepaid expenses and other
  2,940   2,534      5,474 
 
            
Total current assets
  140,179   111,343      251,522 
Cash restricted
     24,573      24,573 
Property, plant and equipment
  404,151   620,511      1,024,662 
Other
  10,533   4,145      14,678 
Deferred income tax
  24,303   54,078      78,381 
Due from unrestricted group
  46,412      (46,412)   
 
            
Total assets
 625,578  814,650  (46,412) 1,393,816 
 
            
 
                
LIABILITIES
                
Current
                
Accounts payable and accrued expenses
 46,867  65,859    112,726 
Debt, current portion
     27,601      27,601 
 
            
Total current liabilities
  46,867   93,460      140,327 
Debt, less current portion
  342,023   580,596      922,619 
Due to restricted group
     46,412   (46,412)   
Unrealized derivative loss
     140,625      140,625 
Other
  20,722   6,336      27,058 
Deferred income tax
  1,851   12,593      14,444 
 
            
Total liabilities
  411,463   880,022   (46,412)  1,245,073 
 
            
SHAREHOLDERS’ EQUITY
Total shareholders’ equity (deficit)
  214,115   (65,372)(1)     148,743 
 
            
Total liabilities and shareholders’ equity
 625,578  814,650  (46,412) 1,393,816 
 
            
 
(1) Shareholders’ equity does not include government grants received or receivable related to the Stendal mill. Shareholders’ equity is impacted by the unrealized non-cash marked to market valuation losses on derivative financial instruments.

FORM 10-Q
QUARTERLY REPORT - PAGE 19


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 9. Restricted Group Supplemental Disclosure (cont’d)
Combined Condensed Statement of Operations
                 
  Six Months Ended June 30, 2006 
  Restricted  Unrestricted      Consolidated 
  Group  Subsidiaries  Eliminations  Group 
Revenues
 169,623  160,813  (4,667) 325,769 
 
            
 
                
Operating costs
  148,388   125,309   (4,434)  269,263 
Operating depreciation and amortization
  14,197   14,585      28,782 
General and administrative expenses
  10,375   8,216      18,591 
(Sale) purchase of emission allowances
  (3,651)  (9,595)     (13,246)
 
            
 
  169,309   138,515   (4,434)  303,390 
 
            
Income from operations
  314   22,298   (233)  22,379 
 
            
 
                
Other income (expense)
                
Interest expense
  (16,442)  (31,355)  1,760   (46,037)
Investment income
  2,119   2,652   (1,760)  3,011 
Derivative financial instruments, net
     85,505      85,505 
Unrealized foreign exchange gain on debt
  12,173         12,173 
 
            
Total other (expense) income
  (2,150)  56,802      54,652 
 
            
Income (loss) before income taxes and minority interest
  (1,836)  79,100   (233)  77,031 
Income tax provision
  (6,905)  (36,015)     (42,920)
 
            
Income (loss) before minority interest
  (8,741)  43,085   (233)  34,111 
Minority interest
     898      898 
 
            
Net income (loss)
 (8,741) 43,983  (233) 35,009 
 
            
                 
  Six Months Ended June 30, 2005 
  Restricted  Unrestricted      Consolidated 
  Group  Subsidiaries  Eliminations  Group 
Revenues
 114,416  113,086    227,502 
 
            
 
                
Operating costs
  87,260   98,024      185,284 
Operating depreciation and amortization
  10,829   13,616   438   24,883 
General and administrative
  11,077   4,239      15,316 
(Sale) purchase of emission allowances
  (2,135)  (4,153)     (6,288)
 
            
 
  107,031   111,726   438   219,195 
 
            
Income from operations
  7,385   1,360   (438)  8,307 
 
            
 
                
Other income (expense)
                
Interest expense
  (15,985)  (26,571)  1,093   (41,463)
Investment income
  1,297   777   (1,093)  981 
Derivative financial instruments, net
  (463)  (72,847)     (73,310)
Unrealized foreign exchange loss on debt
  (7,509)        (7,509)
Impairment of investments
  (1,645)        (1,645)
 
            
Total other expense
  (24,305)  (98,641)     (122,946)
 
            
Loss before income taxes and minority interest
  (16,920)  (97,281)  (438)  (114,639)
Income tax (provision) benefit
  (4,776)  26,188      21,412 
 
            
Loss before minority interest
  (21,696)  (71,093)  (438)  (93,227)
Minority interest
     11,409      11,409 
 
            
Net loss
 (21,696) (59,684) (438) (81,818)
 
            

FORM 10-Q
QUARTERLY REPORT - PAGE 20


 

MERCER INTERNATIONAL INC.
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
FOR SIX MONTHS ENDED JUNE 30, 2006
(Unaudited)
(Euros in thousands, except for shares and per share data)
Note 9. Restricted Group Supplemental Disclosure (cont’d)
Combined Condensed Statement of Operations
                 
  Three Months Ended June 30, 2006 
  Restricted  Unrestricted      Consolidated 
  Group  Subsidiaries  Eliminations  Group 
Revenues
 88,612  80,403  (2,310) 166,705 
 
            
 
                
Operating costs
  79,249   61,253   (1,664)  138,838 
Operating depreciation and amortization
  7,568   7,300      14,868 
General and administrative expenses
  5,415   4,318      9,733 
(Sale) purchase of emission allowances
  (1,884)  (5,724)     (7,608)
 
            
 
  90,348   67,147   (1,664)  155,831 
 
            
Income (loss) from operations
  (1,736)  13,256   (646)  10,874 
 
            
 
                
Other income (expense)
                
Interest expense
  (7,979)  (16,018)  885   (23,112)
Investment income
  (142)  2,294   (885)  1,267 
Derivative financial instruments, net
  79   44,611      44,690 
Unrealized foreign exchange gain on debt
  6,060         6,060 
 
            
Total other (expense) income
  (1,982)  30,887      28,905 
 
            
Income (loss) before income taxes and minority interest
  (3,718)  44,143   (646)  39,779 
Income tax provision
  (3,872)  (17,935)     (21,807)
 
            
Income (loss) before minority interest
  (7,590)  26,208   (646)  17,972 
Minority interest
     449      449 
 
            
Net income (loss)
 (7,590) 26,657  (646) 18,421 
 
            
                 
  Three Months Ended June 30, 2005 
  Restricted  Unrestricted      Consolidated 
  Group  Subsidiaries  Eliminations  Group 
Revenues
 72,704  56,905    129,609 
 
            
 
                
Operating costs
  57,287   47,995      105,282 
Operating depreciation and amortization
  6,704   6,971   221   13,896 
General and administrative
  5,490   2,028      7,518 
(Sale) purchase of emission allowances
  (2,135)  (4,153)     (6,288)
 
            
 
  67,346   52,841   221   120,408 
 
            
Income from operations
  5,358   4,064   (221)  9,201 
 
            
Other income (expense)
                
Interest expense
  (8,314)  (14,585)  699   (22,200)
Investment income
  970   467   (631)  806 
Derivative financial instruments, net
  (358)  (69,093)     (69,451)
Unrealized foreign exchange loss on debt
  (9,806)        (9,806)
Impairment of investments
  (467)     467    
 
            
Total other income (expense)
  (17,975)  (83,211)  535   (100,651)
 
            
Income (loss) before income taxes and minority interest
  (12,617)  (79,147)  314   (91,450)
Income tax (provision) benefit
  (1,661)  26,108      24,447 
 
            
Income (loss) before minority interest
  (14,278)  (53,039)  314   (67,003)
Minority interest
     4,852      4,852 
 
            
Net loss
 (14,278) (48,187) 314  (62,151)
 
            

FORM 10-Q
QUARTERLY REPORT - PAGE 21


 

Note 10. Subsequent Event
In August 2006, we reorganized and divested our equity interests in certain paper production assets, including our Heidenau paper mill, for aggregate consideration of approximately 5.0 million of indebtedness and 5.0 million in cash.

FORM 10-Q
QUARTERLY REPORT - PAGE 22


 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In this document: (i) unless the context otherwise requires, references to “we”, “our”, “us”, the “Company” or “Mercer” mean Mercer International Inc. and its subsidiaries; (ii) references to “Mercer Inc.” mean the Company excluding its subsidiaries; (iii) information is provided as of June 30, 2006, unless otherwise stated; (iv) all references to monetary amounts are to “Euros”, unless otherwise stated; (v) “” refers to Euros and C$ refers to Canadian dollars; and (vi) “ADMTs” refers to air-dried metric tonnes.
The following discussion and analysis of our results of operations and financial condition for the six months ended June 30, 2006 should be read in conjunction with our consolidated financial statements and related notes included in this quarterly report, as well as our most recent annual report on Form 10-K for the fiscal year ended December 31, 2005 filed with the Securities and Exchange Commission (the “SEC”). Certain reclassifications have been made to the prior period financial statements to conform with the current period presentation.
Results of Operations
Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005
Selected sales data for the six months ended June 30, 2006 and 2005 is as follows:
         
  Six Months Ended June 30, 
  2006  2005 
  (ADMTs) 
Sales Volume by Product Class
        
Pulp sales volume by mill:
        
Rosenthal
  149,236   154,800 
Stendal
  277,408   204,988 
Celgar
  229,722   118,188 
 
      
Total pulp sales volume(1)
  656,366   477,976 
Paper sales volume
  32,084   34,478 
 
      
Total sales volume(1)
  688,450   512,454 
 
      
         
  (in thousands) 
Revenues by Product Class
        
Pulp revenues by mill:
        
Rosenthal
 67,545  64,504 
Stendal
  120,522   80,873 
Celgar(1)
  100,811   48,480 
 
      
Total pulp revenues(1)
  288,878   193,857 
Paper revenues
  33,335   31,463 
 
      
Total pulp and paper sales revenues(1)
  322,213   225,320 
Third party transportation revenues
  3,556   2,182 
 
      
Total sales revenues
 325,769  227,502 
 
      
 
(1) Excluding intercompany sales volumes of 9,857 and 7,594 ADMTs of pulp and intercompany net sales revenues of approximately 4.7 million and 3.3 million in the six months ended June 30, 2006 and 2005, respectively.

FORM 10-Q
QUARTERLY REPORT - PAGE 23


 

Selected production data for the six months ended June 30, 2006 and 2005 is as follows:
         
  Six Months Ended June 30,
  2006 2005
  (ADMTs)
Production by Product Class
        
Pulp production by mill:
        
Rosenthal
   143,530   157,315
Stendal
   270,592   231,719
Celgar(1)
   212,088   171,833
 
        
Total pulp production
   626,210   560,867
Paper production
   33,602   33,937
 
        
Total production
   659,812   594,804
 
        
 
(1) The results of the Celgar pulp mill are included from the date of its acquisition on February 14, 2005.
Revenues for the six months ended June 30, 2006 increased to 325.8 million from 227.5 million in the comparative period of 2005, primarily due to higher sales from our Celgar and Stendal pulp mills. Pulp sales by volume increased to 656,366 ADMTs in the first half of 2006 from 477,976 ADMTs in the comparative period of 2005.
Cost of sales and general, administrative and other expenses in the first half of 2006 increased to303.4 million from 219.2 million in the comparative period of 2005, primarily as a result of higher sales from our Celgar and Stendal mills.
For the first half of 2006, revenues from our pulp operations increased to 292.3 million from196.0 million in the same period a year ago. List prices for NBSK pulp in Europe were approximately522 ($642) per ADMT in the first half of 2006, approximately 488 ($628) per ADMT in the first half of 2005 and approximately 506 ($600) in the fourth quarter of 2005.
Mill net pulp sales realizations increased to 440 per ADMT on average in the first half of 2006 from 411 per ADMT in the first half of 2005, primarily as a result of higher pulp prices.
During the current period, we took an aggregate of 42 days scheduled maintenance and strategic capital expenditure downtime at our pulp mills, including 20 days at our Rosenthal mill and 13 days at our Celgar mill. During the downtime at our Rosenthal mill, we completed the installation of a new brownstock washer at a cost of approximately 9.7 million, which is expected to further improve pulp quality and lower chemical costs and effluents. The total maintenance costs associated with such shutdowns were approximately 6.5 million and were expensed as incurred. This negatively impacted our production volumes, costs and operating results. The Stendal mill also underwent extensive testing of various departments and converted some production to TCF pulp pursuant to the terms of its EPC contract which curtailed production during such period. During the comparative period of 2005, our pulp mills took approximately 32 days maintenance and strategic capital expenditure downtime.
Cost of sales and general, administrative and other expenses for the pulp operations increased to273.1 million in the first half of 2006 from 185.7 million in the comparative period of 2005 primarily as a result of higher sales from our Celgar and Stendal mills.
Fiber costs at our German pulp mills increased by approximately 9% in the first half of 2006 versus the same period of 2005. This resulted from lower availability because of severe winter conditions in Germany and central Europe, which caused sawmillers and log harvesters to curtail operations and increased competition for fiber primarily from renewable energy operations. The

FORM 10-Q
QUARTERLY REPORT - PAGE 24


 

increase in worldwide energy prices has made projects generating energy from renewable sources such as wood residuals more viable in Europe. As a result, there has been increased fiber demand and competition in our fiber base. In the first six months of 2006, average fiber costs at our Celgar mill decreased by approximately 18% versus the same period of 2005, primarily because of increased regional wood chip availability.
In the first half of 2006, we recorded a contribution to income from operations of 13.2 million resulting from the sale of emission allowances compared to 6.3 million in the comparative period of 2005.
Depreciation for the pulp operations increased to 28.2 million in the first half of 2006, from24.2 million in the first half of 2005, primarily as a result of the inclusion of depreciation for the Celgar mill for the full period.
For the first six months of 2006, our pulp operations generated operating income of 23.7 million, versus operating income of 13.6 million in the same period of 2005, primarily due to improving pulp markets and the higher operating income at our German pulp mills, including a contribution of 13.2 million from the sale of emission allowances, partially offset by maintenance and strategic capital expenditure downtime at our pulp mills. The overall strength of the Canadian dollar versus the U.S. dollar negatively impacted our Celgar mill’s results.
Revenues from our paper operations in the first half of 2006 increased to 33.5 million from31.5 million in the same period of last year as a result of higher sales volumes and a change in the product mix.
Cost of sales and general, administrative and other expenses for the paper operations in the first half of 2006 increased to 32.7 million from 32.5 million in the comparative quarter of 2005.
In the first half of 2006, our paper operations generated operating income of 0.9 million, compared to an operating loss of1.1 million in the first half of 2005.
In the first half of 2006, income from operations increased to 22.4 million from8.3 million in the same period last year, primarily as a result of higher pulp prices and improved results from our German pulp mills.
Interest expense in the first half of 2006 increased to 46.0 million from41.5 million in the year ago period, primarily due to higher borrowings relating to the Stendal mill.
Stendal entered into certain foreign currency derivatives to swap all of its long-term bank indebtedness from Euros to U.S. dollars in 2005 and certain currency forwards. In addition, Stendal previously entered into interest rate swaps to fix the interest rate on its outstanding bank indebtedness. Due to the weakening of the U.S. dollar versus the Euro and an increase in long-term interest rates, we recorded a net unrealized non-cash holding gain of 90.7 million before minority interests upon the marked to market valuation of such derivatives that were outstanding at the end of the current period, compared to a net non-cash holding loss of 73.0 million before minority interests upon the marked to market valuation of our outstanding derivatives in the comparative period of 2005. In the first six months of 2006 we recorded a realized loss in derivative instruments of5.2 million compared to a realized loss of0.3 million in the comparative period of 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 25


 

In the first half of 2006, minority interest, representing the two minority shareholders’ proportionate interest in the Stendal mill’s losses for the period, was 0.9 million, compared to 11.4 million in the first half of 2005.
We reported net income for the first six months of 2006 of 35.0 million, or1.06 per basic and 0.86 per diluted share, which reflected a net unrealized gain of 85.5 million on our interest rate and currency derivatives, an unrealized non-cash foreign exchange gain on our long-term debt of 12.2 million and improved results at our German pulp mills. In the first half of 2005, we reported a net loss of 81.8 million, or 2.80 per basic and diluted share, which reflected a net unrealized non-cash holding losses on our currency and interest rate derivatives of73.3 million and the unrealized non-cash foreign exchange loss on our long-term debt of 7.5 million, partially offset by the non-cash benefit for income taxes of 21.4 million, and interest expense related to our Stendal mill of 26.3 million and a non-cash impairment charge of 1.6 million relating to investments.
We generated “Operating EBITDA” of 51.2 million and33.2 million in the six months ended June 30, 2006 and 2005, respectively. Operating EBITDA is defined as income (loss) from operations plus depreciation and amortization and non-recurring capital asset impairment charges.
Management uses Operating EBITDA as a benchmark measurement of its own operating results, and as a benchmark relative to its competitors. Management considers it to be a meaningful supplement to operating income as a performance measure primarily because depreciation expense and non-recurring capital asset impairment charges are not an actual cash cost, and depreciation expense varies widely from company to company in a manner that management considers largely independent of the underlying cost efficiency of their operating facilities. In addition, we believe Operating EBITDA is commonly used by securities analysts, investors and other interested parties to evaluate our financial performance.
Operating EBITDA does not reflect the impact of a number of items that affect our net income (loss), including financing costs and the effect of derivative instruments. Operating EBITDA is not a measure of financial performance under GAAP, and should not be considered as an alternative to net income (loss) or income (loss) from operations as a measure of performance, nor as an alternative to net cash from operating activities as a measure of liquidity.
Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are that Operating EBITDA does not reflect: (i) our cash expenditures, or future requirements, for capital expenditures or contractual commitments; (ii) changes in, or cash requirements for, working capital needs; (iii) the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our outstanding debt; (iv) minority interests on our Stendal NBSK pulp mill operations; (v) the impact of realized or marked to market changes in our derivative positions, which can be substantial; and (vi) the impact of impairment charges against our investments or assets. Because of these limitations, Operating EBITDA should only be considered as a supplemental performance measure and should not be considered as a measure of liquidity or cash available to us to invest in the growth of our business. See the Statement of Cash Flows set out in our consolidated financial statements included herein. Because all companies do not calculate Operating EBITDA in the same manner, Operating EBITDA as calculated by us may differ from Operating EBITDA or EBITDA as calculated by other companies. We compensate for these limitations by using Operating

FORM 10-Q
QUARTERLY REPORT - PAGE 26


 

EBITDA as a supplemental measure of our performance and relying primarily on our GAAP financial statements.
The following table provides a reconciliation of net income (loss) to income from operations and Operating EBITDA for the periods indicated:
         
  Six Months Ended 
  June 30, 
  2006  2005(1) 
  (in thousands) 
Net income (loss)
 35,009  (81,818)
Minority interest
  (898)  (11,409)
Income taxes (benefit)
  42,920   (21,412)
Interest expense
  46,037   41,463 
Investment income
  (3,011)  (981)
Derivative financial instruments, net (gain) loss
  (85,505)  73,310 
Foreign exchange (gain) loss on debt
  (12,173)  7,509 
Impairment of investments
     1,645 
 
      
Income from operations
  22,379   8,307 
Add: Depreciation and amortization
  28,782   24,883 
 
      
Operating EBITDA
 51,161  33,190 
 
      
 
(1) The results of the Celgar pulp mill are included from the date of its acquisition on February 14, 2005.
Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005
Selected sales data for the three months ended June 30, 2006 and 2005 is as follows:
         
  Three Months Ended June 30, 
  2006  2005 
  (ADMTs) 
Sales Volume by Product Class
        
Pulp sales volume by mill:
        
Rosenthal
  73,010   75,996 
Stendal
  136,894   102,915 
Celgar
  119,361   99,841 
 
      
Total pulp sales volume(1)
  329,265   278,752 
Paper sales volume
  15,482   17,840 
 
      
Total sales volume(1)
  344,747   296,592 
 
      
         
  (in thousands) 
Revenues by Product Class
        
Pulp revenues by mill:
        
Rosenthal
 33,776  31,115 
Stendal
  60,741   40,345 
Celgar
  54,514   40,864 
 
      
Total pulp revenues(1)
  149,031   112,324 
Paper revenues
  16,097   16,097 
 
      
Total pulp and paper sales revenues(1)
  165,128   128,421 
 
      
Third party transportation revenues
  1,577   1,188 
 
      
Total sales revenues
 166,705  129,609 
 
      
 
(1) Excluding intercompany sales volumes of 4,871 and 4,105 ADMTs of pulp and intercompany net sales revenues of approximately 2.3 million and 1.7 million in the three months ended June 30, 2006 and 2005, respectively.

FORM 10-Q
QUARTERLY REPORT - PAGE 27


 

Selected production data for the three months ended June 30, 2006 and 2005 is as follows:
         
  Three Months Ended June 30,
  2006 2005
  (ADMTs)
Production by Product Class
        
Pulp production by mill:
        
Rosenthal
   67,376   81,443
Stendal
   139,715   123,738
Celgar
   100,651   111,071
 
        
Total pulp production
   307,742   316,252
Paper production
   16,427   17,979
 
        
Total production
   324,169   334,231
 
        
Revenues for the three months ended June 30, 2006 increased to 166.7 million from129.6 million in the comparative period of 2005, primarily due to higher sales from our Celgar and Stendal pulp mills. Pulp sales by volume increased to 329,265 ADMTs in the second quarter of 2006 from 278,752 ADMTs in the comparative period of 2005.
Cost of sales and general, administrative and other expenses in the second quarter of 2006 increased to 155.8 million from 120.4 million in the comparative period of 2005, primarily as a result of higher sales from our Celgar and Stendal mills.
For the second quarter of 2006, revenues from our pulp operations increased to 150.6 million from 113.5 million in the same period a year ago. List prices for NBSK pulp in Europe were approximately 529 ($665) per ADMT in the second quarter of 2006, approximately 514 ($618) per ADMT in the first quarter of 2006, compared to approximately 487 ($613) per ADMT in the second quarter of 2005.
Mill net pulp sales realizations increased to 453 per ADMT on average in the second quarter of 2006 from 403 per ADMT in the second quarter of 2005, primarily as a result of higher pulp prices.
During the current quarter, we took an aggregate of approximately 30 days scheduled maintenance and strategic capital expenditure downtime at our pulp mills, including 16 days at our Rosenthal mill and 8 days at our Celgar mill. During the downtime at our Rosenthal mill, we completed the installation of a new brownstock washer at a cost of approximately 9.7 million, which is expected to further improve pulp quality and lower chemical costs and effluents. The total maintenance costs associated with such shutdowns were approximately 4.3 million and were expensed in the current quarter. The Stendal mill also underwent testing of various departments and converted some production to TCF pulp pursuant to the terms of its EPC contract which curtailed production during such period. Total production volume at our Rosenthal and Celgar mills was down by approximately 24,000 tonnes or 13% in the current quarter of 2006 compared to the same period of 2005. This negatively impacted our production volumes, costs and operating results. During the same period of 2005, we had 12 days of down time at our pulp mills.
Cost of sales and general, administrative and other expenses for the pulp operations increased to141.3 million in the second quarter of 2006 from 102.9 million in the comparative period of 2005, primarily as a result of higher sales from our Celgar and Stendal mills.
Fiber costs at our German pulp mills increased by approximately 8% in the second quarter of 2006 versus the same period of 2005. This resulted from lower availability because of severe

FORM 10-Q
QUARTERLY REPORT - PAGE 28


 

winter conditions in Germany and central Europe, which caused sawmillers and log harvesters to curtail operations and increased competition for fiber primarily from renewable energy operations. In the second quarter of 2006, average fiber costs at our Celgar mill decreased by approximately 23% versus the same quarter of 2005, primarily because of fluctuations in regional wood chip availability. Subsequent to June 30, 2006, lower chip availability resulting from softer lumber markets and an increase in chip demand from coastal pulp and paper mills is expected to put upward pressure on Celgar’s fiber costs in the second half of 2006.
In the second quarter of 2006, we recorded a contribution to income from operations of 7.6 million resulting from the sale of emission allowances compared to 6.3 million in the comparative quarter of 2005.
Depreciation for the pulp operations increased to 14.6 million in the second quarter of 2006, from 13.4 million in the comparative quarter of 2005.
For the second quarter of 2006, our pulp operations generated operating income of 11.5 million, versus operating income of 12.4 million in the comparative quarter of 2005 as scheduled downtime resulted in weaker performance by our pulp mills which offset improvements in markets and the improvements in Stendal’s results. The overall strength of the Canadian dollar versus the U.S. dollar negatively impacted our Celgar mill’s continued results.
Revenues from our paper operations were stable at 16.1 million in the current quarter as well as the same quarter of last year.
Cost of sales and general, administrative and other expenses for the paper operations in the second quarter of 2006 decreased to 15.8 million from 16.9 million in the comparative quarter of 2005.
For the second quarter of 2006, our paper operations generated operating income of 0.4 million, compared to an operating loss of 0.8 million in the second quarter of 2005.
In the second quarter of 2006, we had income from operations of 10.9 million, compared to9.2 million in the same quarter last year. Interest expense in the second quarter of 2006 increased marginally to 23.1 million from 22.2 million in the year ago period, primarily due to higher borrowings relating to the Stendal mill.
Stendal entered into certain foreign currency derivatives to swap all of its long-term bank indebtedness from Euros to U.S. dollars in 2005 and certain currency forwards. In addition, Stendal previously entered into interest rate swaps to fix the interest rate on its outstanding bank indebtedness. Due to the weakening of the U.S. dollar versus the Euro and an increase in long-term interest rates, we recorded a net unrealized non-cash holding gain of 44.7 million before minority interests upon the marked to market valuation of such derivatives that were outstanding at the end of the current quarter, compared to a net non-cash holding loss of 69.5 million before minority interests upon the marked to market valuation of our outstanding derivatives in the comparative quarter of 2005.
In the second quarter of 2006, minority interest, representing the two minority shareholders’ proportionate interest in the Stendal mill, was 0.4 million, compared to 4.9 million in the second quarter of 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 29


 

We reported net income for the three months ended June 30, 2006 of 18.4 million, or0.56 per basic and 0.45 per diluted share, which included an aggregate of 50.8 million unrealized gains on our outstanding derivatives and a foreign exchange gain on our long-term debt. In the second quarter of 2005, we reported a net loss of 62.2 million, or 1.88 per basic and diluted share, which reflected the net unrealized non-cash holding losses on our currency and interest rate derivatives of 69.5 million and the unrealized non-cash foreign exchange loss on our long-term debt of 9.8 million, partially offset by the non-cash benefit for income taxes of24.4 million, and interest expense related to our Stendal mill of 14.5 million.
We generated “Operating EBITDA” of 25.7 million and23.1 million in the three months ended June 30, 2006 and 2005, respectively. Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of our results for the first half of 2006 for additional information relating to Operating EBITDA.
The following table provides a reconciliation of net income (loss) to income from operations and Operating EBITDA for the periods indicated:
         
  Three Months Ended 
  June 30, 
  2006  2005 
  (in thousands) 
Net income (loss)
 18,421  (62,151)
Minority interest
  (449)  (4,852)
Income taxes (benefit)
  21,807   (24,447)
Interest expense
  23,112   22,200 
Investment income
  (1,267)  (806)
Derivative financial instruments, net (gain) loss
  (44,690)  69,451 
Foreign exchange (gain ) loss on debt
  (6,060)  9,806 
 
      
Income from operations
  10,874   9,201 
Add: Depreciation and amortization
  14,868   13,896 
 
      
Operating EBITDA
 25,742  23,097 
 
      
Liquidity and Capital Resources
The following table is a summary of selected financial information for the periods indicated:
         
  As at  As at 
  June 30,  December 31, 
  2006  2005 
  (in thousands) 
Financial Position
        
Cash and cash equivalents
 73,079  83,547 
Working capital(1)
  57,287   111,195 
Property, plant and equipment
  1,008,319   1,024,662 
Total assets
  1,370,798   1,393,816 
Long-term liabilities
  996,383(2)  1,104,746 
Shareholders’ equity
  189,927   148,743 
 
(1) Does not include approximately 7.0 million of government grants in 2006, which we expect to receive in 2006, and approximately 65.9 million of government grants in 2005, all of which has been received, related to the Stendal mill from German federal and state governments.
 
(2) Includes 15.6 million outstanding under the revolving credit facilities for the Celgar mill.
At June 30, 2006, our cash and cash equivalents were 73.1 million, compared to83.5 million at December 31, 2005. We also had 5.9 million of cash restricted to pay current Stendal construction costs payable of 1.0 million and for debt service.

FORM 10-Q
QUARTERLY REPORT - PAGE 30


 

During the second quarter of 2006, Stendal built up the restricted cash in its debt service account for the Stendal project financing to 66.5 million by drawing down 42.0 million under a tranche of the Stendal project financing facility as planned, or the “Stendal Loan Facility”. Approximately 57.0 million of this restricted cash is a debt service security or reserve equal to approximately one year’s worth of Stendal’s scheduled principal and interest payments under the Stendal Loan facility. As this debt service account secures Stendal’s obligations under the Stendal Loan Facility, it is recorded as a long-term asset.
Our reduction in working capital at June 30, 2006 compared to December 31, 2005 of approximately53.9 million resulted principally from the build-up of the restricted cash in the Stendal debt service account, which is classified as a long-term asset, and the reclassification as current liabilities of certain principal payments on the Stendal Loan Facility that mature within one year.
At June 30, 2006, we qualified for investment grants related to the Stendal mill totaling approximately 7.0 million from the federal and state governments of Germany, which we expect to receive in 2006. These grants, when received, will be applied to repay the amounts drawn under the current portion of a dedicated tranche of the Stendal Loan Facility. Under our accounting policies, we do not record these grants until they are received. The grants are not reported in our income and reduce the cost basis of the assets purchased when they are received.
As at June 30, 2006, we had not drawn any amount under the 40.0 million Rosenthal revolving term credit facility and had drawn down approximately 15.6 million of the C$40 million Celgar revolving credit facility. At June 30, 2006, we had utilized the entire 4.7 million available under the credit facilities for our paper operations.
We expect to meet our interest and debt service expenses and the working and maintenance capital requirements for our operations (other than at Stendal) from cash flow from operations, cash on hand and the two revolving working capital facilities for the Rosenthal and Celgar mills.
We expect to meet the capital requirements for the Stendal mill, including working capital and potential losses during ramp up, interest and principal service expenses through cash on hand, cash flow from operations, shareholder advances already made to Stendal, the Stendal Loan Facility (which includes a revolving working capital tranche and a debt service reserve account) and the receipt of government grants.
Operating Activities
Operating activities in the first half of 2006 provided cash of 1.4 million, compared to using cash of5.2 million in the comparative period of 2005. An increase in receivables due primarily to higher sales used cash of 13.5 million in the first half of 2006, compared to an increase in receivables using cash of 20.7 million in the comparative period of 2005. A decrease in inventories due primarily to a reduction in raw materials and finished goods at the Stendal mill provided cash of 10.7 million in the first half of 2006, compared to using cash of 16.8 million in the comparative period of 2005. A decrease in accounts payable and accrued expenses used cash of 3.3 million in the first half of 2006, compared to an increase that provided cash of 41.3 million in the comparative period of 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 31


 

Working capital is subject to cyclical operating needs, the timing of collections, receivables and government grants and the payment of payables and expenses.
Investing Activities
Investing activities in the six months ended June 30, 2006 used cash of 56.3 million, compared to the six months ended June 30, 2005 when investing activities used cash of 119.3 million, of which the acquisition of the Celgar pulp mill comprised 146.6 million. In the six months ended June 30, 2006, a drawdown under a tranche of the Stendal project financing facility to increase our restricted cash in the Stendal debt service reserve account used cash of 40.8 million versus a decrease in restricted cash providing cash of 35.8 million in the comparative period of 2005.
Financing Activities
Financing activities provided cash of 45.7 million in the six months ended June 30, 2006, compared to the first six months of 2005 when, in connection with the acquisition of the Celgar pulp mill, financing activities, including the issuance of common stock and senior notes, provided cash of 175.2. In the first half of 2005, we fully repaid the project loan facility relating to the Rosenthal mill of approximately 143.1 million (net of restricted cash) and indebtedness relating to the landfill at the Rosenthal mill of approximately 7.6 million from the proceeds of such share and senior note offerings.
We have no material commitments to acquire assets or operating businesses. We anticipate that there will be acquisitions of businesses or commitments to projects in the future. To achieve our long-term goals of expanding our asset and earnings base through the acquisition of interests in companies and assets in the pulp and paper and related businesses, and organically through high return capital expenditures at our operating facilities, we will require substantial capital resources. The required necessary resources for such long-term goals will be generated from cash flow from operations, cash on hand, the sale of securities and/or assets, and borrowing against our assets.
Contractual Obligations and Commitments
There were no material changes outside the ordinary course to any of our contractual obligations during the first half of 2006.
Capital Resources
In addition to our revolving credit facilities for the Rosenthal and Celgar mills and the revolving working capital tranche of the Stendal Loan Facility, respectively, we may seek to raise future funding in the debt markets if our indenture relating to our 9.25% senior notes permits, subject to compliance with the indenture. The indenture governing the senior notes provides that, in order for Mercer Inc. and its restricted subsidiaries (as defined in the indenture and which excludes the Stendal mill and our paper operations) to enter into certain types of transactions, including the incurrence of additional indebtedness, the making of restricted payments and the completion of mergers and consolidations (other than, in each case, those specifically permitted by our senior note indenture), we must meet a minimum ratio of Indenture EBITDA to Fixed Charges as defined in the senior note indenture of 2.0 to 1.0 on a pro forma basis for the most recently ended four full fiscal quarters. This ratio is referred to and defined as the Fixed Charge Coverage Ratio in the senior note indenture. As at June 30, 2006, Mercer Inc. and our restricted subsidiaries under the indenture governing the senior notes did not meet the Fixed Charge Coverage Ratio of 2.0 to 1.0 as set out in the senior note indenture.

FORM 10-Q
QUARTERLY REPORT - PAGE 32


 

Stendal Pulp Mill EPC Contract
The Stendal mill was constructed under a 716.0 million fixed price turn-key EPC contract between Stendal and RWE, as head contractor. The contractor’s obligations under the contract are guaranteed by its parent company.
Pursuant to the EPC contract, each department of the mill is to be tested on a stand-alone basis for compliance with its design specifications. Under the EPC contract, RWE warrants conformity to specifications, compliance with permits and laws, suitability for intended use, compliance with performance requirements and against defects in construction for a stipulated period, subject to extension in certain circumstances. The testing and warranty are highly technical and include very detailed design and performance specifications. Much of the prescribed testing, other than testing waived by prior agreement, had been concluded by the quarter ended June 30, 2006 and was unsatisfactory to Stendal. Unless extended, the period under which Stendal can make claims under the warranties in the EPC contract currently expires in September 2006. As is common in large greenfield projects like the Stendal mill, Stendal currently anticipates that it will make a number of claims and seek penalties against the contractor under the EPC contract. Such claims are often highly technical and relate to, among other things, design and performance specifications and reliability, as well as penalties in regards to delays. Currently, we cannot predict with any certainty which or the amount of claims and penalties that Stendal may make against the contractor, the amount, if any, of any recoveries associated therewith or the final determination of such claims whether through further work and retesting by the contractor, legal proceedings, negotiation or other settlement.
Paper Mill Assets
We view our paper mill assets as non-core operations and have been reviewing strategic alternatives therefor. In August 2006, we reorganized and divested our equity interests in certain paper production assets, including our Heidenau paper mill, for aggregate consideration of approximately 5.0 million of indebtedness and approximately 5.0 million in cash. We currently continue to operate and review strategic alternatives for our Fährbrücke paper mill.
Foreign Currency
Effective January 1, 2002, we changed our reporting currency from the U.S. dollar to the Euro as a significant majority of our business transactions are originally denominated in Euros. By adopting the Euro, most cumulative foreign currency translation losses were eliminated. However, we hold certain assets and liabilities in U.S. dollars, Swiss francs and in Canadian dollars. Accordingly, our consolidated financial results are subject to foreign currency exchange rate fluctuations.
We translate foreign denominated assets and liabilities into Euros at the rate of exchange on the balance sheet date. Unrealized gains or losses from these translations are recorded in our consolidated statement of comprehensive income and impact on shareholders’ equity on the balance sheet but do not affect our net earnings.
In the six months ended June 30, 2006, we reported a net 5.4 million foreign exchange translation gain and, as a result, the cumulative foreign exchange translation gain increased to21.1 million at June 30, 2006 from 15.6 million at December 31, 2005.

FORM 10-Q
QUARTERLY REPORT - PAGE 33


 

Based upon the exchange rate at June 30, 2006, the U.S. dollar decreased by approximately 6% in value against the Euro since June 30, 2005. See “Quantitative and Qualitative Disclosures about Market Risk”.
Results of Operations of the Restricted Group Under Our Senior Note Indenture
The indenture governing our 9.25% senior notes requires that we also provide a discussion in annual and quarterly reports we file with the SEC under Management’s Discussion and Analysis of Financial Condition and Results of Operations of the results of operations and financial condition of Mercer Inc. and our restricted subsidiaries under the indenture, referred to as the “Restricted Group”. As at and during the six months ended June 30, 2006, the Restricted Group was comprised of Mercer Inc., certain holding subsidiaries, Rosenthal and Celgar. During the six months ended June 30, 2005 and as at December 31, 2005, the Restricted Group was comprised of Mercer Inc., certain holding subsidiaries, Rosenthal and the Celgar mill from February 14, 2005, the date of the acquisition of the mill . The Restricted Group excludes our paper operations and our Stendal mill.
The following is a discussion of the results of operations and financial condition of the Restricted Group. For further information regarding the operating results of the Rosenthal and Celgar mills, see Note 5 of our quarterly financial statements included herein. For further information regarding the Restricted Group including, without limitation, a reconciliation to our consolidated results of operations, see Note 9 of our quarterly financial statements included herein.
Restricted Group Results — Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005
Total revenues for the Restricted Group for the six months ended June 30, 2006 increased to169.6 million from 114.4 million in the comparative period of 2005, primarily because of higher pulp sales from the Celgar mill and higher pulp prices. Pulp sales realizations for the Restricted Group were 444 per ADMT on average in the six months ended June 30, 2006 and 427 per ADMT in the comparative period of 2005. The increase in NBSK pulp prices was partially offset by the strength of the Canadian dollar versus the U.S. dollar during the current period.
Costs of sales and general, administrative and other expenses for the Restricted Group in the six months ended June 30, 2006 increased to 169.3 million from 107.0 million in the comparative period of 2005 primarily as a result of the inclusion of higher sales from our Celgar mill, partially offset by lower production costs at the Rosenthal mill.
During the current period, we took an aggregate of 33 days scheduled maintenance and strategic capital expenditure downtime comprising 20 days at our Rosenthal mill and 13 days at our Celgar mill. During the downtime at our Rosenthal mill, we completed the installation of a new brownstock washer at a cost of approximately 9.7 million, which is expected to further improve pulp quality and lower chemical costs and effluents. The total maintenance costs associated with such shutdowns were approximately 6.5 million and were expensed as incurred. This negatively impacted our production volumes, costs and operating results. During the comparative period of 2005, the Rosenthal and Celgar mills took approximately 9 days of maintenance and strategic capital expenditure downtime.
In the first half of 2006, we recorded a contribution to income from operations of 3.7 million through the sale of emission allowances by our Rosenthal pulp mill, compared to 2.1 million in the same period of 2005.
On average, fiber costs at our Rosenthal pulp mill increased by approximately 14% in the first half of 2006 versus the same period of 2005. This resulted from lower availability because of severe winter conditions in Germany and central Europe, which caused sawmillers and log

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harvesters to curtail operations and increased competition for fiber primarily from renewable energy operations. In the first half of 2006, average fiber costs at our Celgar mill decreased by approximately 18% versus the same period of 2005, primarily because of increased regional wood chip availability.
Depreciation and amortization for the Restricted Group increased to 14.2 million in the current period from 10.8 million in the comparative period of 2005, primarily as a result of the inclusion of depreciation of the Celgar mill for the full period, partially offset by lower depreciation at our Rosenthal mill.
In the first half of 2006, the Restricted Group reported income from operations of 0.3 million, compared to 7.4 million in the first half of 2005, primarily as a result of a higher operating loss at our Celgar mill which more than offset higher operating income from our Rosenthal mill. Interest expense for the Restricted Group in the six months ended June 30, 2006 increased marginally to 16.4 million from 16.0 million in the first half of 2005.
In the first half of 2006, the Restricted Group recorded a foreign exchange gain on debt of12.2 million, compared to a loss of 7.5 million in the comparative period of 2005. In the first half of 2005, the Restricted Group reported a non-cash impairment charge of 1.6 million related to an investment in a venture company.
For the six months ended June 30, 2006, the net loss reported by the Restricted Group narrowed to8.7 million from 21.7 million in the first half of 2005 as a result of improved operating income of our Rosenthal mill, partially offset by the weaker results of our Celgar mill and scheduled downtime. The overall strength of the Canadian dollar versus the U.S. dollar and 13 days of scheduled maintenance downtime negatively impacted the results of our Celgar mill.
The Restricted Group generated “Operating EBITDA” of 14.5 million and18.2 million in the six months ended June 30, 2006 and 2005, respectively. Operating EBITDA is defined as income (loss) from operations plus depreciation and amortization and non-recurring capital asset impairment charges. Operating EBITDA for the Restricted Group is calculated by adding depreciation and amortization and non-recurring capital asset impairment charges of nil and 1.6 million to the income from operations of 0.3 million and 7.4 million for the six months ended June 30, 2006 and 2005, respectively.
Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of Mercer’s results for the six months ended June 30, 2006 for additional information relating to such limitations and Operating EBITDA.

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The following table provides a reconciliation of net loss to income from operations and Operating EBITDA for the Restricted Group for the periods indicated:
         
  Six Months Ended 
  June 30, 
  2006  2005(1) 
  (in thousands) 
Restricted Group(2)
        
Net loss
 (8,741) (21,696)
Income taxes
  6,905   4,776 
Interest expense
  16,442   15,985 
Investment and other income
  (2,119)  (1,297)
Derivative financial instruments, net
     463 
Unrealized foreign exchange (gain) loss on debt
  (12,173)  7,509 
Impairment of investments
     1,645 
 
      
(Loss) income from operations
  314   7,385 
Add: Depreciation and amortization
  14,197   10,829 
 
      
Operating EBITDA
 14,511  18,214 
 
      
 
(1) The results of the Celgar pulp mill are from the date of its acquisition on February 14, 2005.
 
(2) See Note 9 of the financial statements included elsewhere herein for a reconciliation to our consolidated results.
Restricted Group Results —Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005
Total revenues for the Restricted Group for the three months ended June 30, 2006 increased to88.6 million from 72.7 million in the comparative period of 2005, primarily due to higher sales from our Celgar pulp mill and higher pulp prices. Pulp sales realizations for the Restricted Group were 459 per ADMT on average in the three months ended June 30, 2006 and 430 per ADMT in the comparative period of 2005. The increase in NBSK pulp prices was partially offset by the strength of the Canadian dollar versus the U.S. dollar during the current period. In the second quarter of 2006, Mercer Inc. had responsibility for all pulp sales of the Stendal mill and received fees from Stendal ranging from 0.5% to 1.4% of sales.
Costs of sales and general, administrative and other expenses for the Restricted Group in the three months ended June 30, 2006 increased to 90.3 million from 67.3 million in the comparative period of 2005, primarily as a result of higher pulp sales from the Celgar mill, partially offset by lower production costs of the Rosenthal mill.
During the current quarter we took an aggregate of 24 days scheduled maintenance and strategic capital expenditure downtime comprising 16 days at our Rosenthal mill and 8 days at our Celgar mill. During the downtime at our Rosenthal mill, we completed the installation of a new brownstock washer at a cost of approximately 9.7 million, which is expected to further improve pulp quality and lower chemical costs and effluents. The total maintenance costs associated with such shutdowns were approximately 4.3 million and were expensed in the current quarter. Total volume production at our Rosenthal and Celgar mills was down by approximately 24,000 tonnes or 13% in the current quarter of 2006 compared to the same period of 2005. This negatively impacted our production volumes, costs and operating results. During the same period of 2005, we had approximately 4 days of maintenance and strategic capital expenditure downtime at our Rosenthal and Celgar mills.
In the second quarter of 2006, we recorded a contribution to income from operations of 1.9 million through the sale of emission allowances by our Rosenthal pulp mill, compared to 2.1 million in the same period of 2005.
On average, fiber costs at our Rosenthal pulp mill increased by approximately 8% in the second quarter of 2006 versus the same period of 2005. This resulted from lower availability because of severe winter conditions in Germany and central Europe, which caused sawmillers and log harvesters to curtail operations and increased competition for fiber primarily from renewable energy operations. In the second quarter of 2006, average fiber costs at our Celgar mill decreased by approximately 23% versus the same period of 2005 because of increased regional wood chip availability. Subsequent to June 30, 2006, lower chip availability resulting from softer lumber markets and an increase in chip demand from coastal pulp and paper mills is expected to put upward pressure on Celgar’s fiber costs in the second half of 2006.

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Depreciation and amortization for the Restricted Group increased to 7.6 million in the current quarter from 6.7 million in the comparative period of 2005.
In the second quarter of 2006, the Restricted Group reported a loss from operations of 1.7 million, compared to reported income from operations of 5.4 million in the second quarter of 2005, primarily as a result of a higher operating loss at our Celgar mill which more than offset higher operating income from our Rosenthal mill.
Interest expense for the Restricted Group in the three months ended June 30, 2006 decreased to8.0 million from 8.3 million in the second quarter of 2005.
In the second quarter of 2006, the Restricted Group recorded a foreign exchange gain on debt of6.1 million, compared to a loss of 9.8 million in the comparative period of 2005. In the second quarter of 2005, the Restricted Group reported a non-cash impairment charge of 0.5 million related to an investment in a venture company.
For the three months ended June 30, 2006, the net loss reported by the Restricted Group narrowed to7.6 million from 14.3 million in the second quarter of 2005 as a result of improved operating income of our Rosenthal mill, partially offset by the weaker results of our Celgar mill. The overall strength of the Canadian dollar versus the U.S. dollar and 24 days of scheduled maintenance and strategic capital expenditure downtime at our Rosenthal and Celgar pulp mills in the second quarter of 2006 negatively impacted our results.
The Restricted Group generated “Operating EBITDA” of 5.8 million and12.1 million in the three months ended June 30, 2006 and 2005, respectively. Operating EBITDA for the Restricted Group is calculated by adding depreciation and amortization and non-recurring capital asset impairment charges of nil million and 0.5 million to the (loss) income from operations of(1.7) million and 5.4 million for the three months ended June 30, 2006 and 2005, respectively.
Operating EBITDA has significant limitations as an analytical tool, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. See the discussion of Mercer’s results for the six months ended June 30, 2006 for additional information relating to such limitations and Operating EBITDA.

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The following table provides a reconciliation of net loss to income from operations and Operating EBITDA for the Restricted Group for the periods indicated:
         
  Three Months Ended 
  June 30, 
  2006  2005 
  (in thousands) 
Restricted Group(1)
        
Net loss
 (7,590) (14,278)
Income taxes
  3,872   1,661 
Interest expense
  7,979   8,314 
Investment and other expense (income)
  142   (970)
Derivative financial instruments, net
  (79)  358 
Unrealized foreign exchange (gain) loss on debt
  (6,060)  9,806 
Impairment of investments
     467 
 
      
(Loss) income from operations
  (1,736)  5,358 
Add: Depreciation and amortization
  7,568   6,704 
 
      
Operating EBITDA
 5,832  12,062 
 
      
 
(1) See Note 9 of the financial statements included elsewhere herein for a reconciliation to our consolidated results.
Liquidity and Capital Resources of the Restricted Group
The following table is a summary of selected financial information for the Restricted Group for the periods indicated:
         
  As at As at
  June 30, December 31,
  2006 2005
  (in thousands)
Restricted Group Financial Position(1)
        
Cash and cash equivalents
 37,018  48,790 
Working capital
  80,908   93,312 
Property, plant and equipment
  400,045   404,151 
Total assets
  602,304   625,578 
Long-term liabilities
  346,271   364,596 
Shareholders’ equity
  212,182   214,115 
 
(1) See Note 9 of the financial statements included elsewhere herein for a reconciliation to our consolidated results.
At June 30, 2006, the Restricted Group had cash and cash equivalents of 37.0 million, compared to 48.8 million at December 31, 2005. At June 30, 2006, the Restricted Group had working capital of 80.9 million.
We expect the Restricted Group to meet its interest and debt service expenses and meet the working and maintenance capital requirements for its current operations from cash flow from operations, cash on hand and the revolving working capital loan facilities for the Rosenthal and Celgar mills. As at June 30, 2006, we had not drawn any amount under the Rosenthal revolving term credit facility and had drawn down approximately 15.6 million under the C$40 million Celgar revolving credit facility.

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Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Estimates are used for, but not limited to, the accounting for doubtful accounts, depreciation and amortization, asset impairments, derivative financial instruments, environmental conservation, asset retirement obligations, pensions and post-retirement benefit obligations, income taxes, and contingencies. Actual results could differ from these estimates.
Our management routinely makes judgments and estimates about the effects of matters that are inherently uncertain. As the number of variables and assumptions affecting the probable future resolution of the uncertainties increase, these judgments become even more subjective and complex. We have identified certain accounting policies that are the most important to the portrayal of our current financial condition and results of operations.
For information about our significant accounting policies, see our annual report on Form 10-K for the year ended December 31, 2005.
Cautionary Statement Regarding Forward-Looking Information
The statements in this report that are not reported financial results or other historical information are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. These statements appear in a number of different places in this report and can be identified by words such as “estimates”, “projects”, “expects”, “intends”, “believes”, “plans”, or their negatives or other comparable words. Also look for discussions of strategy that involve risks and uncertainties. Forward-looking statements include statements regarding the outlook for our future operations, forecasts of future costs and expenditures, the evaluation of market conditions, the outcome of legal proceedings, the adequacy of reserves, or other business plans. You are cautioned that any such forward-looking statements are not guarantees and may involve risks and uncertainties. Our actual results may differ materially from those in the forward-looking statements due to risks facing us or due to actual facts differing from the assumptions underlying our estimates. Some of these risks and assumptions include those set forth in reports and other documents we have filed with or furnished to the SEC, including in our annual report on Form 10-K for the year ended December 31, 2005. We advise you that these cautionary remarks expressly qualify in their entirety all forward-looking statements attributable to us or persons acting on our behalf. Unless required by law, we do not assume any obligation to update forward-looking statements based on unanticipated events or changed expectations. However, you should carefully review the reports and other documents we file from time to time with the SEC.

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Cyclical Nature of Business
Revenues
The pulp and paper business is cyclical in nature and markets for our principal products are characterized by periods of supply and demand imbalance, which in turn affects product prices. The markets for pulp and paper are highly competitive and are sensitive to cyclical changes in industry capacity and in the global economy, all of which can have a significant influence on selling prices and our earnings. Demand for pulp and paper products has historically been determined by the level of economic growth and has been closely tied to overall business activity. Although pulp prices have improved recently, we cannot predict the level of economic activity or growth in certain world markets or the impact of war, terrorist activity or other events on our markets and prices for our products.
Commencing in 2005, our German operations became subject to the European Union Emissions Trading Scheme pursuant to which our German mills were granted emission allowances. Emission allowances are granted based upon production volumes and the types of fuels consumed by the manufacturing facilities in Germany. Since then, we have benefited from the sale of emission allowances. However, the market for such sales is relatively new and volatile and we cannot predict the level of any sales thereafter.
Costs
Our production costs are influenced by the availability and cost of raw materials, energy and labor, and our plant efficiencies and productivity. Our main raw material is fiber in the form of wood chips and pulp logs for pulp production, and waste paper and pulp for paper production. Fiber costs are primarily affected by the supply of, and demand for, lumber and pulp, which are both highly cyclical in nature and can vary significantly by location. Recently, fiber demand in Europe has also increased because of a demand from renewable energy projects. Production costs also depend on the total volume of production. Lower operating rates and production efficiencies during periods of cyclically low demand result in higher average production costs and lower margins.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risks from changes in interest rates and foreign currency exchange rates, particularly the exchange rate between the U.S. dollar and the Euro and to a lesser extent the Canadian dollar, which may affect our results of operations and financial condition and, consequently, our fair value. We manage these risks through internal risk management policies and, with respect to risks related to changes in exchange rates between the U.S. dollar and the Euro, with the use of derivatives. We use derivatives to reduce or limit our exposure to interest rate and U.S. dollar/Euro currency risks. We may in the future use derivatives to reduce or limit our exposure to fluctuations in pulp prices. We also use derivatives to reduce our potential losses or to augment our potential gains, depending on our management’s perception of future economic events and developments. These types of derivatives are generally highly speculative in nature. They are also very volatile as they are highly leveraged given that margin requirements are relatively low in proportion to notional amounts.
Many of our strategies, including the use of derivatives, and the types of derivatives selected by us, are based on historical trading patterns and correlations and our management’s expectations of future events. However, these strategies may not be fully effective in all market environments or against all types of risks. Unexpected market developments may affect our risk management strategies during this time, and unanticipated developments could impact our risk management strategies in the future. If any of the variety of instruments and strategies we utilize are not effective, we may incur losses.
All of our derivatives are marked to market at the end of each reporting period, and all unrealized gains and losses are recognized in earnings for a reporting period. We determine market valuations based primarily upon valuations provided by our counterparties.
In the first quarter of 2005, Stendal entered into currency swaps to convert a portion of its indebtedness under the Stendal Loan Facility from Euros into U.S. dollars and certain currency forwards. In April 2005, Stendal entered into a currency swap to convert the balance of its long-term indebtedness under the Stendal Loan Facility from Euros into U.S. dollars. During the first half of 2006, we recorded a net unrealized non-cash holding gain of 90.7 million before minority interests upon the marked to market valuation of such derivatives compared to a net non-cash holding loss of73.0 million before minority interests upon the marked to market valuation of our outstanding derivatives in the first half of 2005. In the first half of 2006, we had a realized loss of5.2 million on certain currency forwards which had matured, compared to a realized loss of 0.3 million on derivative instruments in the first half of 2005

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ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures. Our management, with the participation of our Principal Executive Officer and Principal Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the period covered by this report. Based on such evaluation, our Principal Executive Officer and Principal Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that are filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms and to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to management, including its Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
It should be noted that any system of controls is based in part upon certain assumptions designed to obtain reasonable (and not absolute) assurance as to its effectiveness, and there can be no assurance that any design will succeed in achieving its stated goals.
Changes in Internal Controls. There have been no significant changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In October 2005, our wholly owned subsidiary, Zellstoff Celgar Limited, received a re-assessment for real property transfer tax payable in British Columbia, Canada, in the amount of approximately3.5 million in connection with the transfer of the land where the Celgar mill is situated. The Company is contesting the assessment and the amount, if any, that may be payable in connection therewith is not yet determinable. Any additional amount paid in connection with the re-assessment will increase the cost basis of the assets acquired.
We are subject to routine litigation incidental to our business. We do not believe that the outcome of such litigation will have a material adverse effect on our business or financial condition.
ITEM 1A. RISK FACTORS
There have been no material changes to the factors disclosed in Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2005.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS
We held our annual meeting of shareholders on June 12, 2006. At the meeting, our six directors were re-elected to our board of directors and the selection of Deloitte & Touche LLP as our independent auditors was ratified.
The votes cast by shareholders at the meeting as to the election of directors were as follows:
             
  Votes For Votes Withheld Abstentions and Broker Non-Votes
Jimmy S.H. Lee
  16,840,127   129,064    
Kenneth A. Shields
  16,843,181   126,010    
William D. McCartney
  16,841,981   121,010    
Graeme A. Witts
  16,841,981   127,210    
Eric Lauritzen
  16,843,171   126,020    
Guy W. Adams
  16,841,981   127,210    

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ITEM 6. EXHIBITS
   
Exhibit No. Description
31.1 
Section 302 Certification of Chief Executive Officer
   
31.2 
Section 302 Certification of Chief Financial Officer
   
32.1* 
Section 906 Certification of Chief Executive Officer
   
32.2* 
Section 906 Certification of Chief Financial Officer
 
* In accordance with Release 33-8212 of the Commission, these Certifications: (i) are “furnished” to the Commission and are not “filed” for the purposes of liability under the Securities Exchange Act of 1934, as amended; and (ii) are not to be subject to automatic incorporation by reference into any of the Company’s registration statements filed under the Securities Act of 1933, as amended for the purposes of liability thereunder or any offering memorandum, unless the Company specifically incorporates them by reference therein.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
     
 MERCER INTERNATIONAL INC.
 
 
 By:  /s/ David M. Gandossi   
  David M. Gandossi  
  Secretary and Chief Financial Officer  
 
Date: August 8, 2006

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