Neenah Annual Report 2004

Plain-text annual report

H o w d o y ou ma k e a gre a t first impression ? N e e n a h P a p e r , I n c . 2 0 0 4 A n n u a l R e p o r t 3460 Preston Ridge Road Suite 600 Alpharetta, GA 30005 678.566.6500 2004 Annual Report Shareholder Information Corporate Headquarters Stock Exchange Neenah Paper, Inc. 3460 Preston Ridge Road Suite 600 Alpharetta, GA 30005 678.566.6500 www.neenah.com Annual Meeting of Shareholders The annual meeting of the shareholders of Neenah Paper, Inc. will be held Monday, June 20, 2005, at 2:00 p.m., Central time (3:00 p.m, Eastern time), at Neenah Paper Whiting Mill, 3243 Whiting Road, Stevens Point, WI 54481. Registrar and Transfer Agent EquiServe Trust Company, N.A. P.O. Box 43010 Providence, RI 02940 www.equiserve.com 877.498.8847 Investor Information Inquiries and requests for information, including the Company’s annual report to the Securities and Exchange Commission on Form 10-K, may be obtained at no charge by visiting the Company’s web site at www.neenah.com or by otherwise contacting the company as follows: Neenah Paper, Inc. Attn: Stockholder Services 3460 Preston Ridge Road Suite 600 Alpharetta, GA 30005 866.548.6569 or via e-mail to investors@neenahpaper.com Neenah Paper’s common stock is traded on the New York Stock Exchange under the symbol NP. Independent Accountants Deloitte & Touche LLP 191 Peachtree Street Suite 1500 Atlanta, GA 30303 Business Description Neenah Paper manufactures and distributes a wide range of premium and specialty paper grades, with well-known brands such as CLASSIC®, ENVIRONMENT®, KIMDURA® and MUNISING LP®. The Company also produces and sells bleached pulp, primarily for use in the manufacture of tissue and writing papers. Neenah Paper is based in Alpharetta, Georgia, and has manufacturing operations in Wisconsin, Michigan and in the Canadian provinces of Ontario and Nova Scotia. Trademarks The brand names mentioned in this report – CLASSIC CREST, CLASSIC COTTON, CLASSIC, CLASSIC COLUMNS, NEENAH, UV/ULTRA II, ATLAS, ENVIRONMENT, EAMES, OLD COUNCIL TREE, KIMDURA, EPIC II, DURAFORM, DURAFLEX, BUCKSKIN, PREVAIL, TEXOPRINT, MUNISING LP, TECHNI-PRINT, KIMLON, PHOTO-TRANS, HEIRLOOM – are trademarks of Neenah Paper, Inc. 1. start with a bla nk sh ee t of pape r Every new beginning brings with it a multitude of new possibilities – new opportunities. Such is the case with Neenah Paper. We’re a new stand-alone company created from Kimberly-Clark’s ﬁne paper, technical paper and pulp operations. And while our heritage goes back to the founding of the ﬁrst Neenah Mill in 1873, our future is now what we make of it. For us, it’s a blank sheet of paper – a place to leave an indelible mark. 2 Share a Strong Vision 4 Letter to Shareholders 8 Empower 2,100 Employees 14 Listen to Our Customers 18 Utilize the Best in All Our Businesses 22 Invest in Creative Thinking 26 Respect and Protect the Environment 30 Neenah Paper At-a-Glance 34 Board of Directors 35 Index to Financials pg. 1 Neenah Paper, Inc. 2004 Annual Report pg. 3 Neenah Paper, Inc. 2004 Annual Report To our shareholde rs: “ You don’t create value by talking about it. Only execution produces results.” Sean T. Erwin Chairman, President and Chief Executive Ofﬁcer Right size, right time, right market Neenah Paper was created from three stand-alone businesses. Yet today we function as one integrated and independent company. We’ve taken the strengths and resources from each business and used them to create a strong foundation for our future. A large piece of that foundation is the Neenah Paper brand. It has tremendous equity in the marketplace. It is synony- mous with outstanding quality, customer service and support. Those qualities are being applied equally to all three of our pulp and paper markets. Our focus now is on growing our individual paper businesses – ﬁne paper and technical paper. To facilitate that process and strengthen our structure, we are making a signiﬁcant investment in an integrated ERP (Enterprise Resource Planning) system, which will help align production planning, supply chain management and inven- tory management with the needs of our customers. Our spin-off from Kimberly-Clark allows us to explore new growth opportunities and reinvest in our business in ways that were not open to us before. The math is in our favor. pg. 5 We’re an $800 million company now, as opposed to The power of people being a small part of a $15 billion company. A $20 to $30 On the morning of December 2, 2004, we celebrated million sales opportunity in our context is not only reachable; our spin-off by ringing The Opening BellSM at the New York it’s signiﬁcant. A culture of accountability Neenah Paper may be a new company, but our heritage extends back more than a half century. Under Kimberly- Clark, Neenah Paper established a leadership role in ﬁne paper, technical paper and pulp. We’re not about to let that go. Our ﬁrst priority is safety. Our responsibility is to create value for customers and shareholders alike through innova- tion, service and excellence. It is our employees who will create this value and drive our success. Together, we are a team of smart, engaged, results-oriented people who are committed to making this company a success. For the ﬁrst time ever, we are in control of our own destiny. The decisions we make now have more impact on us than they did when Stock Exchange. It was an exciting occasion for all of us and the fruition of many months of hard work. The honor of ringing the bell went to Bill Platt, Operations Manager for our ﬁne paper mill in Neenah, Wisconsin. During the spin-off process, we decided to establish a “Ring the Bell” contest to recognize the employees who were creating and driving value for the new company – not talking about what they would do, but making things happen. In all, 45 differ- ent teams, comprised of employees from all functions and locations submitted their successes. The winning team then selected Bill as their representative to ring the bell in New York. We are keeping the “Ring the Bell” program alive and using it as a means to capture savings and celebrate creat- ing real value for our new company. we were part of Kimberly-Clark. Bottom line, we are It’s all about execution accountable for everything we do. Execution is what drives us forward. But to keep us on a steady course, we are tracking all of the ﬁnancial and Neenah Paper, Inc. 2004 Annual Report Vision: To be the ﬁrst choice for branded and customized paper and pulp products. Mission: To create value for our customers and shareholders through innovation, service and excellence. It is our employees who will create this value and drive our success. non-ﬁnancial metrics that shape our business. Our mission an investment not only in our future, but in the future is to provide shareholders with a return that’s greater than of our customers. By adding value to our customer the cost of capital as we grow our business. That means relationships, we demonstrate our strong commitment we intend to reinvest our capital and cash wisely to to helping them achieve success. achieve growth. As a whole, the paper and forest products industry has not provided attractive returns to sharehold- ers in recent years. Neenah Paper’s specialty papers business is different. Strategically, we expect these types of higher return businesses to become a larger part of the Neenah Paper portfolio as we continue to grow. Developing a market for pulp For Kimberly-Clark, pulp was a cost center. For us, our pulp operation is an opportunity to become a world-class com- petitive supplier in this industry. Of course, this will only happen with a sound strategy and execution. We intend to bring the same premium performance and value to pulp Reorganizing R&D – Energizing innovation that we bring to our ﬁne paper and technical paper busi- Ours is a customer-centric business. One of the key ways nesses. That includes enhancing the quality and usability we help our customers is to provide innovative solutions of our pulp. Our new, unique wireless bale is an excellent for their needs. Often, that means we are developmental example of that. partners with our customers. Many of our products, espe- cially our technical papers, are customized for speciﬁc applications. Naturally, research and development plays a vital role in that process. For that reason, we have com- bined our disparate R&D operations under one roof and We will have a strong market presence in pulp. We have hired an outstanding sales and marketing team for our pulp business that brings to the table more than 20 years of expe- rience and strong relationships with customers and the mills. are investing to improve our capabilities. We consider it At both Terrace Bay and Pictou, we stand committed to managing the natural resources under our protection in pg. 7 (left to right) James R. Piedmonte Vice President – Operations Bonnie C. Lind Vice President, Chief Financial Ofﬁcer and Treasurer Steven S. Heinrichs Vice President, General Counsel and Secretary Sean T. Erwin Chairman of the Board, President and Chief Executive Ofﬁcer William K. O’Connor Vice President – Sales and Marketing a sustainable and productive manner to maximize their I hope this will be the ﬁrst of a long line of Neenah Paper long-term viability. We are on track for both pulp mills annual reports that you will read with interest. Actually, you to be certiﬁed shortly to the American Forest & Paper can do more than just read this one; you can experience Association’s (AF&PA) Sustainable Forestry Initiative (SFI). it. It’s printed on a variety of some of our best-selling ﬁne Strengthening our competitive position in pulp also requires making some tough decisions. One example is the closing paper brands. Run your ﬁngers across the page. That’s the feel of quality paper. of the No. 1 mill at our Terrace Bay plant in Ontario, Canada. The business segment and ﬁnancial sections of this report As the smaller and older of the two mills at Terrace Bay, the cover the full year’s activities in more detail. However, this No. 1 mill did not justify the investment necessary to com- report for 2004 includes only one month as an independent pete successfully in today’s global pulp market. Also, this company. Our job is now to get to work, begin executing move improved the proﬁt-generating ability of the facility our strategies as a new company, and deliver the results you and allowed the teams to focus on improving the larger expect from us. No. 2 mill and our wood costs, both necessary steps to achieve long-term viability of the plant. The ﬁrst of many annual reports Launching a new company the size of Neenah Paper isn’t something that we could do by ourselves. It took the com- bined efforts and support of our employees, customers and investors to make it happen. For that, and for your contin- ued support, I extend my deepest thanks. We have our work ahead of us, but we are both ready and anxious to get going. Sean T. Erwin Chairman, President and Chief Executive Ofﬁcer Neenah Paper, Inc. 2004 Annual Report pg. 9 Neenah Paper, Inc. 2004 Annual Report pg. 15 Neenah Paper, Inc. 2004 Annual Report A new image Meeting the challenge Working closely with Bank of America’s minority partner, American Product Distributors, Neenah Paper helped enhance the look and feel of the bank’s letterhead and business card – creating a private watermark with greater recycled content (40 percent). The letterhead was developed on a 25 percent CLASSIC COTTON® Papers base sheet, while the business card stock was developed using CLASSIC CREST® Papers. In November 2003, the scrapbook industry was in a virtual panic. Its annual tradeshow was looming and its main paper supplier had gone out of business. Although the quantities were small by Neenah Paper’s standards, we viewed this as an opportunity to enter one of the fast- est growing segments of the hobby market. Neenah’s No. 8 machine ran all of January 2004, changing colors and ﬁnishes 5–6 times a day. The result: 40 new deep colors for the tradeshow and several new customers for us. pg. 17 Keeping up with customer needs How do you react when a customer calls requesting a paper that matches the color of his beloved alma mater? Or when a customer is looking for a product with years of longevity, high strength and a slow cure thermo set coating? If you’re a Neenah Paper Customer Service Analyst, you immediately recognize an opportunity to solve a customer’s problem. In 2004, Fine Paper recognized the need for improved freight service to several Midwestern markets and offered overnight delivery to these customers. Technical Paper found ways to address our cus- tomers’ needs for lower-cost products by improving production processes and offering a selection of alternative raw materials. We also set up a new world-class customer service measurement system called the “perfect order.” This is a more comprehensive and stringent analysis of how we are striving to exceed all facets of our customers’ service expectations. Neenah Paper, Inc. 2004 Annual Report pg. 19 Neenah Paper, Inc. 2004 Annual Report Putting quality in place At Neenah Paper, we see quality in a variety of ways – as process improvement, as enhancements to customer service, as exceeding customers’ expectations as well as our own. formation; a stock screen; and a defect detector. Collectively, those represent the most signiﬁcant pro- cess upgrades to the mill in decades. Right now, process improvement is underway at the Munising mill, where we produce our technical paper. Improvements include the installation of a new head- box, a major piece of equipment used to control sheet We are sharpening our focus on customer service, too. Our online Fine Paper Customer Service System is operational, ensuring that customers receive the right samples at the right time. And when our ERP system goes online later this year, it will add efﬁciency and support to everything from customer service to manufacturing. pg. 21 Exceeding our customers’ expectations is key to our success. Our Munising facility saw a 34 percent reduction in the number of customer complaints. Our Fine Paper facilities experienced a 41 percent reduction in the cost of claims. (from left to right) Recently installed high-speed defect detector scans rolls of paper at our Munising mill. In the process control room at our Pictou mill, where operators monitor the entire process from one central control station. Saturated paper machine at the Munising mill. Safety process inspector watches sheeting operation at our Whiting mill. Neenah Paper, Inc. 2004 Annual Report pg. 23 Neenah Paper, Inc. 2004 Annual Report Solving problems the Neenah Paper way At Neenah Paper, our R&D process is a collaborative one. A good example of that is the recent development of the EAMES™ Paper Collection, our new, innovative paper line. Creating these papers involved a dedicated team of peo- ple, from R&D, Marketing and Operations and cut across both our Fine Paper and Technical Paper facilities. The resultant EAMES Paper Collection, a collaboration with the Eames Ofﬁce Foundation, represents a new approach to paper making based on the design and color principles of renowned designers Charles and Ray Eames. The EAMES Paper Collection also represents something else: how Neenah Paper’s previous stand-alone businesses are now working together to produce results. The major focus of our R&D activity is developing solutions that meet our customers’ needs – both current and pro- spective customers. In one case, a prospective Technical Paper customer encountered a costly manufacturing glitch in developing a new product. Fixing the problem would pg. 25 have required a sizeable investment in new equipment and an expensive change to their production processes. Neenah Paper’s R&D team came to the rescue and developed a more cost-effective solution, one that involved only the addition of a simple step. Consequently, this prospective customer became a new customer for Neenah Paper! (from left to right) Mike Lindquist at our Munising mill: his innovative solution to a customer’s problem helped us keep the business. A battery of quality tests, like this one for internal strength, ensures a quality sheet. Dave Winger at our Neenah mill: one of the team members who developed our new EAMES™ Brand of papers. Neenah Paper, Inc. 2004 Annual Report pg. 27 Neenah Paper, Inc. 2004 Annual Report Doing our part As part of Neenah Paper’s stewardship program, many unique areas have been permanently protected, including old growth forests, seabird sanctuaries, and areas of geolo- gical, cultural and historic signiﬁcance. These areas were identiﬁed through collaboration with government agencies and conservation groups such as the Nature Conservancy of Canada. In addition, Neenah Paper has made available thousands of acres of company owned and leased lands for public enjoyment through the creation of over 30 parks and wilderness areas in Ontario and Nova Scotia. The Pictou woodlands facilities encompass approximately 1.2 million acres of combined owned and licensed or man- aged land in Nova Scotia. As part of this operation, we own and operate a tree nursery which produces and ships 8.5 million seedlings annually that are used in the refores- tation of lands harvested by Neenah Paper as well as other designated areas. Neenah Paper is a leader in the manufacturing of environ- mentally friendly papers. As part of our sustainability program, we use post-consumer and recycled ﬁber as well as alternate ﬁbers, like sugar cane bagasse. Since its debut Neenah Paper’s forest tree nursery in Nova Scotia supplies millions of softwood seedlings for the company’s extensive reforestation programs. The seedlings are also playing an important role in helping children at the IWK Hospital for Children in Halifax. In a unique partnership with students at Prince Andrew High School over the past three years, more than 60,000 seedlings have been distributed to city residents in return for donations to the hospital. The result: over $40,000 raised for the kids and a greener city! pg. 29 in 1990, the ENVIRONMENT® Brand of premium papers from Neenah Paper has led the industry in this category and has been one of our fastest-growing brands. Two colors of ENVIRONMENT Brand – White and Ultra Bright White – have received certiﬁcation from SmartWood, a representative of the Forest Stewardship Council (FSC), an international non-proﬁt organization devoted to encouraging the respon- sible management and sustainability of the world’s forests. In another important step in our history of managing our forestlands responsibly, we are in the process of having our woodlands operations in Ontario and Nova Scotia third-party certiﬁed by the standards of the Sustainable Forestry Initiative (SFI). Similar to ISO 14001, SFI is a com- prehensive system of principles and performance measures that provides a means of assuring the public, our custom- ers and our employees that we are following environmentally sound forestry practices. While our woodlands currently operate in a manner designed to ensure stakeholder involve- ment and considerations for all forest values, obtaining certiﬁcation to the strict standards of SFI provides yet another level of assurance. Neenah Paper, Inc. 2004 Annual Report Neenah Paper At-a-Glance Neenah Paper is recognized as a world-class manufacturer of ﬁne paper, technical paper and pulp. Our Fine Paper division produces premium writing, text, cover, specialty and private watermark papers that are used in corporate annual reports, corporate identity packages, invitations, personal stationery and high-end packaging. Our premium paper brands are some of the most recognized and preferred in the industry, including CLASSIC®, CLASSIC CREST®, ENVIRONMENT®, NEENAH® and UV/ULTRA® II Papers. Our Technical Paper division is regarded as an industry leader in research, technology and problem solving, focused on durable, saturated and coated base papers for a variety of end uses. For more than half a century, our innovative paper products have replaced those made from wood, plastic, cloth and leather. Our technical papers are used in a wide array of applications – from labels and tape to heat transfer and medical packaging – and our customers are located in 39 countries around the world. Our pulp business consists of mills in Pictou, Nova Scotia and Terrace Bay, Ontario, together with related timberlands. These mills produce northern softwood kraft pulp and northern hardwood kraft pulp, which are used in the manu- facture of tissue, publication, premium writing, printing and other specialty papers. pg. 31 Fine Paper In 2004, our Fine Paper business achieved four consecutive quarters of year-on-year volume growth. Q1 Q2 Q3 Q4 Change in Volume 2003 vs. 2004 03 04 Our Brands 2004 Highlights • CLASSIC CREST® • ATLAS™ Bond • Total volumes grew 7 percent, driving 5 percent growth • CLASSIC COTTON® • ENVIRONMENT® in net sales. Papers • Operating income grew 6 percent, with operating margins • EAMES™ Paper Collection • OLD COUNCIL TREE® Bond • CLASSIC® Linen • CLASSIC® Laid • CLASSIC COLUMNS® • NEENAH® Bond • UV/ULTRA® II Market Opportunities Today, Neenah Paper participates in the premium text and cover market segment which represents only 3 percent of the total uncoated printing and writing market. The opportunity to move more customers up to using premium papers to enhance their message is enormous. As a stand-alone company and market leader, Neenah Paper now has the opportunity to drive growth in this segment, as well as explore new distribution channels, products and geographies. maintained over 30 percent. • Our ENVIRONMENT® Papers gradeline was revised to meet evolving customer needs and continues as our fastest-growing Fine Paper brand. • Fine Paper branded print advertising campaign rated number one in awareness and believability in several graphic design industry publications. • Fine Paper assets successfully qualiﬁed and began manu- facturing base paper for Technical Paper to meet demand in this segment. Key Strengths Neenah Paper’s strong brands and focus on customer service and quality, coupled with the newest and most efﬁcient asset base in the premium papers segment, have led paper distributors, printers and designers to specify Neenah Paper for their premium paper needs. Neenah Paper, Inc. 2004 Annual Report Technical Paper Our innovative technical papers provide performance and value to a wide variety of customers and end uses. Premask Label Specialities Tape Abrasive 2004 Net Sales Our Brands 2004 Highlights KIMDURA® EPIC II® MUNISING LP® TECHNI-PRINT® DURAFORM® KIMLON® PHOTO-TRANS® HEIRLOOM® NEENAH™ DURAFLEX® BUCKSKIN® PREVAIL® TEXOPRINT® Key Strengths • Volume grew 7 percent, with contributions across 15 product segments and in U.S., European, Asian and Latin American markets. • Net sales and operating income increased 9 and 32 percent, respectively. • The Munising Mill celebrated 100 years of operation. • Successful launch of EPIC II® Graphic Materials line of text book covers complemented our Decorative Component product line. Our years of experience and signiﬁcant intellectual capital in the production of specialty substrate materials – combining ﬁbers, a variety of synthetic lattices and multiple coating materials – make many products in Neenah Paper’s Technical Paper division unique. This expertise is combined with a R&D group that is passion- ate in their work in driving innovation and working closely with customers in ﬁnding new and improved uses and products. Market Opportunities Technical Paper is positioned to further grow both in the U.S. and overseas. The additional focus and resources in R&D are also expected to result in additional growth opportunities with new and improved products. pg. 33 Pictou Softwood Pictou Hardwood Terrace Bay Softwood 2004 Production (metric tons) Terrace Bay Hardwood • The Terrace Bay mill began producing “wireless bales” for its hardwood pulp production. • Neenah Paper’s Pictou mill set the highest productivity level in its 58-year-old history, with over 264,000 metric tons. Pulp The Terrace Bay and Pictou mills produce more than 700,000 metric tons of pulp annually. The majority of Neenah Paper’s pulp production goes into Kimberly-Clark products. 2004 Highlights • Neenah Paper’s net sales grew 11 percent in 2004. • Terrace Bay was again named the safest paper mill in Canada by Pulp and Paper Canada magazine. Key Strengths Market Opportunities Both the hardwood and softwood pulp produced at the mills have been noted for their many impor- tant quality and product characteristics. Neenah Paper’s background as a paper company and as part of Kimberly-Clark’s tissue operations also give us unique insights into what characteristics are important to our customers. As a new entry to the market pulp industry, Neenah Paper has many opportunities to develop new customers. Pictou’s location in Nova Scotia makes it an ideal shipping point for delivery to Europe. Neenah Paper, Inc. 2004 Annual Report Board of Directors Sean T. Erwin Chairman of the Board, Presi- dent and Chief Executive Ofﬁcer Neenah Paper, Inc. Mary Ann Leeper, Ph.D. President and Chief Operating Ofﬁcer Female Health Company Timothy S. Lucas, CPA Independent Consultant Lucas Financial Reporting Philip C. Moore Partner McCarthy Tétrault, L.L.P. Stephen M. Wood, Ph.D. Former Chief Executive Ofﬁcer Kraton Polymers LLC James G. Grosklaus Retired Executive Vice President Kimberly-Clark Corporation Edward Grzedzinski Former Chief Executive Ofﬁcer NOVA Information Systems pg. 35 Financials 36 Management’s Discussion and Analysis of Financial Condition and Results of Operations 50 Report of Independent Registered Public Accounting Firm 51 Consolidated and Combined Statements of Operations 52 Consolidated and Combined Balance Sheets 53 Consolidated and Combined Statements of Changes in Stockholders’ and Invested Equity 54 Consolidated and Combined Statements of Cash Flows 55 Notes to Consolidated Financial Statements Neenah Paper, Inc. 2004 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis presents the factors that had OV ERV I EW O F B U S I N ES S a material effect on our results of operations during the years ended December 31, 2004, 2003 and 2002. Also discussed is our ﬁ nancial position as of the end of those periods. You should read this discussion in conjunction with our consolidated and combined ﬁ nancial state- ments and the notes to those consolidated and combined ﬁ nancial statements included elsewhere in this Annual Report. This Manage- ment’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. See “Forward- Looking Statements” for a discussion of the uncertainties, risks and assumptions associated with these statements. I N T RO D U C T I O N As more fully described in the “Business Outlook” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the results of opera- tions of our business after the Spin-Off are and will continue to be signiﬁ cantly different than the results of operations of our business prior to the Spin-Off. This difference results from, among other things, the prices at which we sell pulp to Kimberly-Clark after the Spin-Off, which are signiﬁ cantly different than the prices reﬂ ected in transfers of pulp to other Kimberly-Clark operations prior to the Spin-Off, interest expense of new long-term debt and incremental selling, gen- eral and administrative expenses related primarily to reduced economies of scale as a result of operating on a stand-alone basis. To understand how the terms of our pulp supply agree- ment with Kimberly-Clark would have affected our historical results, you should see the “Business Outlook” section. This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide investors with an understanding of the historical performance of our business, its ﬁ nancial condition and its prospects. We will discuss and provide our analysis of the following: (cid:127) Overview of Business; (cid:127) Business Segments; (cid:127) Separation from Kimberly-Clark; (cid:127) Results of Operations and Related Information; (cid:127) Liquidity and Capital Resources; (cid:127) Critical Accounting Policies and Use of Estimates; and (cid:127) Business Outlook. We are a leading North American producer of premium ﬁ ne papers and technical papers. We also produce bleached kraft market pulp in Canada, where we own approximately one million acres of timberlands and have non-exclusive rights to harvest wood from approximately 4.8 million acres of other timberlands. We have three primary operations: our ﬁ ne paper business, our technical paper business and our pulp business. In managing this diverse pulp and paper business, man- agement believes that achieving and maintaining a leadership position for its ﬁ ne paper and technical paper businesses, responding effectively to competitive challenges, employing capital optimally, controlling costs and managing currency and commodity risks are important to the long-term success of the business. The pulp cycle and general economic conditions also impact our results. In this discussion and analysis, we will refer to these factors. Market Leadership. Achieving and maintaining leader- ship for our ﬁ ne paper and technical paper businesses have been an important part of our past performance. We have long been recognized as a leading manufacturer of world-class pre- mium writing, text and cover papers used in corporate annual reports, corporate identity packages, invitations, personal statio- nery and high-end packaging. Maintaining our leadership is important to our results, particularly in light of the competi- tive environment in which we operate. Competitive Environment. Our past results have been and future prospects will be signiﬁ cantly affected by the com- petitive environment in which we operate. We experience intense competition for sales of our principal products in our major markets. Our paper business competes directly with well-known competitors, some of which are larger and more diversiﬁ ed in most of our markets. In our pulp business, we have experienced, and will continue to experience, intense competition from suppliers of softwood pulps and southern hemisphere suppliers of hardwood pulps. We expect our com- petitors to continue to be aggressive in the future. Cost Control. To improve and maintain our competitive position, we must control our raw material, manufacturing, distribution and other costs. A major share of our investments in capital improvements are intended to achieve cost savings and improvements in productivity. pg. 37 Cyclical Nature of the Pulp Industry. Revenues in the pulp industry and our pulp business tend to be cyclical, with Foreign Currency and Commodity Risk. Sales of pulp by our Canadian manufacturing facilities are invoiced in U.S. periods of shortage and rapidly rising market prices, leading dollars in accordance with industry practice; therefore, no cur- to increased production and increased industry investment rency effects are presented in our analysis of the change in until supply exceeds demand. Those periods are then typically net sales for our pulp operations. However, we are exposed to followed by periods of reduced market prices and excess and changes in foreign currency exchange rates because most of idled capacity until the cycle is repeated. the costs relating to our pulp business are incurred in Canadian General Economic Conditions. The markets for all of our products are affected to a signiﬁ cant degree by general economic dollars. These risks could have a material impact on our results of operations if not effectively managed. The following charts conditions. Downturns and improvements in the U.S. economy illustrate changes in currency and pulp prices that occurred or in our export markets affect the demand for our products. during the periods covered by this Management’s Discussion and Analysis of Financial Condition and Results of Operations: Pulp Price History: Average Quarterly Prices U.S. dollars per metric ton $700 $600 $500 $400 Northern bleached softwood kraft pulp Northern bleached hardwood kraft pulp Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2001 2002 2003 2004 Exchange Rate History: Average Quarterly Exchange Rates Canadian dollar per U.S. dollar $0.85 $0.80 $0.75 $0.70 $0.65 $0.60 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2001 2002 2003 2004 Source: Resource Information Systems, Inc. Neenah Paper, Inc. 2004 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations B U S I N ES S S E G M EN T S 4.6 million acres of land owned by the Province of Ontario. Our ﬁ ne paper business is a leading producer of premium writing, text, cover and specialty papers used in corporate annual reports, corporate identity packages, invitations, per- sonal stationery and high-end packaging. Our products include some of the most recognized and preferred papers in North America, where we enjoy leading market positions in many of our product categories. We sell our products primarily to authorized paper distributors, converters and specialty busi- nesses, with sales to distributors and distributor-owned paper stores accounting for approximately 85% of our sales. We believe that our ﬁ ne paper manufacturing facilities located in Neenah and Whiting, Wisconsin are among the most efﬁ cient in their markets and make us one of the lowest cost producers. Our technical paper business is a leading producer of durable, saturated and coated base papers for a variety of end uses. We sell our technical paper globally into 15 product cat- egories, and we focus on nine categories where we believe we are a market leader, which include, among others, the tape, label, abrasive, medical packaging and heat transfer techni- cal paper markets. We are also a global supplier of materials used to create customer-speciﬁ c components for furniture, book covers and original equipment manufacturers’ products. Our customers are located in 39 countries and include 3M Company, Perfecseal, Avery Dennison Corporation and Saint-Gobain Group. Our technical paper manufacturing facility is located in Munising, Michigan. Our pulp business consists of two mills located in Pictou, Nova Scotia and Terrace Bay, Ontario, together with related timberlands. The Pictou mill is comprised of a single-line pulp facility which produces primarily softwood pulp, as well as timberlands encompassing approximately one million acres of owned and 200,000 acres of licensed or managed land in Nova Scotia. In 2004, the Pictou mill produced approximately 260,000 metric tons of bleached kraft pulp. The Terrace Bay mill is comprised of two single-line pulp facilities which pro- duce both softwood and hardwood pulp and a timberlands operation. Terrace Bay holds non-exclusive rights under a sus- tainable forest license to harvest wood from approximately In 2004, the Terrace Bay mill produced approximately 450,000 metric tons of pulp. As described in “Business Outlook – Recent Developments” below, on March 1, 2005, we announced our intention to close one of the two single- line pulp facilities at Terrace Bay in early May 2005. SEPARAT I ON F ROM KIMBERLY-C LARK Neenah Paper, Inc. was incorporated under the laws of the state of Delaware in April 2004, as a wholly owned subsidiary of Kimberly-Clark. We had no material assets or activities until the transfer to us by Kimberly-Clark of the businesses described in this Annual Report, which occurred immediately prior to the Spin-Off. Prior to the Spin-Off, Kimberly-Clark had conducted such businesses through various divisions and subsidiaries. Following the Spin-Off, we became an indepen- dent, public company, and Kimberly-Clark has no continuing ownership interest in us. Prior to the Spin-Off, we entered into several agree- ments with Kimberly-Clark in connection with the separation of our business from Kimberly-Clark’s businesses. These agreements included a distribution agreement, a pulp supply agreement, a corporate services agreement, an employee mat- ters agreement and a tax-sharing agreement. The distribution agreement provided for the transfer to us of the assets relating to Kimberly-Clark’s Canadian pulp business and its ﬁ ne paper and technical paper business in the United States, and the assumption by us of the liabilities relating to these businesses. The pulp supply agreement supports our transition from a captive pulp producer to a market supplier of pulp. The cor- porate services agreement facilitates an orderly transition from being a part of a larger company to a stand-alone company. The employee matters agreement allocates responsibilities relat- ing to employee compensation and beneﬁ t plans and programs and other related matters. The tax-sharing agreement governs tax obligations arising out of our business both before and after the Spin-Off. pg. 39 RESULTS OF OP ERAT ION S AND RELATED Commentary: INFOR MAT ION Year 2004 versus 2003 In this section, we discuss and analyze our net sales, income before interest and income taxes (which we refer to as “operat- ing income” in this Management’s Discussion and Analysis of Financial Condition and Results of Operations) and other information relevant to an understanding of our results of oper- ations for the years ended December 31, 2004, 2003 and 2002. Analysis of Net Sales – Years Ended December 31, 2004, 2003 and 2002 The following table presents net sales by segment, expressed as a percentage of total net sales before intersegment eliminations: Year Ended December 31, 2004 2003 2002 Fine Paper Technical Paper Pulp Total 28% 16 56 100% 29% 16 55 100% 31% 17 52 100% Percent Change in Net Sales Versus Prior Year Total Change Volume Change Due to Net Price Product Mix Currency Combined Fine paper Technical paper Pulp(a) 9 5 9 11 2 7 7 (2) 7 – – 13 – (2) 1 – – – 1 – (a) Sales of pulp by our Canadian manufacturing facilities are invoiced in U.S. dollars in accordance with industry practice; therefore, no currency effects are presented in our analysis of the change in net sales for our pulp operations. Total net sales increased $61.8 million, or 8.7%, in 2004 com- pared with 2003 primarily due to higher average market prices for softwood and hardwood pulp and unit volume growth in the ﬁ ne and technical paper businesses. Our ﬁ ne paper business net sales increased $10.4 million, The following table presents our net sales by segment for the or 4.9%, primarily due to 7% growth in unit volumes. Unit periods indicated: Year Ended December 31,(a) 2004 2003 2002 (in millions) Fine Paper Technical Paper Pulp Eliminations Total $ 220.8 132.3 448.6 (29.6) $ 772.1 $ 210.4 121.6 405.1 (26.8) $ 710.3 $ 224.7 120.7 380.0 (23.4) $ 702.0 (a) The above amounts of Net sales for the years ended December 31, 2003 and 2002 have been increased from the amounts previously reported by $44.5 million and $44.0 million, respectively, to be in conformity with EITF 00-10, which prohibits the netting of shipping and handling costs against revenues. volumes increased due to a strengthening U.S. economy that boosted market demand for premium papers, new product introductions and higher promotional spending. Product mix was unfavorable as sales volumes shifted to a higher propor- tion of lower-priced grades. Our technical paper business net sales increased $10.7 million, or 8.8%, primarily due to 7% growth in unit volumes. The volume growth reﬂ ected increased market demand as a result of an improving global economy and new product introductions. Product mix was favorable as sales vol- umes shifted to a higher proportion of higher-priced grades. Our pulp business net sales increased $43.5 million, or 10.7%, primarily due to higher softwood pulp prices. Average market prices for softwood and hardwood pulp increased 15% and 2%, respectively. The higher prices in 2004, particularly for softwood pulp, reﬂ ected increased global demand. Net sales subsequent to the Spin-Off (in December 2004) were reduced by $12.9 million or 3.2% lower compared to total 2003 pulp revenues, reﬂ ecting the one-time effect resulting from the new pulp supply agreement with Kimberly-Clark which transfers title at product delivery rather than shipment date. Neenah Paper, Inc. 2004 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Year 2003 versus 2002 of net sales for the periods indicated and is intended to provide Percent Change in Net Sales Versus Prior Year a perspective of trends in our historical results: Total Change Volume Change Due to Net Price Product Mix Combined Fine paper Technical paper Pulp(a) 1 (6) 1 7 (5) (6) (2) (5) 6 1 1 12 – (1) 2 – (a) Sales of pulp by our Canadian manufacturing facilities are invoiced in U.S. dollars in accordance with industry practice; therefore, no currency effects are presented in our analysis of the change in net sales for our pulp operations. Total net sales increased $8.3 million, or 1.2%, in 2003 compared with 2002. Our ﬁ ne paper business net sales decreased $14.3 mil- lion, or 6.4%, primarily due to 6% lower sales volumes. Weakness in the U.S. economy and trends toward increased use of lower-priced papers reduced demand for premium papers. Slightly higher net selling prices due to a May 2003 price increase were offset by additional discounts and a less favorable product mix, as sales volumes shifted to a higher proportion of lower-priced grades. Our technical paper business net sales increased $0.9 mil- lion, or 0.7%. Unit sales volumes in total were ﬂ at while selling prices were slightly higher, following a 1.8% average price increase in the second quarter of 2003. Our pulp business net sales increased $25.1 million, or 6.6%, primarily due to price increases. Average market prices Year Ended December 31, 2004 2003 2002 Net sales Cost of products sold Gross proﬁ t Selling, general and administrative expenses Asset impairment loss Other (income) and expense – net Operating income (loss) Interest expense Income (loss) before income taxes Provision (beneﬁ t) for income taxes Net income (loss) 100.0 % 83.9 16.1 100.0 % 84.8 15.2 100.0 % 81.3 18.7 5.9 14.6 0.7 (5.1) 0.2 (5.3) 4.9 – 1.4 8.9 – 8.9 4.8 – (0.2) 14.1 – 14.1 (1.9) (3.4) % 3.4 5.5 % 5.2 8.9 % Analysis of Operating Income (Loss) – Years Ended December 31, 2004, 2003 and 2002 The following table sets forth our pre-tax income (loss) by segment for the periods indicated: Year Ended December 31, (in millions) Fine Paper Technical Paper Pulp Corporate costs Total 2004 2003 2002 $ 67.0 21.9 (120.5) (8.3) $ (39.9) $ 63.2 16.6 (16.5) – $ 63.3 $ 77.2 18.4 3.7 – $ 99.3 for softwood and hardwood pulp increased 13% and 18%, Asset Impairment Loss respectively. These improvements were tempered by a 5% Our Terrace Bay, Ontario pulp mill incurred operating losses decline in volume primarily due to unusually high sales in 2002, in 2002, 2003 and 2004. We anticipate that the facility will as Kimberly-Clark increased consumption of hardwood pulp in continue to incur operating losses in 2005, 2006 and 2007. order to reduce hardwood pulp inventory levels. Hardwood The principal causes of these projected losses are: pulp inventories increased in 2001 as Kimberly-Clark substi- (cid:127) continued high operating costs at this facility; tuted softwood pulp consumption for hardwood pulp and also (cid:127) prices for pulp sold to Kimberly-Clark under the new due to reduced hardwood pulp sales to external customers. pulp supply agreement, which will be at substantially The following table sets forth line items from our consoli- higher discounts than those at which pulp was transferred dated and combined statements of operations as a percentage to Kimberly-Clark prior to the Spin-Off; (cid:127) anticipated lower market prices for pulp in the second half of 2005 and forward as a result of an expected downturn in the pulp cycle; and (cid:127) continued strength of the Canadian dollar relative to the U.S. dollar. pg. 41 Because projected extended periods of operating losses products. Kimberly-Clark’s management concluded that the are indicators of impairment under Statement of Financial Accounting Standards (“SFAS”) 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), we performed an asset impairment test on the facility under facility was not impaired prior to the Spin-Off because, as used by Kimberly-Clark, it was an integrated part of Kimberly- Clark’s tissue and other businesses and the estimated undiscounted future cash ﬂ ows of the businesses consuming the guidance of SFAS 144, which indicated that the carrying such pulp were sufﬁ cient to recover the carrying amounts of amount of the Terrace Bay facility would not be recoverable their long-lived assets, including the Terrace Bay facility. from estimated future cash ﬂ ows. Accordingly, in December 2004, we recorded a pre-tax, non-cash impairment loss of approximately $110.0 million to reduce the carrying amount of the Terrace Bay facility. In addition, in December 2004, in recognition of the probability that the No. 1 mill would be closed (see “Business Outlook–Recent Developments” below), we recorded an additional impairment loss of approximately $2.8 million related to the long-lived assets of the Terrace Bay facility. A deferred tax beneﬁ t of approximately $40.8 million was also recorded as a result of the impairment losses, resulting in a net after-tax charge of approximately $72.0 million. In determining the impairment losses, the estimated Commentary: Year 2004 versus 2003 Percent Change in Operating Income Versus Prior Year Change Due to Fiber/ Net Wood Change Volume Price Mix Currency Other(b) Total Combined(c) Fine paper Technical paper Pulp(a)(c) – 6 32 – – 9 12 – – (2) (3) – – (3) (12) – – – 9 – – 2 26 – (a) The operating loss for our pulp business in 2004 includes an impair- fair value of the Terrace Bay facility was based on probability- ment loss of $112.8 million for our Terrace Bay facility. weighted pre-tax cash ﬂ ows from operating the facility, (b) Includes distribution, pension, energy and other costs. discounted at a risk-free interest rate. The signiﬁ cant assump- tions used to determine fair value of the facility included our long-term projections of the market price of pulp, the projected cost structure of the facility and the long-term rela- tionship of the Canadian dollar and the U.S. dollar. We also considered our plans to improve the cost structure at Terrace Bay, primarily through future capital projects and a plan for a cogeneration arrangement that would lower the cost of elec- tricity, when determining the fair value of the facility used to determine the impairment losses. This estimate of the fair value of the Terrace Bay facility reﬂ ects these assumed improvements to the facility’s cost structure. Prior to the Spin-Off, Kimberly-Clark’s management also performed an impairment test of the Terrace Bay facility under the guidance of SFAS 144. The purpose of that analy- sis was to determine if the Terrace Bay facility was impaired when held by Kimberly-Clark prior to the Spin-Off. As oper- ated by Kimberly-Clark, the Terrace Bay facility supplied more than 90% of the pulp it produced to other Kimberly-Clark businesses where it was used to produce tissue and other (c) Percentage changes from prior period have been omitted from this table for Combined and Pulp because percentage changes are not meaningful when there is operating income in one period and an operating loss in the other. Overall operating income decreased $103.2 million and we incurred an operating loss of $39.9 million in 2004 primarily due to the impairment loss for Terrace Bay ($112.8 million pre-tax). Our ﬁ ne paper business operating income increased $3.8 million primarily due to the higher sales volumes and improved manufacturing operations and the beneﬁ ts of cost reduction programs. These gains were partially offset by higher costs for ﬁ ber, energy and other materials and a less proﬁ table product mix. In addition, results in 2003 included charges of $1.1 million for a workforce reduction and $1.3 million for a write-off of a paper machine. Our technical paper business operating income increased $5.3 million, or 31.9% due to improved manu- facturing operations, higher sales volumes and favorable foreign currency effects. The improved manufacturing costs were due to increased productivity, reduced waste and the beneﬁ ts of cost reduction programs. Neenah Paper, Inc. 2004 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Management’s Discussion and Analysis of Financial Condition and Results of Operations Our pulp business operating loss increased Our technical paper business operating income $104.0 million in 2004 and we incurred an operating decreased $1.8 million, as increased costs for ﬁ ber and loss of $120.5 million primarily due to the impairment manufacturing labor more than offset slightly higher-selling loss for Terrace Bay. Higher selling prices of 15% and 2% for softwood and hardwood pulp, respectively, were partially prices. Included in 2002 was $1.3 million received as a settlement for the synthetic label and specialties contract offset by unfavorable currency effects and increased manufac- that was terminated in 2001. turing costs. The higher costs resulted from a 7% decrease in Our pulp business operating income decreased the average exchange rate for the U.S. dollar relative to the $20.2 million and the business incurred an operating loss Canadian dollar as well as higher ﬁ ber and maintenance costs. of $16.5 million in 2003. Higher-selling prices of 13% and We incurred $8.3 million of corporate expenses in 2004, 18% for softwood and hardwood pulp, respectively, were including approximately $4.5 million of one-time start-up off set by increased manufacturing costs. These higher costs costs relating to our becoming an independent, public com- were a result of an average 12.0% weakening of the U.S. dollar pany and other post-Spin-Off costs to operate as a stand-alone relative to the Canadian dollar as well as higher wood and company. There were no comparable costs in 2003. energy costs and lower mill efﬁ ciencies. Foreign currency Year 2003 versus 2002 Percent Change in Operating Income Versus Prior Year Change Due to Fiber/ Net Wood Change Volume Price Mix Currency Other(a) Total Combined Fine paper Technical paper Pulp (b) (36) (18) (10) – (8) (8) (4) – 9 2 3 – (10) (4) (12) – (4) – 3 – (15) (8) (8) – (a) Includes distribution, pension, energy and other costs. (b) Percentage changes from prior period have been omitted from this table for Pulp because percentage changes are not meaningful when there is pre-tax income in one period and a pre-tax loss in the other. Overall operating income decreased $36.0 million, or 36.3%, in 2003 compared with 2002. Our ﬁ ne paper business operating income declined $14.0 million primarily due to the lower sales volumes and higher manufacturing costs. Manufacturing costs increased due to higher costs for ﬁ ber, energy and other materials and higher pension expense, as well as lower efﬁ ciencies resulting from the volume declines. These increases were partly offset by cost reduction programs that reduced certain raw material transac tional losses in 2003 were $10.5 million, versus a gain in 2002 of $0.2 million. Additional Statement of Operations Commentary: Selling, general and administrative expenses were $45.8 mil- lion, $34.6 million and $33.6 million for the years ended 2004, 2003 and 2002. The increase in 2004 is primarily due to $4.5 million of one-time, start-up costs related to our becoming an independent, public company and other post Spin-Off costs to operate as a stand-alone company. We incurred $1.4 million of interest expense on our $225 million of senior notes for the month of December (following the Spin-Off ). The effective tax rate was 36.1%, 38.5% and 37.3% for the years 2004, 2003 and 2002, respectively. The decrease in the rates between 2004 and 2003 was primarily due to lower state and local income taxes. The increase in the rates between 2002 and 2003 was primarily due to the phase out of a Nova Scotia tax credit related to capital spending that ended in 2002 (see Note 4 of Notes to the Consolidated and Combined Finan cial Statements included elsewhere in this Annual Report for a reconciliation of the annual effective tax rates). LIQ U I D I T Y A N D CA P I TA L RES O U RC ES costs and improved labor efﬁ ciencies, as well as lower spend- (in millions) ing for advertising and general expenses. In addition, 2003 Year Ended December 31, 2004 2003 2002 included the previously mentioned charges of $1.1 million for the workforce reduction and $1.3 million for the write-off of a paper machine. Net cash ﬂ ow provided by (used in): Operating activities Investment activities Financing activities Capital expenditures $ 76.0 (19.1) (37.8) 19.1 $ 73.6 (23.6) (50.0) 24.4 $ 111.8 (16.0) (95.8) 18.4 pg. 43 Operating Cash Flow Commentary $118.4 million. As a percentage of net sales, year-end working Cash provided by operations of $76.0 million for the year capital ranged between 14.0% and 15.3% during the period ended December 31, 2004 increased $2.4 million from 2003. 2002 through 2004. This increase was the result of increased earnings (after adjust- For periods subsequent to the Spin-Off, cash provided ing for the non-cash Terrace Bay impairment loss and related by operations will be adversely impacted by sales of pulp to deferred tax beneﬁ ts), partially offset by a smaller decrease in Kimberly-Clark at higher discounts than those used to price operating working capital than 2003, as discussed below. Cash transfers of pulp to Kimberly-Clark operations in the past. provided by operations decreased $38.2 million or 34.2% in 2003 See “Business Outlook” contained in this “Management’s compared with 2002 primarily due to lower net income. Discussion and Analysis of Financial Condition and Results During 2004, higher average selling prices for pulp resulted of Operations” for a discussion of how our historical results in signiﬁ cantly higher accounts receivable and increased our would have been different if the higher discounts had been investment in working capital at December 31, 2004 to in effect. Contractual Obligations The following table presents the total contractual obligations for which cash ﬂ ows are ﬁ xed or determinable as of December 31, 2004: (in millions) 2005 2006 2007 2008 2009 Unconditional purchase obligations $ 39.5 Long-term debt payments – Interest payments on long-term debt 16.6 Other postretirement beneﬁ t obligations Operating leases Open purchase orders Contributions to pension trusts Transition services payments 1.6 2.7 20.1 18.1 $ 26.0 – 16.6 $ 25.8 – 16.6 $ 25.8 – 16.6 $ 25.8 – 16.6 1.8 2.7 – – 2.0 1.7 – – 2.2 1.7 – – 2.5 1.7 – – to Kimberly-Clark Total contractual obligations 7.5 $ 106.1 – $ 47.1 – $ 46.1 – $ 46.3 – $ 46.6 Beyond 2009 $ 37.2 225.0 81.6 17.0 15.1 – – – $ 375.9 Total $ 180.1 225.0 164.6 27.1 25.6 20.1 18.1 7.5 $ 668.1 The unconditional purchase obligations are for the We entered into a corporate services agreement with purchase of raw materials, primarily wood chips, and utilities, Kimberly-Clark pursuant to which Kimberly-Clark will pro- principally electricity. Although the business is primarily liable vide a variety of administrative services for a period of time for payments on the above operating leases and unconditional following the Spin-Off. Kimberly-Clark provides to us certain purchase obligations, based on historic operating performance employee beneﬁ ts administration and payroll, management and forecasted future cash ﬂ ows, management believes the information, transportation, environment and energy, purchas- business’ exposure to losses, if any, under these arrangements ing and certain accounting functions. Each service is made is not material. available to us on an as-needed basis through December 31, The open purchase orders displayed in the table represent 2005, or such shorter or longer periods as may be provided in amounts the business anticipates will become payable within the corporate services agreement. We paid $0.6 million for the next year for goods and services the business has negotiated these services in the fourth quarter of 2004 and estimate these for delivery. fees will be $7.5 million in 2005 (included in the table above). The above table includes future payments that we will make for postretirement beneﬁ ts other than pensions. Those amounts are estimated using actuarial assumptions, including expected future service, to project the future obligations. Neenah Paper, Inc. 2004 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Investing Commentary: We will incur signiﬁ cant interest expense obligations Capital spending in all years was below annual depreciation under the senior notes and our revolving credit facility. amounts of $35.8, $35.3 million and $34.3 million in 2004, Management believes that the ability to generate 2003 and 2002, respectively. Over the three years ended cash from operations and our borrowing capacity under our December 31, 2004, approximately 40% of cumulative capital revolving credit facility are adequate to fund working capital, spending related to projects to maintain current levels of capital spending and other cash needs in the foreseeable operations by replacing or maintaining existing equipment. future. Our ability to generate adequate cash from operations An additional one-third of cumulative expenditures were for in the future, however, will depend on, among other things, programs to enhance operating performance by increasing our ability to successfully implement our business strategies productivity or reducing operating costs, with the balance for and cost-cutting initiatives, and to manage the impact of environmental and other projects. changes in pulp prices and currencies. We can give no assurance We anticipate that total capital expenditures for 2005 and that we will be able to successfully implement those strategies 2006 will be substantially higher than they have been on aver- and cost-cutting initiatives, or successfully manage our pulp age for historical periods. We have planned capital expenditure pricing and currency exposures. programs for which we anticipate incurring approximately Our ability to issue additional stock will be constrained $37 million in 2005 and approximately $42 million in 2006. because such an issuance of additional stock may cause These amounts include approximately $4 million in 2005 and the Spin-Off to be taxable to Kimberly-Clark under Section approximately $14 million in 2006 for planned capital expendi- 355(e) of the Internal Revenue Code, and under the tax tures relating to protection of the environment. Including the sharing agreement, we would be required to indemnify amounts identiﬁ ed in the preceding sentence, planned expendi- Kimberly-Clark against that tax. See “Risk Factors – Risks tures for major environmental projects during the period 2005 Related to the Spin-Off and Our Separation from Kimberly- through 2009 include approximately $20 million for an efﬂ uent Clark” for a more detailed discussion of Section 355(e). discharge pipeline and a new outfall at the Pictou mill and between approximately $15 million and $25 million for equip- ment and engineering to abate total reduced sulphur emissions and for other environmental matters at the Pictou and Terrace Bay mills, to remove and replace transformers containing poly- chlorinated biphenyls at the Terrace Bay mill, to improve stream crossings in the timberlands licensed from the Province of Ontario and for an air scrubber for the Munising mill’s coal- ﬁ red boiler. These capital expenditures are not expected to have a material adverse effect on the Company’s ﬁ nancial condition, results of operations or liquidity. Financing Commentary: Prior to the Spin-Off, our ﬁ nancing (net of cash transfers to Kimberly-Clark) was provided by Kimberly-Clark. After the Spin-Off, ﬁ nancing is expected to come from cash generated from operations and long-term borrowing. Prior to the Spin-Off, we incurred $225 million of long- term debt through the issuance of the initial senior notes. Proceeds from the note offering were used to pay a one-time Spin-Off payment of $213 million to Kimberly-Clark. C RI T I CAL ACCO UN T I N G PO LIC IES A N D U S E O F ES T IM AT ES The preparation of ﬁ nancial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the ﬁ nancial statements and the reported amounts of net sales and expenses during the reporting period. Actual results could differ from these estimates, and changes in these estimates are recorded when known. The critical accounting policies used in the preparation of the combined ﬁ nancial statements are those that are important both to the presentation of ﬁ nancial condition and results of operations and require signiﬁ cant judgments with regard to estimates used. These critical judg- ments relate to the timing of recognizing sales revenue, the recoverability of deferred income tax assets, pension beneﬁ ts and future cash ﬂ ows associated with impairment testing of long-lived assets. pg. 45 Revenue Recognition period income tax receivables or payables related to our We recognize sales revenue when all of the following have operations, which were ﬁ led on a consolidated basis with occurred: (1) delivery has occurred, (2) persuasive evidence Kimberly-Clark. For all periods, the income tax provisions of an agreement exists, (3) pricing is ﬁ xed or determinable, have been determined as if we were a separate taxpayer. and (4) collection is reasonably assured. Delivery is not con- sidered to have occurred until the customer takes title and assumes the risks and rewards of ownership. The timing of revenue recognition is largely dependent on shipping terms. Revenue is recorded at the time of shipment for terms des- ignated free on board (“FOB”) shipping point. For sales transactions designated FOB destination, revenue is recorded when the product is delivered to the customer’s delivery site. With the exception of pulp sales to Kimberly-Clark and cer- tain other customers, our sales terms are FOB shipping point and revenue is recognized at the time of shipment. For pulp sales to Kimberly-Clark and other customers that are desig- nated FOB destination, revenue is recognized when the product is delivered to the customer’s delivery site. Sales are reported net of allowable discounts and estimated returns. Reserves for cash discounts, trade allowances, credit losses and sales returns are estimated using historical experience. Deferred Income Tax Assets Pension Benefits Prior to the Spin-Off, the employees of our business partici- pated in Kimberly-Clark’s deﬁ ned beneﬁ t pension plans and deﬁ ned contribution retirement plans, which cover substan- tially all regular employees. In connection with the Spin-Off, Kimberly-Clark retained the obligations for former employees of the U.S. paper operations. In connection with the Spin-Off, and as set forth in the employee matters agreement, obligations related to former and active employees of the Canadian pulp operations and active employees of the U.S. paper operations became our responsi- bility. A share of pension assets related to active employees of the U.S. paper operations were transferred from Kimberly- Clark’s pension plan to a new pension plan established by us. This new plan provides substantially similar beneﬁ ts and cred- its our employees for service earned with Kimberly-Clark. With respect to Canadian employees, we assumed the existing pension assets and obligations of the related Kimberly-Clark As of December 31, 2004, we have recorded deferred income pension plans. tax assets totaling $30.5 million related to temporary differ- Kimberly-Clark’s funding policy for the qualiﬁ ed, deﬁ ned ences, and we have established no valuation allowances against beneﬁ t plans that became our responsibility was to contribute these deferred income tax assets. As of December 31, 2003, assets to fully fund the accumulated beneﬁ t obligation. Subject our net deferred income tax assets were $22.8 million. In to regulatory and tax deductibility limits, any funding short- determining the need for valuation allowances, we consider fall was to be eliminated over a reasonable number of years. many factors, including the speciﬁ c taxing jurisdiction, income Nonqualiﬁ ed plans providing pension beneﬁ ts in excess of tax strategies and forecasted earnings for the entities in each limitations imposed by the taxing authorities were not funded. jurisdiction. A valuation allowance would be recognized if, Consolidated and combined pension expense for deﬁ ned based on the weight of available evidence, we conclude that beneﬁ t pension plans was $10.7 million, $13.4 million and it is more likely than not that some portion or all of the $4.2 million for the years ended December 31, 2004, 2003 and deferred income tax asset will not be realized. 2002, respectively. Pension expense is calculated based upon a Our operations have been included in the consolidated number of actuarial assumptions applied to each of the deﬁ ned income tax returns of Kimberly-Clark. Kimberly-Clark will beneﬁ t plans. The weighted-average, expected long-term rate indemnify us for all income tax liabilities and retain rights to of return on pension fund assets used to calculate pension all tax refunds for periods through the date of the Spin-Off. expense in percents was 8.50, 8.50 and 9.31 for the years Accordingly, the consolidated and combined balance sheet for ended December 31, 2004, 2003 and 2002, respectively. The periods prior to the Spin-Off does not include current or prior expected long-term rate of return on pension fund assets held by the Company (and prior to the Spin-Off, Kimberly-Clark), Neenah Paper, Inc. 2004 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations pension trusts was determined based on several factors, The discount (or settlement) rate that is utilized for including input from pension investment consultants and determining the present value of future pension obligations projected long-term returns of broad equity and bond indices. generally has been based in the U.S. on the yield reported for Also considered were the plans’ historical 10-year and 15-year the long-term, AA-rated corporate bond indexes, converted compounded annual returns. Kimberly-Clark anticipated that to an equivalent one-year compound basis. This practice on average the investment managers for each of the plans will was validated at December 31, 2002. The weighted average generate annual long-term rates of return of at least 8.50%. discount in percent was 5.75 and 6.20 for the years ended Kimberly-Clark’s expected long-term rate of return on the December 31, 2004 and 2003, respectively. assets in the plans was based on an asset allocation assumption Our consolidated and combined pension expense of about 70% with equity managers, with expected long-term was $10.7 million for 2004. This is based on an expected rates of return of approximately 10%, and 30% with ﬁ xed weighted-average, long-term rate of return on assets in our income managers, with an expected long-term rate of return plans of 8.50%, a weighted-average discount rate for our of about 6%. The actual asset allocation was regularly reviewed plans of 6.21% and various other assumptions. Pension and periodically rebalanced to the targeted allocation when expense beyond 2004 will depend on future investment per- considered appropriate. Also, when deemed appropriate, hedg- formance, our contributions to the pension trusts, changes in ing strategies were executed using index options and futures to discount rates and various other factors related to the covered limit the downside exposure of certain investments by trading employees in the plans. off upside potential above an acceptable level. Such hedging The fair value of the assets in our deﬁ ned beneﬁ t plans strategies were executed in 2004, 2003 and 2002. Following increased to approximately $329 million at December 31, 2004 the Spin-Off, we are following a similar methodology for from about $275 million at December 31, 2003, primarily determining our long-term rate of return on pension assets due to investment gains, currency exchange effects and plan and investment strategy and also plan to continue to evaluate contributions exceeding payments for pension beneﬁ ts and our long-term rate of return assumptions. plan expenses. Lower discount rates have caused the projected Pension expense was determined based on the fair value beneﬁ ts obligations of the deﬁ ned beneﬁ t plans to exceed of assets rather than a calculated value that averages gains and the fair value of plan assets by approximately $58 million at losses (“Calculated Value”) over a period of years. Investment December 31, 2004, compared with approximately $53 million gains or losses represent the difference between the expected at December 31, 2003. The fair value of plan assets exceeded return calculated using the fair value of the assets and the the accumulated beneﬁ t obligation by about $6.5 million at actual return based on the fair value of assets. The variance the end of 2004. At the end of 2003, the fair value of the between the actual and the expected gains and losses on pen- planned assets exceeded the accumulated beneﬁ t obligation sion assets is recognized in pension expense more rapidly than by about $0.2 million. The Company and Kimberly-Clark it would be if a Calculated Value for plan assets was used. As contributed about $16.6 million to pension trusts related to of December 31, 2004, our plans had cumulative unrecognized plans for which we assumed responsibility in 2004 compared investment losses and other actuarial losses of approximately with $16.2 million in 2003. In addition, we made direct ben- $128.3 million. These unrecognized net losses may increase eﬁ t payments of approximately $0.1 million in each of 2004, our future pension expense if not offset by (i) actual invest- 2003 and 2002 for unfunded supplemental retirement beneﬁ ts. ment returns that exceed the assumed investment returns, (ii) The discount rate used for our pension obligation is iden- other factors, including reduced pension liabilities arising from tical to the discount rate used for our other postretirement higher discount rates used to calculate our pension obligations obligation. The discount rates displayed for the two types of or (iii) other actuarial gains, including whether such accumu- obligations may appear different due to the weighting used in lated actuarial losses at each measurement date exceed the “corridor” determined under SFAS 87, Employers’ Accounting for Pensions. the calculation of the two weighted-average discount rates. Impairment Property, plant and equipment are tested for impairment in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, whenever events or changes in circumstances indicate that the carrying amounts of such long- lived assets may not be recoverable from future net pre-tax cash ﬂ ows. Impairment testing requires signiﬁ cant manage- ment judgment including estimating the future success of product lines, future sales volumes, growth rates for selling prices and costs, alternative uses for the assets and estimated proceeds from disposal of the assets. Impairment testing is conducted at the lowest level where cash ﬂ ows can be mea- sured and are independent of cash ﬂ ows of other assets. An asset impairment would be indicated if the sum of the expected future net pre-tax cash ﬂ ows from the use of the asset (undiscounted and without interest charges) is less than the carrying amount of the asset. An impairment loss would be measured based on the difference between the fair value of the asset and its carrying amount. We determine fair value based on an expected present value technique in which multiple cash ﬂ ow scenarios that reﬂ ect a range of possible outcomes and a risk-free rate of interest are used to estimate fair value. The estimates and assumptions used in the impairment analysis are consistent with the business plans and estimates we use to manage our business operations. The use of different assumptions would increase or decrease the estimated fair value of the asset and would increase or decrease the impair- ment charge. Actual outcomes may differ from the estimates. See “Results of Operations and Related Information – Analysis of Pre-tax Income (Loss) – Asset Impairment Loss” for a summary of our asset impairment test on the Terrace Bay pulp facility, which resulted in a net after-tax impairment loss of approximately $72.0 million in December 2004. pg. 47 B U S I N ES S O U T LO OK Recent Developments On March 1, 2005, we announced the planned closure of the smaller of our two single-line pulp mills at the Terrace Bay facility (the “No. 1 Mill”). The No. 1 Mill was originally con- structed in 1948 and has annual capacity of approximately 125,000 tons of bleached kraft pulp. In conjunction with the closing, we will offer early retirement and severance packages to approximately 130 employees. The closing was authorized by our Chief Executive Ofﬁ cer on February 28, 2005, pursuant to a resolution of the Board of Directors, and is expected to occur in early May 2005. We expect to incur approximately $6.0 million of exit costs in connection with the closure, including one-time ter- mination beneﬁ ts related to early retirement, severance and deﬁ ned-beneﬁ t pension plans of approximately $5.5 million and other associated exit costs of $0.5 million. In addition, we expect to incur approximately $1.0 million of general expenses related to training of employees. Approximately $6.3 million of the estimated costs of $7.0 million will result in future cash expenditures during 2005 and 2006. In addition, in March 2005, we will record a pre-tax, non- cash impairment loss of approximately $0.9 million related to the remaining value of the long-lived assets of the No. 1 Mill at Terrace Bay (See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations and Related Information – Asset Impairment Loss”). As a result of closing the No. 1 Mill, we notiﬁ ed Kimberly-Clark of our intention to terminate a part of our commitment to supply and their requirement to purchase northern bleached hardwood kraft pulp pursuant to the terms of our pulp supply agreement. Under the pulp supply agree- ment, we were obligated to provide 40,000, 30,000, 20,000 and 10,000 tons of northern bleached hardwood kraft pulp produced at the Terrace Bay mill annually in 2005, 2006, 2007 and 2008, respectively. Our commitment to supply and Kimberly-Clark’s requirement to purchase northern bleached hardwood kraft pulp pursuant to the terms of the pulp supply agreement from the Pictou mill (in annual quantities which are identical to those shown above) is unchanged. Neenah Paper, Inc. 2004 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations We believe that the remaining productive capacity at our Terrace Bay and Pictou mills and the availability of Sales of Pulp to Kimberly-Clark after the Spin-Off. Pulp sales to Kimberly-Clark following the Spin-Off are market pulp are sufﬁ cient to supply our internal and external made pursuant to a new pulp supply agreement. The prices pulp requirements. Pulp Operations Transfers of Pulp within Kimberly-Clark prior to the Spin- Off. Historically, our pulp operations have been operated as a captive pulp producer for Kimberly-Clark’s tissue and other businesses. Prior to the Spin-Off, intra-company transfers of pulp by our business to Kimberly-Clark were made pursuant to an advance transfer pricing agreement negotiated among Kimberly-Clark and certain taxing authorities. Under the advance transfer pricing agreement, pulp was transferred to Kimberly-Clark at a transfer price equal to a published industry index price less a discount agreed to among Kimberly-Clark and the taxing authorities. Kimberly-Clark believes that those negotiated and agreed discounts reﬂ ected the then current market conditions for pulp without the exis- tence of a long-term, take or pay supply agreement. at which we will sell pulp to Kimberly-Clark under the new pulp supply agreement are based on published industry index prices (subject to minimum and maximum prices for northern bleached softwood kraft pulp shipped to North America prior to December 31, 2007) less agreed discounts. Those discounts will be substantially higher than the discounts contained in the advance transfer pricing agreement. We believe that the discounts and the other terms reﬂ ected in the new pulp supply agreement are comparable to those which Kimberly-Clark currently could obtain from an unafﬁ liated third party, consid- ering the magnitude of Kimberly-Clark’s purchases, the term of the pulp supply agreement and the other terms reﬂ ected in the agreement. If the new pulp supply agreement had been in place for the years ended December 31, 2004, 2003 and 2002, we estimate that our historical combined net sales and gross proﬁ t would have declined approximately as shown below: (in millions) Year 2004 2003(a) 2002(a) Net Sales New Pulp Agreement Historical Decrease Historical Gross Profit New Pulp Agreement $ 772.1 710.3 702.0 $ 746.5 685.8 684.5 $ 25.6 24.5 17.5 $ 124.2 107.9 131.6 $ 98.6 83.4 114.1 Decrease $ 25.6 24.5 17.5 (a) The above amounts of Net sales for the years ended December 31, 2003 and 2002 have been increased from the amounts previously reported by $44.5 million and $44.0 million, respectively, to be in conformity with EITF 00-10, which prohibits the netting of shipping and handling costs against revenues. pg. 49 If the new pulp supply agreement had been in place for the that the historical net sales and gross proﬁ t (loss) of our pulp years ended December 31, 2004, 2003 and 2002, we estimate business would have decreased approximately as shown below: (in millions) Year 2004 2003(b) 2002(b) Net Sales New Pulp Agreement Historical Gross Profit (Loss) Decrease Historical New Pulp Agreement Decrease $ 448.6 405.1 380.0 $ 423.0 380.6 362.5 $ 25.6 24.5 17.5 $ 7.0 3.4 10.8 $ (18.6) (21.1) (6.7) $ 25.6 24.5 17.5 (b) The above amounts of Net sales for the years ended December 31, 2003 and 2002 have been increased from the amounts previously reported by $38.6 million and $38.0 million, respectively, to be in conformity with EITF 00-10. Other Items that beginning in 2005, we will incur ongoing, full-year As noted elsewhere in this Annual Report, our historical incremental selling, general and administrative expenses of ﬁ nancial results will not be indicative of our future perfor- approximately $14 million related primarily to reduced econo- mance, nor do they reﬂ ect what our ﬁ nancial position and mies of scale as a result of operating on a stand-alone basis. results of operations would have been had we operated as In addition, we expect to pay Kimberly-Clark approximately a separate, independent company during the periods pre- $7.5 million pursuant to transition services agreements in 2005. sented. Among other things, our management anticipates Neenah Paper, Inc. 2004 Annual Report Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of Neenah Paper, Inc.: We have audited the accompanying consolidated balance sheet of Neenah Paper, Inc. and subsidiaries (the “Company”) as of December 31, 2004 and the combined balance sheet of the Pulp and Paper Business of Kimberly-Clark Corporation (“Pulp and Paper Business”), consisting of the Fine Paper and Technical Paper divisions and the Canadian pulp operations, as of December 31, 2003, and the related consolidated and combined statements of operations, cash ﬂ ows and changes in stockholders’ equity and in invested equity for each of the three years in the period ended December 31, 2004. These consolidated and combined ﬁ nancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁ nancial state- ments based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁ nancial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over ﬁ nancial reporting. An audit includes consideration of internal control over ﬁ nancial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over ﬁ nancial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁ nancial statements, assessing the accounting principles used and signiﬁ cant estimates made by management, as well as evaluating the overall ﬁ nancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. The accompanying combined ﬁ nancial statements were prepared to present the assets and liabilities and related results of operations and cash ﬂ ows of the Pulp and Paper Business, which was spun off to Kimberly-Clark Corporation’s stockholders as described in Note 1 to the consolidated and combined ﬁ nancial statements, and may not necessarily be indicative of the conditions that would have existed or the results of operations and cash ﬂ ows if the Pulp and Paper Business had operated as a stand-alone company during the periods presented. In our opinion, such consolidated and combined ﬁ nancial statements present fairly, in all material respects, the ﬁ nancial posi- tion of the Company at December 31, 2004 and the Pulp and Paper Business at December 31, 2003, and the results of its operations and its cash ﬂ ows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles gen- erally accepted in the United States of America. DELOITTE & TOUCHE LLP Atlanta, Georgia March 30, 2005 Consolidated and Combined Statements of Operations pg. 51 (in millions, except share and per share data) Year Ended December 31, 2004 2003 2002 Net Sales Cost of products sold Gross Proﬁ t Selling, general and administrative expenses Asset impairment loss (Note 12) Other (income) and expense – net Operating Income (Loss) Interest expense Income (Loss) Before Income Taxes Provision (beneﬁ t) for income taxes Net Income (Loss) Earnings (Loss) Per Common Share Basic Diluted Weighted Average Common Shares Outstanding (in thousands) Basic Diluted See Notes to Consolidated and Combined Financial Statements $ 772.1 $ 710.3 $ 702.0 647.9 124.2 45.8 112.8 5.5 (39.9) 1.4 (41.3) (14.9) $ (26.4) $ 602.4 107.9 34.6 – 10.0 63.3 – 63.3 24.4 38.9 $ $ (1.79) (1.79) $ $ 2.64 2.64 570.4 131.6 33.6 – (1.3) 99.3 – 99.3 37.0 62.3 4.23 4.23 $ $ $ 14,738 14,738 14,738 14,738 14,738 14,738 Neenah Paper, Inc. 2004 Annual Report Consolidated and Combined Balance Sheets (in millions, except share data) A S S E T S Current Assets Cash and cash equivalents Accounts receivable, net Inventories Deferred income taxes Prepaid and other current assets Total Current Assets Property, Plant and Equipment – net Timberlands Deferred Income Taxes Prepaid and Intangible Pension Costs Other Assets Total Assets LI A B I LI T I ES A N D S TO C K H O L D ER S ’ A N D I N V ES T ED E Q U I T Y Current Liabilities Trade accounts payable Other payables Accrued expenses Total Current Liabilities Long-term Debt Noncurrent Employee Beneﬁ ts and Other Obligations Deferred Income Taxes Total Liabilities Commitments and Contingencies (Notes 9 and 10) Stockholders’ and Invested Equity Common stock, par value $0.01 – authorized: 100,000,000 shares; issued and outstanding: 14,763,319 shares Additional paid-in capital Kimberly-Clark’s net investment Retained deﬁ cit Accumulated other comprehensive income (loss) Unearned compensation on restricted stock Total Stockholders’ and Invested Equity December 31, 2004 2003 $ 19.1 92.4 88.7 3.2 2.2 205.6 257.6 5.2 27.3 72.9 18.0 $ – 77.1 85.7 3.7 4.9 171.4 368.1 5.2 19.1 24.2 4.0 $ 586.6 $ 592.0 $ 43.8 $ 32.7 6.8 36.6 87.2 225.0 48.0 8.4 368.6 0.1 239.2 – (70.7) 51.6 (2.2) 218.0 6.6 30.4 69.7 – 54.1 34.5 158.3 – – 436.8 – (3.1) – 433.7 Total Liabilities and Stockholders’ and Invested Equity $ 586.6 $ 592.0 See Notes to Consolidated and Combined Financial Statements Consolidated and Combined Statements of Changes in Stockholders’ and Invested Equity pg. 53 (in millions, shares in thousands) Shares Amount Common Stock Additional Paid-In Capital Kimberly- Clark’s Net Investment Retained Deficit Accumulated Other Unearned Compensation Comprehensive On Restricted Income (Loss) Stock $ 479.5 $ Balance, December 31, 2001 Net income Other comprehensive income Unrealized foreign currency translation Minimum pension liability Other Net cash transfers to Kimberly-Clark Non-cash transfers from Kimberly-Clark Balance, December 31, 2002 Net income Other comprehensive income Unrealized foreign currency translation Minimum pension liability. Other Net cash transfers to Kimberly-Clark Non-cash transfers from Kimberly-Clark Balance, December 31, 2003 Net income (loss) Other comprehensive income Unrealized foreign currency translation Minimum pension liability Other Net cash transfers to Kimberly-Clark Adjustment to deferred taxes at Spin-Off Other non-cash transfers to Kimberly-Clark Spin-Off payment to Kimberly-Clark Transfer to additional paid-in capital – – – – – – – – – – – – – – – – – – – – – – – – $ – – – – – – – – – – – – – – – – – – – – – – – – Issuance of common stock 14,738 0.1 $ – – – – – – – – – – – – – – – – – – – – – – – 236.9 – Restricted stock awards, less amortization 25 – 2.3 Balance, December 31, 2004 14,763 $ 0.1 $ 239.2 $ See Notes to Consolidated and Combined Financial Statements 62.3 – – – (95.8) 0.5 446.5 38.9 – – – (50.0) 1.4 436.8 44.3 – – – (37.6) 8.2 (1.8) (213.0) (236.9) – – – – – – – – – – – – – – – – – – (70.7) – – – – – – – – – – $ (29.4) $ – 2.5 (26.5) 0.6 – – (52.8) – 59.7 (9.4) (0.6) – – (3.1) – 24.8 30.0 (0.1) – – – – – – – $ (70.7) $ 51.6 $ – – – – – – – – – – – – – – – – – – – – – – – – – (2.2) (2.2) Comprehensive Income $ 62.3 2.5 (26.5) 0.6 $ 38.9 $ 38.9 59.7 (9.4) (0.6) $ 88.6 $ (26.4) 24.8 30.0 (0.1) $ 28.3 Neenah Paper, Inc. 2004 Annual Report Consolidated and Combined Statements of Cash Flows (in millions) Year Ended December 31, 2004 2003 2002 Operating Activities Net income (loss) Adjustments to reconcile net income to net cash provided by operating activities $ (26.4) $ 38.9 $ 62.3 Depreciation and amortization Asset impairment loss Deferred income tax beneﬁ t Loss on asset dispositions Net cash provided by (used in) changes in operating working capital Accounts receivable Inventories Prepaid and other current assets Trade accounts payable Other payables Accrued expenses Foreign currency effects on working capital Pension and other postretirement beneﬁ ts Other Net Cash Provided by Operating Activities Investing Activities Capital expenditures Proceeds from dispositions of property Other Net Cash Used in Investing Activities Financing Activities Proceeds from issuance of long-term debt Debt issuance costs Short-term borrowings Repayments of short-term borrowings Spin-Off payment to Kimberly-Clark Net transfers to Kimberly-Clark Net Cash Used in Financing Activities Net Increase in Cash and Cash Equivalents Cash and Cash Equivalents, Beginning of Year Cash and Cash Equivalents, End of Year Supplemental Disclosure of Cash Flow Information: Cash paid during year for interest Cash paid during year for income taxes Non-cash transfers from Kimberly-Clark See Notes to Consolidated and Combined Financial Statements 36.0 112.8 (43.6) 3.1 (14.1) (9.4) 2.4 11.1 0.2 5.6 5.7 (7.4) – 76.0 (19.1) 0.1 (0.1) (19.1) 225.0 (12.2) 10.0 (10.0) (213.0) (37.6) (37.8) 19.1 – $ 19.1 $ $ $ $ – – 6.4 $ $ $ 35.3 – (8.2) 0.1 (3.6) (5.8) 0.5 6.1 (4.0) 3.6 13.5 (1.3) (1.5) 73.6 (24.4) 1.9 (1.1) (23.6) – – – – – 34.3 – (1.7) 3.1 2.3 21.4 (0.6) (0.8) (5.4) (2.3) 0.7 (1.3) (0.2) 111.8 (18.4) 1.7 0.7 (16.0) – – – – – (50.0) (50.0) (95.8) (95.8) – – – – – 1.4 – – – – – 0.5 $ $ $ $ pg. 55 Notes to Consolidated Financial Statements (dollars in millions, except as noted) N O T E 1. BACKGROUND AND BASIS OF PRES EN TAT I ON Background Neenah Paper, Inc. (“Neenah” or the “Company”), a Delaware corporation, was incorporated in April 2004 in contemplation of the spin-off by Kimberly-Clark Corporation (“Kimberly- Clark”) of its Canadian pulp business and its ﬁ ne paper and technical paper businesses in the United States (collectively, the “Pulp and Paper Business”). The Canadian pulp business consists of the Terrace Bay, Ontario, pulp mill and the Pictou, Paper Business which were operated as part of Kimberly-Clark prior to the Spin-Off. The combined ﬁ nancial statements for periods through November 30, 2004 have been derived from the consolidated ﬁ nancial statements and accounting records of Kimberly-Clark using the historical results of operations and the historical basis of assets and liabilities of the Pulp and Paper Business. Management believes the assumptions underlying the combined ﬁ nancial statements for these periods are reasonable. However, the combined ﬁ nancial statements included herein for periods through November 30, 2004 do not reﬂ ect the Pulp and Paper Business’ results of operations, Nova Scotia, pulp mill and related timberlands. The ﬁ ne paper ﬁ nancial position and cash ﬂ ows in the future or what its business is a leading producer of premium writing, text, cover and specialty papers. The technical paper business is a leading producer of durable, saturated and coated base papers for a results of operations, ﬁ nancial position and cash ﬂ ows would have been had the Pulp and Paper Business been a stand-alone company during the periods presented. See Note 11 for transac- variety of end uses. tions with Kimberly-Clark. On November 30, 2004, Kimberly-Clark completed the distribution of all of the shares of Neenah’s common stock to the stockholders of Kimberly-Clark (the “Spin-Off ”). Kimberly-Clark’s investment in the Pulp and Paper Business is shown as “Kimberly-Clark’s net investment” in the combined ﬁ nancial statements through November 30, Kimberly-Clark stockholders received a dividend of one share 2004, because no direct ownership relationship existed among of Neenah’s common stock for every 33 shares of Kimberly- Clark common stock held. Based on a private letter ruling received by Kimberly-Clark from the Internal Revenue Service, receipt of the Neenah shares in the Spin-Off was tax-free for U.S. federal income tax purposes. As a result of the Spin-Off, Kimberly-Clark transferred all of the assets and liabilities of the Pulp and Paper Business to Neenah. In addition, Kimberly-Clark transferred certain assets and liabilities of Kimberly-Clark sponsored employee beneﬁ t plans to the the entities that comprised the Pulp and Paper Business. Inter-company accounts between the Pulp and Paper Business and Kimberly-Clark are combined with “Kimberly-Clark’s net investment.” As of November 30, 2004, the balance reﬂ ected in the “Kimberly-Clark’s net investment” was transferred to “Additional paid-in capital” of Neenah. “Retained deﬁ cit” reﬂ ected in the consolidated ﬁ nancial statements represents net losses beginning December 1, 2004. Basic earnings (loss) per share were computed by dividing Company. Following the Spin-Off, Neenah is an independent net loss by the number of weighted average shares of common public company and Kimberly-Clark has no continuing stock ownership. Basis of Consolidation and Presentation The consolidated and combined ﬁ nancial statements include the ﬁ nancial statements of the Company, and its wholly owned and majority owned subsidiaries. All signiﬁ cant inter-company balances and transactions have been eliminated in consolidation. The consolidated and combined ﬁ nancial statements reﬂ ect the consolidated operations of Neenah and its subsidiar- ies as a separate, stand-alone entity subsequent to November 30, 2004, combined with the historical operations of the Pulp and stock outstanding during the 2004 reporting period. Diluted earnings (loss) per share were calculated to give effect to all potentially dilutive common shares. In 2004, approximately 875,000 potentially dilutive options that were “out-of-the- money” were excluded from the computation of dilutive common shares. In addition, as a result of the net loss in 2004, the assumed incremental 60,683 shares resulting from the exercises of “in-the-money” stock options and the vesting of restricted stock and restricted stock units were excluded from the diluted earnings per share calculation, as the effect would have been anti-dilutive. Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements For 2003 and 2002, basic and diluted earnings per Income Taxes share were computed using the number of shares of Neenah For periods prior to November 30, 2004, income tax provisions common stock outstanding on November 30, 2004, the and related deferred tax assets and liabilities of the Pulp and date on which Neenah common stock was distributed to Paper Business were calculated on a separate tax return basis. the stockholders of Kimberly-Clark. However, Kimberly-Clark managed its tax position for the ben- Prior to the Spin-Off, certain corporate, general and eﬁ t of its entire portfolio of businesses, and its tax strategies are administrative expenses of Kimberly-Clark were allocated not necessarily reﬂ ective of the tax strategies that the Pulp and to the Pulp and Paper Business, using a three factor formula Paper Business would have followed as a stand-alone entity. comprised of net sales, total assets and employee head count. In the opinion of management, such an allocation is reason- able. However, such expenses are not indicative of, nor is it practical or meaningful for management to estimate for all historical periods presented, the actual level of expenses that might have been incurred had the Pulp and Paper Business been operating as an independent company. General corporate overhead primarily includes information technology, account- ing, cash management, legal, tax, insurance and public relations. These expenses amounted to $0.5 million, $0.7 million and $0.8 million in 2004, 2003 and 2002, respectively. Subsequent to November 30, 2004, the Company performed these functions using its own resources or purchased services, some of which were provided by Kimberly-Clark pursuant to a Corporate Services Agreement (See Note 11). Kimberly-Clark used a centralized approach to cash man- agement and the ﬁ nancing of its operations. Cash deposits from the Pulp and Paper Business prior to the Spin-Off were transferred to Kimberly-Clark on a regular basis and were netted against Kimberly-Clark’s net investment account. N O T E 2. S U M M A RY O F S I G N I F I CA N T ACCO UN T I NG POLICIES Use of Estimates The preparation of ﬁ nancial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the ﬁ nancial statements and the reported amounts of net sales and expenses during the reporting periods. Actual results could differ from these estimates, and changes in these estimates are recorded when known. Signiﬁ cant manage- ment judgment is required in determining the accounting for, among other things, pension and postretirement beneﬁ ts, retained insurable risks, allowances for doubtful accounts, useful lives for depreciation and amortization, future cash ﬂ ows associated with impairment testing for long-lived assets, income taxes and contingencies. Consequently, none of Kimberly-Clark’s cash, cash equivalents Revenue Recognition or debt was allocated to the Pulp and Paper Business in The Company recognizes sales revenue when all of the follow- the combined ﬁ nancial statements for periods through ing have occurred: (1) delivery has occurred, (2) persuasive November 30, 2004. evidence of an agreement exists, (3) pricing is ﬁ xed or deter- Changes in Kimberly-Clark’s net investment represent minable, and (4) collection is reasonably assured. Delivery is any funding from Kimberly-Clark for working capital and not considered to have occurred until the customer takes title capital expenditures after giving effect to the Pulp and and assumes the risks and rewards of ownership. The timing of Paper Business’ transfers to Kimberly-Clark of its cash revenue recognition is largely dependent on shipping terms. ﬂ ows from operations. Cash Payment to Kimberly-Clark On November 30, 2004, the Company paid a Spin-Off pay- ment of $213 million to a Kimberly-Clark subsidiary primarily from the proceeds of a $225 million principal amount senior note offering (See Note 5). Revenue is recorded at the time of shipment for terms designated free on board (“FOB”) shipping point. For sales transactions designated FOB destination, revenue is recorded when the product is delivered to the customer’s delivery site. With the exception of pulp sales to Kimberly-Clark and certain other customers, the Company’s sales terms are FOB shipping pg. 57 point and revenue is recognized at the time of shipment. For labor, materials and production overhead. Inventories of the pulp sales to Kimberly-Clark and other customers that are Canadian pulp operations include both roundwood (logs) and designated FOB destination, revenue is recognized when the wood chips. These inventories are located both at the pulp product is delivered to the customer’s delivery site. Sales are mills and at various timberlands locations. In accordance with reported net of allowable discounts and estimated returns. industry practice, physical inventory counts utilize “scaling” Reserves for cash discounts, trade allowances, credit losses techniques to estimate quantities of roundwood, as well as and sales returns are estimated using historical experience. various electronic devices to calculate wood chip inventory Pursuant to the new pulp supply agreement, sales terms to amounts. These techniques historically have provided reason- Kimberly-Clark subsequent to the Spin-Off were changed to able estimates of such inventories. FOB destination rather than FOB shipping point. As a result, net sales in December 2004 were reduced by $12.9 million, reﬂ ecting the one-time effect of this change in terms. Shipping and Handling Costs Foreign Currency Balance sheet accounts of the Canadian pulp operations are translated from Canadian dollars into U.S. dollars at period- end exchange rates, and income and expense are translated at All amounts billed to customers in a sales transaction related average exchange rates during the period. Translation gains or to shipping and handling are recorded as revenue, and costs losses related to net assets located in Canada are shown as a incurred by the Company for shipping and handling are component of accumulated other comprehensive income (loss) recorded as costs of products sold. in stockholders’ and invested equity. Gains and losses resulting Certain prior years’ amounts of shipping and handling from foreign currency transactions (transactions denominated costs have been adjusted in the combined statements of opera- tions to be in conformity with EITF 00-10, Accounting for Shipping and Handling Fees and Costs, which became effec- tive in 2000 and which prohibits the netting of such costs in a currency other than the entity’s functional currency) are included in other (income) and expense – net in the combined statements of operations. Net foreign currency transaction gains (losses) for 2004, 2003 and 2002 were $(5.1) million, against revenues. Accordingly, amounts reﬂ ected for 2003 $(10.0) million and $0.6 million, respectively. and 2002 for “Net sales” and “Cost of products sold” in the combined statements of operations have been increased from the amounts previously reported by $44.5 million and $44.0 million, respectively. This adjustment had no effect on the amount of “Gross proﬁ t” or any other captioned amounts in the combined statements of operations. Cash and Cash Equivalents Property and Depreciation Property, plant and equipment is stated at cost, less accumu- lated depreciation. Certain costs of software developed or obtained for internal use are capitalized. When property, plant and equipment is sold or retired, the costs and the related accumulated depreciation are removed from the accounts, and the gains or losses are recorded in other (income) and Cash and cash equivalents include all cash balances and highly expense – net. For ﬁ nancial reporting purposes, depreciation liquid investments with an initial maturity of three months or is principally computed on the straight-line method over the less. The Company places its temporary cash investments with estimated useful asset lives. Weighted-average useful lives high-credit, quality ﬁ nancial institutions. are approximately 40 years for buildings, 10 years for land Inventories U.S. inventories are valued at the lower of cost, using the Last-In, First-Out (LIFO) method for ﬁ nancial reporting purposes, or market. Canadian inventories are valued at the lower of cost, using either the First-In, First-Out (FIFO) or a weighted-average cost method, or market. Cost includes improvements and 18 years for machinery and equipment. The cost of permanent and secondary logging roads is capitalized and amortized over the estimated useful lives of the roads, primarily 20 years. The cost of tertiary roads (which are not permanent) is expensed as incurred. For income tax purposes, accelerated methods of depreciation are used. Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements Estimated useful lives are periodically reviewed and, when merchantable timber. Costs of merchantable timber are warranted, changes are made to them. Long-lived assets are currently depletable, whereas costs of pre-merchantable tim- reviewed for impairment whenever events or changes in cir- ber are not yet depletable. Timberland depletion rates for cumstances indicate that their cost may not be recoverable. owned timberlands are calculated periodically, based on capi- An impairment loss would be recognized when estimated talized costs and the total estimated volume of timber that undiscounted future pre-tax cash ﬂ ows from the use of the is mature enough to be harvested and processed. Timber asset are less than its carrying amount. Measurement of an inventory volume is determined by adding an estimate of cur- impairment loss would be based on the excess of the carrying rent-year growth to the prior-year ending balance, less the amount of the asset over its fair value. Fair value is generally current-year harvest. The volume and growth estimates are measured using discounted cash ﬂ ows. See Note 12 for discus- tested periodically using statistical sampling techniques. The sion of asset impairment losses recorded in December 2004 depletion rate calculated at the end of the year is used to cal- related to Terrace Bay’s long-lived assets. culate the cost of timber harvested in the subsequent year. The costs of major rebuilds and replacements of plant and equipment are capitalized, and the cost of maintenance performed on manufacturing facilities, composed of labor, materials and other incremental costs, is charged to operations as incurred. Start-up costs for new or expanded facilities are expensed as incurred. Timberlands Timberlands are stated at cost, less the accumulated cost of timber previously harvested. The Company’s owned timber- lands have long-rotation and growing cycles averaging over 40 years. Capitalized costs for these timberlands include site preparation, initial planting and seeding. The costs of fertili- zation, control of competition (brush control) and seedling protection activities (principally herbicide and insecticide applications) during the stand establishment period also are Research Expense Research and development costs are charged to expense as incurred and are recorded in “Selling, general and administra- tive expenses” on the Consolidated and Combined Statement of Operations. Fair Value of Financial Instruments The carrying amounts reﬂ ected in the Consolidated and Combined Balance Sheets for cash and cash equivalents, accounts receivable and accounts payable approximate fair value due to their short maturities. The fair value of long-term debt is estimated using discounted cash ﬂ ow analyses, based on the Company’s incremental borrowing rates for similar types of arrangements. The fair value of the Company’s long- term debt at December 31, 2004 was $228.4 million compared to the carrying value of $225.0 million. capitalized. The Company charges capitalized costs, excluding Other Comprehensive Income land, to operations at the time the wood is harvested, based Comprehensive income includes, in addition to net income, on periodically determined depletion rates. unrealized gains and losses recorded directly into a separate Fertilization, control of competition and seedling protec- section of stockholders’ equity on the consolidated and com- tion activities following the stand establishment period are bined balance sheet. These unrealized gains and losses are expensed as incurred. The Company pays stumpage fees for referred to as other comprehensive income items. The accu- wood harvested under long-term licenses and charges such mulated other comprehensive income (loss) shown on the costs to operations as incurred. Costs of administration, insur- consolidated and combined balance sheets consists primarily ance, property taxes, and interest are expensed as incurred. of foreign currency translation and minimum pension liability The Company distinguishes between costs associated adjustments. The foreign currency translation adjustments are with pre-merchantable timber and costs associated with not adjusted for income taxes since they relate to indeﬁ nite investments in the Canadian pulp operations. The changes in the components of other comprehensive income (loss) are as follows: pg. 59 Year Ended December 31, 2004 Tax Effect Pre-tax Amount Net Amount Pre-tax Amount 2003 Tax Effect Net Amount Pre-tax Amount 2002 Tax Effect Net Amount Unrealized foreign currency translation $ 24.8 Minimum pension liability 46.3 Other (0.2) Other comprehensive $ – (16.3) 0.1 $ 24.8 30.0 (0.1) $ $ 59.7 (14.5) (0.9) – 5.1 0.3 $ 59.7 (9.4) (0.6) $ 2.5 (41.1) 0.9 $ – 14.6 (0.3) $ 2.5 (26.5) 0.6 income (loss) $ 70.9 $ (16.2) $ 54.7 $ 44.3 $ 5.4 $ 49.7 $ (37.7) $ 14.3 $ (23.4) Accumulated balances of other comprehensive income (loss), net of applicable income taxes are as follows: (dollars in millions, except per share) Year Ended December 31, 2004 2003(a) 2002(a) December 31, 2004 2003 Unrealized foreign currency translation Minimum pension liability (net of income taxes beneﬁ ts of $3.6 and $19.9) Other Accumulated other comprehensive income (loss) $ 57.9 $ 33.1 (6.3) – (36.3) 0.1 $ 51.6 $ (3.1) Stock Based Employee Compensation The Company’s stock based employee compensation plan is described in Note 7. As permitted by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), the Company continues to use the intrinsic value method permitted by Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations to account for stock Reported net income (loss) Pro forma compensation expense, net of tax Pro forma net income (loss) Reported net income (loss) per share: Basic Diluted(b) Pro forma net income (loss) per share: Basic Diluted(b) $ (26.4) $ 38.9 $ 62.3 (1.2) $ (27.6) – $ 38.9 – $ 62.3 $ (1.79) $ (1.79) $ 2.64 $ 2.64 $ 4.23 $ 4.23 $ (1.87) $ (1.87) $ 2.64 $ 2.64 $ 4.23 $ 4.23 (a) The pro forma effect of stock options on net income is only presented for periods after November 30, 2004, the date on which Neenah common stock was distributed to stockholders of Kimberly-Clark. (b) As a result of the net loss in 2004, the assumed incremental 60,683 shares resulting from the exercises of stock options and the vesting of restricted stock and restricted stock units were excluded for the diluted earnings per share calculation, as the effect would have been anti-dilutive. option grants. No employee compensation has been charged The weighted-average fair value at date of grant for to earnings because the exercise prices of all stock options options granted after the Spin-Off and for Kimberly-Clark granted have been equal to the market value of the Company options converted on November 30, 2004 was $11.71 per share or Kimberly-Clark’s common stock at the date of grant. Had and was estimated using the Black-Scholes option valuation compensation expense been recorded under the provisions of model with the following weighted-average assumptions (See SFAS 123, the impact on the Company’s net income (loss) Note 7 for a discussion of the 2004 option grants at a and income (loss) per share would have been: weighted-average exercise price $31.81): Expected life in years Interest rate Volatility Dividend yield 2004 4.7 3.6 % 36.3 % 1.2 % Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements In December 2004, the FASB issued SFAS 123 (revised in prior periods, the effect would have approximated the 2004), Share-Based Payment (“SFAS 123R”), which revises SFAS 123, Accounting for Stock-Based Compensation. SFAS 123R also supersedes APB 25, Accounting for Stock Issued to Employees, and amends SFAS 95, Statement of Cash Flows. (See Accounting Standards Changes below for a discussion of SFAS 123 pro forma net income and earnings per share disclosures shown. SFAS 123R also requires the beneﬁ ts of tax deductions in excess of recognized compensation cost to be reported as a ﬁ nancing cash ﬂ ow, rather than as an operating cash ﬂ ow other standards.) In general, the accounting required by SFAS as currently required, thereby reducing net operating cash 123R is similar to that of SFAS 123. However, SFAS 123 gave ﬂ ows and increasing net ﬁ nancing cash ﬂ ows in periods companies a choice to either recognize the fair value of stock after adoption. Such amounts cannot be estimated for future options in their income statements or to disclose the pro forma periods because they depend on, among other things, when income statement effect of the fair value of stock options in employees will exercise the stock options and the market price the notes to the ﬁ nancial statements. SFAS 123R eliminates of the Company’s stock at the time of exercise. that choice and requires the fair value of all share-based pay- ments to employees, including the fair value of grants of employee stock options, be recognized in the income state- ment, generally over the option vesting period. SFAS 123R must be adopted no later than July 1, 2005. Early adoption is permitted. SFAS 123R permits adoption of its requirements using one of two transition methods: (1) A modiﬁ ed prospective transition (“MPT”) method in which compensation cost is recognized beginning with the effective date (a) for all share-based payments granted after the effective date and (b) for all awards granted to employees prior to the effective date that remain unvested on the effective date. (2) A modiﬁ ed retrospective transition (“MRT”) method which includes the requirements of the MPT method described above, but also permits restatement of ﬁ nancial statements based on the amounts previously disclosed under SFAS 123’s pro forma disclosure requirements either for (a) all prior periods presented or (b) prior interim periods of the year of adoption. The Company is currently evaluating the timing and manner in which it will adopt SFAS 123R. The Company currently accounts for share-based pay- ments to employees using APB 25’s intrinsic value method and, as such, has recognized no compensation cost for employee stock options. Accordingly, adoption of SFAS 123R’s fair value method will have an effect on results of operations, although it will have no impact on overall ﬁ nancial position. The impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had SFAS 123R been adopted Accounting Standards Changes In May 2003, SFAS 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, was issued. SFAS 150 requires that certain instruments classiﬁ ed as part of stockholders’ equity or between stockholders’ equity and liabilities be classiﬁ ed as liabilities. The Company has no instruments that were affected by SFAS 150. In December 2003, FIN 46 (Revised December 2003), Consolidation of Variable Interest Entities, an Interpretation of ARB 51, (“FIN 46R”) was issued effective for the ﬁ rst interim or annual period ending after December 31, 2003. FIN 46R requires consolidation of entities in which the Company is the primary beneﬁ ciary, despite not having voting control. Likewise, it does not permit consolidation of entities in which Neenah has voting control but is not the primary beneﬁ ciary. The Company currently has no interests in any variable inter- est entities. Accordingly, adoption of FIN 46R had no effect on the consolidated and combined ﬁ nancial statements. In December 2003, SFAS 132 (revised 2003), Employers’ Disclosures about Pensions and Other Postretirement Beneﬁ ts, (“SFAS 132R”) was issued. SFAS 132R revises the disclosures for pension plans and other postretirement beneﬁ t plans. The Company has adopted the annual and interim disclosure requirements of SFAS 132R. In May 2004, FASB Staff Position 106-2 (“FSP 106-2”), Accounting and Disclosure Requirements Related to Medicare Prescription Drug, Improvement and Modernization Act of 2003, was issued. See Note 6 where implementation is discussed. pg. 61 In November 2004, SFAS 151, Inventory Costs – an amendment of ARB No. 43, Chapter 4, (“SFAS 151”), was issued. SFAS 151 clariﬁ es the accounting for abnormal records all derivative instruments as assets or liabilities on the balance sheet at fair value. Changes in the fair value of deriva- tives are either recorded in income or other comprehensive amounts of facility expenses, freight, handling costs, and income, as appropriate. The gain or loss on derivatives desig- spoilage. It also requires that allocation of ﬁ xed production nated as cash ﬂ ow hedges is included in other comprehensive overheads to inventory be based on the normal capacity of income in the period that changes in fair value occur and is production facilities. SFAS 151 is effective for inventory costs reclassiﬁ ed to income in the same period that the hedged item incurred during ﬁ scal years beginning after June 15, 2005. affects income. The gain or loss on derivatives that have not Adoption of SFAS 151 is not expected to have a material been designated as hedging instruments is included in current effect on the Company’s ﬁ nancial position, results of opera- income in the period that changes in fair value occur. tions or cash ﬂ ows. In December 2004, SFAS 153, Exchange of Nonmonetary Assets – an amendment of APB Opinion No. 29, (“SFAS 153”), was issued. SFAS 151 amends Opinion 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash ﬂ ows of the entity are expected to change signiﬁ cantly as a result of the exchange. SFAS 153 is effective for nonmonetary exchanges occurring in ﬁ scal periods beginning after June 15, 2005. Adoption of SFAS 153 is not expected to have a material effect on the Company’s ﬁ nancial position, results of operations or cash ﬂ ows. N O T E 3. RI SK MANAGEMEN T The Company is exposed to risks such as changes in foreign currency exchange rates and pulp prices. A variety of practices are employed to manage these risks, including operating and ﬁ nancing activities and, where deemed appropriate, the use of derivative instruments. Derivative instruments are used only for risk management purposes and not for speculation or trading. All foreign currency derivative instruments are either exchange traded or entered into with major ﬁ nancial institutions. Credit risk with respect to the counterparties is considered minimal in view of the ﬁ nancial strength of the counterparties. In accordance with SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended, the Company Pulp Price and Foreign Currency Risk The operating results, cash ﬂ ows and ﬁ nancial condition of the Company are subject to pulp price risk. Pulp prices, which are set in U.S. dollars, are determined by industry supply and demand. The average published industry index price of a metric ton of northern softwood kraft pulp in U.S. dollars was $565 in 2001, $487 in 2002, $553 in 2003 and $637 in 2004. The year-over-year decrease of $78 per ton in the average published industry index price in 2002 resulted in a decline in gross sales of approximately $44 million, whereas the year-over-year increases of $66 per ton and $84 per ton in the average published industry index price in 2003 and 2004, respectively, resulted in an increase in gross sales of approxi- mately $36 million and $46 million, respectively. Because the price of pulp is set in U.S. dollars and the Company’s cost of producing pulp is incurred principally in Canadian dollars, the proﬁ tability of the Company’s pulp operations is subject to foreign currency risk. The foreign cur- rency and pulp price risks are managed from time-to-time by the use of foreign currency forward and pulp futures con- tracts. The use of these instruments allows management of this transactional exposure to exchange rate and pulp price ﬂ uctuations because the gains or losses incurred on the derivative instruments are intended to offset, in whole or in part, losses or gains on the underlying transactional exposure. Translation exposure is not hedged. In addition, the Company is subject to price risk for utilities which are used in its manufacturing operations. Derivative instruments are used to hedge this risk when it is deemed prudent to do so. Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements Cash Flow Hedges The following table presents the U.S. and Canadian The Company‘s cash ﬂ ow hedges were effective in 2004, components of income before income taxes and the 2003 and 2002 and consequently resulted in no net income provisio n for income taxes: effect. During the same period in which the hedged fore - casted transactions affected earnings, the Company reclassiﬁ ed $0.6 million, $(0.5) million and $(0.8) million of after-tax (gains) losses from accumulated other comprehensive income to earnings in 2004, 2003 and 2002, respectively. At December 31, 2004, the Company expects to reclassify less than $0.1 mil- lion of after-tax gains from accumulated other comprehensive income to earnings during the next twelve months. In December 2004, the Company’s Canadian subsidiary entered into a foreign currency forward exchange contract, designated as a cash ﬂ ow hedge of U.S. dollar denominated pulp sales, in a notional principal amount of $25 million Canadian dollars and having a fair market value of $0.4 million at December 31, 2004. The contract matures ratably during the ﬁ rst quarter of 2005. In addition, the Company has a ﬁ xed price forward pur- chase contract to hedge ﬂ uctuations in the price of electricity at the Terrace Bay mill. The contract has a notional value of approximately $8.6 million and the fair market liability value of the contract was less than $0.1 million at December 31, 2004. N O T E 4. I N COM E TAX ES Income tax expense in the Company’s consolidated and com- bined ﬁ nancial statements has been calculated on a separate tax return basis. The following table presents the principal rea- sons for the difference between the effective tax rate and the U.S. federal statutory income tax rate: Year Ended December 31, 2004 2003 2002 U.S. federal statutory income tax rate State and local income taxes, net of federal income tax effect Canadian investment tax credits Other differences – net Effective income tax rate 35.0 % 35.0 % 35.0 % 2.4 4.2 4.1 – (1.3) 36.1 % – (0.7) 38.5 % (1.7) (0.1) 37.3 % Year Ended December 31, 2004 2003 2002 Income before income taxes: U.S. Canada Total Provisions for income taxes: Current: Federal State and local Canadian Subtotal Deferred: Federal State and local Canadian Subtotal Total $ 79.2 (120.5) (41.3) $ 81.5 (18.2) 63.3 $ 100.0 (0.7) 99.3 26.6 2.1 – 28.7 (0.2) – (43.4) (43.6) $ (14.9) 28.5 4.5 (0.4) 32.6 (2.1) (0.5) (5.6) (8.2) $ 24.4 23.2 6.6 8.9 38.7 9.0 (0.3) (10.4) (1.7) $ 37.0 The asset and liability approach is used to recognize deferred tax assets and liabilities for the expected future tax conse- quences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. The components of deferred tax assets and liabilities at December 31, 2004 and 2003 are as follows: December 31, Net current deferred income tax assets: Accrued liabilities Other Net current deferred income tax assets Net noncurrent deferred income tax assets: Canadian timberlands Employee beneﬁ ts Accumulated depreciation Other Net noncurrent deferred income tax assets Net noncurrent deferred income tax liabilities: Accumulated depreciation Other Net noncurrent deferred income tax liabilities 2004 2003 $ $ 4.4 (1.2) 3.2 $ 5.3 (1.6) $ 3.7 $ 72.3 16.1 (58.4) (2.7) $ 33.9 10.7 (26.0) 0.5 $ 27.3 $ 19.1 $ 8.4 – $ 33.3 1.2 $ 8.4 $ 34.5 pg. 63 No valuation allowance has been provided on deferred income tax assets. In determining the need for valuation allow- ances, the Company considers many factors, including the speciﬁ c taxing jurisdiction, income tax strategies and forecasted earnings for the entities in each jurisdiction. A valuation allowance would be recognized if, based on the weight of available evidence, the Company concludes that it is more likely than not that some portion or all of the deferred income tax asset will not be realized. As part of the Spin-Off transaction, the Company paid a one-time Spin-Off payment of $213 million to Kimberly- Clark to fund the purchase of the Canadian pulp assets and related timberlands. In accordance with EITF 94-10, Accounting by a Company for the Income Tax Effects of Transactions among or with Its Shareholders under FASB Statement No. 109, the tax effects of the resulting change in the tax bases of the assets and liabilities were reﬂ ected in stockholders’ and invested equity. The Company recorded a net charge to noncurrent deferred income taxes of approximately $8.2 million and an offsetting credit to “Kimberly-Clark’s net investment” on the consolidated and combined balance sheet and statement of changes in stockholders’ and invested equity. All of the operations of the Pulp and Paper Business were included in the consolidated income tax returns of Kimberly- Clark. Kimberly-Clark agreed to indemnify the Company for all income tax liabilities and retain rights to all tax refunds relating to the Pulp and Paper Business in its consolidated income tax returns for periods through the date of the Spin- N O T E 5. D EBT The following debt was incurred either as a result of or since the Spin-Off. The Company did not have debt prior to November 30, 2004. At December 31, 2004, the Company had no required debt payments during the next ﬁ ve years. Senior Unsecured Notes On November 30, 2004, the Company completed an under- written offering of ten-year, senior unsecured notes (the “Senior Notes”) at face amount of $225 million. The Senior Notes bear interest at a rate of 7.375%, payable May 15 and November 15 of each year, commencing on May 15, 2005, and maturing on November 15, 2014. The proceeds from this offering were used to pay a special payment of $213 million to Kimberly-Clark at the Spin-Off. The Senior Notes are fully and unconditionally guaranteed by substantially all of the Company’s subsidiaries. The Company expects to ﬁ le a registration statement with the Securities and Exchange Commission to exchange the unregistered Senior Notes for registered notes with similar terms in the second quarter of 2005. If the Company does not complete the exchange of the Senior Notes within 270 days from the original issuance of the notes (a “Registration Default”), the Company will be obligated to pay additional interest (“Special Interest”) on the Senior Notes. Special Interest will accrue at a rate of 0.25% per annum during the 90-day period following a Registration Default and will increase by 0.25% per annum for each subse- quent 90-day period to a maximum Special Interest rate of 1.00% per annum. Special Interest is the exclusive remedy for Off. Accordingly, the consolidated and combined balance a Registration Default. sheets do not include current or prior period income tax receiv- ables or payables related to the Pulp and Paper Business. The Company’s stock was distributed in a tax-free Spin- Off. Under terms of the tax sharing agreement between the Company and Kimberly-Clark, the Company could be liable for any income taxes if it commits a tainting event that destroys the tax-free nature of the Spin-Off. Secured Revolving Credit Facility On November 30, 2004, the Company entered into a Credit Agreement by and among Neenah, certain of its subsidiaries, the lenders listed in the Credit Agreement and JP Morgan Chase Bank, N.A. as agent for the lenders. Under the Credit Agreement, the Company has a secured revolving credit facility (“the Revolver”) that provides for borrowings of up to $150 million. As of December 31, 2004, the Company had no amounts outstanding under the Revolver. Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements Under the Revolver, up to $20 million is available for The Company’s ability to pay cash dividends on its the issuance of letters of credit (“LOCs”) on the Company’s Common Stock is limited under the terms of both the behalf. Borrowing availability under the Revolver is reduced Credit Agreement and the Senior Notes. Pursuant to the by outstanding LOCs. At December 31, 2004, the Company terms of these agreements, the Company’s ability to pay had approximately $6.1 million of LOCs outstanding and cash dividends on its common stock is limited to the lesser $143.9 million of borrowing availability under the Revolver. of 50% of Consolidated Net Income (as deﬁ ned) or a total Amounts outstanding under the Revolver may be repaid, in of $10.0 million in a 12-month period. whole or in part, at any time without premium or penalty except for speciﬁ ed make-whole payments on LIBOR-based loans. The Revolver is secured by substantially all of the Company’s assets, including the capital stock of our subsidiar- ies and is guaranteed by Neenah Paper Company of Canada, a wholly-owned subsidiary. The Revolver will terminate on November 30, 2008. Availability under the Revolver will ﬂ uctuate over time depending on the value of inventory, receivables and various capital assets. The interest rate applicable to borrowings under the Revolver will be either (1) the applicable base rate plus 0.25% to 0.75% or (2) a LIBOR-based rate ranging from LIBOR plus 1.75% to LIBOR plus 2.25%. Interest is computed based on actual days elapsed in a 360-day year, payable monthly in arrears for base rate loans, or for LIBOR loans, payable monthly in arrears and at the end of the applicable interest period. The commitment is subject to an annual facility fee of 0.375% on the average daily unused amount of the commitment. The Senior Notes and the Revolver contain, among other provisions, covenants with which the Company must comply during the term of the agreements. Such covenants restrict the Company’s ability to, among other things, incur certain additional debt, make speciﬁ ed restricted payments and capi- tal expenditures, authorize or issue capital stock, enter into transactions with afﬁ liates, consolidate or merge with or acquire another business, sell certain of its assets or liquidate, dissolve or wind-up the Company. In addition, the terms of the Revolver require the Company to achieve and maintain certain speciﬁ ed ﬁ nancial ratios. At December 31, 2004, the Company was in administrative default under the Credit Agreement for failure to provide ﬁ nancial statements in a timely manner. On January 31, 2005, the Credit Agreement was amended to waive the event of default. As of December 31, 2004, the Company was in compliance with all other such covenants. N O T E 6. P O S T RE T I REMEN T A N D O T H ER B EN EF I T S Pension Plans Substantially all active employees of the Pulp and Paper Business participated in Kimberly-Clark’s deﬁ ned-beneﬁ t pension plans and deﬁ ned contribution retirement plans. On November 30, 2004, the Company assumed responsibility for pension and postretirement beneﬁ t obligations for active em- ployees of the Pulp and Paper Business and former employees of the Canadian pulp operations. Pension and postretirement beneﬁ t obligations related to former employees of the U.S. paper operations were retained by Kimberly-Clark. Pension assets related to active employees of the U.S. paper operations for which the Company assumed responsibility were transferred from a Kimberly-Clark pension trust to a new trust for a pension plan established by the Company. The new pension plan provides for substantially similar beneﬁ ts and credits such employees for service earned with Kimberly-Clark. The Company’s funding policy for its qualiﬁ ed deﬁ ned beneﬁ t plans is to contribute assets to fully fund the accumu- lated beneﬁ t obligation (“ABO”). Subject to regulatory and tax deductibility limits, any funding shortfall is to be eliminated over a reasonable number of years. Nonqualiﬁ ed plans providing pension beneﬁ ts in excess of limitations imposed by the taxing authorities are not funded. The Company uses the fair value of pension plan assets to determine pension expense, rather than averaging gains and losses over a period of years. Investment gains or losses represent the difference between the expected return calculated using the fair value of the assets and the actual return based on the fair value of assets. As of December 31, 2004, the Company’s plans had cumulative unrecognized investment losses and other actuarial losses of approximately $128.3 million. pg. 65 A minimum pension liability for underfunded plans beneﬁ t under Medicare (Medicare Part D) and a federal representing the excess of the unfunded ABO over previously subsidy to sponsors of retiree healthcare beneﬁ t plans that recorded net pension liabilities has been reﬂ ected on the con- provide a prescription drug beneﬁ t that is at least actuarially solidated and combined balance sheet. The minimum pension liability is included in noncurrent employee beneﬁ ts and other obligations on the consolidated and combined balance sheets. An offsetting amount is included as an intangible asset to the extent of unrecognized prior service cost, and the balance is equivalent to Medicare Part D. On April 1, 2004, FASB Staff Position 106-2 (“FSP 106-2”), Accounting and Disclosure Requirements Related to Medicare Prescription Drug, Improvement and Modernization Act of 2003, was adopted. Adoption of FSP 106-2 reduced the Company’s included in accumulated other comprehensive income. In 2004, accumulated postretirement beneﬁ t obligation by approxi- the accrual for the additional minimum pension liability mately $6.8 million and resulted in an unrecognized actuarial decreased as the effect of a decrease in the discount rate used gain of a similar amount. Adoption resulted in a $0.3 million to estimate the ABO was more than offset by an increase in reduction in postretirement beneﬁ ts cost for the year ended the fair value of pension plan assets. A decrease in 2003 in the December 31, 2004. discount rate used to estimate the ABO was the principal Prior to 2004, the U.S. plans limited Kimberly-Clark’s cause of the 2003 increase in the accrual for the additional future annual per capita retiree medical beneﬁ ts to no more minimum pension liability. than 200% of the 1992 annual per capita cost. These plans The following is a summary of amounts related to the mini- reached this limitation (the “Cap”) and were amended during mum pension liability recorded in other comprehensive income: 2003. Among other things, the amendments index the Cap by December 31, Minimum pension liability Less intangible asset Accumulated other comprehensive income 2004 2003 $ 12.0 2.1 $ 62.6 6.4 $ 9.9 $ 56.2 Other Postretirement Benefit Plans Prior to the Spin-Off, the employees of the Pulp and Paper Business participated in Kimberly-Clark’s healthcare and life insurance beneﬁ t plans, which covered substantially all retirees and active employees. Certain beneﬁ ts were based on years of service and/or age at retirement. The plans were principally noncontributory for employees who were eligible to retire before December 31, 1992, and contributory for most employ- ees who retire after January 1, 1993. Kimberly-Clark provided no subsidized beneﬁ ts to most employees hired after 2003. On November 30, 2004, the Company assumed responsibility for obligations for the active employees of the Company and former employees of the Canadian pulp operations. The Company established new healthcare and life insurance beneﬁ t plans to provide substantially similar beneﬁ ts and credit such employees for service earned with Kimberly-Clark. On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) became law. Among other things, the Act provides a prescription drug 3% annually beginning in 2005 for certain employees retiring on or before April 1, 2004 and limit the future cost for retiree healthcare beneﬁ ts to a deﬁ ned ﬁ xed per capita cost for certain employees retiring after April 1, 2004. At December 31, 2004, the assumed inﬂ ationary pre-65 healthcare cost trend rate used to determine year-end obligations was 8.7%, decreasing to 7.8% in 2006, and then gradually decreasing to an ultimate rate of 5.0% in 2011. The assumed inﬂ ationary post-65 healthcare cost trend rate used to determine year-end obliga- tions was 8.8%, decreasing to 7.9% in 2006, and gradually decreasing to an ultimate rate of 5.0% in 2011. The assumed inﬂ ationary pre-65 healthcare cost trend rate used to deter- mine obligations at December 31, 2003 and cost for the year ended December 31, 2004 was 7.7%, decreasing to 6.7% in 2005, and gradually decreasing to an ultimate rate of 5.0% in 2010. The assumed inﬂ ationary post-65 healthcare cost trend rate used to determine obligations at December 31, 2003 and cost for the year ended December 31, 2004 was 8.1% decreas- ing to 7.1% in 2005, and gradually decreasing to an ultimate rate of 5.1% in 2010. An accrued beneﬁ t obligation for other postretirement beneﬁ ts assumed by the Company is reﬂ ected in noncurrent employee beneﬁ ts and other obligations on the consolidated and combined balance sheet. Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements The following table reconciles the beneﬁ t obligations, plan assets, funded status and net liability information of the Company’s pension and other beneﬁ t plans. Year Ended December 31, Change in Beneﬁ t Obligation: Beneﬁ t obligation at beginning of year Service cost Interest cost Currency Actuarial loss (gain) Beneﬁ t payments from plans Adjustment related to Spin-Off Participant contributions Other Beneﬁ t obligation at end of year Change in Plan Assets: Fair value of plan assets at beginning of year Actual gain on plan assets Employer contributions Currency Beneﬁ t payments Participant contributions Adjustment related to Spin-Off Fair value of plan assets at end of year Funded Status: Beneﬁ t obligation in excess of plan assets Unrecognized net actuarial loss Unrecognized transition amount Unrecognized prior service cost Net amount recognized Amounts Recognized in the Balance Sheets: Prepaid beneﬁ t cost Intangible asset Accrued beneﬁ t cost Accumulated other comprehensive income Net amount recognized Pension Benefits Postretirement Benefits Other than Pensions 2004 2003 2004 2003 $ 328.7 9.1 24.2 23.2 19.5 (10.9) (8.1) 0.5 (0.1) $ 386.1 $ 275.3 35.1 16.6 19.6 (10.9) 0.5 (7.7) $ 328.5 $ (57.6) 128.3 (0.7) 6.4 $ 76.4 $ 76.4 2.1 (12.0) 9.9 $ 76.4 $ 234.5 7.6 17.5 43.7 35.4 (10.4) – 0.5 (0.1) $ 328.7 $ 198.5 35.4 16.2 35.1 (10.4) 0.5 – $ 275.3 $ (53.4) 113.3 (0.8) 7.0 $ 66.1 $ 66.1 6.4 (62.6) 56.2 $ 66.1 $ 50.5 1.2 3.4 3.2 (1.8) (1.1) (0.4) – – $ 55.0 $ $ – – 1.1 – (1.1) – – – $ (55.0) 14.2 – 0.3 $ (40.5) $ – – (40.5) – $ (40.5) $ 34.7 1.2 2.6 5.4 7.4 (1.0) – – 0.2 $ 50.5 $ $ – – 1.0 – (1.0) – – – $ (50.5) 10.7 – 0.1 $ (39.7) $ – – (39.7) – $ (39.7) pg. 67 Summary disaggregated information about the pension plans follows: December 31, Projected beneﬁ t obligations ABO Fair value of plan assets Assets Exceed ABO ABO Exceeds Assets Total 2004 2003 2004 2003 2004 2003 $ 333.2 275.8 288.7 $ 61.2 45.5 60.0 $ 52.9 46.2 39.8 $ 267.5 229.6 215.3 $ 386.1 322.0 328.5 $ 328.7 275.1 275.3 Components of Net Periodic Benefit Cost Pension Benefits Year Ended December 31, 2004 2003 Service cost Interest cost Expected return on plan assets(a) Recognized net actuarial loss Amortization of unrecognized transition asset Amortization of prior service cost Adjustment related to Spin-Off Net periodic beneﬁ t cost (credit) $ 9.1 24.2 (27.7) 4.7 (0.2) 1.0 (0.4) $ 10.7 $ 7.1 21.9 (22.4) 6.1 (0.2) 0.9 – $ 13.4 $ $ 2002 6.3 19.2 (23.9) 1.9 (0.2) 0.9 – 4.2 Postretirement Benefits Other than Pensions 2004 2003 2002 $ $ 1.2 3.4 – (4.6) – – (0.4) (0.4) $ 1.0 3.6 – 0.2 – – – $ 4.8 $ 1.0 3.2 – – – – – $ 4.2 (a) The expected return on plan assets is determined by multiplying the fair value of plan assets at the prior year-end (adjusted for estimated current year cash beneﬁ t payments and contributions) by the expected long-term rate of return. Weighted-Average Assumptions Used to Determine Benefit Obligations at December 31 Year Ended December 31, Discount rate Rate of compensation increase Pension Benefits Postretirement Benefits Other than Pensions 2004 2003 2004 2003 5.75% 3.75% 6.20% 3.70% 5.75% – 6.17% – Weighted-Average Assumptions Used to Determine Net Periodic Benefit Cost for Years Ended December 31 Year Ended December 31, Discount rate Expected long-term return on plan assets Rate of compensation increase Pension Benefits 2004 2003 6.21% 8.50% 3.75% 6.95% 8.50% 3.90% 2002 7.05% 9.31% 4.00% Postretirement Benefits Other than Pensions 2004 2003 2002 6.17% – – 6.91% – – 7.09% – – Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements Expected Long-Term Rate of Return and Investment Cash Flows Strategies The Company expects to contribute approximately $18.1 million The expected long-term rate of return on pension fund assets to its pension trusts in 2005. held by the Company’s pension trusts was determined based on several factors, including input from pension investment consultants and projected long-term returns of broad equity and bond indices. Also considered were the plans’ historical 10-year and 15-year compounded annual returns. It is antici- pated that on average the investment managers for each of the plans will generate annual long-term rates of return of 8.5%. The expected long-term rate of return on the assets in the plans was based on an asset allocation assumption of about 70% with equity managers, with expected long-term rates of return of approximately 10%, and 30% with ﬁ xed income managers, with an expected long-term rate of return of about Future Benefit Payments The following beneﬁ t payments, which reﬂ ect expected future service, as appropriate, are expected to be paid: (in millions) Pension Plans 2005 2006 2007 2008 2009 Years 2010 - 2014 $ 13.8 15.1 16.4 18.0 19.6 128.9 Other Postretirement Benefits $ 1.6 1.8 2.0 2.2 2.5 17.0 6%. The actual asset allocation is regularly reviewed and peri- Healthcare Cost Trends odically rebalanced to the targeted allocation when considered Assumed healthcare cost trend rates affect the amounts appropriate. Also, when deemed appropriate, hedging strate- reported for postretirement healthcare beneﬁ t plans. A one- gies are executed using index options and futures to limit the percentage-point change in assumed healthcare cost trend downside exposure of certain investments by trading off upside rates would have the following effects: potential above an acceptable level. Such hedging strategies were executed in 2003 and 2002. Following the Spin-Off, the Company is following a similar methodology for determining its long-term rate of return on pension assets and investment strategy and is continuing to evaluate its long-term rate of return assumptions. Plan Assets Pension plan asset allocations are as follows: Effect on total of service and interest cost components Effect on post-retirement beneﬁ t obligation One-Percentage-Point Increase Decrease $ 0.5 $ 0.4 6.8 5.3 Defined Contribution Retirement Plans Contributions to the deﬁ ned contribution retirement plans are primarily based on the age and compensation of covered Percentage of Plan Assets at December 31, 2004 2003 2002 employees. These contributions, all of which were charged to Asset Category Equity securities Debt securities Real estate Cash and money-market funds Total 66% 24% 3% 7% 100% 70% 28% 2% –% 100% 68% 30% 2% –% 100% Plan assets were not invested in Neenah securities for periods subsequent to the Spin-Off or Kimberly-Clark securities prior to the Spin-Off. expense, were $0.5 million in each of 2004, 2003 and 2002. In connection with the Spin-Off, Kimberly-Clark transferred the related assets and liabilities of these plans to trusts estab- lished by the Company. In December 2004, the Company established deﬁ ned contribution retirement plans that provide substantially similar beneﬁ ts. Investment Plans Voluntary contribution investment plans are provided to sub- stantially all employees. Under the plans, Kimberly-Clark matched a portion of employee contributions. Costs charged to expense under the plans were $1.0 million, $1.2 million and pg. 69 $1.2 million in 2004, 2003 and 2002, respectively. In connection terms and expiration dates were also preserved. The number with the Spin-Off, Kimberly-Clark transferred the related of shares and new exercise prices were established using a ratio assets and liabilities to trusts established by the Company. In conversion methodology approved under FASB Interpretation December 2004, the Company established investment plans No. 44 based on the fair market value of the Company’s com- that provide substantially similar beneﬁ ts. mon stock on the date of grant. The Kimberly-Clark stock options awarded to employees N O T E 7. STO CK COMP EN SAT I ON P LA NS of the Pulp and Paper Business prior to the Spin-Off were granted with an exercise price equal to the market value of During 2003, 2002 and in prior years, certain employees of the a share of common stock on the date of grant and were Pulp and Paper Business were granted stock options, restricted accounted for using APB 25. No employee compensation was stock and (prior to 1999) participation shares under Kimberly- charged to earnings in the combined statements of operations Clark’s stock compensation plans. for periods prior to the Spin-Off because the exercise prices On August 31, 2004, Kimberly-Clark, acting as the sole of all stock options granted was equal to the market value of shareholder of the Company, approved the Neenah Paper, Kimberly-Clark’s common stock on the date of grant. Inc. 2004 Omnibus Stock and Incentive Plan (the “Omnibus On December 15, 2004, an award of nonqualiﬁ ed Plan”). The Company then adopted and established the Omnibus Plan under unanimous written consent of the Neenah Board of Directors on December 1, 2004. With this approval, the Company reserved 3,500,000 shares of stock options to purchase 442,540 shares of Common Stock (the “Fresh Start Options”) was made to the management team and directors of the Company. The exercise price of the Fresh Start Options was equal to the market value of the Common Stock for issuance under the Omnibus Plan. the Company’s stock on the date of grant. The Fresh Start Pursuant to the terms of the Omnibus Plan, the compensation Options expire in 10 years and vest 30% on the ﬁ rst anniver- committee of the Company’s Board of Directors may grant sary of the date of grant, 30% on the second anniversary and awards of various type of equity-based compensation, including 40% on the third anniversary. incentive and nonqualiﬁ ed stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares and performance units, in addition to certain cash- based awards. All grants and awards under the plan will be made at fair market value and no grant or award may be repriced after its grant. In general, the options expire 10 years from the date of grant and vest over a three-year service period. At December 31, 2004, a total of 2,263,401 shares of Common Stock were reserved for future issuance under the Omnibus Plan. Stock Options In connection with the Spin-Off, options to acquire 390,508 shares of Kimberly-Clark common stock that were outstand- ing immediately prior to the Spin-Off were converted into 724,449 substitute options to purchase the Company’s Common Stock under the Omnibus Plan. The awards con- verted were adjusted to maintain both the pre-conversion aggregate intrinsic value of each award and the ratio of the per share exercise price to the market value per share. Vesting Data concerning stock option activity follows(a): 2004 Weighted Average Number of Exercise Options Price 724,449 442,540 – – 1,166,989 532,554 $ 31.32 32.60 – – $ 31.81 $ 32.84 Conversion of Kimberly-Clark options Fresh Start Options granted Exercised Expired or cancelled Outstanding – End of year Exercisable – End of year (a) Information with respect to the stock option awards to acquire the Company’s Common Stock is presented for periods subsequent to November 30, 2004, the date on which Neenah common stock was distributed to the stockholders of Kimberly-Clark. Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements Data concerning options at December 31, 2004 follows: $24.01 – $26.04 $26.95 – $30.15 $32.60 – $37.59 Options Outstanding Options Exercisable Number of Options 209,490 82,335 875,164 1,166,989 Weighted- Average Exercise Price Weighted-Average Remaining Contractual Life (Years) $ 24.23 $ 28.97 $ 33.89 $ 31.81 7.7 3.9 8.9 8.3 Number Weighted-Average of Options Price 84,932 82,335 365,287 532,554 $ 24.55 $ 28.97 $ 35.64 $ 32.84 Restricted Stock Awards On December 15, 2004, Neenah awarded 40,800 and A number of employees of the Pulp and Paper Business were 3,450 Restricted Stock Units (“RSUs”) to members of the granted Kimberly-Clark restricted stock awards in previous management team and Board of Directors of the Company, years. These awards generally vested and became unrestricted respectively. The RSUs carry a promise to pay out in Com- shares in three to ﬁ ve years from the date of grant. At the time mon Stock at a future date. In general, the RSUs awarded to of the Spin-Off, the vesting schedule of restricted stock awards members of the management team vest over a ﬁ ve-year period, for employees of the Pulp and Paper Business were adjusted so with one-third vesting on the third anniversary of the date that the awards vested on a prorated basis determined by the of grant, one-third vesting on the fourth anniversary, and the number of full years of employment with Kimberly-Clark dur- balance vesting on the ﬁ fth anniversary. The RSUs awarded ing the restriction period. Unvested restricted shares of to members of the Board of Directors vest on the ﬁ rst anniver- Kimberly-Clark common stock were forfeited. sary of the date of grant. Holders of RSUs are entitled to On December 1, 2004, the Company awarded 25,360 dividends but are not permitted to vote such awarded shares replacement restricted shares to employees whose restricted and the sale or transfer of such shares is limited during the shares of Kimberly-Clark common stock were forfeited. restricted period. The number of restricted shares was calculated using a ratio conversion methodology approved under FASB Interpretation No. 44 based on the fair market value of the Company’s com- mon stock on the date of grant. The shares retained the Kimberly-Clark vesting schedule with 2,489 shares, 3,681 shares, 2,025 shares, 16,591 shares and 574 shares vesting in 2005, 2006, 2007, 2008 and 2009, respectively. Holders of Kimberly-Clark restricted stock are entitled to dividends and are permitted to vote such awarded shares, but the sale or transfer of such shares is limited during the restricted period. The price of Kimberly-Clark’s common stock at the date of grant determined the value of the restricted stock, and such value was recorded at the date of the grant as unearned com- pensation. This unearned compensation is amortized to expense over the periods of restriction. Amounts expensed in the Consolidated and Combined Statements of Operations related to stock-based employee compensation (consisting solely of restricted stock in 2004) were $0.6 million, $0.5 mil- lion and $0.4 million in 2004, 2003 and 2002, respectively. Participation Shares Prior to 1999, Kimberly-Clark awarded key employees par- ticipation shares that were payable in cash at the end of the vesting period. The amount of cash paid to participants was based on the increase in the book value of Kimberly-Clark’s common stock during the award period. Participants did not receive dividends on the participation shares, but their accounts were credited with dividend shares payable in cash at the matu- rity of the award. Neither participation nor dividend shares were shares of Kimberly-Clark common stock. Amounts expensed in the Consolidated and Combined Statements of Operations related to participation shares were $0.4 million and $0.6 million in 2003 and 2002, respectively. The plan was terminated in 2003 and payment was made by Kimberly-Clark in February 2004 for all remaining vested awards. pg. 71 N O T E 8. S TO C K H O L D ERS ’ E Q U I T Y Common Stock The Company has authorized 100 million shares of $0.01 par value common stock (“Common Stock”). Holders of the Company’s Common Stock are entitled to one vote per share. In conjunction with the Spin-Off, 14,737,959 share of Common Stock were issued to the stockholders of Kimberly- Purchase Commitments The Company has entered into long-term contracts for the purchase of sawmill wood chips and utilities, principally electricity. The minimum purchase commitments extend beyond 2009. Commitments under these contracts are approximately $39.5 million in 2005, $26.0 million in 2006, $25.8 million in 2007, $25.8 million in 2008 and $25.8 million in 2009. Total commitments beyond 2009 Clark as a dividend in the ratio of one share of the Company’s are $37.2 million. Common Stock for every 33 shares of Kimberly-Clark com- Although the Company is primarily liable for payments mon stock outstanding. Preferred Stock The Company has authorized 20 million shares of $0.01 par value preferred stock. The preferred stock may be issued in one or more series and with such designations and preferences for each series as shall be stated in the resolutions providing for the designation and issue of each such series adopted by the Board of Directors of the Company. The Board of Directors is authorized by the Company’s articles of incorporation to determine the voting, dividend, redemption and liquidation preferences pertaining to each such series. No shares of pre- ferred stock have been issued by the Company. N O T E 9. COM MI T MEN TS Leases The future minimum obligations under operating leases hav- ing a noncancelable term in excess of one year as of December 31, 2004, are as follows: Year Ending December 31: 2005 2006 2007 2008 2009 Thereafter Future minimum obligations $ 2.7 2.7 1.7 1.7 1.7 15.1 $ 25.6 Rental expense under operating leases was $3.9 million, $2.7 million and $2.4 million in 2004, 2003 and 2002, respectively. on the above-mentioned leases and purchase commitments, management believes exposure to losses, if any, under these arrangements is not material. N O T E 10. CO N T I N G EN C I ES A N D LE GA L MAT TERS Litigation A subsidiary of Kimberly-Clark is a co-defendant in a vehi- cle accident lawsuit pending in Ontario (Canada) Superior Court of Justice since August 1998. The plaintiffs in this law- suit include the driver of one of the vehicles involved in the accident and his passengers. The driver sustained severe inju- ries, including paralysis, as a result of the accident on a bush road located within a forest where the subsidiary conducts logging operations. The plaintiffs claim that Kimberly-Clark was responsible for maintaining the bush road on which the accident occurred. In particular, the plaintiffs claim that Kimberly-Clark should have cut the trees and other growth on the sides of the bush road and the alleged failure to do so caused or contributed to the cause of the accident. The plaintiffs are seeking signiﬁ cant money damages, plus costs and attorneys’ fees. Kimberly-Clark has denied liability and has raised numerous defenses in this lawsuit. Pursuant to the Distribu- tion Agreement, the Company will indemnify Kimberly-Clark for liabilities and costs, including attorneys’ fees and other costs of defense, arising out of this lawsuit, net of any insur- ance recovery by Kimberly-Clark. The Company expects this matter to be set for trial in 2006. Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements The Company is involved in certain other legal actions not currently named as a party in any judicial or administrative and claims arising in the ordinary course of business. While proceeding relating to environmental, health and safety matters. the outcome of these legal actions and claims cannot be pre- While the Company has incurred in the past several dicted with certainty, it is the opinion of management that the years, and will continue to incur, capital and operating expen- outcome of any claim which is pending or threatened, either ditures in order to comply with environmental, health and individually or on a combined basis, will not have a material safety laws, regulations and ordinances, management believes adverse effect on the consolidated ﬁ nancial condition, results that its future cost of compliance with environmental, health of operations or liquidity of the Company. and safety laws, regulations and ordinances, and its exposure to Indemnifications Pursuant to the Distribution Agreement, the Pulp Supply Agreement, the Employee Matters Agreement and the Tax Sharing Agreement, the Company has agreed to indemnify Kimberly-Clark for certain liabilities or risks related to the Spin-Off (See Note 11). Many of the potential indemniﬁ ca- tion liabilities under these agreements are unknown, remote or highly contingent, and most are unlikely to ever require an indemnity payment. Furthermore, even in the event that an indemniﬁ cation claim is asserted, liability for indemniﬁ cation is subject to determination under the terms of the applicable agreement. For these reasons, the Company is unable to esti- mate the maximum potential amount of the potential future liability under the indemnity provisions of these agreements. However, the Company accrues for any potentially indem- niﬁ able liability or risk under these agreements for which it believes a future payment is probable and a range of loss can be reasonably estimated. As of December 31, 2004, we believe liability for environmental, health and safety claims will not have a material adverse effect on its ﬁ nancial condition, results of operations or liquidity. However, future events, such as changes in existing laws and regulations or contamination of sites owned, operated or used for waste disposal by the Company (including currently unknown contamination and contamination caused by prior owners and operators of such sites or other waste generators), may give rise to additional costs which could have a material adverse effect on the Com- pany’s ﬁ nancial condition, results of operations or liquidity. Neenah incurs capital expenditures necessary to meet legal requirements and otherwise relating to the protection of the environment at its facilities in the United States and Canada. For these purposes, the Company has planned capi- tal expenditure programs for which it anticipates incurring approximately $4 million in 2005 and approximately $14 million in 2006, of which no material amount is the result of environmental ﬁ nes or settlements. our liability under such indemniﬁ cation obligations was Employees and Labor Relations not material. Environmental, Health and Safety Matters Neenah is subject to federal, state, provincial and local laws, regulations and ordinances relating to various environmental, health and safety matters. The Company is in compliance with, or is taking actions designed to ensure compliance with, these laws, regulations and ordinances. However, the nature of the Company’s business exposes it to the risk of claims with respect to environmental, health and safety matters, and there can be no assurance that material costs or liabilities will not be incurred in connection with such claims. Except for certain orders issued by environmental, health and safety regulatory agencies, with which management believes the Company is in compliance and which management believes are immaterial to the results of operations of the Company’s business, Neenah is At December 31, 2004, the Company had 2,060 regular, full- time employees. Contracts covering approximately 625 and 501 domestic and Canadian employees, respectively, are scheduled for renegotiation in 2005. Such contracts include approximately 241 employees at the Pictou mill and 184 employees at the Whiting mill who are working under the terms of contracts that expired on June 1, 2004 and February 1, 2005, respectively. By operation of Nova Scotia labor law, the terms of the expired collective bargaining agreement at the Pictou mill will remain in effect until completion of the collec- tive bargaining process. The Company and its unions generally have good working relationships and management believes its labor agreements contain wage and fringe beneﬁ t programs that are competitive within the applicable industry segment and geographic region. Although the Company believes that pg. 73 it has satisfactory relations with its employees, there can be the Company, and ﬁ nancial responsibility for the obligations no assurance that the Company will not have labor disputes and liabilities of Kimberly-Clark’s retained businesses with in the future. Kimberly-Clark, except as may otherwise be provided in the N O T E 11. T RA N S AC T I O N S W I T H KIMBERLY-CLARK During all periods presented, the Company transferred soft- wood and hardwood pulp to Kimberly-Clark. For periods prior to the Spin-Off, such intra-company transfers were made pursuant to an advance transfer pricing agreement negotiated among Kimberly-Clark and certain taxing authorities. Under the advance transfer pricing agreement, pulp was transferred to Kimberly-Clark at a transfer price equal to a published industry index price less a discount. Net sales revenue for the pulp transferred to Kimberly-Clark were $351.0 million, $305.1 million and $262.1 million for the years ended December 31, 2004, 2003 and 2002, respectively. Settlement of such pulp transfers was effected through Kimberly-Clark’s net investment account. In connection with the Spin-Off, the Company and Kimberly-Clark entered into a new Pulp Supply Agreement as described below. In connection with the Spin-Off, the Company and Kimberly-Clark executed and delivered the Distribution Agreement (the “Distribution Agreement”), and certain related agreements, which are summarized below. Distribution Agreement Distribution Agreement. Pulp Supply Agreement The Company and Kimberly-Clark have entered into a Pulp Supply Agreement pursuant to which the Company agreed to supply and Kimberly-Clark agreed to purchase northern bleached softwood kraft pulp and northern bleached hard- wood kraft pulp. Under the Pulp Supply Agreement, the Company must supply and Kimberly-Clark must purchase annually declining speciﬁ ed minimum tonnages of pulp. For each of 2005 and 2006, the minimum commitment for north- ern bleached softwood kraft pulp is 440,000 air-dried metric tons; for 2007 the minimum commitment is 395,000 air-dried metric tons and for 2008 and any subsequent years the mini- mum commitment is 345,000 air-dried metric tons. The amounts of those minimum commitments represent approxi- mately 80%, 71%, and 62%, respectively, of the Company’s total production of northern bleached softwood kraft pulp in 2004. The minimum commitment for northern bleached hard- wood kraft pulp for 2005, 2006, 2007 and 2008 is 80,000, 60,000, 40,000 and 20,000 air-dried metric tons, respectively. The amounts of those minimum commitments represent approximately 52%, 39%, 26% and 13%, respectively, of the Company’s total production of northern bleached hardwood kraft pulp in 2004. In March 2005, the Company notiﬁ ed The Distribution Agreement provided for, among other Kimberly-Clark of its intention to terminate the Pulp Supply things, the principal corporate transactions required to effect Agreement with respect to northern bleached hardwood kraft the separation of the Pulp and Paper Business from Kimberly- pulp produced at the Terrace Bay mill (See Note 15). Clark, the distribution of the Company’s common stock to Under the Pulp Supply Agreement, the prices for north- the holders of record of Kimberly-Clark common stock and ern bleached softwood kraft pulp and northern bleached other agreements governing the Company’s relationship with hardwood kraft pulp will be based on published industry index Kimberly-Clark after the Spin-Off. Pursuant to the Distribu- prices for the pulp (subject to minimum and maximum prices tion Agreement, Kimberly-Clark transferred to the Company for northern bleached kraft softwood pulp shipped to North assets used primarily in the Company’s business and in general America prior to December 31, 2007), less agreed upon dis- the Company assumed and agreed to perform and fulﬁ ll all counts. The commitments are structured as supply-or-pay of the liabilities arising out of the ownership or use of the and take-or-pay arrangements. Accordingly, if the Company transferred assets or the operation of the transferred business. does not supply the speciﬁ ed minimums, the Company must The Distribution Agreement provides for cross-indemnities pay Kimberly-Clark for the shortfall based on the difference principally designed to place ﬁ nancial responsibility for the between the contract price and any higher price that obligations and liabilities of the Pulp and Paper Business with Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements Kimberly-Clark pays to purchase the pulp, plus 10% of that Corporate Services Agreement difference. If Kimberly-Clark does not purchase the speciﬁ ed The Company and Kimberly-Clark have entered into a minimums, Kimberly-Clark must pay for the shortfall based Corporate Services Agreement whereby Kimberly-Clark on the difference between the contract price and any lower will provide to the Company, on an interim, transitional basis, price the Company obtains for the pulp, plus 10% of the dif- various corporate support services, including: certain employee ference. The Company will incur the cost of freight to delivery beneﬁ ts administration and payroll, management information, points speciﬁ ed in the agreement. transportation, environment and energy, purchasing, treasury, Either party can elect a two-year, phase-down period for accounting and other services, as well as transitional ofﬁ ce the agreement, to begin no earlier than January 1, 2009, under space for the Company’s research team. Each service will be which the minimum commitments for northern bleached made available to the Company on an as-needed basis through softwood kraft pulp in the ﬁ rst and second years of the phase- December 31, 2005, or such shorter or longer periods as may down period would be 277,500 and 185,000 air-dried metric be provided in the Corporate Services Agreement. The fees tons, respectively. In addition, the Company has the right charged for the services will generally be based upon the at any time to terminate its obligation to supply northern costs of providing the services. The Company may terminate bleached hardwood kraft pulp upon three months notice to the provision of a particular service upon 30 days’ notice Kimberly-Clark. Either the Company or Kimberly-Clark to Kimberly-Clark except where longer notice periods are may terminate the pulp supply agreement for certain events speciﬁ ed in the Corporate Services Agreement. In addition, speciﬁ ed in the agreement, including a material breach of the either the Company or Kimberly-Clark may terminate the agreement by the other party that is not cured after 30 days’ Corporate Services Agreement for cause or upon certain notice, insolvency or bankruptcy of the other party, or a funda- changes of ownership relating to the other party as set forth mental change in the nature of the business of the other party in the Corporate Services Agreement. that may substantially affect its ability to sell or to purchase or utilize pulp under the agreement. In addition, Kimberly-Clark may terminate the agreement if the ownership or control of the Company or any of its pulp production facilities becomes vested in or is made subject to the control or direction of, any direct competitor of Kimberly-Clark or any governmental or regulatory authority or any other third party, who in Kimberly-Clark’s reasonable judgment may not be able to reli- ably perform the Company’s obligations under the agreement. Kimberly-Clark may also terminate the agreement upon one year’s notice if, as a result of the Company’s forestry activities, continued use of the Company’s pulp by Kimberly-Clark does or, in Kimberly-Clark’s reasonable judgment is likely to, result in a substantial loss of sales of Kimberly-Clark’s products or to otherwise materially and adversely affect the reputation of Kimberly-Clark or its products. Kimberly-Clark may also terminate the agreement upon 180 days notice that the Company’s failure to comply with U.S. customs requirements jeopardizes Kimberly-Clark customs certiﬁ cation. Employee Matters Agreement The Company and Kimberly-Clark have entered into an Employee Matters Agreement which provides for their respec- tive obligations to employees and former employees who are or were associated with the Pulp and Paper Business and for other employment and employee beneﬁ ts matters. Pursuant to the Employee Matters Agreement, the Company agreed to employ or offer to employ all employees of Kimberly-Clark with employment duties principally related to the Pulp and Paper Business on terms and conditions sub- stantially similar to the current terms and conditions of their employment with Kimberly-Clark. The Company agreed that, subject to applicable laws, to maintain labor agreements with substantially the same terms and conditions that existed with Kimberly-Clark. The Company also assumed, and indemniﬁ ed Kimberly- Clark against, certain liabilities related to employees of the Pulp and Paper Business who are employed by the Company and retired Canadian employees. The Company assumed responsibility for the Kimberly-Clark retirement plans in which employees of the Pulp and Paper Business participated. pg. 75 The Company granted credit for service recognized under if such acquisitions or issuances result in the Spin-Off failing the Kimberly-Clark plans for all purposes under its plans. to meet the requirements of a tax-free distribution pursuant Kimberly-Clark transferred the assets and liabilities of the to Section 355(e) of the Code. Kimberly-Clark retirement plans attributable to transferring active employees and retired Canadian employees of the Pulp and Paper Business to the Company. Administrative Matters. The Tax Sharing Agreement also sets forth Kimberly-Clark’s and the Company’s respec- tive obligations with respect to the ﬁ ling of tax returns, the In connection with the Spin-Off, outstanding options administration of tax contests, assistance and cooperation held by transferring employees under Kimberly-Clark’s and other matters. equity compensation plans (other than the Kimberly-Clark Corporation Global Stock Option Plan) were converted into substitute options to purchase Company common stock, or to N O T E 12. A S S E T I M PAI R M EN T LO S S the extent such options were exercisable they may instead, at The Company’s Terrace Bay, Ontario, pulp manufacturing the election of the option holder on or before November 30, facility incurred operating losses in 2002, 2003 and 2004. The 2004, remain exercisable in accordance with the terms of such Company anticipates that the facility will continue to incur plans as applicable to terminated employees. operating losses in 2005, 2006 and 2007. The principal causes Tax Sharing Agreement The Company and Kimberly-Clark have entered into a Tax Sharing Agreement, which generally governs Kimberly-Clark’s and the Company’s respective rights, responsibilities and obli- gations after the Spin-Off with respect to taxes attributable to the Company’s business, as well as any taxes incurred by Kimberly-Clark as a result of the failure of the Spin-Off to qualify for tax-free treatment under Section 355 of the Code. General Taxes. Under the Tax Sharing Agreement, Kimberly-Clark is generally liable for all pre-Spin-Off, and the Company is generally be liable for all post-Spin-Off, U.S. federal income taxes, foreign taxes and certain state tax- es attributable to the Company’s business. The Tax Sharing Agreement sets forth rules for determining which taxes are attributable to pre-Spin-Off and post-Spin-Off periods and rules on the effect of subsequent adjustments to those taxes due to tax audits or examinations. Distribution-Related Taxes. Under the Tax Sharing Agreement, the Company is liable for taxes incurred by Kimberly-Clark that arise as a result of the Company taking or failing to take, as the case may be, certain actions that result in the Spin-Off failing to meet the requirements of a tax-free distribution under Section 355 of the Code. The Company is also liable for taxes incurred by Kimberly-Clark in connection with certain acquisitions or issuances of Company stock, even if such acquisitions or issuances occurred after the Spin-Off, of these projected losses are: (cid:127) continued high operating costs at this facility; (cid:127) prices for pulp sold to Kimberly-Clark under the new pulp supply agreement, which will be at substantially higher discounts than those at which pulp was transferred to Kimberly-Clark prior to the Spin-Off; (cid:127) anticipated lower market prices for pulp in the second half of 2005 and forward as a result of an expected down- turn in the pulp cycle; and (cid:127) continued strength of the Canadian dollar relative to the U.S. dollar. Because projected extended periods of operating losses are indicators of impairment under SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), the Company performed an asset impairment test on the facil- ity under the guidance of SFAS 144, which indicated that the carrying amount of the Terrace Bay facility would not be recoverable from estimated future cash ﬂ ows. Accordingly, in December 2004, the Company recorded a pre-tax, non-cash impairment loss of approximately $110.0 million to reduce the carrying amount of the Terrace Bay facility. In addition, in December 2004, in recognition of the probability that Terrace Bay’s No. 1 mill would be closed (See Note 15), the Company recorded an additional impairment loss of approxi- mately $2.8 million related to the long-lived assets of the Terrace Bay facility. A deferred tax beneﬁ t of approximately Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements $40.8 million was also recorded as a result of the impairment N O T E 13. B U S I N ES S S E G M EN T A N D losses, resulting in a net after-tax charge of approximately GE O GRA P H IC INF ORMAT ION The Company reports its operations in three segments: Fine Paper, Technical Paper and Pulp. The Fine Paper business is a leading producer of premium writing, text, cover and specialty papers. The Technical Paper business is a leading producer of durable, saturated and coated base papers for a variety of end uses. The Pulp business consists of the Terrace Bay, Ontario, pulp mill and the Pictou, Nova Scotia, pulp mill and related timberlands. Each segment requires different technologies and marketing strategies. Disclosure of segment information is on the same basis that management uses internally for evaluating segment performance and allocating resources. Prior to the Spin-Off, Kimberly-Clark provided the Pulp and Paper Business with certain centralized administrative functions to realize economies of scale and efﬁ cient use of resources. The costs of shared services, and other administra- tive functions managed on a common basis, are allocated to the segments based on usage, where possible, or other factors based on the nature of the activity. The accounting policies of the reportable operating segments are the same as those described in the Summary of Signiﬁ cant Accounting Policies (see Note 2). $72.0 million. In determining the impairment losses, the estimated fair value of the Terrace Bay facility was based on probability- weighted, pre-tax cash ﬂ ows from operating the facility, discounted at a risk-free interest rate. The signiﬁ cant assump- tions used to determine fair value of the facility included the Company’s long-term projections of the market price of pulp, the projected cost structure of the facility and the long-term relationship of the Canadian dollar and the U.S. dollar. The Company also considered its plans to improve the cost structure at Terrace Bay, primarily through future capital proj- ects and a plan for a cogeneration arrangement that would lower the cost of electricity, when determining the fair value of the facility used to determine the impairment losses. This estimate of the fair value of the Terrace Bay facility reﬂ ects these assumed improvements to the facility’s cost structure. Prior to the Spin-Off, Kimberly-Clark’s management also performed an impairment test of the Terrace Bay facility under the guidance of SFAS 144. The purpose of that analysis was to determine if the Terrace Bay facility was impaired when held by Kimberly-Clark prior to the Spin-Off. As operated by Kimberly-Clark, the Terrace Bay facility supplied more than 90% of the pulp it produced to other Kimberly-Clark busi- nesses where it was used to produce tissue and other products. Kimberly-Clark’s management concluded that the facility was not impaired prior to the Spin-Off because, as used by Kimberly-Clark, it was an integrated part of Kimberly-Clark’s tissue and other businesses and the estimated undiscounted future cash ﬂ ows of the businesses consuming such pulp were sufﬁ cient to recover the carrying amounts of their long-lived assets, including the Terrace Bay facility. pg. 77 Business Segments Net Sales Year 2004 2003(a) 2002(a) Operating Income (Loss) Year 2004(b) 2003 2002 Depreciation and Amortization Year 2004 2003 2002 Total Assets Year 2004 2003 Fine Paper Technical Paper Pulp Unallocated Corporate Costs Intersegment Combined Sales Total $ 220.8 210.4 224.7 $ 132.3 121.6 120.7 $ 448.6 405.1 380.0 $ – – – $ (29.6) (26.8) (23.4) $ 772.1 710.3 702.0 67.0 63.2 77.2 21.9 16.6 18.4 (120.5) (16.5) 3.7 9.7 9.6 10.0 3.7 4.0 4.0 22.4 21.7 20.3 140.9 131.9 58.2 62.8 382.3 397.3 (8.3) – – 0.2 – – 5.2 – – – – – – – – – (39.9) 63.3 99.3 36.0 35.3 34.3 586.6 592.0 (a) The above amounts of Net sales for the years ended December 31, 2003 and 2002 have been increased from the amounts previously reported to be in confor- mity with EITF 00-10, which prohibits the netting of shipping and handling costs against revenues. Amounts reﬂ ected for “Net sales” in 2003 for the Fine Paper and Pulp businesses increased from the amounts previously reported by $8.1 million and $38.6 million, respectively. Amounts reﬂ ected for “Net sales” in 2002 for the Fine Paper and Pulp businesses increased from the amounts previously reported by $8.1 million and $38.0 million, respectively. (b) Income before income taxes for the pulp business in 2004 includes an impairment loss of $112.8 million for the Terrace Bay facility. Capital Spending Year 2004 2003 2002 Geographic Information Net Sales Year 2004 2003 2002 Total Assets Year 2004 2003 Fine Paper Technical Paper Pulp Corporate Combined Total $ 3.5 2.5 4.8 $ 1.6 2.2 4.6 $ 11.0 19.7 9.0 $ 3.0 – – $ 19.1 24.4 18.4 United States Canada Items Total Inter- Geographic Combined $ 354.0 332.8 349.4 $ 448.2 404.6 378.5 $ (30.1) (27.1) (25.9) $ 772.1 710.3 702.0 250.2 195.0 336.4 397.0 – – 586.6 592.0 Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements Net sales are attributed to geographic areas based on the Supplemental Balance Sheet Data physical location of the entities comprising the Pulp and Paper Business and the Company for the respective years. Segment identiﬁ able assets are those that are directly used in the seg- ments operations. Corporate assets are primarily cash, prepaid pension costs and deferred ﬁ nancing costs. Concentrations For the years 2004, 2003 and 2002, the Company had $351.0 million, $305.1 million and $262.1 million, respectively, December 31, 2004 2003 Summary of Accounts Receivable, net Accounts Receivable: From customers Other Less allowance for doubtful accounts and sales discounts Total $ 84.9 11.8 $ 74.8 3.5 (4.3) $ 92.4 (1.2) $ 77.1 of net sales revenue for pulp transferred to Kimberly-Clark. For Accounts receivable are carried at amounts that approximate the periods presented, other than Kimberly-Clark, no single fair value. customer accounts for more than 10% of the consolidated and combined revenue of the Company. Except for wood chips used by the pulp mills and certain specialty latex grades used by Technical Paper, management is not aware of any signiﬁ - cant concentration of business transacted with a particular supplier that could, if suddenly eliminated, have a material adverse affect on its operations. In 2004 and 2003, over 55% of the wood chips used by the Pictou mill were supplied by two suppliers and approximately 60% of the wood chips used by the Terrace Bay mill were supplied by one supplier. While December 31, 2004 2003 Summary of Inventories Inventories by Major Class: Raw materials Work in process Finished goods Supplies and other Excess of FIFO cost over LIFO cost Total $ 31.1 7.7 42.1 14.4 95.3 (6.6) $ 88.7 $ 37.2 5.7 28.8 20.5 92.2 (6.5) $ 85.7 management believes that alternative sources of critical sup- The FIFO values of total inventories valued on the LIFO plies, such as wood chips, would be available, disruption of its method were $33.5 million and $27.6 million at December 31, primary sources could create a temporary, adverse effect on 2004 and 2003, respectively. product shipments. An interruption in supply of a latex spe- cialty grade could disrupt and eventually cause a shutdown of production of certain technical paper, latex specialty grades. N O T E 14. SUPPLEMEN TA L DATA Supplemental Statement of Operations Data Year Ended December 31, 2004 2003 2002 Summary of Advertising and Research Expenses Advertising expense Research expense December 31, 2004 2003 Summary of Property, Plant and Equipment – Net Land and land improvements Buildings Machinery and equipment Roads Construction in progress Less accumulated depreciation Net Property, Plant and Equipment(a) $ 4.8 84.6 487.9 26.5 13.6 617.4 359.8 $ 257.6 $ 3.2 143.4 820.5 50.7 7.3 1,025.1 657.0 $ 368.1 $ 7.7 1.7 $ 5.8 2.1 $ 6.7 1.8 (a) In December 2004, the Company recorded an impairment loss of $112.8 million to write down the value of the Terrace Bay facility. pg. 79 December 31, 2004 2003 severance and deﬁ ned-beneﬁ t pension plans of approximately Summary of Accrued Expenses Accrued salaries and employee beneﬁ ts Accrued income taxes Accrued interest Other Total $ 27.2 0.5 1.4 7.5 $ 36.6 $ 22.9 – – 7.5 $ 30.4 N O T E 15. S U B S E Q U EN T EV EN T On March 1, 2005, the Company announced the planned closure of the smaller of the two single-line pulp mills at the Terrace Bay facility (the “No. 1 Mill”). The No. 1 Mill was originally constructed in 1948 and has annual capac- ity of approximately 125,000 tons of bleached kraft pulp. In conjunction with the closing, the Company will offer early retirement and severance packages to approximately 130 employees. The closing was authorized by our Chief Executive Ofﬁ cer on February 28, 2005, pursuant to a reso- lution of the Board of Directors, and is expected to occur in early May 2005. The Company expects to incur approximately $6.0 mil- lion of exit costs in connection with the closure, including one-time termination beneﬁ ts related to early retirement, $5.5 million and other associated exit costs of $0.5 million. In addition, we expect to incur approximately $1.0 million of general expenses related to training of employees. Approxi- mately $6.3 million of the estimated costs of $7.0 million will result in future cash expenditures during 2005 and 2006. In addition, in March 2005, the Company will record a pre-tax, non-cash impairment loss of approximately $0.9 mil- lion related to the remaining value of the long-lived assets of the No. 1 Mill (See Note 12). As a result of closing the No. 1 Mill, the Company noti- ﬁ ed Kimberly-Clark of its intention to terminate a part of its commitment to supply and their requirement to purchase northern bleached hardwood kraft pulp pursuant to the terms of the pulp supply agreement. Under the pulp supply agree- ment, the Company was obligated to provide 40,000, 30,000, 20,000 and 10,000 tons of northern bleached hardwood kraft pulp produced at the Terrace Bay mill annually in 2005, 2006, 2007 and 2008, respectively. Our commitment to supply and Kimberly-Clark’s requirement to purchase northern bleached hardwood kraft pulp pursuant to the terms of the pulp supply agreement from the Pictou mill (in annual quantities which are identical to those shown above) are unchanged. Neenah Paper, Inc. 2004 Annual Report Notes to Consolidated Financial Statements N O T E 16. UNAU DI TED Q UARTERLY DATA Net Sales(d) Gross Proﬁ t Operating Income (Loss) Net Income (Losss) Earnings (Loss) Per Common Share(e): Basic Diluted Net Sales (d) Gross Proﬁ t Operating Income Net Income Earnings Per Common Share(e): Basic Diluted 2004 Quarters (a) First Second Third Fourth Year $ 198.4 33.1 24.3 15.1 $ 207.4 45.0 37.3 23.7 $ 188.9 23.3 7.8 4.5 $ 177.4(c) 22.8 (109.3)(b) (69.7)(b) $ 772.1 124.2 (39.9) (26.4) $ 1.03 $ 1.03 $ 1.60 $ 1.60 $ 0.31 $ 0.31 $ (4.73) $ (4.73) $ (1.79) $ (1.79) 2003 Quarters (a) First Second Third Fourth $ 174.9 27.5 14.9 9.4 $ 173.3 24.5 10.8 6.4 $ 179.6 24.1 15.5 8.9 $ 182.5 31.8 22.1 14.2 Year $ 710.3 107.9 63.3 38.9 $ 0.64 $ 0.64 $ 0.43 $ 0.43 $ 0.60 $ 0.60 $ 0.97 $ 0.97 $ 2.64 $ 2.64 (a) The annual maintenance shutdowns for the Company’s two pulp mills occurred during the third quarter in 2004 instead of one each during the second and third quarters in 2003 and 2002. (b) Includes an asset impairment loss of $112.8 million. (c) Net sales subsequent to the Spin-Off (in December 2004) were reduced by $12.9 million, reﬂ ecting the one-time effect resulting from the new pulp supply agreement with Kimberly-Clark which transfers title at product delivery rather than shipment date. (d) The above amounts of Net sales for all quarters prior to the fourth quarter of 2004 have been increased from the amounts previously reported to be in con- formity with EITF 00-10, which prohibits the netting of shipping and handling costs against revenues. Net sales for the ﬁ rst, second and third quarters of 2004 were increased from amounts previously reported by $12.6 million, $12.7 million and $10.9 million, respectively. Net sales for the year and ﬁ rst, second, third and fourth quarters of 2003 were increased from amounts previously reported by $44.5 million, $11.0 million, 10.5 million, $11.5 million and $11.5 million, respectively. (See Note 2) (e) For 2004 prior to the Spin-Off and 2003, basic and diluted earnings per share were computed using the number of shares of Neenah common stock out- standing on November 30, 2004, the date on which Neenah common stock was distributed to the stockholders of Kimberly-Clark. Being one of the world’s most respected paper companies, we couldn’t limit the paper used in our annual report to just one choice. So we’ve used a range of our most popular paper brands. For help in identifying them, use the simple key to the right. Design and production: see see eye / Atlanta, Georgia All photography: Lonnie Kalfus, except executive photography: Jerry Burns, and photos on pages 28–33: Image Studios Illustration: Guy Billout / pages 3, 19 Ken Orvidas / pages 9, 23 Neil Brennan / pages 15, 27 Copywriting: Robert Roth Printing: Williamson Printing Corporation Front Cover: CLASSIC COLUMNS®, Red Pepper / CLASSIC CREST®, Avalanche White, 120 lb. duplex cover Inside Front Cover: CLASSIC COLUMNS®, Red Pepper / CLASSIC CREST®, Avalanche White, 120 lb. duplex cover Flysheet: UV/ULTRA® II, Radiant White, 28 lb. pg. 81 Page 6: CLASSIC CREST®, Avalanche White, Super Smooth, 100 lb. text Page 7: CLASSIC CREST®, Avalanche White, Super Smooth, 100 lb. text Page 8: CLASSIC CREST®, Avalanche White, Super Smooth, 100 lb. text Page 1: CLASSIC CREST®, Avalanche White, Super Smooth, 100 lb. text Page 9: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 2: CLASSIC CREST®, Avalanche White, Super Smooth, 100 lb. text Page 10: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 3: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 4: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 5: CLASSIC CREST®, Avalanche White, Super Smooth, 100 lb. text Page 11: CLASSIC® Linen, Haviland Blue, 80 lb. text Page 12: CLASSIC® Linen, Haviland Blue, 80 lb. text Page 13: CLASSIC® Linen, Haviland Blue, 80 lb. text Neenah Paper, Inc. 2004 Annual Report Page 14: CLASSIC® Linen, Haviland Blue, 80 lb. text Page 15: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 16: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 17: CLASSIC COLUMNS®, Pistachio, 80 lb. text Page 18: CLASSIC COLUMNS®, Pistachio, 80 lb. text Page 19: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 20: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 22: CLASSIC CREST®, Avalanche White, Super Smooth, 100 lb. text Page 30: ENVIRONMENT® , Alpaca, 80 lb. text Page 31: CLASSIC® Linen, Solar White, 80 lb. text Page 32: CLASSIC® Linen, Solar White, 80 lb. text Page 33: CLASSIC® Linen, Solar White, 80 lb. text Page 34: CLASSIC® Linen, Solar White, 80 lb. text Pages 35–82 CLASSIC CREST®, Potomac Blue, 80 lb. text Page 23: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 24: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 25: EAMES™ Furniture, EAMES White, 100 lb. text Page 26: EAMES™ Furniture, EAMES White, 100 lb. text Page 27: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 28: CLASSIC® Laid, Classic Natural White, 100 lb. text Page 21: CLASSIC CREST®, Avalanche White, Super Smooth, 100 lb. text Page 29: ENVIRONMENT®, Alpaca, 80 lb. text Shareholder Information Corporate Headquarters Stock Exchange Neenah Paper, Inc. 3460 Preston Ridge Road Suite 600 Alpharetta, GA 30005 678.566.6500 www.neenah.com Annual Meeting of Shareholders The annual meeting of the shareholders of Neenah Paper, Inc. will be held Monday, June 20, 2005, at 2:00 p.m., Central time (3:00 p.m, Eastern time), at Neenah Paper Whiting Mill, 3243 Whiting Road, Stevens Point, WI 54481. Registrar and Transfer Agent EquiServe Trust Company, N.A. P.O. Box 43010 Providence, RI 02940 www.equiserve.com 877.498.8847 Investor Information Inquiries and requests for information, including the Company’s annual report to the Securities and Exchange Commission on Form 10-K, may be obtained at no charge by visiting the Company’s web site at www.neenah.com or by otherwise contacting the company as follows: Neenah Paper, Inc. Attn: Stockholder Services 3460 Preston Ridge Road Suite 600 Alpharetta, GA 30005 866.548.6569 or via e-mail to investors@neenahpaper.com Neenah Paper’s common stock is traded on the New York Stock Exchange under the symbol NP. Independent Accountants Deloitte & Touche LLP 191 Peachtree Street Suite 1500 Atlanta, GA 30303 Business Description Neenah Paper manufactures and distributes a wide range of premium and specialty paper grades, with well-known brands such as CLASSIC®, ENVIRONMENT®, KIMDURA® and MUNISING LP®. The Company also produces and sells bleached pulp, primarily for use in the manufacture of tissue and writing papers. Neenah Paper is based in Alpharetta, Georgia, and has manufacturing operations in Wisconsin, Michigan and in the Canadian provinces of Ontario and Nova Scotia. Trademarks The brand names mentioned in this report – CLASSIC CREST, CLASSIC COTTON, CLASSIC, CLASSIC COLUMNS, NEENAH, UV/ULTRA II, ATLAS, ENVIRONMENT, EAMES, OLD COUNCIL TREE, KIMDURA, EPIC II, DURAFORM, DURAFLEX, BUCKSKIN, PREVAIL, TEXOPRINT, MUNISING LP, TECHNI-PRINT, KIMLON, PHOTO-TRANS, HEIRLOOM – are trademarks of Neenah Paper, Inc. H o w d o y ou ma k e a gre a t first impression ? N e e n a h P a p e r , I n c . 2 0 0 4 A n n u a l R e p o r t 3460 Preston Ridge Road Suite 600 Alpharetta, GA 30005 678.566.6500 2004 Annual Report

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