Neenah Annual Report 2005

Plain-text annual report

(1,1) -1- 3217Cvr21mar06.indd 4/3/06 2:10:42 PM (1,1) -1- 3217Cvr21mar06.indd 4/3/06 2:10:42 PM Neenah Paper: UnFOLDING 1 Letter to Shareholders 4 Neenah Paper At A Glance 5 Fine Paper 6 Technical Products 7 Pulp 8 Board of Directors / Executive Team 9 Index to Financials IBC Shareholder Information Annual Report 2005 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. Additional information about Neenah Paper can be found at the company’s web site at www.neenah.com. (1,1) -1- 3217Cvr21mar06.indd 4/3/06 2:10:42 PM (1,1) -1- 3217Cvr21mar06.indd 4/3/06 2:10:42 PM Neenah Paper: UnFOLDING 1 Letter to Shareholders 4 Neenah Paper At A Glance 5 Fine Paper 6 Technical Products 7 Pulp 8 Board of Directors / Executive Team 9 Index to Financials IBC Shareholder Information Annual Report 2005 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. Additional information about Neenah Paper can be found at the company’s web site at www.neenah.com. 2005 Annual Report “ We are evolving into something more than the sum of three businesses.” – Sean T. Erwin President and Chief Executive Officer To Neenah Paper Shareholders: As years go, 2005 was a meaningful one for Neenah A Challenging and Exciting First Year Paper. It marked our first full year as a stand-alone Consolidated net sales for 2005 were $733 million versus public company. For us, it was a year of challenge, $772 million in 2004. The decrease in sales was in pulp, learning and progress. Neenah Paper, like most man- where volumes declined due to the decision to close ufacturing companies, faced significant pressures the No. mill at Terrace Bay on May and selling prices from the higher cost of energy and materials. Our pulp operations in Canada were additionally affected by the continued strengthening of the Canadian dollar, which is up by over 30 percent in a little over two years. We responded to these challenges while also taking actions to strengthen and build our business for the long term. The successful launch of the new EAMES™ line of fine papers, the start-up of a new paper machine headbox at our Munising Technical Products mill and cost savings initiatives executed at all our mills are just a few examples of actions we completed. We also invested in our infrastructure and supply chain capabilities with the implementation of the first phase of our Oracle ERP system. Additionally, while making things happen today, we were able to further define our strategic plans and actions going forward. that were lower as a result of higher price discounts given to Kimberly-Clark in 2005, compared with 2004, when our operations were part of that company. In both 2004 and 2005, we recorded non-cash impair- ment charges to write down the amount of our Terrace Bay fixed assets to a value based on expectations of its future cash-generating capabilities. At the spin-off in 2004, there was a pre-tax impairment charge of $3 million. In 2005, an additional $54 million pre-tax charge was taken, bringing the value of the fixed assets to zero. An operating loss of $3 million was reported for 2005, and included the effects of the charges for impairment and the No. mill closure of $60 million. The compara- ble 2004 operating loss was $40 million, but included the impairment charge of $3 million. As expected at the spin-off, results were impacted by higher pulp 2 Neenah Paper, Inc.: UnFOLDING As we evolve, the future of Neenah Paper will be in increasing the size and proportion of our two paper businesses. discounts, added corporate expenses as a stand-alone 2005 was a particularly tough year to be in the Canadian company, and interest expense for the debt we incurred forest products industry. The strong rise of the Cana- at the spin-off. Additional factors impacting results in dian dollar combined with escalating costs for energy 2005 were a stronger Canadian dollar and increased energy and material costs. These factors were partly off- set by our cost improvement programs, which delivered over $25 million of savings in 2005, and selling price and materials put virtually the entire industry in a loss position. Our Pulp segment reported an operating loss of $93 million, including the effects of the charges for impairment and the No. mill closure of $60 million. increases implemented across all product segments. As a result of the difficult environment, we worked to Our Fine Paper segment continued to outperform the market due to the quality and position of our products and the strength of our brands. Net sales of $222 million represented a slight year-on-year increase, despite a market that declined more than three percent. The launch of the EAMES™ Paper Collection in the second quarter was an unqualified success, further solidifying Neenah’s position as the innovative brand leader in the premium paper market. We broadened our product line with the addition of new translucent Web+Plus™ papers. Our mills continued to deliver cost savings and recently entered into an agreement with a waste-to-energy firm in Wisconsin to process some of our manufacturing byproducts to generate steam. This allows us to signi- make progress on a number of fronts to address costs. In March, we made the difficult decision to shut down the older No. mill at Terrace Bay. Its small scale did not justify the investment necessary to compete successfully in today’s global pulp market. Later in the year, the Terrace Bay team re-engineered their approach to the annual maintenance down, saving millions of dollars. Following the down, the mill set numerous new production records and for the year was able to decrease manufacturing costs by seven percent, despite rising wood and energy costs. Both Terrace Bay and Pictou received Sustainable Forestry Initiative® certifica- tion in 2005, indicating our forests are being managed in an environmentally responsible manner. ficantly cut natural gas consumption at our Neenah mill, While we successfully negotiated labor agreements at an example of environmental stewardship that also each of our paper mills and the Pictou mill, the year reduces cost. In Technical Products, volumes increased three percent, driven by growth in tape and abrasives, although net sales fell slightly, from $32 to $3 million. Sales were affected by lower shipments of heat transfer papers, ended on a somber note, as a revised labor agreement with the woodlands workers at Terrace Bay was not reached. The woodland workers chose to go on strike on January 30, 2006, ultimately requiring the mill to shut down for lack of wood in mid-February. which were sold through a distributor until mid-year, at Where We Go from Here which point we terminated that agreement and began As the theme for this annual report points out, as a new to work directly with customers to restore growth for this technologically advanced product. A key challenge that company, Neenah’s story is an unfolding one. While that is true, the message of that story has remained consis- Technical Products faced in 2005 was from rising oil- tent since day one. We have always believed that the based latex costs. To help offset this, our mills delivered foundation for our future lies in our ability to sustain cost savings of over $3 million and we also implemented surcharges and price increases. growth, create value from our Pulp business and deliver attractive returns. In 2005, we further developed and began executing a strategic plan that would bring those objectives to fruition. 2005 Annual Report 3 Strong brands, innovative products, motivated people – at Neenah Paper, that’s what drives our growth. An Evolving Portfolio have increased our research and development staff and At the time Neenah Paper was spun off in November capabilities. In fact, to emphasize the different direc- 2004, it was comprised of three separate business units tions available to us, you may have noticed we have – a very well known branded premium ﬁne paper fran- changed the name of this segment from Technical Paper chise, a technical paper business and pulp operations. to Technical Products. Half of our sales were pulp. As we evolve, the future of Neenah Paper will be in increasing the size and propor- tion of our two paper businesses, through organic growth and also potentially through acquisitions. Growth starts with the top line, but requires constant attention to the bottom line as well. Our “Ring-the-Bell” costs savings program remains active and will continue to be part of our performance expectations each year. We own some of the strongest, most admired brands in We will also deliver proﬁts through increased size and the ﬁne paper industry, giving us a solid foundation scale, improvements in our Technical Products mix and upon which to build. Our Technical Products business control over corporate expenses, debt and taxes. centers on producing a wide range of synthetic and paper-based products. Our research and development activities are now leading us in new directions, where our processes and proprietary capabilities can create value for customers and shareholders. These strengths will be leveraged as we evaluate new opportunities. Growth Expectations Strong brands, innovative products, motivated people – at Neenah Paper, that’s what drives our growth. Prior to the spin-off, our paper businesses were to some extent in a “harvest” mode. We are now choosing how we invest in and manage these businesses for long-term growth. In the Fine Paper segment, we are encouraging custom- ers to “trade up” to the value and quality of Neenah Paper to present their message, and we hope to help grow the premium paper segment, which is now only three percent of the uncoated market. We are also exploring new sales and distribution channels for our products, including retailers and high-end packaging. In our Technical Products segment, we are restoring an important component – customer development partner- Delivering Value At Neenah Paper, return on capital is an important met- ric to us and to our shareholders. We will drive this through wise capital investment decisions, cost savings initiatives, and tough but necessary decision-making. Our job is to make things happen. Neenah’s Board of Directors has adopted strong corpo- rate governance policies and has taken an active interest in ensuring that shareholders’ interests are both repre- sented and protected. These actions should help deliver value and returns to our shareholders. 2005 was an exciting, challenging year for Neenah Paper, a year of tough decisions and determined actions. But to put it in perspective, it was just year one of what we hope will be a long unfolding journey into our future. I’d like to thank our employees, directors, customers and shareholders – both for your support and for shar- ing our vision for success. ships – and are now jointly working with our customers Sean T. Erwin to explore how our products, processes and technology Chairman, President and Chief Executive Ofﬁcer can meet their speciﬁc needs. To facilitate that, we NEENAH PAPER AT A GLANCE Neenah Paper: Setting a new standard in ﬁne paper, technical products and pulp. Our Fine Paper business produces premium writing, text, cover, specialty and private watermark papers that are used in identity packages, annual reports, 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®, UV/ULTRA® II Papers and the EAMES™ Paper Collection. Our Technical Products business is an industry leader in research, technology and problem-solving, focused on durable, saturated, synthetic and coated base papers. Our customers are located in 40 countries around the world. For more than half a century, our innovative paper products have replaced those made from wood, plastic, cloth and leather. Our technical papers are not end-use products; they are essential components in the manufacture of other products. Our papers ﬁt a wide array of applications, including abrasives, labels, decorative components, heat transfer and medical packaging. 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 manufacture of tissue, publication, premium writing, printing and other specialty papers. 2005 NET SALES technical products 17% fine paper 30% pulp 53% Fine Paper Neenah Paper’s powerhouse of fine paper brands reads like a veritable who’s who in premium paper. For more than 20 years, OUR BRANDS designers and printers have considered Neenah brands, such as CLASSIC CREST® and CLASSIC® Linen, to be their first choice for aes- thetics, performance, consistency, availability, quality, and value. Today, Neenah’s fine paper brands continue to occupy a premium position in the marketplace. Our introduction of the EAMES™ Paper Collection put us on the leading edge of paper innovation. As more and more cus- tomers look to high-quality paper to convey their messages, we see an opportunity to tip the scale in Neenah’s favor. VOLUME MIx BRANDED 83% UNBRANDED 17% 2005 • CLASSIC CREST® • CLASSIC COTTON® • CLASSIC® LINEN • CLASSIC® LAID • CLASSIC COLUMNS® • NEENAH® BOND • UV/ULTRA® II • ATLAS™ BOND • ENVIRONMENT® PAPERS • EAMES™ PAPER COLLECTION • OLD COUNCIL TREE® BOND 2005 FINE PAPER HIgHLIgHTS • Net sales up one percent for the year • • • Launched the exclusive EAMES™ Paper Collection, which offers three new color palettes and unique surface finishes previously unexplored on paper Entered into a joint agreement with Sihl Paper, a global manufacturer of specialty papers based in Switzerland, to manufacture UV/ULTRA® II Web+Plus™ papers to provide Neenah Paper customers a broader range of printing applications for these translucent papers Began purchasing “green steam” from Minergy Corporation at our Neenah, Wisconsin mill. By purchasing this steam we will significantly reduce natural gas consumption and reduce paper mill byproducts going to landfill Fine Paper Neenah Paper’s powerhouse of fine paper brands reads like a veritable who’s who in premium paper. For more than 20 years, OUR BRANDS designers and printers have considered Neenah brands, such as CLASSIC CREST® and CLASSIC® Linen, to be their first choice for aes- thetics, performance, consistency, availability, quality, and value. Today, Neenah’s fine paper brands continue to occupy a premium position in the marketplace. Our introduction of the EAMES™ Paper Collection put us on the leading edge of paper innovation. As more and more cus- tomers look to high-quality paper to convey their messages, we see an opportunity to tip the scale in Neenah’s favor. VOLUME MIx BRANDED 83% UNBRANDED 17% 2005 • CLASSIC CREST® • CLASSIC COTTON® • CLASSIC® LINEN • CLASSIC® LAID • CLASSIC COLUMNS® • NEENAH® BOND • UV/ULTRA® II • ATLAS™ BOND • ENVIRONMENT® PAPERS • EAMES™ PAPER COLLECTION • OLD COUNCIL TREE® BOND 2005 FINE PAPER HIgHLIgHTS • Net sales up one percent for the year • • • Launched the exclusive EAMES™ Paper Collection, which offers three new color palettes and unique surface finishes previously unexplored on paper Entered into a joint agreement with Sihl Paper, a global manufacturer of specialty papers based in Switzerland, to manufacture UV/ULTRA® II Web+Plus™ papers to provide Neenah Paper customers a broader range of printing applications for these translucent papers Began purchasing “green steam” from Minergy Corporation at our Neenah, Wisconsin mill. By purchasing this steam we will significantly reduce natural gas consumption and reduce paper mill byproducts going to landfill Premium paper makes an impression. It influences how the world perceives your company. Corporations print on Neenah Fine Paper to communicate quality. Even more important, they select Neenah Fine Paper to communicate a message. With the expanding spectrum of Neenah Fine Paper brands, we command a strong market position. 1. What’s good for the environment is good for FedEx Kinko’s. They chose Neenah ENVIRONMENT® brand papers, made with 100 percent post-consumer fiber, for several of their resumé, executive and card stock papers. 2. Designers often turn to nature for inspiration. Neenah’s Fine Paper brands are a design inspiration in themselves. 3. Everything about the Starwood Preferred Guest Platinum program connotes elite status. That includes the welcome package, printed on Neenah EAMES™ Painting. 4. The designer’s choice. For more than two decades, graphic designers have specified Neenah’s Fine Paper brands for their clients – and for themselves. 5. The most important rule of all. Design firm Rule29 selected CLASSIC CREST® for their award-winning, self-promotional hardbound book, Rules 1–28. 6. What do many award-winning annual reports have in common? Neenah Fine Paper – brands such as CLASSIC®, CLASSIC CREST®, ENVIRONMENT®, EAMES™ and more. 1. Premium paper makes an impression. It influences how the world perceives your company. Corporations print on Neenah Fine Paper to communicate quality. Even more important, they select Neenah Fine Paper to communicate a message. With the expanding spectrum of Neenah Fine Paper brands, we command a strong market position. 1. What’s good for the environment is good for FedEx Kinko’s. They chose Neenah ENVIRONMENT® brand papers, made with 100 percent post-consumer fiber, for several of their resumé, executive and card stock papers. 2. Designers often turn to nature for inspiration. Neenah’s Fine Paper brands are a design inspiration in themselves. 3. Everything about the Starwood Preferred Guest Platinum program connotes elite status. That includes the welcome package, printed on Neenah EAMES™ Painting. 4. The designer’s choice. For more than two decades, graphic designers have specified Neenah’s Fine Paper brands for their clients – and for themselves. 5. The most important rule of all. Design firm Rule29 selected CLASSIC CREST® for their award-winning, self-promotional hardbound book, Rules 1–28. 6. What do many award-winning annual reports have in common? Neenah Fine Paper – brands such as CLASSIC®, CLASSIC CREST®, ENVIRONMENT®, EAMES™ and more. 1. 2005 Annual Report 5 FINE PAPER 2. 3. 5. 4. 6. 6 Neenah Paper, Inc.: UnFOLDING TECHNICAL PRODUCTS 1. 2. 3. 4. 5. Technical Products Neenah’s Technical Products division takes a proactive stance in developing solutions that meet customers’ specific OUR BRANDS needs. Our Research and Development group works closely with cus- tomers to find new and improved uses for our products. Our expertise and experience in developing specialty substrate materials has made Neenah Technical Products a preferred supplier around the world. Our continued focus and investment in R&D opens new opportunities for our solutions and ensures that we maintain a leadership position in our categories. VOLUME gROWTH KIMDURA® EPIC II® DURAFORM® DURAFLEx® BUCKSKIN® PREVAIL® TExOPRINT® MUNISINg LP® TECHNI-PRINT® KIMLON® PHOTOTRANS® HEIRLOOM® NEENAH™ Tape Pre-Mask Abrasive Other 2004 2005 2005 TECHNICAL PRODUCTS HIgHLIgHTS • Expanded our Research and Development capabilities • Introduced new heat transfer technology with PHOTOTRANS® ImageClip™ Heat Transfer Paper • Launched the first breathable reinforced paper that withstands ozone sterilization for medical packaging • Initiated a development project for Neenah™ Mirror Finish Abrasive Paper • Arranged a supply agreement with Performance Industrial Tape Specialists Co. Ltd. (PITS) • Added two new KIMDURA® Synthetic Papers, KIMDURA UV and KIMDURA Multi-Task Labels, tags, tapes, pre-mask, medical packaging, book components, furniture components, abrasives, heat transfer and more – chances are, you’ve come across Neenah’s Technical Products before. They’re in items you use everyday. 1. Scratch the surface of a great abrasive and you’ll find a great backing material. Like Neenah’s latex-saturated and coated papers, used worldwide for nearly 50 years. 2. Neenah makes heat transfer history. New PHOTOTRANS® ImageClip™ does away with those annoying plastic polymer windows around the image area. 3. Some label stock offers strength, while others offer good graphic qualities. Neenah Paper’s KIMDURA® line of synthetic paper provides both, including resistance to UV radiation. 4. It’s tempting to say that Neenah wrote the book on bookbinding. Actually, Neenah just supplies the binding components – from decorative converting base papers to stretch papers for the spine. 5. Neenah Paper Medical Packaging Paper is extremely heat stable, so it holds up under widely used processes. 6. Cellulose pulp reinforced with long, nylon fibers and saturated with durable latex. That’s the formula for Prevail® Paper. Paper so strong you can even put grommets in it. 6. Labels, tags, tapes, pre-mask, medical packaging, book components, furniture components, abrasives, heat transfer and more – chances are, you’ve come across Neenah’s Technical Products before. They’re in items you use everyday. 1. Scratch the surface of a great abrasive and you’ll find a great backing material. Like Neenah’s latex-saturated and coated papers, used worldwide for nearly 50 years. 2. Neenah makes heat transfer history. New PHOTOTRANS® ImageClip™ does away with those annoying plastic polymer windows around the image area. 3. Some label stock offers strength, while others offer good graphic qualities. Neenah Paper’s KIMDURA® line of synthetic paper provides both, including resistance to UV radiation. 4. It’s tempting to say that Neenah wrote the book on bookbinding. Actually, Neenah just supplies the binding components – from decorative converting base papers to stretch papers for the spine. 5. Neenah Paper Medical Packaging Paper is extremely heat stable, so it holds up under widely used processes. 6. Cellulose pulp reinforced with long, nylon fibers and saturated with durable latex. That’s the formula for Prevail® Paper. Paper so strong you can even put grommets in it. 6. Technical Products Neenah’s Technical Products division takes a proactive stance in developing solutions that meet customers’ specific OUR BRANDS needs. Our Research and Development group works closely with cus- tomers to find new and improved uses for our products. Our expertise and experience in developing specialty substrate materials has made Neenah Technical Products a preferred supplier around the world. Our continued focus and investment in R&D opens new opportunities for our solutions and ensures that we maintain a leadership position in our categories. VOLUME gROWTH KIMDURA® EPIC II® DURAFORM® DURAFLEx® BUCKSKIN® PREVAIL® TExOPRINT® MUNISINg LP® TECHNI-PRINT® KIMLON® PHOTOTRANS® HEIRLOOM® NEENAH™ Tape Pre-Mask Abrasive Other 2004 2005 2005 TECHNICAL PRODUCTS HIgHLIgHTS • Expanded our Research and Development capabilities • Introduced new heat transfer technology with PHOTOTRANS® ImageClip™ Heat Transfer Paper • Launched the first breathable reinforced paper that withstands ozone sterilization for medical packaging • Initiated a development project for Neenah™ Mirror Finish Abrasive Paper • Arranged a supply agreement with Performance Industrial Tape Specialists Co. Ltd. (PITS) • Added two new KIMDURA® Synthetic Papers, KIMDURA UV and KIMDURA Multi-Task Pulp Neenah Paper’s Pulp division produces approximately 600,000 metric tons of chlorine-free pulp annually from our two Canadian pulp OUR STRENgTHS operations. Our mills are SFI® certified, adhering to the latest in forest management technology and practices. Our focus in pulp continues to be on reducing costs, and in 2005, we closed the oldest and smallest of our two pulp mills at our Terrace Bay, Ontario facility. 2005 VOLUMES By LOCATION TERRACE BAy 375,000 metric tons PICTOU 265,000 metric tons 2005 FLExIBLE PRODUCTION Softwood and hardwood pulp and various blends SUSTAINABILITy Sustainable Forestry Initiative® (SFI) certification STRATEgIC LOCATION Pulp mills service customers in North America and Europe CHLORINE-FREE 100% elemental chlorine- free (ECF) pulp REFORESTATION Seedling tree nursery at the Pictou timberland 2005 PULP HIgHLIgHTS • Achieved SFI® (Sustainable Forest Initiative) and ISO 14000 certification for Pictou and Terrace Bay woodlands operations • Shutdown the Terrace Bay No. 1 mill, saving $2–$4 million annually • Upgraded Pictou baling to meet market demands for integrity and appearance • Delivered significant cost savings by modifying annual maintenance approach at Terrace Bay Pulp Neenah Paper’s Pulp division produces approximately 600,000 metric tons of chlorine-free pulp annually from our two Canadian pulp OUR STRENgTHS operations. Our mills are SFI® certified, adhering to the latest in forest management technology and practices. Our focus in pulp continues to be on reducing costs, and in 2005, we closed the oldest and smallest of our two pulp mills at our Terrace Bay, Ontario facility. 2005 VOLUMES By LOCATION TERRACE BAy 375,000 metric tons PICTOU 265,000 metric tons 2005 FLExIBLE PRODUCTION Softwood and hardwood pulp and various blends SUSTAINABILITy Sustainable Forestry Initiative® (SFI) certification STRATEgIC LOCATION Pulp mills service customers in North America and Europe CHLORINE-FREE 100% elemental chlorine- free (ECF) pulp REFORESTATION Seedling tree nursery at the Pictou timberland 2005 PULP HIgHLIgHTS • Achieved SFI® (Sustainable Forest Initiative) and ISO 14000 certification for Pictou and Terrace Bay woodlands operations • Shutdown the Terrace Bay No. 1 mill, saving $2–$4 million annually • Upgraded Pictou baling to meet market demands for integrity and appearance • Delivered significant cost savings by modifying annual maintenance approach at Terrace Bay From facial tissue to fine writing paper, Neenah pulp is the quality ingredient for a variety of paper products. Our pulp operations produce both bleached northern hardwood and softwood kraft pulp. The latter has exceptional tensile strength and low coarseness. In other words, it’s a high-quality pulp. 1. Before it became pulp, it was a tree growing in Neenah Paper’s Pictou, Nova Scotia, woodlands. And before it was a tree, it was a seedling growing in Neenah’s nursery facilities, part of Neenah’s Sustainable Forestry Initiative® (SFI) program. 2. Where does the pulp from Neenah’s pulp mills go? Some of it goes to Neenah’s paper mills, where it is turned into Neenah paper. 3. The majority of Neenah’s pulp production goes into the manufacture of tissue paper products. 4. If you ever wondered what wood chips used to make Neenah pulp look like – they look like this. 5. Things that people use in everyday living, like these rolls of masking tape, also use Neenah pulp. 1. From facial tissue to fine writing paper, Neenah pulp is the quality ingredient for a variety of paper products. Our pulp operations produce both bleached northern hardwood and softwood kraft pulp. The latter has exceptional tensile strength and low coarseness. In other words, it’s a high-quality pulp. 1. Before it became pulp, it was a tree growing in Neenah Paper’s Pictou, Nova Scotia, woodlands. And before it was a tree, it was a seedling growing in Neenah’s nursery facilities, part of Neenah’s Sustainable Forestry Initiative® (SFI) program. 2. Where does the pulp from Neenah’s pulp mills go? Some of it goes to Neenah’s paper mills, where it is turned into Neenah paper. 3. The majority of Neenah’s pulp production goes into the manufacture of tissue paper products. 4. If you ever wondered what wood chips used to make Neenah pulp look like – they look like this. 5. Things that people use in everyday living, like these rolls of masking tape, also use Neenah pulp. 1. 2005 Annual Report 7 PULP 4. 2. 3. 5. Neenah Paper, Inc.: UnFOLDING Sean T. Erwin Chairman of the Board, President and Chief Executive Officer, Neenah Paper, Inc. Edward Grzedzinski Former Chief Executive Officer, NOVA Information Systems Mary Ann Leeper, Ph.D. President and Chief Operating Officer, Female Health Company Timothy S. Lucas, CPA Independent Consultant, Lucas Financial Reporting Board of Directors Executive Team John F. McGovern Partner, Aurora Capital, LLC Former Executive Vice President and Chief Financial Officer, Georgia-Pacific Corporation Philip C. Moore Partner, McCarthy Tétrault, L.L.P. Stephen M. Wood, Ph.D. Independent Consultant, AFD Group, LLC Former Chief Executive Officer, Kraton Polymers Steven S. heinrichs Senior Vice President, General Counsel and Secretary Bonnie C. Lind Senior Vice President, Chief Financial Officer and Treasurer William K. O’Connor Senior Vice President, Sales and Marketing James r. Piedmonte Senior Vice President, Operations A Special Thanks On January 0, 2006, Neenah’s Board of Directors elected John F. McGovern to serve as a director of Neenah Paper to replace James G. Grosklaus who resigned from the Board on November 3, 2005. Jim, as a former Executive Vice President with Kimberly-Clark, had a tremendous knowledge of our businesses and was instrumental in their growth and success. We would like to express our sincere appreciation to Jim for his contributions in helping set our new company on the road to success. Annual Report 2005 9 10 Business Summary 14 Selected Financial Data 16 Management’s Discussion and Analysis of Financial Condition and Results of Operations 30 Quantitative and Qualitative Disclosures About Market Risk 33 Report of Management on Internal Control 34 Reports of Independent Registered Public Accounting Firm 36 Consolidated and Combined Statements of Operations 37 Consolidated Balance Sheets 38 Consolidated and Combined Statements of Changes in Stockholders’ and Invested Equity 39 Consolidated and Combined Statements of Cash Flows 40 Notes to Consolidated and Combined Financial Statements 71 Production Notes 10 Business Summary Overview packaging and heat transfer technical products markets. We are Neenah, a Delaware corporation, was incorporated in April also a global supplier of materials used to create customer 2004 in contemplation of the Spin-Off by Kimberly-Clark speciﬁ c components for furniture, book covers and original Corporation (“Kimberly-Clark”) of its Canadian pulp business equipment manufacturers’ products. Our customers are and its ﬁ ne paper and technical products businesses in the located in more than 35 countries and include 3M Company, United States (collectively, the “Pulp and Paper Business”). We Perfecseal, Avery Dennison Corporation and Saint-Gobain had no material assets or activities until Kimberly-Clark’s trans- Group. Our technical products manufacturing facility is located fer to us of the Pulp and Paper business on November 30, in Munising, Michigan. 2004. On that date, Kimberly-Clark completed the distribution Our pulp business primarily produces northern bleached of all of the shares of our common stock to the stockholders of softwood kraft pulp used by paper mills to manufacture tissue Kimberly-Clark (the “Spin-Off”). Kimberly-Clark stockholders and printing and writing papers. Our pulp business consists of received a dividend of one share of our common stock for mills located in Pictou, Nova Scotia and Terrace Bay, Ontario, every 33 shares of Kimberly-Clark common stock held. Based together with related timberlands. The Pictou mill is comprised of on a private letter ruling Kimberly-Clark received from the a single-line pulp facility, which produces primarily softwood pulp, Internal Revenue Service, receipt of our shares in the Spin-Off as well as timberlands encompassing approximately one million was tax-free for United States federal income tax purposes. acres of owned and 200,000 acres of licensed or managed land in Following the Spin-Off, we are an independent, public com- Nova Scotia. Timberland operations on land owned and licensed pany and Kimberly-Clark has no ownership interest in us. by the Pictou mill are provided by third-party contractors. In 2005, We are a leading North American producer of premium the Pictou mill produced approximately 265,000 metric tons of ﬁ ne papers and technical products. We also produce bleached bleached kraft pulp. kraft market pulp in Canada, where we own approximately one On May 1, 2005, we closed the smaller of two single-line million acres of timberlands and have non-exclusive rights to pulp mills at the Terrace Bay facility (the “No. 1 Mill”). The harvest wood off approximately 4.8 million acres of other tim- No. 1 Mill was originally constructed in 1948 and had annual berlands. We have three primary operations: our ﬁ ne paper capacity of approximately 125,000 tons of bleached kraft pulp. business, our technical products business and our pulp business. Following the closure of the No. 1 Mill, the Terrace Bay mill is Our ﬁ ne paper business is a leading producer of premium comprised of a single-line pulp facility, which produces primar- writing, text, cover and specialty papers used in corporate ily softwood pulp, and a timberlands operation. Terrace Bay annual reports, corporate identity packages, invitations, per- holds non-exclusive rights under a sustainable forest license sonal stationery and high-end packaging. Our products include to harvest wood off approximately 4.6 million acres of land some of the most recognized and preferred papers in North owned by the Province of Ontario. In 2005, the Terrace Bay America, where we enjoy leading market positions in many of mill produced approximately 375,000 metric tons of pulp, our product categories. We sell our products primarily to including approximately 45,000 metric tons at the No. 1 Mill. authorized paper distributors, converters and specialty busi- nesses. Our ﬁ ne paper manufacturing facilities are located in Neenah and Whiting, Wisconsin. Our technical products business is a leading producer of durable, saturated and coated base papers and ﬁ lms for a variety of end uses. We sell our technical products globally into 15 prod- uct categories, and we focus on categories where we believe we are a market leader or have a competitive advantage, which include, among others, the specialty tape, label, abrasive, medical Recent Developments In February 2006, we suspended pulp manufacturing activities at our Terrace Bay pulp mill as a result of a lack of wood ﬁ ber for its operations. The mill’s ﬁ ber supply has been exhausted as a result of a strike by the approximately 250 woodlands workers employed by our forestry operations that supply wood ﬁ ber to the mill (See “Employee and Labor Relations”). Pulp shipments will continue until the mill’s ﬁ nished goods inventory is exhausted. Neenah Paper, Inc.: UnFOLDING Annual Report 2005 11 Most of the approximately 400 hourly and salaried workers Technical Products Business. The technical products employed at the mill were laid off for an indeﬁ nite period dur- business is a leading producer of durable, saturated and ing the two weeks following the commencement of closure coated base papers and ﬁ lms for a variety of end uses, includ- activities. A small group of hourly and salaried employees will ing tapes, premask, abrasives, labels, medical packaging, remain at the facility for security operations, boiler and related decorative components and heat transfer papers. Net sales of equipment operation and maintenance during the warm shut- our technical products business were approximately $131 mil- down. An extended work stoppage at the mill could have a lion in 2005, $132 million in 2004 and $122 million in 2003. material impact on our liquidity and results of operations. KIMDURA®, MUNISING LP®, PREVAIL™ and NEENAH® Products Fine Paper Business. The ﬁ ne paper business manufactures and sells branded, world-class premium writing, text, cover and specialty papers used in corporate annual reports, corpo- rate identity packages, invitations, personal stationery and high-end packaging. Net sales of the ﬁ ne paper business were approximately $222 million in 2005, $221 million in 2004 and $210 million in 2003. Premium writing papers are used for business and personal stationery, corporate letterhead, corporate identity packages, private watermarked papers, envelopes and similar end-use appli- cations. Market leading writing papers are sold by the ﬁ ne paper business under the CLASSIC®, ENVIRONMENT®, NEENAH®, ATLAS® and OLD COUNCIL TREE® trademarks, which are denoted by a brand watermark in each sheet of writing paper. During 2005, we successfully introduced the EAMES™ Paper Collection which leveraged processes from both our ﬁ ne paper and technical product businesses to create three unique ﬁ n- ishes and 16 new colors inspired by the work of the designers Charles and Ray Eames. The ﬁ ne paper business also sells private watermarked and other custom-manufactured writing papers. Text and cover papers are used in applications such as corporate annual reports, corporate identity packages, insert advertising, direct mail, facility brochures, business cards, hang tags, scrapbooks, and a variety of other uses where colors, tex- tured ﬁ nishes or heavier weight papers are desired. Our brands in this category include CLASSIC®, CLASSIC CREST® and are brands of our technical products business. Products of the technical products business are typically sold to other manufacturers as a component of a ﬁ nished product. The technical products business sells its products into ﬁ ve major market segments – tape, premask, abrasives, label and medical packaging – and 10 other specialty segments. Several key market segments served, including tape and abra- sives, are global in scope. The technical products business produces tape base sheets from latex saturated crepe and ﬂ at papers and sells them to manufacturers to produce ﬁ nished pressure sensitive products for sale in automotive, automotive aftermarket, industrial gen- eral purpose, transportation, manufacturing and building construction applications. Premask paper is used as a protective over-wrap for products during the manufacturing process and for applying signs, labeling and other ﬁ nished products. The technical products business is a leading producer of latex saturated and coated abrasive backing papers for use by sandpaper manufacturers. The ﬁ nished lightweight sandpaper is sold in the automotive, automotive aftermarket, construc- tion, metal and woodworking industries for both waterproof and dry sanding applications. Label and tag products are produced from saturated (latex impregnated) base label stock and purchased synthetic (bi-axially stretched polypropylene ﬁ lm) base label stock. Top coatings are applied to the base label stock to allow for high-quality variable and digital printing. The synthetic label stock of the technical ENVIRONMENT®. We also sell a variety of custom paper col- products business is recognized as a high-quality, UV (ultra vio- ors, paper ﬁ nishes, and duplex/laminated papers. let) stable product used for outdoor applications. The business The ﬁ ne paper business produces and sells other specialty sells its label and tag stock to pressure sensitive coaters, papers, including translucent papers, art papers and papers for who in turn sell the coated label and tag stock to the label optical scanning and other specialized applications, under the printing community. UV/ULTRA® II trademark and other brands. 12 Business Summary The technical products business’s medical packaging Markets and Customers paper is a polymer impregnated base sheet that provides a Fine Paper Business. Premium papers are used primarily breathable sterilization barrier. When sealed together with ﬁ lm, for stationery and corporate identiﬁ cation applications and this paper becomes a medical packaging material that allows represent approximately 3% of the uncoated free sheet mar- sterilization from steam, ethylene oxide, or gamma radiation ket. The stationery segment of this market is divided into and at the same time provides unique barrier properties. cotton and sulﬁ te grades. The text and cover paper segment Decorative components papers, designed for durability of the market, used in corporate identiﬁ cation applications, is and ﬂ exibility, are made from light- and medium-weight latex split between smooth papers and textured papers. Text papers saturated papers. The base paper can be reinforced with syn- have traditionally been utilized for special, high-end collateral thetic ﬁ ber for additional tear strength. Coatings can also be material such as corporate brochures, annual reports and spe- applied for printability. A variety of different base weights, cial edition books. Cover papers are used as covers primarily colors and textures are available for sale to coater converters, for business cards, pocket folders, brochures and report cov- distributors, publishers and printers for use in book covers, ers, including annual corporate reports. stationery and fancy packaging. The ﬁ ne paper business sells its products through our Heat transfer papers are used to transfer an image from sales and marketing organizations primarily in three channels: paper to tee shirts, hats, coffee mugs, and other surfaces. The authorized paper distributors, converters and direct sales to technical products business produces and applies a proprietary specialty businesses. Distributor sales account for more than imaging coating to its heat transfer papers for use in digital 80% of our customer base in the ﬁ ne paper business, including printing applications. Heat transfer papers are primarily sold distributor-owned paper stores. There is also a small but grow- through large retail outlets and through master distributors ing sales channel in ofﬁ ce supply catalogs and business copy who then offer small quantity options and services to the large center stores, primarily to distributors in North America. Less number of customers in the supply channel. than 5% of the sales of our ﬁ ne paper business in 2005 were The technical products business also produces and sells exported to international distributors in Europe, South Africa, several other specialty papers including furniture backer, clean Asia and Australia. room paper and release paper. Sales to the ﬁ ne paper business’s two largest customers Pulp Business. Our pulp mills produce virgin northern (both of which are distributors) represented approximately bleached softwood and hardwood kraft pulp and various 35% of its total sales in 2005. We have limited our distribution blends of each for sale to paper mill customers located primar- agreements to improve our ability to control the marketing of ily in North America and Europe. In 2005, more than 75% of our our products. Although a complete loss of either of these cus- mills’ output was consumed by Kimberly-Clark and approxi- tomers would cause a temporary decline in the business’s sales mately 5% was used by our ﬁ ne paper and technical products volume, the decline could be partially offset by expanding businesses. The Pictou pulp mill’s major products are Pictou sales to existing distributors, and further offset over a several HARMONY® Softwood (northern bleached softwood kraft pulp) month period with the addition of new distributors. and Pictou Hardwood (northern bleached hardwood kraft pulp). Technical Products Business. The technical products The Terrace Bay mill’s major product is a fully bleached northern business relies on a direct sales team and marketing organiza- softwood kraft pulp used to manufacture publication, printing tion to sell its products into 15 separate market segments in and writing, specialty papers and tissue grades. The Terrace the U.S. and more than 35 export markets. Such segments, Bay operation also sells softwood and hardwood logs from its broadly deﬁ ned as polymer impregnated and synthetic paper, timberlands operations to sawmills and veneer manufacturers include papers used as components in the following applica- who, in turn, sell wood chips and sawdust to Terrace Bay. tions: saturated label, clean room papers, release papers, Net sales of our pulp business were approximately $401 abrasives, masking tape, decal premask, heat transfer, medical million in 2005, $449 million in 2004 and $405 million in 2003. packaging, decorative components, durable printing papers, Neenah Paper, Inc.: UnFOLDING Annual Report 2005 13 furniture components, washable tag and industrial compo- In 2005, Terrace Bay and Pictou produced about 335,000 nents. Our technical products business is recognized as a metric tons and 225,000 metric tons, respectively, of northern leading specialty paper manufacturer in the following market bleached softwood kraft pulp. In 2005, approximately 80% of segments: furniture components, washable tag, decal premask, our pulp mills’ northern bleached softwood kraft pulp produc- saturated label, clean room, saturated release paper, rein- tion was transferred to Kimberly-Clark. Our pulp mills have forced medical packaging and saturated abrasive backings. historically transferred more than 90% of their output of north- Several traditional products (abrasives, tapes, labels) are ern bleached softwood kraft pulp to Kimberly-Clark. used in markets that are directly affected by economic busi- In 2005, worldwide demand for northern bleached ness cycles. Other market segments such as heat transfer hardwood market pulp was estimated to be 18.1 million metric papers used in small/home ofﬁ ce and consumer applications tons of which an estimated 1.7 million metric tons were northern are relatively stable. Price competition is common in most of bleached hardwood kraft pulp produced in Canada. In 2005, the the segments served by the technical products business and United States consumed approximately 0.6 million metric tons of has increased due to a trend of using ﬁ lm and other lower cost Canadian northern bleached hardwood kraft pulp, followed by substrates instead of paper in some applications. Asia at 0.54 and Europe at 0.25 million metric tons. The technical products business relies on a team of direct In 2005, both our Terrace Bay and Pictou mills produced sales representatives and customer service representatives to about 40,000 metric tons of northern bleached hardwood kraft market and sell approximately 95% of its sales volume directly to pulp. In 2005, our pulp mills transferred approximately 50,000 customers and converters. Less than 5% of the sales of the tech- metric tons of northern bleached hardwood kraft pulp to nical products business are sold through industrial distributors. Kimberly-Clark and less than 10,000 metric tons to our ﬁ ne The technical products business has over 500 customers paper business. The balance of the pulp mills’ output of north- worldwide. The distribution of sales in 2005 was approximately ern bleached hardwood kraft pulp was sold to paper mills in 70% in North America, 15% in Europe and 15% in Latin the northeastern and midwestern United States. America and Asia. Customers typically convert and transform Northern bleached softwood kraft pulp and northern base papers and ﬁ lm into ﬁ nished rolls and sheets by adding bleached hardwood kraft pulp are commodity products whose adhesives, coatings and ﬁ nishes. Such transformed product is prices are subject to substantial increase or decrease depending then sold to end-users. on production capacity and customer demand. Northern Several of the smaller customers of the technical products bleached hardwood kraft pulp is subject to increasing competi- business are large multinational corporations with multiple tion, primarily from lower-priced South American eucalyptus pulp manufacturing locations. The primary global customers of the and excess capacity of northern bleached hardwood kraft pulp. technical products business are 3M Company, Perfecseal, Historically, our pulp mills have transferred their pulp Avery Dennison Corporation and Saint-Gobain Group. directly to Kimberly-Clark and used brokers for sales to external Pulp Business. Northern bleached softwood kraft pulp is customers. We will utilize our internal sales team to generate used by paper mills to manufacture tissue and printing and writ- sales to external customers. ing paper. In 2005, worldwide demand for northern bleached For the years ended December 31, 2005, 2004 and 2003, softwood kraft market pulp (which excludes pulp produced for we had pulp sales to Kimberly-Clark of $309 million, $351 mil- internal consumption by integrated pulp manufacturers) was lion and $305 million, respectively. No single customer, other estimated to be 13.0 million metric tons, of which about than Kimberly-Clark, accounted for more than 10% of our net 6.6 million metric tons were produced in Canada. Western sales in those years. Europe consumed an estimated 5.7 million metric tons of Geographic Information. For geographic information northern bleached softwood kraft pulp in 2005, followed by regarding the revenue and assets attributable to each of the prod- the United States at 2.9 million metric tons and China at 1.6 uct segments discussed above see Note 13 of the Consolidated million metric tons. and Combined Financial Statements appearing hereafter. 14 Selected Financial Data The following table sets forth our selected historical ﬁ nancial and liabilities of Kimberly-Clark’s ﬁ ne paper and technical products other data. You should read the information set forth below in businesses in the United States and its Canadian pulp business conjunction with “Management’s Discussion and Analysis of and give effect to allocations of expenses from Kimberly-Clark. Financial Condition and Results of Operations” and our historical For a description of these allocations, see Note 1 of the notes to consolidated and combined ﬁ nancial statements and the notes our audited historical consolidated and combined ﬁ nancial state- to those consolidated and combined ﬁ nancial statements ments included elsewhere in this Annual Report. The historical included elsewhere in this Annual Report. The statement of oper- ﬁ nancial and other data for periods prior to November 30, 2004 ations data for each of the years ended December 31, 2005, will not be indicative of our future performance, nor do they 2004 and 2003 and the balance sheet data as of December 31, reﬂ ect what our ﬁ nancial position and results of operations would 2005 and 2004 set forth below are derived from our audited his- have been had we operated as a separate, independent com- torical consolidated and combined ﬁ nancial statements included pany during the periods presented. elsewhere in this Annual Report. The statement of operations Prior to the Spin-Off, all of the operations of our pulp and data for the years ended December 31, 2002 and 2001 and the paper business were included in the consolidated income tax balance sheet data as of December 31, 2003 and 2002 set returns of Kimberly-Clark. Under the tax-sharing agreement, forth below are derived from our audited historical combined Kimberly-Clark will indemnify us for all income tax liabilities ﬁ nancial statements not included in this Annual Report. The bal- and retain rights to all tax refunds relating to operations in the ance sheet data as of December 31, 2001 set forth below are consolidated income tax returns for periods through the date derived from our unaudited historical combined ﬁ nancial state- of the Spin-Off. Accordingly, the combined balance sheets for ments not included in this Annual Report. 2003, 2002 and 2001 do not include current or prior period The consolidated and combined ﬁ nancial statements reﬂ ect income tax receivables or payables related to our operations, the consolidated operations of Neenah and its subsidiaries as a which were ﬁ led on a consolidated basis with Kimberly-Clark. separate, stand-alone entity subsequent to November 30, 2004. The income tax provisions were determined as if our business The historical ﬁ nancial and other data for periods through were a separate taxpayer. November 30, 2004 have been prepared on a combined basis from Kimberly-Clark’s consolidated ﬁ nancial statements using the historical results of operations and bases of the assets and Neenah Paper, Inc.: UnFOLDING Annual Report 2005 15 (dollars in millions except per share) Year Ended December 31, Consolidated and Combined Statement of Operations Data (a) Net sales Cost of products sold Gross proﬁ t Selling, general and administrative expenses Restructuring costs and asset impairment loss (b) (c) 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 basic share (d) Earnings (loss) per diluted share (d) Other Financial Data (c) Net cash ﬂ ow provided by (used in): Operating activities Investment activities Financing activities Capital expenditures Ratio of earnings to ﬁ xed charges (e) 2005 2004 2003 2002 2001 $ 733.4 655.9 77.5 53.2 59.8 (4.7) (30.8) 18.2 (49.0) (19.3) $ (29.7) $ (2.02) $ (2.02) $ 22.8 (25.8) (3.6) 25.7 (e) $ 772.1 647.9 124.2 45.8 112.8 5.5 (39.9) 1.4 (41.3) (14.9) $ (26.4) $ (1.79) $ (1.79) $ 76.0 (19.1) (37.8) 19.1 (e) $ 710.3 602.4 107.9 34.6 – 10.0 63.3 – 63.3 24.4 $ 38.9 $ 2.64 $ 2.64 $ 73.6 (23.6) (50.0) 24.4 71.3x $ 702.0 570.4 131.6 33.6 – (1.3) 99.3 – 99.3 37.0 $ 62.3 $ 4.23 $ 4.23 $ 111.8 (16.0) (95.8) 18.4 125.1x $ 744.0 601.2 142.8 37.2 – (4.5) 110.1 – 110.1 35.5 $ 74.6 $ 5.06 $ 5.06 $ 145.2 (26.1) (119.1) 29.1 123.3x (dollars in millions) As of December 31, Consolidated and Combined Balance Sheet Data (c) Working capital Total assets Long-term debt Total liabilities Total stockholders’ and invested equity 2005 2004 2003 2002 2001 $ 123.9 537.0 226.3 371.7 165.3 $ 116.4 557.3 225.0 360.2 197.1 $ 101.7 592.0 – 158.3 433.7 $ 98.4 540.3 – 146.6 393.7 $ 114.1 602.0 – 151.9 450.1 (a) As noted elsewhere in this Annual Report, for periods prior to the Spin-Off, our historical ﬁ nancial results will not be indicative of our future performance, nor do they reﬂ ect what our ﬁ nancial position and results of operations would have been had we operated as a separate, independent company during the peri- ods presented. (b) In 2005, we recorded a $53.7 million pre-tax non-cash impairment loss to write off the carrying value of the Terrace Bay facility’s tangible long-lived assets. In addition, we recorded a $6.1 million pre-tax charge for exit costs in connection with the closure of the smaller of the two single-line pulp mills at our Terrace Bay facility. The charge included $5.0 million for one-time termination beneﬁ ts related to early retirement, severance and deﬁ ned beneﬁ t pension plans, $0.3 for other associated exit costs and $0.8 million for a non-cash asset impairment loss (See Management’s Discussion and Analysis of Financial Condition and Results of Operations – Asset Impairment Loss). (c) In 2004, we recorded a $112.8 million pre-tax, non-cash impairment loss to reduce the carrying amount of the Terrace Bay facility (See Management’s Discussion and Analysis of Financial Condition and Results of Operations – Asset Impairment Loss). (d) As a result of the net loss in 2005 and 2004, 48,000 and 61,000 incremental shares, respectively, resulting from the assumed exercises of “in-the-money” stock options and 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. For 2003, 2002 and 2001, basic and diluted earnings per share were computed using the number of shares of Neenah common stock outstanding at the Spin-Off date. (e) For purposes of determining the ratio of earnings to ﬁ xed charges, earnings consist of income before income taxes (less interest) plus ﬁ xed charges. Fixed charges consist of interest expense, including amortization of debt issuance costs, and the estimated interest portion of rental expense. For the years ended December 31, 2005 and 2004, our earnings were insufﬁ cient to cover ﬁ xed charges by $49.0 million and $41.3 million, respectively. 16 Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis presents the factors that market pulp in Canada, where we own approximately one million had a material effect on our results of operations during the years acres of timberlands and have non-exclusive rights to harvest ended December 31, 2005, 2004 and 2003. 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 statements and the notes to those consoli- dated and combined ﬁ nancial statements included elsewhere in this Annual Report. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains wood off approximately 4.8 million acres of other timberlands. We have three primary operations: our ﬁ ne paper business, our technical products business and our pulp business. In managing this diverse pulp and paper business, management believes that achieving and maintaining a leader- ship position for its ﬁ ne paper and technical products businesses, forward-looking statements. See “Forward-Looking Statements” responding effectively to competitive challenges, employing for a discussion of the uncertainties, risks and assumptions capital optimally, controlling costs, and managing currency and associated with these statements. I N T R O D U C T I O N 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. This Management’s Discussion and Analysis of Financial Market Leadership. Achieving and maintaining leadership Condition and Results of Operations is intended to provide for our ﬁ ne paper and technical products businesses have investors with an understanding of the historical performance been an important part of our past performance. We have long of our business, its ﬁ nancial condition and its prospects. The been recognized as a leading manufacturer of world class pre- results of operations of our business after the Spin-Off are and mium writing, text and cover papers used in corporate annual will continue to be signiﬁ cantly different from the results of reports, corporate identity packages, invitations, personal operations of our business prior to the Spin-Off. This difference stationery and high-end packaging. Maintaining our leadership results from, among other things, the prices at which we sell is important to our results, particularly in light of the competi- pulp to Kimberly-Clark after the Spin-Off, which are signiﬁ - tive environment in which we operate. cantly different from the prices reﬂ ected in transfers of pulp to Competitive Environment. Our past results have been and other Kimberly-Clark operations prior to the Spin-Off; interest future prospects will be signiﬁ cantly affected by the competi- expense of new long-term debt and incremental selling; gen- tive environment in which we operate. We experience intense eral and administrative expenses related primarily to reduced competition for sales of our principal products in our major economies of scale as a result of operating on a stand-alone markets. Our paper business competes directly with well- basis. We will discuss and provide our analysis of the following: known competitors, some of which are larger and more (cid:129) Overview of Business; (cid:129) Business Segments; diversiﬁ ed in most of our markets. In our pulp business, we have experienced, and will continue to experience, intense (cid:129) Separation from Kimberly-Clark; competition from suppliers of softwood pulps and southern (cid:129) Results of Operations and Related Information; hemisphere suppliers of hardwood pulps. We expect our (cid:129) Liquidity and Capital Resources; and competitors to continue to be aggressive in the future. (cid:129) Critical Accounting Policies and Use of Estimates. Cost Control. To improve and maintain our competitive O V E R V I E W O F B U S I N E S S position, we must control our raw material, manufacturing, dis- tribution and other costs. A signiﬁ cant share of our investments in capital improvements are intended to achieve cost savings We are a leading North American producer of premium ﬁ ne and improvements in productivity. papers and technical products. We also produce bleached kraft Neenah Paper, Inc.: UnFOLDING Annual Report 2005 17 Cyclical Nature of the Pulp Industry. Revenues in the Foreign Currency and Commodity Risk. Sales of pulp by pulp industry and our pulp business tend to be cyclical, with our Canadian manufacturing facilities are invoiced in U.S. dol- periods of shortage and rapidly rising market prices leading lars in accordance with industry practice; therefore, no currency to increased production and increased industry investment effects are presented in our analysis of the change in net sales until supply exceeds demand. Those periods are then typically for our pulp operations. However, we are exposed to changes followed by periods of reduced market prices and excess in foreign currency exchange rates because most of the costs and idled capacity until the cycle is repeated. relating to our pulp business are incurred in Canadian dollars. General Economic Conditions. The markets for all of our These risks could have a material impact on our results of products are affected to a signiﬁ cant degree by general economic 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 2002 2003 2004 2005 Exchange Rate History: Average Quarterly Exchange Rates value of Canadian dollar versus 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 2002 2003 2004 2005 18 Management’s Discussion and Analysis of Financial Condition and Results of Operations B U S I N E S S S E G M E N T S operation. Terrace Bay holds non-exclusive rights under a 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, personal stationery and high-end packaging. Our products include some of the most rec- ognized 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, con- verters and specialty businesses, with sales to distributors and distributor owned paper stores accounting for approximately 85% of 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 products business is a leading producer of durable, saturated and coated base papers and ﬁ lms for a vari- ety of end uses. We sell our technical products globally into 15 product categories, 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 technical products 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 more than 35 countries and include 3M Company, Perfecseal, Avery Dennison Corporation and Saint-Gobain Group. Our technical products 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 2005, the Pictou mill produced approximately 255,000 metric tons of bleached kraft pulp. In May, 2005, we closed the smaller of the two single-line pulp facilities at Terrace Bay (the “No. 1 Mill”). Following the closure of the No.1 Mill, the Terrace Bay mill is comprised of a single-line pulp facility which produces primarily softwood pulp and a timberlands sustainable forest license to harvest wood off approximately 4.6 million acres of land owned by the Province of Ontario. In 2005, the Terrace Bay mill produced approximately 375,000 metric tons of pulp, including approximately 45,000 metric tons produced by the No. 1 Mill. S E PA R AT I O N F R O M K I M B E R LY- C L A R K 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 independent public company, and Kimberly-Clark has no continuing ownership interest in us. Prior to the Spin-Off, we entered into several agreements 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 matters agree- ment 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 products 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 cap- tive pulp producer to a market supplier of pulp. The corporate 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 relating 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. Neenah Paper, Inc.: UnFOLDING Annual Report 2005 19 R E S U LT S O F O P E R AT I O N S A N D Canadian laws, if the work stoppage continues through May R E L AT E D I N F O R M AT I O N 2006, we will be required to make payments to laid-off workers 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 infor- mation relevant to an understanding of our results of operations for the years ended December 31, 2005, 2004 and 2003. Executive Summary: of approximately $8 million in the second quarter of 2006. Additional payments of from one to three times that amount could be required dependent upon, among other things, the duration of the work stoppage. We will continue to incur certain operating costs for the mill during the work stoppage, including costs for a limited number of hourly and salaried employees who will remain at the facility for security operations, boiler and related equipment operation and maintenance during the win- Our operating results were adversely affected by asset ter months. In addition, pulp shipments will continue until the impairment losses in each of 2005 and 2004 and restructuring mill’s ﬁ nished goods inventory is exhausted. activities in 2005 at our Terrace Bay facility. In May 2005, we Pursuant to the terms of our pulp supply agreement closed the No. 1 Mill at the Terrace Bay facility following a with Kimberly-Clark, during the continuance of a “Terrace Bay strategic review of the facility’s operations which indicated Force Majeure Event,” or a different “Force Majeure Event” that the No. 1 Mill’s small scale and high cost did not justify (as deﬁ ned in the Pulp Supply Agreement), we are generally the investment necessary to make it competitive in the global excused, without penalty, from our obligations to supply and pulp market. In December 2004 and 2005, we recorded pre- Kimberly-Clark is excused, also without penalty, from its com- tax non-cash asset impairment losses of $112.8 million and mitments to purchase pulp under the pulp supply agreement $53.7 million, respectively, that in total reduced the carrying during the continuance, and to the extent of, such event. A value of the Terrace Bay facility’s long-lived assets to zero (see strike, labor disturbance and other events beyond our control Note 12 of Notes to Consolidated and Combined Financial are considered force majeure events under the pulp supply Statements included elsewhere in this Annual Report). agreement if such events ultimately prevent us from supplying Excluding the impact of the restructuring activities contractually agreed upon quantities of pulp to Kimberly-Clark. and asset impairment losses, operating results in 2005 were We have suspended substantially all capital expenditures unfavorable to the prior year primarily due to the continued at Terrace Bay for the duration of the work stoppage. We have strength of the Canadian dollar relative to the U.S. dollar, planned capital expenditures for 2006 of approximately $30 to increased discounts on pulp sales to Kimberly-Clark pursuant $35 million. The timing and amount of actual capital expendi- to our pulp purchase agreement, costs related to our opera- tures in 2006 will depend on, among other things, the outcome tion as a stand-alone company and higher raw material and of negotiations with the labor union (See “Management’s energy costs, partially offset by higher selling prices. Discussion and Analysis of Financial Condition and Results In February 2006, we suspended pulp manufacturing activi- of Operations – Liquidity and Capital Resources”). ties at our Terrace Bay pulp mill as a result of a lack of wood ﬁ ber Availability under our revolving credit facility ﬂ uctuates for its operations. The mill’s ﬁ ber supply has been exhausted as a over time depending on the value of our inventory, receivables result of a strike by the approximately 250 unionized woodlands and various capital assets. An extended work stoppage could workers employed by our forestry operations that supply wood result in a decrease in the value of the assets securing our credit ﬁ ber to the mill. facility and a reduction in availability under the revolving credit Most of the approximately 400 hourly and salaried workers facility. An extended work stoppage at the mill could have a employed at the mill were laid off for an indeﬁ nite period dur- material impact on our liquidity and results of operations. ing the two weeks following the commencement of closure activities. Pursuant to the terms of our labor agreements and 20 Management’s Discussion and Analysis of Financial Condition and Results of Operations Analysis of Net Sales – Years Ended December 31, 2005, 2004 and 2003 Our ﬁ ne paper business net sales increased $1.5 million, or 0.7%, primarily due to higher average net selling prices, The following table presents net sales by segment, expressed as partially offset by lower product mix. Favorable pricing was pri- a percentage of total net sales before intersegment eliminations: marily due to realization of a price increase for most branded Year Ended December 31, 2005 2004 2003 Fine Paper Technical Products Pulp Consolidated 30 % 17 53 28 % 16 56 100 % 100 % 29 % 16 55 100 % The following table presents our net sales by segment for the periods indicated: (in millions) Year Ended December 31, Fine Paper Technical Products Pulp Intersegment sales Consolidated Commentary: Year 2005 versus 2004 2005 2004 2003 $ 222.3 130.6 400.7 (20.2) $ 733.4 $ 220.8 132.3 448.6 (29.6) $ 772.1 $ 210.4 121.6 405.1 (26.8) $ 710.3 Change in Net Sales Versus Prior Year Change Due To Total Change Net Volume Product Price Mix $ 1.5 $ (0.2) $ 3.3 $ (1.6) (1.7) (47.9) 3.7 (52.0) 2.1 (16.5) (7.5) 20.6 9.4 $ (38.7) – $ (48.5) – $ (11.1) 9.4 $ 20.9 Fine Paper Technical Products Pulp (a) Intersegment sales Consolidated (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. Consolidated net sales decreased $38.7 million, or 5.0%, in 2005 compared with 2004 primarily due to lower pulp vol- ume and higher discounts on pulp shipments to Kimberly-Clark, products implemented in December 2004 and an additional increase for selected branded products in the third quarter of 2005. Product mix decreased as a result of shipping a higher proportion of lower-priced grades. Unit volumes were essentially unchanged from the prior year while the uncoated free sheet market decreased approximately 3% in 2005. Our technical products business net sales decreased $1.7 million, or 1.3%, as 3% growth in unit volumes and favorable product pricing was more than offset by lower heat transfer ship- ments and a product mix with a higher proportion of relatively lower priced premask and tape volume. The volume improve- ment reﬂ ected strong growth in sales of premask and tape products partially offset by reduced label shipments. Favorable average net selling prices were due to realization of a price increase implemented in the fourth quarter of 2004 and a sur- charge implemented in the third quarter of 2005 to recover increased costs for oil-based latex. Sales and mix were adversely affected by reduced heat transfer shipments related to our termi- nation of a distribution agreement and the shift in sales volumes. Our pulp business net sales decreased $47.9 million, or 10.7%, primarily due to lower shipment volumes and higher discounts on pulp shipments to Kimberly-Clark, partially offset by a shift in product mix to a higher proportion of softwood pulp shipments. Pulp shipment volume was 11% lower than the prior year due to the closure of the No. 1 Mill and, to a lesser extent, extended downtime at the Terrace Bay mill to replenish wood chip inventories. Average net selling prices were unfavorable to the prior year as marginally higher aver- age market prices for softwood pulp were more than offset by higher discounts (approximately $27.4 million) on shipments to Kimberly-Clark pursuant to our pulp supply agreement. Product mix increased from the prior year due to a higher pro- portion of softwood shipments and increased sales of logs to partially offset by improvement in pulp product mix. sawmills and veneer manufacturers. Neenah Paper, Inc.: UnFOLDING Annual Report 2005 21 Year 2004 versus 2003 Change in Net Sales Versus Prior Year Change Due To subsequent to the Spin-Off (in December 2004) were reduced by $12.9 million or 3.2% of total 2003 pulp revenues, reﬂ ecting the one-time effect of revised sales terms in the new pulp sup- ply agreement with Kimberly-Clark which transfers title at Total Change Net Volume Product Price Mix product delivery rather than shipment date. $ 10.4 $ 15.2 $ (1.1) $ (3.7) The following table sets forth line items from our consoli- Fine Paper Technical Products Pulp (a) Intersegment sales Consolidated 10.7 43.5 8.5 (9.2) (0.5) 53.1 2.7 (0.4) (2.8) $ 61.8 – $ 14.5 – $ 51.5 (2.8) (4.2) $ (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. Consolidated net sales increased $61.8 million, or 8.7%, in 2004 compared with 2003 primarily due to higher average market prices for softwood and hardwood pulp and unit volume growth in the ﬁ ne paper and technical products businesses. Our ﬁ ne paper business net sales increased $10.4 million, or 4.9%, primarily due to 7% growth in unit volumes. Unit 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 products business net sales increased $10.7 million, or 8.8%, primarily due to 7% growth in unit vol- umes. 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 volumes 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 dated and combined statements of operations as a percentage of net sales for the periods indicated and is intended to pro- vide a perspective of trends in our historical results: Year Ended December 31, 2005 2004 2003 Net sales Cost of products sold Gross proﬁ t Selling, general and administrative expenses Restructuring costs and 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 % 89.4 10.6 100.0 % 83.9 16.1 100.0 % 84.8 15.2 7.3 5.9 8.2 14.6 (0.7) (4.2) 2.5 0.7 (5.1) 0.2 (6.7) (5.3) 4.9 – 1.4 8.9 – 8.9 (2.6) (4.1)% (1.9) (3.4)% 3.4 5.5 % Analysis of Operating Income (Loss) – Years Ended December 31, 2005, 2004 and 2003 The following table sets forth our pre-tax income (loss) by seg- ment for the periods indicated: (in millions) Year Ended December 31, Fine Paper Technical Products Pulp Unallocated corporate costs Total 2005 2004 2003 $ 58.4 10.5 (93.2) $ 67.0 21.9 (120.5) $ 63.2 16.6 (16.5) (6.5) $ (30.8) (8.3) $ (39.9) – $ 63.3 22 Management’s Discussion and Analysis of Financial Condition and Results of Operations Commentary: Year 2005 versus 2004 Fine Paper Technical Products Pulp (a) Unallocated corporate costs Consolidated Change in Operating Income Versus Prior Year Total Change $ (8.6) (11.4) 27.3 1.8 $ 9.1 Volume $ $ (0.1) 0.8 (7.0) – (6.3) Net Price (b) $ (0.2) (1.5) (12.2) – $ (13.9) Change Due To Material and Energy Costs (c) Currency Other (d) $ (4.3) (6.4) (11.5) – $ (22.2) $ – – (15.9) – $ (15.9) $ (4.0) (4.3) 73.9 1.8 $ 67.4 (a) The operating loss for our pulp business in 2005 and 2004 includes restructuring costs and asset impairment losses of $59.8 million and $112.8 million, respectively. (b) Includes price changes, net of pulp discounts and changes in product mix. (c) Includes price changes for raw materials and energy. (d) Includes restructuring costs, annual maintenance-related downtime spending, other materials, manufacturing labor, distribution and selling, general and administrative expenses. Our operating loss of $30.8 million in 2005 decreased branded product price increases implemented in December $9.1 million versus the prior year period. Excluding Restructuring 2004 and the third quarter of 2005. costs and asset impairment losses related to our Terrace Operating income for our technical products business Bay mill of $59.8 million and $112.8 million, in 2005 and decreased $11.4 million due to higher manufacturing costs, 2004 respectively, operating results in the current year were costs associated with our operation as a stand-alone company $43.9 million unfavorable to 2004. Higher raw material and and lower average net selling prices, partially offset by favor- energy costs, unfavorable currency translation effects related to able volume. The increase in manufacturing costs was primarily the strengthening of the Canadian dollar compared to the U.S. due to higher costs for oil-based latex and increased utility dollar, higher discounts on pulp sales to Kimberly-Clark and costs related to higher coal prices. Net price was unfavorable costs associated with our operation as a stand-alone company as higher average prices were more than offset by lower heat were the primary drivers of the unfavorable comparison. transfer shipments and the shift in product mix to selling a Operating income for our ﬁ ne paper business decreased higher proportion of relatively lower priced premask and tape $8.6 million primarily due to increased manufacturing and products. Volume was favorable to the prior year primarily due distribution costs and costs associated with our operation as to the strong growth in premask sales. a stand-alone company. The increase in manufacturing costs Our pulp business incurred an operating loss of $93.2 million was primarily due to higher raw material prices including an in 2005, which was $27.3 million favorable to the prior year. 11% increase in average hardwood pulp prices, gas prices that Operating results for our pulp business were affected by increased more than 20% from the prior year and increased Restructuring costs and asset impairment losses related to costs for chemicals and dyes. The increase in distribution costs our Terrace Bay mill of $59.8 million and $112.8 million in 2005 was primarily due to an increase in fuel prices. In addition, net and 2004, respectively. Excluding the effect of Restructuring price was unfavorable to the prior year as an increase in the activities in both years, our pulp business recorded an operat- proportion of unbranded product sales more than offset ing loss of $33.4 million in 2005 which was $25.7 unfavorable Neenah Paper, Inc.: UnFOLDING Annual Report 2005 23 23 to the prior year. The unfavorable comparison to the prior beneﬁ ts of approximately $20.6 million and $40.8 million year was primarily due to higher discounts on pulp shipments were recorded in 2005 and 2004, respectively, as a result of the to Kimberly-Clark pursuant to our pulp supply agreement, impairment losses, resulting in net after-tax charges of approxi- unfavorable currency translation effects, increased ﬁ ber and mately $33.1 million and $72.0 million. The cumulative effect energy-related manufacturing costs and costs associated with of the impairment charges was to reduce the carrying value our operation as a stand-alone company. These unfavorable of the Terrace Bay facilities tangible long-lived assets to zero. factors were partially offset by lower maintenance spending, In May 2005, the No.1 Mill was closed and early retire- costs savings related to the closure of the No. 1 Mill and ment and severance packages were offered to approximately higher average market prices for softwood pulp. The decrease 150 employees. During 2005, we recorded approximately in maintenance spending was primarily due to reducing sched- $5.0 million for one-time termination beneﬁ ts related to early uled downtime at Terrace Bay. retirement, severance and deﬁ ned beneﬁ t pension plans in Restructuring Costs and Asset Impairment Losses In December 2005 and 2004, we recorded pre-tax, non-cash impairment losses of approximately $53.7 million and $112.8 million, respectively, to reduce the carrying amount of the Terrace Bay facility to its estimated fair value. Deferred tax Year 2004 versus 2003 connection with the closure of the mill and approximately $0.3 million for other exit costs. In addition, we recorded a pre-tax, non-cash asset impairment loss of approximately $0.8 million to write off the carrying value of the long-lived assets of the No. 1 Mill. Change in Operating Income Versus Prior Year Change Due To Total Change $ 3.8 5.3 (104.0) (8.3) $ (103.2) Volume $ 5.6 2.0 0.6 – $ 8.2 Net Price (b) $ (6.7) (1.5) 52.1 – $ 43.9 Material and Energy Costs (c) $ $ (2.0) (2.0) (5.6) – (9.6) Currency Other (d) $ – 1.5 (29.4) – $ (27.9) $ 6.9 5.3 (121.7) (8.3) $ (117.8) Fine Paper Technical Products Pulp (a) Unallocated corporate costs Consolidated (a) The operating loss for our pulp business in 2004 includes restructuring costs and asset impairment loss of $112.8 million. (b) Includes price changes, net of pulp discounts and changes in product mix. (c) Includes price changes for raw materials and energy. (d) Includes restructuring costs, annual maintenance-related downtime spending, other materials, manufacturing labor, distribution and selling, general and administrative expenses. Overall operating income decreased $103.2 million, and we programs. These gains were partially offset by higher costs for incurred an operating loss of $39.9 million in 2004 primarily due ﬁ ber, energy and other materials and a less proﬁ table product to the impairment loss for Terrace Bay ($112.8 million pre-tax). mix. In addition, results in 2003 included charges of $1.1 mil- Our ﬁ ne paper business operating income increased $3.8 lion for a workforce reduction and $1.3 million for a write-off million primarily due to the higher sales volumes and improved of a paper machine. manufacturing operations and the beneﬁ ts of cost-reduction 24 Management’s Discussion and Analysis of Financial Condition and Results of Operations Our technical products business operating income increased none of Kimberly-Clark’s cash, cash equivalents, debt or inter- $5.3 million, or 31.9% due to improved manufacturing opera- est income or expense was allocated to the Pulp and Paper tions, higher sales volumes and favorable foreign currency effects. Business for periods prior to the Spin-Off. The improved manufacturing costs were due to increased produc- The effective tax beneﬁ t rate was 39.4% and 36.1% for the tivity, reduced waste and the beneﬁ ts of cost reduction programs. years 2005 and 2004, respectively. The increase in the beneﬁ t Our pulp business operating loss increased $104.0 million rate between 2005 and 2004 was primarily due to an increase in 2004 and we incurred an operating loss of $120.5 million pri- in the proportion of non-taxable income items to the pre-tax marily due to the impairment loss for Terrace Bay. Higher selling loss and generating a higher proportion of the pre-tax losses prices of 15% and 2% for softwood and hardwood pulp, respec- in tax jurisdictions with relatively higher marginal tax rates. The tively, were partially offset by unfavorable currency effects and effective tax rate in 2003 was 38.5%. The change in the effec- increased manufacturing costs. The higher costs resulted from tive beneﬁ t and tax rates in 2004 and 2003, respectively, was a 7% decrease in the average exchange rate for the U.S. dollar primarily due to lower state and local income taxes (see Note 4 relative to the Canadian dollar as well as higher ﬁ ber and main- of Notes to Consolidated and Combined Financial Statements tenance costs. included elsewhere in this Annual Report for a reconciliation of We incurred $8.3 million of corporate expenses in 2004, the annual effective tax rates). including approximately $4.5 million of one-time start-up costs relating to our becoming an independent public company and other post-Spin-Off costs to operate as a stand-alone com- pany. There were no comparable costs in 2003. Additional Statement of Operations Commentary: Selling, general and administrative expenses were $53.2 million, $45.8 million and $34.6 million for the years ended 2005, 2004 and 2003. We incurred $29.6 million of expenses in 2005 related to our operation as a stand-alone company following the Spin- Off, of which $22.2 million was reﬂ ected in selling, general and administrative expenses. The increase in selling, general and administrative expenses in 2004 versus 2003 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. In 2005, we incurred $18.2 million of net interest expense (including $2.0 million of amortization of debt issuance costs) primarily on our $225 million of senior notes. In 2004, we incurred $1.4 million of net interest expense on our $225 mil- lion of senior notes for the month of December (following the Spin-Off). Kimberly-Clark used a centralized approach to cash management and the ﬁ nancing of its operations. As a result, L I Q U I D I T Y A N D C A P I TA L R E S O U R C E S (in millions) Year Ended December 31, Net cash ﬂ ow provided by (used in): Operating activities Investment activities Financing activities Capital expenditures 2005 2004 2003 $ 22.8 (25.8) (3.6) 25.7 $ 76.0 (19.1) (37.8) 19.1 $ 73.6 (23.6) (50.0) 24.4 Operating Cash Flow Commentary Cash provided by operations of $22.8 million for the year ended December 31, 2005 decreased $53.2 million from 2004. This decrease was the result of lower earnings (excluding the non-cash effects of the Terrace Bay impairment loss and related deferred tax beneﬁ ts and depreciation) and higher income tax payments, partially offset by a decrease in our investment in operating working capital. The decrease in operating working capital was primarily due to lower accounts receivable, partially offset by a decrease in accounts payable related to the timing of payments following the Spin-Off. Cash provided by operations of $76.0 million for the year ended December 31, 2004 increased $2.4 million from 2003. This Neenah Paper, Inc.: UnFOLDING Annual Report 2005 25 increase was the result of increased earnings (excluding Financing Commentary: the non-cash effects of the Terrace Bay impairment loss and Our liquidity requirements are being provided by cash gener- related deferred tax beneﬁ ts and depreciation), partially offset ated from operations and short- and long-term borrowings. by a smaller decrease in operating working capital than 2003, Prior to the Spin-Off, our ﬁ nancing (net of cash transfers to as discussed below. Kimberly-Clark) was provided by Kimberly-Clark. During 2005, higher discounts on pulp shipments to In 2005, we ﬁ nanced the acquisition of our ERP software Kimberly-Clark and lower pulp volume resulted in lower ($3.6 million) through third-party ﬁ nancing payable over accounts receivable and reduced our investment in operating three years. We ﬁ nanced our current year insurance premiums working capital (excluding the effects of a stronger Canadian ($2.3 million) through the issuance of a short-term note. dollar relative to the U.S. dollar). Our reduced investment in Payments under the agreements for our ERP software and operating working capital due to lower accounts receivable insurance premiums in the current year were $1.1 million was partially offset by an increase of $7.6 million in inventories and $2.3 million, respectively. (excluding the effects of a stronger Canadian dollar relative We paid cash dividends of $0.40 per share or $5.9 million to the U.S. dollar). We built pulp ﬁ nished good inventories in 2005. to comply with contractually required safety stock levels as Management believes that the ability to generate cash from we transition to being a supplier of market pulp. During 2004, operations and our borrowing capacity under our revolving credit higher average selling prices for pulp resulted in signiﬁ cantly facility are adequate to fund working capital, capital spending higher accounts receivable and increased our investment in and other cash needs for the next 12 months. Our ability to gen- working capital at December 31, 2004 to $118.4 million. erate adequate cash from operations beyond 2006, however, will Investing Commentary: Capital spending in 2005 of $25.7 million was $6.6 million higher than the comparable prior year period. The increased spending was primarily for the acquisition and installation of enterprise resource planning (“ERP”) software and leasehold improvements at our new research and development center. We anticipate capital expenditures for 2006 will be approximately $30 to $35 million. The timing and amount of capital expenditures will depend on the outcome of negotia- tions with regulatory authorities and labor unions, the results of engineering studies and the remediation methods ultimately selected. These capital expenditures are not expected to have a material adverse effect on our ﬁ nancial condition, results of operations or liquidity. depend on, among other things, our ability to successfully imple- ment our business strategies and cost cutting initiatives, and to manage the impact of changes in pulp prices and currencies. We can give no assurance that we will be able to successfully imple- ment those strategies and cost cutting initiatives, or successfully manage our pulp pricing and currency exposures. Our ability to issue additional stock will be constrained because such an issuance of additional stock may cause the Spin-Off to be taxable to Kimberly-Clark under Section 355(e) of the Internal Revenue Code, and under the tax-sharing agreement, we would be required to indemnify Kimberly-Clark against that tax. 26 Management’s Discussion and Analysis of Financial Condition and Results of Operations Contractual Obligations The following table presents the total contractual obligations for which cash ﬂ ows are ﬁ xed or determinable as of December 31, 2005: (in millions) 2006 Unconditional purchase obligations $ 26.9 Long-term debt payments 1.2 Interest payments on long-term debt 16.7 Other postretirement beneﬁ t obligations Operating leases Open purchase orders Contributions to pension trusts Total contractual obligations 1.8 2.6 20.2 12.2 $ 81.6 2007 $ 26.7 1.3 16.7 2.0 1.6 – – $ 48.3 2008 2009 2010 $ 26.8 – 16.6 2.3 1.4 – – $ 47.1 $ 26.7 – 16.6 2.6 1.3 – – $ 47.2 $ 9.6 – 16.6 3.0 1.2 – – $ 30.4 Beyond 2010 $ 28.9 225.0 66.4 20.6 7.3 – – $ 348.2 Total $ 145.6 227.5 149.6 32.3 15.4 20.2 12.2 $ 602.8 The unconditional purchase obligations are for the purchase ations and require signiﬁ cant judgments with regard to estimates of raw materials, primarily wood chips. Although we are pri- used. These critical judgments relate to the reported amounts of marily liable for payments on the above operating leases and assets and liabilities, disclosure of contingent assets and liabilities, unconditional purchase obligations, based on historic operat- and the reported amounts of revenue and expenses. ing performance and forecasted future cash ﬂ ows, we believe The following summary provides further information our exposure to losses, if any, under these arrangements is about the critical accounting policies and should be read in not material. conjunction with the notes to the Consolidated and Combined The open purchase orders displayed in the table represent Financial Statements. We believe that the consistent applica- amounts we anticipate will become payable within the next year tion of our policies provides readers of Neenah’s ﬁ nancial for goods and services that we have negotiated for delivery. statements with useful and reliable information about our The above table includes future payments that we will operating results and ﬁ nancial condition. make for postretirement beneﬁ ts other than pensions. Those We have discussed the application of these critical account- amounts are estimated using actuarial assumptions, including ing policies with our Board of Directors and Audit Committee. expected future service, to project the future obligations. C R I T I C A L A C C O U N T I N G P O L I C I E S A N D U S E O F E S T I M AT E S 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 state- ments 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 consolidated ﬁ nancial statements are those that are important both to the presentation of ﬁ nancial condition and results of oper- Revenue Recognition We recognize sales revenue when all of the following have occurred: (1) delivery has occurred, (2) persuasive evidence of an agreement exists, (3) pricing is ﬁ xed or determinable, and (4) col- lection is reasonably assured. Delivery is not considered 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 designated free on board (“FOB”) shipping point. With the exception of pulp sales to Kimberly-Clark and certain other customers, our sales terms are FOB shipping point. For pulp sales to Kimberly-Clark and other customers that are designated FOB destination, revenue is recognized when the product is delivered to the customer’s delivery site. Sales are Neenah Paper, Inc.: UnFOLDING Annual Report 2005 27 reported net of allowable discounts and estimated returns. hedges are adjusted to fair value through other income. Fair value Reserves for cash discounts, trade allowances, credit losses and estimates are based on relevant market information, including sales returns are estimated using historical experience. current market rates and prices. The fair value estimates for deriv- Deferred Income Tax Assets As of December 31, 2005, we have recorded deferred income tax assets totaling $29.3 million related to temporary differ- ences, and we have established no valuation allowances against these deferred income tax assets. As of December 31, 2004, our net deferred income tax assets were $1.2 million. In deter- mining the need for valuation allowances, we consider many factors, including speciﬁ c taxing jurisdictions, sources of taxable ative instruments are provided to us by banks known to be high-volume participants in these markets. We document relation- ships between hedging instruments and hedged items, and link derivatives designated as cash ﬂ ow hedges to speciﬁ c forecasted transactions. We also assess and document, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash ﬂ ows associated with the hedged items. income, income tax strategies and forecasted earnings for Pension Beneﬁ ts the entities in each jurisdiction. A valuation allowance would In connection with the Spin-Off, and as set forth in the employee be recognized if, based on the weight of available evidence, matters agreement, obligations for Kimberly-Clark’s deﬁ ned ben- we conclude that it is more likely than not that some portion eﬁ t pension plans and deﬁ ned contribution retirement plans or all of the deferred income tax assets will not be realized. related to active and former employees of the Canadian pulp Prior to the Spin-Off, our operations were included in the operations and active employees of the U.S. paper operations consolidated income tax returns of Kimberly-Clark. Kimberly- became our responsibility. Kimberly-Clark retained the obligations Clark will indemnify us for all income tax liabilities and retain for former employees of the U.S. paper operations. A share of rights to all tax refunds for periods through the date of the pension assets related to active employees of the U.S. paper Spin-Off. Accordingly, the consolidated and combined balance operations were transferred from Kimberly-Clark’s pension plan to sheet for periods prior to the Spin-Off does not include current a new pension plan established by us. The new plan provides or prior period income tax receivables or payables related to substantially similar beneﬁ ts and credits our employees for service our operations, which were ﬁ led on a consolidated basis with earned with Kimberly-Clark. With respect to Canadian employ- Kimberly-Clark. For all periods, the income tax provisions have ees, we assumed the existing pension assets and obligations been determined as if we were a separate taxpayer. of the related Kimberly-Clark pension plans. Financial Instruments Cash and cash equivalents include all cash balances and highly liquid investments with an initial maturity of three months or less. We place our temporary cash investments with high credit quality ﬁ nancial institutions. We use derivative instruments to manage exposures to foreign currency and commodity price risks. We principally use foreign currency forward and pulp future contracts to hedge against these exposures. Derivative instruments are recorded on the balance sheet as assets or liabilities and measured at fair mar- ket value. Derivative instruments that have been designated as hedges of anticipated future cash ﬂ ows are marked-to-market through accumulated other comprehensive income (balance sheet adjustments) until such time as the related forecasted trans- actions affect earnings. Derivatives that are not designated as Our funding policy for qualiﬁ ed deﬁ ned beneﬁ t plans is to contribute assets to fully fund the accumulated beneﬁ t obli- gation. 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. Consolidated and combined pension expense for deﬁ ned beneﬁ t pension plans was $13.2 million, $10.7 million and $13.4 million for the years ended December 31, 2005, 2004 and 2003, respectively. In addition, in May 2005 we recognized a pre-tax charge of $1.6 million for a partial settlement of certain pension obligations related to the closure of the No. 1 Mill. Pension expense is calculated based upon a number of actuarial assump- tions applied to each of the deﬁ ned beneﬁ t plans. The 28 Management’s Discussion and Analysis of Financial Condition and Results of Operations weighted-average expected long-term rate of return on pension factors, including reduced pension liabilities arising from higher fund assets used to calculate pension expense in percents was discount rates used to calculate our pension obligations or 8.41, 8.50 and 8.50 for the years ended December 31, 2005, (iii) other actuarial gains, including whether such accumulated 2004 and 2003, respectively. The expected long-term rate of actuarial losses at each measurement date exceed the “corri- return on pension fund assets held by our (and prior to the Spin- dor” determined under Statement of Accounting Standards Off, Kimberly-Clark) pension trusts was determined based on (“SFAS”) 87, Employers’ Accounting for Pensions. several factors, including input from pension investment consul- The discount (or settlement) rate that is utilized for tants and projected long-term returns of broad equity and bond determining the present value of future pension obligations indices. Also considered were the plans’ historical 10-year and 15- generally is based in the U.S. on the yield reported for the year compounded annual returns. We anticipate that on average long-term AA-rated corporate bond indexes, converted to an the investment managers for our U.S. and Canadian plans will equivalent one-year compound basis. The weighted-average generate annual long-term rates of return of at least 8.0% and discount rate in percents was 5.20 and 5.75 at December 31, 8.5%, respectively. Our expected long-term rate of return on the 2005 and 2004, respectively. assets in the plans is based on an asset allocation assumption of Our consolidated pension expense of $13.2 million in about 60% with equity managers, with expected long-term rates 2005 is based on an expected weighted-average long-term of return of approximately 10%, and 40% with ﬁ xed income man- rate of return on assets of 8.41%, a weighted-average discount agers, with an expected long-term rate of return of about 6%. The rate of 5.75% and various other assumptions. Pension expense actual asset allocation is regularly reviewed and periodically rebal- beyond 2005 will depend on future investment performance, anced to the targeted allocation when considered appropriate. our contributions to the pension trusts, changes in discount Also, when deemed appropriate, hedging strategies are executed rates and various other factors related to the covered employees using index options and futures to limit the downside exposure in the plans. of certain investments by trading off upside potential above an The fair value of the assets in our deﬁ ned beneﬁ t plans acceptable level. Such hedging strategies were executed in 2005, increased to approximately $375 million at December 31, 2005 2004 and 2003. We evaluate our investment strategy and long- from about $329 million at December 31, 2004, primarily due term rate of return on pension asset assumptions at least annually. to investment gains, plan contributions and currency exchange Pension expense is estimated based on the fair value of effects exceeding payments for pension beneﬁ ts. Lower dis- assets rather than a calculated value that averages gains and count rates caused the projected beneﬁ t obligations of the losses (“Calculated Value”) over a period of years. Investment deﬁ ned beneﬁ t plans to exceed the fair value of plan assets by gains or losses represent the difference between the expected approximately $75 million at December 31, 2005, compared return, calculated using the fair value of the assets, and the with approximately $58 million at December 31, 2004. The accu- actual return, based on the fair value of assets. The variance mulated beneﬁ t obligation exceeded the fair value of plan assets between the actual and the expected gains and losses on pen- by about $5.4 million at the end of 2005. At the end of 2004, the sion assets is recognized in pension expense more rapidly than fair value of plan assets exceeded the accumulated beneﬁ t obli- it would be if a Calculated Value for plan assets was used. As gation by about $6.5 million. Contributions to pension trusts in of December 31, 2005, our plans had cumulative unrecognized 2005 were $20.3 million (including $1.6 million for special termi- investment losses and other actuarial losses of approximately nation beneﬁ ts related to the closure of the No. 1 Mill) compared $147.8 million. These unrecognized net losses may increase with $16.6 million in 2004. In addition, we made direct beneﬁ t our future pension expense if not offset by (i) actual investment payments of approximately $0.1 million in each of 2005, 2004 returns that exceed the assumed investment returns, (ii) other and 2003 for unfunded supplemental retirement beneﬁ ts. Neenah Paper, Inc.: UnFOLDING Annual Report 2005 29 Impairment between the fair value of the asset and its carrying amount. We Property, plant and equipment are tested for impairment in determine fair value based on an expected present value tech- accordance with SFAS 144, Accounting for the Impairment or nique in which multiple cash ﬂ ow scenarios that reﬂ ect a range Disposal of Long-Lived Assets, whenever events or changes in of possible outcomes and a risk free rate of interest are used to circumstances indicate that the carrying amounts of such long- estimate fair value. lived assets may not be recoverable from future net pre-tax cash The estimates and assumptions used in the impairment ﬂ ows. Impairment testing requires signiﬁ cant management judg- analysis are consistent with the business plans and estimates ment including estimating the future success of product lines, we use to manage our business operations. The use of differ- future sales volumes, growth rates for selling prices and costs, ent assumptions would increase or decrease the estimated fair alternative uses for the assets and estimated proceeds from value of the asset and would increase or decrease the impair- disposal of the assets. Impairment testing is conducted at the ment charge. Actual outcomes may differ from the estimates. lowest level where cash ﬂ ows can be measured and are indepen- See “Results of Operations and Related Information – dent of cash ﬂ ows of other assets. An asset impairment would Analysis of Operating Income (Loss) – Asset Impairment Loss” be indicated if the sum of the expected future net pre-tax cash for a summary of our asset impairment test on the Terrace Bay ﬂ ows from the use of the asset (undiscounted and without inter- pulp facility, which resulted in net pre-tax impairment losses of est charges) is less than the carrying amount of the asset. An approximately $54.5 million and $112.8 million in 2005 and impairment loss would be measured based on the difference 2004, respectively. 30 Quantitative and Qualitative Disclosures About Market Risk As a multinational enterprise, we are exposed to risks such as calculated by multiplying our net monetary asset or liability changes in commodity prices, foreign currency exchange rates, position by a 10% change in the exchange rate of the Canadian interest rates and environmental regulation. A variety of practices dollar versus the U.S. dollar. The results of this sensitivity test are employed to manage these risks, including operating and are presented in the following paragraph. ﬁ nancing activities and, where deemed appropriate, the use of As of December 31, 2005, a 10% unfavorable change in derivative instruments. Derivative instruments are used only for the exchange rate of the U.S. dollar against the Canadian dol- risk management purposes and not for speculation or trading. lar involving balance sheet transactional exposure would have Credit risk with respect to the counterparties is considered resulted in a net pre-tax loss of approximately $4 million. minimal in view of the ﬁ nancial strength of the counterparties. Finally, the translation of the balance sheets of our Canadian Presented below is a description of our most signiﬁ cant risks. operations from Canadian dollars into U.S. dollars also is sensitive Foreign Currency Risk Our results of operations and cash ﬂ ows are affected by changes in the Canadian dollar exchange rate relative to the U.S. dollar. Exchange rate ﬂ uctuations can have a material impact on our ﬁ nancial results because substantially all of our pulp mills’ expenses are incurred in Canadian dollars and our pulp revenues are denominated in U.S. dollars. In 2005, a hypothetical $0.01 increase in the Canadian dollar relative to the U.S. dollar, would have decreased our income before income taxes by approximately $5 million, excluding additional currency re-measurement losses. We use hedging arrangements to reduce our exposure to exchange rate ﬂ uctuations, although these arrangements could result in us incurring higher costs than we would incur without the arrangements. In 2005, we entered into a series of foreign cur- rency forward exchange contracts, designated as cash ﬂ ow hedges, of U.S. dollar denominated pulp sales. At December 31, to changes in the exchange rate of the U.S. dollar against the Canadian dollar. Consequently, we performed a sensitivity test to determine if changes in the exchange rate would have a sig- niﬁ cant effect on the translation of the balance sheets of our Canadian operations into U.S. dollars. These translation gains or losses are recorded as unrealized translation adjustments, or UTA, within stockholders’ equity. The hypothetical change in UTA is calculated by multiplying the net assets of our Canadian operations by a 10% change in the U.S.$/Canadian$ exchange rate. The results of this sensitivity test are presented in the fol- lowing paragraph. As of December 31, 2005, a 10% unfavorable change in the exchange rate of the U.S. dollar against the Canadian dollar would have decreased our stockholders’ equity by approximately $18 million. The hypothetical increase in UTA is based on the difference between the December 31, 2005 exchange rate and the assumed exchange rate. 2005 we had foreign currency contracts outstanding in a notional Commodity Risk amount of $213 million Canadian dollars. The fair value of the Pulp. Our results of operations, cash ﬂ ows and ﬁ nancial position contracts was $9.3 million U.S. dollars and was reﬂ ected on the are sensitive to the selling prices of wood pulp. Wood pulp balance sheet as an asset. The weighted average exchange is a commodity for which there are multiple other suppliers. rate for the foreign currency contracts at December 31, 2005 Typically, commodities businesses compete primarily on the was $0.820 U.S. dollars per Canadian dollar and the contracts basis of price and availability. The revenues from producing a extend through May 2007. commodity tend to be cyclical, with periods of shortage and Currency transactional exposures are also sensitive to rapidly rising prices leading to increased production and changes in the exchange rate of the U.S. dollar against the increased industry investment until supply exceeds demand. Canadian dollar. We performed a sensitivity test to quantify Those periods are then typically followed by periods of reduced the effects that possible changes in the exchange rate of the prices and excess and idled capacity until the cycle is repeated. U.S. dollar would have on our pre-tax income based on the The markets and proﬁ tability of pulp have been, and are transactional exposure at December 31, 2005. The effect is likely to continue to be, cyclical. Because our pulp business com- Neenah Paper, Inc.: UnFOLDING Annual Report 2005 31 petes primarily on the basis of price and availability, the ﬁ nancial we also obtain ﬁ ber harvested from timberland areas licensed to success of our pulp mills depends on their ability to produce others by these governments. There can be no assurance that pulp at a competitive cost. Accordingly, we must continuously the amount of ﬁ ber that we are allowed to harvest from these and effectively manage our cost structure and production licensed areas will not be decreased, or that our licenses will capacity to be able to respond effectively to business cycles continue to be renewed or extended by the governments on in the pulp industry. acceptable terms. In each of the areas where our Canadian pulp We use hedging arrangements to reduce our exposure mills are located, there is increasing competition for wood ﬁ ber to pulp price ﬂ uctuations, although these arrangements could from various other users. Changes in governmental practices and result in us incurring higher costs than we would incur without policies as they apply to us and to others from whom we obtain the arrangements. In 2005, we entered into a series of pulp ﬁ ber may result in less ﬁ ber being available, increased costs to futures contracts to hedge ﬂ uctuations in pulp prices through obtain the ﬁ ber and additional expense in meeting forestry stan- December 2006. At December 31, 2005, we had future con- dards. These results could have a material adverse effect upon tracts for 144,000 metric tons of pulp with a notional amount our ﬁ nancial position, liquidity and results of operations. of approximately $91 million. The fair value of the contracts In 2005, two suppliers provided over 70% of the wood chips was $1.2 million and was reﬂ ected on the balance sheet as a used by the Pictou mill and three suppliers provided approxi- liability. The weighted average price for the pulp futures con- mately 50% of the wood chips used by the Terrace Bay mill. While tracts at December 31, 2005 was $631 per metric ton. we believe that alternative sources of critical supplies, such as Based on 2005 shipment volume, a $10 per metric ton wood chips, would be available, disruption of our primary sources unfavorable change in the market price for northern bleached could create a temporary, adverse effect on product shipments. softwood kraft pulp (excluding the impact of volume and Also, an interruption in supply of single source specialty grade other discounts) would reduce pre-tax income by approxi- latex to our technical products business could disrupt and eventu- mately $6 million. ally cause a shutdown of production of certain technical products. Raw Materials. We purchase a substantial portion of the We generate substantially all of our electrical energy at the raw materials and energy necessary to produce our products Munising and Pictou mills and approximately one-half of the elec- on the open market, and, as a result, the price and other trical energy at the Terrace Bay mill. Availability of energy is not terms of those purchases are subject to change based on fac- expected to be a problem in the foreseeable future, but the pur- tors such as worldwide supply and demand and government chase price of such energy can and likely will ﬂ uctuate signiﬁ cantly regulation. We do not have signiﬁ cant inﬂ uence over our raw based on ﬂ uctuations in demand and other factors. In addition, material or energy prices and generally do not possess enough we have forward purchase contracts for natural gas through June power to pass increases in those prices along to purchasers of 2006. At December 31, 2005, we had future contracts for 373,000 our products, unless those increases coincide with increased MMBTUs of natural gas with a notional amount of approximately demand for the product. Therefore, an increase in raw material $3 million. The weighted average price for the natural gas futures or energy prices could occur at the same time that prices for contracts at December 31, 2005 was $9.01 per MMBTU. In our products are decreasing and have an adverse effect on January 2006, we entered into an agreement to purchase 350 our results of operations, ﬁ nancial position and cash ﬂ ows. million tons per year of “Green Steam” to supply energy at We obtain most of the wood ﬁ ber required for our Terrace our Neenah paper mill. We anticipate that the agreement will Bay pulp mill and a portion of the wood ﬁ ber required for the substantially reduce the mill’s annual consumption of natural gas. Pictou pulp mill from timberland areas licensed by the Ontario There is no assurance that we will be able to obtain electricity or and Nova Scotia provincial governments, respectively. These natural gas purchases on favorable terms in the future. governments have granted us non-exclusive licenses for Interest Rate Risk. We are exposed to interest rate risk on substantial timberland areas from which we obtain ﬁ ber, and our ﬁ xed rate long-term debt and our variable rate bank debt. 32 Quantitative and Qualitative Disclosures About Market Risk Our objective is to manage the impact of interest rate changes Environmental Regulation. Our manufacturing operations on earnings and cash ﬂ ows from our variable rate debt and are subject to extensive regulation by U.S. and Canadian authori- on the market value of our ﬁ xed rate debt. At December 31, ties. The company has made signiﬁ cant capital expenditures to 2005, we had $226.3 million of ﬁ xed rate long-term debt out- comply with environmental laws, rules and regulations. Due to standing and no variable rate borrowings outstanding under changes in environmental laws and regulations, the application our revolving credit agreement. We are exposed to ﬂ uctua- of such regulations and changes in environmental control technol- tions in the fair value of our ﬁ xed rate long-term debt resulting ogy, we are not able to predict with certainty the amount of future from changes in market interest rates, but not to ﬂ uctuations capital spending to be incurred for environmental purposes. in our earnings or cash ﬂ ows. At December 31, 2005, the fair Taking these uncertainties into account, we anticipate expendi- market value of our long-term debt was $200.3 million based tures for major environmental projects during the period 2006 upon the quoted market price of the senior notes. A 100 basis through 2010 will include approximately $20 million to reconﬁ g- point increase in interest rates would not affect our annual ure the efﬂ uent treatment system at the Pictou mill and between interest expense because at December 31, 2005, we had no $15 million and $25 million for equipment and engineering to variable rate borrowings outstanding. abate total sulphur emissions and for other environmental matters We could, in the future, reduce our exposure to interest at the Pictou and Terrace Bay mills, to remove and replace trans- rate ﬂ uctuations by entering into interest rate hedging arrange- formers containing polychlorinated biphenyls at the Terrace Bay ments, although those arrangements could result in us incurring mill, and to improve stream crossings in the timberlands licensed higher costs than we would incur without the arrangements. from the Province of Ontario. We believe that these risks can be managed and will not have a material adverse effect on our business or our consoli- dated ﬁ nancial position, results of operations or cash ﬂ ows. Report of Management on Internal Control 33 Management of the Company is responsible for establishing and maintaining effective internal control over ﬁ nancial reporting as deﬁ ned in Rules 13a -15(f) under the Securities Exchange Act of 1934. The Company’s internal control over ﬁ nancial reporting is designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published ﬁ nancial statements. Because of its inherent limitations, internal control over ﬁ nancial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to ﬁ nancial statement prepara- tion and presentation. Management assessed the effectiveness of the Company’s internal control over ﬁ nancial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. Based on our assessment, we believe that, as of December 31, 2005, the Company’s internal control over ﬁ nancial reporting is effective based on those criteria. Management’s assessment of the effectiveness of internal control over ﬁ nancial reporting as of December 31, 2005, has been audited by Deloitte & Touche, LLP, the independent registered public accounting ﬁ rm who also audited the Company’s consolidated ﬁ nancial statements. Deloitte & Touche’s attestation report on management’s assessment of the Company’s internal control over ﬁ nancial reporting is included herein. Neenah Paper, Inc. March 13, 2006 34 Report of Independent Registered Public Accounting Firm T O T H E B O A R D O F D I R E C T O R S A N D S T O C K H O L D E R S O F N E E N A H PA PE R , I N C . : We have audited the accompanying consolidated balance sheets of Neenah Paper, Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated and combined statements of operations, cash ﬂ ows and changes in stockholders’ and invested equity, of the Company and the Pulp and Paper Business of Kimberly-Clark Corporation (“Pulp and Paper Business”) for each of the three years in the period ended December 31, 2005. These consolidated and combined ﬁ nancial state- ments are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁ nancial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards as established by the Auditing Standards Board (United States) and in accordance with the auditing 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 state- ments are free of material misstatement. 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 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 ﬁ nancial statements present fairly, in all material respects, the ﬁ nancial position of the Company at December 31, 2005 and 2004, and the results of operations and cash ﬂ ows of the Company and the Pulp and Paper Business for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over ﬁ nancial reporting as of December 31, 2005, based on the criteria estab- lished in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2006 expressed an unqualiﬁ ed opinion on management’s assessment of the effectiveness of the Company’s internal control over ﬁ nancial reporting and an unqualiﬁ ed opinion on the effectiveness of the Company’s internal control over ﬁ nancial reporting. Atlanta, Georgia March 13, 2006 Report of Independent Registered Public Accounting Firm 35 T O T H E B O A R D O F D I R E C T O R S A N D S T O C K H O L D E R S O F N E E N A H PA PE R , I N C . : We have audited management’s assessment, included in the accompanying “Management’s Report on Internal Control Over Financial Reporting,” that Neenah Paper, Inc. and subsidiaries (the “Company”) maintained effective internal control over ﬁ nancial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over ﬁ nancial reporting and for its assessment of the effectiveness of internal control over ﬁ nancial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over ﬁ nancial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over ﬁ nancial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over ﬁ nancial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company’s internal control over ﬁ nancial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal ﬁ nancial ofﬁ cers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of ﬁ nancial reporting and the prepara- tion of ﬁ nancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over ﬁ nancial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reason- able detail, accurately and fairly reﬂ ect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁ nancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authori- zations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the ﬁ nancial statements. Because of the inherent limitations of internal control over ﬁ nancial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over ﬁ nancial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the poli- cies or procedures may deteriorate. In our opinion, management’s assessment that the Company maintained effective internal control over ﬁ nancial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over ﬁ nancial reporting as of December 31, 2005, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated ﬁ nancial statements as of and for the year ended December 31, 2005 of the Company and our report dated March 13, 2006 expressed an unqualiﬁ ed opinion on those ﬁ nancial statements. Atlanta, Georgia March 13, 2006 36 Consolidated and Combined Statements of Operations (in millions, except share and per share data) Year Ended December 31, Net Sales Cost of products sold Gross Proﬁ t Selling, general and administrative expenses Restructuring costs and 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 2005 733.4 655.9 77.5 53.2 59.8 (4.7) (30.8) 18.2 (49.0) (19.3) (29.7) (2.02) (2.02) $ $ $ $ 2004 772.1 647.9 124.2 45.8 112.8 5.5 (39.9) 1.4 (41.3) (14.9) (26.4) (1.79) (1.79) $ $ $ $ 2003 710.3 602.4 107.9 34.6 – 10.0 63.3 – 63.3 24.4 38.9 2.64 2.64 $ $ $ $ 14,739 14,739 14,738 14,738 14,738 14,738 Consolidated Balance Sheets 37 (in millions, except share data) December 31, ASSETS 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 LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities Debt payable within one year Accounts payable Accrued expenses Total Current Liabilities Long-Term Debt Noncurrent Employee Beneﬁ ts and Other Obligations Total Liabilities Commitments and Contingencies (Notes 9 and 10) Stockholders’ Equity Common stock, par value $0.01 – authorized: 100,000,000 shares; issued and outstanding: 14,766,203 shares and 14,763,319 shares Additional paid-in capital Treasury stock, at cost (2005 – 814 shares) Retained deﬁ cit Accumulated other comprehensive income Unearned compensation on restricted stock Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity See Notes to Consolidated and Combined Financial Statements 2005 2004 $ $ $ $ 12.6 79.1 87.1 1.7 23.8 204.3 213.0 4.9 27.6 71.7 15.5 537.0 1.2 40.4 38.8 80.4 226.3 65.0 371.7 0.1 219.4 – (106.3) 53.9 (1.8) 165.3 537.0 $ $ $ $ 19.1 92.4 79.5 1.2 11.4 203.6 257.6 5.2 – 72.9 18.0 557.3 – 50.6 36.6 87.2 225.0 48.0 360.2 0.1 218.3 – (70.7) 51.6 (2.2) 197.1 557.3 38 Consolidated and Combined Statements of Changes in Stockholders’ and Invested Equity (in millions, shares in thousands) 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 Restricted stock awards, less amortization Balance, December 31, 2004 Net loss Other comprehensive income Unrealized foreign currency translation Minimum pension liability Deferred gain on cash ﬂ ow hedges Dividends declared Vesting restricted stock units Stock-based compensation awards, less amortization Other (Note 6) 25 14,763 – – – – – 3 – – Common Stock Shares Amount Additional Paid-In Capital Kimberly- Clark’s Net Investment Unearned Accumulated Compensation Other Retained Comprehensive on Restricted Income (Loss) Deﬁ cit Stock $ 446.5 $ 38.9 – – – (50.0) 1.4 436.8 – – – – – – – – 44.3 (70.7) $ – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – 0.1 – 0.1 – – – – – – – – $ – – – – – – – – – – – – – – – – – 2.3 218.3 – – – – – – 0.4 0.7 – – – (37.6) (12.7) (1.8) (213.0) – – – – – – – – – – – – 216.0 (216.0) Comprehensive Income $ 38.9 59.7 (9.4) (0.6) $ 88.6 $ (26.4) 24.8 30.0 (0.1) $ 28.3 $ (29.7) 10.1 (12.5) 4.7 $ (27.4) $ (52.8) $ – 59.7 (9.4) (0.6) – – (3.1) – 24.8 30.0 (0.1) – – – – – – – – – – – – – – – – – (70.7) (29.7) 51.6 – – – – (5.9) – – – 10.1 (12.5) 4.7 – – – – – – – – – – – – – – – – – – – – – – (2.2) (2.2) – – – – – – 0.4 – Balance, December 31, 2005 14,766 $ 0.1 $ 219.4 $ See Notes to Consolidated and Combined Financial Statements $ (106.3) $ 53.9 $ (1.8) Consolidated and Combined Statements of Cash Flows 39 (in millions, except share data) Year Ended December 31, OPERATING ACTIVITIES Net income (loss) Adjustments to reconcile net income to net cash provided by operating activities 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 Accounts payable 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 Repayments of long-term debt Short-term borrowings Repayments of short term borrowings Cash dividends paid Spin-Off payment to Kimberly-Clark Net transfers to Kimberly-Clark Net Cash (Used in) Financing Activities Effect of Exchange Rate Changes on Cash and Cash Equivalents Net Increase (Decrease) 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 (to) from Kimberly-Clark (Note 6) Non-cash investing activities: Liability for equipment acquired See Notes to Consolidated and Combined Financial Statements 2005 2004 2003 $ (29.7) $ (26.4) $ 38.9 29.8 54.5 (20.1) 0.5 13.3 (7.6) (6.9) (10.1) (0.2) 1.4 (2.7) 0.6 22.8 (25.7) – (0.1) (25.8) 3.6 (0.2) (1.1) 2.5 (2.5) (5.9) – – (3.6) 0.1 (6.5) 19.1 $ 12.6 $ 15.8 $ 6.6 $ 0.7 36.0 112.8 (43.6) 3.1 (14.1) (9.4) 2.4 11.3 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 $ $ – – 35.3 – (8.2) 0.1 (3.6) (5.8) 0.5 2.1 3.6 13.5 (1.3) (1.5) 73.6 (24.4) 1.9 (1.1) (23.6) – – – – – – – (50.0) (50.0) – – – – – – $ $ $ $ (14.5) $ 1.4 $ (1.7) $ – $ – 40 Notes to Consolidated and Combined Financial Statements (dollars in millions, except as noted) 1. B A C K G R O U N D A N D B A S I S O F P R E S E N TAT I O N Background Neenah Paper, Inc. (“Neenah” or the “Company”), a Delaware 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 corporation, was incorporated in April 2004 in contemplation of the historical basis of assets and liabilities of the Pulp and Paper the spin-off by Kimberly-Clark Corporation (“Kimberly-Clark”) of its Canadian pulp business and its ﬁ ne paper and technical Business. Management believes the assumptions underlying the combined ﬁ nancial statements for these periods are reasonable. products businesses in the United States (collectively, the “Pulp However, the combined ﬁ nancial statements included herein for and Paper Business”). The Canadian pulp business consists of the Terrace Bay, Ontario pulp mill and the Pictou, Nova Scotia periods through November 30, 2004 are not indicative of the Pulp and Paper Business’ results of operations, ﬁ nancial position pulp mill and related timberlands. The ﬁ ne paper business is a and cash ﬂ ows in the future or what its results of operations, leading producer of premium writing, text, cover and specialty ﬁ nancial position and cash ﬂ ows would have been had the papers. The technical products business is a leading producer of durable, saturated and coated base papers and ﬁ lms for a Pulp and Paper Business been a stand-alone company during the periods presented. See Note 11 for a discussion of 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 stockholders received a dividend of one share of Neenah’s common stock for every 33 shares of Kimberly-Clark common stock held. Based on a private letter ruling received 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, 2004 because no direct ownership relationship existed among the entities that comprised the Pulp and Paper Business. Inter-company accounts between the Pulp and Paper Business and Kimberly- by Kimberly-Clark from the Internal Revenue Service, receipt of Clark are combined with “Kimberly-Clark’s net investment.” the Neenah shares in the Spin-Off was tax-free for U.S. federal As of November 30, 2004, the balance reﬂ ected in “Kimberly- income tax purposes. As a result of the Spin-Off, Kimberly-Clark Clark’s net investment” was transferred to “Additional paid-in transferred all of the assets and liabilities of the Pulp and Paper capital” of Neenah. “Retained deﬁ cit” reﬂ ected in the consoli- Business to Neenah. In addition, Kimberly-Clark transferred dated ﬁ nancial statements represents net losses beginning certain assets and liabilities of Kimberly-Clark sponsored December 1, 2004. employee beneﬁ t plans to the Company. Following the Spin-Off, Neenah is an independent 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 bal- ances and transactions have been eliminated in consolidation. The consolidated and combined ﬁ nancial statements reﬂ ect the consolidated operations of Neenah and its subsidiaries as a separate, stand-alone entity subsequent to November 30, 2004, combined with the historical operations of the Pulp and Paper Basic earnings (loss) per share (“EPS”) were computed by dividing net income (loss) by the number of weighted-average shares of common stock outstanding during 2005 and 2004. Diluted earnings (loss) per share were calculated to give effect to all potentially dilutive common shares applying the “Treasury Stock” method. Outstanding stock options, restricted shares and restricted stock units represent the only potentially dilutive effects on the Company’s weighted-average shares. Approximately 789,000 and 875,000 potentially dilutive options in 2005 and 2004, respectively, that were “out-of-the-money” were excluded from the computation of dilutive common shares. In addition, as Neenah Paper, Inc.: UnFOLDING Annual Report 2005 41 a result of net losses in 2005 and 2004, 48,000 and 61,000 Cash Payment to Kimberly-Clark incremental shares resulting from the assumed exercises of “in- On November 30, 2004, the Company made a Spin-Off payment the-money” stock options and vesting of restricted stock and of $213 million to a Kimberly-Clark subsidiary primarily from restricted stock units were excluded from the diluted earnings the proceeds of a $225 million principal amount senior note per share calculation, as the effect would have been anti-dilutive. offering (See Note 5). For 2003, basic and diluted EPS were computed using the number of shares of Neenah common stock outstanding on November 30, 2004, the date on which Neenah common stock was distributed to the stockholders of Kimberly-Clark. Prior to the Spin-Off, certain corporate, general and administrative expenses of Kimberly-Clark were allocated to the Pulp and Paper Business, using a three-factor formula com- prised of net sales, total assets and employee head count. In the opinion of management, such an allocation is reasonable. However, such expenses are not indicative of, nor is it practical or meaningful for management to estimate for all historical peri- ods 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 Income Taxes For periods prior to November 30, 2004, income tax provisions and related deferred tax assets and liabilities of the Pulp and Paper Business were calculated on a separate tax return basis. However, Kimberly-Clark managed its tax position for the ben- eﬁ t of its entire portfolio of businesses, and its tax strategies are not necessarily reﬂ ective of the tax strategies that the Pulp and Paper Business would have followed as a stand-alone entity. 2. S U M M A RY O F S I G N I F I C A N T A C C O U N T I N G P O L I C I E S includes information technology, accounting, cash management, Use of Estimates legal, tax, insurance and public relations. These expenses The preparation of ﬁ nancial statements in conformity with amounted to $0.5 million and $0.7 million in 2004 and 2003, accounting principles generally accepted in the United States respectively. Subsequent to November 30, 2004, the Company requires management to make estimates and assumptions that performed these functions using its own resources or purchased affect the reported amounts of assets and liabilities at the date of services, some of which were provided by Kimberly-Clark pursu- the ﬁ nancial statements and the reported amounts of net sales ant to a Corporate Services Agreement (See Note 11). and expenses during the reporting periods. Actual results could Kimberly-Clark used a centralized approach to cash man- differ from these estimates, and changes in these estimates are agement and the ﬁ nancing of its operations. Cash deposits from recorded when known. Signiﬁ cant management judgment is the Pulp and Paper Business prior to the Spin-Off were trans- required in determining the accounting for, among other things, ferred to Kimberly-Clark on a regular basis and were netted pension and postretirement beneﬁ ts, retained insurable risks, against Kimberly-Clark’s net investment account. Consequently, allowances for doubtful accounts, useful lives for depreciation and none of Kimberly-Clark’s cash, cash equivalents or debt was allo- amortization, future cash ﬂ ows associated with impairment testing cated to the Pulp and Paper Business in the combined ﬁ nancial for long-lived assets, income taxes and contingencies. statements for periods through November 30, 2004. Changes in Kimberly-Clark’s net investment represent any funding from Kimberly-Clark for working capital and capital expenditures after giving effect to the Pulp and Paper Business’ transfers to Kimberly-Clark of its cash ﬂ ows from operations. Revenue Recognition The Company recognizes sales revenue when all of the following have occurred: (1) delivery has occurred, (2) persuasive evidence of an agreement exists, (3) pricing is ﬁ xed or determinable, and (4) collection is reasonably assured. Delivery is not considered to have occurred until the customer takes title and assumes the risks and rewards of ownership. The timing of revenue 42 Notes to Consolidated and Combined Financial Statements recognition is largely dependent on shipping terms. Revenue instruments are provided to the Company by banks known to be is recorded at the time of shipment for terms designated free high-volume participants in these markets. The Company docu- on board (“FOB”) shipping point. With the exception of pulp ments relationships between hedging instruments and hedged sales to Kimberly-Clark and certain other customers, the items, and link derivatives designated as cash ﬂ ow hedges to Company’s sales terms are FOB shipping point. For pulp sales speciﬁ c forecasted transactions. The Company also assesses and to Kimberly-Clark and other customers that are designated documents, both at the hedge’s inception and on an ongoing FOB destination, revenue is recognized when the product is basis, whether the derivatives that are used in hedging transac- delivered to the customer’s delivery site. Sales are reported net tions are highly effective in offsetting changes in cash ﬂ ows of allowable discounts and estimated returns. Reserves for cash associated with the hedged items. Any hedge ineffectiveness is discounts, trade allowances, credit losses and sales returns are charged to expense in the period incurred. estimated using historical experience. Pursuant to the pulp supply agreement, sales terms to Kimberly-Clark subsequent to the Spin-Off were changed to 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. 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 labor, materials Shipping and Handling Costs and production overhead. Inventories of the Canadian pulp All amounts billed to customers in a sales transaction related operations include both roundwood (logs) and wood chips. to shipping and handling are recorded as revenue, and costs These inventories are located both at the pulp mills and at incurred by the Company for shipping and handling are various timberlands locations. In accordance with industry recorded as costs of products sold. practice, physical inventory counts utilize “scaling’ techniques Financial Instruments Cash and cash equivalents include all cash balances and highly liquid investments with an initial maturity of three months or less. The Company places its temporary cash investments with to estimate quantities of roundwood, as well as various elec- tronic devices to calculate wood chip inventory amounts. These techniques historically have provided reasonable esti- mates of such inventories. high credit quality ﬁ nancial institutions. Foreign Currency The Company uses derivative instruments to manage Balance sheet accounts of the Canadian pulp operations are exposures to foreign currency and commodity price risks. The translated from Canadian dollars into U.S. dollars at period- Company principally uses foreign currency forward and pulp end exchange rates, and income and expense are translated at future contracts to hedge against these exposures. Derivative average exchange rates during the period. Translation gains or instruments are recorded on the balance sheet as assets or lia- losses related to net assets located in Canada are shown as a bilities and measured at fair market value. Derivative instruments component of accumulated other comprehensive income (loss) that have been designated as hedges of anticipated future cash in stockholders’ and invested equity. Gains and losses resulting ﬂ ows are marked-to-market through accumulated other compre- from foreign currency transactions (transactions denominated hensive income (balance sheet adjustments) until such time as in a currency other than the entity’s functional currency) are the related forecasted transactions affect earnings. Derivatives included in Other (income) and expense-net in the consoli- that are not designated as hedges are adjusted to fair value dated and combined statements of operations. Net foreign through Other (income) and expense – net. Fair value estimates currency transaction losses for 2005, 2004 and 2003 were are based on relevant market information, including current $0.6 million, $5.1 million and $10.0 million, respectively. market rates and prices. The fair value estimates for derivative Neenah Paper, Inc.: UnFOLDING Annual Report 2005 43 Property and Depreciation (principally herbicide and insecticide applications) during the Property, plant and equipment is stated at cost, less accumulated stand establishment period also are capitalized. The Company depreciation. Certain costs of software developed or obtained for charges capitalized costs, excluding land, to operations at the internal use are capitalized. When property, plant and equipment time the wood is harvested, based on periodically determined is sold or retired, the costs and the related accumulated deprecia- depletion rates. tion are removed from the accounts, and the gains or losses are Fertilization, control of competition and seedling protection recorded in other (income) and expense – net. For ﬁ nancial activities following the stand establishment period are expensed reporting purposes, depreciation is principally computed on as incurred. The Company pays stumpage fees for wood har- the straight-line method over the estimated useful asset lives. vested under long-term licenses and charges such costs to Weighted-average useful lives are approximately 40 years for build- operations as incurred. Costs of administration, insurance, ings, 10 years for land improvements and 18 years for machinery property taxes and interest are expensed as incurred. and equipment. The cost of permanent and secondary logging The Company distinguishes between costs associated roads is capitalized and amortized over the estimated useful lives of with pre-merchantable timber and costs associated with mer- the roads, generally 20 years. The cost of tertiary roads (which are chantable timber. Costs of merchantable timber are currently not permanent) is expensed as incurred. For income tax purposes, depletable, whereas costs of pre-merchantable timber are not accelerated methods of depreciation are used. yet depletable. Timberland depletion rates for owned timber- Estimated useful lives are periodically reviewed and, when lands are calculated periodically, based on capitalized costs warranted, changes are made to them. Long-lived assets are and the total estimated volume of timber that is mature reviewed for impairment whenever events or changes in cir- enough to be harvested and processed. Timber inventory cumstances indicate that their cost may not be recoverable. volume is determined by adding an estimate of current-year An impairment loss would be recognized when estimated growth to the prior-year ending balance, less the current-year undiscounted future pre-tax cash ﬂ ows from the use of the harvest. The volume and growth estimates are tested periodi- asset are less than its carrying amount. cally using statistical sampling techniques. The depletion rate Measurement of an impairment loss is based on the excess calculated at the end of the year is used to calculate the cost of the carrying amount of the asset over its fair value. Fair value of timber harvested in the subsequent year. is generally measured using discounted cash ﬂ ows. See Note 12 for a discussion of asset impairment losses recorded in 2005 and 2004 related to Terrace Bay’s long-lived assets. 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, 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. materials and other incremental costs, is charged to opera- Fair Value of Financial Instruments tions as incurred. Start-up costs for new or expanded facilities The carrying amounts reﬂ ected in the Consolidated Balance are expensed as incurred. Timberlands Timberlands are stated at cost, less the accumulated cost of timber previously harvested. The Company’s owned timberlands 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 fertilization, control of competition (brush control) and seedling protection activities 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 current market prices for the Company’s publicly traded debt. The fair value of the Company’s long-term debt at December 31, 2005 was $200.3 million compared to the carrying value of $226.3 million. 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. Year Ended December 31, Unrealized foreign currency translation 44 Notes to Consolidated and Combined Financial Statements Other Comprehensive Income Comprehensive income includes, in addition to net income, unrealized gains and losses recorded directly into a separate section of stockholders’ equity on the consolidated balance sheet. These unrealized gains and losses are referred to as other comprehensive income items. The accumulated other comprehensive income (loss) shown on the consolidated balance sheets consists of foreign cur- rency translation, deferred gains and (losses) on cash ﬂ ow hedges and minimum pension liability adjustments. The foreign currency translation adjustments are 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: Pre-tax Amount 2005 Tax Effect Net Amount Pre-tax Amount 2004 Tax Effect Net Amount Pre-tax Amount 2003 Tax Effect Net Amount Minimum pension liability (20.5) $ 10.1 $ – 8.0 $ 10.1 $ 24.8 $ – $ 24.8 $ 59.7 $ (12.5) 46.3 (16.3) 30.0 (14.5) Deferred gain (loss) on cash ﬂ ow hedges Other comprehensive 7.4 (2.7) 4.7 (0.2) 0.1 (0.1) (0.9) – 5.1 0.3 $ 59.7 (9.4) (0.6) income (loss) $ (3.0) $ 5.3 $ 2.3 $ 70.9 $ (16.2) $ 54.7 $ 44.3 $ 5.4 $ 49.7 Accumulated balances of other comprehensive income of grant. Had compensation expense been recorded under (loss), net of applicable income taxes are as follows: the provisions of SFAS 123, the impact on the Company’s net December 31, 2005 2004 income (loss) and income (loss) per share would have been: Unrealized foreign currency translation $ 68.0 Minimum pension liability (net of income tax beneﬁ ts of $11.6 million and $3.6 million, respectively) Deferred gain on cash ﬂ ow hedges (net of income taxes of $2.7 million) Accumulated other comprehensive income (loss) $ 53.9 4.7 (18.8) $ 57.9 (6.3) – $ 51.6 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 option grants. No employee compensation related to stock option grants has been charged to earnings because the exercise prices of all stock options granted have been equal to the market value of the Company’s or Kimberly-Clark’s common stock at the date (dollars in millions, except per share) Year Ended December 31, 2005 2004 2003 (a) Reported net income (loss) $ (29.7) Pro forma compensation (2.0) expense, net of tax Pro forma net income (loss) $ (31.7) Reported net income (loss) per share: Basic Diluted (b) Pro forma net income (loss) per share: Basic Diluted (b) $ (2.15) $ (2.15) $ (2.02) $ (2.02) $ (26.4) $ 38.9 (1.2) $ (27.6) – $ 38.9 $ (1.79) $ (1.79) $ 2.64 $ 2.64 $ (1.87) $ (1.87) $ 2.64 $ 2.64 (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 com- mon stock was distributed to stockholders of Kimberly-Clark. (b) As a result of net losses in 2005 and 2004, 48,000 and 61,000 incremen- tal shares, respectively, resulting from the assumed exercises of 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.: UnFOLDING Annual Report 2005 45 The weighted-average fair value at date of grant for stock options. Accordingly, adoption of SFAS 123R’s fair value options granted during 2005 was $12.46 per share and was method will have an effect on results of operations, although estimated using the Black-Scholes option valuation model with it will have no impact on overall ﬁ nancial position. The impact the following weighted-average assumptions (See Note 7 for a of adoption of SFAS 123R cannot be predicted at this time discussion of the 2005 and 2004 option grants at a weighted- because it will depend on levels of share-based payments average exercise price of $32.52 per share and $31.81 per granted in the future. However, had SFAS 123R been adopted share, respectively): Expected life in years Interest rate Volatility Dividend yield 2005 2004 5.9 3.9 % 39.0 % 1.2 % 4.7 3.6 % 36.3 % 1.2 % In December 2004, the Federal Accounting Standards Board (“FASB”) issued SFAS 123 (revised 2004), Share-Based Payment (“SFAS 123R”), which revises SFAS 123, Accounting for Stock-Based Compensation. SFAS 123R also supersedes APB 25 and amends SFAS 95, Statement of Cash Flows (See Accounting Standards Changes below for a discussion of other standards). In general, the accounting required by SFAS 123R is similar to that of SFAS 123. However, SFAS 123 gave compa- nies a choice to either recognize the fair value of stock options in prior periods, the effect would have approximated the SFAS 123 pro forma net income (loss) and earnings (loss) per share disclosures shown. At December 31, 2005, unearned compen- sation for the fair value of outstanding employee stock options was approximately $4.8 million and will be recognized as com- pensation expense in future periods as stock options vest. 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 as currently required, thereby reducing net operating cash ﬂ ows and increasing net ﬁ nancing cash ﬂ ows in periods after adop- tion. Such amounts cannot be estimated for future periods because they depend on, among other things, when employ- ees will exercise the stock options and the market price of the Company’s stock at the time of exercise. in their income statements or to disclose the pro forma income Accounting Standards Changes statement effect of the fair value of stock options in the In November 2004, SFAS 151, Inventory Costs – an amendment notes to the ﬁ nancial statements. SFAS 123R eliminates that of ARB No. 43, Chapter 4 (“SFAS 151”), was issued. SFAS choice and requires the fair value of all share-based payments 151 clariﬁ es the accounting for abnormal amounts of facility to employees, including the fair value of grants of employee stock options, be recognized in the income statement, gener- ally over the option vesting period. expenses, freight, handling costs, and spoilage. It also requires that allocation of ﬁ xed production overheads to inventory be based on the normal capacity of production facilities. SFAS On April 14, 2005, the SEC announced the adoption of a 151 is effective for inventory costs incurred during ﬁ scal years new rule that amended the compliance dates for SFAS 123R. beginning after June 15, 2005. Adoption of SFAS 151 is not The new rule requires the Company to adopt SFAS 123R by expected to have a material effect on the Company’s ﬁ nancial January 1, 2006. The Company will adopt SFAS 123R using a position, results of operations or cash ﬂ ows. modiﬁ ed prospective transition method in which compensation In December 2004, SFAS 153, Exchange of Nonmonetary cost is recognized beginning with the effective date (a) for all Assets – an amendment of APB Opinion No. 29 (“SFAS 153”), share-based payments granted after the effective date and (b) was issued. SFAS 153 amends Opinion 29 to eliminate the for all awards granted to employees prior to the effective date exception for nonmonetary exchanges of similar productive that remain unvested on the effective date. assets and replaces it with a general exception for exchanges The Company currently accounts for share-based payments of nonmonetary assets that do not have commercial substance. to employees using APB 25’s intrinsic value method and, as such, has recognized no compensation cost for employee A nonmonetary exchange has commercial substance if the 46 Notes to Consolidated and Combined Financial Statements future cash ﬂ ows of the entity are expected to change signiﬁ - obligations) on the balance sheet at fair value. Changes in the cantly as a result of the exchange. SFAS 153 is effective for fair value of derivatives are either recorded in income or other nonmonetary exchanges occurring in ﬁ scal periods beginning comprehensive income, as appropriate. The related unrealized after June 15, 2005. Adoption of SFAS 153 did not have a gain or loss from changes in the fair value of highly effective material effect on the Company’s ﬁ nancial position, results derivatives designated as cash ﬂ ow hedges is recorded in of operations or cash ﬂ ows. Accumulated other comprehensive income (loss) in the period In March 2005, FASB Interpretation No. 47 (“FIN 47”), that changes in fair value occur and is reclassiﬁ ed to income in Accounting for Conditional Asset Retirement Obligations – an the same period that the hedged item affects income. interpretation of FASB Statement No. 143, was issued. FIN 47 clariﬁ es that the term “conditional asset retirement obligation” as used in FASB Statement No. 143, Accounting for Asset Retirement Obligations, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN 47 also clariﬁ es when an entity would have sufﬁ cient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effec- tive no later than the end of ﬁ scal years ending after December 15, 2005 (December 31, 2005, for calendar-year enterprises). The adoption of FIN 47 did not have a material effect on the Company’s results of operations or ﬁ nancial position. 3. R I S K M A N A G E M E N T The Company is exposed to risks such as changes in foreign currency exchange rates and pulp prices. A variety of practices is 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 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. Because the price of pulp is established 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 Company uses foreign currency for- ward and pulp futures contracts to manage its foreign currency and pulp price risk. The use of these instruments allows man- agement 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 (See “Cash Flow Hedges” below). The Company’s translation exposure related to its net investment in its Canadian subsid- iaries is not hedged. The Company is also subject to price risk for electricity used in its manufacturing operations. At the Spin-Off, Kimberly-Clark transferred to the Company a ﬁ xed-price for- ward purchase contract to hedge ﬂ uctuations in the price of electricity at the Terrace Bay mill through December 31, 2005. The contract has matured and has not been replaced. foreign currency and commodity derivative instruments are either Cash Flow Hedges exchange traded or entered into with major ﬁ nancial institutions. During 2005, the Company entered into a series of foreign Credit risk with respect to the counterparties is considered mini- currency forward exchange contracts, designated as cash ﬂ ow mal in view of the ﬁ nancial strength of the counterparties. hedges, of U.S. dollar denominated pulp sales. At In accordance with SFAS 133, Accounting for Derivative December 31, 2005, the Company had foreign currency con- Instruments and Hedging Activities, as amended, the Company tracts outstanding in a notional amount of $213 million records all derivative instruments as assets (in Prepaid and other Canadian dollars. The fair value of the contracts was $9.3 million current assets and Other assets) or liabilities (in Accrued U.S. dollars and was reﬂ ected on the balance sheet as an asset expenses or Noncurrent employee beneﬁ ts and other ($7.2 million of which was current). The weighted-average Neenah Paper, Inc.: UnFOLDING Annual Report 2005 47 exchange rate for the foreign currency contracts at December $(0.6) million and $0.5 million of after-tax gains (losses) from 31, 2005 was $0.820 U.S. dollars per Canadian dollar. The accumulated other comprehensive income to earnings in 2005, contracts extend through May 2007 with the highest value of 2004 and 2003, respectively. If future market rates are consistent contracts maturing in January 2006. The Company recorded net with the rates assumed at December 31, 2005, approximately pre-tax gains of $4.3 million on foreign currency contracts as the $6.1 million (or $3.9 million after-tax) of the $8.2 million (or forecasted transactions occurred in 2005. All realized gains and $5.2 million after-tax) unrealized gain included in accumulated losses on currency derivatives are recorded in Other (income) other comprehensive income is expected to be recognized in expense – net on the consolidated and combined statements earnings during the next 12 months. of operations. The notional amounts of the Company’s hedging instru- During 2005, the Company also entered into a series ments do not represent amounts exchanged by the parties of pulp futures contracts to hedge ﬂ uctuations in pulp and, as such, are not a measure of exposure to credit loss. prices through December 2006. At December 31, 2005, the The amounts exchanged are determined by reference to Company had future contracts for 144,000 metric tons of pulp the notional amounts and the other terms of the contracts. with a notional amount of approximately $91 million. The fair value of the contracts was $1.2 million and was reﬂ ected on the balance sheet as a liability. The weighted-average price for the pulp futures contracts at December 31, 2005 was $631 per 4. I N C O M E TA X E S metric ton. The contracts expire at the rate of 12,000 metric Income tax expense in the Company’s consolidated and tons per month in 2006. The Company recorded net pre-tax combined ﬁ nancial statements has been calculated on a sepa- gains of $0.6 million on pulp futures contracts as the fore- rate tax return basis. Income tax beneﬁ ts represented 39.4% casted transactions occurred in 2005. Substantially all realized and 36.1% of pre-tax losses in 2005 and 2004, respectively. In gains and losses on pulp derivatives are recorded in Net sales 2003, the income tax provision represented 38.5% of pre-tax on the consolidated statements of operations. income. The following table presents the principal reasons for In addition, the Company had a ﬁ xed-price forward pur- the difference between the effective tax rate and the U.S. fed- chase contract to hedge ﬂ uctuations in the price of electricity eral statutory income tax rate: Year Ended December 31, 2005 2004 2003 U.S. federal statutory income tax rate State and local income taxes, net of federal income tax effect Other differences – net Effective income tax rate (35.0)% (35.0)% 35.0% (3.9) (0.5) (39.4)% (2.4) 1.3 (36.1)% 4.2 (0.7) 38.5% at the Terrace Bay mill. The contract matured on December 31, 2005. The Company recorded net pre-tax gains of $0.9 million on the forward purchase contract as the forecasted transac- tions occurred in 2005. In addition, during 2005, the Company recorded a pre-tax gain of approximately $0.5 million related to discontinued cash ﬂ ow hedges where occurrence of the forecasted transaction was not probable. Realized gains and losses on the electricity derivative and gains and losses on dis- continued cash ﬂ ow hedges are recorded in Cost of product sold on the consolidated statements of operations. During 2005 the Company’s cash ﬂ ow hedges were effective, and changes in the fair value of the derivative instruments were reﬂ ected in other comprehensive income. During the same period in which the hedged forecasted transactions affected earnings, the Company reclassiﬁ ed approximately $(36,000), 48 Notes to Consolidated and Combined Financial Statements The following table presents the U.S. and Canadian No valuation allowance has been provided on deferred components of income before income taxes and the provision income tax assets. In determining the need for valuation allow- for income taxes: Year Ended December 31, 2005 2004 2003 Income (loss) before income taxes: U.S. Canada Total Provisions (beneﬁ ts) for income taxes: Current: Federal State and local Canadian Subtotal Deferred: Federal State and local Canadian Subtotal Total $ 44.2 (93.2) $ (49.0) $ 79.2 (120.5) $ (41.3) $ 81.5 (18.2) $ 63.3 $ 1.2 (0.4) – 0.8 (17.5) (2.6) – (20.1) $ (19.3) $ 26.6 2.1 – 28.7 (37.9) (3.3) (2.4) (43.6) $ (14.9) $ 28.5 4.5 (0.4) 32.6 (2.1) (0.5) (5.6) (8.2) $ 24.4 The asset and liability approach is used to recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. The com- ponents of deferred tax assets and liabilities are as follows: ances, the Company considers many factors, including speciﬁ c taxing jurisdictions, sources of taxable income, income tax strategies and forecasted earnings for the entities in each juris- diction. 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 of December 31, 2005, the Company had $24.8 million of Canadian net operating losses, substantially all of which may be carried for- ward to 2015 to offset future taxable income. Due to the U.S. Dual Consolidated Loss Recapture rules and provisions under SFAS 109, the Company has recorded a corresponding deferred tax liability to offset the deferred tax asset related to the Canadian net operating losses. The Company has no for- eign tax credits. As part of the Spin-Off transaction, the Company made 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 December 31, 2005 2004 equity. The Company recorded a net credit to deferred income Net current deferred income tax assets: $ 2.4 Accrued liabilities 0.5 Employee beneﬁ ts Other (1.2) Net current deferred income tax assets $ 1.7 Net noncurrent deferred income tax assets: Canadian timberlands Employee beneﬁ ts Accumulated depreciation Other Net noncurrent deferred income tax assets $ 67.7 17.3 (57.4) – $ 27.6 $ 2.4 – (1.2) $ 1.2 $ 72.3 11.7 (81.3) (2.7) $ – tax assets of approximately $12.7 million and an offsetting charge to “Kimberly-Clark’s net investment” on the statement of changes in stockholders’ and invested equity. Prior to the Spin-Off, 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 con- solidated income tax returns for periods through the date of the Spin-Off. Accordingly, the consolidated balance sheets do not include current or prior period income tax receivables 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 Neenah Paper, Inc.: UnFOLDING Annual Report 2005 49 Company and Kimberly-Clark, the Company could be liable for Secured Revolving Credit Facility any income taxes if it commits a tainting event that destroys On November 30, 2004, the Company entered into a Credit the tax-free nature of the Spin-Off. Agreement by and among Neenah, certain of its subsidiaries, For periods subsequent to the Spin-Off, the Company has the lenders listed in the Credit Agreement and JP Morgan elected to treat its Canadian operations as a branch for U.S. Chase Bank, N.A. as agent for the lenders (the “Credit income tax purposes. Therefore, the amount of income (loss) Agreement”). Under the Credit Agreement, the Company has a before income taxes from Canadian operations, generated after secured revolving credit facility (the “Revolver”) that provides for the November 30, 2004 Spin-Off date, are included in the borrowings of up to $150 million. No amounts were outstanding Company’s consolidated U.S. income tax returns and such under the Revolver as of December 31, 2005. Borrowing avail- amounts are subject to U.S. income taxes. The previously ability under the Revolver is reduced by outstanding letters of reported deferred income tax liability of $8.4 million at December credit (“LOCs”). At December 31, 2005, the Company had 31, 2004 has been reclassiﬁ ed to net noncurrent deferred income approximately $5.2 million of LOCs outstanding and $144.8 tax assets to conform to the current year presentation of deferred million of borrowing availability under the Revolver. Amounts tax assets and liabilities by tax jurisdiction. In addition, certain outstanding under the Revolver may be repaid, in whole or in amounts of the previously reported components of the current part, at any time without premium or penalty except for speci- and deferred provision (beneﬁ t) for income taxes for the year ﬁ ed make-whole payments on LIBOR-based loans. ended December 31, 2004 have been reclassiﬁ ed to conform The Credit Agreement is secured by substantially all of the to the current year presentation by tax jurisdiction. Company’s assets, including the capital stock of its subsidiaries 5. D E B T and is guaranteed by Neenah Paper Company of Canada, a wholly owned subsidiary. The Credit Agreement will terminate on November 30, 2008. Availability under the Credit Agreement will ﬂ uctuate over time depending on the value of the Company’s The following debt was incurred either as a result of or since inventory, receivables and various capital assets. the Spin-Off. The Company did not have debt prior to The interest rate applicable to borrowings under the November 30, 2004. Senior Unsecured Notes On November 30, 2004, the Company completed an under- written offering of 10-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. Interest payments commenced on May 15, 2005, and the Senior Notes mature on November 15, 2014. The Senior Notes are fully and unconditionally guaranteed by sub- stantially all of the Company’s subsidiaries. A registration rights agreement relating to the Senior Notes required the Company to exchange the Senior Notes for registered notes within 270 days from the original issuance of the notes. In August 2005, the Company completed an offer to exchange the unregis- tered Senior Notes for registered notes with similar terms. 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 indenture governing the Senior Notes and the Credit Agreement contain, among other provisions, covenants with which the Company must comply during the term of the agree- ments. Such covenants restrict the Company’s ability to, among other things, incur certain additional debt, make speciﬁ ed restricted payments and capital expenditures, authorize or issue capital stock, enter into transactions with afﬁ liates, con- solidate or merge with or acquire another business, sell certain of its assets or liquidate, dissolve or wind-up. In addition, the 50 Notes to Consolidated and Combined Financial Statements terms of the Credit Agreement require the Company to Kimberly-Clark. During 2005, hourly employees at the Pictou achieve and maintain certain speciﬁ ed ﬁ nancial ratios. At pulp mill, represented by Local 440 of the Communications, December 31, 2005, the Company was in compliance with Energy and Paperworkers Union of Canada and the Company all such covenants. executed a new collective bargaining agreement providing The Company’s ability to pay cash dividends on its for enhanced pension beneﬁ ts. The amendment to the plan Common Stock is limited under the terms of both the Credit resulted in an increase of $6.9 million in the Company’s pro- Agreement and the Senior Notes. At December 31, 2005 jected beneﬁ t obligation and did not require a remeasurement under the most restrictive terms of these agreements, the of the plan. Company’s ability to pay cash dividends on its common stock Pension assets related to active employees of the U.S. is limited to a total of $10.0 million in a 12-month period. paper operations for which the Company assumed responsibil- Other Notes During the ﬁ rst quarter of 2005, the Company obtained third- party ﬁ nancing to fund its purchase of enterprise resource planning (“ERP”) software. At inception, the present value of the ﬁ nancing agreement was $3.6 million (discounted at 7.375%) payable in quarterly installments through January 2008. At December 31, 2005, $2.5 million of such third-party ﬁ nancing was outstanding. In the ﬁ rst quarter of 2005, the Company issued a short-term note for $2.3 million to ﬁ nance current year insurance premiums. The note was repaid in monthly installments through October 2005 including interest at the rate of 3.9% per annum. At December 31, 2005, the Company had required debt payments under these ﬁ nancing arrangements of $1.2 million and $1.3 million in 2006 and 2007, respectively. The Company has no other required debt payments during the next ﬁ ve years. 6. P O S T R E T I R E M E N T A N D O T H E R B E N E F I T S Pension Plans ity 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. In the fourth quarter of 2005, the transfer of assets by Kimberly- Clark to the new pension trust for obligations assumed by the Company in the Spin-Off was ﬁ nalized and resulted in a credit of $0.7 million to Additional paid-in capital. 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 provid- ing 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 calcu- lated using the fair value of the assets and the actual return based on the fair value of assets. The Company’s pension and other postretirement obligations are measured as of Substantially all active employees of the Pulp and Paper December 31. As of December 31, 2005, the Company’s Business participated in Kimberly-Clark’s deﬁ ned beneﬁ t plans had cumulative unrecognized investment losses and pension plans and deﬁ ned contribution retirement plans. other actuarial losses of approximately $147.8 million. On November 30, 2004, the Company assumed responsibility A minimum pension liability for underfunded plans for pension and postretirement beneﬁ t obligations for active representing the excess of the unfunded ABO over previously employees of the Pulp and Paper Business and former recorded net pension liabilities has been reﬂ ected on the con- employees of the Canadian pulp operations. Pension and solidated balance sheets. The minimum pension liability is postretirement beneﬁ t obligations related to former employ- included in Noncurrent employee beneﬁ ts and other obligations ees of the U.S. paper operations were retained by Neenah Paper, Inc.: UnFOLDING Annual Report 2005 51 on the consolidated balance sheets. An offsetting amount is Company’s accumulated postretirement beneﬁ t obligation by included as an intangible asset to the extent of unrecognized approximately $6.8 million and resulted in an unrecognized actu- prior service cost, and the balance is included in accumulated arial gain of a similar amount and resulted in a $0.5 million and other comprehensive income. In 2005, the additional minimum $0.3 million reduction in postretirement beneﬁ t costs for 2005 pension liability increased as the effect of a decrease in the dis- and 2004, respectively. During 2005, the Company paid less than count rate used to estimate the ABO more than offset the $0.1 million for prescription drug beneﬁ ts for retirees who were increase in the fair value of pension plan assets. eligible for Medicare Part D and has not been reimbursed for The following is a summary of amounts related to the mini- any such payments. mum pension liability recorded in other comprehensive income: Prior to 2004, the U.S. beneﬁ t plans limited future annual December 31, Minimum pension liability Less intangible asset Accumulated other comprehensive income 2005 2004 $ 42.4 12.0 $ 12.0 2.1 $ 30.4 $ 9.9 Other Postretirement Beneﬁ t Plans Prior to the Spin-Off, the employees of the Pulp and Paper Business participated in Kimberly-Clark’s health care and life insurance beneﬁ t plans (the “Beneﬁ t Plans”), which covered per capita retiree medical beneﬁ ts to no more than 200% of the 1992 annual per capita cost. These plans reached this limi- tation (the “Cap”) and were amended during 2003. Among other things, the amendments index the Cap by 3% annually beginning in 2005 for certain employees retiring on or before April 1, 2004 and limit the future cost for retiree health care beneﬁ ts to a deﬁ ned ﬁ xed per capita cost for certain employ- ees retiring after April 1, 2004. At December 31, 2005, the assumed inﬂ ationary pre-65 and post-65 health care cost trend substantially all retirees and active employees. Certain beneﬁ ts rates used to determine year-end obligations was 9.8%, were based on years of service and/or age at retirement. The plans were principally noncontributory for employees who were eligible to retire on or before December 31, 1992 and contribu- tory for most employees who retire on or after January 1, 1993. Kimberly-Clark provided no subsidized beneﬁ ts to most employ- ees 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 opera- tions and established new health care and life insurance beneﬁ t plans to provide substantially similar beneﬁ ts and credit such decreasing to 8.8% in 2007, and then gradually decreasing to an ultimate rate of 4.8% in 2013. The assumed inﬂ ationary pre- 65 health care cost trend rate used to determine obligations at December 31, 2004 and cost for the year ended December 31, 2005 was 8.7% in 2005, decreasing to 7.8% in 2006, and grad- ually decreasing to an ultimate rate of 5.0% in 2011. The assumed inﬂ ationary post-65 health care cost trend rate used to determine obligations at December 31, 2004 and cost for the year ended December 31, 2005 was 8.8% in 2005 decreas- ing to 7.9% in 2006, and gradually decreasing to an ultimate employees for service earned with Kimberly-Clark. rate of 5.0% in 2011. 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 beneﬁ t under Medicare (Medicare Part D) and a federal subsidy In May 2005, the Company closed the No. 1 Mill at the Terrace Bay facility (See Note 12). In conjunction with the closure, the Company recognized a pre-tax charge of approxi- mately $1.6 million related to a partial settlement of certain to sponsors of retiree health care beneﬁ t plans that provide a pre- pension obligations. scription drug beneﬁ t that is at least actuarially equivalent to Medicare Part D. On April 1, 2004, FASB Staff Position 106-2 (“FSP 106-2”), Accounting and Disclosure Requirements Related 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 to Medicare Prescription Drug, Improvement and Modernization balance sheet. Act of 2003, was adopted. Adoption of FSP 106-2 reduced the 52 Notes to Consolidated and Combined 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 Special termination beneﬁ ts Plan amendments 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 Special termination beneﬁ t contributions Currency Beneﬁ t payments Participant contributions Adjustment related to Spin-Off Other 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 Beneﬁ ts Postretirement Beneﬁ ts Other than Pensions 2005 2004 2005 2004 $ 386.1 10.7 21.9 11.7 34.1 (23.9) – 0.6 1.6 6.9 0.2 $ 449.9 $ 328.5 38.9 18.7 1.6 9.8 (23.9) 0.6 0.7 0.2 $ 375.1 $ (74.8) 147.8 (0.6) 12.4 $ 84.8 $ 84.8 12.0 (42.4) 30.4 $ 84.8 $ 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 $ 55.0 1.5 3.1 1.9 14.7 (1.3) – – – 1.2 – $ 76.1 $ $ – – 1.3 – – (1.3) – – – – $ (76.1) 31.3 – (0.8) $ (45.6) $ – – (45.6) – $ (45.6) $ 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) Neenah Paper, Inc.: UnFOLDING Annual Report 2005 53 Summary disaggregated information about the pension plans follows: December 31, Projected beneﬁ t obligations ABO Fair value of plan assets Components of Net Periodic Beneﬁ t Cost Assets Exceed ABO ABO Exceeds Assets Total 2005 $ 279.5 227.5 239.4 2004 2005 2004 $ 333.2 275.8 288.7 $ 170.4 153.0 135.7 $ 52.9 46.2 39.8 2005 $ 449.9 380.5 375.1 2004 $ 386.1 322.0 328.5 Pension Beneﬁ ts Postretirement Beneﬁ ts Other than Pensions Year Ended December 31, 2005 2004 2003 2005 2004 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) $ 10.7 21.9 (27.7) 7.1 (0.2) 1.4 – $ 13.2 $ 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 $ 1.5 3.1 – 0.7 – 0.1 – $ 5.4 $ 1.2 3.4 – (4.6) – – (0.4) (0.4) $ 2003 $ 1.0 3.6 – 0.2 – – – $ 4.8 (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 Beneﬁ t Obligations at December 31 Discount rate Rate of compensation increase Pension Beneﬁ ts Postretirement Beneﬁ ts Other than Pensions 2005 2004 2005 2004 5.20% 3.24% 5.75% 3.75% 5.22% 5.75% – – Weighted-average Assumptions Used to Determine Net Periodic Beneﬁ t Cost for Years Ended December 31 Pension Beneﬁ ts Postretirement Beneﬁ ts Other than Pensions 2005 2004 2003 2005 2004 2003 Discount rate Expected long-term return on plan assets Rate of compensation increase 5.75% 8.41% 3.75% 6.21% 8.50% 3.75% 6.95% 8.50% 3.90% 5.75% 6.17% 6.91% – – – – – – 54 Notes to Consolidated and Combined Financial Statements Expected Long-Term Rate of Return Cash Flows and Investment Strategies Based on December 31, 2005 exchange rates, the Company The expected long-term rate of return on pension fund assets expects to contribute approximately $12.2 million to its pen- held by the Company’s pension trusts was determined based sion trusts in 2006. 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 60% with equity managers, with expected long-term rates of return of approximately 10%, and 40% with ﬁ xed income managers, with an expected long-term rate of return of about 6%. The actual asset allocation is regularly reviewed Future Beneﬁ t Payments The following beneﬁ t payments, which reﬂ ect expected future service, as appropriate, are expected to be paid: Pension Plans Other Postretirement Beneﬁ ts $ 18.4 19.8 21.2 22.8 24.6 158.1 $ 1.8 2.0 2.3 2.6 3.0 20.6 2006 2007 2008 2009 2010 Years 2011–2015 and periodically rebalanced to the targeted allocation when Health Care Cost Trends considered appropriate. Also, when deemed appropriate, Assumed health care cost trend rates affect the amounts hedging strategies are executed using index options and reported for postretirement health care beneﬁ t plans. A one- futures to limit the downside exposure of certain investments percentage point change in assumed health care cost trend by trading off upside potential above an acceptable level. Such rates would have the following effects: hedging strategies were executed in 2005, 2004 and 2003. 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: Percentage of Plan Assets at December 31, 2005 2004 2003 Asset Category Equity securities Debt securities Real estate Cash and money market funds Total 68 % 24 % – % 66 % 24 % 3 % 70 % 28 % 2 % 8 % 100 % 7 % 100 % – % 100 % Plan assets were not invested in Neenah securities for periods subsequent to the Spin-Off or Kimberly-Clark securi- ties prior to the Spin-Off. Effect on total of service and interest cost components Effect on postretirement beneﬁ t obligation One Percentage Point Increase Decrease $ 0.7 $ 0.5 9.9 7.9 Deﬁ ned Contribution Retirement Plans Kimberly-Clark’s contributions to its deﬁ ned contribution retirement plans were primarily based on the age and compen- sation of covered employees. In connection with the Spin-Off, Kimberly-Clark transferred the related assets and liabilities of these plans to trusts established by the Company. In December 2004, the Company established deﬁ ned contribution retirement plans that provide substantially similar beneﬁ ts. Contributions to these plans, all of which were charged to expense, were $1.0 million in 2005 and $0.5 million in each of 2004 and 2003. Investment Plans The Company provides voluntary contribution investment plans to substantially all employees. Under the plans, Kimberly-Clark matched a portion of employee contributions. In connection Neenah Paper, Inc.: UnFOLDING Annual Report 2005 55 with the Spin-Off, Kimberly-Clark transferred the related per share. In August 2005, the Company granted options to assets and liabilities of these plans to trusts established by the purchase 62,650 shares of common stock at $31.70 per share. Company. In December 2004, the Company established invest- The exercise price of the options was equal to the market price ment plans that provide substantially similar beneﬁ ts. Costs of the Company’s common stock on the date of grant. The charged to expense for company matching contributions under options expire in 10 years and one-third vest on each of the these plans were $1.2 million in each of 2005, 2004 and 2003. ﬁ rst three anniversaries of the date of grant. In June 2005, the 7. S T O C K C O M P E N S AT I O N P L AN S Company awarded options to purchase 11,250 shares of com- mon stock at $33.32 per share to members of its Board of Directors. The options vest one year from the date of grant and expire 10 years from the date of grant. On August 31, 2004, Kimberly-Clark, acting as the sole In connection with the Spin-Off, options to acquire shareholder of the Company, approved the Neenah Paper, Inc. 390,508 shares of Kimberly-Clark common stock that were out- 2004 Omnibus Stock and Incentive Plan (the “Omnibus Plan”). standing immediately prior to the Spin-Off were converted into The Company then adopted and established the Omnibus Plan 724,449 substitute options to purchase the Company’s com- under unanimous written consent of the Neenah Board of mon stock under the Omnibus Plan. The awards converted Directors on December 1, 2004. With this approval, the Company were adjusted to maintain both the pre-conversion aggregate reserved 3,500,000 shares of the Common Stock for issuance intrinsic value of each award and the ratio of the per share under the Omnibus Plan. Pursuant to the terms of the Omnibus exercise price to the market value per share. Vesting terms and Plan, the compensation committee of the Company’s Board of expiration dates were also preserved. The number of shares Directors may grant various types of equity based compensation and new exercise prices were established using a ratio conver- awards, including incentive and nonqualiﬁ ed stock options, stock sion methodology approved under FASB Interpretation No. 44 appreciation rights, restricted stock, restricted stock units, perfor- based on the fair market value of the Company’s common mance shares and performance units, in addition to certain stock on the date of grant. cash-based awards. All grants and awards under the plan will be On December 15, 2004, an award of nonqualiﬁ ed stock made at fair market value and no grant or award may be repriced options to purchase 442,540 shares of Common Stock (the “Fresh after its grant. In general, the options expire 10 years from the Start Options”) was made to LTIP participants and directors of the date of grant and vest over a three-year service period. At Company. The exercise price of the Fresh Start Options was equal December 31, 2005, a total of 2,154,995 shares of the Company’s to the market value of the Company’s common stock on the common stock were reserved for future issuance under the date of grant. The Fresh Start Options expire 10 years from the Omnibus Plan. date of grant and vest 30%, 30% and 40% on the ﬁ rst, second During 2003 and in prior years, certain employees of and third anniversaries of the date of grant, respectively. the Pulp and Paper Business were granted stock options and Stock options awarded by Kimberly-Clark to employees of restricted stock under Kimberly-Clark’s stock compensation plans. the Pulp and Paper Business prior to the Spin-Off were granted Stock Options In February 2005, the Company informed participants in its Long-Term Incentive Plan (the “LTIP”) of its intention to award nonqualiﬁ ed stock options to purchase a total of 126,100 shares of common stock (subject to forfeitures due to termina- tion of employment and other conditions) during 2005. In February 2005, the Company granted to LTIP participants options to purchase 63,050 shares of common stock at $33.19 with an exercise price equal to the market value of a share of common stock on the date of grant and were accounted for using APB 25. No compensation expense for stock options awarded to employees was recognized in the combined state- ments of operations for periods prior to the Spin-Off because the exercise prices of all stock options granted was equal to the market value of Kimberly-Clark’s common stock on the date of grant. 56 Notes to Consolidated and Combined Financial Statements Data concerning stock option activity follows (a): Outstanding – Beginning of year Options granted Conversion of Kimberly-Clark options Options expired or cancelled Outstanding – End of year Exercisable – End of year 2005 2004 Number of Options 1,166,989 136,950 – (19,511) 1,284,428 740,284 Weighted- Average Exercise Price $ $ $ $ $ 32.84 32.52 – 30.61 31.90 32.39 Number of Options – 442,540 724,449 – 1,166,989 532,554 Weighted- Average Exercise Price $ $ $ – 32.60 31.32 – 31.81 32.84 (a) Information with respect to the stock option awards to acquire the Company’s Common Stock are presented for periods subsequent to November 30, 2004, the date on which Neenah common stock was distributed to the stockholders of Kimberly-Clark. Data concerning options at December 31, 2005 follows: Options Outstanding Options Exercisable $24.01 – $26.04 $26.95 – $31.70 $32.60 – $37.59 Number of Options 202,998 144,985 936,445 1,284,428 Weighted- Average Exercise Price Weighted-Average Remaining Contractual Life (Years) $ $ $ $ 24.24 30.15 33.83 31.90 6.7 5.8 7.5 7.2 Number of Options 114,496 82,335 543,453 740,284 Weighted- Average Price $ $ $ $ 24.41 28.97 34.60 32.39 Other Stock-Based Compensation expense is recognized pro rata over the three-year vesting period. In February 2005, the Company granted 38,300 performance Upon adoption of SFAS 123R, the Company will be required to shares (subject to forfeitures due to termination of employment recognize compensation expense related to stock-based com- and other conditions) to LTIP participants. Based on Company pensation awards over the shorter of (i) the contractual vesting performance compared to revenue growth and return on invested period of the award or (ii) the period between the grant date for capital targets, Restricted Stock Units (“RSUs”) equal to between the award and the recipient reaching 55 years of age with ﬁ ve 30% and 225% of the performance share award would be issued. years of vesting service (retirement eligibility). In June 2005, The measurement period for the performance shares was the Company awarded 3,510 RSUs to members of its Board January 1, 2005 through December 31, 2005. On December 31, of Directors that vest on the ﬁ rst anniversary of the date of grant. 2005, 11,430 RSUs (equal to 30% of the performance shares In December 2004, Neenah awarded 40,800 and 3,450 granted) were awarded. In general, the RSUs become 100% RSUs to LTIP participants and non-employee members of the vested three years from the start of the performance period Board of Directors of the Company, respectively. The RSUs (December 31, 2007) and are subject to an additional two-year carry a promise to pay out in Common Stock at a future date. holding period before the award recipient can sell or transfer such In general, the RSUs awarded to LTIP participants vest over a shares. During the vesting period, but not the performance ﬁ ve year period, with one third vesting on the third anniversary period, holders of the RSUs are entitled to dividends, but are not of the date of grant, one-third vesting on the fourth anniver- permitted to vote such shares, and the RSUs are forfeited in the sary, and the balance vesting on the ﬁ fth anniversary. The RSUs event of termination of employment (as deﬁ ned). Compensation awarded to members of the Board of Directors vest on the ﬁ rst Neenah Paper, Inc.: UnFOLDING Annual Report 2005 57 anniversary of the date of grant. Holders of RSUs are entitled restricted period. The price of Kimberly-Clark’s common stock to dividends but are not permitted to vote such awarded at the date of grant determined the value of the restricted shares and the sale or transfer of such shares is limited during stock, and such value was recorded at the date of grant as the restricted period. unearned compensation. At the time of the Spin-Off, the vesting schedule of Stock-based compensation expense in the Consolidated Kimberly-Clark restricted stock awards for employees of the and Combined Statements of Operations (consisting primarily Pulp and Paper Business were adjusted so that the awards of amortization of unearned compensation relating to vested on a prorated basis determined by the number of full restricted stock and RSUs) was $0.8 million, $0.6 million and years of employment with Kimberly-Clark during the restriction $0.9 million in 2005, 2004 and 2003, respectively. period. Unvested restricted shares of Kimberly-Clark common stock were forfeited. In December 2004, the Company awarded 25,360 replacement restricted shares to employees whose restricted shares of Kimberly-Clark common stock were for- feited. 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 common stock on the date of grant. At December 31, 2005, 22,871 of such restricted shares were outstanding, with 3,681 shares, 2,025 shares, 16,591 shares and 574 shares vesting in 2006, 2007, 2008 and 2009, respectively. The Company records unearned compensation for the fair value of compensatory stock awards based on the price of the Company’s stock on the measurement date (date of grant for RSUs and completion of the measurement period for perfor- mance shares). Performance shares, prior to completion of the 8. S T O C K H O L D E R S ’ 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-Clark as a divi- dend in the ratio of one share of the Company’s Common Stock for every 33 shares of Kimberly-Clark common stock outstanding. During 2005, the Company acquired 814 shares of Common Stock at a cost of approximately $25,000 for shares sold by employees to pay taxes due on vested restricted stock awards. measurement period, are accounted for as a variable award pur- Preferred Stock suant to APB 25. As such, the Company recognized unearned The Company has authorized 20 million shares of $0.01 par compensation for the expected number of shares to be awarded value preferred stock. The preferred stock may be issued in (but not less than 30%). In general, the Company amortizes one or more series and with such designations and preferences unearned compensation to expense over the service period for each series as shall be stated in the resolutions providing (generally the vesting period) for the award. for the designation and issue of each such series adopted by A number of employees of the Pulp and Paper Business the Board of Directors of the Company. The board of directors were granted Kimberly-Clark restricted stock awards in is authorized by the Company’s articles of incorporation to previous years. These awards generally vested and became determine the voting, dividend, redemption and liquidation unrestricted shares in three to ﬁ ve years from the date of grant. preferences pertaining to each such series. No shares of pre- Holders of Kimberly-Clark restricted stock were entitled to divi- ferred stock have been issued by the Company. dends and were permitted to vote such awarded shares, but the sale or transfer of such shares was limited during the 58 Notes to Consolidated and Combined Financial Statements 9. C O M M I T M E N T S Leases the outcome of these legal actions and claims cannot be pre- dicted with certainty, it is the opinion of management that the outcome of any claim which is pending or threatened, either individually or on a combined basis, will not have a material The future minimum obligations under operating leases having adverse effect on the consolidated ﬁ nancial condition, results a noncancelable term in excess of one year as of December 31, of operations or liquidity of the Company. 2005, are as follows: Year Ending December 31: 2006 2007 2008 2009 2010 Thereafter Future minimum obligations $ 2.6 1.6 1.4 1.3 1.2 7.3 $ 15.4 Rental expense under operating leases was $4.6 million, $3.9 million and $2.7 million in 2005, 2004 and 2003, respectively. Purchase Commitments Indemniﬁ cations 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 cation 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- The Company has entered into long-term contracts for the mate the maximum potential amount of the potential future purchase of sawmill wood chips. The minimum purchase com- liability under the indemnity provisions of these agreements. mitments extend beyond 2009. Commitments under these However, the Company accrues for any potentially indemniﬁ able contracts are approximately $26.9 million in 2006, $26.7 mil- liability or risk under these agreements for which it believes a lion in 2007, $26.8 million in 2008, $26.7 million in 2009 and future payment is probable and a range of loss can be reason- $9.6 million in 2010. Total commitments beyond 2010 are ably estimated. As of December 31, 2005, we believe our $28.9 million. liability under such indemniﬁ cation obligations was not material. Although the Company is primarily liable for payments on the above mentioned leases and purchase commitments, man- agement believes exposure to losses, if any, under these arrangements is not material. 10. C O N T I N G E N C I E S A N D L E G A L M AT T E R S Litigation 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 During the third quarter of 2005, the Company settled a in connection with such claims. Except for certain orders issued previously disclosed lawsuit relating to a vehicle accident by environmental, health and safety regulatory agencies, with pending in the Ontario (Canada) Superior Court of Justice. which management believes the Company is in compliance and The settlement did not have a material effect on the which management believes are immaterial to the results of Company’s results of operations or liquidity. operations of the Company’s business, Neenah is not currently The Company is involved in certain other legal actions named as a party in any judicial or administrative proceeding and claims arising in the ordinary course of business. While relating to environmental, health and safety matters. Neenah Paper, Inc.: UnFOLDING Annual Report 2005 59 While the Company has incurred in the past several years, On June 1, 2005, hourly employees at the Pictou pulp and will continue to incur, capital and operating expenditures mill, represented by Local 440 of the Communications, Energy in order to comply with environmental, health and safety laws, and Paperworkers Union of Canada and the Company exe- regulations and ordinances, management believes that the cuted a new collective bargaining agreement expiring on May Company’s future cost of compliance with environmental, 31, 2009. Hourly employees at the Terrace Bay pulp mill are health and safety laws, regulations and ordinances, and its represented by locals of the United Steelworkers (the “USW”) exposure to liability for environmental, health and safety claims and the International Brotherhood of Electrical Workers with will not have a material adverse effect on its ﬁ nancial condition, each collective bargaining agreement expiring on May 1, 2007. results of operations or liquidity. However, future events, such The collective bargaining agreement covering 230 hourly as changes in existing laws and regulations or contamination employees at the Longlac, Ontario operations represented by of sites owned, operated or used for waste disposal by the Local 1-2693 of the USW expired on September 1, 2005. On Company (including currently unknown contamination and January 30, 2006, the hourly employees working in the Longlac contamination caused by prior owners and operators of such woodlands operations commenced a strike. In February 2006, the sites or other waste generators) may give rise to additional Company suspended pulp manufacturing activities at the Terrace costs which could have a material adverse effect on the Bay pulp mill as a result of a lack of wood ﬁ ber for its operations. Company’s ﬁ nancial condition, results of operations or liquidity. Most of the approximately 400 hourly and salaried workers Neenah incurs capital expenditures necessary to meet employed at the mill were laid off for an indeﬁ nite period during legal requirements and otherwise relating to the protection the two weeks following the commencement of closure activities. of the environment at its facilities in the United States and Pursuant to the terms of the Company’s labor agreements and Canada. For these purposes, the Company’s planned capital Canadian laws, if the work stoppage continues through May expenditures for major environmental projects during the 2006, the Company will be required to make payments to laid-off period 2006 through 2010 include approximately $20 million workers of approximately $8 million in the second quarter of to reconﬁ gure the efﬂ uent treatment system at the Pictou mill 2006. Additional payments of from one to three times that and between $15 million and $25 million for equipment and amount could be required dependent upon, among other things, engineering to abate total sulphur emissions and for other the duration of the work stoppage. An extended work stoppage environmental matters at the Pictou and Terrace Bay mills, to at the Terrace Bay mill could have a material impact on the liquid- remove and replace transformers containing polychlorinated ity and results of operations of the Company. biphenyls at the Terrace Bay mill, to improve stream crossings Hourly employees at the Munising, Neenah and Whiting in the timberlands licensed from the Province of Ontario. The paper mills are represented by locals of the USW. On December timing and amount of such expenditures will depend on the 23, 2005, hourly employees at the Munising paper mill, repre- outcome of negotiations with regulatory authorities, the results sented by Locals 7-0087 and 7-0096 of the USW voted to of engineering studies and the remediation methods ultimately accept a new collective bargaining agreement expiring on July selected. These capital expenditures are not expected to have 15, 2009. On January 8, 2006, hourly employees at the Whiting a material adverse effect on our ﬁ nancial condition, results of paper mill, represented by Local 7-370 of the USW voted to operations or liquidity. Employees and Labor Relations As of December 31, 2005, the Company had approximately 1,900 regular full time employees of whom 620 hourly and 280 salaried employees were located in the United States and 780 hourly and 220 salaried employees were located in Canada. accept a new collective bargaining agreement expiring on February 1, 2009. On February 21, 2006, hourly employees at the Neenah paper mill, represented by Local 7-1170 of the USW voted to accept a new collective bargaining agreement expiring on July 1, 2009. Additionally, these mills have bargained jointly with the union on pension matters. The agreements on pension matters for these mills expire June 30, 2007. 60 Notes to Consolidated and Combined Financial Statements 11. T R A N S A C T I O N S W I T H K I M B E R LY- C L A R K During all periods presented, the Company sold or transferred softwood 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 sold or transferred to Kimberly-Clark were $309 million, $351 million and $305 million for the years ended December 31, 2005, 2004 and 2003, respectively. For periods prior to the Spin-Off, settle- ment of 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 (the “Pulp Supply Agreement”) as described below. In connection with the Spin-Off, the Company and Kimberly-Clark executed and delivered a distribution agree- ment (the “Distribution Agreement”), and certain related agreements, which are summarized below. Distribution Agreement Pulp Supply Agreement The Company and Kimberly-Clark have entered into the Pulp Supply Agreement pursuant to which the Company agreed to supply and Kimberly-Clark agreed to purchase annually speci- ﬁ ed minimum tonnages of northern bleached softwood and hardwood kraft pulp. For 2006, the minimum commitment for northern bleached softwood kraft pulp is 440,000 air-dried metric tons (“ADMT”), for 2007 the minimum commitment is 395,000 ADMT and for 2008 and any subsequent years the minimum commitment is 345,000 ADMT. The amounts of those minimum commitments represent approximately 80%, 70%, and 60%, respectively, of the Company’s total production of northern bleached softwood kraft pulp in 2005. The Company’s minimum commitment to supply northern bleached hardwood kraft pulp for 2005, 2006, 2007 and 2008 was 80,000, 60,000, 40,000 and 20,000 ADMT, respectively. In May 2005, the Company closed the smaller of the two single- line pulp mills at the Terrace Bay facility (the “No. 1 Mill”) and terminated, without penalty, its commitment to supply north- ern bleached hardwood kraft pulp produced at that facility. Under the terms of the Pulp Supply Agreement, the Company was obligated to provide 40,000, 30,000, 20,000 and 10,000 metric tons of northern bleached hardwood kraft pulp pro- The Distribution Agreement provided for, among other things, duced at the Terrace Bay mill annually in 2005, 2006, 2007 the principal corporate transactions required to effect the sepa- and 2008, respectively. The Company’s commitment to supply ration of the Pulp and Paper Business from Kimberly-Clark, the and Kimberly-Clark’s requirement to purchase, pursuant to the distribution of the Company’s common stock to the holders of terms of the Pulp Supply Agreement, northern bleached hard- record of Kimberly-Clark common stock and other agreements wood kraft pulp from the Pictou mill (in annual quantities which governing the Company’s relationship with Kimberly-Clark after are identical to those shown above) are unchanged. The the Spin-Off. Pursuant to the Distribution Agreement, Kimberly- amounts of those minimum commitments represent approxi- Clark transferred to the Company assets used primarily in the mately 100%, 75%, 50% and 25%, respectively; of the Pictou Company’s business and in general the Company assumed and mill’s production of northern bleached hardwood kraft pulp in agreed to perform and fulﬁ ll all of the liabilities arising out of the 2005. During 2005, the Company fulﬁ lled its supply commit- ownership or use of the transferred assets or the operation of ments pursuant to the Pulp Supply Agreement. the transferred business. The Distribution Agreement provides Under the Pulp Supply Agreement, the prices for northern for cross indemnities principally designed to place ﬁ nancial bleached softwood kraft pulp and northern bleached hardwood responsibility for the obligations and liabilities of the Pulp and kraft pulp will be based on published industry index prices for Paper Business with the Company and ﬁ nancial responsibility the pulp (subject to minimum and maximum prices for north- for the obligations and liabilities of Kimberly-Clark’s retained ern bleached kraft softwood pulp shipped to North America businesses with Kimberly-Clark except as may otherwise be prior to December 31, 2007), less agreed-upon discounts. The provided in the Distribution Agreement. commitments are structured as supply-or-pay and take-or-pay Neenah Paper, Inc.: UnFOLDING Annual Report 2005 61 arrangements. Accordingly, if the Company does not supply Either party can elect a two-year phase-down period for the speciﬁ ed minimums, the Company must pay Kimberly-Clark the agreement, to begin no earlier than January 1, 2009, under for the shortfall based on the difference between the contract which the minimum commitments for northern bleached soft- price and any higher price that Kimberly-Clark pays to purchase wood kraft pulp in the ﬁ rst and second years of the phase-down the pulp, plus 10% of that difference. If Kimberly-Clark does not period would be 277,500 and 185,000 ADMT, respectively. If the purchase the speciﬁ ed minimums, Kimberly-Clark must pay Company were to choose to reduce its annual supply obligation for the shortfall based on the difference between the contract to Kimberly-Clark, the phase-down commitments in the ﬁ rst and price and any lower price the Company obtains for the pulp, second years would be 165,000 and 101,000 ADMT, respectively. plus 10% of the difference. The Company will incur the cost of In addition, the Company has the right at any time to terminate freight to delivery points speciﬁ ed in the agreement. its obligation to supply northern bleached hardwood kraft pulp On January 17, 2006, the Company and Kimberly-Clark upon three months’ notice to Kimberly-Clark. Either the entered into an amendment (the “PSA Amendment”) to the Company or Kimberly-Clark may terminate the pulp supply Pulp Supply Agreement. The PSA Amendment provides the agreement for certain events speciﬁ ed in the agreement, includ- Company with the option to reduce its annual softwood and ing a material breach of the agreement by the other party that is hardwood supply obligation to Kimberly-Clark to 235,000 not cured after 30 days’ notice, insolvency or bankruptcy of the ADMT in 2006, 235,000 ADMT in 2007 and 215,000 ADMT in other party, or a fundamental change in the nature of the busi- 2008. The Company can only exercise such option by giving ness of the other party that may substantially affect its ability Kimberly-Clark advance written notice of its election to do to sell or to purchase or utilize pulp under the agreement. In so prior to June 30, 2007. The Company’s right to give such addition, Kimberly-Clark may terminate the agreement if the notice is also subject to certain limitations that affect the timing ownership or control of the Company or any of its pulp produc- and the effective date of the notice. tion facilities becomes vested in or is made subject to the Additionally, the PSA Amendment provides Kimberly-Clark control or direction of, any direct competitor of Kimberly-Clark with the option to reduce its annual purchase obligation for North or any governmental or regulatory authority or any other third American northern bleached softwood kraft pulp during 2006 by party, who in Kimberly-Clark’s reasonable judgment may not be up to 50,000 ADMT. The PSA Amendment also permits Kimberly- able to reliably perform the Company’s obligations under the Clark to reduce its purchase obligation from the Company’s agreement. Kimberly-Clark may also terminate the agreement Terrace Bay, Ontario pulp operations (“Terrace Bay”), on upon one year’s notice if, as a result of the Company’s forestry one occasion only, by up to an additional 80,000 ADMT in the activities, continued use of the Company’s pulp by Kimberly- event that Terrace Bay resumes operations following a Terrace Clark does or, in Kimberly-Clark’s reasonable judgment is likely Bay Force Majeure Event (as deﬁ ned in the PSA Amendment). to, result in a substantial loss of sales of Kimberly-Clark’s prod- During the continuance of a Terrace Bay Force Majeure Event, or ucts or to otherwise materially and adversely affect the a different Force Majeure Event (as deﬁ ned in the Pulp Supply reputation of Kimberly-Clark or its products. Kimberly-Clark may Agreement), the Company is generally excused, without penalty, also terminate the agreement upon 180 days notice that the from its obligations to supply and Kimberly-Clark is excused, also Company’s failure to comply with United States customs require- without penalty, from its commitments to purchase pulp under ments jeopardizes Kimberly-Clark customs certiﬁ cation. the Pulp Supply Agreement during the continuance, and to the The preceding description is a summary of principal provi- extent of, such event. A strike, labor disturbance and other events sions of the Pulp Supply Agreement and the PSA Amendment beyond the Company’s control are considered Force Majeure and is qualiﬁ ed in its entirety by the Pulp Supply Agreement Events under the Pulp Supply Agreement if such events ultimately and PSA Amendment. prevent the Company from supplying contractually agreed upon quantities of pulp to Kimberly-Clark. 62 Notes to Consolidated and Combined Financial Statements Corporate Services Agreement In connection with the Spin-Off, outstanding options held The Company and Kimberly-Clark entered into a Corporate by transferring employees under Kimberly-Clark’s equity com- Services Agreement whereby Kimberly-Clark provided the pensation plans (other than the Kimberly-Clark Corporation Company, on an interim, transitional basis, various corporate sup- Global Stock Option Plan) were converted into substitute options port services, including: certain employee beneﬁ ts administration to purchase Company common stock, or to the extent such and payroll, management information, transportation, environ- options were exercisable they could, at the election of the option ment and energy, purchasing, treasury, accounting and other holder on or before November 30, 2004, remain exercisable in services, as well as transitional ofﬁ ce space for the Company’s accordance with the terms of such plans as applicable to termi- research team. Each service was made available to the Company nated employees. on an as-needed basis through December 31, 2005, or such shorter or longer periods as may be provided in the Corporate Services Agreement. The fees charged for the services were gen- erally based upon the costs of providing the services. In January 2006, the Company terminated substantially all services provided by Kimberly-Clark pursuant to the corporate services agreement. 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 Employee Matters Agreement Kimberly-Clark as a result of the failure of the Spin-Off to qual- The Company and Kimberly-Clark entered into an Employee ify for tax-free treatment under Section 355 of the Code. Matters Agreement which provides for their respective obliga- General Taxes. Under the Tax-sharing Agreement, Kimberly- tions to employees and former employees who are or were Clark is generally liable for all pre-Spin-Off, and the Company associated with the Pulp and Paper Business and for other is generally be liable for all post-Spin-Off, U.S. federal income employment and employee beneﬁ ts matters. taxes, foreign taxes and certain state taxes attributable to the Pursuant to the Employee Matters Agreement, the Company’s business. The Tax-sharing Agreement sets forth rules Company employed or offered to employ all employees of for determining which taxes are attributable to pre-Spin-Off and Kimberly-Clark with employment duties principally related to post-Spin-Off periods and rules on the effect of subsequent the Pulp and Paper Business on terms and conditions substan- adjustments to those taxes due to tax audits or examinations. tially similar to the terms and conditions of their employment Distribution-Related Taxes. Under the Tax-sharing with Kimberly-Clark. The Company maintained, subject to Agreement the Company is liable for taxes incurred by Kimberly- applicable laws, labor agreements with substantially the same Clark that arise as a result of the Company taking or failing to terms and conditions that existed with Kimberly-Clark. take, as the case may be, certain actions that result in the Spin-Off The Company also assumed, and indemniﬁ ed Kimberly- failing to meet the requirements of a tax-free distribution under Clark against, certain liabilities related to employees of the Pulp Section 355 of the Code. The Company is also liable for taxes and Paper Business who are employed by the Company or incurred by Kimberly-Clark in connection with certain acquisitions retired Canadian employees. The Company assumed responsibil- or issuances of Company stock, even if such acquisitions or issu- ity for the Kimberly-Clark retirement plans in which employees of ances occurred after the Spin-Off, if such acquisitions or issuances the Pulp and Paper Business participated. The Company granted result in the Spin-Off failing to meet the requirements of a tax-free credit for service recognized under the Kimberly-Clark plans distribution pursuant to Section 355(e) of the Code. for all purposes under its plans. Kimberly-Clark transferred the Administrative Matters. The Tax-sharing Agreement also assets and liabilities of the Kimberly-Clark retirement plans attrib- sets forth Kimberly-Clark’s and the Company’s respective obliga- utable to transferring active employees and retired Canadian tions with respect to the ﬁ ling of tax returns, the administration employees of the Pulp and Paper Business to the Company. of tax contests, assistance and cooperation and other matters. Neenah Paper, Inc.: UnFOLDING Annual Report 2005 63 12. R E S T R U C T U R I N G C O S T S A N D A S S E T I M PA I R M E N T L O S S Restructuring Activities at Terrace Bay: The Company closed the No. 1 Mill on May 1, 2005. The No. 1 (cid:129) continued high operating costs at this facility; (cid:129) substantially higher discounts, under the pulp supply agree- ment, for pulp sold to Kimberly-Clark than those at which pulp was transferred to Kimberly-Clark prior to the Spin-Off; (cid:129) anticipated lower market prices for pulp in the foresee- able future as a result of an expected downturn in the Mill was originally constructed in 1948 and had annual capacity pulp cycle; and of approximately 125,000 metric tons of bleached kraft pulp. In (cid:129) continued strength of the Canadian dollar relative to the conjunction with the closure, the Company offered early retire- U.S. dollar. ment and severance packages to approximately 150 employees. An extended period of operating losses is an indicator of During 2005, the Company recorded approximately $5.0 impairment under SFAS 144. The results of the impairment test million for one-time termination beneﬁ ts related to early retire- indicated that the carrying amount of the Terrace Bay facility ment, severance and deﬁ ned beneﬁ t pension plans in connection would not be recoverable from estimated future undiscounted with the closure of the No.1 Mill and approximately $0.3 million cash ﬂ ows. The Company’s estimate of the fair value of the for other exit costs. As of December 31, 2005, termination beneﬁ ts of approximately $4.5 million had been paid to 139 employees and approximately $0.5 million was accrued but unpaid. The Company expects the payment of termination beneﬁ ts to be substantially complete by March 31, 2006. 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 assumptions the Company used to determine the estimate of fair value included its long-term projections of the market price of pulp, the projected cost During the ﬁ rst quarter of 2005, the Company recorded a structure of the facility and the long-term relationship of the pre-tax, non-cash asset impairment loss of approximately $0.8 Canadian dollar and the U.S. dollar. The estimated fair value million related to the remaining value of the long-lived assets of the Terrace Bay facility also reﬂ ected assumed improvements of the No. 1 Mill. In addition, the Company recorded $0.4 mil- to the facility’s cost structure resulting from the Company’s lion of incremental training costs for employees in new plans for future capital projects and a plan for a cogeneration positions as a result of the closure in 2005. Such training costs arrangement that would lower the cost of electricity. were expensed as incurred. Costs associated with the closure, In December 2004, the Company recorded a pre-tax, non- excluding expenses related to employee training, are recorded cash impairment loss of approximately $110.0 million to reduce in Restructuring costs and asset impairment loss on the con- solidated and combined statements of operations. Asset Impairment Losses: In December 2004, the Company performed an asset impair- ment test on the Terrace Bay, Ontario pulp mill under the guidance of SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). The facility had incurred operating losses in each of 2002, 2003 and 2004. The Company anticipated that the facility would continue to incur operating losses in 2005, 2006 and 2007. The principal causes of these projected losses were: the carrying amount of the Terrace Bay facility to its estimated fair value. In addition, in December 2004, in recognition of the probability that the No. 1 mill would be closed, the Company recorded an additional impairment loss of approximately $2.8 million related to the long-lived assets of the Terrace Bay facil- ity. A deferred tax beneﬁ t of approximately $40.8 million was recorded as a result of the impairment losses, resulting in a net after-tax charge of approximately $72.0 million. In December 2005, due to continued large operating losses at the Terrace Bay facility, a review of strategic alterna- tives and anticipated continuing losses in 2006, the Company performed another impairment test of the facility which indi- cated that the carrying value of its long-lived assets was not recoverable from estimated future cash ﬂ ows. In estimating 64 Notes to Consolidated and Combined Financial Statements the impairment loss, the fair value of the facility was deter- Business Segments mined in a manner consistent with that applied in December 2004. While the signiﬁ cant assumptions used to determine the fair value of the facility were applied in a manner consistent with the prior year, the Company’s probability-weighting of the estimated future cash ﬂ ows were different. The estimated fair value for the facility indicated that its long-lived assets were fully impaired. As a result, the Company recorded a pre-tax, non-cash impairment loss of approximately $53.7 million to reduce the carrying amount of the facility’s tangible long-lived assets to zero. A deferred tax beneﬁ t of approximately $20.6 million was recorded as a result of the impairment losses, result- ing in a net after-tax charge of approximately $33.1 million. Restructuring costs and asset impairment losses recognized in 2005 and 2004 were recorded in the Pulp segment (See Note 13). 13. B U S I N E S S S E G M E N T A N D G E O G R A P H I C I N F O R M AT I O N The Company reports its operations in three segments: Fine Paper, Technical Products and Pulp. The Fine Paper business is a leading producer of premium writing, text, cover and specialty December 31, 2005 2004 2003 Net Sales Fine Paper Technical Products Pulp Intersegment sales Total Operating Income (Loss) Fine Paper Technical Products Pulp (a) Unallocated corporate costs Total Depreciation and Amortization Fine Paper Technical Products Pulp Unallocated corporate costs Total Capital Expenditures Fine Paper Technical Products Pulp Corporate Total $ 222.3 130.6 400.7 (20.2) $ 733.4 $ 58.4 10.5 (93.2) (6.5) $ (30.8) $ 9.5 4.0 13.5 2.8 $ 29.8 $ 5.5 2.4 9.8 8.0 $ 25.7 $ 220.8 132.3 448.6 (29.6) $ 772.1 $ 67.0 21.9 (120.5) (8.3) $ (39.9) $ 9.7 3.7 22.4 0.2 $ 36.0 $ 3.5 1.6 11.0 3.0 $ 19.1 $ 210.4 121.6 405.1 (26.8) $ 710.3 $ 63.2 16.6 (16.5) – $ 63.3 $ 9.6 4.0 21.7 – $ 35.3 $ 2.5 2.2 19.7 – $ 24.4 papers. The Technical Products business is a leading producer (a) of durable, saturated and coated base papers and ﬁ lms for a vari- ety of end uses. The Pulp business consists of mills and related timberlands, which produce northern bleached softwood and hardwood kraft pulp. Each segment requires different technolo- gies and marketing strategies. Disclosure of segment information is on the same basis that management uses internally for evaluat- ing 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 administrative functions man- Income before income taxes for the pulp business in 2005 and 2004 include restructuring costs and asset impairment losses of $59.8 million ($6.1 million of which represent costs related to the closure of the No. 1 Mill) and $112.8 million, respectively, for the Terrace Bay facility. December 31, 2005 2004 Total Assets Fine Paper Technical Products Pulp Unallocated corporate and intersegment items Total Geographic Information $ 105.2 58.3 352.0 $ 140.9 49.8 361.4 21.5 $ 537.0 5.2 $ 557.3 aged on a common basis, are allocated to the segments based December 31, 2005 2004 2003 on usage, where possible, or other factors based on the nature of the activity. The accounting policies of the reportable operat- ing segments are the same as those described in the Summary of Signiﬁ cant Accounting Policies (See Note 2). Net Sales United States Canada Intergeographic Items Total $ 352.9 400.7 (20.2) $ 733.4 $ 354.0 448.2 (30.1) $ 772.1 $ 332.8 404.6 (27.1) $ 710.3 Neenah Paper, Inc.: UnFOLDING Annual Report 2005 65 December 31, Total Assets United States Canada Total 2005 2004 $ 231.9 305.1 $ 537.0 $ 241.8 315.5 $ 557.3 14. S U P P L E M E N TA L D ATA Supplemental Statement of Operations Data Year Ended December 31, 2005 2004 2003 Net sales are attributed to geographic areas based on the 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- Summary of Advertising and Research Expenses Advertising expense Research expense $ 7.9 2.3 $ 7.7 1.7 $ 5.8 2.1 ments operations. Corporate assets are primarily cash, prepaid Supplemental Balance Sheet Data pension costs and deferred ﬁ nancing costs. Concentrations For the years 2005, 2004 and 2003, the Company had pulp sales to Kimberly-Clark of $309 million, $351 million and $305 million, respectively. For the periods presented, other than Kimberly- Clark, no single customer accounted 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 Products, management is not aware of any signiﬁ cant concentration of business transacted with a par- ticular supplier that could, if suddenly eliminated, have a material adverse affect on its operations. In 2005, two suppliers provided over 70% of the wood chips used by the Pictou mill and three suppliers provided approximately 50% of the wood chips used by the Terrace Bay mill. While management believes that alterna- tive sources of critical supplies, such as wood chips, would be available, disruption of its primary sources could create a tempo- December 31, 2005 2004 Summary of Accounts Receivable, net Accounts Receivable: From customers Other Less allowance for doubtful accounts and sales discounts Total $ 76.7 6.0 $ 84.9 11.8 (3.6) $ 79.1 (4.3) $ 92.4 December 31, 2005 2004 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 $ 30.5 8.2 47.8 7.6 94.1 (7.0) $ 87.1 $ 31.1 7.7 42.1 5.2 86.1 (6.6) $ 79.5 rary, adverse effect on product shipments. In February 2006, the The FIFO values of total inventories valued on the LIFO Company suspended pulp manufacturing activities at the Terrace method were $35.2 million and $33.5 million at December 31, Bay pulp mill as a result of a lack of wood ﬁ ber for its operations 2005 and 2004, respectively. (See Note 10 – Employees and Labor Relations). An interruption Certain prior year amounts of Supplies and others, related in supply of a latex specialty grade could disrupt and eventually to inventories of spare parts, have been reclassiﬁ ed to Prepaid cause a shutdown of production of certain technical products. and other current assets in the consolidated balance sheet to more closely conform with Accounting Research Bulletin 43, Restatement and Revision of Accounting Research Bulletins, deﬁ nition of inventory as tangible personal property to be currently consumed in the production of goods or services. Accordingly, amounts reﬂ ected at December 31, 2004 for “Supplies and other” and “Total Inventories” have been decreased and “Prepaid and other current assets” have been increased from the amounts previously reported by $9.2 million. 66 Notes to Consolidated and Combined Financial Statements December 31, 2005 2004 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 $ 2.7 81.2 478.7 23.4 15.0 601.0 388.0 $ 213.0 $ 4.8 84.6 487.9 26.5 13.6 617.4 359.8 $ 257.6 Depreciation expense was $27.0 million, $35.8 million and $35.3 million in 2005, 2004 and 2003, respectively. Interest expense capitalized as part of the costs of capital projects was $0.4 million in 2005. No amount of interest expense was capi- talized for periods prior to the Spin-Off or in December 2004 following the Spin-Off. December 31, 2005 2004 Summary of Accrued Expenses Accrued salaries and employee beneﬁ ts $ 25.8 – Accrued income taxes 2.1 Accrued interest 10.9 Other $ 38.8 Total $ 27.2 0.5 1.4 7.5 $ 36.6 15. C O N D E N S E D C O N S O L I D AT I N G F I N A N C I A L I N F O R M AT I O N Neenah Paper Company of Canada, Neenah Paper Michigan, Inc. and Neenah Paper Sales, Inc. (the “Subsidiary Guarantors”) guarantee the Company’s Senior Notes. The Subsidiary Guarantors are 100% owned by the Company and all guarantees are full and unconditional. The following con- densed consolidating ﬁ nancial information is presented in lieu of consolidated ﬁ nancial statements for the Subsidiary Guarantors as of December 31, 2005 and 2004 and for the year ended December 31, 2005. Condensed consolidating ﬁ nancial information is not included for the years ended December 31, 2004 and 2003 because: (a) historical informa- tion required to prepare the comparative consolidating statements was not maintained on a discrete comparable basis within Kimberly-Clark, (b) prior to the Spin-Off, the business operations that now constitute Neenah were not part of sepa- rate operating units or divisions of Kimberly-Clark for which discrete ﬁ nancial statements were prepared and (c) the func- tions and operations of the assets and the related businesses as currently structured are substantially different from that which existed as a part of Kimberly-Clark. CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS (in millions) For the Year Ended December 31, 2005 Net sales Cost of products sold Gross proﬁ t Selling, general and administrative expenses Restructuring costs and asset impairment loss Equity in losses of subsidiaries Other income – net Operating income (loss) Interest expense – net Income (loss) before income taxes Provision (beneﬁ t) for income taxes Net income (loss) Neenah Paper, Inc. Subsidiary Guarantors Consolidating Adjustments Consolidated Amounts $ $ 78.7 69.3 9.4 5.8 – 21.1 (0.2) (17.3) 18.1 (35.4) (5.7) (29.7) $ 800.8 732.7 68.1 47.4 59.8 – (4.5) (34.6) 0.1 (34.7) (13.6) (21.1) $ $ $ (146.1) (146.1) – – – (21.1) – 21.1 – 21.1 – 21.1 $ 733.4 655.9 77.5 53.2 59.8 – (4.7) (30.8) 18.2 (49.0) (19.3) (29.7) $ Neenah Paper, Inc.: UnFOLDING Annual Report 2005 67 CONDENSED CONSOLIDATING BALANCE SHEET (in millions) As of December 31, 2005 ASSETS Current assets Cash and cash equivalents Accounts receivable – net Inventories Intercompany amounts receivable Other current assets Total current assets Property, plant and equipment, at cost Less accumulated depreciation Property, plant and equipment – net Investments in subsidiaries Prepaid and intangible pension costs Other assets Total Assets LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities Debt payable within one year Accounts payable Intercompany amounts payable Accrued expenses Total current liabilities Long-term debt Other noncurrent liabilities Total Liabilities Stockholders’ equity Total Liabilities and Stockholders’ Equity Neenah Paper, Inc. Subsidiary Guarantors Consolidating Adjustments Consolidated Amounts $ 12.0 (5.9) 0.1 32.1 8.7 47.0 222.1 127.5 94.6 288.3 9.8 (10.9) $ 428.8 $ 1.2 10.1 – 10.1 21.4 226.3 15.8 263.5 165.3 $ 428.8 $ 0.6 87.0 87.0 – 16.8 191.4 394.7 271.4 123.3 – 61.9 54.0 $ 430.6 $ – 32.3 32.1 28.7 93.1 – 49.2 142.3 288.3 $ 430.6 $ $ $ $ – (2.0) – (32.1) – (34.1) – – – (288.3) – – (322.4) – (2.0) (32.1) – (34.1) – – (34.1) (288.3) (322.4) 12.6 79.1 87.1 – 25.5 204.3 616.8 398.9 217.9 – 71.7 43.1 $ 537.0 $ 1.2 40.4 – 38.8 80.4 226.3 65.0 371.7 165.3 $ 537.0 68 Notes to Consolidated and Combined Financial Statements CONDENSED CONSOLIDATING BALANCE SHEET (in millions) As of December 31, 2004 ASSETS Current assets Cash and cash equivalents Accounts receivable–net Inventories Other current assets Total current assets Property, plant and equipment, at cost Less accumulated depreciation Property, plant and equipment–net Investments in subsidiaries Prepaid and intangible pension costs Other assets Total Assets LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities Accounts payable Accrued expenses Total current liabilities Long-term debt Other noncurrent liabilities Total Liabilities Stockholders’ equity Total Liabilities and Stockholders’ Equity Neenah Paper, Inc. Subsidiary Guarantors Consolidating Adjustments Consolidated Amounts $ 13.9 (2.5) 0.1 2.5 14.0 212.8 120.9 91.9 362.5 10.4 (20.1) $ 458.7 $ 15.1 8.5 23.6 225.0 13.0 261.6 197.1 $ 458.7 $ 5.2 98.1 79.4 10.1 192.8 419.9 249.0 170.9 – 62.5 38.1 $ 464.3 $ 38.7 28.1 66.8 – 35.0 101.8 362.5 $ 464.3 $ $ $ $ – (3.2) – – (3.2) – – – (362.5) – – (365.7) (3.2) – (3.2) – – (3.2) (362.5) (365.7) $ 19.1 92.4 79.5 12.6 203.6 632.7 369.9 262.8 – 72.9 18.0 $ 557.3 $ 50.6 36.6 87.2 225.0 48.0 360.2 197.1 $ 557.3 Neenah Paper, Inc.: UnFOLDING Annual Report 2005 69 CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS (in millions) As of December 31, 2005 OPERATING ACTIVITIES Net income (loss) Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization Asset impairment loss Deferred income tax provision (beneﬁ t) Loss on asset dispositions Decrease (increase) in working capital Equity in earnings of subsidiaries Pension and other postretirement beneﬁ ts Other Net Cash Provided by (Used for) Operating Activities INVESTING ACTIVITIES Capital expenditures Other Net Cash Used in Investing Activities FINANCING ACTIVITIES Proceeds from issuance of long-term debt Repayments of long-term debt Proceeds from issuance of short-term debt Repayments of short-term debt Cash dividends paid Other Net Cash Provided by (Used in) Financing Activities Effect of Exchange Rate Changes on Cash and Cash Equivalents Net Decrease in Cash and Cash Equivalents Cash and Cash Equivalents, Beginning of Year Cash and Cash Equivalents, End of Year Neenah Paper, Inc. Subsidiary Guarantors Consolidating Adjustments Consolidated Amounts $ (29.7) $ (21.1) $ 21.1 $ (29.7) 13.3 – (2.5) 0.1 (36.7) 21.1 2.5 0.2 (31.7) (8.4) (0.3) (8.7) 3.4 (1.1) 2.5 (2.5) (5.9) 42.1 38.5 – (1.9) 13.9 12.0 $ 16.5 54.5 (17.6) 0.4 26.6 – (5.2) 0.4 54.5 (17.3) 0.2 (17.1) – – – – – (42.1) (42.1) 0.1 (4.6) 5.2 0.6 $ – – – – – (21.1) – – – – – – – – – – – – – – – – – $ 29.8 54.5 (20.1) 0.5 (10.1) – (2.7) 0.6 22.8 (25.7) (0.1) (25.8) 3.4 (1.1) 2.5 (2.5) (5.9) – (3.6) 0.1 (6.5) 19.1 12.6 $ 70 Notes to Consolidated and Combined Financial Statements 16. UN AUDI TE D QU A R TERLY D ATA Net Sales Gross Proﬁ t Operating Income (Loss) (b) Net Income (Loss) (b) Earnings (Loss) Per Common Share: Basic Diluted Net Sales (d) Gross Proﬁ t Operating Income (Loss) Net Income (Loss) Earnings Per Common Share (e): Earnings (Loss) Per Common Share (e): Basic Diluted First $ 196.6 25.3 8.9 2.7 $ $ 0.18 0.18 First $ 198.4 33.1 24.3 15.1 Second $ 189.3 29.5 14.8 6.8 $ $ 0.46 0.46 Second $ 207.4 45.0 37.3 23.7 2005 Quarters (a) Third $ 167.7 15.4 1.5 (1.5) $ $ (0.10) (0.10) 2004 Quarters (a) Third $ 188.9 23.3 7.8 4.5 Fourth (c) $ 179.8 7.3 (56.0) (37.7) $ $ (2.56) (2.56) Fourth (c) $ 177.4 22.8 (109.3) (69.7) Year $ 733.4 77.5 (30.8) (29.7) $ $ (2.02) (2.02) Year $ 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) (a) The annual maintenance shutdowns for the Company’s two pulp mills occurred during the third quarter and fourth quarters in 2005 compared to 2004 when both occurred during the third quarter. (b) Results for the ﬁ rst, second and third quarters of 2005 and for the year include costs associated with the closure of the No. 1 Mill of $4.3 million, $1.7 million, $0.1 million and $6.1 million, respectively. (c) Includes asset impairment losses of $53.7 million and $112.8 million in December 2005 and 2004, respectively. (d) 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. (e) For 2004 prior to the Spin-Off, basic and diluted earnings per share were computed using the number of shares of Neenah common stock outstanding on November 30, 2004, the date on which Neenah common stock was distributed to the stockholders of Kimberly-Clark. Production Notes 71 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 below. POSTER: Side 1: CLASSIC CREST®, Solar White, 80 lb. text BOOK: Side 2: CLASSIC CREST®, Solar White, 80 lb. text Front Cover: CLASSIC COLUMNS®, Red Pepper / CLASSIC CREST®, Avalanche White, 120 lb. duplex cover Page 1: CLASSIC® Linen, Solar White, 80 lb. text Page 2: CLASSIC® Linen, Solar White, 80 lb. text Page 3: CLASSIC® Linen, Monterey Sand, 80 lb. text Page 4: CLASSIC® Linen, Monterey Sand, 80 lb. text Fly Sheet Front: EAMES™ Architecture, Case Study Red, 50 lb. text 72 Production Notes Fine Paper Short Sheet Front: CLASSIC CREST®, Saw Grass, 80 lb. text Fine Paper Short Sheet Back: CLASSIC CREST®, Saw Grass, 80 lb. text Page 5: CLASSIC® Laid, Recycled Natural White, 75 lb. text Page 6: CLASSIC® Laid, Recycled Natural White, 75 lb. text Fly Sheet Front: EAMES™ Furniture, Paciﬁ c Blue 80 lb. text Technical Products Short Sheet Front: EAMES™ Painting, Eames Natural White, 80 lb. text Pulp Short Sheet Front: ENVIRONMENT®, Desert Storm, 80 lb. text Technical Products Short Sheet Back: EAMES™ Painting, Eames Natural White, 80 lb. text Pulp Short Sheet Back: ENVIRONMENT®, Desert Storm, 80 lb. text Page 7: EAMES™ Painting, Brushwork Beige, 80 lb. text Page 8: EAMES™ Painting, Brushwork Beige, 80 lb. text Pages 9–72: CLASSIC CREST®, Potomac Blue, 80 lb. text Back Cover: CLASSIC COLUMNS®, Red Pepper / CLASSIC CREST®, Avalanche White, 120 lb. duplex cover Design and production: see see eye / Atlanta, Georgia Principal photography: Greg Neumaier Copywriting: Robert Roth Printing: Williamson Printing Corporation Executive photography: Daemon Baizon Jerry Burns Additional photography: Daemon Baizon Image Studios Illustrations: Daniel Chang: Poster, Page 4, Pulp Short Sheet Stéphan Daigle: Fine Paper Short Sheet Harvey Chan : Technical Products Short Sheet Shareholder Information Corporate Headquarters Neenah Paper, Inc. 3460 Preston Ridge Road Suite 600 Alpharetta, GA 30005 678.566.6500 www.neenah.com Certifications Neenah has included as exhibits to its Annual Report on Form 10-K for the fiscal year ended December 31, 2005 filed with the SEC, certifications of Neenah’s Chief Executive Officer and Chief Financial Officer certifying the quality of our public disclo- sure. Further, Neenah’s Chief Executive Officer has certified to the New York Stock Exchange (NYSE) that he is not aware of any violations by Neenah of the NYSE corporate governance Annual Meeting of Shareholders The 2006 annual meeting of the shareholders of Neenah Paper, listing standards. Inc. will be held Thursday, May 4, 2006, at 10:00 a.m., Eastern Trading and Dividend Information time at Neenah’s headquarters in Alpharetta, Georgia. Registrar and Transfer Agent Computershare Trust Company, N.A. P.O. Box 43010 Providence, RI 02940-3010 www.computershare.com/equiserve 877.498.8847 Common Stock Market Price High Low Dividends Declared $ 30.52 $ 33.58 $ 33.90 $ 36.62 $ 26.25 $ 28.71 $ 29.19 $ 31.03 $ 0.10 $ 0.10 $ 0.10 $ 0.10 2005 Fourth quarter Third quarter Second quarter First quarter 2004 Financial and Other Company Information Our Annual Report on Form 10-K for the fiscal year Fourth quarter* $ 33.50 $ 30.50 None * Neenah common stock began trading on the New York Stock Exchange ended December 31, 2005 is available on our website at on December 1, 2004. www.neenah.com. In addition, financial reports, recent filings with the Securities and Exchange Commission (SEC), As of February 28, 2006, Neenah had approximately 12,400 news releases and other information are available on holders of record of its common stock. our website. For a printed copy of our Form 10-K, without charge, please contact: 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 Stock Exchange 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 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, PHOTOTRANS, HEIRLOOM – are trademarks of Neenah Paper, Inc. (1,1) -1- 3217Cvr21mar06.indd 4/3/06 2:22:20 PM (1,1) -1- 3217Cvr21mar06.indd 4/3/06 2:22:20 PM Neenah Paper: UnFOLDING N e e n a h P a p e r , I n c . 2 0 0 5 A n n u a l R e p o r t 3460 Preston Ridge Road Suite 600 Alpharetta, GA 30005 678.566.6500 Annual Report 2005

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