10-Q 1 jd8-15nahc_10q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20459 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 333-115587 NORTH ATLANTIC HOLDING COMPANY, INC. ----------------------------------------------------- (Exact Name of Registrant as Specified in Its Charter) DELAWARE 20-0709285 ------------------------------- ------------------ (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 257 Park Avenue South, New York, New York 10010-7304 ----------------------------------------- ---------------- (Address of Principal Executive Offices) (Zip Code) (212) 253-8185 --------------------------------------------------- (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]. Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 589,176 shares of common stock, $.01 par value, as of August 12, 2005. PART I FINANCIAL INFORMATION Item 1. Financial Statements NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands except share data) (unaudited)

December 31, 2004 June 30, As Restated, 2005 Note 1 ---- ------ Current assets: Cash $ 10,296 $ 2,347 Accounts receivable, net 8,071 7,839 Inventories 35,169 37,959 Other current assets 5,131 5,861 ---------------- --------------- Total current assets 58,667 54,006 Property, plant and equipment, net 11,635 10,771 Deferred financing costs, net 13,585 13,105 Goodwill 128,697 128,697 Other intangible assets, net 10,073 10,293 Other assets 16,863 15,526 ---------------- --------------- Total assets $ 239,520 $ 232,398 ================ =============== Current liabilities: Accounts payable $ 4,447 $ 7,005 Accrued expenses 7,571 4,642 Accrued interest expense 6,314 6,274 Deferred income taxes 4,228 4,801 Revolving credit facility - 14,500 ---------------- --------------- Total current liabilities 22,560 37,222 Senior notes and long-term debt 270,657 266,622 Term loan 30,000 - Deferred income taxes 5,581 5,005 Postretirement benefits 6,049 6,061 Pension benefits and other long-term liabilities 3,394 4,013 ---------------- --------------- Total liabilities 338,241 318,923 ---------------- --------------- Stockholder's equity: Common stock, voting, $.01 par value authorized shares, 10; issued and outstanding shares, 10 6 6 Additional paid-in capital 5,351 5,291 Loans to stockholders for stock purchase (96) (99) Accumulated other comprehensive income (loss) (1,351) (1,351) Accumulated deficit (102,631) (90,372) ---------------- --------------- Total stockholders' equity (deficit) (98,721) (86,525) ---------------- --------------- Total liabilities and stockholders' deficit $ 239,520 $ 232,398 ================ ===============

The accompanying notes are an integral part of the condensed consolidated financial statements. 2 NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands except per share amounts) (unaudited)

Three months Three months Ended Ended June 30, 2005 June 30, 2004 -------------------- -------------------- Net sales $ 30,521 $ 37,207 Cost of sales 15,108 17,067 -------------------- -------------------- Gross profit 15,413 20,140 Selling, general and administrative expenses 10,394 9,926 Restructuring charges 2,171 - -------------------- -------------------- Operating income (loss) 2,848 10,214 Interest expense and financing costs, net 7,817 8,479 Other expense 830 425 -------------------- -------------------- Income (loss) before income tax expense (benefit) (5,799) 1,310 Income tax expense (benefit) (198) 498 -------------------- -------------------- Net income (loss) applicable to common shares $ (5,601) $ 812 ==================== ==================== Basic earnings per common share: Net income (loss) applicable to common shares $ (9.51) $ 1.38 ==================== ==================== Diluted earnings per common share: Net income (loss) applicable to common shares $ (9.51) $ 1.11 ==================== ==================== Weighted average common shares outstanding: Basic 589.2 588.8 Diluted 589.2 734.4

The accompanying notes are an integral part of the condensed consolidated financial statements. 3 NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands except per share amounts) (unaudited)

Six months Six months Ended Ended June 30, 2005 June 30, 2004 -------------------- -------------------- Net sales $ 57,869 $ 59,312 Cost of sales 28,262 29,320 -------------------- -------------------- Gross profit 29,607 29,992 Selling, general and administrative expenses 20,829 21,365 Restructuring charges 4,067 - -------------------- -------------------- Operating income (loss) 4,711 8,627 Interest expense and financing costs, net 15,368 17,019 Other expense 1,600 513 -------------------- -------------------- Income (loss) before income tax expense (benefit) (12,257) (8,905) Income tax expense (benefit) 3 (3,384) -------------------- -------------------- Net income (loss) (12,260) (5,521) Preferred stock dividends - (1,613) -------------------- -------------------- Net income (loss) applicable to common shares $ (12,260) $ (7,134) ==================== ==================== Basic and Diluted earnings per common share: Net income (loss) $ (20.80) $ (9.78) Preferred stock dividends - (2.86) -------------------- -------------------- Net income (loss) applicable to common shares $ (20.80) $ (12.64) ==================== ==================== Common stock dividends $ - $ (4,884) ==================== ==================== Basic and Diluted earnings per common share: Common stock dividends $ - (8.65) ==================== ==================== Weighted average common shares outstanding: Basic 589.4 564.6 Diluted 589.4 564.6

The accompanying notes are an integral part of the condensed consolidated financial statements. 4 NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)

Six months Six months Ended Ended June 30, 2005 June 30, 2004 --------------------- ------------------- Cash flows from operating activities: Net income (loss) $ (12,260) $ (5,521) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation 436 429 Amortization of other intangible assets 220 338 Amortization of deferred financing costs 1,329 570 Amortization of interest on senior discount notes 4,035 2,752 Deferred income taxes 3 (3,732) Stock compensaton expense 60 - Changes in operating assets and liabilities: Accounts receivable, net (232) (420) Inventories 2,790 (1,893) Other current assets 730 (207) Other assets (1,337) (2,358) Accounts payable (2,559) (3,212) Accrued expenses and other 2,179 6,749 Accrued pension liabilities 148 (868) Accrued postretirement liabilities 12 509 --------------------- ------------------- Net cash provided by (used in) operating activities (4,446) (6,864) --------------------- ------------------- Cash flows from investing activities: Capital expenditures (1,300) (602) --------------------- ------------------- Net cash provided by (used in) investing activities (1,300) (602) --------------------- ------------------- Cash flows from financing activities: Proceeds (payments) from (to) revolving credit facility (14,500) 17,900 Proceeds from term loan 30,000 - Proceeds from issuance of new senior notes, net - 45,000 Proceeds from issuance of senior discount notes - 60,010 Payment of financing costs (1,808) (9,125) Payments on notes payable - (30,686) Redemption of preferred stock - (65,080) Preferred stock cash dividends - (1,613) Proceeds from issuance of common stock - 1 Common stock cash dividends - (4,884) Loans to stockholders for stock purchases 3 - --------------------- ------------------- Net cash provided by (used in) financing activities 13,695 11,523 --------------------- ------------------- Net increase (decrease) in cash 7,949 4,057 Cash, beginning of period 2,347 304 --------------------- ------------------- Cash, end of period $ 10,296 $ 4,361 ===================== ===================

The accompanying notes are an integral part of the condensed consolidated financial statements. 5 North Atlantic Holding Company, Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements 1. RESTATEMENT OF CONSOLIDATED BALANCE SHEET The Company is restating its consolidated financial statements to correct an error in accounting for income taxes. During the fourth quarter of 2004, North Atlantic Holding Company, Inc. (the "Company") and its subsidiaries provided a full valuation allowance against its net deferred tax assets. On August 11, 2005, the Company determined that in calculating the amount of the valuation allowance, deferred tax liabilities relating to inventories and tax-deductible goodwill had been inappropriately netted against certain deferred tax assets. It cannot be determined that the temporary differences related to inventories and goodwill will reverse during the time period in which the Company's temporary differences related to its deferred tax assets are expected to reverse or expire. These deferred tax liabilities should therefore, not have been utilized to reduce the amount of the valuation allowance against deferred tax assets. This resulted in an understatement of the valuation allowance in the amount of the deferred tax liabilities of $4.8 million and $5.0 million related to inventories and goodwill, respectively. The correction of this understatement has the effect of increasing deferred tax liabilities, increasing accumulated deficit and decreasing net income, with no effect on net cash flows, for the year ended December 31, 2004 and the quarter ended March 31, 2005. The following table represents the effect of the restatement on the Company's Consolidated Balance Sheet as of December 31, 2004: Consolidated Balance Sheet as of December 31, 2004 --------------------------------------------------

As Previously Reported Adjustment As Restated ----------------- ---------------- ---------------- Deferred income taxes - current $ - $ 4,801 $ 4,801 Deferred income taxes - non-current $ - $ 5,005 $ 5,005 Accumulated deficit $ (80,566) $ (9,806) $ (90,372)

2. ORGANIZATION These condensed consolidated financial statements should be read in conjunction with the financial statements and related notes thereto included in the Company's Annual Report on Form 10-K, as amended, for the year ended December 31, 2004. The accompanying condensed consolidated financial statements are presented in accordance with the requirements of Form 10-Q and, accordingly, do not include all the disclosures normally required by generally accepted accounting principles. The condensed consolidated financial statements have been prepared in accordance with the Company's customary accounting practices and have not been audited. In the opinion of management, all adjustments necessary to fairly present the results of operations for the reported interim periods have been recorded and were of a normal and recurring nature. The year-end balance sheet data was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. 6 On February 9, 2004, North Atlantic Trading Company, Inc. a Delaware corporation ("NATC) consummated a holding company reorganization whereby the Company became the parent company of NATC. The holding company reorganization was effected pursuant to an Agreement and Plan of Merger (the "Merger Agreement"), dated February 9, 2004, among the Company, NATC and NATC Merger Sub, Inc., a Delaware corporation and a direct wholly-owned subsidiary of the Company ("Merger Sub"). Pursuant to the Merger Agreement, (i) Merger Sub was merged with and into NATC (the "Merger"), with NATC as the surviving corporation; (ii) NATC became a wholly-owned subsidiary of the Company; (iii) each of the 539,235 issued and outstanding shares of voting common stock of NATC, par value $0.01 per share, was converted into the right to receive one share of common stock of the Company, par value $0.01 per share ("Company Common Stock"); (iv) each issued and outstanding share of common stock of Merger Sub was converted into one issued and outstanding share of common stock of NATC, par value $0.01 per share ( "NATC Common Stock"); and (v) all of the issued and outstanding shares of the Company's Common Stock held by NATC were cancelled. Immediately after the Merger, (i) 539,235 shares of Company Common Stock were issued and outstanding; and (ii) ten (10) shares of NATC Common Stock were issued and outstanding. Subsequently, the Company issued 49,523 shares of Company Common Stock upon the exercise of certain warrants pursuant to a Warrant Agreement (the "Warrant Agreement"), dated June 25, 1997, between the Company (as assignee to NATC's rights and obligations under the Warrant Agreement) and The Bank of New York, as warrant agent (as successor to the United States Trust Company of New York). As of June 30, 2005, (i) 591,343 shares of Company Common Stock were issued and 589,176 were outstanding; and (ii) ten (10) shares of NATC Common Stock were issued and outstanding. 3. RECAPITALIZATION AND REORGANIZATION On February 9, 2004, NATC consummated its general corporate reorganization in which the Company was created and became the parent company of NATC. On February 17, 2004, NATC consummated the refinancing of its existing debt and preferred stock and the Company issued senior discount notes as part of the refinancing. The refinancing consisted principally of (1) the offering and sale of $200.0 million principal amount of 9 1/4% senior notes due 2012 by NATC (the "New Senior Notes"), (2) the entering into by NATC of an amended and restated loan agreement (the "Old Credit Agreement") that provided a $50.0 million senior secured revolving credit facility (the "Senior Revolving Credit Facility") to NATC (see Note 8 for a discussion of the refinancing of the Senior Revolving Credit Facility), and (3) the concurrent offering and sale of $97.0 million aggregate principal amount at maturity of 12 1/4% senior discount notes due 2014 of the Company (the "Company Notes"). Both the New Senior Notes and the Company Notes were offered pursuant to Rule l44A and Regulation S and subsequently registered under the Securities Act of 1933, as amended. 7 Concurrently with the closing of the refinancing, NATC also called for the redemption of all its outstanding 11% senior notes due 2004 (the "Old Senior Notes"), in accordance with the terms of the indenture governing such notes, at the applicable redemption price of 100.0% of the principal amount of $155.0 million, plus interest accrued to the redemption date of April 2, 2004. The proceeds from the offering of the New Senior Notes, along with borrowings under the Senior Revolving Credit Facility (see Notes 7 and 8) and the proceeds from the concurrent offering of the Company Notes were used to (1) repay $36.6 million in outstanding borrowings under the existing senior credit facility (the "Old Senior Credit Facility"), including borrowings used to finance the cash purchase price for the acquisition of Stoker, Inc., (2) redeem the Old Senior Notes, (3) redeem NATC's existing 12% senior exchange payment-in-kind preferred stock on March 18, 2004, (4) pay a $4.9 million pro rata distribution to stockholders of the Company and make a distribution to certain holders of warrants of the Company, (5) make $2.1 million in incentive payments to certain key employees and outside directors, and (6) pay fees and expenses of $12.8 million incurred in connection with the offerings. 4. RESTRUCTURING In January 2005, the Company engaged the management consulting firm of Alvarez and Marsal, LLC ("A&M") to identify the potential for performance improvement opportunities and to provide for the services of Douglas P. Rosefsky as Chief Financial Officer. For the six months ended June 30, 2005, total restructuring charges amounted to approximately $4.0 million, including, but not limited to, severance and separation expenses, A&M fees and other non-recurring expenses. The Company anticipates incurring additional expenses relating to the restructuring during 2005. In April 2005, the Company appointed Douglas P. Rosefsky (formerly Chief Financial Officer) as President and Chief Executive Officer, Thomas F. Helms, Jr. (formerly Chairman of the Board of Directors, President and Chief Executive Officer) as Chairman of the Board of Directors, and Brian C. Harriss as Chief Financial Officer. In June 2005, NATC appointed Lawrence S. Wexler (President of the Company's North Atlantic Cigarette Company, Inc., subsidiary) as Chief Operating Officer. 5. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: For the three and six months ended June 30, 2005, the condensed consolidated financial statements include the accounts of the Company and its subsidiaries. For the three and six months ended June 30, 2004, the condensed consolidated statement of operations includes the accounts of the Company from inception (February 9, 2004) through June 30, 2004 and the accounts of NATC and its subsidiaries for January 1, 2004 through June 30, 2004. All significant intercompany accounts have been eliminated. REVENUE RECOGNITION: The Company recognizes revenues and the related costs upon transfer of title and risk of loss to the customer. 8 SHIPPING COSTS: The Company records shipping costs incurred as a component of selling, general and administrative expenses. Shipping costs incurred were $1.1 million and $0.9 million for the three months ended June 30, 2005 and 2004, respectively, and $2.3 million and $1.7 million for the six months ended June 30, 2005 and 2004, respectively. MASTER SETTLEMENT AGREEMENT ESCROW ACCOUNT: Pursuant to the Master Settlement Agreement (the "MSA") entered into in November 1998 by most states (represented by their attorneys general acting through the National Association of Attorneys General) and subsequent states' statutes, a "cigarette manufacturer" (which is defined to include a manufacturer of make-your-own cigarette tobacco) has the option of either becoming a signatory to the MSA or opening, funding, and maintaining an escrow account to have funds available for certain potential tobacco-related liabilities, with sub-accounts on behalf of each settling state. The Company has chosen to open and fund an escrow account as its method of compliance. It is the Company's policy to record amounts on deposit in the escrow account for prior years, as well as cash-on-hand to fund its projected deposit based on its monthly sales for the current year, as an Other non-current asset. Each year's obligation is required to be deposited in the escrow account by April 15 of the following year. During April 2005, approximately $3.4 million relating to 2004 sales was deposited. As of June 30, 2005 and December 31, 2004, the Company has recorded approximately $15.3 million and $13.2 million, respectively, in Other assets. For the six months ended June 30, 2005, approximately $2.0 million relating to 2005 sales was recorded in Other assets. COMPREHENSIVE INCOME: The Company's Comprehensive income for the three and six months ended June 30, 2005 and 2004 is equal to the Company's Net income (loss) for the respective periods. 6. INVENTORIES Inventories are stated at the lower of cost or market. Cost is determined on the last-in, first-out ("LIFO") method for approximately 97% of the inventories. Leaf tobacco is presented in current assets in accordance with standard industry practice, notwithstanding the fact that such tobaccos are carried longer than one year for the purpose of curing. For the six months ended June 30, 2005, inventory quantities were reduced. This reduction resulted in a liquidation of LIFO inventory quantities carried at higher costs prevailing in prior years as compared with the cost of 2005 purchases, the effect of which increased cost of goods sold and decreased net income by approximately $0.7 million. The components of inventories are as follows (in thousands): 6/30/05 12/31/04 -------------- ------------- Raw materials and work in process $ 3,993 $ 4,246 Leaf tobacco 6,711 7,878 Finished goods - loose leaf tobacco 3,675 3,069 Finished goods - MYO products 8,308 8,539 Other 1,917 2,163 -------------- ------------- 24,604 25,895 LIFO reserve 10,565 12,064 -------------- ------------- $ 35,169 $ 37,959 ============== ============= 9 7. COMPANY NOTES AND NEW SENIOR NOTES The Company Notes and New Senior Notes are as follows (in thousands): 6/30/05 12/31/04 -------------- ------------- Company Notes $ 70,657 $ 66,622 New Senior Notes 200,000 200,000 -------------- ------------- $ 270,657 $ 266,622 ============== ============= On February 17, 2004, NATC consummated the refinancing of its existing debt and preferred stock. The refinancing consisted principally of (1) the offering and sale of the New Senior Notes, (2) entering into the Senior Revolving Credit Facility, (3) the concurrent sale of the Company Notes and (4) the repayment of $30.7 million in debt relating principally to the acquisition of Stoker, Inc. The New Senior Notes are senior unsecured obligations of NATC, which has no independent assets or operations, and will mature on March 1, 2012. The New Senior Notes bear interest at the rate of 9 1/4% per annum, payable semiannually on March 1 and September 1 of each year, commencing on September 1, 2004. Each of NATC's existing subsidiaries jointly and severally guarantees the New Senior Notes on a senior unsecured basis. Each of NATC's future subsidiaries (other than those designated unrestricted subsidiaries) will jointly, severally and fully and unconditionally guarantee the New Senior Notes on a senior unsecured basis. NATC is not required to make mandatory redemptions or sinking fund payments prior to the maturity of the New Senior Notes. The Company or NATC may, from time to time, seek to retire all or a portion of the New Senior Notes through cash purchases and/or exchanges from other securities in open market purchases, privately negotiated transactions or otherwise. On and after March 1, 2008, the New Senior Notes will be redeemable, at NATC's option, in whole at any time or in part from time to time, upon not less than 30 nor more than 60 days prior notice at the following redemption prices (expressed in percentages of principal amount), if redeemed during the 12-month period commencing March 1 of the years set forth below, plus accrued and unpaid interest to the redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date): Year Redemption Price ---- ---------------- 2008 104.625% 2009 102.313% 2010 and thereafter 100.000% In addition, prior to March 1, 2008, NATC may redeem the New Senior Notes, at its option, in whole at any time or in part from time to time, upon not less than 30 nor more than 60 days prior notice at a redemption price equal to 100% of the principal amount of the New Senior Notes redeemed plus a "make-whole" premium based on U.S. Treasury rates as of, and accrued and unpaid interest to, the applicable redemption date. 10 Further, at any time prior to March 1, 2007, NATC may, at its option, redeem up to 35% of the aggregate principal amount of the New Senior Notes with the net cash proceeds of one or more equity offerings by the Company, at its option, or NATC, subject to certain conditions, at a redemption price equal to 109.250% of the principal amount thereof, plus accrued and unpaid interest thereon, if any, to the date of redemption; provided, however, that after any such redemption at least 65% of the aggregate principal amount of the New Senior Notes remains outstanding. In order to affect the foregoing redemption with the proceeds of any equity offering, NATC shall make such redemption not more than 60 days after the consummation of any such equity offering. Concurrently with the offering of the New Senior Notes, the Company issued $97.0 million aggregate amount at maturity of the Company Notes. Proceeds of approximately $53.8 million from this issuance were used to make a capital contribution to NATC. The Company Notes are the Company's senior obligations and are unsecured. Prior to March 1, 2008, interest will accrue on the Company Notes in the form of an increase in the accreted value of the Company Notes. Thereafter, cash interest on the Company Notes will accrue and be payable semi-annually in arrears on March 1 and September 1, commencing on September 1, 2008, at a rate of 12 1/4% per annum. The Company Notes were issued with an initial accreted value of $618.66 per $1,000 principal amount of maturity of Company Notes. The accreted value of each Company Note will increase from the date of issuance until March 1, 2008, at a rate of 12 1/4% per annum, compounded semi-annually reflecting the accrual of non-cash interest, such that the accreted value will equal the principal amount at maturity of each Company Note on March 1, 2008. The Company Notes are not guaranteed by NATC or any of its subsidiaries and are structurally subordinated to all of NATC's and its subsidiaries' obligations, including the New Senior Notes and the Financing Agreement (see Note 8). The Company is not required to make mandatory redemptions or sinking fund payments prior to the maturity of the Company Notes. The Company or NATC may, from time to time, seek to retire all or a portion of the Company Notes through cash purchases and/or exchanges for other securities in open market purchases, privately negotiated transactions, or otherwise. On and after March 1, 2009, the Company Notes will be redeemable, at the Company's option, in whole at any time or in part from time to time, upon not less than 30 nor more than 60 days prior notice at the following redemption prices (expressed in percentages of principal amount at maturity), if redeemed during the 12-month period commencing March 1 of the years set forth below, plus accrued and unpaid interest to the redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date): Year Redemption Price ---- ---------------- 2009 106.125% 2010 104.083% 2011 102.042% 2012 and thereafter 100.000% In addition, prior to March 1, 2009, the Company may redeem the Company Notes, at its option, in whole at any time or in part from time to time, upon not less than 30 nor more than 60 days prior notice at a redemption price equal to 100% of the accreted value of the Company Notes redeemed plus a "make-whole" premium based on U.S. Treasury rates as of, and accrued and unpaid interest to, the applicable redemption date. 11 Further, at any time prior to March 1, 2007, the Company may, at its option, redeem up to 35% of the aggregate principal amount at maturity of the Company Notes with the net cash proceeds of one or more equity offerings by the Company or NATC, subject to certain conditions, at a redemption price equal to 112.250% of the accreted value thereof, plus accrued and unpaid interest thereon, if any, to the date of redemption; provided, however, that after any such redemption at least 65% of the aggregate principal amount at maturity of the Company Notes remains outstanding. In order to affect the foregoing redemption with the proceeds of any equity offering, the Company shall make such redemption not more than 60 days after the consummation of any such equity offering. The Company is dependent on NATC's cash flows to service its debt. The amount of cash interest to be paid during the next five years is as follows: $0 in each of 2005, 2006, 2007 and March 1, 2008; $5,941 payable on September 1, 2008 and $5,941 payable on each of March 1 and September 1 thereafter until maturity. 8. FINANCING AGREEMENT On June 16, 2005, NATC refinanced its existing $35.0 million Amended and Restated Loan Agreement, dated as of February 17, 2004, by entering into a Financing Agreement (the "Financing Agreement") with various financial institutions ("Lenders") and Fortress Credit Corp., as agent for the Lenders ("Agent'). The Financing Agreement consists of a $30.0 million term loan facility and a $55.0 million revolving credit facility, and includes a letter of credit sublimit of $10.0 million (collectively, the "Credit Facility"). As of June 30, 2005, NATC had not borrowed any monies under the revolving credit facility. The Credit Facility will mature on June 30, 2010, and does not provide for any amortization of the term loan prior to maturity. NATC will use the revolving credit facility for working capital requirements and other general corporate purposes. Indebtedness under the Financing Agreement is guaranteed by the Company and each of the Company's current and future subsidiaries, and is secured by a first perfected lien on substantially all of the Company's and its direct and indirect subsidiaries' current and future assets and property. The collateral includes a pledge by the Company of its equity interest in NATC and a first priority lien on all equity interests and intercompany notes held by NATC and its direct and indirect subsidiaries. Loans and advances under the Financing Agreement bear interest at a variable rate based on either the prime rate or LIBOR, at NATC's option, plus a specified margin ranging from 1.00% to 3.75% in case of prime rate indebtedness, and from 3.50% to 6.25% in the case of LIBOR indebtedness, based on the sum of NATC's secured indebtedness in relation to its EBITDAR, as defined in the Financing Agreement. NATC paid the Lenders a closing fee of $1.275 million and is required to pay the Agent a quarterly servicing fee in the amount of $25,000. Under the revolving credit facility, the NATC is required to pay the Lenders an annual commitment fee in an amount equal to 0.50% of the difference between $40 million and the average usage of the revolving credit facility, payable on a monthly basis. NATC is also required to pay the Lenders letter of credit fees equal to 4.00% per annum multiplied by the face of amount of the letters of credit issued under the Financing Agreement, payable on the date any such letter of credit is issued. In addition, NATC is required to pay the Agent the standard charges customarily charged by the institution issuing letters of credit under the Financing Agreement in connection with the issuance, administration, amendment, payment or cancellation of any such letters of credit. 12 The Financing Agreement requires NATC to meet a maximum leverage ratio and a test of minimum earnings before interest, taxes, depreciation, amortization, certain cash and non-cash charges, other income and expenses and restructuring charges ("EBITDAR"). The Financing Agreement also contains covenants which, among other things, limit the incurrence of additional indebtedness, distribution of dividends, transactions with affiliates, asset sales, acquisitions, mergers, prepayments of other indebtedness, liens and encumbrances, capital expenditures, and other matters customarily restricted in such agreements. In addition, the Financing Agreement requires that the Chief Executive Officer of NATC be reasonably acceptable to the Agent and the Lenders during the term of the Credit Facility. The Financing Agreement contains customary events of default, including payment defaults, breach of representations and warranties, covenant defaults, cross-acceleration, cross-defaults to certain other indebtedness, bankruptcy and insolvency, the occurrence of a Change of Control, as defined in the Financing Agreement, and judgment defaults. Further, it is an event of default under the Financing Agreement if an event or development occurs that results in a Material Adverse Effect (as defined in the Financing Agreement), as determined by the Agent in its reasonable business judgment. If any events of default occur and are not cured within applicable grace periods or waived, the outstanding loans may be accelerated and the Lenders' commitments may be terminated. The occurrence of the bankruptcy and insolvency event of default will result in the automatic termination of commitments and acceleration of outstanding loans under the Financing Agreement. 9. SENIOR REVOLVING CREDIT FACILITY In connection with the February 2004 refinancing, NATC amended and restated its prior Revolving Credit Facility, resulting in a $50.0 million Senior Revolving Credit Facility with Bank One, N.A., as agent (the "Agent Bank"), and LaSalle Bank, National Association. The Old Credit Agreement governing the old Senior Revolving Credit Facility includes a letter of credit sublimit of $25.0 million and was scheduled to mature three years from the closing date. NATC's intentions were to use the Senior Revolving Credit Facility for working capital and general corporate purposes. On January 19, 2005, the Old Credit Agreement was amended to reduce the old Senior Revolving Credit Facility to $35.0 million. As of December 31, 2004, NATC had borrowed $14.5 million under the old Senior Revolving Credit Facility. Indebtedness under the Old Credit Agreement was guaranteed by each of NATC's current and future direct and indirect subsidiaries, and secured by a first perfected lien on substantially all of NATC's and its direct and indirect subsidiaries' current and future assets and property. The collateral included a pledge by the Company of its equity interest in NATC and a first priority lien on all equity interests and intercompany notes held by NATC and each of its subsidiaries. 13 Each advance under the Old Credit Agreement will bear interest at variable rates based, at NATC's option, on either the prime rate plus 1% or LIBOR plus 3%. The Old Credit Agreement provides for voluntary prepayment, subject to certain exceptions, of loans. In addition, without the prior written consent of the Agent Bank, NATC will not allow a Change in Control (as defined in the Old Credit Agreement), the sale of any material part of its assets and the assets of its subsidiaries on a consolidated basis or, subject to certain exceptions, the issuance of equity or debt. Under the Old Credit Agreement, NATC was required to pay the lenders an annual commitment fee in variable amounts ranging from 0.50% to 0.65% of the difference between the commitment amount and the average usage of the facility, payable on a quarterly basis. NATC was also required to pay to the lenders letter of credit fees equal to 3.00% per annum multiplied by the maximum amount available from time to time to be drawn under such letters of credit issued under the Old Credit Agreement and to the lenders issuing letters of credit a fronting fee of 0.125% per annum multiplied by the aggregate face amount of letters of credit outstanding during a fiscal quarter plus other customary administrative, amendment, payment and negotiation charges in connection with such letters of credit. The Old Credit Agreement required NATC and its subsidiaries to meet certain financial tests, including a minimum fixed charge coverage ratio and a minimum consolidated adjusted earnings before interest, taxes, dividends and amortization ("EBITDA"). The Old Credit Agreement also contained covenants which, among other things, limited the incurrence of additional indebtedness, dividends, transactions with affiliates, asset sales, acquisitions, mergers, prepayments of other indebtedness, liens and encumbrances and other matters customarily restricted in such agreements. In addition, the Old Credit Agreement required that certain members of executive management remain active in the day-to-day operation and management of NATC and its subsidiaries during the term of the facility. The Old Credit Agreement contained customary events of default, including payment defaults, breach of representations and warranties, covenant defaults, cross-acceleration, cross-defaults to certain other indebtedness, certain events of bankruptcy and insolvency, the occurrence of a Change in Control and judgment defaults. On March 30, 2005, the Old Credit Agreement was amended to modify the fixed charge coverage ratio covenant, which now applies only to quarters ending June 30, 2005 and thereafter, and the minimum consolidated adjusted EBITDA covenant, which now applies only to quarters ending from June 30, 2004 through March 31, 2005. The fixed charge coverage ratio definition was also amended to include any future cash equity contributions to the Company. In addition, the amendment changed the Old Credit Agreement maturity date from February 28, 2007 to January 31, 2006. See Note 8 of the Condensed Consolidated Financial Statements for discussion of the June 16, 2005 Financing Agreement, the proceeds of which were used to refinance and terminate the Old Credit Agreement. 10. PROVISION FOR INCOME TAXES The Company has determined that at June 30, 2005, its ability to realize future benefits of net deferred tax assets does not meet the "more likely than not" criteria in SFAS No. 109, "Accounting for Income Taxes"; therefore, a valuation allowance continues to be recorded. Deferred income tax liabilities are provided relating to inventories and tax-deductible goodwill that is not amortized for financial reporting. 14 11. PENSION AND POSTRETIREMENT BENEFIT PLANS The components of Net Periodic Benefit Cost for the six months ended June 30 are as follows (in thousands):

Pension Benefits Other Benefits -------------------------------- ---------------------------- 2005 2004 2005 2004 --------------- ------------- ------------ ------------ Service cost $ 22 $ 161 $ 80 $ 142 Interest cost 389 391 74 134 Expected return of plan assets (313) (495) - - Amortization of net (gain) loss 50 61 27 204 --------------- ------------- ------------ ------------ Net periodic pension cost $ 148 $ 118 $ 181 $ 480 =============== ============= ============ ============

NATC has a defined benefit pension plan covering substantially all of its hourly employees. Benefits for the hourly employees' plan are based on a stated benefit per year of service, reduced by amounts earned in a previous plan. Effective June 30, 2004 and July 31, 2004, NATC froze the defined benefit retirement plan for the respective hourly employees of its three collective bargaining units. Effective September 30, 2004, NATC terminated its postretirement benefit plan for its salaried employees. NATC expects to contribute approximately $400 to its postretirement plan in 2005 for the payment of benefits. Plan contributions and benefits have amounted to $193 for the six months ended June 30, 2005. Based upon the above decision, management believes that any future contributions will not be material. 12. RECONCILIATION OF INCOME (LOSS) PER COMMON SHARE (DOLLARS AND SHARES IN THOUSANDS, EXCEPT PER SHARE AMOUNTS): Three Months Ended June 30, 2005 --------------------------------

Income Shares Per Share (Numerator) (Denominator) Amount -------------- ---------------- ---------------- Basic and Diluted: Net loss (5,601) -------------- Net income applicable to common shares $ (5,601) 589.2 $ (9.51) ============== ================ ================

15

Three Months Ended June 30, 2004 -------------------------------- Income Shares Per Share (Numerator) (Denominator) Amount -------------- ----------------- ----------------- Basic: Net income $ 812 -------------- Net income applicable to common shares $ 812 588.8 $ 1.38 ============== ================= ================= Diluted: Net income $ 812 -------------- Net income applicable to common shares $ 812 734.4 $ 1.11 ============== ================= ================= Six Months Ended June 30, 2005 ------------------------------ Income Shares Per Share (Numerator) (Denominator) Amount -------------- ----------------- ----------------- Basic and Diluted: Net loss (12,260) -------------- Net income applicable to common shares $ (12,260) 589.4 $ (20.80) ============== ================= ================= Six Months Ended June 30, 2004 ------------------------------ Income Shares Per Share (Numerator) (Denominator) Amount --------------- ----------------- ----------------- Basic and Diluted: Net loss $ (5,521) Less: preferred stock dividends (1,613) --------------- Net income applicable to common shares $ (7,134) 564.6 $ (12.64) =============== ================= =================

On February 9, 2004, in connection with the Merger, all the common shares of NATC were cancelled and shares of the Company were issued to NATC's shareholders on a one-for-one basis. The earnings per share calculations are based on the weighted average number of shares of common stock outstanding during the respective periods. Common stock equivalent shares from warrants representing 63,490 shares were excluded from the computations for the three months ended June 30, 2005 and the six months ended June 30, 2005 and 2004, respectively. 13. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued SFAS No. 123R (Revised 2004), "Accounting for Stock Based Compensation" ("SFAS No. 123R"). SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or that may be settled by the issuance of those equity instruments. SFAS No. 123R eliminates the alternative to use APB 25's intrinsic value method of accounting that was provided in SFAS 16 No. 123 as originally issued. SFAS No. 123R requires entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award or the vesting period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. A public entity will initially measure the cost of liability based service awards based on their current fair value; the fair value of those awards will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The provisions of SFAS No. 123R shall become effective for the Company in the first quarter of 2006 and will apply to all awards granted after December 31, 2005 and to awards modified, repurchased, or cancelled after that date. The Company is evaluating SFAS No. 123R and believes it will not have a material effect on financial results of operations. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an amendment of ARB No. 43, Chapter 4," to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that items be recognized as current-period charges regardless of whether they meet the criterion of "so abnormal" that was previously stated in ARB No. 43, Chapter 4. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this statement shall be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect SFAS No. 151 to have a material impact on the Company's financial condition or results of operations. In December 2004, the FASB issued two FASB Staff Positions ("FSP") regarding the accounting implications of the American Jobs Creation Act of 2004 (the "Act"). The Act provides a deduction for income from qualified domestic production activities, which will be phased in from 2005 through 2010. In return, the Act also provides for a two-year phase-out of the existing extra-territorial income exclusion ("ETI") for foreign sales. Under the guidance in FSP No. FAS 109-1, "Application of FASB Statement 109, `Accounting for Income Taxes,' to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004," the deduction will be treated as a "special deduction" as described in FASB Statement No. 109. As such, the special deduction has no effect on deferred tax assets and liabilities existing at the enactment date. FSP No. FAS 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004," was effective for the first quarter of 2005 and had no material impact on the Company's Condensed Consolidated Financial Statements. In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act"), which introduces a Medicare prescription drug benefit, as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to the Medicare benefit, was enacted. In May 2004, the FASB issued Financial Staff Position No. 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" ("FSP 106-2") to discuss certain accounting and disclosure issues raised by the Act. In January 2005, the Centers for Medicare and Medicaid Services released the final regulations implementing the Medicare Prescription Drug, Improvement, and 17 Modernization Act of 2003. FSP No. 106-2 provides guidance to employers that have determined that prescription drug benefits available under their retiree health care benefit plans are at least actuarially equivalent to Medicare Part D. The Company's postretirement healthcare plans provide for prescription drug benefits for certain participants. Due to the limited number of participants in the Company's Hourly postretirement healthcare plans that are affected by the Act, the adoption of FSP No. 106-2 did not have a material impact on the Company's financials. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3." SFAS No. 154 requires retrospective application to prior periods' financial statements for changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 also requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle, such as a change in non-discretionary profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will comply with the provisions of this statement for any accounting changes or error corrections that occur after December 31, 2005. 14. CONTINGENCIES LITIGATION WITH REPUBLIC TOBACCO On July 15, 1998, North Atlantic Operating Company, Inc. ("NAOC") and National Tobacco Company, L.P. ("NTC"), which are subsidiaries of the Company, filed a complaint (the "Kentucky Complaint") against Republic Tobacco, Inc. and its affiliates ("Republic Tobacco") in Federal District Court for the Western District of Kentucky. Republic Tobacco imports and sells Roll-Your-Own ("RYO") premium cigarette papers under the brand names JOB and TOP as well as other brand names. The Kentucky Complaint alleges, inter alia, that Republic Tobacco's use of exclusivity agreements, rebates, incentive programs, buy-backs and other activities related to the sale of premium cigarette papers in the southeastern United States violate federal and state antitrust and unfair competition laws and that Republic Tobacco defaced and directed others to deface NAOC's point of purchase vendor displays for premium cigarette papers by covering up the ZIG-ZAG brand name and advertising material with advertisements for Republic Tobacco's RYO cigarette paper brands. The Kentucky Complaint alleges that these activities constitute unfair competition under federal and state laws. On June 30, 1998, Republic Tobacco filed a complaint against NATC, NAOC and NTC in the U.S. District Court of the Northern District of Illinois (the "Illinois Complaint") and served it on NATC after the institution of the Kentucky action. In the Illinois Complaint, Republic Tobacco seeks declaratory relief with respect to NATC's claims. In addition, the Illinois Complaint alleges that certain actions taken by NATC to inform its customers of its claims against Republic Tobacco constitute tortious interference with customer relationships, false advertising, violations of Uniform Deceptive Trade Practices and Consumer Fraud Acts, defamation and unfair competition. In addition, although not included in its original complaint but in its amended complaint, Republic Tobacco alleged that NATC has unlawfully monopolized and attempted to monopolize the market on a national and regional basis for premium cigarette papers. Republic sought unspecified compensatory damages, injunctive relief and attorneys fees and costs. 18 On October 20, 2000, Republic Tobacco filed a motion to dismiss, stay, or transfer the Kentucky Complaint to the Illinois Court. On December 19, 2000, the Court denied Republic Tobacco's motion, holding that it was premature. The Court noted also that it had communicated with the Court in Illinois and that it had concluded that Republic Tobacco may not be entitled to any preference on forum selection, which would ordinarily be given because it was first to file. The Kentucky complaint is still on file. Prior to the completion of discovery, the Court dismissed Republic Tobacco's antitrust claims against NATC. After discovery was completed in 2001, both parties moved for summary judgment on the others claims. In April 2002, the District Court for the Northern District of Illinois decided the summary judgment motions by dismissing all claims of both NATC and Republic Tobacco and its affiliates, except for Republic Tobacco's claim of defamation per se against NATC, on which it granted summary judgment on liability in favor of Republic Tobacco, and a Lanham Act false advertising claim, based on the same facts as the defamation claim, for equitable relief. In February 2003, the District Court granted Republic's motion for summary judgment on NATC's counterclaim that Republic tortiously interfered with NATC's business relationships and economic advantage. The only claim that remained to be tried was Republic's Lanham Act claim and damages on the defamation claim on which the Court previously ruled that Republic could only obtain equitable relief if successful. On July 8, 2003, following a four-day trial, an Illinois jury returned a verdict in favor of Republic on the defamation claims of $8.4 million in general damages and $10.2 million in punitive damages, for a total damage award of $18.6 million. NATC recorded an $18.8 million charge during the second quarter 2003 relating to this transaction. NATC filed post-trial motions for a new trial and, in the alternative, for a reduction of the awards. On August 1, 2003, NATC posted a judgment bond in the amount of $18.8 million with the U.S. District Court. This was accomplished by obtaining a $19.0 million senior secured term loan pursuant to a July 31, 2003 amendment to NATC's existing credit facility. On November 20, 2003, the court ruled that the awards were excessive and reduced the awards by approximately 60%, with the award of compensatory damages being reduced to $3.36 million and the award of punitive damages being reduced to $4.08 million, for a total of $7.44 million. On December 18, 2003, Republic accepted these reduced awards. NATC reversed $11.16 million during the fourth quarter 2003 due to this court ruling. On January 8, 2004, NATC appealed the final judgment, including the finding of liability in this case as well as the amount of the award. On January 22, 2004, Republic filed a general notice of cross appeal and argued in its appellate briefs that the judgment should be affirmed and also asserted, in its cross-appeal, that the original judgment should be reinstated despite its acceptance of the District Court's order reducing the judgment amount. On September 1, 2004, the Court of Appeals issued its ruling affirming the finding of liability against NATC for defamation, but reducing the amount of the damage award to $3.0 million. The Court of Appeals also affirmed the dismissal of NATC's antitrust claim against Republic and the dismissal of Republic's motion to re-instate the original jury award of $18.8 million. As a result of these rulings, in October 2004 NATC received approximately $4.5 million relating to the cash bond it had posted with the Court in 2003. This amount was included in Other income during the third quarter of 2004. 19 NATC has also applied to the Court of Appeals for an order awarding NATC approximately $1.0 million for the difference in the expense of the original bond of $18.8 million and the subsequent reduced bond of $7.0 million, on the one hand, and the lesser expense NATC would have incurred to bond the final $3.0 million judgment, on the other hand. On November 30, 2004, the Court of Appeals ruled that the application for costs should be directed to the District Court. On December 17, 2004, NATC filed this motion with the District Court. That motion has been fully briefed and the parties are waiting for the Court to rule. On August 3, 2005, the Court issued its ruling and awarded NATC approximately $1.1 million. Republic has the option to appeal this award. LITIGATION RELATED TO COUNTERFEITING Texas Infringing Products Litigation. In Bollore, S.A. v. Import Warehouse, Inc., Civ. No. 3-99-CV-1196-R (N.D. Texas), Bollore, the Company's Licensor of ZIG-ZAG brand premium cigarette papers, obtained a sealed order allowing it to conduct a seizure of infringing and counterfeit ZIG-ZAG products in the United States. On June 7, 1999, seizures of products occurred in Michigan and Texas. Subsequently, all named defendants have been enjoined from buying and selling such infringing or counterfeit goods. Bollore and NATC negotiated settlements with all defendants. These defendants included Import Warehouse, Ravi Bhatia, Tarek Makki and Adham Makki. Those settlements included a consent injunction against distribution of infringing or counterfeit goods. On May 18, 2001, NATC, in conjunction with Bollore and law enforcement authorities conducted raids on the businesses and homes of certain defendants previously enjoined (including Tarek Makki and Adham Makki) from selling infringing or counterfeit ZIG-ZAG brand products in the Bollore S.A. v. Import Warehouse litigation. Evidence was uncovered that showed that these defendants and certain other individuals were key participants in importing and distributing counterfeit ZIG-ZAG premium cigarette papers. After a two day hearing in the U.S. District Court for the Northern District of Texas, on May 30, 2001, the Court held the previously enjoined defendants in contempt of court, and enjoined the additional new defendants, including Ali Makki, from selling infringing or counterfeit ZIG-ZAG premium cigarette papers. NATC entered into a settlement with the defendants, the principal terms of which included a cash payment, an agreed permanent injunction, the withdrawal of the defendants' appeal of the civil contempt order, an agreed judgment of $11.0 million from the civil contempt order and an agreement to forbear from enforcing that $11.0 million money judgment until such time in the future that the defendants violate the terms of the permanent injunction. Two of the defendants, Tarek Makki and Adham Makki, also agreed to provide complete information concerning the counterfeiting conspiracy as well as information on other parties engaged in the purchase and distribution of infringing ZIG-ZAG premium cigarette papers. On February 17, 2004, NATC and Bollore filed a motion in the U.S. District Court for the Northern District of Texas, which had issued the original injunctions against the infringing defendants, seeking, with respect to respondents Adham Makki, Tarek Makki and Ali Makki, to have the $11.0 million judgment released from the forbearance agreement and to have the named respondents held in contempt of court. The motion alleged that the three respondents had trafficked in counterfeit ZIG-ZAG cigarette papers after the execution of the settlement, citing evidence that all three had been charged in the United States District Court for the Eastern District of Michigan with criminal violations of the United States counterfeiting laws by trafficking in counterfeit ZIG-ZAG cigarette papers, which trafficking occurred after the settlement agreement. 20 On April 13, 2004, the Court entered an order (the "Contempt 2 Order"), finding Ali Mackie, Tarek Makki, Adham Mackie and their companies Best Price Wholesale (the "Makki Defendants") and Harmony Brands LLC in civil contempt, freezing all of their assets, releasing the July 12, 2002 Final Judgment of $11.0 million from the forbearance agreement as to the Makki Defendants, and again referring the matter to the United States Attorney for Criminal Prosecution. Subsequent to the entry of the Contempt 2 Order, the Company settled with defendant Harmony Brands and its members for the amount of $750,000 and the entry of a permanent injunction. The Company is seeking to execute on the outstanding $11.0 million judgment against the remaining Makki Defendants and those efforts are currently underway. Pursuant to the U.S. Distribution Agreement and a related agreement between Bollore and NATC, any collections on the judgments issued in the Bollore v. Import Warehouse case are to be divided evenly between Bollore and NATC after the payment of all expenses. On February 7, 2002, Bollore, NAOC and NATC filed a motion with the District Court in the Texas action seeking to hold Ravi Bhatia and Import Warehouse Inc. in contempt of court for violating the terms of the consent order and injunction entered against those defendants. NATC alleges that Mr. Bhatia and Import Warehouse sold counterfeit goods to at least three different companies over an extended period of time. On June 27, 2003, the Court found Import Warehouse and Mr. Bhatia in contempt of court for violating an existing injunction barring those parties from distributing infringing ZIG-ZAG cigarette paper products. The Court requested that NATC and Bollore (NATC's co-plaintiff in the case) file a submission detailing the damages incurred. NATC and Bollore filed their submission on July 25, 2003 which reported and requested damages of $2.4 million. On July 1, 2004, the Court issued an Order awarding approximately $2.5 million in damages to NATC for the damages incurred by the Company as a result of the Import Warehouse Defendants' civil contempt. On July 15, 2004, the Court entered a Final Judgment in that amount for which defendants Import Warehouse, Inc. and Ravi Bhatia are jointly and severally liable. After NATC and Bollore commenced collection proceedings, Import Warehouse paid NATC and Bollore an amount equal to the entire judgment plus the expenses incurred in collection. Accordingly, approximately $1.2 million has been recorded in Other income during the third quarter of 2004. The Import Warehouse Defendants filed a notice of appeal on July 24, 2004. No briefing schedule has been established. LITIGATION RELATED TO ALLEGED PERSONAL INJURY West Virginia Complaints. Trial of the West Virginia complaints against the smokeless tobacco defendants has been postponed indefinitely, as described below. On October 6, 1998 NTC was served with a summons and complaint on behalf of 65 individual plaintiffs in an action in the Circuit Court of Kanawha County, West Virginia, entitled Kelly Allen, et al. v. Philip Morris Incorporated, et al. (Civil Action Nos. 98-C-240l). On November 13, 1998, NTC was served with a second summons and complaint on behalf of 18 plaintiffs in an action in the Circuit Court of Kanawha County, West Virginia, entitled Billie J. Akers, et al. v. Philip Morris Incorporated et al. (Civil Action Nos. 98-C-2696 to 98-C-2713). The complaints are identical in most material respects. In the Allen case, the plaintiffs have specified the defendant companies for each of the 65 cases. NTC is named in only one action. One Akers plaintiff alleged use of an NTC product, alleging lung cancer. 21 On September 14, 2000, NTC was served with a summons and complaint on behalf of 539 separate plaintiffs filed in Circuit Court of Ohio County, West Virginia, entitled Linda Adams, et al. v. Philip Morris Inc., et al. (Civil Action Nos. 00-C-373 to 00-C-911). Only one of these plaintiffs alleged use of a product currently manufactured by NTC. The time period during which this plaintiff allegedly used the product has not yet been specified. Thus, it is not yet known whether NTC is a proper defendant in this case. On September 19, 2000, NTC was served with a second summons and complaint on behalf of 561 separate plaintiffs filed in Circuit Court of Ohio County, West Virginia, entitled Ronald Accord, et al. v. Philip Morris Inc., et al. (Civil Action Nos. 00-C-923 to 00-C-1483). A total of five of these plaintiffs alleged use of a product currently manufactured by NTC. One of these plaintiffs does not specify the time period during which the product was allegedly used. Another alleges use that covers, in part, a period when NTC did not manufacture the product. On motion by cigarette company defendants, this claim was dismissed on February 11, 2004, for failure to follow the case management order. Of the remaining three, one alleges consumption of a competitor's chewing tobacco from 1966 to 2000 and NTC's Beech-Nut chewing tobacco from 1998 to 2000; another alleges a twenty-four year smoking history ending in 1995 and consumption of Beech-Nut chewing tobacco from 1990 to 1995; and the last alleges a thirty-five year smoking history ending in 2000, and consumption of NTC's Durango Ice chewing tobacco from 1990 to 2000 (although Durango Ice did not come onto the market until 1999). In November 2001, NTC was served with an additional four separate summons and complaints in actions filed in the Circuit Court of Ohio County, West Virginia. The actions are entitled Donald Nice v. Philip Morris Incorporated, et al. (Civil Action No. 01-C-479), Korene S. Lantz v. Philip Morris Incorporated, et al. (Civil Action No. 01-C-480), Ralph A. Prochaska, et al. v. Philip Morris, Inc., et al. (Civil Action No. 01-C-481), and Franklin Scott, et al. v. Philip Morris, Inc., et al., (Civil Action No. 01-C-482). All of the West Virginia smokeless tobacco actions have been consolidated before the West Virginia Mass Litigation Panel for discovery and trial of certain issues. Trial of these matters was planned in two phases. In the initial phase, a trial was to be held to determine whether tobacco products, including all forms of smokeless tobacco, cigarettes, cigars and pipe and roll-your-own tobacco, can cause certain specified diseases or conditions. In the second phase, individual plaintiffs would attempt to prove that they were in fact injured by tobacco products. Fact and expert discovery in these cases has closed, however, in the cigarette cases the Court has allowed additional discovery. The claims against NTC in the various consolidated West Virginia actions include negligence, strict liability, fraud in differing forms, conspiracy, breach of warranty and violations of the West Virginia consumer protection and antitrust acts. The complaints in the West Virginia cases request unspecified compensatory and punitive damages. The manufacturers of smokeless tobacco products (as well as the manufacturers of cigarettes) moved to sever the claims against the smokeless tobacco manufacturer defendants from the claims against the cigarette manufacturer defendants. That motion was granted and the trial date on the smokeless tobacco claims has now been postponed indefinitely. The trial court has now vacated the initial trial plan in its entirety because of concerns that its provisions violated the dictates of the United States Supreme Court's decision in State Farm Mutual Automobile Insurance Company v. Campbell, 538 U.S. 408 (2003). A new trial plan has not yet been implemented with regard to the consolidated claims against the cigarette manufacturer defendants. The West Virginia Supreme Court has accepted review of the case management order and briefing by the parties was commenced. The claims against the smokeless tobacco manufacturer defendants remain severed and indefinitely stayed. 22 Minnesota Complaint. On September 24, 1999, NTC was served with a complaint in a case entitled Tuttle v. Lorillard Tobacco Company, et al. (Case No. C2-99-7105), brought in Minnesota. The other manufacturing defendants are Lorillard and The Pinkerton Tobacco Company. The Complaint alleges that plaintiff's decedent was injured as a result of using NTC's (and, prior to the formation of NTC, Lorillard's) Beech-Nut brand and Pinkerton's Red Man brand of loose-leaf chewing tobacco. Plaintiff asserts theories of liability, breach of warranty, fraud, and variations on fraud and misrepresentation. Plaintiff specifically requests in its complaint an amount of damages in excess of fifty thousand dollars ($50,000) along with costs, disbursements and attorneys' fees, and ". . . an order prohibiting defendants from disseminating in Minnesota further misleading advertising and making further untrue, deceptive and/misleading statements about the health effects and/or addictive nature of smokeless tobacco products. . . ." After discovery, summary judgment motions were filed on behalf of all defendants. On March 3, 2003, the Court granted defendants' motions, dismissing all claims against all defendants and the Court has since denied the plaintiff's motion for reconsideration. Plaintiff has appealed the dismissal. Briefing has been completed. Oral argument before the Court of Appeals was held on February 11, 2004. On July 30, 2004, the Court of Appeals affirmed the dismissal of all of the claims. In addition to the above described legal proceedings, the Company is subject to other litigation in the ordinary course of its business. The Company does not believe that any of these other proceedings will have a material adverse effect on the results of operations, financial position or cash flows of the Company. OTHER EMPLOYMENT MATTERS The Company may, from time to time, have claims from and make settlements with former officers or employees. David I. Brunson, the former President, Chief Financial Officer and Treasurer of the Company, resigned from the Company effective January 19, 2005, at which time his employment agreement with the Company (the "Brunson Employment Agreement") was effectively terminated. Pursuant to the Brunson Employment Agreement, the Company is required to make certain severance payments to Mr. Brunson, including $425,000, which was paid within ten business days after January 19, 2005, and an additional $425,000 payable within the next 12 months. In addition, Mr. Brunson may become entitled to a bonus payment of up to $725,000 relating to synergies achieved in the integration of the business of Stoker, Inc. that was acquired by the Company in 2003. Pursuant to the Brunson Employment Agreement, after the last severance payment is made, Mr. Brunson will have an option to require the Company to repurchase all or a portion of his shares of the Company at their fair market value. The Company will not be obligated to repurchase these shares if, upon or after the payment, it would be in default under any instrument, agreement or law by which it is bound; in this case, the repurchase may be deferred until it can be completed without such default. Similarly, the Company has an option to repurchase Mr. Brunson's shares at their fair market value. In the event the Company and Mr. Brunson are unable to agree upon the fair market value of these shares, an independent investment banking firm will be selected to determine such fair market value, in accordance with the procedure provided for by the Brunson Employment Agreement. If neither Mr. Brunson nor the Company 23 exercise their respective options by the earliest of the fifth anniversary of the termination of Mr. Brunson's employment or the date on which the Company refinances, or uses proceeds derived from refinancing, certain of its obligations, the Company will be required to repurchase Mr. Brunson's shares on such date unless Mr. Brunson waives his right to require the Company to purchase his shares. Any liability is deemed, at this time, not to be material to the Company's Condensed Consolidated Financial Statements. During the six months ended June 30, 2005, the Company recorded approximately $1.2 million relating to the resignation of Mr. Brunson. Any options or shares of restricted stock granted to Mr. Brunson vested in full as of the date of such resignation. As part of the A&M agreement, as amended in April 2005, the Company paid a cash incentive fee of $0.3 million to A&M upon the closing of the refinancing of the Company's Old Credit Agreement, which was equal to 0.5% of the total commitment amount of the refinancing (reduced by $50,000 per month for the period from April 11, 2005 to the date of such refinancing). As of June 30, 2005, the Company has recorded an expense of approximately $0.3 million relating to the incentive fee. A&M is also entitled to a fee based on improvement in the Company's financial performance as measured against the Company's 2005 Business Plan, to be paid upon the termination of the engagement. One portion of the fee will be a specified percentage of the sustainable annualized EBITDAR improvement, as defined, and the other portion of the fee will be an amount to be determined by the Board of Directors of the Company in their reasonable judgment for significant and sustainable improvement in working capital investment and management, in each case as measured against the Company's 2005 Business Plan. As of June 30, 2005, no related liability or expense has been recorded relating to financial performance improvements. 15. SEGMENT INFORMATION In accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," the Company has three reportable segments. The smokeless tobacco segment manufactures smokeless tobacco products which are distributed primarily through wholesale and food distributors in the United States. The make-your-own segment imports and distributes premium cigarette papers and contract manufactures and distributes cigarette tobaccos and related products primarily through wholesale distributors in the United States. The premium cigarette segment distributes contract manufactured cigarettes through wholesale distributors in the United States. The accounting policies of these segments are the same as those of the Company. Segment data includes a charge allocating corporate costs to the Smokeless Tobacco and Make-Your-Own segments based on their respective Net sales. Other includes the assets of the Company not assigned to segments and Eliminations includes the elimination of intercompany accounts between segments. The Company evaluates the performance of its segments and allocates resources to them based on Operating income. RECLASSIFICATIONS: Certain prior year amounts have been reclassified to conform to the current year presentation. These changes had no impact on previously reported net income. 24 The table below presents financial information about reported segments for the three months and six months ended June 30, 2005 and 2004, respectively (in thousands):

FOR THE MAKE PREMIUM THREE MONTHS ENDED: SMOKELESS YOUR MANUFACTURED JUNE 30, 2005 TOBACCO OWN CIGARETTES OTHER ELIMINATIONS TOTAL ------------------------- -------------- ------------ ----------------- ---------- --------------- ------------- Net sales $ 11,707 $ 17,398 $ 151 $ 1,265 $ - $ 30,521 Operating income 1,339 4,595 (1,174) (1,912) - 2,848 Assets 84,407 289,571 2,948 21,723 (159,129) 239,520 JUNE 30, 2004 ------------------------- Net sales $ 12,548 $ 23,195 $ 107 $ 1,357 $ - $ 37,207 Operating income 3,841 7,366 (1,111) 118 - 10,214 Assets 71,592 279,409 3,407 21,460 (114,458) 261,410 FOR THE MAKE PREMIUM SIX MONTHS ENDED: SMOKELESS YOUR MANUFACTURED JUNE 30, 2005 TOBACCO OWN CIGARETTES OTHER ELIMINATIONS TOTAL ------------------------- -------------- ------------ ----------------- ---------- --------------- ------------- Net sales $ 21,543 $ 33,537 $ 331 $ 2,458 $ - $ 57,869 Operating income 1,914 8,707 (2,158) (3,752) - 4,711 Assets 84,407 289,571 2,948 21,723 (159,129) 239,520 JUNE 30, 2004 ------------------------- Net sales $ 23,962 $ 32,705 $ 123 $ 2,522 $ - $ 59,312 Operating income 6,039 5,284 (2,506) (190) - 8,627 Assets 71,592 279,409 3,407 21,460 (114,458) 261,410

ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The Company competes in three distinct markets: (1) the smokeless tobacco market; (2) the Make-Your-Own ("MYO") cigarette market; and (3) the premium manufactured cigarette market. The smokeless tobacco market includes the loose leaf chewing tobacco sector. The MYO cigarette market is comprised of the MYO premium cigarette papers sector and the MYO cigarette tobaccos and related products sector. The Company's subsidiaries manufacture and market loose leaf chewing tobacco, import and distribute MYO premium cigarette papers, contract manufacture and market MYO cigarette tobaccos and related products, and contract manufacture and market premium manufactured cigarettes. To date, the Company's premium manufactured cigarette segment continues in its development phase and net sales of this segment have not been significant. 25 RESULTS OF OPERATIONS COMPARISON OF THREE MONTHS ENDED JUNE 30, 2005 AND 2004 Net Sales. Net sales for the three months ended June 30, 2005 were $30.5 million, a decrease of $6.7 million or 18.0% from the corresponding period of the prior year. Net sales of the smokeless tobacco segment for the current period decreased $0.8 million or 6.7% from the corresponding period of the prior year. The volume of the Company's brands declined 20.2% in net cases due to promotional activity during the second quarter of 2004 as compared to limited promotional activity during the second quarter of 2005, coupled with a continuing decline in the segment. Net sales of the Company's MYO segment decreased $5.8 million or 25.0% in comparison to the corresponding period of the prior year. Within the MYO segment, premium cigarette paper sales decreased $5.2 million or 31.3% from the corresponding period of the prior year due to significant promotional activities occurring in the second quarter of 2004 as compared to no significant promotional activities occurring during the second quarter of 2005. The MYO cigarette tobaccos and related product sales decreased $0.6 million or 8.7% in comparison to the corresponding period of the prior year. The aggregate volume in net cases decreased 12.7% driven substantially by a reduction in premium cigarette paper case sales due to the timing in promotional activities. Gross Profit. Gross profit for the three months ended June 30, 2005 totaled $15.4 million, a decrease of $4.7 million or 23.5% from the corresponding period of the prior year. Gross profit of the smokeless tobacco segment decreased $0.6 million or 10.6% from the corresponding period of the prior year. Gross margin for this segment decreased to 46.2% of net sales for the current period from 48.2% in the corresponding period of the prior year due to several factors, including increased manufacturing costs per case coupled with an increase in case sales of lower margin products. Gross profit of the MYO segment for the current period decreased $4.3 million or 32.0% in comparison to the corresponding period of the prior year. The gross margin of the MYO segment decreased to 52.6% of net sales for the current period in comparison to 58.0% for the corresponding period of the prior year. This decrease in gross margin was due principally to product mix resulting from decreased sales of its premium cigarette papers. Selling, General, and Administrative Expenses. Selling, general, and administrative expenses for the three months ended June 30, 2005 were $10.4 million, an increase of $0.5 million or 4.7% in comparison to the corresponding period of the prior year. Of this increase, $0.8 million relates to compensation expense, $0.2 million for travel and entertainment, $0.1 million relating to consulting services, offset by decreased legal and professional fees of $0.5 million and other of $0.1 million. Interest Expense and Amortization of Financing Costs. Interest expense and amortization of financing costs decreased $0.7 million or 7.8% to $7.8 million for the three months ended June 30, 2005 as compared to the corresponding period of the prior year. This decrease related principally to the write off of deferred financing costs of approximately $1.2 million relating to the Old Senior Notes which were redeemed during April 2004 partially offset by the write off of deferred financing costs of approximately $0.2 million relating to the Senior Revolving Credit Facility which was refinanced during June 2005. 26 Other Expense. Other expense was $0.8 million for the three months ended June 30, 2005 as compared to $0.4 million during the corresponding period of the prior year. This increase relates principally to non-recurring legal related expenses partially offset by recoveries and lower expenses associated with counterfeiting activity. Restructuring Charges. For the three months ended June 30, 2005, total restructuring charges amounted to approximately $2.2 million, including, but not limited to, severance and separation expenses, A&M fees and other non-recurring expenses. The Company anticipates incurring additional expenses relating to the restructuring during 2005. Income Tax Benefit (Expense). The Company has determined that at December 31, 2004, its ability to realize future benefits of net deferred tax assets does not meet the "more likely than not" criteria in SFAS No. 109, "Accounting for Income Taxes". Therefore, only deferred tax expense related to inventories and tax-deductibe goodwill is being recorded in 2005. Tax benefit of $0.2 million for the three months ended June 30, 2005 was recorded, compared to tax expense of $0.5 million for the corresponding period of the prior year. As of June 30, 2005, a valuation allowance continues to be recorded. The effective income tax rate for the three months ended June 30, 2004 was 38.0%. Net Income (Loss). Due to the factors described above, net loss for the three months ended June 30, 2005 was $5.6 million compared to net income of $0.8 million for the corresponding period of the prior year. COMPARISON OF SIX MONTHS ENDED JUNE 30, 2005 AND 2004 Net Sales. Net sales for the six months ended June 30, 2005 were $57.9 million, a decrease of $1.4 million or 2.4% from the corresponding period of the prior year. Net sales of the smokeless tobacco segment for the current period decreased $2.4 million or 10.1% from the corresponding period of the prior year. The volume of the Company's brands declined 7.1% in net cases due to promotional activity during the first six months of 2004 as compared to limited promotional activity during the first six months of 2005, coupled with a continuing decline in the segment. Net sales of the Company's MYO segment increased $0.8 million or 2.5% in comparison to the corresponding period of the prior year. Within the MYO segment, premium cigarette paper sales increased $0.2 million or 0.7% from the corresponding period of the prior year due to the timing in promotional activities. The MYO cigarette tobaccos and related product sales increased $0.7 million or 6.0% in comparison to the corresponding period of the prior year. The aggregate volume in net cases increased 3.7% reflecting higher sales of lower price product. Gross Profit. Gross profit for the six months ended June 30, 2005 totaled $29.6 million, a decrease of $0.4 million or 1.3% from the corresponding period of the prior year. Gross profit of the smokeless tobacco segment decreased $1.7 million or 14.6% from the corresponding period of the prior year. Gross margin for this segment decreased to 46.1% of net sales for the current period from 48.6% in the corresponding period of the prior year due to several factors, including increased manufacturing costs per case coupled with an increase in case sales of lower margin products. 27 Gross profit of the MYO segment for the current period increased $0.6 million or 3.2% in comparison to the corresponding period of the prior year. The gross margin of the MYO segment increased to 53.8% of net sales for the current period in comparison to 53.5% for the corresponding period of the prior year. This increase in gross margin was due principally to product mix resulting from increased sales of its premium cigarette papers. Selling, General, and Administrative Expenses. Selling, general, and administrative expenses for the six months ended June 30, 2005 were $20.8 million, a decrease of $0.5 million or 2.5% in comparison to the corresponding period of the prior year. Of this decrease, $2.1 million relates to management incentive payments incurred in conjunction with the refinancing in February 2004, $0.2 million relates to a reduction in legal expenses, $0.1 million reduction in travel and entertainment, offset by increased compensation expense of $1.4 million, freight of $0.4 million and other of $0.1 million. Interest Expense and Amortization of Financing Costs. Interest expense and amortization of financing costs decreased $1.7 million or 9.7% to $15.4 million for the six months ended June 30, 2005 as compared to the corresponding period of the prior year. This decrease related principally to the write off of old deferred financing costs of approximately $1.6 million during the first six months of 2004, relating to the recapitalization and reorganization consummated in 2004, partially offset by the write off of deferred financing costs of approximately $0.3 million relating to the Senior Revolving Credit Facility which was refinanced during June 2005 and increased interest expense during the first six months of 2005 due to higher average outstanding indebtedness resulting from the recapitalization and reorganization consummated in 2004. Other Income (Expense). Other expense was $1.6 million for the six months ended June 30, 2005 as compared to $0.5 million during the corresponding period of the prior year. This increase relates principally to higher litigation and related expenses associated with counterfeiting activity and non-recurring legal related expenses. Restructuring Charges. For the six months ended June 30, 2005, total restructuring charges amounted to approximately $4.1 million, including, but not limited to, severance and separation expenses, A&M fees and other non-recurring expenses. The Company anticipates incurring additional expenses relating to the restructuring during 2005. Income Tax Benefit (Expense). The Company has determined that at June 30, 2005, its ability to realize future benefits of net deferred tax assets does not meet the "more likely than not" criteria in SFAS No. 109, "Accounting for Income Taxes". Therefore, only deferred tax expense related to inventories and tax-deductible goodwill is being recorded in 2005. Tax expense of $0.003 million for the six months ended June 30, 2005 was recorded, compared to a benefit of $3.4 million for the corresponding period of the prior year. As of June 30, 2005, a valuation allowance continues to be recorded. The effective income tax rate for the six months ended June 30, 2004 was 38.0%. Net Loss. Due to the factors described above, net loss for the six months ended June 30, 2005 was $12.3 million compared to $5.5 million for the corresponding period of the prior year. LIQUIDITY AND CAPITAL RESOURCES At June 30, 2005, working capital was $36.1 million compared to $16.8 million at December 31, 2004. This increase was the result of a decrease in the revolving credit facility of $14.5 million, a higher cash balance of $7.9 million, a decrease in accounts payable of $2.6 million, an increase in accounts receivable of $0.2 million and a decrease in deferred taxes of $0.5 million offset by decreased inventory of $2.8 million, increased accrued liabilities of $3.0 million and decreased other current assets of $0.7 million. 28 For the six months ended June 30, 2005, net cash used in operating activities was $4.4 million compared with $6.9 million in the corresponding period of the prior year. This change was due primarily to reductions in inventory, increased amortization of deferred financing costs, offset by increases in accounts payable and a higher net loss. For the six months ended June 30, 2005, net cash used in investing activities was $1.3 million compared with $0.6 million in the corresponding period of the prior year. This change was due to an increase in capital expenditures. The Company believes that its capital expenditure requirements for 2005 will be approximately $3.0-5.0 million due to the Stoker integration, purchasing of certain manufacturing equipment and the continuing investment in data and related systems. For the six months ended June 30, 2005, net cash provided by financing activities was $13.7 million compared with $11.5 million in the corresponding period of the prior year. This change was due primarily to the February 2004 refinancing and the June 2005 refinancing. The Company expects to be able to fund its seasonal working capital requirements through its operating cash flows and, if needed, borrowings under the Financing Agreement. As of June 30, 2005, the Company had additional availability of $55.0 million under the Financing Agreement. On June 16, 2005, NATC refinanced its Old Credit Agreement by entering into the Financing Agreement. See Note 8 to the Condensed Consolidated Financial Statements included herein for a description of the Financing Agreement, which description is incorporated herein by reference. The Financing Agreement consists of a $30.0 million term loan facility and a $55.0 million revolving credit facility, and includes a letter of credit sublimit of $10.0 million (collectively, the "Credit Facility"). As of June 30, 2005, NATC had not borrowed any monies under the revolving credit facility. The Credit Facility will mature on June 30, 2010, and does not provide for any amortization of the term loan prior to maturity. NATC will use the revolving credit facility for working capital requirements and other general corporate purposes. CONTRACTUAL OBLIGATIONS ----------------------- Certain contractual obligations are summarized in our Annual Report on Form 10-K, as amended, for the year ended December 31, 2004 under the heading "Contractual Obligations" in "Management's Discussion and Analysis of Financial Condition and Results of Operations." As of June 30, 2005, with the exception of the term loan and payoff of the Senior Revolving Credit Facility in connection with the June 2005 refinancing (see Note 8 to the Condensed Consolidated Financial Statements contained herein) there have been no material changes outside the ordinary course of our business in such contractual obligations from December 31, 2004. 29 FORWARD-LOOKING STATEMENTS The Company cautions the reader that certain statements in the Management's Discussion and Analysis of Financial Condition and Results of Operations section as well as elsewhere in this Form 10-Q are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and other important factors, including the risks discussed below. The Company's actual future results, performance or achievement of results may differ materially from any such results, performance or achievement implied by these statements. Among the factors that could affect the Company's actual results and could cause results to differ from those anticipated in the forward-looking statements contained herein is the Company's ability to comply with certain Financing Agreement financial covenants, its ability to implement its business strategy successfully, which may be dependent on business, financial, and other factors beyond the Company's control, including, among others, federal, state and/or local regulations and taxes, competitive pressures, prevailing changes in consumer preferences, consumer acceptance of new product introductions and other marketing initiatives, market acceptance of the Company's current distribution programs, access to sufficient quantities of raw material or inventory to meet any sudden increase in demand, disruption to historical wholesale ordering patterns, product liability litigation and any disruption in access to capital necessary to achieve the Company's business strategy. The Company cautions the reader not to put undue reliance on any forward-looking statements. In addition, the Company does not have any intention or obligation to update the forward-looking statements in this document. The Company claims the protection of the safe harbor for forward-looking statements contained in Section 21E of the Securities Exchange Act of 1934. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. There have not been any significant changes with respect to quantitative and qualitative disclosures about market risk from what was previously disclosed in the Company's Annual Report on Form 10-K, as amended, for the year ended December 31, 2004. ITEM 4. CONTROLS AND PROCEDURES. Disclosure Controls and Procedures ---------------------------------- The Company's management, with the participation of the Company's principal executive and principal financial officers, has evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), as of June 30, 2005. In connection with the restatement described in Note 1 to the Company's consolidated financial statements, management determined that there was a material weakness in the Company's internal control over financial reporting as of December 31, 2004, as more fully described below. Based on their evaluation, the Company's principal executive and principal financial officers concluded that the Company's disclosure controls and procedures were not effective as of June 30, 2005 because of the material weakness discussed below. 30 Restatement of Previously Issued Consolidated Financial Statements ------------------------------------------------------------------ During the fourth quarter of 2004, the Company and its subsidiaries provided a full valuation allowance against its net deferred tax assets. Following a review of the Company's deferred tax assets and deferred tax liabilities, the Company determined that in calculating the valuation allowance, deferred tax liabilities relating to inventories and tax-deductible goodwill had been inappropriately netted against certain deferred tax assets. It cannot be determined that the temporary differences related to inventories and goodwill will reverse during the time period in which the Company's temporary differences related to its deferred tax assets are expected to reverse or expire. Therefore, deferred tax liabilities should not have been utilized to reduce the amount of the valuation allowance against deferred tax assets. This resulted in an understatement of the valuation allowance in the amount of these deferred tax liabilities of $9.8 million and $10.0 million as of December 31, 2004 and March 31, 2005, respectively, and an understatement of income tax expense of $9.8 million and $0.2 million for the year ended December 31, 2005 and the three months ended March 31, 2005, respectively. The correction of this understatement has the effect of increasing deferred tax liabilities, increasing accumulated deficit and decreasing net income, with no effect on net cash flows, as of and for the year ended December 31, 2004 and as of and for the three months ended March 31, 2005. The Company is in the process of determining the remedial steps necessary to eliminate the material weakness relating to financial disclosure controls that resulted in the restatement and intends to engage the services of consultants with appropriate levels of income tax accounting knowledge to assist in the review of complex tax matters. The Company evaluated the materiality of the correction on its consolidated financial statements using the guidelines of Staff Accounting Bulletin No. 99, "Materiality" and concluded that the effects of the corrections were material to its consolidated financial statements as of and for the year ended December 31, 2004 and as of and for the three months ended March 31, 2005. As a result, the Company concluded that it will restate such previously issued consolidated financial statements to recognize the impact of the correction. See Note 1 - Restatement of Consolidated Financial Statements, in the notes to the consolidated financial statements included under Item 1 within this Quarterly Report on Form 10-Q. Internal Control Over Financial Reporting ----------------------------------------- The Company has determined that, as of December 31, 2004, it had a deficiency in internal controls over the valuation of deferred income tax assets. Specifically, the Company did not have adequate controls over the accounting for and the review and approval of income tax related financial statement accounts requiring a significant degree of technical knowledge related to deferred tax assets and liabilities. As a result of the ineffective review, an error in the deferred tax valuation allowance was not detected prior to the issuance of the 2004 consolidated financial statements. This control deficiency resulted in the restatement of the Company's 2004 annual and first quarter 2005 consolidated financial statements as described in Note 1 to the consolidated financial statements. In addition, unless effectively remediated, this control deficiency could result in a misstatement to deferred tax valuation allowance that could result in a material misstatement to the annual or interim financial statements. Accordingly, management determined that this control deficiency constitutes a material weakness. A material weakness is a control deficiency, or combination of control deficiencies, that results in a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Accordingly, management has concluded that this control deficiency constitutes a material weakness. 31 Changes in Internal Control --------------------------- Other than the changes discussed above, there has been no change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15-d-15(f) under the Exchange Act) that occurred during the Company's fiscal quarter ended June 30, 2005, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. However, subsequent to August 11, 2005, the Company is in the process of determining the remedial steps necessary to eliminate the material weakness relating to financial disclosure controls that resulted in the restatement and intends to engage the services of consultants with appropriate levels of income tax accounting knowledge to assist in the review of complex tax matters. PART II OTHER INFORMATION Item 1. Legal Proceedings ----------------- Reference is made to the information contained in Note 14 to the Condensed Consolidated Financial Statements included herein, which information is incorporated herein by reference. Item 6. Exhibits -------- 10.1 Employment Agreement, dated June 8, 2005, between North Atlantic Trading Company, Inc. ( "NATC") and Lawrence S. Wexler (supersedes and replaces the Employment Agreement, dated December 1, 2003, between NATC, North Atlantic Cigarette Company, Inc., a subsidiary of NATC, and Lawrence S. Wexler. 31.1 Certification by the Chief Executive Officer pursuant to rule 13-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification by the Chief Financial Officer pursuant to rule 13-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to section 302 of the Sarbanes-Oxley Act of 2002. 32 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NORTH ATLANTIC HOLDING COMPANY, INC. Date: August 15, 2005 /s/ Douglas P. Rosefsky. -------------------------------------- Douglas P. Rosefsky Chief Executive Officer /s/ Brian C. Harriss -------------------------------------- Brian C. Harriss Chief Financial Officer 33 EXHIBIT INDEX No. Description --- ----------- 10.1 Employment Agreement, dated June 8, 2005, between North Atlantic Trading Company, Inc. ( "NATC") and Lawrence S. Wexler (supersedes and replaces the Employment Agreement, dated December 1, 2003, between NATC, North Atlantic Cigarette Company, Inc., a subsidiary of NATC, and Lawrence S. Wexler. 31.1 Certification by the Chief Executive Officer pursuant to rule 13-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification by the Chief Financial Officer pursuant to rule 13-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to section 302 of the Sarbanes-Oxley Act of 2002. 34