Cautionary Statement Regarding Forward-Looking Information

This report contains, in addition to historical information, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including without limitation, statements regarding future revenues, cash flows, distributions, compliance with REIT tax rules, costs, manufacturing output, capital expenditures, timber harvest levels and other timber supply issues. Words such as “anticipate,” “expect,” “will,” “intend,” “plan,” “target,” “project,” “believe,” “seek,” “schedule,” “estimate,” and similar expressions are intended to identify such forward-looking statements. These forward-looking statements reflect management’s current views regarding future events based on estimates and assumptions, and are therefore subject to known and unknown risks and uncertainties and are not guarantees of future performance. Our actual results of operations could differ materially from those expressed or implied by forward-looking statements contained in this report. Important factors that could cause or contribute to such differences include, but are not limited to, changes in the United States and international economies; changes in exchange rates between the U.S. dollar and other currencies; changes in the level of construction activity; changes in worldwide demand for our products; changes in worldwide production and production capacity in the forest products industry; competitive pricing pressures for our products; unanticipated manufacturing disruptions; changes in general and industry-specific environmental laws and regulations; unforeseen environmental liabilities or expenditures; weather conditions; changes in raw material, energy, and other costs; implementation or revision of governmental policies and regulations affecting import and export controls or taxes; the ability to satisfy complex rules in order to remain qualified as a REIT; and changes in tax laws that could reduce the benefits associated with REIT status. Forward-looking statements contained in this report present management’s views only as of the date of this report. Except as required under applicable law, we do not intend to issue updates concerning any future revisions of management’s views to reflect events or circumstances occurring after the date of this report.

Overview

Potlatch is a real estate investment trust, or REIT, with 1.5 million acres of forestland in Arkansas, Idaho, Minnesota and Oregon. Through a taxable subsidiary, the company also operates 13 manufacturing facilities that produce lumber and panel products and bleached pulp products, including paperboard and tissue products. We completed our conversion to a REIT effective January 1, 2006. By converting to a REIT, we expect to be better able to compete for timberland acquisitions against other tax-advantaged entities, and we believe that our stockholders will benefit from the increased distributions we expect to make as a REIT. Our regular annual distribution is expected to be approximately $76 million in 2006, compared to $17.5 million in 2005.

Beginning in 2006, the REIT conversion, discussed in Note 3 on page 6 resulted in the separation of the Resource segment into two reportable business segments. The new Resource segment consists of the following activities: managing our timberlands to optimize stumpage sales, the harvesting of our timber, the procurement of other wood fiber, log buying and selling, and entering into recreational and hunting leases. For the first six months of 2006, Resource segment revenues were $134.0 million, representing approximately 15% of our total revenue, before elimination of intersegment revenues. Intersegment revenues were $76.6 million for the period.

The new Land Sales and Development segment consists of the development and sale of selected land parcels, including sales for higher and better use purposes. Results for this segment depend on the timing of closing of transactions related to our efforts to identify, develop and market property with higher and better use values. For the first six months of 2006, revenues for the Land Sales and Development segment were $2.7 million, before elimination of intersegment revenues. The segment did not have any intersegment revenues during the period.

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The remaining three segments of our business consist of the following:

Factors Influencing Our Results of Operations and Cash Flows

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

Our results of operations and cash flow are affected by the fluctuating nature of timber prices. The demand for and supply of standing timber have been and are expected to be subject to cyclical and other fluctuations, which often result in variations in timber prices. The demand for softwood sawtimber is primarily affected by the level of new residential construction activity and, to a lesser extent, home repair and remodeling activity and other industrial uses of wood fiber, which are subject to fluctuations due to changes in economic conditions, interest rates, population growth, weather conditions and other factors. The demand for pulpwood is also cyclical, and tends to fluctuate based on changes in the demand for paper, tissue and similar products, as well as conversion capacity in the relevant region. Reductions in residential construction activity and other events reducing the demand for standing timber could have a material adverse effect on our results of operations and cash flow.

Our results of operations and cash flow are also affected by changes in timber availability at the local and national level. Increases in timber supply could adversely affect the prices that we receive for timber. Our timberland ownership is currently concentrated in Idaho, Arkansas and Minnesota. In Arkansas and Minnesota, most timberlands are privately owned. Historically, increases in timber prices have often resulted in substantial increases in harvesting on private timberlands, including lands not previously made available for commercial timber operations, causing a short-term increase in supply that has tended to moderate price increases. In Idaho, where a greater proportion of timberland is publicly owned, any substantial increase in timber harvesting from these lands could significantly reduce timber prices, which could harm our results of operations. In the last twenty years, environmental concerns and other factors have limited timber sales by government agencies, which historically had been major suppliers of timber to the United States forest products industry, particularly in the West. Any reversal of

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policy that substantially increases public timber sales could materially adversely affect our results of operations and cash flow. On a local level, timber supplies can fluctuate depending upon factors such as changes in weather conditions and harvest strategies of local forest products industry participants, as well as occasionally high timber salvage efforts due to unusual pest infestations or fires.

Changes in harvest levels on our timberlands also may have a significant impact on our results of operations, due in part to the low cost basis of our timber from timberlands we acquired many years ago. Over the long term, we manage our timberlands on a sustainable yield basis to achieve a balance between timber growth and timber harvests. From time to time, however, we may choose, consistent with our environmental commitments, to harvest timber at levels above or below our estimate of sustainability for various reasons. For example, for several years prior to 2005, we had been harvesting timber in Idaho at a level below the estimated long-term sustainable harvest level. Due to a current imbalance in timber ages on our Idaho timberlands, beginning in 2005 and for a period of approximately 5-10 years, we expect to significantly increase the timber harvest level on our Idaho timberlands in order to improve the long-term productivity and sustainability of these timberlands. We also anticipate that, as a result of this period of increased timber harvest activity, the annual harvest levels on our existing Idaho timberlands will subsequently decrease to a level below the sustainable harvest level for a period of time, before increasing again to achieve the optimal long-term sustainable harvest level. On a short-term basis, our timber harvest levels may be impacted by factors such as demand for timber and harvesting capacity. We also experience seasonally lower harvest activity during the winter and early spring due to weather conditions. Longer term, our timber harvest levels may also be affected by purchases of additional timberlands, sales of existing timberlands and changes in estimates of long-term sustainable yield because of genetic improvements and other silvicultural advances, as well as by natural disasters, regulatory constraints and other factors beyond our control.

Beginning in the fourth quarter of 2005, our 17,000 acre hybrid poplar plantation in Boardman, Oregon, transitioned from a development stage to an operating stage. As a result, we expect to increase our harvest and sale of wood fiber over the next three to five years to a sustainable annual harvest level of approximately 340,000 tons and thereby increase our cash flow from the plantation operations. The increased harvests will also increase the amount of depletion and depreciation expense that we expect to incur as we amortize our approximate $100 million investment in the plantation over an eleven-year harvest cycle. This plantation was originally established to provide an alternative source of wood chips for pulp making. In 2001, due to declining wood chip prices, we altered our strategy for the plantation toward the production of high quality logs for conversion into higher value, non-structural lumber products, such as furniture and moldings. It is our belief that hybrid poplar lumber will serve as a cost-competitive alternative to other regional hardwood species, mainly red alder, which are in tight supply. However, because there are no other producers of hybrid poplar sawlogs in the United States, it is uncertain whether we will be successful in developing an adequate market for hybrid poplar lumber. The cash flow that we will generate from our Boardman operation will depend primarily on the development of new markets for products manufactured from hybrid poplar sawlogs and on the prices we are able to obtain for hybrid poplar sawlogs converted into these products.

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

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

Tariffs, quotas or trade agreements can also affect the markets for our products, particularly our wood products. For example, in 2002, the United States imposed duties on imported lumber from Canada in response to a dispute over the stumpage pricing policies of some provincial governments. On April 27, 2006, the United States and Canada announced a negotiated agreement to end the trade dispute. The details of the agreement were finalized on July 1, 2006, although Canada’s Parliament must approve the deal prior to it being implemented. The essence of the agreement is a system of quotas and taxes triggered at certain lumber price thresholds. We have not determined at this time if the agreement will have a significant effect on our financial condition and results of operations.

Our manufacturing businesses are capital intensive, which leads to high fixed costs and generally results in continued production as long as prices are sufficient to cover variable costs. These conditions have contributed to substantial price competition, particularly during periods of reduced demand. Some of our competitors may currently be lower-cost producers in some of the businesses in which we operate, and accordingly these competitors may be less adversely affected than we are by price decreases. For the periods presented in this Form 10-Q, no downtime was taken at any of our facilities due to an inability to cover variable costs. The profitability of our manufacturing segments depends largely on our ability to operate our manufacturing facilities efficiently and at or near full capacity. Our operating results would be adversely affected if market demand does not justify operating at these levels or if our operations are inefficient or suffer significant interruption for any reason.

Energy costs, which have become one of our most volatile operating expenses over the past several years, impact almost every aspect of our operations, from natural gas used at our manufacturing facilities to in-bound and out-bound transportation surcharges. In periods of high energy prices, market conditions may prevent us from passing higher energy costs on to our customers through price increases, and therefore such increased costs could adversely affect our operating results. We have taken steps through conservation and electrical production to reduce our exposure to both the volatile spot market for energy and to rate increases by regulated utilities. Our energy costs in future periods will depend principally on our ability to continue to produce a substantial portion of our electricity needs internally, on changes in market prices for natural gas and on reducing energy usage.

Another significant expense is the cost of wood fiber needed to supply our manufacturing facilities. The cost of various types of wood fiber that we purchase in the market has at times fluctuated greatly because of economic or industry conditions. Selling prices of our products have not always increased in response to wood fiber price increases, nor have wood fiber prices always decreased in conjunction with declining product prices. On occasion, our results of operations have been and may in the future be adversely affected if we are unable to pass cost increases through to our customers.

The disparity between the cost of wood fiber harvested from our timberlands and the cost of wood fiber purchased on the open market is due to the fact that the capitalized costs to establish our fee timber were expended many years ago. Our initial stand establishment costs remain as a capitalized asset until the timber reaches maturity, which typically ranges from 30 to 60 years. Ongoing forest management costs, which include recurring items necessary to the ownership and administration of timber producing property, are expensed as incurred. The cost of purchased wood fiber is significantly higher due to the fact that the wood fiber being purchased from third parties is mature and is purchased at the current market price.

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Changes in our manufacturing capacity, primarily as a result of capital spending programs or asset purchases and dispositions, have affected our results of operations in recent periods. In May 2005, we purchased a lumber mill in Gwinn, Michigan. This change has affected or will affect our levels of net revenues and expenses, as well as the comparability of our operating results from period to period.

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

As a REIT, we expect to be better able to compete for acquisitions of timberlands against other entities that use tax-efficient structures. It is uncertain whether any timberland acquisitions will occur and, if an acquisition is consummated, whether it will perform in accordance with our expectations. In addition, we anticipate financing acquisitions through cash from operations, borrowings under our credit facility or proceeds from equity or debt offerings. Our inability to finance future acquisitions on favorable terms or the failure of any acquisition to perform as we expect could harm our results of operations.

Critical Accounting Policies

Our principal accounting policies are discussed on pages 51-55 of our Annual Report on Form 10-K for the year ended December 31, 2005. The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported financial position and operating results of the company. Management believes the critical accounting policies discussed below represent the most complex, difficult and subjective judgments it makes in this regard.

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

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

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There are currently no authoritative accounting rules relating to costs to be capitalized in the timber and timberlands category. We have used relevant portions of current accounting rules, industry practices and our judgment in determining costs to be capitalized or expensed. Alternate interpretations and judgments could significantly affect the amounts capitalized. Additionally, models and observations used to estimate the current recoverable timber volume on our lands are subject to judgments that could significantly affect volume estimates. Following are examples of factors that add to the complexity of the assumptions we make regarding capitalized or expensed costs:

Different assumptions for either the cost or volume estimates, or both, could have a significant effect upon amounts reported in our statements of operations and financial condition. Because of the number of variables involved and the interrelationship between the variables, sensitivity analysis of individual variables is not practical.

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

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

Note 12 to our 2005 Form 10-K consolidated financial statements included information for the three years ended December 31, 2005, on the components of pension and OPEB expense and the underlying actuarial assumptions used to calculate periodic expense, as well as the funded status for our pension and OPEB plans as of December 31, 2005 and 2004. Note 8, “Pension and Other Postretirement Benefit Plans,” on page 12 of this Form 10-Q, includes information on the components of pension and OPEB expense for the quarters and six months ended June 30, 2006 and 2005.

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The discount rate used in the determination of pension benefit obligations and pension expense is based on high-quality fixed income investment interest rates. At December 31, 2005, we calculated obligations using a 5.60% discount rate. The discount rates used at December 31, 2004 and 2003 were 5.90% and 6.25%, respectively. To determine the expected long-term rate of return on pension assets, we employ a process that analyzes historical long-term returns for various investment categories, as measured by appropriate indices. These indices are weighted based upon the extent to which plan assets are invested in the particular categories in arriving at our determination of a composite expected return. The assumed long-term rate of return on pension plan assets used for the three-year period ended December 31, 2005, was 9.5%. Over the past 28 years, the period we have actively managed pension assets, our actual average annual return on pension plan assets has been approximately 11.5%.

Total periodic pension plan income in 2005 was $14.1 million. An increase in the discount rate or the expected return on plan assets, all other assumptions remaining the same, would reduce pension plan expense, and conversely, a decrease in either of these measures would increase plan expense. As an indication of the sensitivity that pension expense has to the discount rate assumption, a 25 basis point change in the discount rate would affect annual plan expense by approximately $1.4 million. A 25 basis point change in the assumption for expected return on plan assets would affect annual plan expense by approximately $1.6 million. The actual rates on plan assets may vary significantly from the assumption used because of unanticipated changes in financial markets.

No minimum pension contributions to our qualified plans are required for 2006 due to the funded status of those pension plans at December 31, 2005. However, we expect to make contributions to our pension plans totaling approximately $19.5 million in 2006, which will consist of a $1.4 million contribution to our non-qualified plan and a voluntary $18.1 million contribution to our qualified plans.

For our OPEB plans, expense for 2005 was $29.6 million. The discount rate used to calculate OPEB obligations was 5.60% at December 31, 2005, and 5.90% and 6.25% at December 31, 2004 and 2003, respectively. The assumed health care cost trend rate used to calculate OPEB obligations and expense for 2005 was a 12% increase over the previous year, with the rate of increase scheduled to decline one percent annually to a long-term ultimate rate increase assumption of 6% for 2011 and thereafter.

As an indication of the sensitivity that OPEB expense has to the discount rate assumption, a 25 basis point change in the discount rate would affect annual plan expense by approximately $1.2 million. A 1% change in the assumption for health care cost trend rates would have affected 2005 plan expense by approximately $2.0 - $2.4 million and the total postretirement obligation by approximately $29.5 - $34.8 million. The actual rates of health care cost increases may vary significantly from the assumption used because of unanticipated changes in health care costs.

Periodic pension and OPEB expense are included in “Materials, labor and other operating expenses” and “Selling, general and administrative expenses” in the Statements of Operations. The expense is allocated to all business segments. Depending upon the funded status of the different plans, either a long-term asset or long-term liability is recorded for plans with overfunding or underfunding, respectively. Any unfunded accumulated pension benefit obligation in excess of recorded liabilities is accounted for in stockholders’ equity as “accumulated other comprehensive income.” See Note 12 to our 2005 Form 10-K financial statements for related balance sheet effects at December 31, 2005 and 2004.

Recent Accounting Pronouncements

Note 2 on pages 5-6 discusses SFAS No. 155, which was issued by the FASB in February 2006 and FIN 48, which was issued in July 2006. We believe that adoption of SFAS No. 155 on its effective date will not have a material effect on our financial position or results of operations. FIN 48 will become effective for fiscal years beginning after December 15, 2006. We are currently reviewing FIN 48 to

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determine the effect it will have on our financial condition, results of operations and disclosure requirements. Note 2 also discusses a proposed SFAS related to accounting for defined benefit pension and other postretirement plans, which, if adopted, will be effective for fiscal years beginning after December 15, 2006. Refer to Note 2 for a summary of this proposed Statement.

Results of Operations

As noted above, our business is organized into five reporting segments: Resource; Land Sales and Development; Wood Products; Pulp and Paperboard; and Consumer Products. Sales or transfers between segments are recorded as intersegment revenues based on prevailing market prices. Because of the role of the Resource segment in supplying our manufacturing segments with wood fiber, intersegment revenues represent a significant portion of the Resource segment’s total net revenues. Intersegment revenues represent a substantially smaller percentage of revenues for our other segments.

A summary of period-to-period changes in items included in the Statements of Operations is presented on page 29 of this Form 10-Q. In the period-to-period discussion of our results of operations below, when we discuss our consolidated revenues, contributions by each of the segments to our revenues are reported after elimination of intersegment revenues. In the “Discussion of Business Segments” section below, each segment’s revenues are set forth before elimination of intersegment revenues.

Certain 2005 amounts have been reclassified to conform to the 2006 presentation.

Quarter Ended June 30, 2006, Compared to Quarter Ended June 30, 2005

Revenues – Total revenues increased 13%, to $414.6 million for the quarter ended June 30, 2006, from $368.5 million for the same period in 2005. Resource segment revenues increased $4.9 million to $23.9 million for the second quarter of 2006, primarily due to increased sales of logs to external customers and higher selling prices for logs in Idaho. Land Sales and Development revenues were $2.0 million for the second quarter of 2006, compared to $1.0 million for the second quarter of 2005. This increase was the result of conservation easement revenues recorded in the second quarter of 2006; no conservation easement revenues were recorded in the second quarter of 2005. Wood Products revenues increased to $134.1 million for the second quarter of 2006, a $6.4 million increase from $127.7 million in the second quarter of 2005, primarily as a result of increased lumber shipments. Revenues for the Pulp and Paperboard segment increased to $137.4 million for the second quarter of 2006, compared to $129.3 million for the second quarter of 2005, primarily due to higher selling prices and increased shipments for paperboard and pulp to external customers. Consumer Products revenues were $117.1 million for the second quarter of 2006, $25.6 million more than in the same 2005 period due to increased shipments and higher selling prices for consumer tissue products.

Depreciation, depletion and amortization – For the quarter ended June 30, 2006, depreciation, depletion and amortization totaled $22.3 million, compared to $19.7 million for the same period in 2005. The increase was primarily due to depreciation and higher depletion expense related to our Boardman, Oregon, hybrid poplar operation, combined with depreciation related to the Gwinn, Michigan, lumber mill, which we acquired in May 2005.

Materials, labor and other operating expenses – Materials, labor and other operating expenses increased 15% to $353.9 million for the quarter ended June 30, 2006. The higher costs were due primarily to increased lumber, paperboard, pulp and consumer tissue shipments, and higher log costs for the Wood Products segment.

Selling, general and administrative expenses – For the second quarter of 2006, selling, general and administrative expenses were $22.1 million, compared to $21.3 million incurred for the same period in 2005. The increase was due to higher corporate administration expense in 2006.

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Interest expense – Interest expense totaled $7.3 million for the three months ended June 30, 2006, compared to $7.2 million for the quarter ended June 30, 2005.

Interest income – For the quarter ended June 30, 2006, interest income was $0.3 million, compared to $0.6 million for the same period in 2005.

Provision (benefit) for taxes – We recorded an income tax provision of $1.3 million for the quarter ended June 30, 2006, compared to $5.1 million for the three months ended June 30, 2005. The lower provision for 2006 was due largely to the company’s conversion to a REIT in 2006.

Net Earnings – For the quarter ended June 30, 2006, we recorded net earnings of $8.0 million, compared to net earnings of $8.2 million for the same period in 2005. The slight decrease in net earnings was primarily due to lower results for the Wood Products and Resource segments, which were mostly offset by better earnings for the Consumer Products, Pulp and Paperboard and Land Sales and Development segments, as well as the lower income tax provision.

Discussion of business segments

The Resource segment reported operating income of $9.8 million for the three months ended June 30, 2006, down from $13.5 million earned in the second quarter of 2005. The decreased income was due largely to a decreased harvest of fee timber in Arkansas and a loss for our Boardman, Oregon, hybrid poplar operation, partially offset by an increased harvest of fee timber and higher selling prices in Idaho. Revenues for the segment were $68.8 million for the second quarter of 2006, compared to $60.6 million for the same period in 2005. The increase in revenues was attributable to the increased harvest of fee timber and higher selling prices in Idaho. Resource segment expenses were $59.0 million in the second quarter of 2006, compared to $47.1 million in the second quarter of 2005. The increased expenses were due primarily to the increased harvest of fee timber in Idaho and higher costs for the Boardman operation. The Boardman operation was in a development stage in the second quarter of 2005, and most of the expenses were capitalized in that quarter. Following the start of harvesting operations in late 2005, most operating costs are now expensed against income.

The Land Sales and Development segment reported operating income of $1.5 million for the second quarter of 2006, compared to $0.5 million for the second quarter of 2005. Results for this segment depend on the timing of closing of transactions related to our efforts to identify, develop and market property with higher and better use values. Revenues for the segment were $2.0 million for the 2006 quarter, versus $1.0 million for the same period of 2005. The increased income and revenues for the segment were due to the completion of a conservation easement in the second quarter of 2006; no conservation easements were completed in the second quarter of 2005. Expenses for the segment were $0.5 million for the second quarter of 2006, compared to $0.6 million for the same quarter of 2005.

The Wood Products segment reported operating income of $3.5 million for the quarter ended June 30, 2006, $10.2 million lower than the $13.7 million of income recorded in the second quarter of 2005. Segment revenues were $137.8 million for the second quarter of 2006, compared to $131.5 million for the same period in 2005. Lumber revenues were $107.7 million, up from $102.4 million in 2005. The favorable comparison was due to an 11% increase in lumber shipments, which was largely the result of shipments from the Gwinn, Michigan, lumber mill, which we acquired in May 2005, as well as increased shipments from our lumber mills in Lewiston and St. Maries, Idaho. Plywood revenues were $15.4 million for the second quarter of 2006, slightly higher than $14.9 million reported in the second quarter of 2005. Particleboard revenues were $5.0 million for the second quarter of 2006, compared to $4.5 million for the same period of 2005, due primarily to increased shipments. “Other” sales for the segment, which consist primarily of by-products such as chips, were $9.8 million for the three months ended June 30, 2006, compared to $9.7 million for the second quarter of 2005. Segment expenses were higher for the second quarter of 2006, totaling $134.3 million versus $117.8 million for the second quarter of 2005. Increased lumber shipments and higher log costs were primarily responsible for the higher segment expenses.

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The Pulp and Paperboard segment reported operating income for the second quarter of 2006 of $3.9 million, compared to an operating loss of $0.1 million for the second quarter of 2005. Segment revenues were $147.7 million for the second quarter of 2006, $7.3 million higher than the $140.4 million recorded in the same period of 2005. Paperboard revenues increased to $132.1 million, compared to $126.2 million reported for the second quarter of 2005. The favorable comparison was primarily due to higher selling prices and increased shipments. Pulp revenues (including intersegment revenues) were $15.3 million for the three months ended June 30, 2006, $1.3 million higher than the $14.0 million recorded in the second quarter of 2005. The increase in pulp revenues was due to increased shipments to external customers and higher selling prices. Expenses for the segment were $143.8 million for the second quarter of 2006, compared to $140.5 million for the same period in 2005. The slightly higher expenses were primarily due to the increased shipments of paperboard and pulp, partially offset by lower wood fiber and maintenance costs.

The Consumer Products segment reported operating income of $7.0 million for the three months ended June 30, 2006, compared to $1.8 million for the second quarter of 2005. Revenues for the segment were $117.1 million for the second quarter of 2006, a 28% increase from $91.5 million recorded in the same period of 2005. The significant increase in revenues was due to a 20% increase in shipments and higher net selling prices. The increased shipments were primarily the result of our plan to reduce inventories. The higher net selling prices were due to a combination of price increases and sheet count reductions. Segment expenses were $110.2 million for the second quarter of 2006, compared to $89.7 million for the second quarter of 2005. The higher expenses were largely attributable to the increased shipments of consumer tissue products.

Six Months Ended June 30, 2006, Compared to Six Months Ended June 30, 2005

Revenues – For the six months ended June 30, 2006, revenues increased 16%, to $817.1 million, from $705.4 million for the same period in 2005. Resource revenues increased to $57.3 million, compared to $41.1 million for the first six months of 2005. The increased revenues were due primarily to increased sales of logs to external customers. Land Sales and Development revenues were $2.7 million for the first half of 2006, compared with $2.6 million for the first half of 2005. Conservation easement revenues in 2006 were mostly offset by decreased revenues from land sales. Wood Products revenues increased to $265.7 million, from $231.6 million for the first six months of 2005, due primarily to increased lumber and plywood shipments. Pulp and Paperboard segment revenues were $274.7 million for the six months ended June 30, 2006, $30.2 million more than in the same period in 2005 due to increased shipments of paperboard and pulp to external customers, as well as higher paperboard selling prices. Consumer Products segment revenues increased to $216.6 million from $185.6 million due to higher selling prices and increased shipments of consumer tissue products.

Depreciation, depletion and amortization - For the six months ended June 30, 2006, depreciation, depletion and amortization totaled $45.0 million, compared to $38.7 million recorded in the first six months of 2005. The increase was primarily due to depreciation and higher depletion expense related to our Boardman, Oregon operation, combined with depreciation related to the Gwinn, Michigan, lumber mill.

Materials, labor and other operating expenses - Materials, labor and other operating expenses increased to $693.6 million for the six months ended June 30, 2006, from $591.8 million for the six months ended June 30, 2005. The higher costs were due primarily to increased lumber, plywood, pulp, paperboard and consumer tissue shipments, higher log and freight costs for the Wood Products segment, and higher maintenance and freight costs for the Pulp and Paperboard segment.

Selling, general and administrative expenses - Selling, general and administrative expenses were $45.7 million for the first half of 2006, compared to $42.3 million incurred for the same period of 2005. The increase was primarily due to higher corporate administration expense in 2006.

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Interest expense - Interest expense totaled $14.7 million for the six months ended June 30, 2006, compared to $14.5 million in the prior year period.

Interest income – For the six months ended June 30, 2006, interest income was $1.1 million, compared to $1.3 million for the same period in 2005.

Provision (benefit) for taxes - For the six months ended June 30, 2006, we recorded an income tax benefit of $51.6 million. The tax benefit was largely due to the reversal of $51.2 million in timber-related deferred tax liabilities that were no longer necessary as a result of our REIT conversion. Excluding the tax benefit related to the reversal of the deferred tax liabilities, we recorded an income tax benefit of $0.4 million. During the first six months of 2005, an estimated tax rate of 38.5% was used to derive an income tax provision of $7.5 million, calculated on our income from operations, before taxes, of $19.4 million.

Net earnings - We recorded net earnings of $70.8 million for the six months ended June 30, 2006, compared to net earnings of $12.0 million for the same period in 2005. The benefit for taxes discussed above and better results for the Consumer Products segment were responsible for the higher earnings.

Discussion of business segments

The Resource segment reported operating income of $24.1 million for the first six months of 2006, compared to $23.0 million for the same period of 2005. Segment revenues were $134.0 million for the first six months of 2006, compared to $118.4 million recorded for the same period in 2005. The higher earnings for 2006 were due to an increased harvest of fee timber and higher selling prices in Idaho, partially offset by a loss for our Boardman operation and a lower harvest of fee timber in Arkansas. Resource segment expenses were $109.8 million in the first six months of 2006, compared to $95.4 million in the first six months of 2005. The higher expenses reflected the increased costs associated with the increased harvest of fee timber in Idaho and higher costs at Boardman. The Boardman operation was in a development stage in the first half of 2005, and most of the expenses were capitalized. Following the start of harvesting operations in late 2005, most operating costs are now expensed against income.

The Land Sales and Development segment reported operating income of $2.0 million for the first half of 2006, compared to $1.5 million for the first half of 2005. Revenues for the segment were $2.7 million for the first half of 2006, versus $2.6 million for the same period of 2005. The higher income for the segment was due to conservation easement income in the first half of 2006, compared to none in the first half of 2005, partially offset by fewer land sales in the first half of 2006. Expenses for the segment were $0.7 million for the first half of 2006, compared to $1.1 million for the same period of 2005.

The Wood Products segment reported operating income of $10.7 million for the first six months of 2006, compared to income of $22.3 million recorded in the first six months of 2005. Revenues for the segment rose to $272.9 million for the first six months of 2006, 14% higher than the $239.1 million recorded for the same period in 2005. Lumber revenues were $213.1 million, up from $185.8 million in the same period in 2005. The favorable comparison was due to a 22% increase in lumber shipments, which was largely the result of shipments from the Gwinn, Michigan, lumber mill, which we acquired in May 2005, as well as increased shipments from most of our other lumber mills. Lower selling prices for lumber partially offset the increased shipments. Plywood revenues increased to $29.8 million for the first six months of 2006, compared to $27.3 million for the first six months of 2005. The increased plywood revenues were due to a 10% increase in shipments. Particleboard revenues were $9.2 million for the first six months of 2006, compared to $9.3 million for the first six months of 2005. “Other” sales for the segment were $20.8 million for the first half of 2006, 25% higher than the $16.7 million recorded for the first half of 2005, due largely to chip sales at our Gwinn lumber mill. Segment expenses were higher for the first six months of 2006, totaling $262.2 million, versus $216.8 million for the first six months of 2005. Increased lumber and plywood shipments and higher log and freight costs largely accounted for the increase over 2005.

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The Pulp and Paperboard segment reported operating income of $2.3 million for the first six months of 2006, which was unchanged from the first six months of 2005. Segment revenues were $296.1 million for the first six months of 2006, up from $267.2 million for the same period in 2005. Paperboard revenues increased to $264.7 million for the first six months of 2006, compared to $239.5 million in the first six months of 2005. Increased shipments and higher selling prices were primarily responsible for the increased revenues. Pulp revenues (including intersegment revenues) were higher for the first six months of 2006, totaling $30.8 million, compared to $27.2 million for the same period in 2005. The increase in pulp revenues for the 2006 period was due to increased shipments to external customers. Segment expenses were higher for the first six months of 2006, totaling $293.8 million, compared to $264.9 million in the first six months of 2005. The increase reflected the higher volumes of pulp and paperboard shipments for the first six months of 2006 compared to 2005, combined with higher maintenance, freight, chemical and energy costs.

The Consumer Products segment reported operating income of $13.9 million for the first six months of 2006, compared to $0.9 million for the first six months of 2005. Segment revenues were $216.7 million for the first six months of 2006, $31.0 million higher than the $185.7 million recorded for the same period in 2005. The increase in revenues was due to a 9% increase in selling prices and increased shipments compared to the prior year period. The higher selling prices in 2006 were attributable to a combination of price increases and sheet count reductions. Segment expenses were higher for the first six months of 2006, totaling $202.8 million, versus $184.8 million in the first six months of 2005. Increased shipments were primarily responsible for the higher segment expenses.

Funds from Operations

Funds from Operations, or FFO, is a non-GAAP measure that is commonly used by REITs in the real estate industry. The most directly comparable GAAP measure to FFO is net earnings. Although the National Association of Real Estate Investment Trusts ^® , or NAREIT, has published a definition of FFO, modifications to the NAREIT definition of FFO are common among REITs, as companies seek to provide financial measures that meaningfully reflect their businesses. FFO as we define it is presented as a supplemental financial measure. We do not use FFO as, nor should it be considered to be, an alternative to net earnings computed under GAAP as an indicator of our operating performance or as an alternative to cash from operating activities computed under GAAP as an indicator of our ability to fund our cash needs. FFO, as we define it, may not be comparable with measures of similar titles reported by other companies.

We define FFO as net earnings, less the benefit from taxes resulting from the reversal of timber-related deferred tax liabilities that are no longer necessary as a result of our REIT conversion, plus depreciation, depletion and amortization. Management believes that FFO is a meaningful supplemental measure of our operating performance because historical cost accounting for assets such as our manufacturing facilities and timberlands assumes that the value of such assets diminishes predictably over time. However, the values of our manufacturing facilities and timberlands have historically risen and fallen based on market conditions for the products we manufacture and for timber and timberlands. Management also considers the FFO measure in determining, among other things, quarterly and annual distribution rates, future levels of capital spending and debt repayment. We disclose this supplemental financial measure to enable investors to align their analysis and evaluation of our operating results along the same lines as our management uses in planning and executing our business strategy.

For the quarter and six months ended June 30, 2006, FFO was $30.3 million and $64.6 million, respectively, compared to $27.9 million and $50.6 million for the quarter and six months ended June 30, 2005, respectively.

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Below is a reconciliation of Net Earnings to FFO for the quarters and six months ended June 30, 2006 and 2005:

Liquidity and Capital Resources

At June 30, 2006, our financial position included long-term debt of $333.1 million, including current installments on long-term debt of $8.7 million. The balance in current installments at June 30, 2006, included $5.5 million of 10%, senior subordinated notes. These notes, which had a maturity of 2011, were redeemed on July 15, 2006. Long-term debt at June 30, 2006 (including current installments) decreased from the balance at December 31, 2005 of $335.5 million due to normal repayments on maturing debt of $2.4 million. Stockholders’ equity for the first six months of 2006 decreased by $47.4 million due to distributions to common stockholders totaling $127.1 million, which were partially offset by net earnings of $70.8 million. The distributions to common stockholders consisted of the cash portion of the special E&P distribution, which totaled $89.0 million, and regular quarterly distributions of $38.1 million. The ratio of long-term debt (including current installments) to stockholders’ equity was .51 to 1 at June 30, 2006, compared to .48 to 1 at December 31, 2005.

Scheduled payments due on long-term debt during each of the five years subsequent to December 31, 2006, are as follows:

Working capital totaled $160.3 million at June 30, 2006, a decrease of $95.6 million from the December 31, 2005 balance of $255.9 million. The significant changes in the components of working capital are as follows:

Net cash provided by operating activities for the first six months of 2006 totaled $104.7 million, compared with $12.1 million for the same period in 2005. Cash provided by working capital changes in the first half of 2006 of $40.3 million, versus cash used for working capital changes of $38.2 million in the first half of 2005, was largely responsible for the favorable comparison.

For the six months ended June 30, 2006, net cash provided by investing activities was $12.1 million, compared to net cash used for investing activities of $16.8 million for the first six months of 2005. In the first half of 2006, a decrease in our short-term investments provided $43.2 million in cash, as discussed above, and we used $27.3 million for capital spending. Capital spending in the first half of 2006 included $2.2 million for a new bathroom tissue line at our tissue converting facility in Elwood, Illinois, and $4.7 million toward the installation of coating equipment at our paperboard facility in

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Lewiston, Idaho. The balance of capital spending in the first half of 2006 focused on forest resources and various smaller projects designed to improve product quality and manufacturing efficiency. Cash was used in the first six months of 2005 primarily for capital spending projects, partially offset by cash provided by a decrease in our short-term investments.

Net cash used for financing activities totaled $117.0 million for the six months ended June 30, 2006, compared with net cash provided by financing activities of $4.7 million during the same period in 2005. The cash used for financing in the first six months of 2006 consisted of distributions to common stockholders of $127.1 million, which was slightly offset by a $5.6 million increase in book overdrafts and the issuance of $5.5 million of common stock related to the exercise of stock options. The majority of the cash provided in the first six months of 2005 was from an increase in book overdrafts and the issuance of treasury stock related to the exercise of stock options, partially offset by the payment of distributions to common stockholders.

In connection with our REIT conversion, we expect to increase our regular annual distribution rate from an aggregate amount of $17.5 million in 2005 to approximately $76 million in 2006. Based on historical operating results and taking into account planned increases in harvest activities on our Idaho timberlands, we expect to fund a substantial majority of these annual distributions using the cash flows from our REIT-qualifying timberland operations. Any shortfall between cash available for distribution from REIT operations and the anticipated initial annual distribution to stockholders of approximately $76 million is expected to be funded through cash on hand, bank borrowings, dividends from Potlatch’s Taxable REIT Subsidiary, or Potlatch TRS, or a combination thereof. Our ability to fund distributions through bank borrowings is subject to our continued compliance with debt covenants, as well as the availability of borrowing capacity under our lending arrangements. If our operations do not generate sufficient cash flows and we are unable to borrow, we may be required to reduce our quarterly distributions. In addition, even if cash available for distribution from our REIT operations is sufficient on an annual basis to fund the entire distribution to stockholders, we anticipate that it will be necessary to utilize some short-term borrowing to fully fund distributions in the first half of each year as a result of the lower harvest activity during winter and early spring. Significant decreases in timber prices or other factors that materially adversely affect the cash flows from our REIT operations could result in our inability to maintain the expected distribution rate.

In addition, the rules with which we must comply to maintain our status as a REIT limit our ability to use dividends from our manufacturing businesses for the payment of stockholder distributions. In particular, at least 75% of our gross income for each taxable year as a REIT must be derived from sales of our standing timber and other types of real estate income. No more than 25% of our gross income may consist of dividends from Potlatch TRS and other non-qualifying types of income. This requirement may limit our ability to receive dividends from Potlatch TRS and may impact our ability to fund distributions to stockholders using cash flows from Potlatch TRS. Our board of directors, in its sole discretion, will determine the actual amount of distributions to be made to stockholders based on consideration of a number of factors, including, but not limited to, our results of operations, cash flow and capital requirements, economic conditions, tax considerations and borrowing capacity.

Our current unsecured bank credit facility, which expires on December 22, 2008, provides for a revolving line of credit of up to $175 million, including a $35 million subfacility for letters of credit and a $10 million subfacility for swing line loans. Usage under either or both subfacilities reduces availability under the revolving line of credit. As of June 30, 2006, there were no borrowings outstanding under the revolving line of credit; however, approximately $20.6 million of the letter of credit subfacility was being used to support several outstanding letters of credit. Loans under the credit facility bear interest at LIBOR plus between 0.625% and 1.625% for LIBOR loans, and a base rate effectively equal to the bank’s prime rate plus up to 0.625% for other loans. Currently, we are eligible to borrow under the credit facility at LIBOR plus 0.875%.

The agreement governing our credit facility contains certain covenants that, among other things, limit to a certain degree our ability and our subsidiaries’ ability to create liens, merge or consolidate, dispose of assets, incur indebtedness and guarantees, repurchase or redeem capital stock and

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indebtedness, make certain investments or acquisitions, enter into certain transactions with affiliates or change the nature of our business. The credit facility also contains financial maintenance covenants establishing a maximum funded indebtedness to capitalization ratio, a minimum consolidated net worth requirement, and a minimum interest coverage ratio. We will be permitted to pay dividends under the terms of the credit facility so long as we remain in pro forma compliance with the financial covenants.

The table below sets forth the most restrictive covenants in the credit facility and our status with respect to these covenants as of June 30, 2006.

Events of default under the credit facility include, but are not limited to, payment defaults, covenant defaults, breaches of representations and warranties, cross defaults to certain other material agreements and indebtedness, bankruptcy and other insolvency events, material adverse judgments, actual or asserted invalidity of security interests or loan documentation, and certain change of control events involving our company.

Potlatch Corporation and several subsidiaries are parties to the credit agreement and eligible to borrow thereunder, subject to the $175 million aggregate credit limit and continued compliance with debt covenants. Any borrowings by one of these entities under the credit facility reduces the credit available for all the entities. As a result, borrowings by Potlatch TRS under the credit facility would, until repaid, reduce the amount of borrowings otherwise available to Potlatch for purposes such as the funding of quarterly distributions.

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

In October 2005, Standard & Poor’s Ratings Services (S&P) downgraded our senior unsecured debt from BB+ to BB. Since the first quarter of 2003, Fitch, Inc. has rated our senior unsecured debt at BB+. Moody’s Investors Service Inc. has rated our senior unsecured debt at Ba1 and our senior secured subordinated debt at Ba2 since October 2004. Both Fitch and Moody’s affirmed their ratings, with stable outlooks, in October 2005. The interest rate we pay on some of our debt is influenced by our credit ratings. See Item 3, “Quantitative and Qualitative Disclosures About Market Risk” on page 30 for additional information.

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