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MONTREAL - Forest products company Tembec Inc. (TSX:TMB) continues to struggle to turnaround its business, posting a drop in second quarter sales Friday as a result of lower demand for lumber and pulp.

The Quebec-based company said third-quarter losses fell to $27 million from $164 million a year ago, when it took a $173 million charge for an idled paper mill in Louisiana.

The loss of 27 cents per share in the April-June period, compared to a $1.91 loss in the same period for 2007, after Tembec reduced selling and corporate costs and benefited from a $14 million adjustment to the value of its lumber inventories.

But sales fell to $609 million from $712 million as a result of lower volumes in all four of its operating segments: lumber, pulp, paper and chemicals.

"Overall, the June quarterly operating results were an improvement over the previous quarter, but remained well below acceptable levels," the company stated.

The quarterly results covered the first full period since Tembec completed a financial recapitalization Feb. 29 that saw US$1.2 billion of debt converted into 95 per cent equity.

During the quarter, pricing was negatively affected by a nine per cent increase in the value of the Canadian dollar since last year.

Lumber sales suffered the largest decline, falling 31.6 per cent to $145 million. The larger pulp division's sales fell only 2.9 per cent to $369 million. Paper was down 12.5 per cent to $112 million and chemicals were off 26.7 per cent to $33 million.

Operating losses improved to $13 million from $34 million as depreciation was trimmed by $17 million and the carrying value of fixed assets was reduced by $811 million.

Extremely low U.S. lumber selling prices continued to depress earnings, with no improvement in the American housing market in sight.

Pulp markets remained stable, with a new round of newsprint price increases slated for September.

Tembec said it will continue to focus on controllable items such as costs and operating efficiency but is being hampered by dramatic increase in fuel prices.

"If global energy prices remain at these lofty levels, manufacturers will have to increase selling prices well beyond normal historical levels to earn satisfactory margins," Tembec stated. The company recently announced a fuel surcharges on chemical resins and specialty dissolving pulp.

Stephen Atkinson of BMO Capital Markets said extremely high wood costs are punishing all Canadian forestry companies.

"They're doing what they can but you've got very little flexibility if you have very, very high wood costs, because that is by far your highest cost component," he said in an interview.

Atkinson said Tembec has to hope that pulp prices increase as it attempts to generate free cash from operations.

Tembec generated $30 million of negative cash flow during the quarter. In the first nine months, cash flow from operations before working capital was negative $64 million, a $230 million decline from a year ago when it benefited from a $268 million refund on lumber deposits and interest.

"It's not as bad as it was, but they're still not free cash flow positive yet."

Tembec's shares were down six cents, or 1.71 per cent, at $3.45 Friday afternoon on the Toronto Stock Exchange.