**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

WASHINGTON, D.C. 20549

 

**FORM 10-K**

** **

**ANNUAL REPORT**

**PURSUANT TO SECTION 13 OR15(d) OF THE**

**SECURITIES EXCHANGE ACTOF 1934**

** **

**[X]**                               ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2006

 

Commission File No.: 000-51444

 

**KapStone Paper and Packaging Corporation**

 

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Name of issuer as specified in its charter

 

c/o Stone-Kaplan Investments, LLC

One Northfield Plaza, Suite 480

Northfield, Illinois 60093

 

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(address of principalexecutive offices) (Zip Code)

| **Delaware**                     | ** ** | **20-2699372**       |
|----------------------------------|------------|----------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer     |
| Incorporation or  organization)  |       | Identification  No.) |

 

Registrant’s telephone number, including area code:(847) 441-0929

** **

**SECURITIES REGISTEREDPURSUANT TO SECTION 12(B) OF THE ACT: NONE**

** **

**SECURITIES REGISTEREDPURSUANT TO SECTION 12(G) OF THE ACT:**

** **

**Common Stock, $.0001 parvalue**

**(Title of Class)**

** **

**Common Stock PurchaseWarrants**

**(Title of Class)**

** **

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act.   Yes o     Nox

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act.  Yes o    Nox

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes x  No ̈

Indicate by check mark ifdisclosure of delinquent filers pursuant to item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form10-K.    ̈

Indicate by check mark ifthe registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. 

Large AcceleratedFiler   ̈           Accelerated Filer  x         Non-Accelerated Filer      ̈

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes  ̈  Nox

The aggregate market valueof the 19,500,000 shares of Common Stock held by non-affiliates of theregistrant on June 30, 2006 was $106,860,000. This calculation was made using aprice per share of Common Stock of $5.48, the closing price of the Common Stockon the OTC Bulletin Board on June 30, 2006, the last day of the registrant’smost recently completed second fiscal quarter of 2006. Solely for purposes ofthis calculation, all shares held by directors and executive officers of theregistrant have been excluded. This exclusion should not be deemed an admissionthat these individuals are affiliates of the registrant.

On March 9, 2007, thenumber of shares of Common Stock outstanding, excluding 40,000 treasury shares,was 24,960,000, including 2,863,245 Units which convert into 2,863,245 sharesof Common Stock.

**DOCUMENTS INCORPORATED BY REFERENCE:**

The registrant’sDefinitive Proxy Statement for its 2007 Annual Meeting of Stockholders will befiled with the Securities and Exchange Commission no later than 120 days afterthe end of the fiscal year covered by this Form 10-K pursuant to GeneralInstruction G(3) of the Form 10-K. Information from such Definitive Proxy Statement will be incorporated byreference into Part III, Items 10, 11, 12, 13 and 14 hereof.

 

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TABLE OF CONTENTS
| Item 1.   |   | Business                                                                                                           |   | 2      |
|-----------|--------|--------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1A.  |   | Risk Factors                                                                                                       |   | 9      |
| Item 1B.  |   | Unresolved Staff Comments                                                                                          |   | 17     |
| Item 2.   |   | Properties                                                                                                         |   | 17     |
| Item  3.  |   | Legal  Proceedings                                                                                                 |   | 18     |
| Item 4.   |   | Submission of Matters to a Vote of Security Holders                                                                |   | 18     |
| Item 5.   |   | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   | 19     |
| Item  6.  |   | Selected  Financial Data                                                                                           |   | 20     |
| Item 7.   |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |   | 21     |
| Item 7A.  |   | Quantitative and Qualitative Disclosures About Market  Risk                                                        |   | 23     |
| Item 8.   |   | Financial Statements and Supplementary Data                                                                        |   | 24     |
| Item 9.   |   | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                              |   | 24     |
| Item 9A.  |   | Controls and Procedures                                                                                            |   |   |
| Item  9B. |   | Other  Information                                                                                                 |   |   |
| Item 10.  |   | Directors and Executive Officers of the Company                                                                    |   | 25     |
| Item 11.  |   | Executive Compensation                                                                                             |   | 25     |
| Item 12.  |   | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |   | 25     |
| Item 13.  |   | Certain Relationships and Related Transactions                                                                     |   | 25     |
| Item 14.  |   | Principal Accountant Fees and Services                                                                             |   | 25     |
| Item 15.  |   | Exhibits and Financial Statement Schedules                                                                         |   | 25     |
| Item  16. |   | INDEX  TO FINANCIAL STATEMENTS                                                                                     |   |   |

 

 

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**EXPLANATORY NOTE**

As of December 31, 2006, KapStone Paper and PackagingCorporation (formerly Stone Arcade Acquisition Corporation) (“KapStone” andtogether with its subsidiary, “we,” “us,” “our” and “Company”) was a shellcompany.   On January 2, 2007, KapStoneconsummated the purchase of substantially all of the assets, and the assumptionof certain liabilities, of the Kraft Paper Business (“KPB”) from InternationalPaper (IP).  Except for “Item 1.  Business”, “Item 1A.  Risk Factors”, “Item 2.  Properties” and “Item 7  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations — Liquidity and CapitalResources”, the information contained in this Form 10-K, including thefinancial statements contained in “Item 8. Financial Statements and Supplementary Data”, is as of December 31, 2006and does not purport to include information on KPB.

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**Forward Looking Statements.**

This Annual Report on Form 10-K includesforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended.  We have based theseforward-looking statements on our current expectations and projections aboutfuture events.  These forward-lookingstatements are subject to known and unknown risks, uncertainties andassumptions about us, including the risks set forth in Item 1A. Risk Factorsbelow, that may cause our actual results, levels of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by suchforward-looking statements.  In somecases, you can identify forward-looking statements by terminology such as “may,”“should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,”“continue,” or the negative of such terms or other similar expressions.  Factors that might cause or contribute tosuch a discrepancy include, but are not limited to, those described in ourother Securities and Exchange Commission filings.  All subsequent written and oral forward-lookingstatements attributable to KapStone or persons acting on our behalf areexpressly qualified in their entirety by the cautionary statements in thisparagraph.  KapStone disclaims anyintention or obligation to publicly announce the results of any revisions toany of the forward-looking statements contained herein to reflect futureevents or developments.

**PART I**

**Item 1.**                          Business

**Overview**

KapStone was a special purpose acquisition corporationformed on April 15, 2005 for the purpose of effecting a merger, capital stockexchange, asset acquisition or other similar business combination with anunidentified operating business in the paper, packaging, forest products andrelated industries.

On August 19, 2005, we consummated our initial publicoffering of 20,000,000 units with each unit consisting of one share of ourcommon stock and two warrants.  Eachwarrant entitles the holder to purchase one share of our common stock at anexercise price of $5.00 per share.  Theunits sold in our initial public offering were sold at an offering price of$6.00 per unit, generating gross proceeds of $120,000,000.  After deducting the underwriting discountsand commissions and the offering expenses, the total net proceeds to us fromthe offering were approximately $113,236,000, of which $110,854,000 wasdeposited into a trust account and the remaining proceeds of $2,382,000 becameavailable to be used to provide for business, legal and accounting duediligence for a prospective business combination and continuing operatingexpenses.

On January 2, 2007, we consummated the purchase fromIP of substantially all of the assets, and the assumption of certainliabilities, of KPB through our wholly owned subsidiary KapStone Kraft PaperCorporation (“KapStone Kraft”). The assets consist of an unbleached kraft papermanufacturing facility in Roanoke Rapids, North Carolina and Ride Rite®Converting, an inflatable dunnage bag manufacturer located in Fordyce,Arkansas. The liabilities assumed consist of trade accounts payables, accruedexpenses and certain long term liabilities. The purchase price wasapproximately $155 million in cash, subject to certain post-closingadjustments, plus two contingent earn-out payments.  We obtained a $95 million senior securedcredit facility from LaSalle Bank National Association, which was used to funda portion of the purchase price and will be used for our working capital needs.

We intend to pursue other acquisition opportunities inan effort to diversify and/or grow the KPB business. We have been and continueto be engaged in evaluating a number of potential acquisition opportunities,have had preliminary discussions with several potential targets, and havecommenced preliminary due diligence on several candidates. There are currentlyno agreements with respect to any acquisition, nor can an assurance be giventhat we will ever consummate any such transaction. The structuring andfinancing of any future acquisitions may be dependent on the terms and availabilityof additional financing to us that 

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either replaces or does not conflict with the Company’sexisting credit facility with LaSalle Bank National Association.

**Business**

**General**

We produce and sell unbleached kraft paper andlightweight linerboard at our facility in Roanoke Rapids, NC and manufactureand sell dunnage bags at Ride Rite® Converting, located in Fordyce, AR.

*Business of Roanoke Rapids*

Roanoke Rapids, a production facility consisting of anintegrated pulp and paper mill located in Roanoke Rapids, North Carolina,produces kraft paper and lightweight linerboard. Roanoke Rapids beganoperations in 1907 and, by 1909, was the first business in the United States toproduce kraft pulp using southern pine in the sulphate pulping process.

Historically, Roanoke Rapids has produced a mix ofboth kraft paper and linerboard. Roanoke Rapids currently has an annualproduction capacity of approximately 415,000 tons of unbleached kraft paper andlightweight linerboard. Roanoke Rapids offers a portfolio of paper grades,which are sold to customers who convert the paper into a wide range ofproducts. These products include multiwall bags for agricultural products, petfood, cement and chemicals, grocery bags, and specialty conversion productssuch as wrapping paper products and rollwrap. The linerboard grades areprimarily produced for manufacturing corrugated containers for packagingproducts.

During 2003 and 2004, Roanoke Rapids implemented akraft paper conversion project. The intent of this conversion project was toincrease facility production of kraft paper, and at the same time reduceoverall facility production capacity in order to conform to newly implementedenvironmental regulations. The shift in product mix to primarily kraft paperreduced the pulp production demand of the mill and permitted the shutdown of arecovery boiler and avoided the capital expense related to Cluster Rulecompliance for this boiler. With the shutdown of this recovery boiler, a secondrecovery boiler was upgraded to support approximately 440,000 annual tons ofproduction. We believe that this conversion project allowed Roanoke Rapids todevote additional resources toward product development in the kraft paperindustry and concentrate on facility efficiency.

Unbleached softwood pulp used to make kraft paper andlinerboard is produced from a combination of locally sourced roundwood and pinewoodchips. KPB has historically purchased approximately 40% of roundwood andwoodchips from IP and approximately 60% from third parties. After the wood isdebarked and chipped, the chips are loaded into digesters for cooking.Woodchips, chemicals and steam are mixed in the digester to produce softwoodpulp. The pulp is screened and washed through a series of washers, and thenstored prior to the paper making process. Roanoke Rapids processes softwoodpulp using two unbleached kraft paper machines; Paper Machine #3 (“PM3”) andPaper Machine #4 (“PM4”), both of which are capable of producing eitherunbleached kraft paper or linerboard. PM3 produces approximately 570 tons ofkraft paper daily, totaling approximately 195,000 tons annually. PM4 producesapproximately 600 tons of kraft and linerboard paper daily, totalingapproximately 205,000 tons annually. Management monitors productivity on areal-time basis with on-line reporting tools that track production valuesversus targets. Overall equipment efficiency is also monitored daily throughproduction reporting systems.

*Business of Ride Rite® Converting*

Ride Rite® Converting introduced the disposable inflatablepaper dunnage bag in 1965. The bags are constructed of an internal poly linerencased by multiple layers of high strength kraft paper or linerboard and areused to secure freight to minimize movement and potential damage of goods andproducts during transport. Ride Rite® Converting relies on Roanoke Rapids forapproximately two-thirds of its supply of kraft paper. Additionally, the bagshave an optional reusable valve design, which allows for the inflation

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 and deflationof the bags for multiple uses. Ride Rite® Converting produces over 230varieties of its inflatable dunnage bags. In 2006, the Ride Rite® Converting segment sold approximately 9.4million dunnage bags.  Ride Rite®Converting products are sold to manufacturers and less-than-trailer-loaddistributors, as well as retail regional distribution centers.

**Corporate Support**

We entered into a transitional services agreement withIP to cover certain services that IP provided to KPB, including corporatemanagement, payroll and benefits administration, public warehouse space,information technology, and centralized transaction processing.  The term of each of the services range fromsix months to approximately 18 months but our goal is to terminate all of theservices by December 31, 2007.  The costof transferring these services from IP to us, including applicable relocationcosts, is estimated by us to be approximately $3,500,000 to $4,800,000,consisting primarily of the cost of installing a new enterprise resourceplanning system which will include general ledger, order entry and receivablesmanagement, purchasing and payment plus additional modules. The system willsupport operations in North Carolina and Arkansas as well as corporateheadquarters.

**Transactions with IP**

We sell rollwrap, dunnage bags, tall oil, turpentineand linerboard to IP and certain of IP’s businesses which have been sold, ortheir suppliers.  Additionally, we buywood chips, pulpwood, sawdust, plastic valves for dunnage bags, chucks andcorrugated boxes from IP or current owners of businesses divested by IP.  We also continue to market certain bleachedpaper products manufactured by IP and sold to our customers under a salesagreement between us and IP.

**Industry Overview**

*Kraft Paper Market*

American Forest and Paper Association (“AFPA”)estimates that the U.S. unbleached kraft paper market was approximately 1.4million tons in 2005. An additional 300,000 tons were imported, bringing the2005 total U.S. demand to approximately 1.7 million tons. The kraft paperindustry is comprised of three general product types: (1) Multiwall; (2)Specialty converting (including rollwrap); and (3) Grocery bag and sack.

Multiwall bags are used in a variety of convertedproducts including cement bags, flour bags, pet food bags and charcoal bags.Multiwall bags represented approximately 500,000 tons of the unbleached kraftpaper market in 2005. Although the market for multiwall bags experienced aslight decline between 1999 and 2004, the Paper Shipping Sack ManufacturersAssociation has forecasted a multiwall bag market growth of 0.5% during 2006.

The specialty converting products include a variety ofunique products, such as rollwrap, shingle wrap, dunnage bags, lawn and leafbags and trash compactor bags. Specialty converting products representedapproximately 331,000 tons of the unbleached kraft paper market in 2005, ofwhich rollwrap represented approximately 130,000 tons. Rollwrap is used toprovide barrier and moisture protection for shipping of paper rolls. Theprimary markets utilizing rollwrap include uncoated free sheet paper, highvalue specialty industrial papers, coated papers, newsprint and bleached boardrolls.

The grocery bag and sack products representedapproximately 560,000 tons of the unbleached kraft paper market in 2005. Althoughthe kraft paper grocery bag market has declined as the industry has increasedthe use of alternative materials such as plastic, this still remains thelargest segment of the unbleached kraft paper market.

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*Linerboard Market*

Linerboard is primarily used to manufacture corrugatedcontainers for packaging products. U.S. demand for corrugated boxes andlinerboard tends to be driven by industrial production of processed foods andother nondurable goods. AFPA estimates that U.S. demand for unbleached linerboardwas approximately 17.3 million tons in 2004. Between 1998 and June 2006, AFPAreported 2.8 million tons of unbleached kraft linerboard capacity closures,which represented approximately 16% of the linerboard capacity. As a result,AFPA reported in the July 2006 *Statistical Report*for kraft paper that unbleached kraft linerboard machines are running at a99.1% (2006 YTD) capacity versus 94.2% for the same period in 2005.Additionally, the unbleached linerboard market is expected to grow by 1.7% in2007, and 2.3% in 2008 driven by demand for consumer durables.

*Dunnage Bag Market*

The demand for dunnage bags, which are used to protectproducts during transportation, is correlated to the general freighttransportation industry. The American Trucking Association (“ATA”) estimatesthat nearly 70% of U.S. freight volume, which includes general and bulkfreight, is transported by trucks and is forecasted to grow, on average, 2.5%per year through 2016. ATA also estimates that the annual growth rate forfreight transported by rail will be 1.9% through 2016. Historically, the nation’sfreight industry tracked prevailing economic conditions in the United States.

*Market Trends*

Both the multiwall packaging markets and the grocerybag and sack markets contracted between 2001 and 2005. The multiwall marketcontracted due to conversion to plastics in certain end-use markets (primarilyin the insulation and lawn and garden markets) as well as the transition to2-ply extensible sack packaging in certain markets (primarily in the cementmarket) where the package was considered a large percentage in the overall costof the total product. AFPA estimates a 1.8% growth in market size during 2006compared with 2005.

Over the years, the plastic grocery and retail bag hasgained an approximately 80% market share in the grocery and retail markets,displacing paper grocery and retail bags and sacks. We believe that thisconversion has slowed substantially from early 1990’s.

The lightweight linerboard market has grown over 17%since 2001 and represents a large market compared to the grocery bag and sackmarket.  We will be targeting ourlightweight linerboard for specialty independent corrugated and laminatedproducts customers who focus on specialty niche packaging.

**Customers**

*Roanoke Rapids*

Roanoke Rapids has over 60 customers, many of whichare leading world class converters of kraft paper. Its top ten customersaccounted for approximately $165.9 million in revenues in 2006 and $165.0million in revenues in 2005, or approximately 78.8% and 88.0% of all revenuesgenerated by Roanoke Rapids in 2006 and 2005, respectively. Altivity PackagingCorporation, Exopack, L.L.C. and Hood Packaging Corporation accounted for 21.6%,13.0% and 12.0% of the revenues in 2006, respectively, and 28.4%, 13.1% and12.0% of the revenues in 2005, respectively. Roanoke Rapids has built long-termrelationships with its customers averaging in excess of 25 years. We believethat the risk of losing customers or business with customers is reduced due tothe long-term relationships that have been established.

During 2006 and 2005, approximately 64.0% of RoanokeRapids’ production capacity was contracted. The contracts are typically twoyears in length, in which pricing moves with the market and price tiers aredetermined based on volume. Any risk associated with contracted customer volumeis minimal due to exit options for both parties and the absence of penaltyprovisions. The loss of, or reduced sales to, these key customers could resultin decreased revenues and adversely impact our cash flows.

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*Ride Rite® Converting*

Ride Rite® Converting’s customer base consists ofleading distributors of shipping and packing materials, manufacturers,less-than-truckload carriers and retail regional distribution centers. Its topten customers accounted for a $23.4 million revenues in 2006 and $23.7 millionin revenues in 2005, representing 65.5% and 67.1% of Ride Rite® Converting’srevenues in 2006 and 2005, respectively. Sunrise Arkansas, Inc. and YRCWorldwide Inc. accounted for 18.7% and 13.9% of revenues in 2006, respectively,and 17.8% and 12.2% of revenues in 2005, respectively. IP is one of Ride Rite®Converting’s largest customers with purchases originating from various IP papermills and converting facilities. IP’s xpedx distribution business serves as oneof Ride Rite® Converting’s distributors of dunnage bags. In connection with theacquisition, IP has entered into an agreement to continue purchasing dunnageproducts from Ride Rite® Converting for a period of five years.

During 2006 and 2005, approximately 34% and 39%,respectively, of Ride Rite® Converting’s capacity was contracted.

**Suppliers**

*Roanoke Rapids*

The raw materials needed to process kraft paper andlightweight linerboard consists primarily of roundwood, woodchips, sawdust,chemicals, coal and fuel oil. We believe that these raw materials are readilyavailable and that there are a number of large suppliers from whom thematerials can be bought in the current market. Roanoke Rapids has a largenumber of suppliers providing the raw materials that are needed to operate thepaper mill. Two of the largest suppliers, aside from wood suppliers, are CoalEnergy Resources, which provides coal, and the Amerada Hess Corporation, whichsupplies No. 6 fuel oil. Roanoke Rapids has long standing relationships withboth of these suppliers. Typical contracts for raw materials range from one tothree years in length and are at fixed pricing or tied to a documented movingindex for each material. As costs for raw materials, supplies, services andlabor go up; paper price increases are implemented to recover these risingmaterial costs, when possible. We currently do not use futures contracts orenter into hedging arrangements to manage the risk of fluctuations in coal orfuel prices. Thus, if we cannot pass on the rise in energy or other costs toour customers, such rise in costs will have an adverse effect on our profitmargins.

During 2006 and 2005, approximately 19% and 27%,respectively, of the Roanoke Rapids mill’s wood requirement was sourced fromroundwood supplied by IP’s Forest Resources Division. Approximately 12% of thewood requirement in each of 2006 and 2005 was supplied from woodchips suppliedby IP’s Wood Products Division. In addition, 9% and 11%, respectively, of thesawdust used by Roanoke Rapids for fuel in 2006 and 2005 was supplied by IP’sForest Resources Division. We entered into a long-term supply agreement with IP’sWood Products Division with market based pricing for woodchips and thirdparties, who now own forestlands previously owned by IP, for market basedpricing for roundwood.

For major supplies, we entered into a joint purchasingagreement with IP which enables the continuation of procurement advantages thatarise from the economies of scale.

*Ride Rite® Converting*

Ride Rite® Converting has historically purchased mostof its raw materials, comprised mainly of kraft paper, boxes and valves fromother IP businesses, with Roanoke Rapids being the largest supplier. We enteredinto long-term arrangements to ensure steady availability of parts used inconstruction of the dunnage bags for Ride Rite® Converting.

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**Sales and Marketing**

The sales and marketing team works directly with ourtechnical, manufacturing and product development teams to offer solutions and meetnew customer demands and product requirements. We market and sell our productswith the help of a national sales force.

**Competition**

*Roanoke Rapids*

We are the leading manufacturer of unbleached kraftpaper in North America. During 2004, the eight companies that accounted forapproximately 80% of North American unbleached kraft paper production based onannual tonnage were: KPB (19%), Longview Fibre Company (12%), Smurfit-StoneContainer Corporation (11%), Georgia-Pacific Corporation (10%), Delta Natural Kraft(9%), Tolko Industries Ltd. (7%), Canfor Corporation (6%) and Grupo Durango(6%).  A number of other competitorscomprise the remainder of North American unbleached kraft paper production.

We believe the key parameters on which North Americanunbleached kraft suppliers compete are supply reliability, delivered price andproduct quality. KPB has longstanding relationships with many of its customersand historically has entered into contracts with initial terms of at least twoyears. We believe that this is based on its reputation for surety of supply,roll-to-roll consistency, product runnability and high tensile strength.

*Ride Rite® Converting*

We believe that the two companies that account for themajority of the North American inflatable dunnage bag market are Ride Rite®Converting and Shippers Paper, a division of Illinois Tool Works.

**Environmental Regulation**

Our operations are subject to environmental regulationby federal, state, and local authorities in the United States, includingrequirements that regulate discharge into the environment, waste management,and remediation of environmental contamination. Environmental permits arerequired for the operation of our businesses, and are subject to revocation,modification and renewal. Governmental authorities have the power to enforcecompliance with environmental requirements and violators are subject toinjunctions, civil penalties and criminal fines. Third parties may also havethe right to sue to enforce compliance with such regulations.

There are four components of the EPA’s Cluster Rule,with which the Roanoke Rapids mill must comply. MACT I-Phase 1 and MACT II arecomplete and the mill is fully compliant with these standards. We use aspecially designed software system for process monitoring, reporting andrecordkeeping.

Boiler MACT compliance (particulate standards) will beachieved with existing emission control equipment, boiler fuel analysis andreporting, regulatory risk-out option for manganese. The compliance date isSeptember 13, 2007.

We expect to achieve compliance with MACT-1 Phase 2through the Innovations Project, an EPA and State of North Carolina approvedproject resulting in superior environmental technology and emission controlequivalent to or better than the federal minimum requirement. The RoanokeRapids mill will complete installation of hoods on the B- and C-Washer lines inearly 2007 to incinerate the collected gasses in the power boiler, complete “environmentallybeneficial projects” as agreed with community leaders and regulators. Thecompliance date is April 17, 2007.

The Roanoke Rapids mill is permitted to operate itsA-Washer line without hoods (uncontrolled emissions) as needed (up to 30,000air dried pulp tons/year) to support the mill’s production capability.

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The Roanoke Rapids mill is currently permitted toproduce 557,000 EPT (equivalent paper tons) annually. After the April 17, 2007compliance deadline, the mill will be permitted to produce 455,000 EPTannually. Upon completion of the Boiler MACT and MACT I-Phase 2 projects, wewill be fully compliant with the Cluster Rules. The remaining cost of achievingcompliance as described above is estimated to be approximately $0.1 million. Weare not aware of any future regulatory actions that will require significantcapital expenditures.

The EPA is continuing the development of new programsand standards such as additional wastewater discharge allocations, water intakestructure requirements and national ambient air quality standards. We believethat our operations are in compliance in all material respects with allenvironmental regulations and are not aware of any pending regulatory agencycompliance actions.

**Legal Proceedings**

We are involved in litigation from time to time in theordinary course of business. We currently are not aware of any pending orthreatened litigation that would be likely to have a material adverse effect onour operations.

**Employees**

There are approximately 680 employees at the RoanokeRapids and Ride Rite® Converting facilities. As of March 1, 2007, there wereapproximately 400 hourly employees and approximately 120 salaried employees atRoanoke Rapids, and approximately 140 hourly employees and approximately 20salaried employees at Ride Rite® Converting. Ride Rite® Converting alsoemployed approximately 10 temporary employees as of March 1, 2007. All hourlyemployees are unionized and represented by the United Steelworkers Union.Currently, there are collective bargaining agreements in place with RoanokeRapids through August 31, 2010 (recently ratified) and with Ride Rite®Converting through June 30, 2008. There have been no strikes, work stoppages orsimilar actions in over 50 years. We believe that we have a good relationshipwith our employees.

In January 2007, upon consummation of the acquisitionof KPB, we began hiring a corporate staff to manage the operations. Thisincluded a vice president and chief financial officer, a vice president tomanage KPB and other corporate staff employees. Additional hiring is planned atthe corporate headquarters in 2007.

**Executive Officers of Registrant**

Our executive officers are as follows:

| **Name**            | ** ** | **Age** | ** **                                        | **Position** |
|---------------------|------------|---------|---------------------------------------------------|--------------|
|                |       |    |                                              |         |
| Roger W. Stone      |       | 72      | Chairman of the Board and Chief Executive Officer |
| Matthew Kaplan      |       | 50      | President, Secretary and Director                 |
| Andrea K. Tarbox    |       | 56      | Vice President and Chief Financial Officer        |
| Timothy P. Keneally |       | 59      | Vice President                                    |

***RogerW. Stone*** has been Chairman of the Board since ourinception.  Mr. Stone has been Manager ofStone-Kaplan Investments, LLC, a private investment company, since July2004.  He was Chairman and ChiefExecutive Officer of Box USA Holdings, Inc., a corrugated box manufacturer,from July 2000 until the sale of that company in July 2004.  Mr. Stone was Chairman, President and ChiefExecutive Officer of Stone Container Corporation, a multinational paper companyprimarily producing and selling pulp, paper and packaging products, from March1987 to November 1998 when Stone Container Corporation merged with JeffersonSmurfit Corporation, at which time he became President and Chief ExecutiveOfficer of Smurfit-Stone Container Corporation until March 1999.  Mr. Stone has served on the board ofdirectors of

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 McDonald’s Corporation since 1989.  Mr. Stone received a B.S. in Economics fromthe Wharton School at the University of Pennsylvania.  Mr. Stone is the father-in-law of MatthewKaplan.

***Matthew Kaplan***has been our President and a member of our board of directors since ourinception.  Mr. Kaplan has been Managerof Stone-Kaplan Investments, LLC, a private investment company, since July2004.  He was President, Chief OperatingOfficer and a director of Box USA Holdings, Inc., a corrugated boxmanufacturer, from July 2000 until the sale of the company in July 2004.  Mr. Kaplan began his career at StoneContainer Corporation in 1979 and was serving as its Senior Vice President andGeneral Manager of North American Operations when Stone Container Corporationmerged with Jefferson Smurfit Corporation in November 1998.  He was Vice President/ General Manager,Container Division with Smurfit-Stone Container Corporation until March1999.  Mr. Kaplan received a B.A. inEconomics from the University of Pennsylvania and an M.B.A. from the Universityof Chicago.  Mr. Kaplan is the son-in-lawof Roger W. Stone.

***AndreaK. Tarbox*** was appointed Vice President and ChiefFinancial Officer in January 2007.  Ms. Tarbox has served as afinancial consultant to the Company since April 2006.  Ms. Tarbox played akey financial role in the acquisition by the Company of the Kraft Papers Businessfrom International Paper Company.  From March 2003 through March 2006, Ms.Tarbox served as Chief Financial and Administrative Officer for UniscribeProfessional Services, Inc.  From July, 1994 until February 2003,Ms. Tarbox was employed by Gartner Inc., last serving as Group VicePresident-Finance and Treasurer.  Prior to that, Ms. Tarbox had assumedfinancial positions of increasing responsibility in several global companiesincluding British Petroleum, p.l.c. and Fortune Brands, Inc.  Ms. Tarboxbegan her career with Ernst & Young LLP and is a Certified PublicAccountant.  Ms. Tarbox earned a B.A. degree in Psychology fromConnecticut College and an M.B.A. from the University of Rhode Island.

***Timothy P. Keneally***hasbeen our vice president and general manager of the kraft paper business sinceJanuary 2007. Previously, Mr. Keneally led the International Paper team thatassessed the review of strategic alternatives relating to the kraft paperbusiness. He was the lead person in presenting the historical performance ofthe business and assisted in defining the future strategy for the business. Mr.Keneally has 34 years of experience in the paper and packaging industry. He waswith International Paper since the merger of Union Camp Corporation and InternationalPaper in 1999 and was a corporate officer at IP since 1992. Mr. Keneally earneda B.A degree in History from Marist College.

**Other Matters**

Our Annual Report on Form 10-K, including this Form10-K, as well as the Quarterly Reports on Form 10-Q and Current Reports on Form8-K, are filed electronically with the SEC. You may read or copy any materialswe file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street,NW, Washington, DC 20549. You may obtain information on the operation of thePublic Reference Room by calling the SEC at 1-800-SEC-0300. The SEC maintainsan Internet site that contains reports, proxy and information statements, andother information regarding issuers that electronically file with the SEC. Theaddress of that site is www.sec.gov. Our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K and all amendmentsto those reports are also available free of charge through our website, www.kapstonepaper.comas soon as reasonably practicable after such material is filed electronicallywith, or furnished to, the Securities and Exchange Commission. Also, copies ofour annual report will be made available, free of charge, upon written request.

**Item 1A.**                 Risk Factors

You should carefully consider the following riskfactors, together with the other information contained in this annual report onForm 10-K, in evaluating us and our business before making an investmentdecision regarding our securities.  Ifany of the events or circumstances described in the following risks actuallyoccurs, our business, financial condition or results of operations could bematerially adversely affected.  The riskslisted below are not the only risks that we face.  Additional risks that we do not yet know ofor that we currently think are immaterial may also impair our businessoperations.

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**Risks associated with our business**

***If the benefits of ouracquisition of KPB do not meet the expectations of the marketplace, orfinancial or industry analysts, the market price of our common stock maydecline.***

We acquired KPB on January 2, 2007.  The market price of our common stock maydecline if KPB does not perform as expected, or we do not otherwise achieve theperceived benefits of the acquisition as rapidly as, or to the extent anticipatedby, the marketplace, or financial or industry analysts. Accordingly, investorsmay experience a loss as a result of a decreasing stock price and we may not beable to raise future capital, if necessary, in the equity markets.

***We are dependent upon keymanagement executives whose loss may adversely impact our business.***

Our success will depend significantly on the effortsand abilities of Roger Stone, Chief Executive Officer, and Matthew Kaplan,President.  The loss of services of oneor both of these individuals could have a material adverse effect on ourbusiness.

In addition, we depend on the expertise, experienceand continued services of KPB’s management. The loss of such management, or aninability to attract or retain other key individuals, could materiallyadversely affect us. We seek to compensate management, as well as otheremployees, through competitive salaries, bonuses and other incentive plans, butthere can be no assurance that these programs will allow us to retain keymanagement executives or hire new key employees.

***KPB’s operations may not be ableto generate sufficient cash flows to meet KapStone Kraft’s debt serviceobligations.***

KapStone Kraft’s ability to make payments on itsindebtedness will depend on its ability to generate cash from KPB’s operations.KPB’s business may not generate sufficient cash flow from operations to enableit to repay KapStone Kraft’s indebtedness and to fund other liquidity needs,including capital expenditure requirements. The indebtedness incurred by KapStoneKraft under the credit facility bears interest at variable rates, and thereforeif interest rates increase, KapStone Kraft’s debt service requirements willincrease. In such case, KapStone Kraft may need to refinance or restructure allor a portion of its indebtedness on or before maturity. KapStone Kraft may notbe able to refinance any of its indebtedness, including the new creditfacility, on commercially reasonable terms, or at all.  KapStone Kraft’s expected debt serviceobligation is initially estimated to be approximately $4,000,000 in interestpayments per annum, which amount will be reduced each year in accordance withscheduled debt amortization payments, if made. In addition, debt servicerequirements will also include scheduled quarterly principal payments startingat $1,875,000 during the first year and rising to $2,250,000 in the fifth andfinal year of the facility. If KapStone Kraft cannot service or refinance itsindebtedness, it may have to take actions such as selling assets, seeking additionalequity or reducing or delaying capital expenditures, any of which could have amaterial adverse effect on KPB’s operations and financial condition.

***Adefault under KapStone Kraft’s indebtedness may have a material adverse effecton our business and our financial condition.***

In the event of a default under KapStone Kraft’scredit facility, the lenders generally would be able to declare all of suchindebtedness, together with accrued interest, to be due and payable. Inaddition, borrowings under the credit facility are secured by a first prioritylien on all of the assets of KPB and, in the event of a default under thatfacility the lenders generally would be entitled to seize the collateral.Moreover, upon the occurrence of an event of default under the credit facility,the commitment of the lenders to make any further loans would be terminated.Accordingly, a default under any debt instrument, unless cured or waived, wouldlikely have a material adverse effect on KPB’s business and our results of operationsand financial condition.

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***Servicing debt could limit fundsavailable for other purposes.***

We will use KapStone Kraft’s cash from KPB operationsto pay the principal and interest on our debt. These payments limit fundsavailable for other purposes, including expansion of our operations throughacquisitions and funding of capital expenditures.

KapStone Kraft’s credit facility contains restrictivecovenants that limit its liquidity and corporate activities.  KapStone Kraft’s credit facility imposesoperating and financial restrictions that limit KapStone Kraft’s ability to:

·                                          incuradditional indebtedness;

·                                          createadditional liens on its assets;

·                                          makeinvestments;

·                                          engage inmergers or acquisitions;

·                                          paydividends; and

·                                          sellany of KPB’s assets outside the ordinary course of business.

In addition, the credit facility also imposes certainlimited restrictions on KapStone. Therefore, we will need to seek permissionfrom the lender in order to engage in certain corporate actions. The lender’sinterests may be different from ours, and no assurance can be given that wewill be able to obtain the lender’s permission when needed. This may prevent usfrom taking actions that are in our best interest.

***Future acquisitions of businessesby us would subject us to additional business, operating and industry risks,the impact of which cannot presently be evaluated, and could adversely impactour capital structure.***

We intend to pursue other acquisition opportunities inan effort to diversify our investments and/or grow the KPB business. Anybusiness acquired by us may cause it to be affected by numerous risks inherentin the acquired business’s operations. If we acquire a business in an industrycharacterized by a high level of risk, we may be affected by the currentlyunascertainable risks of that industry. Although our management will endeavorto evaluate the risks inherent in a particular industry or target business, wecannot assure you that we will be able to properly ascertain or assess all ofthe significant risk factors.

In addition, the financing of any acquisitioncompleted by us could adversely impact our capital structure as any suchfinancing would likely include the issuance of additional equity securitiesand/or the borrowing of additional funds. The issuance of additional equitysecurities may significantly reduce the equity interest of our stockholdersand/or adversely affect prevailing market prices for our common stock.Increasing our indebtedness could increase the risk of a default that wouldentitle the holder to declare all of such indebtedness due and payable and/orto seize any collateral securing the indebtedness. In addition, default underone debt instrument could in turn permit lenders under other debt instrumentsto declare borrowings outstanding under those other instruments to be due andpayable pursuant to cross default clauses. Accordingly, the financing of futureacquisitions could adversely impact our capital structure and your equityinterest in us.

Except as required by law or the rules of anysecurities exchange on which our securities might be listed at the time itseeks to consummate a subsequent acquisition, you will not be asked to vote onany such proposed acquisition and no redemption rights in connection with anysuch acquisition will exist.

***If we fail to maintain effectivesystems for disclosure controls and internal controls over financing reportingas a result of the acquisition of the KPB assets, we may be unable to complywith the requirements of Section 404 of the Sarbanes Oxley Act of 2002 in atimely manner.***

Because we acquired assets of a division of IP, andnot a stand-alone entity with its own management information and reportingsystems in place, we currently depend on IP’s systems to monitor the operationof the KPB business. As a division of IP, KPB’s internal controls overfinancial reporting have been maintained as part of IP’s overall enterprisewide reporting system. In assuming assets that are part of an

 

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ongoing business operation, we will face the risk thatdeficiencies and weaknesses in internal controls over financial reporting maybe identified during the transition phase to a stand-alone business. We will beresponsible for developing and establishing our own systems, processes andprocedures to adequately and effectively monitor disclosure controls andinternal controls over financial reporting. We believe that the cost involvedto develop these systems will range from $3,500,000 to $4,800,000 and will takeapproximately 10 months to complete.

Section 404 of the Sarbanes-Oxley Act of 2002 requiresus to document and test the effectiveness of its internal controls overfinancial reporting in accordance with an established internal controlframework and to report on its conclusion as to the effectiveness of itsinternal controls. It also requires an independent registered public accountingfirm to test our internal controls over financial reporting and report on theeffectiveness of such controls for our fiscal year ending December 31, 2006 andsubsequent years. An independent registered public accounting firm will also berequired to test, evaluate and report on the completeness of our assessment. Itmay cost us more than we expect to comply with these controls and procedurerelated requirements. If we discover areas of our internal controls that needimprovement, we cannot be certain that any remedial measures taken will ensurethat we implement and maintain adequate internal controls over financial processesand reporting in the future. Any failure to implement required new or improvedcontrols, or difficulties encountered in their implementation could harm ouroperating results or cause us to fail to meet our reporting obligations.

***Operation of KPB will bedependent upon certain operating agreements with IP.***

We are dependent upon IP for certain operationalsupport services as well as certain supply and purchase arrangements. In thisregard, we rely upon a transition services agreement for support, rely upon IP(or buyers of certain IP businesses) to supply pulpwood, residual woodchips,sawdust, valve and chucks and containers, and rely upon IP (or buyers ofcertain IP businesses) to purchase unbleached rollwrap base paper, crude talloil, black liquor soap, crude sulfate turpentine, dunnage bags and linerboardfrom us.

IP is the exclusive supplier of corrugated containersto us. We currently believe that containers and the other materials supplied byIP as described above are readily available from other sources on the openmarket. However, in the event that IP, or any other supplier of key materials,for any reason fails to meet our supply requirements, the loss of supply couldprevent us from meeting our scheduled product deliveries and/or lead to increasesin the prices of such supplies, which could have a material adverse effect onour operating results and financial condition.

We have agreed to supply to IP 100% of IP’srequirements of dunnage bags. Also, we agreed to supply to IP, the buyer of IP’sbeverage packaging business and the buyer of IP’s coated paper business, 100%of each of their requirements of unbleached rollwrap paper. Any reduction inmarket prices or in the volume of products to be purchased by such parties,whether due to decreased demand, adverse market conditions or otherwise, couldhave a potential adverse effect on our operating results and financialcondition. In addition, if we are unable to supply to such parties theirrequirements of the foregoing products, such parties would have the right toobtain their requirements from other suppliers, which could have a materialadverse effect on our operating results and financial condition.

In addition, we rely upon a patent license agreementwith IP, whereby we can continue to use certain patented technology used inconstructing dunnage bags on a royalty-free basis for the life of the patent.The failure of IP to protect the patent could have a material adverse effect onKPB’s business and our operating results and financial condition.

***If we fail to extend orrenegotiate the collective bargaining agreements with the United SteelworkersUnion as they expire from time to time, or if our unionized employees were toengage in a strike or other work stoppage, our business and operating results couldbe materially harmed.***

All of KPB’s hourly paid employees (approximately 400at Roanoke Rapids and 140 at Ride Rite® Converting) are represented by theUnited Steelworkers Union. KPB is a party to collective bargaining

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contracts, which represent approximately 81% and 78%of its employees at Roanoke Rapids and Ride Rite® Converting, respectively. Noassurance can be given that we will be able to successfully extend orrenegotiate the collective bargaining agreements as they expire from time totime. Currently, there are collective bargaining agreements in effect withrespect to Roanoke Rapids through August 31, 2010 (recently ratified) and withrespect to Ride Rite® Converting through June 30, 2008. If we fail to extend orrenegotiate our collective bargaining agreements, if disputes with the unionarise, or if the unionized workers engage in a strike or other work stoppage,we could incur higher ongoing labor costs or experience a significantdisruption of operations, which could have a material adverse effect on ourbusiness and results of operations. The impact of future negotiations,including changes in wages and benefit levels that are collectively bargainedfor as part of the overall contracts with the unions, could have a materialimpact on our financial results.

***A few customers account for asignificant portion of our revenues.***

During the year ended December 31, 2006, the topthree customers (Altivity Packaging Corporation, Exopack, LLC and HoodPackaging Corporation) accounted for 46.6% and the top ten customers accountedfor 78.8% of revenues generated by Roanoke Rapids.  During the year ended December 31, 2005, thetop three customers (Altivity Packaging, Exopack, LLC and Hood PackagingCorporation) accounted for 53.5% and the top ten customers accounted for 88.0%of revenues generated by Roanoke Rapids. During 2006 and 2005, two customersaccounted for 32.6% and 30.0%, respectively, and the top ten customersaccounted for 65.5% and 67.1% respectively, of revenues generated by Ride Rite®Converting. The contracts with KPB’s clients typically have a two-year term andpricing is market-indexed, based on volume and do not contain any penaltyprovisions. The loss of or reduced sales to these key customers could result indecreased revenues and adversely impact KPB’s cash flows.

***The Roanoke Rapids facilityconsists of a single paper mill from which all of its kraft paper andlinerboard products are manufactured. If the equipment at the millmalfunctions, KPB may be unable to manufacture its products.***

KPB relies on a single paper mill with two papermakingmachines to produce its kraft paper and linerboard products. The mill operates24 hours a day, seven days a week, and with this high rate of utilization, theability to recover from unplanned outages is limited. Further, since theRoanoke Rapids facility relies solely on two papermaking machines, anybreakdown in one or both machines could result in an interruption in productionat the mill and we may be unable to fulfill our product delivery obligations toour customers. Our failure to produce and deliver our products could lead tocancellation of customer contracts, which could adversely affect our results ofoperations, financial condition and relationship with customers.

***Although IP has agreed to indemnifyus with respect to environmental liabilities that are being assumed, we mayincur significant remediation and other costs if such losses exceed the cap onindemnification or occur after the expiration of the indemnification period.***

The Roanoke Rapids facility operated as an industrialfacility for many years prior to the enactment of environmental legislationthat would have required certain pollution prevention concepts to be addressedat the facility. Due to its long history of industrial operations, thepossibility of onsite and offsite environmental impact to the soil andgroundwater may present a heightened risk of liability for contamination. Theoverall indemnification by IP for certain losses includes assumed environmentalliabilities, subject to a $1,000,000 threshold and a cap of $15,000,000. IP’sindemnification for assumed environmental liabilities will survive for threeyears. However, with respect to environmental claims, the cap described abovewill be reduced by $1,800,000 every six months during the three year survivalperiod. Because we are unable to presently make a determination as to whetherthe environmental impact, if any, would be widespread or significant, thenegotiated cap and survival period may not be sufficient to cover futurelosses. Further, if we are required to make significant expenditures forremediation and other costs that exceed the cap, the cost of such efforts mayhave a significant negative impact on our results of operations and financialcondition.

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***If the actual employee pensionand post-retirement liabilities we have assumed are greater than currentlyestimated, it could have a negative effect on our results of operations andfinancial condition.***

We have agreed to assume certain collective bargainingagreements and to provide benefits through the expiration of those agreements,including the provision of pension and post-retirement medical benefits thatare substantially similar to the collectively bargained benefits previouslynegotiated by IP. To the extent entitlement to pension and post-retirementmedical benefits under these agreements had vested at the time of the KPBacquisition, the liabilities associated with the provision of those benefitswere excluded liabilities that were retained by IP under the PurchaseAgreement, and we did not assume those liabilities. However, to the extentpost-retirement liabilities for collectively bargained employees at the time ofthe closing of the acquisition were greater than the liabilities for vestedbenefits retained by IP, we intend to provide credits to the applicableemployees under the benefits plans we establish such that these employeesreceive benefits after the closing that are substantially similar to thosepreviously negotiated by IP under the collective bargaining agreements, oruntil new collective bargaining agreements are negotiated and ratified.Consequently, these liabilities will be our obligation. The amount of theseassumed liabilities, for financial accounting purposes, have been determined tobe approximately $3,015,000. If the actual liabilities are greater than theestimate, our pension obligations and related expense will be increased, whichcould have a material adverse effect upon our operating results and financialcondition.

***The impact of severe weather onroundwood availability could result in unfavorable wood pricing.***

Historically, KPB controlled company-owned stumpageconsisting of all-weather loggable tracts. This provided a buffer from large market pricing swings during weatherevents which resulted in reduced roundwood availability.  While KPB believes its current fiberprocurement strategy contains provisions to minimize the impact of such events,in the absence of company-owned stumpage, KPB could be more susceptible tomarket pricing spikes, which could have a negative impact on our results ofoperations and financial condition.

***Our officers and directorscontrol a substantial interest in us and thus may influence certain actionsrequiring a stockholder vote.***

At December 31, 2006 our officers and directors ownedapproximately 25% of our issued and outstanding shares of common stock and mayhave considerable influence over the outcome of all matters requiring approvalby our stockholders, including future acquisitions and the election ofdirectors.  In addition, our board ofdirectors is divided into three classes, each of which will generally serve fora term of two years with only one class of directors being elected in eachyear. At the annual meeting, as a consequence of our “staggered” board ofdirectors, only a minority of the board of directors will be considered forelection and our officers and directors, because of their ownership position,will have considerable influence regarding the outcome.

***Someof our officers and directors may in the future become affiliated with entitiesengaged in business activities similar to those intended to be conducted by usand, accordingly, may have conflicts of interest in determining to which entitya particular business opportunity should be presented.***

Some of our officers and directors may in the futurebecome affiliated with entities, including “blank check” companies, engaged inbusiness activities similar to those conducted by us.  Additionally, our officers and directors maybecome aware of business opportunities which may be appropriate forpresentation to us as well as the other entities to which they have fiduciaryobligations.  Accordingly, they may haveconflicts of interest in determining to which entity a particular businessopportunity should be presented.

**Risksassociated with the paper, packaging, forest products and related industries.**

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***The paper, packaging, forestproducts and related industries are highly cyclical.  Fluctuations in the prices of and the demandfor a target company’s products could result in smaller profit margins andlower sales volumes.***

Historically, economic and market shifts, fluctuationsin capacity and changes in foreign currency exchange rates have createdcyclical changes in prices, sales volume and margins for products in the paper,packaging, forest products and related industries.  The length and magnitude of industry cycleshave varied over time and by product, but generally reflect changes inmacroeconomic conditions and levels of industry capacity.  Most paper products and many wood productsused in the packaging industry are commodities that are widely available frommany producers.  Because commodityproducts have few distinguishing qualities from producer to producer,competition for these products is based primarily on price, which is determinedby supply relative to demand.  Theoverall levels of demand for these commodity products reflect fluctuations inlevels of end-user demand, which depend in large part on general macroeconomicconditions in North America and regional economic conditions in our markets, aswell as foreign currency exchange rates. The foregoing factors could materially and adversely impact sales andprofitability of a target company with which we might seek a businesscombination.

***Difficultyobtaining timber at favorable prices, or at all, may negatively impactcompanies in the packaging industry.***

Wood fiber is the principal raw material in many partsof the packaging industry.  Wood fiber isa commodity, and prices historically have been cyclical.  Environmental litigation and regulatorydevelopments have caused, and may cause in the future, significant reductionsin the amount of timber available for commercial harvest in the United States.  These reductions have caused the closure ofplywood and lumber operations in some of the geographic areas in which a targetcompany might operate.  In addition,future domestic or foreign legislation and litigation concerning the use oftimberlands, the protection of endangered species, the promotion of foresthealth and the response to and prevention of catastrophic wildfires could alsoaffect timber supplies.  Availability ofharvested timber may further be limited by fire, insect infestation, disease,ice storms, wind storms, flooding and other natural and man made causes,thereby reducing supply and increasing prices.

Industry supply of commodity paper and wood productsis also subject to fluctuation, as changing industry conditions can influenceproducers to idle or permanently close individual machines or entiremills.  In addition, to avoid substantialcash costs in connection with idling or closing a mill, some producers willchoose to continue to operate at a loss, sometimes even a cash loss, whichcould prolong weak pricing environments due to oversupply.  Oversupply in these markets can also resultfrom producers introducing new capacity in response to favorable short-termpricing trends.  Industry supply of commoditypapers and wood products is also influenced by overseas production capacity,which has grown in recent years and is expected to continue to grow.  Wood fiber pricing is subject to regionalmarket influences, and the cost of wood fiber may increase in particularregions due to market shifts in those regions. In addition, the ability to obtain wood fiber from foreign countries maybe impacted by legal and political conditions in that country as well astransportation difficulties.

***An increase in the cost ofpurchased energy or chemicals would lead to higher manufacturing costs, therebyreducing margins.***

Energy is a significant raw material in the paper,packaging, forest products and related industries.  Energy prices, particularly for electricity,natural gas and fuel oil, have been volatile in recent years and currently exceedhistorical averages.  These fluctuationshave historically impacted manufacturing costs of companies in theseindustries, often contributing to earnings volatility.  Recent significant increases in energy pricescan be expected to adversely impact businesses in these industries.  In addition, we could be materially adverselyimpacted by supply disruptions.

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***Paper, packaging and forestproducts companies face strong competition.***

The paper, packaging, forest products and relatedindustries are highly fragmented, and we face competition from numerouscompetitors, domestic as well as foreign. Some of our competitors will be large, vertically integrated companiesthat have greater financial and other resources, greater manufacturingeconomies of scale, greater energy self-sufficiency and/or lower operatingcosts.

***Certain paper and wood productsare vulnerable to long-term declines in demand due to competing technologies ormaterials.***

Companies in the paper, packaging, forest products andrelated industries are subject to possible declines in demand for theirproducts as the use of alternative materials and technologies grows and theprices of such alternatives become more competitive.  Any substantial shift in demand from wood andpaper products to competing technologies or materials could result in amaterial decrease in sales of our products. While we would seek to adapt our product offerings to changes in marketdemand, we cannot assure you that any efforts will be successful or sufficient.

***Packaging companies are subjectto significant environmental regulation and environmental complianceexpenditures, as well as other potential environmental liabilities.***

Companies in the packaging industry are subject to awide range of general and industry-specific environmental laws and regulations,particularly with respect to air emissions, wastewater discharges, solid andhazardous waste management, site remediation, forestry operations andendangered species habitats.  We may incursubstantial expenditures to maintain compliance with applicable environmentallaws and regulations.  Failure to complywith applicable environmental laws and regulations could expose us to civil orcriminal fines or penalties or enforcement actions, including orders limitingoperations or requiring corrective measures, installation of pollution controlequipment or other remedial actions.

**RisksAssociated with Stone’s Warrants**

***We may choose to redeem ouroutstanding warrants at a time that is disadvantageous to our warrant holders.***

Subject to there being a current prospectus under theSecurities Act of 1933 with respect to the shares of common stock issuable uponexercise of the warrants issued as a part of the units in our initial publicoffering, during the entire period between any notice of redemption and theactual redemption date, we may redeem the warrants at any time after thewarrants become exercisable, in whole and not in part, at a price of $.01 perwarrant, upon a minimum of 30 days prior written notice of redemption, if andonly if, the last sales price of our common stock equals or exceeds $8.50 pershare for any 20 trading days within a 30 trading day period ending threebusiness days before the notice of redemption is sent. Redemption of thewarrants could force the warrant holders (i) to exercise the warrants and paythe exercise price therefore at a time when it may be disadvantageous for theholders to do so, (ii) to sell the warrants at the then current market pricewhen they might otherwise wish to hold the warrants, or (iii) to accept thenominal redemption price which, at the time the warrants are called forredemption, is likely to be substantially less than the market value of thewarrants.

***Although we currently have aneffective registration statement covering the issuance of the shares underlyingthe warrants issued in our initial public offering at the time that the warrantholders exercise their warrants, we cannot guarantee that a registrationstatement will continue to be effective, in which case the warrant holders maynot be able to exercise their warrants.***

Holders of the warrants issued in our initial publicoffering will be able to receive shares upon exercise of the warrants only if(i) a current registration statement under the Securities Act of 1933 relatingto the shares of common stock underlying the warrants is then effective and(ii) such shares are qualified for sale or exempt from qualification under theapplicable securities laws of the states in which the various holders ofwarrants reside. Although we currently have a current registration statementcovering the shares underlying the warrants to the extent required by federalsecurities laws, we cannot give assurance that we

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will be able to maintain the effectiveness of suchregistration statement. In addition, some states may not permit us to registerthe shares issuable upon exercise of our warrants for sale. Since we have noobligation to net cash settle the warrants in the absence of an effectiveregistration statement, the value of the warrants will be greatly reduced if aregistration statement covering the shares issuable upon the exercise of thewarrants is not kept current or if the securities are not qualified, or exemptfrom qualification, in the states in which the holders of warrants reside. Holdersof warrants who reside in jurisdictions in which the shares underlying thewarrants are not qualified and in which there is no exemption will be unable toexercise their warrants and would either have to sell their warrants in theopen market or allow them to expire unexercised. If and when the warrantsbecome redeemable by us, we may exercise our redemption right even if we areunable to qualify the underlying securities for sale under all applicable statesecurities laws. In light of the foregoing, the warrants may expire worthlessand a purchaser of units may have paid the full unit purchase price solely forthe share component of the units.

**Item 1B.**                 Unresolved StaffComments

[None.]

**Item 2.**                          Properties

Wemaintain our executive offices at c/o Stone-Kaplan Investments, LLC, OneNorthfield Plaza, Suite 480, Northfield, IL 60093. Stone-Kaplan Investments hasagreed to provide us with certain administrative, technology and secretarialservices, as well as the use of certain limited office space at this locationat a cost of $7,500 per month pursuant to a letter agreement between us andStone-Kaplan Investments. Stone-Kaplan Investments uses a portion of the$7,500 monthly fee to pay Arcade Partners for overhead expendituresincurred on our behalf. We believe, based on rents and fees for similarservices in the Chicago metropolitan area, that the $7,500 fee is at least asfavorable as we could have obtained from an unaffiliated person. This fee wasdiscontinued upon consummation of the KPB acquisition.

KapStonewill likely expand its headquarters by leasing additional office space at ornear its current corporate headquarters located in Northfield, IL.  KapStone is seeking to leaseapproximately 12,000 sq. ft. of office space to serve as its headquarters.The current leasing rate for such space is estimated to be approximately$28 per sq. ft. per year, or $336,000 per year in aggregate. At this time,we are negotiating to acquire such additional office space.

*RoanokeRapids*

TheRoanoke Rapids facility is located on over 1,600 acres of land along theRoanoke River in Roanoke Rapids, North Carolina. The facility is an integratedpulp and paper mill, consisting of two papermaking machines, a single-linewoodyard, a batch digester operation, three brown stock washer lines, onerecovery boiler, one power boiler and a turbine generator. The facility is a24-hour per day operation and typically operates 365 days per year, except forscheduled annual maintenance. The facility has approximately 670 acresdedicated to landfill. We believe that the facility is in good operatingcondition and is suited for the purposes for which it is presently being usedand provides significant ability for potential plant and landfill expansion.

*RideRite® Converting*

RideRite® Converting is located in Fordyce, Arkansas, approximately 70 miles southof Little Rock. The facility consists of two buildings that house the mainoffices, production lines and warehousing space of over 154,000 square feet.Ride Rite® Converting is located on over 20 acres of land that is leased fromthe town of Fordyce. The current lease term ends in 2017, with options to renewfor up to nine years. The facility includes two converting production linesthat operate 24 hours a day, five days a week to process kraft paper,lightweight linerboard, extensible paper and poly bags into Ride Rite®Converting inflatable

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dunnagebags. We believe that the facilities are in good operating condition and aresuited for the purposes for which they are presently being used.

**Item 3.**                          LegalProceedings

To the knowledge of management, there is no litigationcurrently pending or contemplated against us or any of our officers ordirectors in their capacity as such.

**Item 4.**                          Submissionof Matters to a Vote of Security Holders

On December 29, 2006, we held a special meeting of ourstockholders.  Our stockholders voted toadopt the KPB acquisition proposal, adopt an amendment proposal to change thename of the corporation from Stone Arcade Acquisition Corporation to KapStonePaper and Packaging Corporation, adopt the Article SIXTH amendment proposal andadopt the 2006 incentive plan proposal. The voting results were as follows:
| **Proposal**                                      | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Abstain** | ** ** |
|---------------------------------------------------|------------|--------------------|------------|------------------------|------------|-------------|------------|
| Adopt Asset  Purchase Agreement                   |       | 23,614,853         |       | 40,000                 |       | 7,000       |       |
|                                              |       |               |       |                   |       |        |       |
| Amend  Certificate of Incorporation (Name change) |       | 23,620,853         |       | —                 |       | 41,000      |       |
|                                              |       |               |       |                   |       |        |       |
| Amend Article  SIXTH                              |       | 23,606,103         |       | 14,750                 |       | 41,000      |       |
|                                              |       |               |       |                   |       |        |       |
| Approve 2006 Incentive  Plan                      |       | 22,644,901         |       | 975,952                |       | 41,000      |       |

 

18

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**PART II**

**Item 5.**                          Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

The Company’s units, common stock and warrants havebeen traded on the Over-the-Counter Bulletin Board under the symbols “SCDEU,” “SCDE”and “SCDEW,” respectively since August 16, 2005, September 14, 2005 andSeptember 14, 2005, respectively.  Thefollowing table sets forth the high and low bid information for the Company’ssecurities from the commencement of trading through December 31, 2006 asreported by the Over-the-Counter Bulletin Board.  The Over-the-Counter Bulletin Boardquotations reflect inter-dealer prices, are without retail markup, markdowns orcommissions, and may not represent actual transactions.
| ** **   | ** ** | ** ** | ** ** | **2006** | ** ** | **2005*** | ** ** |
|--------------|------------|------------|------------|----------|------------|-----------|------------|
| ** **   | ** ** | ** ** | ** ** | **Low**  | ** ** | **High**  | ** ** | **Low** | ** ** | **High** | ** ** |
| Common Stock |       | 1st        |       | $        | 5.32       |      | $          | 5.68 |   | — |   | — |   |
|         |       | 2nd        |       | $        | 5.48       |      | $          | 5.70 |   | — |   | — |   |
|         |       | 3rd        |       | $        | 5.45       |      | $          | 5.78 |   | $ | 5.00 |   | $ | 5.35 |   |
|         |       | 4th        |       | $        | 5.62       |      | $          | 6.49 |   | $ | 5.25 |   | $ | 5.40 |   |
| Warrants     |       |       |       |     |       |      |       |   |   |   |   |
|         |       | 1st        |       | $        | 0.37       |      | $          | 0.74 |   | — |   | — |   |
|         |       | 2nd        |       | $        | 0.40       |      | $          | 0.67 |   | — |   | — |   |
|         |       | 3rd        |       | $        | 0.44       |      | $          | 0.83 |   | $ | 0.35 |   | $ | 0.58 |   |
|         |       | 4th        |       | $        | 0.82       |      | $          | 1.75 |   | $ | 0.39 |   | $ | 0.59 |   |
| Units        |       |       |       |     |       |      |       |   |   |   |   |
|         |       | 1st        |       | $        | 6.10       |      | $          | 7.30 |   | — |   | — |   |
|         |       | 2nd        |       | $        | 6.20       |      | $          | 6.95 |   | — |   | — |   |
|         |       | 3rd        |       | $        | 6.35       |      | $          | 7.29 |   | $ | 5.95 |   | $ | 6.40 |   |
|         |       | 4th        |       | $        | 7.10       |      | $          | 10.00 |   | $ | 6.05 |   | $ | 6.50 |   |

_________________________* No amounts are included in the first and second quarters as none of oursecurities commenced trading on the OTC Bulletin Board prior to August 16,2005.  Additionally, the amounts includedfor the third quarter of 2005 are for the period from August 16, 2005 throughSeptember 30, 2005.

Effective March 1, 2007, the Company’s trading symbolswere changed to KPPC (common stock), KPPCU (units) and KPPCW (warrants) on theOver-the-Counter Bulletin Board.

**Number of Holders of Common Stock.**

The number of holders of record of our common stock onMarch 9, 2007 was 8.  However, the totalnumber of beneficial holders is unknown as the majority of our common stock isheld in street name through CEDE & Co.

**Dividends.**

There were no cash dividends or other cashdistributions made by us during the fiscal years 2006 or 2005.  Future dividend policy will be determined byour Board of Directors based on our earnings, financial condition, capitalrequirements and other then existing conditions.  It is anticipated that cash dividends willnot be paid to the holders of our common stock in the foreseeable future.  The Company’s credit facility prohibits thedeclaration or payment of cash dividends.

19

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**Securities Authorized for Issuance Under EquityCompensation Plans.**

The following table summarizes our equity compensationplans as of December 31, 2006.  

 
| ** **                                                  | ** ** | ** **                     | ** ** | ** **              | ** ** | **Securities**          | ** ** |
|-------------------------------------------------------------|------------|--------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                  | ** ** | ** **                     | ** ** | ** **              | ** ** | **remaining**           | ** ** |
| ** **                                                  | ** ** | ** **                     | ** ** | ** **              | ** ** | **available for**  | ** ** |
| ** **                                                  | ** ** | ** **                     | ** ** | ** **              | ** ** | **the future**     | ** ** |
| ** **                                                  | ** ** | **Number of**             | ** ** | ** **              | ** ** | **issuance under** | ** ** |
| ** **                                                  | ** ** | **securities to be** | ** ** | **Weighted-**           | ** ** | **equity**              | ** ** |
| ** **                                                  | ** ** | **issued upon**           | ** ** | **average**             | ** ** | **compensation**        | ** ** |
| ** **                                                  | ** ** | **exercise of**           | ** ** | **Exercise price** | ** ** | **plans**               | ** ** |
| ** **                                                  | ** ** | **outstanding**                | ** ** | **of outstanding** | ** ** | **(excluding**          | ** ** |
| ** **                                                  | ** ** | **options,**                   | ** ** | **options,**            | ** ** | **securities**          | ** ** |
| ** **                                                  | ** ** | **warrants and**          | ** ** | **warrants and**   | ** ** | **reflected in**   | ** ** |
| ** **                                                  | ** ** | **rights**                     | ** ** | **rights**              | ** ** | **column (a))**    | ** ** |
| **Plan Category**                                      | ** ** | **(a)**                        | ** ** | **(b)**                 | ** ** | **(c)**                 | ** ** |
| Equity  compensation plans approved by security holders (1) |       | —                         |       | $                       | —     |                    | 3,000,000  |   |
| Equity  compensation not approved by security holders       |       | —                         |       | $                       | —     |                    | —     |   |
| Total                                                       |       | —                         |       | —                  |       | 3,000,000               |       |
|                                                        |       |                           |       |                    |       |                    |       |

 

(1)             The2006 Incentive Plan was approved by stockholders on December 29, 2006.

**Item 6.**                          SelectedFinancial Data

The selected financial data presented below summarizescertain financial data which has been derived from and should be read inconjunction with our financial statements and notes thereto included in thesection beginning on page F-1.  See also “Item7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations.” 
| ** **                                                                   | ** ** | **Year Ended  December 31,  2006** | ** **  | **Inception (April 15, 2005)  through December 31, 2005** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------|-------------|-----------------------------------------------------------------------------------------|------------|
| Statement of Operations Data:                                 |       |                                         |        |                                                                                    | ** ** |
| Operating  Expenses                                                          |       | $                                            | 1,975,904   |                                                                                    | $          | 221,100 |   |
| Other Income                                                                 |       | $                                            | 5,290,717   |                                                                                    | $          | 1,460,158 |   |
| Net Income                                                                   |       | $                                            | 2,195,908   |                                                                                    | $          | 817,779 |   |
| Interest Income  attributable to common stock subject to possible redemption |       | $                                            | (686,166    | )                                                                                       | $          | (189,462 | ) |
| Net Income  allocable to holders of nonredeemable common stock               |       | $                                            | 1,509,742   |                                                                                    | $          | 628,317 |   |
| Basic Net Income  per share                                                  |       | $                                            | 0.09        |                                                                                    | $          | 0.05 |   |
| Diluted Net  Income per share                                                |       | $                                            | 0.07        |                                                                                    | $          | 0.05 |   |
|                                                                         |       |                                         |        |                                                                                    |       |
| Balance Sheet  Data:                                                         |       |                                         |        |                                                                                    |       |
| Cash and  investments, held in trust                                         |       | $                                            | 115,239,411 |                                                                                    | $          | 111,965,034 |   |
| Working Capital                                                              |       | $                                            | 112,376,350 |                                                                                    | $          | 114,024,661 |   |
| Total Assets                                                                 |       | $                                            | 119,256,944 |                                                                                    | $          | 114,305,614 |   |
| Total  Stockholders Equity                                                   |       | $                                            | 116,044,189 |                                                                                    | $          | 91,729,578 |   |
|                                                                         |       |                                         |        |                                                                                    |       |

 

20

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**Item 7.**                          Management’sDiscussion and Analysis of Financial Condition and Results of Operations

**Overview.**

The following discussion of our financial conditionand results of operations should be read in conjunction with our financialstatements and the related notes included in this annual report on Form 10-K.This discussion contains forward-looking statements. Please see Item 1A. RiskFactors, above, for a discussion of the uncertainties, risks and assumptionsassociated with these statements.

We were a special purpose acquisition corporationformed on April 15, 2005 for the purpose of effecting a merger, capital stockexchange, asset acquisition or other similar business combination with anunidentified operating business in the paper, packaging, forest products andrelated industries.

On January 2, 2007, we consummated the purchase fromIP of substantially all of the assets, and the assumption of certain liabilities,of KPB through our wholly owned subsidiary KapStone Kraft. Since we did nothave any operations prior to our acquisition of KPB, all of our income for theyear ended December 31, 2006 and the period from April 15, 2005 (dateof inception) through December 31, 2005 (the “2005 period”) was derivedfrom interest income.

**Critical Accounting Policies.**

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities at the date of the financial statements andthe reported amounts of expenses during the reporting period.  Actual results could differ from thoseestimates.

Management does not believe that any recently issued,but not yet effective, accounting standards if currently adopted would have amaterial effect on the accompanying financial statements.

**Results of Operations for the Years Ended December31, 2006 and the 2005 Period.**

For the year ended December 31, 2006 and the 2005period, our net income attributed to holders of nonredeemable common stock was$1,509,742 ($2,195,908 before the deduction of $686,166 of interest net oftaxes attributable to common stock subject to possible redemption) as comparedto $628,317 ($817,779 before the deduction of $189,462 of interest net of taxesattributable to common stock subject to possible redemption), respectively.Since KapStone did not have any operations, all income was derived frominterest income, most of which was earned on funds held in a trust account.Interest income earned for the year ended December 31, 2006 was higher than the2005 period by $3,830,559 because the principal balance was not invested untilAugust 19, 2005, upon the completion of KapStone’s initial public offeringand receipt of $113,235,876 of net proceeds.

On January 2, 2007, upon consummation of the KPBacquisition, a large portion of the funds held in trust were used to pay forthe business and as a result, the amount of interest income will be greatlyreduced in 2007.

KapStone’s operating expenses for the year endedDecember 31, 2006 and the 2005 period were $1,975,904 and $221,100,respectively. The expenses for the period ended December 31, 2006 were higherthan the 2005 period by $1,754,804, primarily due to increased expenses relatedto pursuing a business combination, professional fees, insurance and franchisetaxes.  KapStone also expensed $1,118,905and $421,279 for income taxes for the year ended December 31, 2006 and the2005 period, respectively.

21

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**Liquidity and Capital Resources.**

***KPBAcquisition***

On January 2, 2007, we consummated the purchase ofsubstantially all of the assets and the assumption of certain liabilities ofKPB. The assets consist of an unbleached kraft paper manufacturing facility in RoanokeRapids, North Carolina and Ride Rite® Converting, an inflatable dunnage bagmanufacturer located in Fordyce, Arkansas. The liabilities assumed consist oftrade accounts payable, accrued expenses and certain long term liabilities. Thepurchase price for the acquisition was approximately $155 million in cash,subject to certain post-closing adjustments, plus contingent earn-out paymentsof up to $60 million  based on KPB’sannual earnings before interest, income taxes, depreciation and amortization (“EBITDA”)during the five year period immediately following the acquisition. The firstcontingent payment will be equal to 5.3x KPB’s average annual EBITDA for thefive year period immediately following the acquisition, less $165 million andsubject to a maximum of $35 million. The second contingent payment is an “allor nothing” payment and is payable if, and only if, KPB’s average annual EBITDAfor the same five year period equals or exceeds $49.2 million. Generally, bothpayments, if earned, will be due and paid at the end of the five year period.

If these contingent earn-out payments are made, theywill be accounted for as additional purchase price consideration.

***CreditFacility***

In connection with the acquisition, the Companyobtained a senior secured credit facility from LaSalle Bank NationalAssociation.  The credit facilitycurrently provides us with the ability to borrow up to $95.0 millionpursuant to a $35.0 million revolving loan and a $60.0 million termloan.  Advances under the revolving lineof credit are primarily based upon percentages of eligible accounts receivableand inventories.  The facility has amaturity date of December 31, 2011.

The term loan has scheduled principal paymentsof:  (a) $1.875 million onMarch 31, June 30, September 30 and December 31 of 2007;(b) $2.0 million on March 31, June 30, September 30and December 31 of 2008; (c) $2.125 million on March 31,June 30, September 30 and December 31 of 2009 and March 31,June 30, September 30 and December 31 of 2010;(d) $2.25 million on March 31, June 30 andSeptember 30 of 2011; and (e) $20.75 million onDecember 31, 2011.  We are alsorequired to make prepayments on the term loan under certain circumstances fromthe net cash proceeds of certain assets dispositions and issuances of securitiesor debt and, within 100 days after the end of December 31, 2007 and 2008,respectively, 50% of excess cash flow from such fiscal years.

Borrowings under the revolving loan accrue interest,at our option, at either:  LIBOR plus1.00% to 1.75% depending on KapStone Kraft’s total debt to EBITDA ratio; or theBase Rate (prime rate) plus 0% to .50% depending on KapStone Kraft’s total debtto EBITDA ratio.  Borrowings under theterm loan accrue interest, at our option, at either:  LIBOR plus 1.25% to 2.00% depending onKapStone Kraft’s total debt to EBITDA ratio; or the Base Rate (prime rate) plus0% to .50% depending on KapStone Kraft’s total debt to EBITDA ratio. The BaseRate margin and LIBOR margin shall adjust quarterly upon receipt of quarterlyfinancial statements.

The credit facility contains a number of significantcovenants that, among other things, restrict KapStone Kraft’s ability todispose of assets, incur additional indebtedness, prepay other indebtedness,pay dividends, repurchase or redeem capital stock, enter into certaininvestments, make certain acquisitions, engage in mergers and consolidations,create liens, or engage in certain transactions with affiliates and otherwiserestrict KapStone Kraft’s corporate and business activities.  In addition, under the credit facility,KapStone Kraft is required to comply with a minimum EBITDA, fixed chargecoverage ratio and total debt to EBITDA ratio. The credit facility also restricts the aggregate amount of capitalexpenditures incurred by KapStone.

22

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Events of default under the senior secured creditfacility include, but are not limited to: (a) failure to pay principal or interest when due;(b) material breach of any representation or warranty; (c) covenantdefaults; (d) default with respect to any other debt with an outstandingprincipal amount in excess of $2.5 million if the effect thereof is toaccelerate or permit the acceleration of such debt; and (e) events ofbankruptcy.

The credit facility is secured by all of the KapStoneKraft’s tangible and intangible assets and all of the tangible and intangibleassets of KapStone Kraft and its subsidiaries and a pledge of the capital stockof KapStone Kraft and its subsidiaries.

***Sourcesand Uses of Cash***

At December 31, 2006, $115,239,411 of the proceedsfrom KapStone’s initial public offering, together with interest, was being heldin a trust account.

Upon consummation of the acquisition, $86,673,349 ofthe funds held in the trust account was used to fund the acquisition ofKPB.  $230,475 was left in the trust topay the holder of IPO shares that elected redemption, $83,635 was paid inclosing costs and the balance of $28,251,948 was added to our working capital,of which $1,200,000 was paid as an investment banking fee to Morgan Joseph. Workingcapital is sufficient to fund current liabilities of $2,982,280.

Proceeds of the LaSalle Bank National Associationcredit facility were used to pay the $59,145,000 balance of the purchase priceand $855,000 in fees to LaSalle.

***Post-Acquisition***

While it is anticipated that the borrowings from thecredit facility, together with funds generated from KPB operating activities,will be sufficient for KapStone’s expected short-term and long-term operatingneeds, our ability to meet projected capital expenditures, satisfy workingcapital requirements and make payments on amounts outstanding under the creditfacility will depend on KPB’s ability to generate cash from its operations.KapStone Kraft’s expected debt service obligation is initially estimated to beapproximately $4,000,000 in interest payments per annum, which will be reducedeach year in accordance with scheduled debt amortization payments, if made. Inaddition, debt service requirements will also include scheduled quarterlyprincipal amortizations starting at $1,875,000 during the first year and risingto $2,250,000 in the final year of the facility. Management believes thatKapStone Kraft’s cash flow from operations will be sufficient to fund all suchprincipal repayments, and that such payments will not have a material adverseeffect on our business plans, liquidity and growth opportunities.

**Off-Balance Sheet Arrangements.**

We have never entered into any off-balance sheetfinancing arrangements and have never established any special purpose entities.  We have not guaranteed any debt orcommitments of other entities or entered into any options on non-financialassets.

**Contractual Obligations.**

As of December 31, 2006, we did not have any long termdebt, capital lease obligations, operating lease obligations, purchaseobligations or other long term liabilities. See “-Liquidity and CapitalRecourses” above for a description of the contingent earn-out payments inconnection with the acquisition of KPB and scheduled principal payments underour credit facility.

**Item 7A.   Quantitative and Qualitative DisclosuresAbout Market Risk**

Market risk is the risk of loss arising from adversechanges in market rates and prices. The principal market risk to which we areexposed is commodity and energy price risk. We are exposed to pricefluctuations of certain commodities used in production as well as fluctuationsin the price of its finished goods. Key raw 

23

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materials and energy used in the production processinclude wood, coal, electricity and caustic soda. We purchase these rawmaterials and energy at the market prices, and do not use any forward contractsor other financial instruments to hedge its exposure to price risk related tothese commodities. Prices for paper and related products are subject to marketconditions. We have no long-term contracts to purchase raw materials at fixedprices.

**Item 8.**                          FinancialStatements and Supplementary Data

Financial statements are attached hereto followingbeginning on Page F-1.

**Item 9.**                          Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

**Changesin the Company’s Independent Auditor.**

On April 7, 2006, the Board of Directors of KapStonedismissed its principal independent accountant, Eisner LLP, which becameeffective on April 11, 2006 upon KapStone’s engagement of Ernst & Young LLP(E&Y).

The report of Eisner LLP on KapStone’s financialstatements for the period from April 15, 2005 (date of inception) throughDecember 31, 2005 contained no adverse opinion or disclaimer of opinion, norwas it qualified or modified as to uncertainty, audit scope or accountingprinciples. During the period from April 15, 2005 through December 31, 2005,there were no disagreements with Eisner LLP on any matter of accountingprinciples or practices, financial statement disclosure, or auditing scope orprocedure, which disagreements if not resolved to the satisfaction of EisnerLLP would have caused them to make reference thereto in their report on thefinancial statements for such period. Eisner did not review the KapStone’sfinancial statements for the three month period ended March 31, 2006.

**Item 9A.**                 Controls andProcedures

**Disclosure Controls and Procedures.**

An evaluation of the effectiveness of our disclosurecontrols and procedures as of December 31, 2006 was made by our Chief ExecutiveOfficer and Chief Financial Officer. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures areeffective as of the end of the period covered by this report to ensure thatinformation required to be disclosed by us in reports that we file or submitunder the Securities Exchange Act of 1934 is recorded, processed, summarizedand reported within the time periods specified in Securities and ExchangeCommission rules and forms.

**Internal Control over Financial Reporting.**

*Management Annual Report on Internal Control overFinancial Reporting*. Our management’s report on internalcontrol over financial reporting is set forth on page F-2 of this report.

*Changes in Internal Control over FinancialReporting*.  Nosignificant change was identified in connection with the evaluation required byRule 13a-15(d) under the Securities Exchange Act of 1934 that occurred duringthe fourth quarter of fiscal 2006 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

**Item 9B.**                 Other Information

None.

24

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**PART III**

**Item 10.**                   Directors andExecutive Officers of the Company

The information called for by Item 401 of Regulation S-Krelating to the Executive Officers is furnished in Part I of this Form 10-Kunder the caption “Executive Officers of the Registrant” and is incorporatedherein by reference.

Additional information required by this Item iscontained in the Company’s Proxy Statement and is incorporated herein by thisreference.

The Company has adopted a Code of Ethics and BusinessConduct (the “Code”) which applies to all of its directors, officers (includingthe Company’s Chief Executive Officer and senior financial officers) andemployees in January 2007. The Code imposes significant responsibilities on theChief Executive Officer and the senior financial officers of the Company.  The Code is attached as Exhibit 14 hereto.

**Item 11.**                   ExecutiveCompensation

The information required by this Item is contained inthe Company’s Proxy Statement and is incorporated herein by this reference.

**Item 12.**                   SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

The information required by this Item is contained inthe Company’s Proxy Statement and is incorporated herein by this reference.

**Item 13.**                   CertainRelationships and Related Transactions

The information required by this Item is contained inthe Company’s Proxy Statement and is incorporated herein by this reference.

**Item 14.**                   PrincipalAccountant Fees and Services

The information required by this Item is contained inthe Company’s Proxy Statement and is incorporated herein by this reference.

**Item 15.**                   Exhibits andFinancial Statement Schedules

(a)(1) **Financial Statements.**

An index to Consolidated Financial Statements appearson page F-1.

(a)(2) Financial Statement Schedules

These schedules have been omitted because the requiredinformation is included in the consolidated financial statements or notesthereto or because they are not applicable or not required.

(b) **Exhibits.**

The following Exhibits are filed as part of thisreport:

25

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|  Exhibit No. |   | Description                                                                                                                                                                                      |
|-------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1               |   | Purchase Agreement, dated June 23, 2006, by and  among International Paper Company, the Registrant, and KapStone Kraft Paper  Corporation. (1)                                                   |
|              |   |                                                                                                                                                                                             |
| 2.2               |   | Letter Amendment to Purchase Agreement, dated June  23, 2006, by and among International Paper Company, the Registrant, and  KapStone Kraft Paper Corporation, dated December 15, 2006. (2) |
|              |   |                                                                                                                                                                                             |
| 3.1               |   | Amended and Restated Certificate of Incorporation.  (3)                                                                                                                                          |
|              |   |                                                                                                                                                                                             |
| 3.2               |   | Certificate of Amendment of the Amended and Restated  Certificate of Incorporation (2)                                                                                                           |
|              |   |                                                                                                                                                                                             |
| 3.3               |   | By-laws.(3)                                                                                                                                                                                      |
|              |   |                                                                                                                                                                                             |
| 4.1               |   | Specimen Unit Certificate.(3)                                                                                                                                                                    |
|              |   |                                                                                                                                                                                             |
| 4.2               |   | Specimen Common Stock Certificate.(3)                                                                                                                                                            |
|              |   |                                                                                                                                                                                             |
| 4.3               |   | Specimen Warrant Certificate.(3)                                                                                                                                                                 |
|              |   |                                                                                                                                                                                             |
| 4.4               |   | Form of Unit Purchase Option to be granted to  Representative. (2)                                                                                                                               |
|              |   |                                                                                                                                                                                             |
| 4.5               |   | Form of Warrant Agreement between Continental Stock  Transfer & Trust Company and the Registrant. (3)                                                                                        |
|              |   |                                                                                                                                                                                             |
| 4.6               |   | Amended and Restated Warrant Clarification  Agreement.(4)                                                                                                                                        |
|              |   |                                                                                                                                                                                             |
| 4.7               |   | Amended and Restated Unit Purchase Clarification  Agreement (5)                                                                                                                                  |
|              |   |                                                                                                                                                                                             |
| 10.1              |   | Form of Letter Agreement among the Registrant,  Morgan Joseph & Co. Inc. and each of the Initial Stockholders. (3)                                                                           |
|              |   |                                                                                                                                                                                             |
| 10.2              |   | Form of Promissory Note issued to each of Roger  Stone, Matthew Kaplan, John Chapman, Jonathan Furer and Muhit Rahman. (3)                                                                       |
|              |   |                                                                                                                                                                                             |
| 10.3              |   | Form of Investment Management Trust Agreement  between Continental Stock Transfer & Trust Company and the Registrant.  (3)                                                                   |
|              |   |                                                                                                                                                                                             |
| 10.4              |   | Form of Stock Escrow Agreement between the  Registrant, Continental Stock Transfer & Trust Company and the Initial  Stockholders. (3)                                                        |
|              |   |                                                                                                                                                                                             |
| 10.5              |   | Form of Letter Agreement between Stone-Kaplan  Investments LLC and Registrant regarding administrative support. (3)                                                                              |
|              |   |                                                                                                                                                                                             |
| 10.6              |   | Form of Registration Rights Agreement among the  Registrant and the Initial Stockholders. (3)                                                                                                    |
|              |   |                                                                                                                                                                                             |
| 10.7              |   | Form of Warrant Purchase Agreement among each of the  Initial Stockholders and Morgan Joseph & Co. Inc.(3)                                                                                   |

26

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| 10.8   |   | 2006 Equity Incentive Plan. (2)                                                                                                                      |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                 |
| 10.9   |   | Credit Agreement among KapStone Kraft, LaSalle Bank  National Association, and various lenders thereto.(2)                                           |
|   |   |                                                                                                                                                 |
| 10.10  |   | Form of Agreement for the Provision of Transition  Services between KapStone Kraft and IP.(2)                                                        |
|   |   |                                                                                                                                                 |
| 10.11  |   | Lease Agreement between City of Fordyce, Arkansas  and IP.(2)                                                                                        |
|   |   |                                                                                                                                                 |
| 14     |   | Code of Ethics.                                                                                                                                      |
|   |   |                                                                                                                                                 |
| 16.1   |   | Letter Regarding Change in Certifying Accountant.(6)                                                                                                 |
|   |   |                                                                                                                                                 |
| 21     |   | Subsidiary.                                                                                                                                          |
|   |   |                                                                                                                                                 |
| 23.1   |   | Consent of Ernst & Young LLP, independent registered  public accounting firm.                                                                    |
|   |   |                                                                                                                                                 |
| 23.2   |   | Consent of Eisner LLP, independent registered public  accounting firm.                                                                               |
|   |   |                                                                                                                                                 |
| 31.1   |   | Certification of the Chief Executive Officer  pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended.                                 |
|   |   |                                                                                                                                                 |
| 31.2   |   | Certification of the Principal Financial Officer  pursuant to Rule 13a-14(a) of the Securities Exchange Act, as amended.                             |
|   |   |                                                                                                                                                 |
| 32.l   |   | Certification of the Chief Executive Officer  pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.     |
|   |   |                                                                                                                                                 |
| 32.2   |   | Certification of the Principal Financial Officer  pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

(1)                      Incorporatedby reference to the Registrant’s current Report on Form 8-K filed onJune 23, 2006.

(2)                      Incorporatedby reference to the Registrant’s Current Report on Form 8-K filed on January 4,2007.

(3)                      Incorporatedby reference to the Registrant’s Registration Statement on Form S-1 (File No.333-124601).

(4)                      Incorporatedby reference to the Registrant’s Quarterly Report on Form 10-Q/A for the periodended June 30, 2006 filed on December 12, 2006.

(5)                      Incorporatedby reference to the Registrant’s Quarterly Report on Form 10-Q/A for the periodended September 30, 2006 filed on December 12, 2006.

(6)                      Incorporatedby reference to the Registrant’s Current Report on Form 8-K/A filed on April19, 2006.

27

----

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15 (d)of the Securities Exchange Act of 1934, the Registrant had duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.
|                      | **KAPSTONE PAPER AND PACKAGING CORPORATION**                    |
|----------------------|-----------------------------------------------------------------|
| ** **           | ** **                                                      |
| March 13,  2007 | By: /s/ Roger Stone                                             |
|                 | Roger Stone, Chairman of the Board and Chief  Executive Officer |   |

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.
| March 13, 2007       |   | By: /s/ Roger Stone                                             |
|----------------------|--------|-----------------------------------------------------------------|
|                 |   | Roger Stone, Chairman of the Board and Chief  Executive Officer |
|                 |   |                                                            |
| March 13,  2007 |   | By: /s/ Andrea K. Tarbox                                        |
|                 |   | Andrea K. Tarbox, Vice President and Chief Financial  Officer   |
|                 |   |                                                            |
| March 13,  2007 |   | By: /s/ Matthew Kaplan                                          |
|                 |   | Matthew Kaplan, President, Secretary and Director               |
|                 |   |                                                            |
| March 13,  2007 |   | By: /s/ John M. Chapman                                         |
|                 |   | John M. Chapman, Director                                       |
|                 |   |                                                            |
| March 13,  2007 |   | By: /s/ James Doughan                                           |
|                 |   | James Doughan, Director                                         |
|                 |   |                                                            |
| March 13,  2007 |   | By: /s/ Jonathan R.Furer                                        |
|                 |   | Jonathan R. Furer, Director                                     |
|                 |   |                                                            |
| March 13,  2007 |   | By: /s/ Muhit U. Rahman                                         |
|                 |   | Muhit U. Rahman, Director                                       |
|                 |   |                                                            |
| March 13,  2007 |   | By: /s/ S. Jay Stewart                                          |
|                 |   | S. Jay Stewart, Director                                        |

** **

28

----

**KapStonePaper and Packaging Corporation(a development stage company)INDEX TO FINANCIAL INFORMATION**
|                                                                                                                                                    |   | Page   |
|----------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| **Financial  Statements**                                                                                                                          |   |   |
| ** **                                                                                                                                         |   |   |
| Management’s  Annual Report on Internal Control over Financial Reporting                                                                      |   | F-2    |
|                                                                                                                                               |   |   |
| Report  of Independent Registered Public Accounting Firm for 2006                                                                                  |   | F-3    |
|                                                                                                                                               |   |   |
| Report of Independent Registered Public Accounting  Firm for 2005                                                                                  |   | F-4    |
|                                                                                                                                               |   |   |
| Report of Independent Registered Public Accounting  Firm on Internal Control                                                                       |   |   |
| over Financial Reporting                                                                                                                           |   | F-5    |
|                                                                                                                                               |   |   |
| Consolidated  Balance Sheets as of December 31, 2006 and December 31, 2005                                                                         |   | F-6    |
|                                                                                                                                               |   |   |
| Consolidated Statements of Operations for the period  from April 15, 2005 (date of inception) through December 31, 2006                            |   | F-7    |
|                                                                                                                                               |   |   |
| Consolidated Statements of Changes in Stockholders’  Equity for the period from April 15, 2005 (date of inception) through  December 31, 2006 |   | F-8    |
|                                                                                                                                               |   |   |
| Consolidated  Statements of Cash Flows for the period from April 15, 2005 (date of  inception)                                                     |   |   |
| through  December 31, 2006                                                                                                                         |   | F-9    |
|                                                                                                                                               |   |   |
| Notes to Consolidated Financial Statements                                                                                                         |   | F-10   |

 

F-1

----

**MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL****OVER FINANCIAL REPORTING**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting. Internalcontrol over financial reporting is defined in Rule 13a-15(f) and15d-15(f) under the Securities Exchange Act of 1934. Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements and can provide only reasonable assurance with respect tofinancial statement preparation and presentation. Also, projections of anyevaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of our internalcontrol over financial reporting as of December 31, 2006. Management basedthis assessment on the criteria set forth by the Committee of SponsoringOrganizations of the Treadway Commission (COSO) in *“Internal Control — Integrated Framework.”*

Based on this assessment, management concluded that,as of December 31, 2006, our internal control over financial reporting iseffective.

The independent registered public accounting firm ofErnst & Young LLP has issued an attestation report on management’sassessment of our internal control over financial reporting. This reportappears on page F-5.

F-2

----

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

Board of Directors and StockholdersKapStone Paper and Packaging Corporation

We have audited the accompanying consolidated balancesheet of KapStone Paper and Packaging Corporation (a development stage company)(the “Company”) as of December 31, 2006 and the related consolidated statementsof operations, changes in stockholders’ equity and cash flows for the year thenended, and for the period from April 15, 2005 (inception) through December 31,2006.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audit. The financial statements as of December 31, 2005, and for the periodApril 15, 2005 (inception) through December 31, 2005, were audited by otherauditors whose report dated March 9, 2006 expressed an unqualified opinion onthose statements. The financial statements for the period April 15, 2005(inception) through December 31, 2005 include total other income and net incomeof $1,460,158 and $817,779, respectively.  Our opinion on the statementsof operations, stockholders' equity, and cash flows for the period April 15,2005 (inception) through December 31, 2006, insofar as it relates to amountsfor prior periods through December 31, 2005, is based solely on the report ofother auditors.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audit provides areasonable basis for our opinion.

In our opinion, based on our  audit and the report of other auditors, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of KapStone Paper andPackaging Corporation as of December 31, 2006 and the consolidated results ofits operations and its cash flows for the year then ended and the period fromApril 15, 2005 (inception) through December 31, 2006, in conformity with U.S.generally accepted accounting principles.

We have also audited, in accordance with the standardsof the Public Company Oversight Board (United States), the effectiveness ofKapStone Paper and Packaging Corporation’s internal control over financialreporting as of December 31, 2006, based on criteria established in *Internal Control – Integrated Framework,* issued by the Committeeof Sponsoring Organizations of the Treadway Commission and our report datedMarch 15, 2007 expressed an unqualified opinion thereon.
| /s/ Ernst & Young  LLP |
|----------------------------|
| Ernst &  Young LLP     |
|                       |
| Chicago, IL                |
| March 15, 2007             |

 

F-3

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

Board of Directors andStockholdersKapStone Paper and Packaging Corporation

We have audited the accompanying balance sheet of KapStonePaper and Packaging Corporation (formerly Stone Arcade Acquisition Corporation)(a development stage company) (the “Company”) as of December 31, 2005 andthe related statements of operations, changes in stockholders’ equity and cashflows for the period from April 15, 2005 (date of inception) throughDecember 31, 2005. These financial statements are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audit.

We conducted our audit in accordance with the standardsof the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the financial position of KapStonePaper and Packaging Corporation as of December 31, 2005 and the results ofits operations and its cash flows for the period from April 15, 2005 (date ofinception) through December 31, 2005 in conformity with U.S. generallyaccepted accounting principles.
| /s/ Eisner LLP |   |
|----------------|--------|
| Eisner LLP     |   |

 

New York, New York

March 9, 2006

Except for the thirdparagraph of Note C, as to which the date is January 4, 2007.

F-4

----

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

**ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

To the Board of Directors and Stockholders

KapStone Paper andPackaging Corporation

We have audited management’s assessment, included inthe accompanying Management Annual Report on Internal Control over FinancialReporting, that KapStone Paper and Packaging Corporation maintained effectiveinternal control over financial reporting as of December 31, 2006, basedon criteria established in “Internal Control — Integrated Framework”issued by the Committee of Sponsoring Organizations of the Treadway Commission(the COSO criteria). KapStone Paper and Packaging Corporation’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express an opinion on management’sassessment and an opinion on the effectiveness of the company’s internalcontrol over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that KapStonePaper and Packaging Corporation maintained effective internal control overfinancial reporting as of December 31, 2006, is fairly stated, in allmaterial respects, based on the COSO criteria. Also, in our opinion, KapStonePaper and Packaging Corporation maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2006, basedon the COSO criteria.

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheet of KapStone Paper and Packaging Corporation as ofDecember 31, 2006 and the related consolidated statements of operations,stockholders’ equity, and cash flows for the  period endedDecember 31, 2006 of KapStone Paper and Packaging and our report datedMarch 15, 2007 expressed an unqualified opinion thereon. 
| /s/ Ernst & Young LLP |
|--------------------------------|

 

Chicago, Illinois

March 15, 2007

F-5

----

**KapStonePaper and Packaging Corporation (a development stage company)  Consolidated Balance Sheets**
| ** **                                                                                                                                                                                                                   | ** ** | **December 31,** | ** **  | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                   | ** ** | **2006**              | ** **  | **2005**              | ** ** |
|                                                                                                                                                                                                                         |       |                  |        |                  |       |
| Assets                                                                                                                                                                                                                       |       |                  |        |                  |       |
| Current assets:                                                                                                                                                                                                              |       |                  |        |                  |       |
| Cash                                                                                                                                                                                                                         |       | $                     | —      |                  | $          | 2,157,611 |   |
| Restricted cash and cash equivalents, held in trust  (including interest receivable of $266,239 at December 31, 2005)                                                                                                        |       | 115,239,411           |        | 111,965,034           |       |
| Prepaid income tax                                                                                                                                                                                                           |       | 92,587                |        | —                |       |
| Prepaid insurance                                                                                                                                                                                                            |       | 23,055                |        | 122,500               |       |
| Other prepaid expenses                                                                                                                                                                                                       |       | —                |        | 6,375                 |       |
| Income tax refund receivable                                                                                                                                                                                                 |       | 3,577                 |        | —                |       |
| Total current  assets                                                                                                                                                                                                        |       | 115,358,630           |        | 114,251,520           |       |
| Deferred  acquisition costs                                                                                                                                                                                                  |       | 3,058,163             |        | —                |       |
| Deferred income  taxes                                                                                                                                                                                                       |       | 688,652               |        | 54,094                |       |
| Other assets                                                                                                                                                                                                                 |       | 151,499               |        | —                |       |
| Total assets                                                                                                                                                                                                                 |       | $                     | 119,256,944 |                  | $          | 114,305,614 |   |
|                                                                                                                                                                                                                         |       |                  |        |                  |       |
| Liabilities and  Stockholders’ Equity                                                                                                                                                                                   |       |                  |        |                  |       |
| Current  liabilities:                                                                                                                                                                                                        |       |                  |        |                  |       |
| Accounts payable                                                                                                                                                                                                             |       | $                     | 196,024     |                  | $          | — |   |
| Accrued expenses                                                                                                                                                                                                             |       | 2,786,256             |        | 76,486                |       |
| Accrued income taxes                                                                                                                                                                                                         |       | —                |        | 59,852                |       |
| Deferred income taxes                                                                                                                                                                                                        |       | —                |        | 90,521                |       |
| Total current  liabilities                                                                                                                                                                                                   |       | 2,982,280             |        | 226,859               |       |
|                                                                                                                                                                                                                         |       |                  |        |                  |       |
| Common stock,  subject to possible redemption-40,000 and 3,998,000 shares at December 31,  2006 and 2005, respectively)                                                                                                      |       | 221,596               |        | 22,159,715            |       |
| Interest income  attributable to common stock subject to possible redemption (net of taxes of  $97,601 at December 31, 2005)                                                                                                 |       | 8,879                 |        | 189,462               |       |
|                                                                                                                                                                                                                         |       | 230,475               |        | 22,349,177            |       |
| Commitments and  contingencies (Note J)                                                                                                                                                                                      |       | —                |        | —                |       |
|                                                                                                                                                                                                                         |       |                  |        |                  |       |
| Stockholders’  equity:                                                                                                                                                                                                  |       |                  |        |                  |       |
| Preferred stock $.0001 par value; 1,000,000 shares  authorized; no shares issued and outstanding                                                                                                                             |       | —                |        | —                |       |
| Common stock $.0001 par value, 175,000,000 shares  authorized; 25,000,000 shares issued and outstanding (including 40,000 and  3,998,000 shares subject to possible redemption at December 31, 2006 and  2005, respectively) |       | 2,500                 |        | 2,500                 |       |
| Additional paid-in capital                                                                                                                                                                                                   |       | 113,903,630           |        | 91,098,761            |       |
| Income accumulated during the development stage                                                                                                                                                                              |       | 2,138,059             |        | 628,317               |       |
| Total  stockholders’ equity                                                                                                                                                                                             |       | 116,044,189           |        | 91,729,578            |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                             |       | $                     | 119,256,944 |                  | $          | 114,305,614 |   |

 

 **Seenotes to consolidated financial statements **

 

F-6

----

 

**KapStone Paper and PackagingCorporation(a development stage company)Consolidated Statements of Operations**

 
| ** **                                                                                          | ** ** | **Year Ended  December 31, 2006** | ** ** | **Inception  (April 15, 2005)  Through December 31, 2005** | ** ** | **Accumulated Inception  (April 15, 2005)  Through December 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| Cost and  expenses:                                                                                 |       |                                             |       |                                                                           |       |                                                                                            |       |
| Operating  expenses                                                                                 |       | $                                                | 1,975,904  |                                                                           | $          | 221,100                                                                                         |       | $ | 2,197,004 |   |
|                                                                                                |       |                                             |       |                                                                           |       |                                                                                            |       |
| Other income:                                                                                       |       |                                             |       |                                                                           |       |                                                                                            |       |
| Bank interest                                                                                       |       | 61,230                                           |       | 24,124                                                                         |       | 85,354                                                                                          |       |
| Interest on  restricted cash and cash equivalents held in trust                                     |       | 5,229,487                                        |       | 1,436,034                                                                      |       | 6,665,521                                                                                       |       |
| Total other  income                                                                                 |       | 5,290,717                                        |       | 1,460,158                                                                      |       | 6,750,875                                                                                       |       |
| Income before  provision for income taxes:                                                          |       | 3,314,813                                        |       | 1,239,058                                                                      |       | 4,553,871                                                                                       |       |
| Provision for  income taxes                                                                         |       | 1,118,905                                        |       | 421,279                                                                        |       | 1,540,184                                                                                       |       |
| Net income                                                                                          |       | 2,195,908                                        |       | 817,779                                                                        |       | 3,013,687                                                                                       |       |
|                                                                                                |       |                                             |       |                                                                           |       |                                                                                            |       |
| Interest income,  net of taxes, attributable to common stock subject to possible redemption         |       | (686,166                                         | )          | (189,462                                                                       | )          | (875,628                                                                                        | )          |
|                                                                                                |       |                                             |       |                                                                           |       |                                                                                            |       |
| Net income  attributable to holders of nonredeemable common stock                                   |       | $                                                | 1,509,742  |                                                                           | $          | 628,317                                                                                         |       | $ | 2,138,059 |   |
|                                                                                                |       |                                             |       |                                                                           |       |                                                                                            |       |
| Weighted-average  number of shares outstanding:                                                     |       |                                             |       |                                                                           |       |                                                                                            |       |
| Basic                                                                                               |       | 25,000,000                                       |       | 15,307,692                                                                     |       | 20,968,000                                                                                      |       |
| Diluted                                                                                             |       | 29,601,770                                       |       | 16,547,715                                                                     |       | 24,080,895                                                                                      |       |
| Earnings per  share:                                                                                |       |                                             |       |                                                                           |       |                                                                                            |       |
| Basic                                                                                               |       | $                                                | 0.09       |                                                                           | $          | 0.05                                                                                            |       | $ | 0.14 |   |
| Diluted                                                                                             |       | $                                                | 0.07       |                                                                           | $          | 0.05                                                                                            |       | $ | 0.13 |   |
|                                                                                                |       |                                             |       |                                                                           |       |                                                                                            |       |
| Weighted average  number of shares outstanding exclusive of shares subject to possible  redemption: |       |                                             |       |                                                                           |       |                                                                                            |       |
| Basic                                                                                               |       | 21,023,688                                       |       | 13,247,185                                                                     |       | 17,788,662                                                                                      |       |
| Diluted                                                                                             |       | 25,625,458                                       |       | 14,487,208                                                                     |       | 20,901,558                                                                                      |       |
|                                                                                                |       |                                             |       |                                                                           |       |                                                                                            |       |
| Earnings per  share exclusive of shares subject to possible redemption:                             |       |                                             |       |                                                                           |       |                                                                                            |       |
| Basic                                                                                               |       | $                                                | 0.07       |                                                                           | $          | 0.05                                                                                            |       | $ | 0.12 |   |
| Diluted                                                                                             |       | $                                                | 0.06       |                                                                           | $          | 0.04                                                                                            |       | $ | 0.10 |   |

 

 **Seenotes to consolidated financial**statements

F-7

----

****KapStone Paper and Packaging Corporation****

**(a development stage company)**

****ConsolidatedStatements of Changes in Stockholders’ Equity****

 
| ** **                                                                                                                                                                                      | ** ** | **Common Stock** | ** ** | ** ** | ** ** | ** **                             | ** ** | ** **                                                   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|----------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | **Shares**            | ** ** | **Amount** | ** ** | **Additional  Paid-In   Capital** | ** ** | **Income  Accumulated  During the  Development  Stage** | ** ** | **Total** | ** ** |
| Balance - April  15, 2005 (date of inception)                                                                                                                                                   |       | —                |       | $          | —     |                                   | $          | —                                                       |       | $ | — |   | $ | — |   |
| Initial capital  from founding stockholders                                                                                                                                                     |       | 5,000,000             |       | 500        |       | 24,500                                 |       |                                                         |       | 25,000 |   |
| Sale of  20,000,000 units and underwriter’s option (including 3,998,000 shares of  common stock subject to possible redemption), net of underwriter’s discount  and offering expenses |       | 20,000,000            |       | 2,000      |       | 113,233,976                            |       |                                                         |       | 113,235,976 |   |
| Reclassification  as a result of 3,998,000 shares of common stock being subject to possible  redemption                                                                                         |       |                  |       |       |       | (22,159,715                            | )          |                                                         |       | (22,159,715 | ) |
| Accretion of  trust fund relating to common stock subject to possible redemption                                                                                                                |       |                  |       |       |       |                                   |       | (189,462                                                     | )          | (189,462 | ) |
| Net income for  the period                                                                                                                                                                      |       |                  |       |       |       |                                   |       | 817,779                                                      |       | 817,779 |   |
|                                                                                                                                                                                            |       |                  |       |       |       |                                   |       |                                                         |       |   |   |
| **Balance  — December 31, 2005**                                                                                                                                                           |       | 25,000,000            |       | $          | 2,500      |                                   | $          | 91,098,761                                                   |       | $ | 628,317 |   | $ | 91,729,578 |   |
| Reclassification  as a result of 3,958,000 shares of common stock no longer subject to possible  redemption                                                                                     |       |                  |       |       |       | 22,804,869                             |       |                                                         |       | 22,804,869 |   |
| Accretion of  trust fund relating to common stock subject to possible redemption                                                                                                                |       |                  |       |       |       |                                   |       | (686,166                                                     | )          | (686,166 | ) |
|                                                                                                                                                                                            |       |                  |       |       |       |                                   |       |                                                         |       |   |   |
| Net income for  the period                                                                                                                                                                      |       |                  |       |       |       |                                   |       | 2,195,908                                                    |       | 2,195,908 |   |
| **Balance-December 31, 2006**                                                                                                                                                                   |       | 25,00,000             |       | $          | 2,500      |                                   | $          | 113,903,630                                                  |       | $ | 2,138,059 |   | $ | 116,044,189 |   |

 

**See notes to consolidated financial statements**

 

 

F-8

----

**KapStone Paper and Packaging Corporation(a development stage company)Consolidated Statements of CashFlows**
| ** **                                                                       | ** ** | ** **                      | ** **  | **Inception**                   | ** ** | **Accumulated  Inception**      | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------|-------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                                                       | ** ** | ** **                      | ** **  | **(April 15, 2005)**  | ** ** | **(April 15, 2005)**  | ** ** |
| ** **                                                                       | ** ** | **Year Ended**             | ** **  | **Through**                     | ** ** | **Through**                     | ** ** |
| ** **                                                                       | ** ** | **December 31, 2006** | ** **  | **December 31, 2005** | ** ** | **December 31, 2006** | ** ** |
| Operating  activities:                                                           |       |                            |        |                            |       |                            |       |
| Net income                                                                       |       | $                               | 2,195,908   |                            | $          | 817,779                         |       | $ | 3,013,687 |   |
| Deferred income taxes                                                            |       | (725,079                        | )           | 36,427                          |       | (688,652                        | )          |
| Changes in:                                                                      |       |                            |        |                            |       |                            |       |
| Interest receivable on investments held in trust                                 |       | 266,239                         |        | (266,239                        | )          | —                          |       |
| Prepaid income tax                                                               |       | (92,587                         | )           | —                          |       | (92,587                         | )          |
| Income tax refund receivable                                                     |       | (3,577                          | )           | —                          |       | (3,577                          | )          |
| Prepaid insurance                                                                |       | 99,445                          |        | (122,500                        | )          | (23,055                         | )          |
| Other prepaid expenses                                                           |       | 6,375                           |        | (6,375                          | )          | —                          |       |
| Accounts payable                                                                 |       | 196,024                         |        | —                          |       | 196,024                         |       |
| Accrued expenses                                                                 |       | 548,564                         |        | 76,486                          |       | 625,050                         |       |
| Accrued income taxes payable                                                     |       | (59,852                         | )           | 59,852                          |       | —                          |       |
| Net cash  provided by operating activities                                       |       | 2,431,460                       |        | 595,430                         |       | 3,026,890                       |       |
|                                                                             |       |                            |        |                            |       |                            |       |
| Investing  activities:                                                           |       |                            |        |                            |       |                            |       |
| Acquisition costs  paid                                                          |       | (985,631                        | )           | —                          |       | (985,631                        | )          |
| Financing fees                                                                   |       | (62,824                         | )           | —                          |       | (62,824                         | )          |
| Purchase of U.S.  government securities held in trust                            |       | (1,482,963,376                  | )           | (556,765,009                    | )          | (2,039,728,385                  | )          |
| Maturities of  U.S. government securities held in trust                          |       | 1,594,662,171                   |        | 445,066,214                     |       | 2,039,728,385                   |       |
| Cash held in  trust                                                              |       | (115,239,411                    | )           | —                          |       | (115,239,411                    | )          |
| Net cash (used  in) investing activities                                         |       | (4,589,071                      | )           | (111,698,795                    | )          | (116,287,866                    | )          |
|                                                                             |       |                            |        |                            |       |                            |       |
| Financing  activities:                                                           |       |                            |        |                            |       |                            |       |
| Proceeds from  public offering, net of expenses                                  |       | —                          |        | 113,235,876                     |       | 113,235,876                     |       |
| Proceeds from  sale of common stock to founding stockholders                     |       | —                          |        | 25,000                          |       | 25,000                          |       |
| Proceeds from  notes payable to stockholders                                     |       | —                          |        | 200,000                         |       | 200,000                         |       |
| Repayment of  notes payable to stockholders                                      |       | —                          |        | (200,000                        | )          | (200,000                        | )          |
| Proceeds from  issuance of underwriters’ option                             |       | —                          |        | 100                             |       | 100                             |       |
| Net cash  provided by financing activities                                       |       | —                          |        | 113,260,976                     |       | 113,260,976                     |       |
|                                                                             |       |                            |        |                            |       |                            |       |
| Net (decrease)  increase in cash                                                 |       | (2,157,611                      | )           | 2,157,611                       |       | —                          |       |
| Cash and cash  equivalents-beginning of period                                   |       | 2,157,611                       |        | —                          |       | —                          |       |
| Cash and cash  equivalents-end of period                                         |       | $                               | —      |                            | $          | 2,157,611                       |       | $ | — |   |
| Cash paid during  the period:                                                    |       |                            |        |                            |       |                            |       |
| Federal income  taxes                                                            |       | $                               | 1,990,000   |                            | $          | 325,000                         |       | $ | 2,315,000 |   |
| Supplemental  disclosure of non cash activities:                                 |       |                            |        |                            |       |                            |       |
| Reclassification  of common stock subject to possible redemption                 |       | $                               | (22,804,869 | )                               | $          | 22,159,715                      |       | $ | (645,154 | ) |
| Accretion of  trust fund relating to common stock subject to possible redemption |       | $                               | 686,166     |                            | $          | 189,462                         |       | $ | 875,628 |   |
| Acquisition costs  accrued                                                       |       | $                               | 2,072,532   |                            | —     |                            | $          | 2,072,532 |   |

 

**See notes to consolidated financial statements**

 

F-9

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**KapStone Paperand Packaging Corporation(a development stage company)NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note A:  Organization and Business Operations**

KapStone Paper and Packaging Corporation (formerlyStone Arcade Acquisition Corporation) or the “Company” was incorporated inDelaware on April 15, 2005.  On May 25,2006, the Company formed a wholly-owned subsidiary, KapStone Kraft PaperCorporation, or KapStone Kraft.  TheCompany was formed to serve as a vehicle for the acquisition through a merger,capital stock exchange, asset acquisition, or other similar businesscombination (“Business Combination”) of an operating business in the paper,packaging, forest products and related industries.  The Company has neither engaged in anyoperations nor generated operating revenue and is considered to be in thedevelopment stage and is subject to the risks associated with activities ofdevelopment stage companies as of December 31, 2006.  The Company selected December 31 as its fiscalyear end.

The registration statement for the Company’s initialpublic offering (the “Offering”) was declared effective on August 15,2005.  The Company consummated theOffering on August 19, 2005 and received net proceeds of approximately$113,236,000.  The Company’s managementhas broad discretion with respect to the specific application of the netproceeds of the Offering, which are intended to be generally applied toward aBusiness Combination.   As of December31, 2006, of the net proceeds, $115,239,411, including interest earned of$6,665,521, net of taxes, is being held in the Trust Account and invested inU.S. Government securities until the earlier of (i) the consummation of thefirst Business Combination or (ii) the distribution of the Trust Account asdescribed below.

The remaining proceeds may be used to pay forbusiness, legal and accounting due diligence on prospective businesscombinations and continuing general and administrative expenses.  See Note C.

**Note B:   Summary of Significant Accounting Policies**

**Principles of Consolidation and Use of Estimates**

The consolidated financial statements include theaccounts of the Company and its wholly-owned subsidiary. All intercompanyaccounts and transactions have been eliminated.

The accompanying consolidated financial statementshave been prepared by the Company and reflect all adjustments, which, in theopinion of management, are necessary for the fair presentation of the results.The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the amounts in thefinancial statements and accompanying notes. Actual results could differ from those estimates.

**Cash and cash equivalents**

All highly liquid investments with original maturitiesof three months or less are considered to be cash equivalents.

**Deferred acquisition costs**

Deferred acquisition costs include costs incurredrelating to the January 2007 purchase of Kraft Paper Business (KPB) and includelegal fees, due diligence and other costs. These costs have been capitalizedand will be included in the purchase price of the KPB acquisition.

**Earnings per common share**

Basic income per share is based on the weighted average number ofcommon shares outstanding during the period. Diluted income per share reflects the potential dilution assuming commonshares were issued upon the exercise of outstanding in-the-money warrants andthe proceeds thereof were used to purchase common shares at the average marketprice during the period.

 

F-10

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**Income Taxes**

The Company accounts for income taxes under theliability method. Accordingly, deferred income taxes are provided for thefuture tax consequences attributable to differences between the carryingamounts of assets and liabilities for financial reporting and income taxpurposes.  Deferred tax assets andliabilities are measured using tax rates in effect for the year in which thosetemporary differences are expected to be recovered or settled.  A valuation allowance is established whennecessary to reduce deferred tax assets to the amount expected to be realized.

**Note C:  Initial Public Offering**

On August 19, 2005, the Company sold 20,000,000 units(“Units”) for a gross price of $6.00 per Unit. Each Unit consists of one share of the Company’s common stock, $.0001par value, and two warrants (“Warrants”). Each Warrant entitles the holder to purchase from the Company one shareof common stock at an exercise price of $5.00. Each warrant is exercisable on the later of (a) the completion of aBusiness Combination or (b) August 15, 2006, and expires on August 15,2009.  The Warrants are redeemable at aprice of $.01 per Warrant upon 30 days notice after the Warrants becomeexercisable, only in the event that the last sale price of the common stock isat least $8.50 per share for any 20 trading days within a 30 trading day periodending on the third day prior to the date on which notice of redemption isgiven.

In connection with the Offering, the Company paid theunderwriters an underwriting discount of five percent of the gross proceeds ofthe Offering.  The Company also issuedfor $100 an option to the representative of the underwriters to purchase up toa total of 1,000,000 units at a price of $7.50 per unit.  The units issuable upon the exercise of thisoption are identical to those offered in the prospectus, except that theexercise price of the warrants included in the underwriters’ purchase option is$6.25.  This option is exercisable commencingon the later of the consummation of a Business Combination or one year from thedate of the Offering, expires five years from the date of the Offering, and maybe exercised on a cashless basis.  Theoption may not be sold, transferred, assigned, pledged or hypothecated untilAugust 16, 2006.  However, the option maybe transferred to any underwriter or selected dealer participating in theOffering and their bona fide officers or partners.

The underwriters’ purchase option and the Warrants(including the warrants underlying the underwriters’ option) will beexercisable only if at the time of exercise a current registration statementcovering the underlying securities is effective or, in the opinion of counsel,not required, and if the securities are qualified for sale or exempt fromqualification under the applicable state securities laws of the exercisingholder.  The Company is obligated to useits best efforts to maintain an effective registration statement during theterm of the option and the Warrants; however, it may be unable to do so.  Holders of the option and the Warrants arenot entitled to receive a net cash settlement or other settlement in lieu ofphysical settlement if the common stock underlying the Warrants, or securitiesunderlying the option, as applicable, are not covered by an effectiveregistration statement.  Accordingly, theWarrants, which do not have a cashless exercise provision, may expireunexercised and worthless if a current registration statement covering thecommon stock is not effective.

The holders of the option have demand and piggy-backregistration rights under the Securities Act for periods of five and sevenyears, respectively, from the date of the prospectus with respect toregistration of the securities directly and indirectly issuable upon exerciseof the option.  The exercise price andnumber of units issuable upon exercise of the option may be adjusted in certaincircumstances, including issuances of a stock dividend, recapitalization,reorganization, merger or consolidation. However, the option will not be adjusted for issuances at a price belowits exercise price.

The Company has estimated, based upon a Black Scholesmodel, that the fair value of the purchase option on the date of sale wasapproximately $980,000, using an expected life of four years, volatility of23.9 percent, and a risk-free interest rate of 3.93 percent. However, becausethe Units did not have a trading history, the volatility assumption was basedon information available to management. The volatility estimate was derived using  five-year historical stock prices for thenine companies in the Standard and Poor’s Supercomposite Paper Packaging Index.The Company believes the volatility estimate calculated from this index is areasonable benchmark to use in estimating the expected volatility of the Units;however, the use of an index to estimate volatility may not necessarily berepresentative of the volatility of the underlying securities.

The Company accounted for this purchase option,inclusive of the receipt of the $100 cash payment, as an expense of theOffering resulting in a charge directly to stockholders’ equity.  Accordingly there was no impact in theCompany’s financial position or results of operations except for the recordingof the $100 proceeds from the sale.

In accordance with a commitment entered into in connection with theOffering, the Founding Stockholders have purchased 3,500,000 warrants in thepublic marketplace.  They have furtheragreed that such warrants will not be sold or transferred until the completionof a Business Combination.

F-11

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**Note D — Accrued Expenses**

Accrued expenses at December 31, 2006 and 2005 consistof the following:

|                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|
|                       |       |     |       |     |       |
| Legal fees                 |       | $        | 1,694,659  |     | $          | — |   |
| Acquisition due  diligence |       | 372,239  |       | —   |       |
| Franchise taxes            |       | 224,021  |       | 59,021   |       |
| Proxy costs and other      |       | 223,847  |       | —   |       |
| Audit and accounting       |       | 160,637  |       | —   |       |
| Other                      |       | 110,853  |       | 17,465   |       |
| Total                      |       | $        | 2,786,256  |     | $          | 76,486 |   |

 

**Note E - Income Taxes**

The Company’s statutory tax rate is 34.0%.  The effective tax rate is 33.8% for the yearended December 31, 2006.

The provision for income taxes for the periods endedDecember 31, 2006 and 2005 consists of the following:

|           | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------|------------|----------|------------|----------|------------|
| Current:  |       |     |       |     |       |
| Federal   |       | $        | 1,817,494  |     | $          | 384,852 |   |
| State     |       | 6,423    |       | —   |       |
| Deferred: |       |     |       |     |       |
| Federal   |       | (705,012 | )          | 36,427   |       |
| Total     |       | $        | 1,118,905  |     | $          | 421,279 |   |

 

Deferred tax assets and liabilities at December 31,2006 and 2005 consist of the following:

|                                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets —  acquisition costs              |       | $        | 688,652    |     | $          | 54,094 |   |
| Deferred tax liability  — accrued interest receivable |       | —   |       | (90,521  | )          |
|                                                       |       |     |       |     |       |
| Net deferred tax asset / (liability)                       |       | $        | 688,652    |     | $          | (36,427 | ) |

 

**Note F:  Notes Payable to Stockholders**

The Company issued non-interest bearing unsecuredpromissory notes to the Founding Stockholders of the Company totaling $200,000on April 16 and April 25, 2005.  TheNotes were repaid in accordance with their terms on August 19, 2005 from theproceeds of the Offering.

**Note G:  Redemption Status of Common Stock**

The registrationstatement for the Company’s initial public offering indicated that, aftersigning a definitive agreement for the acquisition of a target business, theCompany would submit such transaction for stockholder approval. In the eventthat holders of 20 percent or more of the shares issued in the offeringvoted against the business combination and elected to redeem their shares, thebusiness combination would not be consummated. If holders of less than20 percent of the shares issued in the offering voted against the businesscombination and elected to have their shares redeemed, the business combinationwould be consummated and the shares of such holders would be redeemed at thenet offering price, $5.54, plus interest income allocable to such shares, netof income taxes. The number of shares subject to possible redemption is3,998,000. At December 31, 2005, the Company classified $22,349,177 of thenet proceeds from the initial offering plus interest, but net of taxes, ascommon

F-12

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stock subject to possibleredemption in the accompanying consolidated balance sheet. Based on the votessubmitted on December 29, 2006 (Note L), 40,000 shares voted against theproposed KPB Business Combination and as a result, $230,475 of the net proceedsfrom the initial offering plus interest have been classified as common stocksubject to redemption in the accompanying consolidated balance sheets as ofDecember 31, 2006. The stock redemption occurred in February 2007.

**Note H:  2006 Incentive Plan**

OnDecember 29, 2006, stockholders approved the 2006 Incentive Plan (“Plan”).

The Planis administered by a committee of not fewer than two members of the board ofdirectors (“Administrator”). To the extent necessary to comply with Rule 16b-3under the Securities Act of 1934, as amended and to the extent necessary toexclude Awards granted under the Plan from the calculation of the income taxdeduction limit under Section 162 (m) of the Internal Revenue Code of 1986,each member of the committee shall be an “outside director” within the meaningof Section 162 (m) of the Code and Treasury Regulations promulgated thereunder.

A maximumof 3,000,000 shares of our common stock, available for issuance pursuant tostock options, restricted stock awards or stock appreciation rights(collectively called “Awards”), may be granted under the Plan. If any Award isforfeited or expires without being exercised, or if restricted stock isrepurchased by the Company, the shares of stock subject to the Award shall beavailable for additional grants under the Plan. The number of shares availableunder the Plan is subject to adjustment in the event of any stock split, stockdividend, recapitalization, spin-off or other similar action.

Awardsmay be granted to employees, officers and directors of, and consultants oradvisors to, the Company and any subsidiary corporations. Options intended toqualify, under the standards set forth in certain federal tax rules, asincentive stock options (“ISOs”) may be granted only to employees whileactually employed the Company. Non-employee directors, consultants and advisorsare not entitled to receive ISOs.

OptionAwards granted under the Plan are exercisable for a period fixed by theAdministrator, but no longer than 10 years from the date of grant, at anexercise price which is not less than the fair market value of the shares onthe date of the grant.

No Awardswere approved in 2006 and, as a result, no stock compensation expense wasrecognized.

**NoteI:  Related-Party Transactions**

The Company agreed to pay Stone-Kaplan Investments,LLC, a company where certain of the Founding Stockholders serve in executivecapacities, an administrative fee of $7,500 per month for office space andgeneral and administrative services from August 15, 2005 through the date of aBusiness Combination.  Stone-KaplanInvestments LLC has agreed to pay a portion of the aforementionedadministration fee to Arcade Partners LLC, a company where certain of theFounding Stockholders serve in executive capacities.  From time to time, the Company retains theservices of White Oak Aviation, an aviation services company solely owned bycertain Founding Stockholders.  For theperiod from inception to December 31, 2005 and the twelve months ended December31, 2006, the amount paid to this entity was $11,829 and $80,554, respectively.

**Note J:  Commitments and Contingencies**

The Company engaged the representative of theunderwriters to act as its investment banker in connection with a BusinessCombination.  The Company agreed to paythe representative a cash fee of $1,200,000 at the closing of the BusinessCombination for assisting the Company in structuring and negotiating the termsof the transaction. The Company paid the underwriters $1,200,000 in January2007 following the consummation of the KPB acquisition (Note L).

**Note K:  Common Stock Reserved for Issuance**

At December 31, 2006, 44,000,000 shares of commonstock were reserved for issuance upon exercise of warrants, stock options andthe underwriter’s option.

F-13

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**Note L: Subsequent Event**

**KPB acquisition**

On January 2, 2007, the Company purchasedsubstantially all of the assets and assumed certain liabilities of the Kraft Papers Business, or KPB, adivision of IP, consisting of an unbleached kraft paper manufacturing facilityin Roanoke Rapids, North Carolina and Ride Rite® Converting, an inflatabledunnage bag manufacturer located in Fordyce, Arkansas, for a cash purchaseprice of $155 million plus two contingent earn-out payments of up to $35million and $25 million, based on KPB’s annual earnings before interest, incometaxes, depreciation and amortization, or EBITDA, during the five yearsimmediately following the acquisition. Any contingent earn-out payments will be accounted for as additionalpurchase price consideration. The purchase price payable on the closing datewill be adjusted dollar-for-dollar to the extent IP’s working capital as ofsuch date is greater or less than $42,637,709. KPB was deemed an attractiveacquisition candidate based on meeting the objectives of being a North Americanbased profitable operating company in the paper and packaging industry.

The Company used the proceeds of its initial publicoffering, which totals $115,239,411, including interest earned, and held intrust at December 31, 2006, together with borrowings of $60,000,000 from a$95,000,000 senior secured credit facility to acquire KPB.

**Credit facility**

On January 2, 2007, in connection with the KPBacquisition, the Company obtained a senior secured credit facility from LaSalleBank National Association.  The creditfacility currently provides the Company with the ability to borrow up to$95,000,000 pursuant to a $35,000,000 revolving loan and a $60,000,000 term loan.  Advances under the revolving line of creditare primarily based upon percentages of eligible accounts receivable andinventories.  The facility has a maturitydate of December 31, 2011.

Borrowings under the term loan accrue interest, at ouroption, at either:  LIBOR plus 1.25% to2.00% depending on the Company’s total debt to EBITDA ratio (as defined in theagreement); or the Base Rate (prime rate) plus 0% to .50% depending on KapStoneKraft’s total debt to EBITDA ratio. The Base Rate margin and LIBOR margin shalladjust quarterly upon receipt of quarterly financial statements.

**Purchase accounting**

The purchase was accounted for in accordance with theprovisions of SFAS No. 141, *Business Combinations*and SFAS No. 142, *Goodwill and Other Intangible Assets.*

The preliminary purchase price includes cash of $155million less working capital adjustments of $7.1 million plus transaction costsof $3.3 million. The following table summarizes the estimated fair value of theassets acquired and the liabilities assumed at the date of the acquisition. TheCompany is in the process of obtaining third party valuations of tangible andintangible assets acquired, thus the allocation of the purchase price ispreliminary and subject to refinement:
| Cash                           |   | $           | 1,000       |   |
|--------------------------------|--------|-------------|-------------|--------|
| Accounts receivable            |   | 30,705,000  |        |
| Inventories                    |   | 21,636,000  |        |
| Prepaid expenses               |   | 1,251,000   |        |
| Property, plant and  equipment |   | 105,855,000 |        |
| Deferred income taxes          |   | 1,191,000   |        |
| Other assets                   |   | 2,624,000   |        |
| Goodwill                       |   | 6,396,000   |        |
| Intangible Assets              |   | 700,000     |        |
| Accounts payable               |   | (7,931,000  | )           |
| Accrued expenses               |   | (6,311,000  | )           |
| Other liabilities              |   | (4,857,000  | )           |
| Allocated purchase price       |   | $           | 151,260,000 |   |

 

The intangible assets represent the value for customerlists and are planned to be amortized over 15 years.

F-14

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Note M: Summarized Quarterly Financial Information(Unaudited)

        Summarizedquarterly financial information for fiscal 2006 and 2005 are as follows: 
| ** **                                                        | ** ** | ** **               | ** ** | **Quarters Ended,**     | ** ** | ** **                   |
|-------------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|------------------------------|
| ** **                                                        | ** ** | **March 31,  2006** | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,**

**2006(1)** |
| Operating expenses                                                |       | $                        | 154,457    |                    | $          | 363,711                      |   | $ | 373,519 |   | $ | 1,084,217 |
| Other income (2)                                                  |       | 1,207,065                |       | 1,319,731               |       | 1,395,791                    |   | 1,368,130 |
| Provision for income  taxes                                       |       | 361,186                  |       | 315,696                 |       | 350,872                      |   | 91,151 |
| Net income                                                        |       | 691,422                  |       | 640,324                 |       | 671,400                      |   | 192,762 |
| Net  income allocable to holders of non-redeemable   common stock |       | 535,763                  |       | 468,994                 |       | 488,585                      |   | 16,400 |
| Diluted earnings per share of common stock                        |       | $                        | 0.02       |                    | $          | 0.02                         |   | $ | 0.02 |   | $ | 0.01 |

----

(1)   Higher operating expensesfor the quarter ended December 31, 2006 relate to start-up costsconsisting of human resources consulting costs for new benefit plans to beprovided for the employees of the KPB business.

(2)   Other income represents interest earned onfunds invested in US treasury bills and held in trust.
| ** **                                                               | ** ** | ** **                                                                                                                            | ** ** | **Quarters  Ended,**                                                                                                                  | ** ** | ** **                                                                                                        | ** ** | ** **                                                                                                        |
|--------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|
| ** **                                                               |       | **March  31,   2005**                                                                                                                 |       | **June 30,    2005(1)**                                                                                                               |       | **September  30,   2005**                                                                                         |       | **December  31,   2005**                                                                                          |   |   |
| ** **                                                               |       |                                                                                                                                  |       |                                                                                                                                  |       |                                                                                                              |       |                                                                                                              |   |   |
| Operating expenses                                                       |       | $                     — |       | $                1,000                                |       | $              37,799                       |       | $            182,301                                  |   |   |
| Other income                                                             |       | —                                                                                                                                |       | —                                                                                                                                |       | 430,180                                                                                                           |       | 1,029,978                                                                                                         |   |   |
| Provision for income taxes                                               |       | —                                                                                                                                |       | —                                                                                                                                |       | 133,070                                                                                                           |       | 288,209                                                                                                           |   |   |
| Net income / (loss)                                                      |       | —                                                                                                                                |       | (1,000                                                                                                                                | )          | 259,311                                                                                                           |       | 559,468                                                                                                           |   |   |
| Net income / (loss) allocable to holders of non-redeemable common  stock |       | —                                                                                                                                |       | (1,000                                                                                                                                | )          | 203,590                                                                                                           |       | 425,727                                                                                                           |   |   |
| Diluted earnings per share of common stock                               |       | $                     — |       | $                     — |       | $                  0.02 |       | $                  0.02 |   |   |

----

(1)    The Company was formed on April 15, 2005.Proceeds from the initial offering were received on August 19, 2005 and totaled$113,236,000. These funds were invested in US treasury bills held in trust.Other income reflects interest earned on the investment.

 

F-15

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