Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30, 2010**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition period from              to             **

 

**Commission File Number: 001-33494**

 

**KapStonePaper and Packaging Corporation**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                    | ** ** | **20-2699372**      |
|---------------------------------|------------|---------------------|
| (State or Other Jurisdiction of |       | (I.R.S. Employer    |
| Incorporation or Organization)  |       | Identification No.) |

 

**KapStone Paper and Packaging Corporation**

**1101 Skokie Blvd., Suite 300**

**Northbrook, IL 60062**

(Address of Principal Executive Offices including zip code)

 

Registrant’s Telephone Number, including area code **(847)239-8800**

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).  Yes  o No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer,” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer o                     |   | Accelerated filer x         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                       |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).  Yeso  No  x

 

Therewere 45,976,601 shares of the Registrant’s Common Stock, $0.0001 par value,outstanding as of July 30, 2010, excluding 40,000 shares held as treasuryshares.

 

 

 

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Table of Contents

 

**KapStone Paper and Packaging Corporation Index to Form 10-Q**

 

**TABLE OF CONTENTS**

 
| PART I. — FINANCIAL INFORMATION |                                                                                                         |
|-------------------------------------------|--------------------------------------------------------------------------------------------------------------|
|                                      |                                                                                                         |
|                                      | Item 1. — Consolidated Financial  Statements (Unaudited) and Notes to Consolidated Financial Statements | 1 |
|                                      |                                                                                                         |   |
|                                      | Item 2. —  Management’s Discussion and Analysis of Financial Condition and Results of  Operations  | 13 |
|                                      |                                                                                                         |   |
|                                      | Item 3. —  Quantitative and Qualitative Disclosures about Market Risk                                   | 21 |
|                                      |                                                                                                         |   |
|                                      | Item 4. —  Controls and Procedures                                                                      | 21 |
|                                      |                                                                                                         |   |
| PART II. — OTHER  INFORMATION   |                                                                                                         |
|                                      |                                                                                                         |   |
|                                      | Item 1. — Legal Proceedings                                                                             | 22 |
|                                      |                                                                                                         |   |
|                                      | Item 1A. — Risk Factors                                                                                 | 22 |
|                                      |                                                                                                         |   |
|                                      | Item 2. —  Unregistered Sales of Equity Securities and Use of Proceeds                                  | 22 |
|                                      |                                                                                                         |   |
|                                      | Item 3. — Defaults Upon Senior Securities                                                               | 22 |
|                                      |                                                                                                         |   |
|                                      | Item 4.  — Reserved                                                                                     | 22 |
|                                      |                                                                                                         |   |
|                                      | Item  5. — Other Information                                                                            | 22 |
|                                      |                                                                                                         |   |
|                                      | Item 6. — Exhibits                                                                                      | 23 |
|                                      |                                                                                                         |   |
| SIGNATURE                                 | 24                                                                                                           |

 

i

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Table of Contents

 

**PART 1.FINANCIAL INFORMATION**

 

**ITEM 1. -FINANCIAL STATEMENTS**

 

**KapStone Paper and Packaging Corporation**

**Consolidated Balance Sheet**

**(In thousands, except share and per share amounts)**

 
| ** **                                                                                                                                                                                                                                                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                | ** ** | **2010**          | ** ** | **2009**              | ** ** |
| ** **                                                                                                                                                                                                                                                                | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                                                                |       |              |       |                  |       |
| Current assets:                                                                                                                                                                                                                                                           |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                 |       | $                 | 21,888     |                  | $          | 2,440 |   |
| Trade accounts receivable, less allowances of  $1,264 in 2010 and $1,217 in 2009                                                                                                                                                                                          |       | 70,096            |       | 58,408                |       |
| Other receivables                                                                                                                                                                                                                                                         |       | 3,392             |       | 16,487                |       |
| Inventories                                                                                                                                                                                                                                                               |       | 70,044            |       | 61,377                |       |
| Refundable and prepaid income taxes                                                                                                                                                                                                                                       |       | 5,362             |       | 13,757                |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                 |       | 4,817             |       | 1,690                 |       |
| Restricted cash                                                                                                                                                                                                                                                           |       | 2,500             |       | 2,500                 |       |
| Deferred income taxes                                                                                                                                                                                                                                                     |       | 5,172             |       | 5,604                 |       |
| Total current assets                                                                                                                                                                                                                                                      |       | 183,271           |       | 162,263               |       |
|                                                                                                                                                                                                                                                                      |       |              |       |                  |       |
| Plant, property and equipment, net                                                                                                                                                                                                                                        |       | 464,351           |       | 470,278               |       |
| Other assets                                                                                                                                                                                                                                                              |       | 3,820             |       | 4,935                 |       |
| Intangible assets, net                                                                                                                                                                                                                                                    |       | 24,432            |       | 26,198                |       |
| Goodwill                                                                                                                                                                                                                                                                  |       | 4,811             |       | 5,449                 |       |
|                                                                                                                                                                                                                                                                      |       |              |       |                  |       |
| Total assets                                                                                                                                                                                                                                                              |       | $                 | 680,685    |                  | $          | 669,123 |   |
|                                                                                                                                                                                                                                                                      |       |              |       |                  |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                                                                                                                            |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                                                      |       |              |       |                  |       |
| Current portion of long-term debt                                                                                                                                                                                                                                         |       | $                 | 19,229     |                  | $          | 18,630 |   |
| Borrowings under revolving credit facility                                                                                                                                                                                                                                |       | —            |       | 7,400                 |       |
| Other current borrowings                                                                                                                                                                                                                                                  |       | 1,285             |       | —                |       |
| Accounts payable                                                                                                                                                                                                                                                          |       | 57,417            |       | 52,147                |       |
| Accrued expenses                                                                                                                                                                                                                                                          |       | 18,654            |       | 20,800                |       |
| Accrued compensation costs                                                                                                                                                                                                                                                |       | 12,948            |       | 7,719                 |       |
| Total current liabilities                                                                                                                                                                                                                                                 |       | 109,533           |       | 106,696               |       |
|                                                                                                                                                                                                                                                                      |       |              |       |                  |       |
| Other liabilities:                                                                                                                                                                                                                                                        |       |              |       |                  |       |
| Long-term debt, net of current portion                                                                                                                                                                                                                                    |       | 103,570           |       | 121,031               |       |
| Pension and post-retirement benefits                                                                                                                                                                                                                                      |       | 6,402             |       | 5,949                 |       |
| Deferred income taxes                                                                                                                                                                                                                                                     |       | 44,800            |       | 38,577                |       |
| Other liabilities                                                                                                                                                                                                                                                         |       | 51,560            |       | 48,080                |       |
| Total other liabilities                                                                                                                                                                                                                                                   |       | 206,332           |       | 213,637               |       |
|                                                                                                                                                                                                                                                                      |       |              |       |                  |       |
| Commitments and contingencies                                                                                                                                                                                                                                             |       | —            |       | —                |       |
| 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; 45,969,136 shares issued and outstanding (40,000 treasury shares  outstanding) at June 30, 2010 and 45,418,074 issued and outstanding  (40,000 treasury shares outstanding) at December 31, 2009 |       | 5                 |       | 5                     |       |
| Additional paid-in capital                                                                                                                                                                                                                                                |       | 222,403           |       | 219,828               |       |
| Retained earnings                                                                                                                                                                                                                                                         |       | 142,530           |       | 129,046               |       |
| Accumulated other comprehensive loss                                                                                                                                                                                                                                      |       | (118              | )          | (89                   | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                           |       | 364,820           |       | 348,790               |       |
|                                                                                                                                                                                                                                                                      |       |              |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                           |       | $                 | 680,685    |                  | $          | 669,123 |   |

 

See notes to consolidated financial statements

 

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**KapStone Paper and Packaging Corporation**

**Consolidated Statement of Income**

**(In thousands, except share and per share amounts)**

 

**(unaudited)**

 
| ** **                                              | ** ** | **Three  Months Ended June 30,** | ** ** | **Six  Months Ended June 30,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                              | ** ** | **2010**                                   | ** ** | **2009**                                 | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                    |       |                                       |       |                                     |       |   |   |   |   |
| Net sales                                               |       | $                                          | 199,119    |                                     | $          | 156,493 |   | $ | 375,618 |   | $ | 297,077 |   |
| Cost of sales,  excluding depreciation and amortization |       | 146,684                                    |       | 88,354                                   |       | 276,985 |   | 184,838 |   |
| Freight and  distribution expenses                      |       | 20,048                                     |       | 13,165                                   |       | 36,118 |   | 26,493 |   |
| Selling, general  and administrative expenses           |       | 8,942                                      |       | 7,630                                    |       | 16,041 |   | 16,187 |   |
| Depreciation and  amortization                          |       | 11,149                                     |       | 13,488                                   |       | 22,495 |   | 27,097 |   |
| Gain/(loss) on  sale of business                        |       | —                                     |       | (704                                     | )          | — |   | 16,695 |   |
| Other operating  income                                 |       | 227                                        |       | 216                                      |       | 510 |   | 448 |   |
| Operating income                                        |       | 12,523                                     |       | 33,368                                   |       | 24,489 |   | 59,605 |   |
| Foreign exchange  gain/(loss)                           |       | (532                                       | )          | 171                                      |       | (898 | ) | (127 | ) |
| Interest income                                         |       | 9                                          |       | —                                   |       | 18 |   | 1 |   |
| Interest expense                                        |       | 1,301                                      |       | 5,011                                    |       | 2,938 |   | 10,744 |   |
| Income before  provision for income taxes               |       | 10,699                                     |       | 28,528                                   |       | 20,671 |   | 48,735 |   |
| Provision for  income taxes                             |       | 3,606                                      |       | 10,416                                   |       | 7,187 |   | 19,511 |   |
|                                                    |       |                                       |       |                                     |       |   |   |   |   |
| Net income                                              |       | $                                          | 7,093      |                                     | $          | 18,112 |   | $ | 13,484 |   | $ | 29,224 |   |
|                                                    |       |                                       |       |                                     |       |   |   |   |   |
| Weighted-average  number of shares outstanding:         |       |                                       |       |                                     |       |   |   |   |   |
| Basic                                                   |       | 45,917,254                                 |       | 28,370,298                               |       | 45,700,323 |   | 28,370,273 |   |
| Diluted                                                 |       | 47,004,892                                 |       | 28,646,527                               |       | 46,813,744 |   | 28,563,291 |   |
| Net income per  share:                                  |       |                                       |       |                                     |       |   |   |   |   |
| Basic                                                   |       | $                                          | 0.15       |                                     | $          | 0.64 |   | $ | 0.30 |   | $ | 1.03 |   |
| Diluted                                                 |       | $                                          | 0.15       |                                     | $          | 0.63 |   | $ | 0.29 |   | $ | 1.02 |   |

 

See notes to consolidated financial statements

 

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**KapStone Paper and Packaging Corporation**

**Consolidated Statement of Cash Flows**

**(In thousands)**

 

**(unaudited)**

 
| ** **                                                                                   | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                   | ** ** | **2010**                           | ** ** | **2009** | ** ** |
| **Operating activities**                                                                     |       |                               |       |   |   |
| Net income                                                                                   |       | $                                  | 13,484     |   | $ | 29,224 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                               |       |   |   |
| Depreciation and amortization                                                                |       | 22,495                             |       | 27,097 |   |
| Stock based compensation expense                                                             |       | 2,157                              |       | 1,034 |   |
| Amortization of debt issuance costs                                                          |       | 1,259                              |       | 1,678 |   |
| Loss on disposal of fixed assets                                                             |       | 460                                |       | 288 |   |
| Deferred income taxes                                                                        |       | 6,655                              |       | 11,345 |   |
| Gain on sale of dunnage bag business                                                         |       | —                             |       | (16,695 | ) |
| Changes in operating assets and liabilities:                                                 |       |                               |       |   |   |
| Trade accounts receivable, net                                                               |       | (11,688                            | )          | 9,627 |   |
| Other receivables                                                                            |       | 13,240                             |       | (11,017 | ) |
| Inventories                                                                                  |       | (8,667                             | )          | 18,794 |   |
| Refundable and prepaid income taxes                                                          |       | 8,395                              |       | 9,371 |   |
| Prepaid expenses and other current assets                                                    |       | (3,127                             | )          | (1,181 | ) |
| Other assets                                                                                 |       | (199                               | )          | — |   |
| Accounts payable                                                                             |       | 5,270                              |       | (5,852 | ) |
| Accrued expenses and other                                                                   |       | 3,033                              |       | (13,328 | ) |
| Accrued compensation costs                                                                   |       | 5,229                              |       | (4,502 | ) |
| Accrued income taxes                                                                         |       | —                             |       | 6,904 |   |
| Net cash provided by (used in) operating  activities                                         |       | 57,996                             |       | 62,787 |   |
|                                                                                         |       |                               |       |   |   |
| **Investing activities**                                                                     |       |                               |       |   |   |
| CKD acquisition                                                                              |       | 638                                |       | 1,000 |   |
| KPB earn-out                                                                                 |       | —                             |       | (3,977 | ) |
| Proceeds from sale of dunnage bag business                                                   |       | —                             |       | 36,083 |   |
| Restricted cash                                                                              |       | —                             |       | (2,500 | ) |
| Capital expenditures                                                                         |       | (15,504                            | )          | (12,910 | ) |
| Net cash provided by (used in) investing  activities                                         |       | (14,866                            | )          | 17,696 |   |
|                                                                                         |       |                               |       |   |   |
| **Financing activities**                                                                     |       |                               |       |   |   |
| Proceeds from revolving credit facility                                                      |       | 76,700                             |       | 61,300 |   |
| Repayments on revolving credit facility                                                      |       | (84,100                            | )          | (73,700 | ) |
| Repayments of long-term debt                                                                 |       | (17,986                            | )          | (49,731 | ) |
| Proceeds from other current borrowings                                                       |       | 2,564                              |       | — |   |
| Repayments on other current borrowings                                                       |       | (1,279                             | )          | — |   |
| Payment of withholding taxes on vested restricted  stock awards                              |       | (624                               | )          | — |   |
| Proceeds from the exercises of stock options                                                 |       | 544                                |       | — |   |
| Excess tax benefits from stock based compensation                                            |       | 388                                |       | — |   |
| Debt issuance costs                                                                          |       | —                             |       | (370 | ) |
| Other                                                                                        |       | 111                                |       | — |   |
| Net cash provided by (used in) financing  activities                                         |       | (23,682                            | )          | (62,501 | ) |
|                                                                                         |       |                               |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                        |       | 19,448                             |       | 17,982 |   |
| Cash and cash equivalents-beginning of period                                                |       | 2,440                              |       | 4,165 |   |
| Cash and cash equivalents-end of period                                                      |       | $                                  | 21,888     |   | $ | 22,147 |   |

 

See notes to consolidated financial statements

 

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**KAPSTONE PAPER AND PACKAGING CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**(In thousands, except share and per share amounts)**

 

**(unaudited)**

 

**1.****             ****FinancialStatements**

 

Theaccompanying unaudited consolidated financial statements of KapStone Paper andPackaging Corporation (the “Company,” “we,” “us,” “our” or “KapStone”) havebeen prepared in accordance with U.S. generally accepted accounting principlesfor interim financial information, the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all ofthe information and footnotes required by generally accepted accountingprinciples for complete financial statements. In the opinion of management, alladjustments (consisting of a normal recurring nature) considered necessary fora fair presentation have been included. Operating results for the three and sixmonths ended June 30, 2010 are not necessarily indicative of the resultsthat may be expected for the year ended December 31, 2010. For furtherinformation, refer to the consolidated financial statements and relatedfootnotes included in our Annual Report on Form 10-K for the year endedDecember 31, 2009.

 

**2.****             ****Recent AccountingPronouncements**

 

InJanuary 2010, the Financial Accounting Standards Board (“FASB”) issuedAccounting Standard Update (“ASU”) No. 2010-06, “Fair Value Measurementsand Disclosures,” which amends the disclosure requirements related to recurringand nonrecurring fair value measurements.  The guidance requiresdisclosure of transfers of assets and liabilities between Level 1 and Level 2of the fair value measurement hierarchy, including the reasons and the timingof the transfers and information on purchases, sales, issuance, and settlementson a gross basis in the reconciliation of the assets and liabilities measuredunder Level 3 of the fair value measurement hierarchy. The guidance iseffective for annual and interim reporting periods beginning after December 15,2009, except for Level 3 reconciliation disclosures which are effective forannual and interim periods beginning after December 15, 2010. Theimplementation of this standard did not have a material impact on theconsolidated financial statements.

 

InDecember 2007, the FASB issued SFAS No. 141(R), *Business Combinations* (“SFASNo. 141(R)”). This guidance is included in FASB ASC 805, *Business Combinations*. This guidancerequires the Company to continue to follow the guidance in SFAS No. 141(also included in FASB ASC 805) for certain aspects of business combinations,and provides additional guidance defining the acquirer, recognizing andmeasuring the identifiable assets acquired, the liabilities assumed, anynoncontrolling interest in the acquiree, assets and liabilities arising fromcontingencies, defining a bargain purchase and recognizing and measuringgoodwill or a gain from a bargain purchase. This guidance also requirestransaction costs to be charged to earnings and requires contingent considerationto be recorded at its fair value on the acquisition date. In addition, underthis guidance, adjustments associated with changes in tax contingencies thatoccur after the measurement period, not to exceed one year, are recorded asadjustments to income. This guidance is effective for all business combinationsfor which the acquisition date is on or after the beginning of an entity’sfirst fiscal year that begins after December 15, 2008; however, theguidance regarding the treatment of income tax contingencies is retrospectiveto business combinations completed prior to 2009.  No businesscombinations occurred during the six months ended June 30, 2010.

 

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**3.****             ****AlternativeFuel Mixture Tax Credit**

 

A summary of alternative fuel mixture tax credits (“AFTC”) recognizedin the consolidated financial statements for the three and six months ended June 30,2010 and 2009 is as follows:

 
| ** **                                                                                                                                       | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                                       | ** ** | **2010**                                   | ** ** | **2009**                                 | ** ** | **2010** | ** ** | **2009** | ** ** |
| Gallons of fuel burned (000’s) (unaudited)                                                                                                  |       | —                                     |       | 91,343                                   |       | — |   | 139,161 |   |
| Tax credit for each gallon burned                                                                                                                |       | —                                     |       | $                                        | 0.50       |   | — |   | $ | 0.50 |   |
| Total alternative fuel mixture tax credit  generated (1)                                                                                         |       | $                                          | —     |                                     | $          | 45,671 |   | $ | — |   | $ | 69,580 |   |
| Recognition of tax credit deferred in  March 31, 2009 inventory                                                                             |       | —                                     |       | 18,465                                   |       | — |   | — |   |
| Recognition of tax credit deferred in  December 31, 2009 inventory                                                                          |       | —                                     |       | —                                   |       | 14,260 |   | — |   |
| Tax credit related to inorganic content burned in  2009                                                                                          |       | 40                                         |       | —                                   |       | 7,935 |   | — |   |
| Tax credit deferred in ending inventory at  June 30, 2009                                                                                   |       | —                                     |       | (15,574                                  | )          | — |   | (15,574 | ) |
| Total alternative fuel mixture tax credits  included as a reduction to cost of sales for three and six months ended  June 30, 2010 and 2009 |       | $                                          | 40         |                                     | $          | 48,562 |   | $ | 22,195 |   | $ | 54,006 |   |

 

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(1) The alternate fuel mixture tax credit expired onDecember 31, 2009.

 

AtDecember 31, 2009 the Company included $14.3 million of AFTC as areduction to the cost of inventory based on its FIFO accounting policy. Noamounts were deferred in inventory at June 30, 2010.

 

TheCompany earned an additional $7.9 million AFTC during 2009 based on a U.S.Internal Revenue Service (“IRS”) Advice Memorandum released on March 12,2010 which indicated that the portion of inorganic content included in the fuelburned was eligible for a $0.50 per gallon refund. The Company had excludedthis amount when submitting refunds during 2009. Inorganic content representedabout 4% of the total gallons burned in 2009. The Company received $7.9 millionfrom the IRS in the six months ended June 30, 2010.

 

**4.****             ****PlannedMaintenance Outage**

 

Costof sales for the six months ended June 30, 2010 included approximately$6.8 million for the tri-annual planned maintenance outage for the Company’sSouth Carolina paper mill.

 

**5.****             ****Inventories**

 

Inventoriesconsist of the following at June 30, 2010, and December 31, 2009,respectively:

 
| ** **                     | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
|--------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                     | ** ** | **2010**          | ** ** | **2009**              | ** ** |
| Raw materials                  |       | $                 | 19,005     |                  | $          | 13,082 |   |
| Work in process                |       | 548               |       | 980                   |       |
| Finished goods                 |       | 30,521            |       | 27,475                |       |
| Replacement parts and supplies |       | 19,970            |       | 19,840                |       |
| Inventories                    |       | $                 | 70,044     |                  | $          | 61,377 |   |

 

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**6.****             ****DerivativeInstruments and Hedging Activities**

 

TheCompany uses derivative instruments to manage its foreign currency exchangerisks associated with euro-denominated sales of its U.S. operations. Foreigncurrency forward contracts are used to hedge the variability of exchange rateson the Company’s cash flows and foreign exchange forward contracts are used tooffset the impact on earnings relating to the variability in exchange rates oneuro-denominated sales.  The derivativeinstruments are valued using Level 2 inputs which are significant observableinputs for similar assets and liabilities in active markets. The Company doesnot acquire or issue derivative financial instruments for trading purposes.

 

The foreign currencyforward contracts are designated as cash flow hedges.  The contracts are recorded in theconsolidated balance, measured at fair value. The effective portion of the gain or loss on the derivative is recordedas a component of accumulated other comprehensive income (“AOCI”) in theaccompanying consolidated balance sheet and is reclassified into net sales inthe consolidated statement of income upon recognition of the hedged sales. Theforeign currency forward contracts outstanding have monthly maturity datesthrough December 31, 2010. The effectiveness of these forward contractsare assessed both at inception and on a quarterly basis to ensure that they areeffective in offsetting changes in the cash flows attributable to the hedgedrisk.

 

The notional amount ofthese foreign currency forward contracts was $18.3 million and $0 at June 30,2010 and December 31, 2009, respectively. The estimated pre-tax gain to berecognized in earnings during the next twelve months upon settlement of theforward contracts is $0.1 million.

 

The Company’s foreignexchange forward contracts, which are not designated as qualifying accountinghedges, are recorded at fair value with changes in the fair value of thesecontracts recognized in earnings.

 

Forconsolidated financial statement presentation, net cash flows from such hedgesare classified in the categories of the consolidated statement of cash flowswith the items being hedged.

 

Thetable below lists the fair value and location of the Company’s derivativeinstruments in the consolidated balance sheet:

 
| **Derivatives designated as  hedging instruments** | ** ** | **Balance Sheet  Account** | ** ** | **Fair Value  at 6/30/2010** | ** ** | **Fair Value  at 12/31/2009** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|------------------------------|------------|-------------------------------|------------|
| Foreign currency forward contracts                 |       | Other receivables          |       | $                            | 140        |                          | $          | — |   |
| Total                                              |       |                       |       | $                            | 140        |                          | $          | — |   |

 
| **Derivatives not designated as  hedging instruments** | ** ** | **Balance Sheet  Account** | ** ** | **Fair Value  at 6/30/2010** | ** ** | **Fair Value  at 12/31/2009** | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|------------------------------|------------|-------------------------------|------------|
| Foreign exchange forward contracts                     |       | Trade accounts receivable  |       | $                            | 34         |                          | $          | — |   |
| Total                                                  |       |                       |       | $                            | 34         |                          | $          | — |   |

 

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Thetable below presents the pre-tax effect of derivative instruments and theirlocation within the consolidated statement of income for the six months endedJune 30, 2010 and 2009:

 
| ** **                                                                                          | ** ** | **Foreign currency  cash flow hedges** | ** ** | **Foreign**** ****exchange  derivatives not  designated as hedges** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2010**                                              | ** ** | **2009**                                                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| Gain (loss) recognized in other comprehensive loss  (effective portion)                             |       | $                                                     | 145        |                                                                                    | $          | — |   | $ | — |   | $ | — |   |
|                                                                                                |       |                                                  |       |                                                                                    |       |   |   |   |   |
| Gain (loss) reclassified to earnings from  accumulated other comprehensive loss (effective portion) |       | $                                                     | —     |                                                                                    | $          | — |   | $ | — |   | $ | — |   |
| Gain (loss) recognized in earnings (1)                                                              |       | (4                                                    | )          | —                                                                                  |       | 34 |   | — |   |
| Total gain (loss) recognized in earnings                                                            |       | $                                                     | (4         | )                                                                                       | $          | — |   | $ | 34 |   | $ | — |   |

 

----

| (1) | Represents  amounts excluded from effectiveness testing for foreign currency cash flow  hedges and derivative instruments not designated as hedges. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------|

 

**7.     Long-Term Debt**

 

Forthe three months ended June 30, 2010, long-term debt repayments totaled$3.8 million. For the six months ended June 30, 2010, long-term debtrepayments totaled $18.0 million including a $10.0 million voluntaryprepayment. In connection with the voluntary prepayment, $0.3 million of debtissuance costs were amortized.

 

At June 30, 2010 thecarrying amount and fair value of the Company’s long-term debt was $103.6million and $83.4 million, respectively. At December 31, 2009 the carrying amount and fair value of theCompany’s long term debt was $121.0 million and $94.8 million, respectively.The fair value of the Company’s long-term debt was estimated using an incomeapproach based on current interest rates available to the Company for debt ofsimilar terms and maturities.

 

**8.     Income Taxes**

 

TheCompany’s U.S. federal statutory income tax rate is 35% for 2010 and 2009. TheCompany’s effective tax rate for the six months ended June 30, 2010 and2009 was 34.8% and 40.0%, respectively.  The differences between theeffective tax rate and the federal statutory tax rate for the six months ended June 30,2010 were due to the benefit related to the refundable tax credit from theinorganic content of the black liquor burned in 2009 and a higher expectedbenefit from the domestic manufacturing deduction.

 

Differencesbetween the effective tax rate and the federal statutory tax rate for the sixmonths ended June 30, 2009 were due to the impact of state tax net offederal benefit, the domestic manufacturing tax deduction and a discrete itemrelating to the sale of the dunnage bag business.

 

Thegross unrecognized tax benefits, including interest as of June 30, 2010increased by $5.8 million to $68.8 million from $63.0 million at December 31,2009.  Unrecognized tax benefits of $68.8 million were included inother long term liabilities in the accompanying consolidated balance sheet.

 

Inthe normal course of business, we are subject to examination by taxingauthorities. The Company’s open tax years are 2006 through 2009. The Company’stax returns for 2007, 2008 and 2009 are currently under examination by theInternal Revenue Service.

 

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**9.  ** **Net IncomePer Share**

 

Basicand diluted net income per share is calculated as follows:

 
| ** **                                                               | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                               | ** ** | **2010**                                            | ** ** | **2009**                                          | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net income                                                               |       | $                                                   | 7,093      |                                              | $          | 18,112 |   | $ | 13,484 |   | $ | 29,224 |   |
| Weighted-average number of common shares for basic  net income per share |       | 45,917,254                                          |       | 28,370,298                                        |       | 45,700,323 |   | 28,370,273 |   |
| Incremental effect of dilutive common stock  equivalents:                |       |                                                |       |                                              |       |   |   |   |   |
| Unexercised stock options                                                |       | 727,812                                             |       | —                                            |       | 646,564 |   | — |   |
| Underwriter’s purchase option                                       |       | —                                              |       | —                                            |       | 108,423 |   | — |   |
| Unvested restricted stock awards                                         |       | 359,826                                             |       | 276,229                                           |       | 358,434 |   | 193,018 |   |
|                                                                     |       |                                                |       |                                              |       |   |   |   |   |
| Weighted-average number of shares for diluted net  income per share      |       | 47,004,892                                          |       | 28,646,527                                        |       | 46,813,744 |   | 28,563,291 |   |
|                                                                     |       |                                                |       |                                              |       |   |   |   |   |
| Net income per share – basic                                        |       | $                                                   | 0.15       |                                              | $          | 0.64 |   | $ | 0.30 |   | $ | 1.03 |   |
|                                                                     |       |                                                |       |                                              |       |   |   |   |   |
| Net income per share – diluted                                      |       | $                                                   | 0.15       |                                              | $          | 0.63 |   | $ | 0.29 |   | $ | 1.02 |   |

 

Commonstock warrants were not included in the calculation of diluted earnings pershare for the three and six months ended June 30, 2009 since the weightedaverage share price per share of common stock was $3.68 and $2.81,respectively, compared to the warrant’s conversion price of $5.00, and theeffect would be anti-dilutive.  Thecommon stock warrants expired on August 17, 2009.

 

Unexercisedstock options totaling 2.2 million were outstanding during the three and sixmonths ended June 30, 2009, but were not included in the computation ofdiluted earnings per share because the options were not-in-the-money.

 

InMarch 2010, the underwriter’s purchase option was exercised and convertedinto 348,393 shares of common stock. Underwriter’s purchase option of 1,000,000units were outstanding at June 30, 2009, but were not included in thecomputation of diluted earnings per share because the option was not-in-themoney for the three and six month periods ended June 30, 2009.

 

**10.    Pension Plan and Post Retirement Benefits**

 

**Defined Benefit Pension Plan**

 

TheKapStone Paper and Packaging Corporation Defined Benefit Pension Plan (“PensionPlan”) provides benefits for approximately 1,000 union employees.

 

Netpension cost recognized for the three and six months ended June 30, 2010and 2009 for the Pension Plan, is as follows:

 
| ** **                                         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                         | ** ** | **2010**                                       | ** ** | **2009**                                | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                               |       |                                           |       |                                    |       |   |   |   |   |
| Service cost for benefits earned during the period |       | $                                              | 715        |                                    | $          | 703 |   | $ | 1,430 |   | $ | 1,442 |   |
| Interest cost on projected benefit obligation      |       | 141                                            |       | 93                                      |       | 282 |   | 186 |   |
| Expected return on plan assets                     |       | (129                                           | )          | (38                                     | )          | (257 | ) | (76 | ) |
| Amortization of prior service cost                 |       | 10                                             |       | —                                  |       | 20 |   | — |   |
| Net pension cost                                   |       | $                                              | 737        |                                    | $          | 758 |   | $ | 1,475 |   | $ | 1,552 |   |

 

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KapStonefunds its Pension Plan according to Internal Revenue Service fundingrequirements. Based on those limitations, KapStone has funded $1.2 million forthe six months ended June 30, 2010 and expects to fund an additional $2.9million to the Pension Plan in 2010.

 

**Other Post-retirement Benefits**

 

Netpost-retirement cost recognized for each of the three and six months ended June 30,2010 and 2009 for the Company’s retiree medical and life insurance plan wasless than $0.1 million.

 

**Defined Contribution Plans**

 

The KapStone Defined Contribution Plan (“Contribution Plan”) covers alleligible employees. Company monthly contributions to the Contribution Plan arebased on the matching of employee contributions, vest immediately for salaried,non-bargained hourly and certain union employees, and vest after three yearsfor other union employees. For the three months ended June 30, 2010 and2009, the Company recognized expense of $0.9 million and $0.4 million,respectively, for matching contributions. For the six months ended June 30, 2010 and 2009, the Companyrecognized expense of $1.9 million and $1.2 million, respectively, for matchingcontributions.

 

The Company’s Retirement Savings Plan (“Savings Plan”), which coversall eligible salaried and non-bargained hourly employees, provides for anannual contribution based on an employee’s salary and age.  The Company contributions vest 100% afterthree years. For the three and six months ended June 30, 2010, the Companyrecognized expense of $0.5 million and $1.0 million, respectively. EffectiveFebruary 1, 2009, the Company temporarily suspended contributions to theSavings Plan due to economic conditions, and as a result, no expense wasrecognized during the three and six months ended June 30, 2009. TheCompany reinstated contributions to the Savings Plan in November 2009.

 

**11.         Stock-Based Compensation**

 

OnMay 27, 2010, stockholders approved the Amended and Restated 2006Incentive Plan to increase the maximum shares of common stock available forissuance under the 2006 Plan to 5.7 million shares.

 

TheCompany accounts for stock awards in accordance with ASC 718, *Compensation – Stock Compensation*, which requires that thecost resulting from all share-based payment transactions be recognized ascompensation cost over the vesting period based on the fair value of theinstrument on the date of grant. The Company recognized $1.6 million and $2.2million of non-cash compensation cost for the three and six months ended June 30,2010, respectively, and $0.5 million and $1.0 million for the three and sixmonths ended June 30, 2009, respectively.

 

**Stock Options**

 

InMay 2010, the Company’s Compensation Committee granted 450,098 stockoptions to directors, executive officers and employees of the Company.  The stock options vest as follows: 50% aftertwo years and the remaining 50% after three years or upon reaching age65.  The stock options awarded in 2010 have a contractual term of tenyears. The stock options are subject to forfeiture should the recipientterminate his or her employment with the Company for certain reasons prior tovesting in their awards, or the occurrence of certain other events such astermination with cause. The exercise price of these stock options is based onthe closing market price of our common stock on the date of grant ($11.36 forthe 2010 awards) and compensation expense is recorded on an accelerated basisover the awards’ vesting periods.

 

Theweighted average fair value of the KapStone stock options granted in May 2010was $4.90. The fair value was calculated using the Black-Scholes-Mertonoption-pricing model based on the market price at the grant date and theweighted average assumptions specific to the underlying options. The expectedvolatility assumption is based on volatility of related industry stocks. TheCompany uses the “simplified method”, defined in SEC Staff Accounting Bulletin(“SAB”) No. 107, to determine the expected life assumption for all of itsoptions.  The Company uses the “simplified method”, as permitted by SAB No. 110,as it does not have historical exercise data to provide a reasonable basis uponwhich to estimate expected life due to the limited time its equity shares havebeen publicly traded. The risk-free interest rate was selected based uponyields of U.S. Treasury issues with a term similar to the expected life of thestock options.

 

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Theassumptions utilized for calculating the fair value of stock options during theperiod are as follows:

 
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                   | ** ** | **June 30, 2010**      | ** ** |
| KapStone Stock Options Black-Scholes-Merton  assumptions (weighted average): |       |                        |       |
| Expected volatility                                                          |       | 41.54                       | %          |
| Expected life (years)                                                        |       | 5.94                        |       |
| Risk-free interest rate                                                      |       | 2.42                        | %          |
| Expected dividend yield                                                      |       | —                      | %          |

 

The following tablesummarizes stock options amounts and activity:

 
| ** **                               | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Weighted**          | ** ** | **Intrinsic**        | ** ** |
|------------------------------------------|------------|-------------|------------|--------------|------------|-----------------------|------------|----------------------|------------|
| ** **                               | ** ** | ** **  | ** ** | **Average**  | ** ** | **Average**           | ** ** | **Value**            | ** ** |
| ** **                               | ** ** | ** **  | ** ** | **Exercise** | ** ** | **Remaining**         | ** ** | **(dollars in** | ** ** |
| ** **                               | ** ** | **Options** | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Thousands)**       | ** ** |
| **Outstanding at January 1,  2010** |       | 2,162,077   |       | $            | 5.66       |                  | 7.6        |                 | $          | 9,029 |   |
| Granted                                  |       | 450,098     |       | 11.36        |       | 9.9                   |       |                 |       |
| Exercised                                |       | (80,236     | )          | 6.77         |       |                  |       |                 |       |
| Forfeited                                |       | (5,528      | )          | 4.91         |       |                  |       |                 |       |
| **Outstanding at June 30, 2010**    |       | 2,526,411   |       | $            | 6.64       |                  | 7.7        |                 | $          | 11,377 |   |
| **Exercisable at June 30, 2010**    |       | 975,177     |       | $            | 7.33       |                  | 5.9        |                 | $          | 3,719 |   |

 

Totalstock-based compensation related to the stock option grants was $0.9 millionand $1.2 million for the three and six months ended June 30, 2010,respectively, and $0.3 million and $0.6 million for the three and six monthsended June 30, 2009, respectively.

 

Asof June 30, 2010 and 2009, there was $2.5 million and $2.1 million,respectively, of total unrecognized compensation cost related to non-vestedstock options. The cost is expected to be recognized over a weighted averageperiod of 2.0 years.

 

**Restricted Stock**

 

InMay 2010, the Company’s Compensation Committee granted 166,534 restrictedstock units to executive officers, directors and employees as compensation forservice. These restricted stock units are restricted as to transferabilityuntil they vest three years from the grant date or upon reaching age 65. Theserestricted stock units are subject to forfeiture should these employeesterminate their employment with the Company for certain reasons prior tovesting in their awards, or the occurrence of certain other events. The valueof these restricted stock units is based on the closing market price of our commonstock on the date of grant and compensation expense is recorded on astraight-line basis over the awards’ vesting periods.

 

Thefollowing table summarizes restricted stock amounts and activity:

 
| ** **                               | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|------------------------------------------|------------|------------|------------|--------------|------------|
| ** **                               | ** ** | ** ** | ** ** | **Average**  | ** ** |
| ** **                               | ** ** | **Units/** | ** ** | **Grant**    | ** ** |
| ** **                               | ** ** | **Shares** | ** ** | **Price**    | ** ** |
| **Outstanding at January 1,  2010** |       | 585,669    |       | $            | 5.68       |   |
| Granted                                  |       | 166,534    |       | 11.36        |       |
| Vested                                   |       | (213,464   | )(1)       | 7.64         |       |
| Forfeited                                |       | (1,780     | )          | 4.95         |       |
| **Outstanding at June 30, 2010**    |       | 536,959    |       | $            | 6.94       |   |

 

----

(1) Includes 40,714 of restricted stock unitsthat immediately vested upon issuance in May 2010 for awardees age 65 or older.

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Totalstock-based compensation related to the restricted stock awards was $0.7million and $1.0 million for the three and six months ended June 30, 2010,respectively, and $0.2 million and $0.4 million for the three and six monthsended June 30, 2009, respectively.

 

Asof June 30, 2010 and 2009, there was $2.1 million and $1.8 million,respectively, of total unrecognized compensation cost related to the restrictedstock. The cost will be recognized over the remaining vesting period of 1.8years.

** **

**12.   Stockholder’s Equity**

 

In connection with the Company’s initial public offering on August 19,2005, the Company issued for $100 an option to the representative of theunderwriters to purchase up to a total of 1,000,000 units at a price of $7.50per unit. Each unit consisted of one share of the Company’s common stock,$0.0001 par value, and two warrants. The warrants expired on August 17,2009, but were not exercised. In March 2010, the purchase option wasexercised at a market price of $11.51 per share.  The purchase option was exercised on acashless basis and therefore no cash proceeds were received by theCompany.  Accordingly, 348,393 shares ofcommon stock were issued in March 2010.

 

Forthe three and six months ended June 30, 2010, exercises of employee stockoptions totaled 31,786 shares and 80,236 shares, respectively, with cashproceeds to the Company of $0.3 million and $0.5 million, respectively.

 

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**13.   SegmentInformation**

 

The Company has one reportable segment, unbleached kraft. Theunbleached kraft segment consists of the Company’s paper mills in RoanokeRapids, North Carolina and North Charleston, South Carolina, which producekraft paper, linerboard, saturating kraft and unbleached folding carton board.These products are sold to customers who convert our products into end marketfinished products.

 

In the table below, “Other” represents the Company’s dunnage bagbusiness, which was sold on March 31, 2009.

 

The Company’s reportable and operating segment is based on financialinformation regularly evaluated by the chief operating decision maker indetermining resource allocation and assessing performance, in accordance withASC 805, “*Segment Reporting*.” Inthe third quarter 2009, the Company revised its reporting structure. Segmentdisclosures have been revised to conform to the current presentation for allreporting periods.

 
| ** **                       | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **Operating Segment:**      | ** ** | **2010**                                            | ** ** | **2009**                                          | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales:                       |       |                                                |       |                                              |       |   |   |   |   |
| Unbleached kraft                 |       | $                                                   | 199,119    |                                              | $          | 156,493 |   | $ | 375,618 |   | $ | 291,049 |   |
| Other                            |       | —                                              |       | —                                            |       | — |   | 6,927 |   |
| Intersegment sales               |       | —                                              |       | —                                            |       | — |   | (899 | ) |
|                             |       |                                                |       |                                              |       |   |   |   |   |
| Total                            |       | $                                                   | 199,119    |                                              | $          | 156,493 |   | $ | 375,618 |   | $ | 297,077 |   |
|                             |       |                                                |       |                                              |       |   |   |   |   |
| Net sales to external customers: |       |                                                |       |                                              |       |   |   |   |   |
| Unbleached kraft                 |       | $                                                   | 199,119    |                                              | $          | 156,493 |   | $ | 375,618 |   | $ | 290,194 |   |
| Other                            |       | —                                              |       | —                                            |       | — |   | 6,883 |   |
|                             |       |                                                |       |                                              |       |   |   |   |   |
| Total                            |       | $                                                   | 199,119    |                                              | $          | 156,493 |   | $ | 375,618 |   | $ | 297,077 |   |
|                             |       |                                                |       |                                              |       |   |   |   |   |
| Operating income / (loss):       |       |                                                |       |                                              |       |   |   |   |   |
| Unbleached kraft                 |       | $                                                   | 18,684     |                                              | $          | 39,397 |   | $ | 35,439 |   | $ | 53,293 |   |
|                             |       |                                                |       |                                              |       |   |   |   |   |
| Other                            |       | —                                              |       | —                                            |       | — |   | 748 |   |
| Gain/(loss) on sale of business  |       | —                                              |       | (704                                              | )          | — |   | 16,695 |   |
| Corporate                        |       | (6,161                                              | )          | (5,325                                            | )          | (10,950 | ) | (11,131 | ) |
|                             |       |                                                |       |                                              |       |   |   |   |   |
| Total                            |       | $                                                   | 12,523     |                                              | $          | 33,368 |   | $ | 24,489 |   | $ | 59,605 |   |

 
| ** **             | ** ** | **(Unaudited)********June 30,** | ** ** | **December 31,** | ** ** |
|------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| **Operating Segment:** | ** ** | **2010**                             | ** ** | **2009**              | ** ** |
| Total assets:          |       |                                 |       |                  |       |
| Unbleached kraft       |       | $                                    | 636,854    |                  | $          | 638,050 |   |
| Corporate              |       | 43,831                               |       | 31,073                |       |
|                   |       |                                 |       |                  |       |
| Total                  |       | $                                    | 680,685    |                  | $          | 669,123 |   |

 

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**Item 2. — MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

ThisQuarterly Report on Form 10-Q includes forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended. We have based theseforward-looking statements on our current expectations and projections aboutfuture events. These forward-looking statements are subject to known andunknown risks, uncertainties and assumptions about us that may cause our actualresults, levels of activity, performance or achievements to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by such forward-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. Factorsthat might cause or contribute to such a discrepancy include, but are notlimited to, those described in Part I Item 1A of our Form 10-K forthe fiscal year ended December 31, 2009 and in our other Securities andExchange Commission filings.  Theinformation contained in this Form 10-Q represents our best judgment atthe date of this report based on information currently available.  In providing forward-looking statements,KapStone does not intend, and does not undertake any duty or obligations, toupdate its statements as a result of new information, future events orotherwise.

 

Thefollowing discussion should be read in conjunction with our Consolidated FinancialStatements and related Notes thereto included elsewhere in this report.

 

**Comparison of Results of Operations for the Three MonthsEnded June 30, 2010 and the Three Months Ended June 30, 2009**

 
| ** **                                              | ** ** | **Three Months Ended June 30,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):**                     | ** ** | **2010**                             | ** ** | **2009**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                    | 199,119    |          | $          | 156,493 |   | $ | 42,626 |   |
| Cost of sales, excluding depreciation and  amortization |       | 146,684                              |       | 88,354        |       | 58,330 |   |
| Freight and distribution expenses                       |       | 20,048                               |       | 13,165        |       | 6,883 |   |
| Selling, general and administrative expenses            |       | 8,942                                |       | 7,630         |       | 1,312 |   |
| Depreciation and amortization                           |       | 11,149                               |       | 13,488        |       | (2,339 | ) |
| Gain (loss) on sale of business                         |       | —                               |       | (704          | )          | 704 |   |
| Other operating income                                  |       | 227                                  |       | 216           |       | 11 |   |
| Operating income                                        |       | 12,523                               |       | 33,368        |       | (20,845 | ) |
| Foreign exchange gain/(loss)                            |       | (532                                 | )          | 171           |       | (703 | ) |
| Interest income                                         |       | 9                                    |       | —        |       | 9 |   |
| Interest expense                                        |       | 1,301                                |       | 5,011         |       | (3,710 | ) |
| Income before provision for income taxes                |       | 10,699                               |       | 28,528        |       | (17,829 | ) |
| Provision for income taxes                              |       | 3,606                                |       | 10,416        |       | (6,810 | ) |
| Net income                                              |       | $                                    | 7,093      |          | $          | 18,112 |   | $ | (11,019 | ) |

 

Netsales for the quarter ended June 30, 2010 were $199.1 million compared to$156.5 million for the second quarter of 2009, an increase of $42.6 million or27.2%. The increase in net sales was driven by $23.7 million of higher salesvolume in the second quarter of 2010 compared to the second quarter of 2009,mainly due to increased demand reflecting improving economic conditions, $12.2million due to higher average selling prices and $8.0 million due to a morefavorable product mix reflecting a lower percentage of export linerboard sales.Exchange rates negatively impacted net sales by $1.3 million.

 

Costof sales, excluding depreciation and amortization expense, for the quarterended June 30, 2010 was $146.7 million compared to $88.4 million for thesecond quarter of 2009, an increase of $58.3 million, or 66.0%. The increase incost of sales was mainly due to a $48.5 million decrease in alternative fuelmixture tax credits (the tax credit expired on December 31, 2009), $7.9million from increased sales volume and a $2.4 million increase in compensationand benefit costs as the Company reinstated certain benefits in November 2009and January 2010. Partially offsetting the increase in cost of sales was$0.8 million due to deflation on input costs.

 

Freightand distribution expenses for the quarter ended June 30, 2010 totaled$20.0 million compared to $13.2 million for the quarter ended June 30,2009. The increase of $6.8 million was primarily due to $3.4 million reflectinga 14.5% increase in sales volume, $1.8 million due to product mix and $1.6million due to inflation.

 

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Selling,general and administrative expenses for the quarter ended June 30, 2010totaled $8.9 million compared to $7.6 million for the quarter ended June 30,2009. The increase of $1.3 million reflects $1.6 million of higher compensationand benefit expenses as the Company reinstated certain benefits in November 2009and January 2010 and $1.0 million of higher stock compensation expense.Partially offsetting the increase in selling, general and administrativeexpense was a $1.4 million reduction in expense for the termination oftransitional services provided by MeadWestvaco in the fourth quarter of 2009.

 

Depreciationand amortization for the quarter ended June 30, 2010 totaled $11.1 millioncompared to $13.5 million for the quarter ended June 30, 2009. Thedecrease of $2.4 million was due to lower intangible asset amortization. TheCompany acquired a coal contract with below market prices in conjunction withthe Charleston Kraft Division (“CKD”) acquisition. The contract and relatedamortization expired on December 31, 2009.

 

Gain(loss) on sale of business reflects a working capital adjustment of $0.7million for the three months ended June 30, 2009 in connection with thesale of the dunnage bag business.  Thedunnage bag business was sold in March 2009.

 

Foreign exchange losses for the three months ended June 30, 2010were $0.5 million compared to a foreign exchange gain of $0.2 millionfor the three months ended June 30, 2009. The change reflects the impactof a strengthening U.S. dollar compared to the euro in 2010.

 

Interestexpense for the quarters ended June 30, 2010 and 2009 was $1.3 million and$5.0 million, respectively. Interest expense reflects interest on the Company’ssenior credit agreement and amortization of debt issuance costs. Interestexpense was $3.7 million lower in the quarter ended June 30, 2010primarily due to lower debt balances resulting from $280 million of debtrepayments in 2009.

 

Provisionfor income taxes for the quarters ended June 30, 2010 and 2009 was $3.6million and $10.4 million, respectively, reflecting an effective tax rate of33.7% for the quarter ended June 30, 2010 compared to 36.5% for the sameperiod in 2009. The lower provision for income taxes in 2010 reflects a $17.8million reduction in pre-tax income. The lower effective tax rate in 2010 isdue to the benefit related to the refundable tax credit from the inorganiccontent of black liquor burned in 2009 and a higher expected benefit from thedomestic manufacturing deduction.

 

**Segment Results**

 

Thefollowing table presents a reconciliation of consolidated net sales andoperating income to amounts reported by operating segment:

 
| ** **                           | ** ** | **Three Months Ended June 30,** | ** **  |
|--------------------------------------|------------|--------------------------------------|-------------|
| **Operating Segment ($000’s):** | ** ** | **2010**                             | ** **  | **2009** | ** ** |
| Consolidated net sales:              |       |                                 |        |   |   |
| Unbleached kraft                     |       | $                                    | 199,119     |   | $ | 156,493 |   |
|                                 |       |                                 |        |   |   |
| **Total net sales**                  | ** ** | **$**                                | **199,119** | ** ** | **$** | **156,493** | ** ** |
|                                 |       |                                 |        |   |   |
| Operating income / (loss):           |       |                                 |        |   |   |
| Unbleached kraft                     |       | $                                    | 18,684      |   | $ | 39,397 |   |
| Gain/(loss) on sale of business      |       | —                               |        | (704 | ) |
| Corporate                            |       | (6,161                               | )           | (5,325 | ) |
|                                 |       |                                 |        |   |   |
| **Total operating income**           | ** ** | **$**                                | **12,523**  | ** ** | **$** | **33,368** | ** ** |

 

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Thefollowing represents analysis and commentary for results of operations for theCompany’s operating segment.

 

***Unbleached Kraft***

 
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| Net sales                       |       | $                                    | 199,119    |   | $ | 156,493 |   |
| Operating income                |       | $                                    | 18,684     |   | $ | 39,397 |   |
| Operating income % of net sales |       | 9.4                                  | %          | 25.2 | % |
|                            |       |                                 |       |   |   |
| Average revenue per ton         |       | $                                    | 585        |   | $ | 529 |   |
| Tons of paper sold              |       | 325,657                              |       | 284,514 |   |

 

Forthe quarter ended June 30, 2010, unbleached kraft segment net salesincreased by $42.6 million, or 27.2%, to $199.1 million compared to $156.5million for the quarter ended June 30, 2009. The increase in net sales wasmainly due to $23.7 million of higher sales volume, resulting from an increaseof 41,143 tons of paper sold, $12.2 million from higher average selling pricesand $8.0 million due to a more favorable product mix reflecting a lowerpercentage of export linerboard sales partially offset by $1.3 million due toforeign exchange rates. Average selling prices in the second quarter of 2010 of$585 per ton were $56 per ton higher than average selling prices in the secondquarter of 2009 and $50 per ton above average selling prices in the quarterended March 31, 2010, reflecting full realization of kraft paper andlinerboard price increases announced in late 2009 and early 2010. The Companyexpects to fully realize a $60 per ton price increase for kraft paper andlinerboard announced in April 2010 in the quarter ended September 30,2010.

 

Unbleachedkraft segment operating income decreased by $20.7 million, or 52.5%, to $18.7million for the quarter ended June 30, 2010 compared to $39.4 million forthe quarter ended June 30, 2009. The decrease in operating income wasprimarily due to a $48.5 million decrease in alternative fuel mixture taxcredits (the tax credit expired on December 31, 2009), a $2.8 millionincrease in compensation and benefit costs as the Company reinstated certainbenefits in November 2009 and January 2010 and $1.3 million due toforeign exchange rates. Partially offsetting the decrease in operating incomewas $12.4 million of higher sales volume, $12.2 million from higher average sellingprices and $6.2 million due to a more favorable product mix.

 

Forthe quarter ended June 30, 2010, operating income as a percentage of netsales declined to 9.4% from 25.2% for the second quarter of 2009, mainly due toa decrease in alternative fuel mixture tax credits partially offset by higheraverage selling prices.

 

***Corporate***

 

Corporateoperating expense for the quarter ended June 30, 2010 totaled $6.2 millioncompared to $5.3 million for the three months ended June 30, 2009. Theincrease of $0.9 million reflects $1.2 million of higher compensation andbenefit expenses as the Company reinstated certain benefits in 2010 that weretemporarily suspended in 2009 as a result of poor economic conditions and $1.0million of higher stock compensation expense. Partially offsetting these increases in corporate expenses was a $1.4million reduction in expense for the termination of transitional servicesprovided by MeadWestvaco in the fourth quarter of 2009.

 

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**Comparison of Results of Operations for the Six Months Ended June 30,2010 and the Six Months Ended June 30, 2009**

** **
| ** **                                              | ** ** | **Six Months Ended June 30,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):** | ** ** | **2010**                                          | ** ** | **2009**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                                 | 375,618    |          | $          | 297,077 |   | $ | 78,541 |   |
| Cost of sales, excluding depreciation and  amortization |       | 276,985                                           |       | 184,838       |       | 92,147 |   |
| Freight and distribution expenses                       |       | 36,118                                            |       | 26,493        |       | 9,625 |   |
| Selling, general and administrative expenses            |       | 16,041                                            |       | 16,187        |       | (146 | ) |
| Depreciation and amortization                           |       | 22,495                                            |       | 27,097        |       | (4,602 | ) |
| Gain on sale of business                                |       | —                                            |       | 16,695        |       | (16,695 | ) |
| Other operating income                                  |       | 510                                               |       | 448           |       | 62 |   |
| Operating income                                        |       | 24,489                                            |       | 59,605        |       | (35,116 | ) |
| Foreign exchange gain/(loss)                            |       | (898                                              | )          | (127          | )          | 771 |   |
| Interest income                                         |       | 18                                                |       | 1             |       | 17 |   |
| Interest expense                                        |       | 2,938                                             |       | 10,744        |       | (7,806 | ) |
| Income before provision for income taxes                |       | 20,671                                            |       | 48,735        |       | (28,064 | ) |
| Provision for income taxes                              |       | 7,187                                             |       | 19,511        |       | (12,324 | ) |
| Net income                                              |       | $                                                 | 13,484     |          | $          | 29,224 |   | $ | (15,740 | ) |

 

Netsales for the six months ended June 30, 2010 were $375.6 million comparedto $297.1 million for the first six months of 2009, an increase of $78.5million or 26.4%. The increase in net sales was driven by $82.3 million ofhigher sales volume in the first six months of 2010 compared to the first sixmonths of 2009, mainly due to increased demand reflecting improving economicconditions, and $3.6 million of a more favorable product mix.  Partially offsetting the increase in netsales was $6.9 million due to the sale of the dunnage bag business in March 2009.

 

Costof sales, excluding depreciation and amortization expense, for the six monthsended June 30, 2010 was $277.0 million compared to $184.8 million for thefirst six months of 2009, an increase of $92.2 million, or 49.9%. The increasein cost of sales was mainly due to $50.0 million from increased sales volume, a$31.8 million decrease in alternative fuel mixture tax credits (the tax creditexpired December 31, 2009), $6.8 million related to the Charleston milltri-annual planned maintenance outage which occurred in March 2010, a $4.0million increase in compensation and benefit costs as the Company reinstatedcertain benefits in November 2009 and January 2010 and $3.4 milliondue to inflation on input costs. Partially offsetting the increase in cost ofsales was $5.5 million of lower costs due to the sale of the dunnage bagbusiness.

 

Freightand distribution expenses for the six months ended June 30, 2010 totaled$36.1 million compared to $26.5 million for the six months ended June 30,2009. The increase of $9.6 million was primarily due to $7.5 million reflectinga 27.9% increase in sales volume, $1.3 million due to inflation and $1.2million due to product mix, partially offset by $0.4 million due to the sale ofthe dunnage bag business.

 

Selling,general and administrative expenses for the six months ended June 30, 2010totaled $16.0 million compared to $16.2 million for the six months ended June 30,2009. The decrease of $0.2 million reflects $3.0 million for the termination oftransitional services provided by MeadWestvaco in the fourth quarter of 2009,$0.4 million of lower bad debts and $0.3 million related to the sale of thedunnage bag business. Partially offsetting these decreases in selling, generaland administrative expense was $2.4 million of higher compensation and benefitexpenses as the Company reinstated certain benefits in November 2009 and January 2010that were previously suspended as a result of poor economic conditions in early2009 and $1.1 million of higher stock compensation expense.

 

Depreciationand amortization for the six months ended June 30, 2010 totaled $22.5million compared to $27.1 million for the six months ended June 30, 2009.The decrease of $4.6 million was primarily due to $4.9 million of lowerintangible asset amortization. The Company acquired a coal contract with belowmarket prices in conjunction with the CKD acquisition. The contract and relatedamortization expired on December 31, 2009.

 

The$16.7 million gain on sale of a business for the six months ended June 30,2009 was the result of the sale of the dunnage bag business to Illinois ToolWorks Inc. in March 2009.

 

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Foreign exchange losses for the six months ended June 30, 2010were $0.9 million compared to a foreign exchange loss of $0.1 millionfor the six months ended June 30, 2009. The change reflects the impact ofa strengthening U.S. dollar in 2010 compared to the euro.

Interestexpense for the six months ended June 30, 2010 and 2009 was $2.9 millionand $10.7 million, respectively. Interest expense reflects interest on theCompany’s senior credit agreement and amortization of debt issuance costs.Interest expense was $7.8 million lower in the six months ended June 30,2010 primarily due to lower debt balances and interest rates.

 

Provisionfor income taxes for the six months ended June 30, 2010 and 2009 was $7.2million and $19.5 million, respectively, reflecting an effective tax rate of34.8% for the six months ended June 30, 2010 compared to 40.0% for thesame period in 2009. The lower provision for income taxes mainly reflects a$28.1 million reduction in pre-tax income. The lower effective tax rate in 2010is due to the benefit related to the refundable tax credit from the inorganiccontent of black liquor burned in 2009 and a higher expected benefit from thedomestic manufacturing deduction.

 

**Segment Results**

 

Thefollowing table presents a reconciliation of consolidated net sales andoperating income to amounts reported by operating segment:

 
| ** **                           | ** ** | **Six Months Ended June 30,** | ** **  |
|--------------------------------------|------------|------------------------------------|-------------|
| **Operating Segment ($000’s):** | ** ** | **2010**                           | ** **  | **2009** | ** ** |
| Consolidated net sales:              |       |                               |        |   |   |
| Unbleached kraft                     |       | $                                  | 375,618     |   | $ | 291,049 |   |
| Other                                |       | —                             |        | 6,927 |   |
| Intersegment sales                   |       | —                             |        | (899 | ) |
|                                 |       |                               |        |   |   |
| **Total net sales**                  | ** ** | **$**                              | **375,618** | ** ** | **$** | **297,077** | ** ** |
|                                 |       |                               |        |   |   |
| Operating income / (loss):           |       |                               |        |   |   |
| Unbleached kraft                     |       | $                                  | 35,439      |   | $ | 53,293 |   |
| Other                                |       | —                             |        | 748 |   |
| Gain on sale of business             |       | —                             |        | 16,695 |   |
| Corporate                            |       | (10,950                            | )           | (11,131 | ) |
|                                 |       |                               |        |   |   |
| **Total operating income**           | ** ** | **$**                              | **24,489**  | ** ** | **$** | **59,605** | ** ** |

 

Thefollowing represents analysis and commentary for results of operations for theCompany’s operating segment.

 

***Unbleached Kraft***

 
| ** **                      | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------|------------|------------------------------------|------------|
| ** **                      | ** ** | **2010**                           | ** ** | **2009** | ** ** |
| Net sales                       |       | $                                  | 375,618    |   | $ | 291,049 |   |
| Operating income                |       | $                                  | 35,439     |   | $ | 53,293 |   |
| Operating income % of net sales |       | 9.4                                | %          | 18.3 | % |
|                            |       |                               |       |   |   |
| Average revenue per ton         |       | $                                  | 560        |   | $ | 558 |   |
| Tons of paper sold              |       | 641,962                            |       | 501,926 |   |

 

Forthe six months ended June 30, 2010, unbleached kraft segment net salesincreased by $84.6 million, or 29.1%, to $375.6 million compared to $291.0million for the six months ended June 30, 2009. The increase in net saleswas mainly due to $82.3 million of higher sales volume resulting from anincrease of 140,036 tons of paper sold, and $3.6 million of a more favorableproduct mix due to a lower percentage of export linerboard sales.

 

Unbleachedkraft segment operating income decreased by $17.9 million, or 33.5%, to $35.4million for the six months ended June 30, 2010 compared to $53.3 millionfor the six months ended June 30, 2009. Operating income decreasedprimarily due to $31.8 million from lower alternate fuel mixture tax credits,$6.8 million related to the Charleston mill tri-annual planned maintenanceoutage, $3.4 million of inflation on input costs and $4.7 million of highercompensation and benefit expenses as the Company reinstated certain benefits inNovember 2009 and January 2010 that were previously suspended inearly 2009.

 

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Thedecrease in operating income was partially offset by $24.8 million from highersales volume, $4.9 million related to decreased amortization expense related toan expired intangible asset, $2.4 million of a more favorable product mix dueto a lower percentage of export linerboard sales and $0.4 million of lower baddebts.

 

Forthe six months ended June 30, 2010, operating income as a percentage ofnet sales declined to 9.4% from 18.3% for the first six months of 2009, mainlydue to a lower alternative fuel mixture tax credit and the tri-annual plannedmaintenance outage at the Charleston mill.

 

***Other***

 

Otherincludes the Company’s former dunnage bag business which was sold on March 31,2009 to Illinois Tool Works, Inc.

 

***Corporate***

 

Corporateoperating expense for the six months ended June 30, 2010 totaled $11.0million compared to $11.1 million for the six months ended June 30, 2009.The decrease of $0.1 million was due to $3.0 million for the termination oftransitional services provided by MeadWestvaco in the fourth quarter of 2009partially offset by $1.7 million of higher compensation and benefit expenses asthe Company reinstated certain benefits in 2010 that were temporarily suspendedin 2009 as a result of poor economic conditions and $1.1 million of higherstock compensation expense.

 

**Liquidity and Capital Resources**

 

***Senior Credit Agreement***

 

Weentered into a Senior Credit Agreement, dated as of June 12, 2008. TheSenior Credit Agreement provides for an aggregate of up to $515 millionconsisting of a $390 million term A loan facility, a $25 million term B loanfacility and a $100 million revolving credit facility, including a letter ofcredit subfacility (collectively, the “Senior Credit Facilities”).  The Senior Credit Facilities are guaranteedby KapStone Kraft and our other domestic subsidiaries and are secured bysubstantially all of our assets, including all of our capital stock, thecapital stock of our guarantor subsidiaries and up to 66% of the capital stockof our foreign subsidiaries.

 

Inaddition, $40 million of 8.3% seven year senior notes were issued in July 2008as part of the financing for the CKD acquisition and were extinguished in July 2009using cash from operations.

 

Forthe six months ended June 30, 2010, the Company made a $10.0 millionvoluntary loan prepayment on the term loan facility. The Company does notexpect to make any additional voluntary prepayments for the balance of 2010.

 

***Debt Covenants***

 

Underthe financial covenants of the Senior Credit Agreement, KapStone must comply ona quarterly basis with a maximum permitted leverage ratio of 3.0 to 1. TheSenior Credit Agreement also includes a financial covenant requiring a minimumfixed charge coverage ratio that is 1.1 to 1. As of June 30, 2010, the Company was in compliance with the SeniorCredit Agreement with a leverage ratio of 0.82 to 1 and a fixed charge coverageratio of 5.64 to 1.

 

AtJune 30, 2010, the Company was in compliance with all other applicablecovenants in the Senior Credit Agreement.

 

***Other Borrowings***

 

For the six months ended June 30,2010, the Company reduced its revolving credit facility by $7.4 million. TheCompany utilizes its revolving credit facility for general business purposes.

 

OnJanuary 5, 2010, the Company entered into a twelve month financingagreement of $2.6 million at an annual interest rate of 1.62% for the Company’sannual property insurance premium. The agreement requires the Company to makeconsecutive monthly repayments of $0.2 million through the term of thefinancing agreement ending on December 1, 2010. As of June 30, 2010,$1.3 million was outstanding under this agreement.

 

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***Restricted Cash***

 

OnMarch 31, 2009, the Company consummated the sale of its dunnage bagbusiness to Illinois Tool Works Inc. for $36.0 million less$1.1 million of working capital adjustments. As a condition of sale,$2.5 million of the sale proceeds are being held in escrow untilSeptember 30, 2010 to be available to satisfy any losses or indemnityclaims that may arise against the Company in connection with the sale. TheCompany expects the full $2.5 million held in escrow to be returned on September 30,2010.

 

***Alternative Fuel Mixture Tax Credit***

 

Based on a U.S. InternalRevenue Service Advice Memorandum released on March 12, 2010, the Companywas eligible to receive an additional $7.9 million tax credit related toinorganic content burned in 2009. The inorganic content, which representedabout 4% of the total gallons burned, was excluded from refunds submitted in2009. The Company recorded this benefit in pre-tax income during the quarterended March 31, 2010. The Company received this refund in May 2010.

 

The alternative fuelmixture tax credit expired on December 31, 2009.

 

***Income taxes***

 

The Company has recorded a $68.8 million tax contingency reserveat June 30, 2010 for an unrecognized tax benefit relating to thetaxability of alternative fuel mixture tax credits (“AFTC”). The Company hastaken the position that the AFTC is similar to a federal excise tax and as aresult is not taxable. To date, the Internal Revenue Service has not issuedguidance concerning this issue.

 

The Companyreceived a $13.2 million federal income tax refund in June 2010.  No additional refunds are expected during2010.

 

InDecember 2009, the Company filed its registration as a cellulosic biofuelproducer for the year 2009 and is awaiting approval. The cellulosic biofuel taxcredit (“CBTC”), under Section 40(b)(6) of the Internal Revenue Service (“IRS”)Code, is a $1.01 per gallon credit for cellulosic biofuel producers. The IRSrecently indicated in a memorandum dated June 28, 2010 that black liquorqualifies for the cellulosic biofuel producer credit.  However, the IRS stated any gallon of blackliquor claimed as an AFTC would not qualify for the CBTC.  The IRS is expected to provide guidance forconverting AFTC’s to cellulosic credits for qualifying producers.  KapStone claimed the AFTC for all gallons ofblack liquor produced once its AFTC registrations were approved in early2009.  At this time, the Companyestimates a $22 million potential future after-tax credit for CBTC relating toblack liquor burned in 2009 prior to the Company’s AFTC registrations beingapproved.  If the Company were to receiveany tax credits related to cellulosic biofuel it would be realized by reducingincome tax payable beginning in late 2010.

 

***Sources and Uses of Cash***

 
| **Six months ended June 30 ($000’s)** | ** ** | **2010**   | ** ** | **2009**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating activities                            |       | $          | 57,996     |       | $          | 62,787 |   |
| Investing activities                            |       | (14,866    | )          | 17,696     |       |
| Financing activities                            |       | (23,682    | )          | (62,501    | )          |
|                                                 |            |            |            |            |            |  |  |

 

Cashand cash equivalents increased by $19.4 million from December 31, 2009,reflecting $58.0 million of net cash provided by operating activities, $14.9million of net cash used in investing activities and $23.7 million of net cashused in financing activities.

 

Netcash provided by operating activities was $58.0 million primarily due to $13.5million of net income for the first six months of 2010, $33.0 million ofnon-cash charges and $11.5 million of changes in operating assets andliabilities. Net cash provided by operating activities decreased by $4.8million in the six months ended June 30, 2010 compared to the six monthsended June 30, 2009 due to a $15.7 million reduction in net income, an$8.3 million increase of non-cash charges primarily due to a $16.7 million gainon the sale of the dunnage bag business in March 2009 and a $2.7 millionincrease of changes in operating assets and liabilities primarily due to $10.9million for the alternative fuel mixture tax credit receivable.

 

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Netcash used in investing activities was $14.9 million reflecting $15.5 million ofcapital expenditures partially offset by $0.6 million received fromMeadWestvaco relating to the CKD acquisition. For the six months ended June 30,2010, capital expenditures included $13.5 million for equipment upgrades andreplacements at the paper mills. In addition, $2.0 million was spent on ITsystems projects.  Net cash provided byinvesting activities decreased by $32.6 million in the six months ended June 30,2010 compared to the six months ended June 30, 2009 mainly due to $36.1million of proceeds received from the sale of the dunnage bag business in thefirst quarter of 2009.

 

Netcash used in financing activities was $23.7 million and reflects $18.0 millionof term loan repayments including a $10.0 million voluntary prepayment and $7.4million of net repayments on the revolving credit facility partially offset by$1.3 million of net other borrowings and $0.5 million of proceeds fromexercises of stock options. Net cash used in financing activities decreased by$38.8 million in the six months ended June 30, 2010 compared to the sixmonths ended June 30, 2009 due to a lower amount of debt and revolverrepayments in the first six months of 2010.

 

***Future Cash Needs***

 

Weexpect that cash generated from operating activities, and if needed, theability to draw from our revolving credit facility will be sufficient to meetthe anticipated 2010 cash needs. The Company expects to spend approximately $17.8million on capital expenditures for the balance of 2010. In addition, theCompany has $9.6 million of required long-term debt repayments for the balanceof 2010 and expects to fund an additional $2.9 million to its defined benefitpension plan.

 

 

**Off-Balance Sheet Arrangements**

 

Wehave not entered into any off-balance sheet financing arrangements and have notestablished any special purpose entities. We have not guaranteed any debt orcommitments of other entities or entered into any options on non-financialassets.

 

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**Item 3. — QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

Marketrisk is the sensitivity of income to changes in interest rates, commodityprices, equity prices, and other market-driven rates or prices.

 

UnderKapStone Kraft’s Senior Credit Facilities, we have two term loans totaling$126.9 million outstanding at June 30, 2010. The maturity date is the earlier of: (a) June 12, 2013 with respect to the term A loan facility and therevolving credit facility, and June 12, 2015 with respect to the term B loanfacility, and (b) the date which is 90 days prior to the date on which anyearn-out, obligations to International Paper Company will become (or are reasonablyexpected to become) due, provided that the maturity date will not be soaccelerated if, among other things, the total leverage ratio as of the end ofthe then most recent fiscal quarter, is less than 2.0 to 1.0.

 

Changesin market rates may impact the base rate in our Senior Credit Agreement. Forinstance, if the bank’s LIBOR rate was to increase or decrease by onepercentage point (1.0%), our annual interest expense would change byapproximately $1.2 million based upon our expected future monthly loan balancesper our existing repayment schedule.

 

Weare exposed to price fluctuations of certain commodities used in production.Key raw materials and energy used in the production process include roundwoodand woodchips, fuel oil, electricity and caustic soda.  We purchase these raw materials and energy atmarket prices, and do not use forward contracts or other financial instrumentsto hedge our exposure to price risk related to these commodities.  We have two contracts to purchase coal atfixed prices that expire on December 31, 2010.

 

We are exposed to price fluctuations in the price of our finishedgoods. The prices we charge for our products are primarily based on marketconditions.

 

Weare exposed to currency fluctuations as we invoice certain European customersin euros. The Company uses foreign currency forward contracts and foreignexchange forward contracts to manage some of the foreign currency exchangerisks associated with foreign sales of its U.S. operations. Using such foreigncurrency forward contracts, the Company receives or pays the difference betweenthe contracted forward rate and the exchange rate at the settlement date. Thesecontracts are used to hedge the variability of exchange rates on the Company’scash flows.

 

**Item 4. —CONTROLS AND PROCEDURES**

 

Asof the end of the period covered by this report, our Chief Executive Officerand our Chief Financial Officer carried out an evaluation of the effectivenessof the design and operation of our disclosure controls and procedures, as requiredby Rule 13a-15(b) under the Securities Exchange Act of 1934. Based upon thatevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures were effective as of June 30, 2010.

 

Therewere no changes in our internal control over financial reporting during thethree months ended June 30, 2010 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II. —OTHER INFORMATION**

 

**Item 1. — LEGAL PROCEEDINGS**

 

None.

 

**Item 1A. — RISK FACTORS**

 

Therehave been no material changes from the Risk Factors described in our Form 10-Kfor the year ended December 31, 2009.

 

**Item 2. — UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS**

 

None.

 

**Item 3. — DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**Item 4. — RESERVED**

 

**Item 5. — OTHER INFORMATION**

 

None.

 

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**PART II. — OTHER INFORMATION**

 

**Item 6. — EXHIBITS**

 

Thefollowing Exhibits are filed as part of this report.

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                         |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                    |
| 10.1             |       | 2009  Employee Stock Purchase Plan (Incorporated by reference to Appendix A of the  Registrants’s Definitive Proxy Statement filed on April 15, 2010).                             |
|             |       |                                                                                                                                                                                    |
| 10.2             |       | Amended  and Restated 2006 Incentive Plan (Incorporated by reference to Appendix B of  the Registrant’s Definitive Proxy Statement filed on April 15, 2010).                       |
|             |       |                                                                                                                                                                                    |
| 31.1             |       | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a) under the Securities  Exchange Act of 1934, as Adopted Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                                                                    |
| 31.2             |       | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a) under the Securities  Exchange Act of 1934, as Adopted Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                                                                    |
| 32.1             |       | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                    |
|             |       |                                                                                                                                                                                    |
| 32.2             |       | Certification  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                    |

 

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**SIGNATURE**

 

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|           |   | KAPSTONE  PAPER AND PACKAGING CORPORATION   |
|----------------|--------|---------------------------------------------|
|           |   |                                        |
|           |   |                                        |
| August 4, 2010 | By:    | /s/  Andrea K. Tarbox                       |
|           |   | Andrea  K. Tarbox                           |
|           |   | Vice  President and Chief Financial Officer |

 

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