Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
| **x** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|--------------------------------------------------------------------------------------------------------|

 

**For thequarterly period ended June 30, 2009**

 
| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|---------------------------------------------------------------------------------------------------------|

 

**For thetransition period from              to             **

 

**Commission File Number: 001-33494**

 

**KapStone Paper and PackagingCorporation**

(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 Officesincluding zip code)

 

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

 

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theExchange Act during the preceding 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months(or for such shorter period that the registrant was required to submit and postsuch files).  Yes  o No o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See definitions of “large accelerated filer,” “acceleratedfiler,” and “smaller reporting 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) |   |                             |

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

 

There were 28,370,348 shares of the Registrant’sCommon Stock, $0.0001 par value, outstanding as of July 24, 2009,excluding 40,000 shares held as treasury shares.

 

 

 

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**KapStone Paper and PackagingCorporation 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    | 11     |
|                                                                                                          |   |
| Item 3. — Quantitative and Qualitative Disclosures  about Market Risk                                    | 20     |
|                                                                                                          |   |
| Item 4. — Controls and Procedures                                                                        | 20     |
|                                                                                                          |   |
| PART II.  — OTHER INFORMATION                                                                       |   |
|                                                                                                          |   |
| Item  1. — Legal Proceedings                                                                             | 21     |
|                                                                                                          |   |
| Item  1A. — Risk Factors                                                                                 | 21     |
|                                                                                                          |   |
| Item 2. — Unregistered Sales of Equity Securities and  Use of Proceeds                                   | 21     |
|                                                                                                          |   |
| Item 3. — Defaults Upon Senior Securities                                                                | 21     |
|                                                                                                          |   |
| Item 4. — Submission of Matters to a Vote of Security  Holders                                           | 21     |
|                                                                                                          |   |
| Item  5. — Other Information                                                                             | 21     |
|                                                                                                          |   |
| Item 6.  — Exhibits                                                                                      | 22     |
|                                                                                                          |   |
| SIGNATURE                                                                                                     | 23     |

 

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**Part 1. Financial Information**

 

**Item 1. — Financial Statements**

 

**KapStonePaper and Packaging Corporation**

**ConsolidatedBalance Sheets**

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

 
| ** **                                                                                                                                                                                                                                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                          | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                                                                                                                          | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                                          | ** ** |              |       |                  |       |
| Current assets:                                                                                                                                                                                                                                     | ** ** |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                                          |       | $                 | 22,147     |                  | $          | 4,165 |   |
| Trade accounts  receivable, less allowances of $2,771 in 2009 and $2,421 in 2008                                                                                                                                                                    |       | 59,069            |       | 71,489                |       |
| Other receivables                                                                                                                                                                                                                                   |       | 13,958            |       | 6,207                 |       |
| Inventories                                                                                                                                                                                                                                         |       | 66,048            |       | 89,692                |       |
| Refundable and prepaid  income taxes                                                                                                                                                                                                                |       | —            |       | 14,145                |       |
| Prepaid expenses and  other current assets                                                                                                                                                                                                          |       | 2,929             |       | 1,748                 |       |
| Deferred income taxes                                                                                                                                                                                                                               |       | 5,469             |       | 3,363                 |       |
| Total current assets                                                                                                                                                                                                                                |       | 169,620           |       | 190,809               |       |
|                                                                                                                                                                                                                                                |       |              |       |                  |       |
| Plant, property and  equipment, net                                                                                                                                                                                                                 |       | 475,758           |       | 483,780               |       |
| Restricted cash                                                                                                                                                                                                                                     |       | 2,500             |       | —                |       |
| Other assets                                                                                                                                                                                                                                        |       | 685               |       | 882                   |       |
| Intangible assets, net                                                                                                                                                                                                                              |       | 32,836            |       | 45,195                |       |
| Goodwill                                                                                                                                                                                                                                            |       | 5,449             |       | 6,524                 |       |
|                                                                                                                                                                                                                                                |       |              |       |                  |       |
| Total assets                                                                                                                                                                                                                                        |       | $                 | 686,848    |                  | $          | 727,190 |   |
|                                                                                                                                                                                                                                                |       |              |       |                  |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                      | ** ** |              |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                                | ** ** |              |       |                  |       |
| Current portion of  long-term debt and notes                                                                                                                                                                                                        |       | 39,913            |       | 40,556                |       |
| Accounts payable                                                                                                                                                                                                                                    |       | 35,654            |       | 42,214                |       |
| Accrued expenses                                                                                                                                                                                                                                    |       | 16,086            |       | 30,462                |       |
| Accrued compensation  costs                                                                                                                                                                                                                         |       | 9,184             |       | 13,646                |       |
| Accrued income taxes                                                                                                                                                                                                                                |       | 2,130             |       | —                |       |
| Total current  liabilities                                                                                                                                                                                                                          |       | 102,967           |       | 126,878               |       |
|                                                                                                                                                                                                                                                |       |              |       |                  |       |
| Other liabilities:                                                                                                                                                                                                                                  |       |              |       |                  |       |
| Long-term debt and  notes, net                                                                                                                                                                                                                      |       | 329,078           |       | 389,374               |       |
| Pension and  post-retirement benefits                                                                                                                                                                                                               |       | 9,678             |       | 8,355                 |       |
| Deferred income taxes                                                                                                                                                                                                                               |       | 28,280            |       | 15,951                |       |
| Other liabilities                                                                                                                                                                                                                                   |       | 5,841             |       | 5,865                 |       |
| Total other liabilities                                                                                                                                                                                                                             |       | 372,877           |       | 419,545               |       |
|                                                                                                                                                                                                                                                |       |              |       |                  |       |
| 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; 28,370,348 shares outstanding (40,000  treasury shares outstanding) at June 30, 2009 and 28,370,248 outstanding  at December 31, 2008 (40,000 treasury shares outstanding) |       | 3                 |       | 3                     |       |
| Additional paid-in  capital                                                                                                                                                                                                                         |       | 133,241           |       | 132,206               |       |
| Retained earnings                                                                                                                                                                                                                                   |       | 77,990            |       | 48,766                |       |
| Accumulated other  comprehensive loss                                                                                                                                                                                                               |       | (230              | )          | (208                  | )          |
| Total stockholders’  equity                                                                                                                                                                                                                    |       | 211,004           |       | 180,767               |       |
|                                                                                                                                                                                                                                                |       |              |       |                  |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                    |       | $                 | 686,848    |                  | $          | 727,190 |   |

 

See notes to consolidated financial statements

 

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**KapStone Paper and Packaging Corporation**

**Consolidated Statements of Income**

**(Inthousands, except share and per share amounts)**

**(unaudited)**

 
| ** **                                              | ** ** | **Three  Months Ended June 30,** | ** ** | **Six  Months Ended June 30,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                              | ** ** | **2009**                              | ** ** | **2008**                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                              | ** ** | ** **                            | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  sales                                              |       | $                                     | 156,493    |                                | $          | 68,162 |   | $ | 297,077 |   | $ | 135,291 |   |
| Cost  of sales, excluding depreciation and amortization |       | 88,354                                |       | 40,800                              |       | 184,838 |   | 82,358 |   |
| Freight  and distribution expenses                      |       | 13,165                                |       | 6,924                               |       | 26,493 |   | 13,511 |   |
| Selling,  general and administrative expenses           |       | 7,630                                 |       | 4,564                               |       | 16,187 |   | 9,494 |   |
| Depreciation  and amortization                          |       | 13,488                                |       | 2,835                               |       | 27,097 |   | 5,428 |   |
| Gain/(loss)  on sale of business                        |       | (704                                  | )          | —                              |       | 16,695 |   | — |   |
| Other  operating income                                 |       | 216                                   |       | 187                                 |       | 448 |   | 371 |   |
| Operating  income                                       |       | 33,368                                |       | 13,226                              |       | 59,605 |   | 24,871 |   |
| Foreign  exchange gain/(loss)                           |       | 171                                   |       | —                              |       | (127 | ) | — |   |
| Interest  income                                        |       | —                                |       | 293                                 |       | 1 |   | 840 |   |
| Interest  expense                                       |       | 5,011                                 |       | 460                                 |       | 10,744 |   | 1,213 |   |
| Income  before provision for income taxes               |       | 28,528                                |       | 13,059                              |       | 48,735 |   | 24,498 |   |
| Provision  for income taxes                             |       | 10,416                                |       | 4,808                               |       | 19,511 |   | 9,017 |   |
|                                                    |       |                                  |       |                                |       |   |   |   |   |
| Net  income                                             |       | $                                     | 18,112     |                                | $          | 8,251 |   | $ | 29,224 |   | $ | 15,481 |   |
|                                                    |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average  number of shares outstanding:         |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                   |       | 28,370,298                            |       | 25,391,330                          |       | 28,370,273 |   | 25,336,688 |   |
| Diluted                                                 |       | 28,646,527                            |       | 36,719,720                          |       | 28,563,291 |   | 35,638,521 |   |
| Net  income per share:                                  |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                   |       | $                                     | 0.64       |                                | $          | 0.32 |   | $ | 1.03 |   | $ | 0.61 |   |
| Diluted                                                 |       | $                                     | 0.63       |                                | $          | 0.22 |   | $ | 1.02 |   | $ | 0.43 |   |

 

See notes to consolidated financial statements

 

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**KapStonePaper and Packaging Corporation**

**ConsolidatedStatements of Cash Flows**

**(In thousands)**

**(unaudited)**

 
| ** **                                                                         | ** ** | **Six  Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2009**                            | ** ** | **2008** | ** ** |
| **Operating  activities**                                                          |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 29,224     |   | $ | 15,481 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                |       |   |   |
| Depreciation and  amortization                                                     |       | 27,097                              |       | 5,428 |   |
| Stock based  compensation expense                                                  |       | 1,034                               |       | 691 |   |
| Amortization of debt  issuance costs                                               |       | 1,678                               |       | 100 |   |
| Loss on disposal of  fixed assets                                                  |       | 288                                 |       | 11 |   |
| Deferred income taxes                                                              |       | 11,345                              |       | 1,686 |   |
| Gain on sale of  business                                                          |       | (16,695                             | )          | — |   |
| Changes in operating  assets and liabilities:                                      |       |                                |       |   |   |
| Trade accounts  receivable, net                                                    |       | 9,627                               |       | (3,959 | ) |
| Other receivables                                                                  |       | (11,017                             | )          | — |   |
| Inventories                                                                        |       | 18,794                              |       | (356 | ) |
| Refundable and prepaid  income taxes                                               |       | 9,371                               |       | — |   |
| Prepaid expenses and  other current assets                                         |       | (1,181                              | )          | (1,383 | ) |
| Accounts payable                                                                   |       | (5,852                              | )          | 2,076 |   |
| Accrued expenses                                                                   |       | (13,328                             | )          | 1,987 |   |
| Accrued compensation  costs                                                        |       | (4,502                              | )          | (181 | ) |
| Accrued income taxes                                                               |       | 6,904                               |       | (648 | ) |
| Net cash provided by  operating activities                                         |       | 62,787                              |       | 20,933 |   |
|                                                                               |       |                                |       |   |   |
| **Investing  activities**                                                          |       |                                |       |   |   |
| CKD acquisition                                                                    |       | 1,000                               |       | (2,393 | ) |
| KPB earn-out                                                                       |       | (3,977                              | )          | — |   |
| Proceeds from sale of  business                                                    |       | 36,083                              |       | — |   |
| Restricted cash                                                                    |       | (2,500                              | )          | — |   |
| Capital expenditures                                                               |       | (12,910                             | )          | (4,620 | ) |
| Net cash provided by  (used in) investing activities                               |       | 17,696                              |       | (7,013 | ) |
|                                                                               |       |                                |       |   |   |
| **Financing  activities**                                                          |       |                                |       |   |   |
| Proceeds from revolving  credit facility                                           |       | 61,300                              |       | — |   |
| Repayments on revolving  credit facility                                           |       | (73,700                             | )          | — |   |
| Repayments of long-term  debt and notes                                            |       | (49,731                             | )          | (15,139 | ) |
| Proceeds from the  exercises of warrants into common stock                         |       | —                              |       | 1,092 |   |
| Debt issuance costs                                                                |       | (370                                | )          | — |   |
| Net cash used in  financing activities                                             |       | (62,501                             | )          | (14,047 | ) |
|                                                                               |       |                                |       |   |   |
| Net increase in cash  and cash equivalents                                         |       | 17,982                              |       | (127 | ) |
| Cash and cash  equivalents-beginning of period                                     |       | 4,165                               |       | 56,635 |   |
| Cash and cash equivalents-end  of period                                           |       | $                                   | 22,147     |   | $ | 56,508 |   |

 

See notes to consolidated financial statements

 

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**KAPSTONE PAPER AND PACKAGINGCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

** **

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

** **

**(unaudited)**

 

# **1.**             Financial Statements

# ** **

The accompanyingunaudited consolidated financial statements of KapStone Paper and PackagingCorporation (the “Company,” “we,” “us,” “our” or “KapStone”) have been preparedin accordance with U.S. generally accepted accounting principles for interimfinancial information, the instructions to Form 10-Q and Article 10of Regulation S-X. Accordingly, they do not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof a normal recurring nature) considered necessary for a fair presentation havebeen included. Operating results for the three and six months ended June 30,2009 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2009. For further information, refer to theconsolidated financial statements and related footnotes included in our AnnualReport on Form 10-K for the year ended December 31, 2008.

 

# **2.**             Reclassification

# ** **

Receivables from sales ofshaft horsepower of $2.9 million as of December 31, 2008 have beenreclassified from prepaid and other current assets to trade account receivablesto conform to the current period presentation.

 

# **3.**             Accounting Pronouncements

# ** **

In April 2009, theFinancial Accounting Standards Board (“FASB”) issued Staff Position (“FSP”) FAS157-4,* Determining Fair Value When the Volume and Level of Activity for theAsset or Liability Have Significantly Decreased and Identifying TransactionsThat Are Not Orderly*. This FSP provides additional guidance forestimating fair value in accordance with FASB Statement No. 157,*Fair Value Measurements*, when the volumeand level of activity for the asset or liability have significantly decreased.This FSP also includes guidance on identifying circumstances that indicate atransaction is not orderly. This FSP emphasizes that even if there has been asignificant decrease in the volume and level of activity for the asset orliability and regardless of the valuation technique(s) used, the objectiveof a fair value measurement remains the same. Fair value is the price thatwould be received to sell an asset or paid to transfer a liability in anorderly transaction (that is, not a forced liquidation or distressed sale)between market participants at the measurement date under current marketconditions. FSP FAS 157-4 is effective for interim and annual reporting periodsending after June 15, 2009, and is appliedprospectively. Accordingly, the Company adopted FSP FAS 157-4prospectively in the second quarter of 2009. The adoption of this standard didnot have a material effect on the consolidated financial statements.

 

In April 2009, theFASB issued FSP FAS 107-1 and Accounting Principles Board (“APB”) 28-1,*Interim Disclosures about Fair Value of FinancialInstruments.*   This FSP amends FASB Statement No. 107,*Disclosures about Fair Value of FinancialInstruments*, to require disclosures about fair value of financialinstruments for interim reporting periods of publicly traded companies as wellas in annual financial statements. This FSP also amends APB Opinion No. 28,*Interim Financial Reporting*, to requirethose disclosures in summarized financial information at interim reportingperiods. FSP FAS 107-1 and APB 28-1 are effective for interim and annualreporting periods ending after June 15, 2009. The adoption of these standardsdid not have a material effect on the consolidated financial statements.

 

In May 2009, theFASB issued Statement of Financial Accounting Standard (“SFAS”) No. 165, *Subsequent Events*(SFAS 165). SFAS 165establishes general standards of accounting for and disclosure of events thatoccur after the balance sheet date but before financial statements are issued.This statement is effective for interim and annual periods ending after June 15,2009. Accordingly, the Company adopted SFAS 165 in the second quarter of 2009.The adoption of this standard did not have a material effect on theconsolidated financial statements.

 

The Company has evaluated subsequent eventsafter the balance sheet date of June 30, 2009 through July 30, 2009, which isthe date the accompanying financial statements were issued.

 

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# **4.**             Sale of Dunnage Bag Business

# ** **

On March 31, 2009the Company consummated the sale of its dunnage bag business to Illinois ToolWorks Inc. for $36.0 million less working capital adjustments. The Companyconsidered the sale an opportunity to lower its debt and focus on its corebusiness. As a condition of sale, $2.5 million of the sale proceeds are beingheld in escrow until September 30, 2010 to be available to satisfy anylosses or indemnity claims that may arise against the Company in connectionwith the sale.  The Company realized a gain on the sale of the dunnage bagbusiness as follows ($000’s):

 
| Sale  price                                     |   | $       | 36,000 |   |
|-------------------------------------------------|--------|---------|--------|--------|
| Working  capital adjustment                     |   | (813    | )      |
|                                            |   | 35,187  |   |
| Transaction  costs                              |   | (45     | )      |
| Net  assets of dunnage bag business             |   | (18,447 | )      |
| Gain  on sale before provision for income taxes |   | $       | 16,695 |   |

 

The following table showsthe major categories of net assets of the dunnage bag business as of March 31,2009 and December 31, 2008, respectively ($000’s):

 
| ** **                             | ** ** | **(unaudited)**    | ** ** | ** **            | ** ** |
|----------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                             | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| Trade  accounts receivable, net        |       | $                  | 2,793      |                  | $          | 2,742 |   |
| Inventories                            |       | 4,850              |       | 5,281                 |       |
| Plant,  property and equipment         |       | 2,261              |       | 2,318                 |       |
| Intangible  assets                     |       | 5,701              |       | 5,727                 |       |
| Goodwill                               |       | 3,934              |       | 1,064                 |       |
| Accounts  payable and accrued expenses |       | (1,092             | )          | (2,522                | )          |
| Total  net assets                      |       | $                  | 18,447     |                  | $          | 14,610 |   |

 

As a result of the sale,the Company recorded an earn-out liability of $4.0 million in accordance withthe asset purchase agreement dated June 23, 2006 with International PaperCompany (“IP”). The terms of the asset purchase agreement include a contingentearn-out payment on the fifth anniversary of the acquisition; however, in theevent of a sale of the dunnage bag business prior to that date, a percentage ofthe earn-out becomes due and payable within 30 days following the sale providedcertain criteria is met. The earn-out was paid on April 30, 2009.

 

Inthe quarter ended June 30, 2009, the Company accrued an estimated workingcapital adjustment of $0.9 million as a reduction on the gain. The terms of thesale agreement also provide a contingency for certain inventory excluded fromthe working capital adjustment. Any contingency related to this inventory willbe determined based on inventory volumes on-hand as of September 30, 2009. TheCompany does not expect the resolution of any contingency related to thisinventory to have a material effect on the Company’s financial statements.

 

Forsegment reporting purposes, the dunnage bag business is included in all other.

 

# **5.**             Alternative Fuel Mixture Tax Credit

# ** **

The federal governmenthas implemented an incentive program through the U.S. Internal Revenue Codethat provides payments under certain circumstances for the use of alternativefuels and alternative fuel mixtures in lieu of fossil-based fuels.  Thecredit is based on the amount of alternative fuel contained in the mixture.KapStone qualifies for the alternative fuel mixture tax credit because it usesa bio-fuel known as black liquor, which is a byproduct of its wood pulpingprocess, to power its mills.

 

In March 2009, theInternal Revenue Service approved the Company’s registration as an alternativefuel mixer. The Company submitted refund claims totaling $69.6 million for thefirst six months of 2009 covering fuel used at its Charleston mill from January 29th through June 30th and at itsRoanoke Rapids mill from February 14th  through June 30th.  At June 30,2009, $15.6 million of the credit was included as a reduction to finished goodsinventory. For the three and six month periods ended June 30, 2009, $48.6million and $54.0 million, respectively, were recorded as a reduction to costof sales.

 

The credit is scheduledto expire on December 31, 2009.

 

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# **6.**             Inventories

 

Inventories consist ofthe following at June 30, 2009, and December 31, 2008, respectively($000’s):

# ** **

| ** **                      | ** ** | **(unaudited)  June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|--------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2009**                       | ** ** | **2008**              | ** ** |
| Raw materials                   |       | $                              | 14,593     |                  | $          | 19,877 |   |
| Work in process                 |       | 1,575                          |       | 2,070                 |       |
| Finished goods                  |       | 31,448                         |       | 49,804                |       |
| Replacement parts and  supplies |       | 18,432                         |       | 17,941                |       |
|                            |       |                           |       |                  |       |
| Inventories                     |       | $                              | 66,048     |                  | $          | 89,692 |   |

 

# **7.**             Income taxes

 

The Company’s U.S.federal statutory income tax rate is 35% for 2009 and 2008. The Company’seffective tax rate for the six months ended June 30, 2009 and 2008 was40.0% and 36.8%, respectively.  The primary reasons for the higher 2009effective tax rate are a difference between the book and tax basis of thedunnage bag assets and a lower expected benefit from the domestic manufacturingtax deduction. Differences between the effective tax rate and the federalstatutory tax rate are due to the impact of state tax net of federal benefit,the domestic manufacturing tax deduction and the gain on the sale of thedunnage bag assets.

 

In the normal course ofbusiness, we are subject to examination by taxing authorities. The Company’sopen tax years are 2005 through 2008. The Company’s 2007 tax year is currentlyunder examination by the Internal Revenue Service.

 

**8.****            ****Net income per share**

 

Basic and diluted netincome per share is calculated as follows ($000’s except for share and pershare data):

# ** **

| ** **                                                               | ** ** | **Three  Months Ended June 30,** | ** ** | **Six  Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                               | ** ** | **2009**                              | ** ** | **2008**                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net income as reported                                                   |       | $                                     | 18,112     |                                | $          | 8,251 |   | $ | 29,224 |   | $ | 15,481 |   |
| Weighted-average number  of common shares for basic net income per share |       | 28,370,298                            |       | 25,391,330                          |       | 28,370,273 |   | 25,336,688 |   |
| Incremental effect of  dilutive common stock equivalents:                |       |                                  |       |                                |       |   |   |   |   |
| Common stock warrants                                                    |       | —                                |       | 11,040,067                          |       | — |   | 10,129,922 |   |
| Underwriter’s purchase  options                                     |       | —                                |       | 117,052                             |       | — |   | 58,526 |   |
| Unvested restricted  stock awards                                        |       | 276,229                               |       | 171,271                             |       | 193,018 |   | 113,385 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average number  of shares for diluted net income                |       | 28,646,527                            |       | 36,719,720                          |       | 28,563,291 |   | 35,638,521 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Net income per share —  basic                                       |       | $                                     | 0.64       |                                | $          | 0.32 |   | $ | 1.03 |   | $ | 0.61 |   |
|                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Net income per share —  diluted                                     |       | $                                     | 0.63       |                                | $          | 0.22 |   | $ | 1.02 |   | $ | 0.43 |   |

 

Common stock warrantswere not included in the calculation of diluted earnings per share for thethree and six months ended June 30, 2009 since the weighted average shareprice per share of common stock was $3.68 and $2.81, respectively, compared tothe warrant’s conversion price of $5.00 and the effect would be anti-dilutive.

# ** **

Stock option grantstotaling 2.2 million were outstanding during the three and six months ended June 30,2009, but were not included in the computation of diluted earnings per sharebecause the effect of including the stock option grants would be anti-dilutive.Stock option grants totaling 1.3 million were outstanding during the three andsix months ended June 30, 2008, but were not included in the computationof diluted earnings per share because the effect of including the stock optiongrants would be anti-dilutive.

 

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Underwriter’s purchaseoption of 1,000,000 units were outstanding at June 30, 2009, but were notincluded in the computation of diluted earnings per share because the effect ofincluding the underwriter’s option would be anti-dilutive.

# ** **

# **9.**                                      Pension plan and post retirement benefits

# ** **

**DefinedBenefit Plan**

 

The KapStone Paper andPackaging Corporation Defined Benefit Plan (“Plan”) provides benefits forapproximately 1,000 union employees.

 

As part of the July 1,2008 Charleston Kraft Division acquisition, approximately 615 union employeeswere added to the Company’s Plan. As a consequence of the sale of the dunnagebag business approximately 124 union employees ceased earning benefits underthe Plan as of March 31, 2009.

# ** **

Net pension costrecognized for the three and six months ended June 30, 2009 and 2008 forthe Company’s pension plan, is as follows ($000’s):

 
| ** **                                        | ** ** | **Three  Months Ended June 30,** | ** ** | **Six  Months Ended June 30,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                        | ** ** | **2009**                              | ** ** | **2008**                            | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                              |       |                                  |       |                                |       |   |   |   |   |
| Service cost for  benefits earned during the year |       | $                                     | 703        |                                | $          | 306 |   | $ | 1,442 |   | $ | 612 |   |
| Interest cost on  projected benefit obligation    |       | 93                                    |       | 39                                  |       | 186 |   | 78 |   |
| Expected return on plan  assets                   |       | (38                                   | )          | (6                                  | )          | (76 | ) | (12 | ) |
| Amortization of prior  service cost               |       | —                                |       | —                              |       | — |   | — |   |
| Net pension cost                                  |       | $                                     | 758        |                                | $          | 339 |   | $ | 1,552 |   | $ | 678 |   |

 

KapStone funds its Planaccording to IRS funding requirements. Based on those limitations, KapStoneexpects to fund $5.4 million to the Plan in 2009 to achieve an 80% fundedstatus.

# ** **

**OtherPost-retirement Benefits**

# ** **

Net post-retirement costrecognized for the three and six months ended June 30, 2009 and 2008 forthe Company’s retiree medical and life insurance plan was less than $0.1million.

 

**DefinedContribution Plans**

 

The KapStone DefinedContribution Plan (“Contribution Plan”) covers all eligible employees. Companycontributions to the Contribution Plan are based on matching of employeecontributions, vest immediately for salaried and non-bargained hourly employeesand vest after three years for union employees. For the three months ended June 30,2009 and 2008, the Company recognized expense of $0 and $0.3 million,respectively, for matching contributions. For the six months ended June 30,2009 and 2008, the Company recognized expense of $0.8 million and $0.7 million,respectively, for matching contributions.

 

The Company’s RetirementSavings Plan, which covers all eligible salaried and non-bargained hourlyemployees, provides for contributions based on an employee’s salary andage.  The Company contributions vest 100% after three years. For the threemonths ended June 30, 2009 and 2008, the Company recognized expense of $0and $0.1 million, respectively. For the six months ended June 30, 2009 and2008, the Company recognized expense of $0 and $0.3 million, respectively.

 

The Company temporarilysuspended these benefits for salaried and non-bargained hourly employees in thefirst quarter of 2009 due to economic conditions.

** **

**10.          Stock-Based Compensation**

# ** **

On December 29,2006, stockholders approved the 2006 Incentive Plan (“2006 Plan”).  Amaximum of 3.0 million shares of our common stock, available for issuancepursuant to stock options, restricted stock awards or stock appreciation rights(collectively called “Awards”), may be granted under the 2006 Plan. If anyAward is forfeited or expires without being exercised, or if restricted stockis repurchased by the Company, the shares of

 

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stock subject to theAward shall be available for additional grants under the 2006 Plan. Awards maybe granted to employees, officers and directors of, and consultants or advisorsto, the Company and any subsidiary corporations. Options intended to qualify,under the standardsset forth in certain federal tax rules, as incentive stock options (“ISOs”) maybe granted only to employees.

 

The Company accounts forstock awards under SFAS No. 123(R),*Share-Based Payment*, which requires that the cost resulting from allshare-based payment transactions be recognized as compensation cost over thevesting period based on the fair value of the instrument on the date of grant.The Company recognized $0.5 million and $1.0 million of compensation cost forthe three and six months ended June 30, 2009, respectively, and $0.5million and $0.7 million for the three and six months ended June 30, 2008,respectively.

 

**StockOptions**

# ** **

In May 2009, theCompany’s Compensation Committee granted 829,702 stock options 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.  The stock optionsawarded in 2009 have a contractual term of ten years. The stock options aresubject to forfeiture should the recipient terminate his or her employment withthe Company for certain reasons prior to vesting in their awards, or theoccurrence of certain other events such as termination with cause. The exerciseprice of these stock options is based on the closing market price of our commonstock on the date of grant (May 13, 2009 for the 2009 awards) andcompensation expense is recorded on an accelerated basis over the awards’vesting periods.

 

The fair value of theKapStone stock options granted in May 2009 was $1.52. The fair value wascalculated using the Black-Scholes-Merton option-pricing model based on themarket price at the grant date and the weighted average assumptions specific tothe underlying options. The expected volatility assumption is based onvolatility of related industry stocks. The Company uses the “simplified method”,defined in SEC Staff Accounting Bulletin (“SAB”) No. 107, to determine theexpected life assumption for all of its options.  The Company uses the “simplifiedmethod”, as permitted by SAB No. 110, as it does not have historicalexercise data to provide a reasonable basis upon which to estimate expectedlife due to the limited time its equity shares have been publicly traded.The risk-free interest rate was selectedbased upon yields of U.S. Treasury issues with a term similar to the expectedlife of the stock options.

 

The assumptions utilizedfor stock options during the period are as follows:

 
| ** **                                                                   | ** ** | **Three Months********Ended June 30,  2009** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| KapStone Stock  Options Black-Scholes-Merton assumptions (weighted average): |       |                                                   |       |
| Expected  volatility                                                         |       | 38.9                                                   | %          |
| Expected  life (years)                                                       |       | 6.0                                                    |       |
| Risk-free  interest rate                                                     |       | 2.3                                                    | %          |
| Expected  dividend yield                                                     |       | —                                                 | %          |

 

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# **A summaryof information related to stock options is as follows:**

# ** **

| ** **                               | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Intrinsic  Value (dollars  in Thousands)** | ** ** |
|------------------------------------------|------------|-------------|------------|---------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| **Outstanding  at January 1, 2009** |       | 1,346,347   |       | $                                     | 6.87       |                                           | 7.7        |                                         | $          | (6,045 | ) |
| Granted                                  |       | 829,702     |       | 3.70                                  |       | 9.9                                            |       | 821                                          |       |
| Exercised                                |       | —      |       | —                                |       | —                                         |       | —                                       |       |
| Lapsed (forfeited or  canceled)          |       | (9,522      | )          | 6.85                                  |       | —                                         |       | —                                       |       |
| **Outstanding  at June 30, 2009**   |       | 2,166,527   |       | 5.66                                  |       | 8.1                                            |       | (2,093                                       | )          |
| **Exercisable  at June 30, 2009**   |       | 308,525     |       | $                                     | 6.76       |                                           | 4.8        |                                         | $          | (1,277 | ) |

 

Total stock-basedcompensation related to the stock option grants was $0.3 million and $0.6million for the three and six months ended June 30, 2009, respectively,and $0.3 million and $0.4 million for the three and six months ended June 30,2008, respectively.

 

As of June 30, 2009and 2008, there was $2.1 million and $1.9 million, respectively, of totalunrecognized compensation cost related to non-vested stock options. The cost isexpected to be recognized over a weighted average period of 2 years.

 

**RestrictedStock**

# ** **

In May 2009, theCompany’s Compensation Committee granted 219,864 restricted stock units toexecutive officers and employees as compensation for service. These restrictedstock units are restricted as to transferability until they vest three yearsfrom the grant date. These restricted stock units are subject to forfeitureshould these employees terminate their employment with the Company for certainreasons prior to vesting in their awards, or the occurrence of certain otherevents. The value of these restricted stock units is based on the closingmarket price of our common stock on the date of grant and compensation expenseis recorded on a straight-line basis over the awards’ vesting periods.

# ** **

The following tablesummarizes our restricted stock amounts and activity:

 

| ** **                               | ** ** | **Units/  Shares** | ** ** | **Weighted  Average  Grant Price** | ** ** |
|------------------------------------------|------------|--------------------|------------|------------------------------------|------------|
| **Outstanding  at January 1, 2009** |       | 368,903            |       | $                                  | 6.88       |   |
| Granted                                  |       | 219,864            |       | 3.70                               |       |
| Vested                                   |       | —             |       | —                             |       |
| Forfeited                                |       | (3,098             | )          | 6.84                               |       |
| **Outstanding  at June 30, 2009**   |       | 585,669            |       | $                                  | 5.68       |   |

 

Total stock-basedcompensation related to the restricted stock awards was $0.2 million and $0.4million for the three and six months ended June 30, 2009, respectively,and $0.2 million and $0.3 million for the three and six month ended June 30,2008, respectively.

 

As of June 30, 2009and 2008, there was $1.8 million and $1.7 million, respectively, of totalunrecognized compensation cost related to the restricted stock which will berecognized over the remaining vesting period of approximately 2 years. Norestricted stock awards were vested as of June 30, 2009.

 

# **11.             Stockholder’sEquity**

 

In connection with theCompany’s initial public offering, on August 19, 2005, the Company sold20,000,000 units (“Units”) for a gross price of $6.00 per Unit. Each Unitconsists of one share of the Company’s common stock, $0.0001 par value, and twowarrants. Each warrant entitles the holder to purchase from the Company oneshare of common stock at an exercise price of $5.00 and expires on August 17,2009. The warrants are

 

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redeemable by the Companyat a price of $0.01 per warrant upon 30 days notice after the warrantsbecome exercisable, only in the event that the last sale price of the commonstock is at least $8.50 per share for any 20 trading days within a 30 daytrading period ending on the third day prior to the date on which notice ofredemption is given. The closing share price of the Company’s common stock at June 30,2009 was $4.69.

 

**12.          Segment Information**

 

The Company has tworeportable segments, unbleached kraft and all other.  The unbleached kraftsegment consists of the Company’s paper mills in Roanoke Rapids, North Carolinaand North Charleston, South Carolina, which produce unbleached kraft paper,linerboard, unbleached kraft board and saturating kraft. These products aresold to customers who convert our products into end-market finished products.The all other segment consists of the Company’s former dunnage bag business,based in Fordyce Arkansas, which converts unbleached kraft paper and film intoinflatable dunnage bags and the lumber mill operations, based in Summerville,South Carolina, which produces dimensional softwood board lumber that is soldprimarily to regional and local retailers, wood treating operations andindustrial customers.

 

On March 31, 2009the Company consummated the sale of its dunnage bag business to Illinois ToolWorks Inc.

 

Corporate expenses thatbenefit the entire organization are not charged to the operating segments.

 
| ** **                                            | ** ** | ** **                            | ** ** | ** ** | ** **                          | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|------------|-------------------------------------|------------|
| ** **                                            | ** ** | **Three  Months Ended June 30,** | ** ** | ** ** | **Six  Months Ended June 30,** | ** ** |
| **Operating Segment (in thousands of U.S. dollars):** | ** ** | **2009**                              | ** ** | **2008**   | ** **                          | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net  sales:                                           |       |                                  |       |       |                                |       |   |   |   |   |
| Unbleached  kraft                                     |       | $                                     | 150,398    |       | $                                   | 60,545     |   |   | $ | 279,858 |   | $ | 120,905 |   |
| All  other                                            |       | 6,095                                 |       | 8,905      |                                |       | 18,118 |   | 16,797 |   |
| Intersegment  sales                                   |       | —                                |       | (1,288     | )                                   |       | (899 | ) | (2,411 | ) |
|                                                  |       |                                  |       |       |                                |       |   |   |   |   |
| Total                                                 |       | $                                     | 156,493    |       | $                                   | 68,162     |   |   | $ | 297,077 |   | $ | 135,291 |   |
|                                                  |       |                                  |       |       |                                |       |   |   |   |   |
| Net  sales to external customers:                     |       |                                  |       |       |                                |       |   |   |   |   |
| Unbleached  kraft                                     |       | $                                     | 150,398    |       | $                                   | 59,257     |   |   | $ | 278,959 |   | $ | 118,494 |   |
| All  other                                            |       | 6,095                                 |       | 8,905      |                                |       | 18,118 |   | 16,797 |   |
|                                                  |       |                                  |       |       |                                |       |   |   |   |   |
| Total                                                 |       | $                                     | 156,493    |       | $                                   | 68,162     |   |   | $ | 297,077 |   | $ | 135,291 |   |
|                                                  |       |                                  |       |       |                                |       |   |   |   |   |
| Operating  income/(loss):                             |       |                                  |       |       |                                |       |   |   |   |   |
| Unbleached  kraft                                     |       | $                                     | 40,935     |       | $                                   | 15,930     |   |   | $ | 56,416 |   | $ | 30,480 |   |
| All  other                                            |       | (1,538                                | )          | 1,269      |                                |       | (2,375 | ) | 2,600 |   |
| Gain/(loss)  on sale of business                      |       | (704                                  | )          | —     |                                |       | 16,695 |   | — |   |
| Corporate                                             |       | (5,325                                | )          | (3,973     | )                                   |       | (11,131 | ) | (8,209 | ) |
|                                                  |       |                                  |       |       |                                |       |   |   |   |   |
| Total                                                 |       | $                                     | 33,368     |       | $                                   | 13,226     |   |   | $ | 59,605 |   | $ | 24,871 |   |
|                                                  |       |                                  |       |       |                                |       |   |   |   |   |

 
| ** **                                            | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| **Operating Segment (in thousands of U.S. dollars):** | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| Total  assets:                                        |       |              |       |                  |       |
| Unbleached  kraft                                     |       | $                 | 623,741    |                  | $          | 657,610 |   |
| All  other                                            |       | 22,857            |       | 39,128                |       |
| Corporate                                             |       | 40,250            |       | 30,452                |       |
|                                                  |       |              |       |                  |       |
| Total                                                 |       | $                 | 686,848    |                  | $          | 727,190 |   |

 

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

 

This Quarterly Report on Form 10-Qincludes forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. We have based these forward-lookingstatements on our current expectations and projections about future events.These forward-looking statements are subject to known and unknown risks,uncertainties and assumptions about us that may cause our actual results,levels of activity, performance or achievements to be materially different fromany future results, levels of activity, performance or achievements expressedor implied by such forward-looking statements. In some cases, you can identifyforward-looking statements by terminology such as “may,” “should,” “could,” “would,”“expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or thenegative of such terms or other similar expressions. Factors that might causeor contribute to such a discrepancy include, but are not limited to, thosedescribed in Part II Item 1A in this Form 10-Q, in Part I Item1A of our Form 10-K for the fiscal year ended December 31, 2008 andin our other Securities and Exchange Commission filings.  The informationcontained in this Form 10-Q represents our best judgment at the date ofthis report based on information currently available.  In providingforward-looking statements, KapStone does not intend, and does not undertakeany duty or obligations, to update its statements as a result of newinformation, future events or otherwise.

 

The following discussionshould be read in conjunction with our Consolidated Financial Statements andrelated Notes thereto included elsewhere in this report.

 

**Overview**

 

We were formed on April 15,2005 to serve as a vehicle to effect a merger, capital stock exchange, assetacquisition or other similar business combination with an operating business inthe paper, packaging, forest products and related industries.

 

On January 2, 2007,the Company purchased substantially all of the assets and  assumed certainliabilities of the Kraft Papers Business (“ KPB”), a division of IP, consistingof an unbleached kraft paper manufacturing facility in Roanoke Rapids, NorthCarolina and Ride Rite® Converting, an inflatable dunnage bag manufacturerlocated in Fordyce, Arkansas, for a cash purchase price of $155 million incash, less certain post-closing adjustments of $7.8 million, plus twocontingent earn-out payments of up to $55 million (in aggregate and adjustedfor the 2009 sale of Ride Rite® Converting), based on KPB’s annual earningsbefore interest, income taxes, depreciation and amortization, or EBITDA, duringthe five years immediately following the acquisition.

 

On July 1, 2008, theCompany  purchased substantially all ofthe assets and assumed certain liabilities of the Charleston KraftDivision (“CKD”), a division of MeadWestvaco Corporation (“MWV”), consistingof  an unbleached kraft papermanufacturing facility in North Charleston, South Carolina, including acogeneration facility, chip mills located in Elgin, Hampton, Andrews andKinards, South Carolina and a lumber mill located in Summerville, SouthCarolina, for a cash purchase price of $485 million less certain adjustments of$14.0 million.

 

The results reportedbelow do not reflect any actual or pro forma adjustments related to theacquisition prior to the consummation of the acquisition on July 1, 2008.The results reported below include the results of CKD since the date ofacquisition, July 1, 2008.

 

On March 31, 2009,the Company consummated the sale of its dunnage bag business for $36.0 millionless certain working capital adjustments to Illinois Tool Works Inc. (“ITW”). The results of operations for the dunnage bag business are included in the allother segment until the date of the sale. In conjunction with the sale, theCompany signed a long-term supply agreement with ITW.

 

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**Comparison of Results of Operationsfor the Three Months Ended June 30, 2009 and the Three Months Ended June 30,2008**

 
| ** **                                              | ** ** | **Three  Months Ended June 30,** | ** ** | **Increase/** | ** ** | **%  Increase/** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------|------------|---------------|------------|------------------|------------|
| **(in  thousands of U.S. dollars):**                    | ** ** | **2009**                              | ** ** | **2008**      | ** ** | **(Decrease)**   | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                     | 156,493    |          | $          | 68,162           |       | $ | 88,331 |   | 129.6 | % |
| Cost of sales,  excluding depreciation and amortization |       | 88,354                                |       | 40,800        |       | 47,554           |       | 116.6 | % |
| Freight and  distribution expenses                      |       | 13,165                                |       | 6,924         |       | 6,241            |       | 90.1 | % |
| Selling, general and  administrative expenses           |       | 7,630                                 |       | 4,564         |       | 3,066            |       | 67.2 | % |
| Depreciation and  amortization                          |       | 13,488                                |       | 2,835         |       | 10,653           |       | 375.8 | % |
| Gain/(loss) on sale of  business                        |       | (704                                  | )          | —        |       | (704             | )          | N/A |   |
| Other operating income                                  |       | 216                                   |       | 187           |       | 29               |       | 15.5 | % |
| Operating income                                        |       | 33,368                                |       | 13,226        |       | 20,142           |       | 152.3 | % |
| Foreign exchange  gain/(loss)                           |       | 171                                   |       | —        |       | 171              |       | N/A |   |
| Interest income                                         |       | —                                |       | 293           |       | (293             | )          | N/A |   |
| Interest expense                                        |       | 5,011                                 |       | 460           |       | 4,551            |       | 989.3 | % |
| Income before provision  for income taxes               |       | 28,528                                |       | 13,059        |       | 15,469           |       | 118.5 | % |
| Provision for income  taxes                             |       | 10,416                                |       | 4,808         |       | 5,608            |       | 116.6 | % |
| Net income                                              |       | $                                     | 18,112     |          | $          | 8,251            |       | $ | 9,861 |   | 119.5 | % |

 

Net sales for the quarterended June 30, 2009, were $156.5 million compared to $68.2 million for thesecond quarter of 2008, an increase of $88.3 million or 129.6%. The increase innet sales was driven by the CKD acquisition on July 1, 2008, whichaccounted for $102.4 million of the increase. Excluding the CKD acquisition,net sales were lower in the second quarter of 2009 compared to the secondquarter of 2008 by $14.1 million, of which $8.9 million is a result of the saleof the dunnage bag business on March 31, 2009. Net sales also decreased by$7.5 million due to lower average revenue per ton and by $2.0 million as aresult of unfavorable product mix due to a higher percentage of linerboardsales, which has a lower average selling price than other products, partiallyoffset by a $3.1 million increase in sales volume.

 

Tobalance production with demand, the Company ran four of its five paper machinesalternating downtime among the three machines at the Charleston mill.  By mid-June 2009, both paper mills wererunning at normal capacity.

 

Cost of sales for thequarter ended June 30, 2009, was $88.4 million compared to $40.8 millionfor the second quarter of 2008, an increase of $47.6 million, or 116.6%. Theincrease in cost of sales was mainly due to the CKD acquisition, whichaccounted for $66.7 million of the increase and was partially offset by $16.4million for the alternative fuel mixture tax credit.  Cost of sales also decreased by $6.6 millionas a result of the sale of the dunnage bag business on March 31, 2009.Excluding the impact of the CKD acquisition, the sale of the dunnage bagbusiness and the alternative fuel mixture tax credit, cost of sales increasedby $3.9 million mainly due to $1.5 million of inflation, $1.0 million in salesvolume and $0.5 million of higher property taxes.

 

The total amount of thealternative fuel mixture tax credit recorded as a reduction in cost of salesfor the quarter ended June 30, 2009 was $48.6 million of which $32.2million is included in CKD results.

 

Freight and distributionexpenses for the quarter ended June 30, 2009 totaled $13.2 millioncompared to $6.9 million for the quarter ended June 30, 2008. The increaseof $6.3 million was due to the CKD acquisition, which accounted for $7.6million of the increase. Excluding the CKD acquisition, freight anddistribution expenses were lower by $1.3 million in the second quarter of 2009due to $0.9 million of lower fuel oil surcharges, realization of favorablecontract negotiations and the sale of the dunnage bag business.

 

Selling, general andadministrative expenses for the quarter ended June 30, 2009 totaled $7.6million compared to $4.6 million for the quarter ended June 30, 2008. The increaseof $3.0 million reflects $2.3 million of CKD’sdirect selling and administrative expenses, $1.4 million of transitionalservices provided by MWV, $0.5 million of professional fees related to the CKDacquisition partially offset by $0.8 million of lower compensation andbenefit expenses as the Company temporarily suspended certain benefits as aresult of economic conditions.

 

Depreciation andamortization for the quarter ended June 30, 2009 totaled $13.5 millioncompared to $2.8 million for the quarter ended June 30, 2008. The increaseof $10.7 million is primarily due to the CKD acquisition, which added anadditional $7.1 million of depreciation and $3.4 million of amortization of

 

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intangibles, including$2.4 million of amortization for the intangible asset related to an acquiredcoal contract with below market prices at July 1, 2008. The acquired coalcontract expires December 31, 2009.

 

A working capitaladjustment of $0.9 million in connection with the sale of the dunnage bagbusiness was recorded in the second quarter. The dunnage bag business was soldin March 2009.

 

Interestincome for the quarter ended June 30, 2009 decreased by $0.3 millioncompared with the same period in 2008, reflecting lower average cash balancesbeing invested and lower interest rates in 2009.

 

Interestexpense for the quarters ended June 30, 2009 and 2008 was $5.0 million and$0.5 million, respectively. Interest expense reflects interest on the Company’slong-term debt and amortization of debt issuance costs. Interest expense was$4.5 million higher in the quarter ended June 30, 2009 primarily due tohigher debt levels relating to the CKD acquisition. Amortization of debtissuance costs for the quarters ended June 30, 2009 and 2008 was $0.9million and $0.1 million, respectively, and reflects higher costs for the newSenior Credit Facility.

 

Provisionfor income taxes for the quarters ended June 30, 2009 and 2008 was $10.4million and $4.8 million, respectively, reflecting an effective tax rate of36.5% compared to 36.8% for the similar period in 2008.

 

**SegmentResults**

 

The following tablepresents a reconciliation of consolidated net sales and operating income toamounts reported by operating segment:

 

| ** **                       | ** ** | **Three  Months Ended June 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| **Operating  Segment ($000s):**  | ** ** | **2009**                              | ** ** | **2008** | ** ** |
| Consolidated net sales:          |       |                                  |       |   |   |
| Unbleached kraft                 |       | $                                     | 150,398    |   | $ | 60,545 |   |
| All other                        |       | 6,095                                 |       | 8,905 |   |
| Intersegment sales               |       | —                                |       | (1,288 | ) |
|                             |       |                                  |       |   |   |
| Total net sales                  |       | $                                     | 156,493    |   | $ | 68,162 |   |
|                             |       |                                  |       |   |   |
| Operating  income/(loss):        |       |                                  |       |   |   |
| Unbleached kraft                 |       | $                                     | 40,934     |   | $ | 15,930 |   |
| All other                        |       | (1,538                                | )          | 1,269 |   |
| Gain/(loss) on sale of  business |       | (704                                  | )          | — |   |
| Corporate                        |       | (5,324                                | )          | (3,973 | ) |
|                             |       |                                  |       |   |   |
| Total operating income           |       | $                                     | 33,368     |   | $ | 13,226 |   |

 

The following representsanalysis and commentary for results of operations for the Company’s twooperating segments: unbleached kraft and all other.

 

***Unbleached Kraft***

 

| ** **                       | ** ** | **Three  Months Ended June 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2009**                              | ** ** | **2008** | ** ** |
| Net sales                        |       | $                                     | 150,398    |   | $ | 60,545 |   |
| Operating income                 |       | $                                     | 40,934     |   | $ | 15,930 |   |
| Operating income % of  net sales |       | 27.2                                  | %          | 26.3 | % |
|                             |       |                                  |       |   |   |
| Average revenue per ton          |       | $                                     | 529        |   | $ | 581 |   |
| Tons of paper sold               |       | 284,514                               |       | 104,131 |   |

 

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For the three monthsended June 30, 2009, unbleached kraft segment net sales increased by$89.9 million, or 148.4%, to $150.4 million compared to$60.5 million for the three months ended June 30, 2008. The increasein net sales is due to the CKD acquisition, which increased sales by $96.3million and 175,202 tons of paper sold. Average revenue per ton in the secondquarter of 2009 was $529/ton, or $52/ton lower than average revenue per ton inthe second quarter of 2008, reflecting the impact of market driven pricereductions and product mix. Excluding the CKD acquisition, net sales were lowerby $6.4 million in the second quarter of 2009 compared to the second quarter of2008, mainly due to $7.5 million of lower average revenue per ton and $2.0million of unfavorable product mix due to a higher percentage of linerboardsales, partially offset by a $3.1 million volume increase.

 

Tobalance production with demand, the Company ran four of its five paper machinesalternating downtime among the three machines at the Charleston mill.  By mid-June 2009, both paper mills wererunning at normal capacity.

 

Unbleached kraft segmentoperating income increased by $25.0 million, or 157.2%, to$40.9 million for the three months ended June 30, 2009 compared to$15.9 million for the three months ended June 30, 2008. Operatingincome increased by $16.8 million due to the CKD acquisition and $16.4 milliondue to the alternate fuel mixture tax credit partially offset by $7.5 millionof lower average revenue per ton and $1.7 million of unfavorable product mix.Included in operating income is $2.4 million of amortization of an intangibleasset recorded for an acquired coal contract with favorable prices.  The coal contract will terminate on December 31,2009.

 

The total amount of thealternative fuel mixture tax credit recorded in operating income for the threemonths ended June 30, 2009 was $48.6 million of which $32.2 million is relatedto the CKD business.

 

For the quarter ended June 30,2009, operating income as a percentage of net sales increased to 27.2% from26.3% for the second quarter of 2008 due to the alternative fuel mixture taxcredit partially offset by lower margins on sales.

 

***All Other***

 

| ** **                              | ** ** | **Three  Months Ended June 30,** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                              | ** ** | **2009**                              | ** ** | **2008** | ** ** |
| Net sales                               |       | $                                     | 6,095      |   | $ | 8,905 |   |
| Operating (loss) income                 |       | $                                     | (1,538     | ) | $ | 1,269 |   |
| Operating (loss) income  % of net sales |       | -25.2                                 | %          | 14.3 | % |

 

For the three monthsended June 30, 2009, net sales for the all other segment decreased by $2.8million, or 31.5%, to $6.1 million compared to $8.9 million for the threemonths ended June 30, 2008. The decrease is due to the sale of the dunnagebag business, which accounted for $8.9 million of net sales in 2008, offset bythe acquisition of the CKD lumber business, which increased net sales by $6.1million.

 

Operating loss for thethree months ended June 30, 2009 was $1.5 million reflecting lower salesvolume and selling prices in the lumber business, mainly due to a continuedslowdown in the number of new housing starts and lower consumer spending.Operating income in the three months ended June 30, 2008 reflects theresults of the dunnage bag business.

 

***Corporate***

 

Corporate expenses forthe three months ended June 30, 2009 totaled $5.3 million compared to$4.0 million for the three months ended June 30, 2008. The increaseof $1.3 million is primarily due to $1.4 million of  MWV transitional services and $0.5 million ofprofessional fees related to the CKD acquisition partially offset by $0.8million of lower compensation and benefit expenses as the Company temporarilysuspended certain benefits as a result of economic conditions.

 

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**Comparisonof Results of Operations for the Six Months Ended June 30, 2009 and theSix Months Ended June 30, 2008**

 
| ** **                                              | ** ** | **Six  Months Ended June 30,** | ** ** | **Increase/** | ** ** | **% Increase/** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------|------------|---------------|------------|-----------------|------------|
| **(in  thousands of U.S. dollars):**                    | ** ** | **2009**                            | ** ** | **2008**      | ** ** | **(Decrease)**  | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                   | 297,077    |          | $          | 135,291         |       | $ | 161,786 |   | 119.6 | % |
| Cost of sales,  excluding depreciation and amortization |       | 184,838                             |       | 82,358        |       | 102,480         |       | 124.4 | % |
| Freight and  distribution expenses                      |       | 26,493                              |       | 13,511        |       | 12,982          |       | 96.1 | % |
| Selling, general and  administrative expenses           |       | 16,187                              |       | 9,494         |       | 6,693           |       | 70.5 | % |
| Depreciation and  amortization                          |       | 27,097                              |       | 5,428         |       | 21,669          |       | 399.2 | % |
| Gain on sale of  business                               |       | 16,695                              |       | —        |       | 16,695          |       | N/A |   |
| Other operating income                                  |       | 448                                 |       | 371           |       | 77              |       | 20.8 | % |
| Operating income                                        |       | 59,605                              |       | 24,871        |       | 34,734          |       | 139.7 | % |
| Foreign exchange  gain/(loss)                           |       | (127                                | )          | —        |       | (127            | )          | N/A |   |
| Interest income                                         |       | 1                                   |       | 840           |       | (839            | )          | -99.9 | % |
| Interest expense                                        |       | 10,744                              |       | 1,213         |       | 9,531           |       | 785.7 | % |
| Income before provision  for income taxes               |       | 48,735                              |       | 24,498        |       | 24,237          |       | 98.9 | % |
| Provision for income  taxes                             |       | 19,511                              |       | 9,017         |       | 10,494          |       | 116.4 | % |
| Net income                                              |       | $                                   | 29,224     |          | $          | 15,481          |       | $ | 13,743 |   | 88.8 | % |

 

Net sales for the sixmonths ended June 30, 2009, were $297.1 million compared to $135.3 millionfor the first six months of 2008, an increase of $161.8 million or 119.6%. Theincrease in net sales was driven by the CKD acquisition on July 1, 2008,which accounted for $188.2 million of the increase. Excluding the CKDacquisition, net sales were lower in the first six months of 2009, compared tothe same period in 2008 by $26.4 million of which $9.9 million is a result ofthe sale of the dunnage bag business on March 31, 2009. In addition netsales decreased by $8.6 million due to lower volume, $7.0 million due to loweraverage revenue per ton and $2.4 million due to unfavorable product mix, as theCompany had a higher percentage of linerboard sales, which has a lower averageselling price than other products.

 

Tobalance production with demand, the Company ran four of its five paper machinesalternating downtime among the three machines at the Charleston mill.  By mid-June 2009, both paper mills wererunning at normal capacity.

 

Cost of sales for the sixmonths ended June 30, 2009, was $184.8 million compared to $82.4 million forthe first six months of 2008, an increase of $102.4 million, or 124.4%. Theincrease in cost of sales was due to the CKD acquisition, which accounted for$130.7 million of the increase. Excluding the CKD acquisition, cost of salesdecreased by $19.8 million due to the alternative fuel mixture tax credit, $6.6million due to the sale of the dunnage bag business in the first quarter of2009 and $4.9 million due to lower sales volume. Inflation increased costs by$1.7 million mainly for energy and raw materials.

 

The total amount of thealternative fuel mixture tax credit recorded as a reduction in cost of salesfor the first six months of 2009 was $54.0 million of which $34.2 million isincluded in CKD results.

 

Freight and distributionexpenses for the six months ended June 30, 2009, totaled $26.5 millioncompared to $13.5 million for the six months ended June 30, 2008. Theincrease of $13.0 million was due to the CKD acquisition, which accounted for$15.9 million of the increase. Excluding the CKD acquisition and the sale ofthe dunnage bag business, freight and distribution expenses were lower by $2.9million due to a $1.6 million reduction in sales volume, mainly due to lowerdemand reflecting economic conditions, $1.3 million of lower fuel oil surchargesand realization of favorable contract negotiations.

 

Selling, general andadministrative expenses for the six months ended June 30, 2009 totaled$16.2 million compared to $9.5 million for the similar period in 2008. Theincrease of $6.7 million reflects $4.2 million of CKD’sdirect selling and administrative expenses, $3.0 million of transitionalservices provided by MWV and $1.4 million of professional fees related to theCKD acquisition partially offset by $1.6 million of lower compensationand benefit expenses as the Company temporarily suspended certain benefits as aresult of economic conditions.

 

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Depreciation andamortization for the six months ended June 30, 2009, totaled $27.1 millioncompared to $5.4 million for the six month period ended June 30, 2008. Theincrease of $21.7 million was due to the CKD acquisition, which added anadditional $14.3 million of depreciation and $6.7 million of amortization ofintangibles, including $4.9 million of amortization for the intangible assetrelated to an acquired coal contract with below market prices at July 1,2008. The acquired coal contract expires December 31, 2009.

 

The $16.7 million gain onsale of business is the result of the sale of the dunnage bag business toIllinois Tool Works, Inc. on March 31, 2009.

 

Interestincome for the six months ended June 30, 2009 decreased by $0.8 millioncompared with the same period in 2008, reflecting lower cash balances beinginvested as the Company used cash and cash equivalents to fund a portion of theCKD acquisition, and lower average interest rates.

 

Interestexpense for the six months ended June 30, 2009 and 2008 was $10.7 millionand $1.2 million, respectively. Interest expense reflects interest on theCompany’s long-term debt and amortization of debt issuance costs. Interestexpense was $9.5 million higher in the six months ended June 30, 2009primarily due to higher debt levels relating to the CKD acquisition.Amortization of debt issuance costs for the periods ended June 30, 2009and 2008 was $1.7 million and $0.1 million, respectively, and reflects highercosts for the new Senior Credit Facility.

 

Provisionfor income taxes for the six months ended June 30, 2009 and 2008 was $19.5million and $9.0 million, respectively, reflecting higher pre-tax income and aneffective tax rate of 40.0% compared to 36.8% for the similar period in 2008.The primary reasons for the increase in the effective tax rate are due todifferences between the book and tax basis of the dunnage bag assets and alower expected benefit from the domestic manufacturing tax deduction.

 

**SegmentResults**

 

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

 
| ** **                      | ** ** | **Six  Months Ended June 30,** | ** ** |
|---------------------------------|------------|-------------------------------------|------------|
| **Operating  Segment ($000s):** | ** ** | **2009**                            | ** ** | **2008** | ** ** |
| Consolidated net sales:         |       |                                |       |   |   |
| Unbleached kraft                |       | $                                   | 279,858    |   | $ | 120,905 |   |
| All other                       |       | 18,118                              |       | 16,797 |   |
| Intersegment sales              |       | (899                                | )          | (2,411 | ) |
|                            |       |                                |       |   |   |
| Total net sales                 |       | $                                   | 297,077    |   | $ | 135,291 |   |
|                            |       |                                |       |   |   |
| Operating  income/(loss):       |       |                                |       |   |   |
| Unbleached kraft                |       | $                                   | 56,416     |   | $ | 30,480 |   |
| All other                       |       | (2,375                              | )          | 2,600 |   |
| Gain on sale of  business       |       | 16,695                              |       | — |   |
| Corporate                       |       | (11,131                             | )          | (8,209 | ) |
|                            |       |                                |       |   |   |
| Total operating income          |       | $                                   | 59,605     |   | $ | 24,871 |   |

 

The following representsanalysis and commentary for results of operations for the Company’s twooperating segments: unbleached kraft and all other.

 

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***Unbleached Kraft***

 
| ** **                       | ** ** | **Six  Months Ended June 30,** | ** ** |
|----------------------------------|------------|-------------------------------------|------------|
| ** **                       | ** ** | **2009**                            | ** ** | **2008** | ** ** |
| Net sales                        |       | $                                   | 279,858    |   | $ | 120,905 |   |
| Operating income                 |       | $                                   | 56,416     |   | $ | 30,480 |   |
| Operating income % of  net sales |       | 20.2                                | %          | 25.2 | % |
|                             |       |                                |       |   |   |
| Average revenue per ton          |       | $                                   | 558        |   | $ | 576 |   |
| Tons of paper sold               |       | 501,926                             |       | 209,781 |   |

 

For the six months ended June 30,2009, unbleached kraft segment net sales increased by $159.0 million, or131.5%, to $279.9 million compared to $120.9 million for the sixmonths ended June 30, 2008. The increase in net sales is due to the CKDacquisition, which increased net sales by $177.0 million and 307,705 tons ofpaper sold. Average revenue per ton in the first six months of 2009 was$558/ton, or $18/ton lower than average revenue per ton in the first six monthsof 2008. Excluding the CKD acquisition, net sales were lower by $18.0 millionin the first six months of 2009 compared to the first six months of 2008,mainly due to $8.6 million of lower volume, reflecting economic conditions,$7.0 million due to lower average revenue per ton, and $2.4 million ofunfavorable product mix, as the Company had a higher percentage of linerboardsales.

 

Tobalance production with demand, the Company ran four of its five paper machinesalternating downtime among the three machines at the Charleston mill.  By mid-June 2009, both paper mills wererunning at normal capacity.

 

Unbleached kraft segmentoperating income increased by $25.9 million, or 84.9%, to $56.4 millionfor the six months ended June 30, 2009 compared to $30.5 million forthe six months ended June 30, 2008. Operating income increased by $19.4 million due to the CKD acquisitionand $19.8 million due to the alternate fuel mixture tax credit partially offsetby $7.0 million of lower average revenue per ton, $3.2 million of lower salesvolume and $2.0 million of unfavorable product mix. Included in operatingincome is $4.9 million of amortization of an intangible asset recorded for anacquired coal contract with favorable prices. The coal contract will terminateon December 31, 2009.

 

The total amount of thealternative fuel mixture tax credit recorded in operating income for the firstsix months of 2009 was $54.0 million of which $34.2 million is related to the CKDbusiness.

 

For the six months ended June 30,2009, operating income as a percentage of net sales decreased to 20.2% from25.2% for the first six months of 2008 mainly due to lower average revenue perton and lower sales volume partially offset by the alternative fuel mixture taxcredit.

 

***All Other***

* *
| ** **                              | ** ** | **Six  Months Ended June 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------------|------------|
| ** **                              | ** ** | **2009**                            | ** ** | **2008** | ** ** |
| Net  sales                              |       | $                                   | 18,118     |   | $ | 16,797 |   |
| Operating  (loss) income                |       | $                                   | (2,375     | ) | $ | 2,600 |   |
| Operating  (loss) income % of net sales |       | -13.1                               | %          | 15.5 | % |

 

For the six months ended June 30,2009, net sales for the all other segment increased by $1.3 million, or 7.7%,to $18.1 million compared to $16.8 million for the first six months of 2008.The increase is due to the acquisition of the CKD lumber business, whichincreased sales by $11.2 million and was offset by the sale of the dunnage bagbusiness in March 2009.

 

Operating loss for thesix months ended June 30, 2009 of $2.4 million, was a decrease of $5.0million compared to the first six months of 2008, reflecting low sales volumeand selling prices in the lumber business, mainly 

 

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due to a continuedslowdown in the number of new housing starts, lower consumer spending and thesale of the dunnage bag business.

 

***Corporate***

 

Corporate expenses forthe six months ended June 30, 2009, totaled $11.1 million compared to $8.2million for the six months ended June 30, 2008. The increase of $2.9million is primarily due to $3.0 million of transitional services provided by MWV and $1.4 million of professional fees relatedto the CKD acquisition partially offset by $1.6 million of lowercompensation and benefit expenses as the Company temporarily suspended certainbenefits as a result of economic conditions.

 

**Liquidityand Capital Resources**

 

***Senior Credit Agreement and Senior Notes***

 

KapStone entered into aSenior Credit Agreement dated June 12, 2008. The Senior Credit Agreementprovides for an aggregate of up to $515 million of borrowing capacityconsisting of a $390 million term A loan, a $25 million term B loan and a $100 million revolving credit facility(including a letter of credit subfacility).  Borrowings under the SeniorCredit Agreement are guaranteed by KapStone Kraft and our other domesticsubsidiaries and are secured by substantially all of our consolidated assets,including all the capital stock of KapStone Kraft, the capital stock of ourguarantor subsidiaries and up to 66% of the capital stock of our foreignsubsidiaries.

 

At June 30, 2009,the Company had no outstanding borrowings under the revolving credit facility.

 

In addition, $40 millionof 8.3% seven year senior notes were issued in July 2008 as part of thefinancing for the CKD acquisition.

 

***Debt Covenants***

 

Under the financialcovenants of the Senior Credit Agreement, KapStone must comply on a quarterlybasis with a maximum permitted leverage ratio that is currently 3.5 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, 2009the Company was in compliance with the Senior Credit Agreement with a leverageratio of 2.90 to 1.00 and a fixed charge coverage ratio of 2.05 to 1.00.  The maximum permitted leverage ratios for thequarters ending September 30, 2009 and December 31, 2009 are 3.5 to1.and 3.0 to 1, respectively. The minimum fixed charge coverage ratio for thequarters ending September 30, 2009 and December 31, 2009 is 1.1 to 1.

 

***Alternative Fuel Mixture Tax Credit***

 

On March 31, 2009,the Company received approval from the Internal Revenue Service for itsregistration as an alternative fuel mixer, which provides for a refund of $0.50per gallon of alternate fuel used in the Company’s pulp making process. As aresult, for the six months ended June 30, 2009, the Company receivedrefunds of $58.7 million.  The Company expects credits for the last sixmonths of 2009 to approximate $102.0 million.

 

The alternative fuelmixture tax credit expires on December 31, 2009. If this tax credit wereto be terminated or materially changed prior to December 31, 2009, thismay have a material effect on our future cash flows and results of operations.

 

***Sale of Dunnage Bag Business***

 

On March 31, 2009,the Company sold its dunnage bag business to Illinois Tool Works Inc. for $36.0million. Of the net cash proceeds, $32.8 million was required to pay down theCompany’s long-term debt and notes under the terms of the Senior CreditAgreement.  As a condition of sale, $2.5 million of the sale proceeds arebeing held in escrow until September 30, 2010 to be available to satisfyany losses or indemnity claims that may arise against the Company in connectionwith the sale.

 

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As a result of the sale,the Company recorded an earn-out liability of $4.0 million in accordance withthe asset purchase agreement dated June 23, 2006 with International PaperCompany (“IP”). The terms of the asset purchase agreement include a contingentearn-out payment on the fifth anniversary of the acquisition; however, in theevent of a sale of the dunnage bag business prior to that date, a percentage ofthe earn-out becomes due and payable within 30 days following the sale providedcertain criteria is met. The earn-out was paid on April 30, 2009.

 

In the quarter ended June 30,2009 the Company accrued a working capital adjustment of $0.9 million as areduction on the gain in connection with the sale.

 

***Income Taxes***

 

In the six months ended June 30,2009, the Company received a $9.4 million federal income tax refund. Anadditional refund of $3.8 million was received in July 2009.

 

***Sources and Uses of Cash***

 
| **Six months ended June 30  ($000’s)** | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
| Operating  activities                            |       | $        | 62,787     |     | $          | 20,933 |   |
| Investing  activities                            |       | 17,696   |       | (7,013   | )          |
| Financing  activities                            |       | (62,501  | )          | (14,047  | )          |
|                                                  |            |          |            |          |            |  |  |

 

Cash flow from allactivities during the six months ended June 30, 2009 increased cash by$18.0 million from December 31, 2008, reflecting cash provided by operatingactivities of $62.8 million, cash provided by investing activities of $17.7million offset by cash used in financing activities of $62.5 million.

 

Cash provided byoperating activities was $62.8 million due to $29.2 million of net income forthe first six months of 2009 and $41.5 million of non-cash charges offset bythe gain on sale of the dunnage bag business of $16.7 million. Changes inoperating assets and liabilities provided $8.8 million of cash.

 

Cash provided byinvesting activities was $17.7 million reflecting proceeds from the sale of thedunnage bag business of $36.1 million and $1.0 million for the CKD acquisitionoffset by capital expenditures of $12.9 million, $4.0 million paid for the KPBearn-out related to the sale of the dunnage bag business and $2.5 million ofproceeds from the sale of the dunnage bag business held in escrow. For the sixmonths ended June 30, 2009, capital expenditures include $11.7 million forthe unbleached kraft segment for equipment upgrades, IT projects andreplacements at the paper mills. In addition, $1.2 million was spent onCorporate IT systems projects.

 

Cash used in financingactivities totaled $62.5 million during the six months ended June 30,2009, and reflects $123.4 million of repayments on long-term debt, notes andrevolver offset by borrowings under the revolving credit facility of $61.3million and $0.4 million paid in connection with an amendment to the SeniorCredit Agreement.

 

***Future Cash Needs***

 

We expect that cashgenerated from operating activities, and if needed, the ability to draw fromour revolving credit facility will be sufficient to meet anticipated 2009 cashneeds. The Company expects to spend an additional $17.0 million on capitalexpenditures in 2009. In addition, the Company has $21.4 million of requiredlong-term debt and note repayments for the remainder of 2009 and plans to fund$5.1 million for its defined benefit pension plan for union employees. TheCompany also intends to make a significant voluntary pre-payment on itslong-term debt in the third quarter of 2009.

 

**Off-BalanceSheet Arrangements**

 

We have not entered intoany off-balance sheet financing arrangements and have not established any specialpurpose entities. We have not guaranteed any debt or commitments of otherentities or entered into any options on non-financial assets.

 

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**Item 3. — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Market risk is thesensitivity of income to changes in interest rates, commodity prices, equityprices, and other market-driven rates or prices.

 

Under KapStone Kraft’snew Senior Credit Facilities, we have two term loans totaling $341.6 millionoutstanding at June 30, 2009.  The maturity date is the earlierof:  (a) June 12, 2013 with respect to the term A loan facilityand the revolving credit facility, and June 12, 2015 with respect to theterm B loan facility, and (b) the date which is 90 days prior to the dateon which any earn-out, obligations to IP will become (or are reasonablyexpected to become) due, excluding the earn-out as a result of the sale of thedunnage bag business; 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 3.5 to 1.0.

 

Changes in market ratesmay impact the base rate in our Senior Credit Agreement. For instance, if thebank’s LIBOR rate was to increase or decrease by one percentage point (1.0%),our annual interest expense would change by approximately $3.3 million basedupon our existing repayment schedule.

 

We are exposed to pricefluctuations of certain commodities used in production. Key raw materials andenergy used in the production process include roundwood and woodchips, fueloil, electricity and caustic soda.  We purchase these raw materials and energyat market prices, and do not use forward contracts or other financialinstruments to hedge our exposure to price risk related to thesecommodities.  We have two contracts to purchase coal at fixed prices thatexpire on December 31, 2009.

 

We are exposed tocurrency fluctuations as we invoice certain European customers in euros. Attimes, the Company has used forward contracts to reduce the impact of currencyfluctuations. No such contracts were outstanding at June 30, 2009.

 

**Item4. — CONTROLS AND PROCEDURES**

 

As of the end of theperiod covered by this report, our Chief Executive Officer and our ChiefFinancial Officer carried out an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures, as required by Rule 13a-15(b) underthe Securities Exchange Act of 1934. Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were effective as of June 30, 2009.

 

There were no changes inour internal control over financial reporting during the three months ended June 30,2009 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**PART II.— OTHER INFORMATION**

 

**Item 1. — LEGAL PROCEEDINGS**

 

None.

 

**Item 1A. — RISK FACTORS**

 

With the exception of thefollowing update to the risk factors relating to the alternative fuel mixturetax credit, there have been no material changes from the Risk Factors describedin our Form 10-K for the year ended December 31, 2008 (“Form 10-K”). The Risk Factor below should be read in conjunction with the Risk Factors andinformation disclosed in our Form 10-K.

 

The alternative fuelmixture tax credit provided by the U.S. government is being challenged inCongress and may be amended in a manner that eliminates or reduces the benefitsof the tax credit for pulp and paper companies.

 

The U.S. governmentprovides an excise tax credit to taxpayers for the use of alternative fuelmixtures.  The alternative fuel mixture tax credit, as it relates toliquid fuel derived from biomass, is scheduled to expire on December 31, 2009.  Inrecent months, certain members of Congress and others have indicated theiropposition to pulp and paper companies receiving the taxcredit.  They have called for the amendment of the tax credit in amanner that would eliminate or reduce its benefits for pulp and papercompanies.  In response, other members of Congress and interestedparties have voiced their support for maintaining the tax credit and itsavailability to all taxpayers, including pulp and papercompanies.  We do not know whether the U.S. government will amend thetax credit to eliminate or reduce its benefits for pulp and paper companies,but there is the possibility that such action may be taken.  Any suchamendment of the tax credit could have a material adverse effect on our financialcondition and results of operations.

 

**Item 2. — UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

 

None.

 

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

 

None.

 

**Item 4. — SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

The Registrant’s AnnualMeeting of Stockholders was held on May 21, 2009. At the meeting,stockholders voted on (1) the election of three directors for terms ofoffice expiring at the Annual Meeting of Stockholders in 2012, and (2) theratification of the appointment of Ernst & Young LLP as independentregistered public accounting firm of the Company for 2009.

 

The voting results are asfollows:

 
| ** ** | ** ** | ** **                                 | ** ** | **Votes  For** | ** ** | **Votes  Against** | ** ** | **Withheld/Abstentions** | ** ** |
|------------|------------|--------------------------------------------|------------|----------------|------------|--------------------|------------|--------------------------|------------|
| 1.         |       | Directors for re-election                  |       |           |       |               |       |                     |       |
|       |       |                                       |       |           |       |               |       |                     |       |
|       |       | James Doughan                              |       | 26,251,514     |       | —             |       | 605,549                  |       |
|       |       |                                       |       |           |       |               |       |                     |       |
|       |       | Jonathan R. Furer                          |       | 26,142,591     |       | —             |       | 714,472                  |       |
|       |       |                                       |       |           |       |               |       |                     |       |
|       |       | Roger W. Stone                             |       | 26,334,730     |       | —             |       | 522,333                  |       |
|       |       |                                       |       |           |       |               |       |                     |       |
| 2.         |       | Ratification of Ernst & Young LLP |       | 26,812,036     |       | 23,657             |       | 21,370                   |       |

 

**Item 5. — OTHER INFORMATION**

 

None.

 

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**PART II. — OTHER INFORMATION**

 

**Item 6. — EXHIBITS**

 

The following Exhibitsare filed as part of this report.

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                        |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                   |
| 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**

 

In accordance withthe requirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|               |   | KAPSTONE PAPER AND  PACKAGING CORPORATION   |
|--------------------|--------|---------------------------------------------|
|               |   |                                        |
|               |   |                                        |
| July 30, 2009 | By:    | /s/ Andrea K. Tarbox                        |
|               |   | Andrea K. Tarbox                            |
|               |   | Vice President and  Chief Financial Officer |

 

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