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 the quarterly period ended September 30, 2010**

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

 

**For the transition period from           to          **

 

**Commission File Number: 001-33494**

 

**KapStone Paper and Packaging Corporation**

(Exact name of registrant as specified in its charter)

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

 

**KapStone Paper and Packaging Corporation**

**1101 Skokie Blvd., Suite 300**

**Northbrook, IL 60062**

(Address of Principal Executive Offices including zip code)

 

 

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

 

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

 

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

 

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

 

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

 

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

 

Therewere 46,009,382 shares of the Registrant’s Common Stock, $0.0001 par value,outstanding as of October 27, 2010, excluding 40,000 shares held astreasury shares.

 

 

 

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Table ofContents

 

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

 

**TABLE OF CONTENTS**

 
| PART I. — FINANCIAL INFORMATION |                                                                                                          |
|-------------------------------------------|---------------------------------------------------------------------------------------------------------------|
|                                      |                                                                                                          |   |
|                                      | Item 1. —  Consolidated Financial Statements (Unaudited) and Notes to Consolidated  Financial Statements | 1 |
|                                      |                                                                                                          |   |
|                                      | Item 2. — Management’s Discussion and Analysis of  Financial Condition and Results of Operations    | 12 |
|                                      |                                                                                                          |   |
|                                      | 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. —  Reserved                                                                                      | 21 |
|                                      |                                                                                                          |   |
|                                      | Item  5. — Other Information                                                                             | 21 |
|                                      |                                                                                                          |   |
|                                      | Item 6. —  Exhibits                                                                                      | 22 |
|                                      |                                                                                                          |   |
| SIGNATURE                                 | 23                                                                                                            |

 

i

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Table ofContents

 

**PART 1.FINANCIAL INFORMATION**

 

**ITEM 1. -FINANCIAL STATEMENTS**

 

**KapStone Paper and Packaging Corporation**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                                                                                                                                                                                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                      | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| ** **                                                                                                                                                                                                                                                                      | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                       |       | $                      | 41,617     |                  | $          | 2,440 |   |
| Trade accounts receivable, less allowances of  $1,303 in 2010 and $1,217 in 2009                                                                                                                                                                                                |       | 72,425                 |       | 58,408                |       |
| Other receivables                                                                                                                                                                                                                                                               |       | 2,893                  |       | 16,487                |       |
| Inventories                                                                                                                                                                                                                                                                     |       | 71,836                 |       | 61,377                |       |
| Refundable and prepaid income taxes                                                                                                                                                                                                                                             |       | 980                    |       | 13,757                |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                       |       | 3,897                  |       | 1,690                 |       |
| Restricted cash                                                                                                                                                                                                                                                                 |       | —                 |       | 2,500                 |       |
| Deferred income taxes                                                                                                                                                                                                                                                           |       | 5,917                  |       | 5,604                 |       |
| Total current assets                                                                                                                                                                                                                                                            |       | 199,565                |       | 162,263               |       |
|                                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Plant, property and equipment, net                                                                                                                                                                                                                                              |       | 462,504                |       | 470,278               |       |
| Other assets                                                                                                                                                                                                                                                                    |       | 4,235                  |       | 4,935                 |       |
| Intangible assets, net                                                                                                                                                                                                                                                          |       | 23,548                 |       | 26,198                |       |
| Goodwill                                                                                                                                                                                                                                                                        |       | 4,811                  |       | 5,449                 |       |
| Total assets                                                                                                                                                                                                                                                                    |       | $                      | 694,663    |                  | $          | 669,123 |   |
|                                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                                                                                                                                  |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Current portion of long-term debt                                                                                                                                                                                                                                               |       | $                      | 18,835     |                  | $          | 18,630 |   |
| Borrowings under revolving credit facility                                                                                                                                                                                                                                      |       | —                 |       | 7,400                 |       |
| Other current borrowings                                                                                                                                                                                                                                                        |       | 644                    |       | —                |       |
| Accounts payable                                                                                                                                                                                                                                                                |       | 51,966                 |       | 52,147                |       |
| Accrued expenses                                                                                                                                                                                                                                                                |       | 20,832                 |       | 20,800                |       |
| Accrued compensation costs                                                                                                                                                                                                                                                      |       | 16,164                 |       | 7,719                 |       |
| Total current liabilities                                                                                                                                                                                                                                                       |       | 108,441                |       | 106,696               |       |
|                                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Other liabilities:                                                                                                                                                                                                                                                              |       |                   |       |                  |       |
| Long-term debt, net of current portion                                                                                                                                                                                                                                          |       | 97,157                 |       | 121,031               |       |
| Pension and post-retirement benefits                                                                                                                                                                                                                                            |       | 6,663                  |       | 5,949                 |       |
| Deferred income taxes                                                                                                                                                                                                                                                           |       | 19,663                 |       | 38,577                |       |
| Other liabilities                                                                                                                                                                                                                                                               |       | 59,377                 |       | 48,080                |       |
| Total other liabilities                                                                                                                                                                                                                                                         |       | 182,860                |       | 213,637               |       |
|                                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                      |       |                   |       |                  |       |
| Preferred stock $0.0001 par value; 1,000,000  shares authorized; no shares issued and outstanding                                                                                                                                                                               |       | —                 |       | —                |       |
| Common stock $0.0001 par value, 175,000,000 shares  authorized; 46,009,382 shares issued and outstanding (40,000 treasury shares  outstanding) at September 30, 2010 and 45,418,074 issued and outstanding  (40,000 treasury shares outstanding) at December 31, 2009 |       | 5                      |       | 5                     |       |
| Additional paid-in capital                                                                                                                                                                                                                                                      |       | 223,440                |       | 219,828               |       |
| Retained earnings                                                                                                                                                                                                                                                               |       | 180,896                |       | 129,046               |       |
| Accumulated other comprehensive loss                                                                                                                                                                                                                                            |       | (979                   | )          | (89                   | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                                 |       | 403,362                |       | 348,790               |       |
|                                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                 |       | $                      | 694,663    |                  | $          | 669,123 |   |

 

See notes to consolidated financial statements

 

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**KapStone Paper and Packaging Corporation**

**Consolidated Statements of Income**

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

 

**(unaudited)**

 
| ** **                                              | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                              | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Net sales                                               |       | $                                                        | 207,493    |                                                    | $          | 170,335 |   | $ | 583,111 |   | $ | 467,412 |   |
| Cost of sales, excluding depreciation and  amortization |       | 142,212                                                  |       | 86,812                                                  |       | 419,197 |   | 271,650 |   |
| Freight and distribution expenses                       |       | 20,161                                                   |       | 16,262                                                  |       | 56,279 |   | 42,755 |   |
| Selling, general and administrative expenses            |       | 7,631                                                    |       | 7,105                                                   |       | 23,672 |   | 23,292 |   |
| Depreciation and amortization                           |       | 11,129                                                   |       | 13,664                                                  |       | 33,624 |   | 40,761 |   |
| Gain/(loss) on sale of business                         |       | —                                                   |       | (278                                                    | )          | — |   | 16,417 |   |
| Other operating income                                  |       | 250                                                      |       | 285                                                     |       | 760 |   | 733 |   |
| Operating income                                        |       | 26,610                                                   |       | 46,499                                                  |       | 51,099 |   | 106,104 |   |
| Foreign exchange gain/(loss)                            |       | 301                                                      |       | 175                                                     |       | (597 | ) | 48 |   |
| Interest income                                         |       | 9                                                        |       | —                                                  |       | 27 |   | 1 |   |
| Interest expense                                        |       | 1,319                                                    |       | 5,353                                                   |       | 4,257 |   | 16,097 |   |
| Income before provision (benefit) for income taxes      |       | 25,601                                                   |       | 41,321                                                  |       | 46,272 |   | 90,056 |   |
| Provision (benefit) for income taxes                    |       | (12,765                                                  | )          | 15,649                                                  |       | (5,578 | ) | 35,160 |   |
|                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income                                              |       | $                                                        | 38,366     |                                                    | $          | 25,672 |   | $ | 51,850 |   | $ | 54,896 |   |
|                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted-average number of shares outstanding:          |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                   |       | 45,984,422                                               |       | 36,548,515                                              |       | 45,795,023 |   | 31,096,354 |   |
| Diluted                                                 |       | 47,049,913                                               |       | 36,940,773                                              |       | 46,892,468 |   | 31,355,785 |   |
| Net income per share:                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                   |       | $                                                        | 0.83       |                                                    | $          | 0.70 |   | $ | 1.13 |   | $ | 1.77 |   |
| Diluted                                                 |       | $                                                        | 0.82       |                                                    | $          | 0.69 |   | $ | 1.11 |   | $ | 1.75 |   |

 

See notes to consolidated financial statements

 

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**KapStone Paper and Packaging Corporation**

**Consolidated Statements of Cash Flows**

**(In thousands)**

 

**(unaudited)**

 
| ** **                                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2010**                                                | ** ** | **2009** | ** ** |
| **Operating activities**                                                                     |       |                                                    |       |   |   |
| Net income                                                                                   |       | $                                                       | 51,850     |   | $ | 54,896 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                                                    |       |   |   |
| Depreciation and amortization                                                                |       | 33,624                                                  |       | 40,761 |   |
| Stock based compensation expense                                                             |       | 2,833                                                   |       | 1,686 |   |
| Amortization of debt issuance costs                                                          |       | 1,797                                                   |       | 4,210 |   |
| Loss on disposal of fixed assets                                                             |       | 628                                                     |       | 756 |   |
| Deferred income taxes                                                                        |       | (18,730                                                 | )          | 13,750 |   |
| Gain on sale of dunnage bag business                                                         |       | —                                                  |       | (16,417 | ) |
| Changes in operating assets and liabilities:                                                 |       |                                                    |       |   |   |
| Trade accounts receivable, net                                                               |       | (14,017                                                 | )          | 9,081 |   |
| Other receivables                                                                            |       | 13,594                                                  |       | (12,100 | ) |
| Inventories                                                                                  |       | (10,459                                                 | )          | 23,242 |   |
| Refundable and prepaid income taxes                                                          |       | 12,777                                                  |       | 13,124 |   |
| Prepaid expenses and other current assets                                                    |       | (2,207                                                  | )          | (1,445 | ) |
| Other assets                                                                                 |       | (624                                                    | )          | (1,041 | ) |
| Accounts payable                                                                             |       | (181                                                    | )          | (5,102 | ) |
| Accrued expenses and other                                                                   |       | 11,806                                                  |       | 3,386 |   |
| Accrued compensation costs                                                                   |       | 8,445                                                   |       | (4,997 | ) |
| Net cash provided by (used in) operating  activities                                         |       | 91,136                                                  |       | 123,790 |   |
|                                                                                         |       |                                                    |       |   |   |
| **Investing activities**                                                                     |       |                                                    |       |   |   |
| CKD acquisition                                                                              |       | 638                                                     |       | 1,000 |   |
| KPB earn-out                                                                                 |       | —                                                  |       | (3,977 | ) |
| Proceeds from sale of dunnage bag business                                                   |       | —                                                  |       | 34,898 |   |
| Restricted cash                                                                              |       | 2,500                                                   |       | (2,500 | ) |
| Capital expenditures                                                                         |       | (23,829                                                 | )          | (18,656 | ) |
| Net cash provided by (used in) investing  activities                                         |       | (20,691                                                 | )          | 10,765 |   |
|                                                                                         |       |                                                    |       |   |   |
| **Financing activities**                                                                     |       |                                                    |       |   |   |
| Proceeds from revolving credit facility                                                      |       | 76,700                                                  |       | 64,300 |   |
| Repayments on revolving credit facility                                                      |       | (84,100                                                 | )          | (76,700 | ) |
| Repayments of long-term debt                                                                 |       | (25,293                                                 | )          | (208,093 | ) |
| Proceeds from other current borrowings                                                       |       | 2,564                                                   |       | — |   |
| Repayments on other current borrowings                                                       |       | (1,920                                                  | )          | — |   |
| Payment of withholding taxes on vested restricted  stock awards                              |       | (624                                                    | )          | — |   |
| Proceeds from the exercises of warrants into  common stock                                   |       | —                                                  |       | 85,217 |   |
| Proceeds from the exercises of stock options                                                 |       | 777                                                     |       | — |   |
| Excess tax benefits from stock based compensation                                            |       | 447                                                     |       | — |   |
| Proceeds from employee stock purchase plan                                                   |       | 70                                                      |       | — |   |
| Debt issuance costs                                                                          |       | —                                                  |       | (370 | ) |
| Other                                                                                        |       | 111                                                     |       | — |   |
| Net cash provided by (used in) financing  activities                                         |       | (31,268                                                 | )          | (135,646 | ) |
|                                                                                         |       |                                                    |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                        |       | 39,177                                                  |       | (1,091 | ) |
| Cash and cash equivalents-beginning of period                                                |       | 2,440                                                   |       | 4,165 |   |
| Cash and cash equivalents-end of period                                                      |       | $                                                       | 41,617     |   | $ | 3,074 |   |

 

See notes to consolidated financial statements

 

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

 

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

 

**(unaudited)**

 

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

 

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

 

**2.****             ****RecentAccounting Pronouncements**

 

InJanuary 2010, the Financial Accounting Standards Board (“FASB”) issued AccountingStandard Update (“ASU”) No. 2010-06, “Fair Value Measurements andDisclosures,” which amends the disclosure requirements related to recurring andnonrecurring fair value measurements.  The guidance requires disclosure oftransfers of assets and liabilities between Level 1 and Level 2 of the fairvalue measurement hierarchy, including the reasons and the timing of thetransfers and information on purchases, sales, issuance, and settlements on agross basis in the reconciliation of the assets and liabilities measured underLevel 3 of the fair value measurement hierarchy. The guidance is effective forannual and interim reporting periods beginning after December 15, 2009,except for Level 3 reconciliation disclosures which are effective for annualand interim periods beginning after December 15, 2010. The implementationof this standard did not have a material impact on the consolidated financialstatements.

 

InDecember 2007, the FASB issued Statement of Financial Accounting StandardsNo. 141(R), *Business Combinations*(“SFAS No. 141(R)”). This guidance is included in FASB ASC 805, *Business Combinations*. This guidancerequires the Company to continue to follow the guidance in SFAS No. 141(also included in FASB ASC 805) for certain aspects of business combinations,and provides additional guidance defining the acquirer, recognizing andmeasuring the identifiable assets acquired, the liabilities assumed, anynoncontrolling interest in the acquiree, assets and liabilities arising fromcontingencies, defining a bargain purchase and recognizing and measuringgoodwill or a gain from a bargain purchase. This guidance also requirestransaction costs to be charged to earnings and requires contingentconsideration to be recorded at its fair value on the acquisition date. Inaddition, under this guidance, adjustments associated with changes in taxcontingencies that occur after the measurement period, not to exceed one year,are recorded as adjustments to income. This guidance is effective for allbusiness combinations for which the acquisition date is on or after thebeginning of an entity’s first fiscal year that begins after December 15,2008; however, the guidance regarding the treatment of income tax contingenciesis retrospective to business combinations completed prior to 2009.  Nobusiness combinations occurred during the nine months ended September 30,2010.

 

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

 

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

 
| ** **                                                                                                                                             | ** ** | **Three Months******** Ended********September 30,** | ** ** | **Nine Months   Ended********September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                                                                                                             | ** ** | **2010**                                                           | ** ** | **2009**                                                    | ** ** | **2010** | ** ** | **2009** | ** ** |
| Gallons of fuel burned (000’s) (unaudited)                                                                                                        |       | —                                                             |       | 104,608                                                     |       | — |   | 243,769 |   |
| Tax credit for each gallon burned                                                                                                                      |       | —                                                             |       | $                                                           | 0.50       |   | — |   | $ | 0.50 |   |
|                                                                                                                                                   |       |                                                               |       |                                                        |       |   |   |   |   |
| Total alternative fuel mixture tax credit  generated (1)                                                                                               |       | $                                                                  | —     |                                                        | $          | 52,304 |   | $ | — |   | $ | 121,884 |   |
|                                                                                                                                                   |       |                                                               |       |                                                        |       |   |   |   |   |
| Recognition of tax credit deferred in  June 30, 2009 inventory                                                                                    |       | —                                                             |       | 15,574                                                      |       | — |   | — |   |
|                                                                                                                                                   |       |                                                               |       |                                                        |       |   |   |   |   |
| Recognition of tax credit deferred in  December 31, 2009 inventory                                                                                |       | —                                                             |       | —                                                      |       | 14,260 |   | — |   |
|                                                                                                                                                   |       |                                                               |       |                                                        |       |   |   |   |   |
| Tax credit related to inorganic content burned in  2009                                                                                                |       | —                                                             |       | —                                                      |       | 7,935 |   | — |   |
|                                                                                                                                                   |       |                                                               |       |                                                        |       |   |   |   |   |
| Tax credit deferred in ending inventory at  September 30, 2009                                                                                    |       | —                                                             |       | (14,420                                                     | )          | — |   | (14,420 | ) |
|                                                                                                                                                   |       |                                                               |       |                                                        |       |   |   |   |   |
| Total alternative fuel mixture tax credits  included as a reduction to cost of sales for three and nine months ended  September 30, 2010 and 2009 |       | $                                                                  | —     |                                                        | $          | 53,458 |   | $ | 22,195 |   | $ | 107,464 |   |

 

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

 

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

 

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

 

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

 

Costof sales for the nine months ended September 30, 2010 includedapproximately $6.8 million for the tri-annual planned maintenance outage forthe Company’s South Carolina paper mill.

 

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

 

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

 
| ** **                     | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                     | ** ** | **2010**               | ** ** | **2009**              | ** ** |
| Raw materials                  |       | $                      | 17,444     |                  | $          | 13,082 |   |
| Work in process                |       | 1,226                  |       | 980                   |       |
| Finished goods                 |       | 31,828                 |       | 27,475                |       |
| Replacement parts and supplies |       | 21,338                 |       | 19,840                |       |
| Inventories                    |       | $                      | 71,836     |                  | $          | 61,377 |   |

 

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

 

TheCompany uses derivative instruments to manage its foreign currency exchangerisks associated with Euro-denominated sales of its U.S. operations. Foreigncurrency forward contracts are used to hedge the variability of exchange rateson the Company’s cash flows.  Thederivative instrument is valued using Level 2 inputs which are significantobservable inputs for similar assets and liabilities in active markets. Thefair value was estimated using a market approach based on the Euro to U.S.dollar exchange rates. The Company does not acquire or issue derivativefinancial instruments for trading purposes.

 

The foreign currencyforward contracts are designated as cash flow hedges.  The contracts are recorded in theconsolidated balance sheet and measured at fair value.  The effective portion of the gain or loss onthe derivative is recorded as a component of accumulated other comprehensiveloss (“AOCL”) in the accompanying consolidated balance sheet and is reclassifiedinto net sales in the consolidated statement of income upon recognition of thehedged sales. The foreign currency forward contracts outstanding have monthlymaturity dates through December 31, 2010. The effectiveness of theseforward contracts are assessed both at inception and on a quarterly basis toensure that they are effective in offsetting changes in the cash flowsattributable to the hedged risk.

 

The notional amount ofthese foreign currency forward contracts was $10.2 million and $0 at September 30,2010 and December 31, 2009, respectively. The estimated pre-tax loss to berecognized in earnings during the next twelve months upon settlement of theforward contracts is $1.0 million.

 

Forconsolidated financial statement presentation, net cash flows from such hedgesare classified in the categories of the consolidated statement of cash flowswith the items being hedged. The table below lists the fair value and locationof the Company’s derivative instrument in the consolidated balance sheets:

 
| **Derivatives designated as********hedging instruments** | ** ** | **Balance Sheet Account** | ** ** | **Fair Value********at 9/30/2010** | ** ** | **Fair Value********at 12/31/2009** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|
| Foreign currency forward contracts                                      |       | Accrued expenses                    |       | $                                            | (996       | )                                             | $          | — |   |
|                                                                         |            |                                     |            |                                              |            |                                               |            |  |  |

 

Thetable below presents the pre-tax effect of the derivative instrument and itslocation within the consolidated statements of income for the nine months endedSeptember 30, 2010 and 2009:

 
| ** **                                                                                          | ** ** | **Foreign currency  cash flow hedges** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2010**                                              | ** ** | **2009** | ** ** |
|                                                                                                |       |                                                  |       |   |   |
| Gain (loss) recognized in other comprehensive loss  (effective portion)                             |       | $                                                     | (983       | ) | $ | — |   |
|                                                                                                |       |                                                  |       |   |   |
| Gain (loss) reclassified to earnings from  accumulated other comprehensive loss (effective portion) |       | $                                                     | (459       | ) | $ | — |   |
| Gain (loss) recognized in earnings (1)                                                              |       | (2                                                    | )          | — |   |
| Total gain (loss) recognized in earnings                                                            |       | $                                                     | (461       | ) | $ | — |   |

 

----

(1)     Represents amounts excluded fromeffectiveness testing for foreign currency cash flow hedges.

 

**7.****             ****Debt**

 

Forthe three months ended September 30, 2010, long-term debt repaymentstotaled $7.3 million including a $2.5 million mandatory prepayment. For thenine months ended September 30, 2010, long-term debt repayments totaled$25.3 million including a $10.0 million voluntary prepayment and a $2.5 millionmandatory prepayment. In connection with the prepayments, $0.3 million of debtissuance costs were amortized.

 

AtSeptember 30, 2010 the carrying amount and fair value of the Company’sdebt was $116.0 million and $97.4 million, respectively.  At December 31, 2009 the carrying amountand fair value of the Company’s debt was $139.7 million and $113.4 million,respectively. The fair value of the Company’s debt was estimated using anincome approach based on current interest rates available to the Company fordebt of similar terms and maturities.

 

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**8.     Income Taxes**

 

TheCompany’s U.S. federal statutory income tax rate is 35% for each of 2010 and2009. The Company’s effective tax rates for the nine months ended September 30,2010 and 2009 were (12.1%) and 39.0%, respectively.  The differencesbetween the effective tax rate and the federal statutory tax rate for the ninemonths ended September 30, 2010 was due primarily to the benefit relatedto the Cellulosic Biofuel credit, the benefit related to the refundable taxcredit from the inorganic content of black liquor burned in 2009 and state taxnet of federal benefit.

 

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

 

TheCompany’s gross unrecognized tax benefits, including interest as of September 30,2010 increased by $4.8 million to $67.7 million from $62.9 million at December 31,2009.  Unrecognized tax benefits of $67.7 million were included in otherlong term liabilities in the accompanying consolidated balance sheet.

 

InAugust 2010, the U.S. Internal Revenue Service (“IRS”) approved theCompany’s registration as a producer of cellulosic biofuel for the tax year2009. With this registration, the Company applied for a nonrefundable incometax credit of $1.01 per gallon of qualified cellulosic biofuel for black liquorburned by the Company in early 2009 for which the Company did not claim thealternative fuel mixture tax credit. A $20.7 million benefit (net of U.S.federal and state taxes) related to the cellulosic biofuel tax credit wasreflected in the Company’s income tax provision as a discrete item for thequarter ended September 30, 2010. The Company reported $33.9 million (thegross tax credit amount) as a deferred tax asset as of September 30, 2010which is available to offset taxable income in future years.

 

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

 

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

 

Basicand diluted net income per share is calculated as follows:

 
| ** **                                                               | ** ** | **Three Months Ended******** September 30,** | ** **   | **Nine Months Ended******** September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------------------|--------------|-----------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2010**                                                         | ** **   | **2009**                                                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net income                                                          |       | $                                                                |  38,366 |                                                            | $          |  25,672 |   | $ | 51,850 |   | $ |  54,896 |   |
| Weighted-average number of common shares for basic  net income per share |       | 45,984,422                                                       |         | 36,548,515                                                      |       | 45,795,023 |   | 31,096,354 |   |
| Incremental effect of dilutive common stock  equivalents:                |       |                                                             |         |                                                            |       |   |   |   |   |
| Unexercised stock options                                                |       | 740,589                                                          |         | 92,083                                                          |       | 677,907 |   | 30,694 |   |
| Underwriter’s purchase option                                       |       | —                                                           |         | —                                                          |       | 72,282 |   | — |   |
| Unvested restricted stock awards                                         |       | 324,902                                                          |         | 300,175                                                         |       | 347,256 |   | 228,737 |   |
|                                                                     |       |                                                             |         |                                                            |       |   |   |   |   |
| Weighted-average number of shares for diluted net  income per share      |       | 47,049,913                                                       |         | 36,940,773                                                      |       | 46,892,468 |   | 31,355,785 |   |
|                                                                     |       |                                                             |         |                                                            |       |   |   |   |   |
| Net income per share – basic                                        |       | $                                                                | 0.83         |                                                            | $          | 0.70 |   | $ | 1.13 |   | $ | 1.77 |   |
|                                                                     |       |                                                             |         |                                                            |       |   |   |   |   |
| Net income per share – diluted                                      |       | $                                                                | 0.82         |                                                            | $          | 0.69 |   | $ | 1.11 |   | $ | 1.75 |   |

 

Commonstock warrants were not included in the calculation of diluted earnings pershare for the three and nine months ended September 30, 2009 since theweighted average share price per share of common stock was $4.96 and $3.42,respectively, compared to the warrant’s conversion price of $5.00, and theeffect would be anti-dilutive.  Thecommon stock warrants expired on August 17, 2009.

 

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Unexercisedstock options totaling 0.5 million were outstanding during the three and ninemonths ended September 30, 2010, but were not included in the computationof diluted earnings per share because the options were not dilutive.Unexercised stock options totaling 2.1 million and 2.2 million were outstandingduring the three and nine months ended September 30, 2009, respectively,but were not included in the computation of diluted earnings per share becausethe options were not dilutive.

 

Inconnection with the Company’s initial public offering on August 19, 2005,the Company issued, for $100, an option to the representative of theunderwriters to purchase up to a total of 1,000,000 units at a price of $7.50per unit. Each unit consisted of one share of the Company’s common stock,$0.0001 par value, and two warrants. The warrants expired on August 17,2009, after which each unit consisted of only one share of common stock. In March 2010,the underwriter’s purchase option was exercised and converted into 348,393shares of common stock. The underwriter’s purchase option of 1,000,000 unitswas outstanding at September 30, 2009, but was not included in thecomputation of diluted earnings per share because the option was not dilutivefor the three and nine month periods ended September 30, 2009.

 

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

 

**Defined Benefit Pension Plan**

 

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

 

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

 
| ** **                                         | ** ** | **Three Months Ended********September 30,** | ** ** | **Nine Months Ended********September 30,** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                         | ** ** | **2010**                                                   | ** ** | **2009**                                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                               |       |                                                       |       |                                                      |       |   |   |   |   |
| Service cost for benefits earned during the period |       | $                                                          | 715        |                                                      | $          | 703 |   | $ | 2,145 |   | $ | 2,145 |   |
| Interest cost on projected benefit obligation      |       | 141                                                        |       | 93                                                        |       | 423 |   | 280 |   |
| Expected return on plan assets                     |       | (129                                                       | )          | (38                                                       | )          | (386 | ) | (115 | ) |
| Amortization of prior service cost                 |       | 10                                                         |       | —                                                    |       | 30 |   | — |   |
| Net pension cost                                   |       | $                                                          | 737        |                                                      | $          | 758 |   | $ | 2,212 |   | $ | 2,310 |   |

 

KapStonefunds its Pension Plan according to Internal Revenue Service fundingrequirements. Based on those limitations, KapStone has funded $1.7 million forthe nine months ended September 30, 2010 and expects to fund an additional$0.5 million to the Pension Plan in 2010.

 

**Other Post Retirement Benefits**

 

Netpost-retirement cost recognized for each of the three and nine months ended September 30,2010 were credits of $0.1 million and $0.2 million, respectively, due torecognition of an actuarial gain from 2009 for the Company’s retiree medicaland life insurance plans. Net post-retirement cost recognized for each of thethree and nine months ended September 30, 2009 for the Company’s retireemedical and life insurance plan was less than $0.1 million.

 

**Defined Contribution Plans**

 

The KapStone Defined Contribution Plan (“Contribution Plan”) covers alleligible employees. Company monthly contributions to the Contribution Plan arebased on the matching of employee contributions, vest immediately for salaried,non-bargained hourly and certain union employees, and vest after three yearsfor other union employees. For the three months ended September 30, 2010and 2009, the Company recognized expense of $0.9 million and $0.4 million,respectively, for matching contributions. For the nine months ended September 30, 2010 and 2009, the Companyrecognized expense of $2.7 million and $1.6 million, respectively, for matchingcontributions.  Effective March 1,2009, matching contributions for salaried employees were temporarily suspendeddue to economic conditions. The Company reinstated matching contributionseffective January 1, 2010.

 

The Company’s Retirement Savings Plan (“Savings Plan”), which coversall eligible salaried and non-bargained hourly employees, provides for anannual contribution based on an employee’s salary and age.  The Company contributions vest 100% afterthree years.  For the three and ninemonths ended September 30, 2010, the Company recognized expense of $0.5million and $1.5 million, respectively. Effective February 1, 2009, theCompany temporarily suspended contributions to the Savings Plan due to economicconditions, and as a result, no expense was recognized during the three andnine months ended September 30, 2009. The Company reinstated the SavingsPlan in November 2009.

 

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**11.          Stock-BasedCompensation**

 

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

 

TheCompany accounts for stock awards in accordance with ASC 718, *Compensation — Stock Compensation*, which requires that thecost resulting from all share-based payment transactions be recognized ascompensation cost over the vesting period based on the fair value of theinstrument on the date of grant.

 

Totalstock-based compensation expense related to the stock option and restrictedstock unit grants for the three and nine months ended September 30, 2010and 2009 is as follows:

 
| ** **                                 | ** ** | **Three Months Ended********September 30,** | ** ** | ** ** | **Nine Months Ended********September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------------|------------|------------|-----------------------------------------------------------|------------|
| ** **                                 | ** ** | **2010**                                                   | ** ** | **2009**   | ** **                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                       |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Stock option compensation expense          |       | $                                                          | 385        |       | $                                                         | 383        |   |   | $ | 1,590 |   | $ | 978 |   |
| Restricted stock unit compensation expense |       | 291                                                        |       | 270        |                                                      |       | 1,243 |   | 708 |   |
| Total stock-based compensation expense     |       | $                                                          | 676        |       | $                                                         | 653        |   |   | $ | 2,833 |   | $ | 1,686 |   |

 

Totalunrecognized stock-based compensation cost related to the stock option grantsand restricted stock units as of September 30, 2010 and 2009 is asfollows:

 
| ** **                                      | ** ** | **September 30,** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|------------|------------|------------|
| ** **                                      | ** ** | **2010**               | ** ** | **2009**   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unrecognized stock option compensation cost     |       | $                      | 2,121      |       | $          | 1,914      |   |   |   |   |   |   |
| Unrecognized restricted stock compensation cost |       | 1,865                  |       | 1,534      |       |       |   |   |   |   |
| Total stock-based compensation cost             |       | $                      | 3,986      |       | $          | 3,448      |   |   |   |   |   |   |

 

Asof September 30, 2010, total unrecognized compensation cost related tonon-vested stock options and restricted stock units is expected to berecognized over a weighted average period of 1.8 years and 1.5 years,respectively.

 

**Stock Options**

 

InMay 2010, the Company’s Compensation Committee granted 450,098 stockoptions to directors, executive officers and employees of the Company.  The stock options vest as follows: 50% aftertwo years and the remaining 50% after three years or upon the grantee of suchstock options reaching age 65.  The stock options awarded in 2010 have acontractual term of ten years. The stock options are subject to forfeitureshould the recipient terminate his or her employment with the Company forcertain reasons prior to vesting in his or her awards, or the occurrence ofcertain other events such as termination with cause. The exercise price ofthese stock options is based on the closing market price of our common stock onthe date of grant ($11.36 for the 2010 awards described above) and compensationexpense is recorded on an accelerated basis over the awards’ vesting periods.

 

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

 

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

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

 

The following tablesummarizes stock options amounts and activity:

 
| ** **                                  | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Weighted**          | ** ** | **Intrinsic**        | ** ** |
|---------------------------------------------|------------|-------------|------------|--------------|------------|-----------------------|------------|----------------------|------------|
| ** **                                  | ** ** | ** **  | ** ** | **Average**  | ** ** | **Average**           | ** ** | **Value**            | ** ** |
| ** **                                  | ** ** | ** **  | ** ** | **Exercise** | ** ** | **Remaining**         | ** ** | **(dollars in** | ** ** |
| ** **                                  | ** ** | **Options** | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Thousands)**       | ** ** |
| **Outstanding at January 1,  2010**    |       | 2,162,077   |       | $            | 5.66       |                  | 7.6        |                 | $          | 9,029 |   |
| Granted                                     |       | 450,098     |       | 11.36        |       | 9.7                   |       |                 |       |
| Exercised                                   |       | (113,841    | )          | 6.81         |       |                  |       |                 |       |
| Forfeited                                   |       | (5,528      | )          | 4.91         |       |                  |       |                 |       |
| **Outstanding at September 30,  2010** |       | 2,492,806   |       | $            | 6.63       |                  | 7.5        |                 | $          | 13,728 |   |
| **Exercisable at September 30,  2010** |       | 967,859     |       | $            | 7.35       |                  | 5.7        |                 | $          | 4,634 |   |

 

**Restricted Stock**

 

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

 

Thefollowing table summarizes restricted stock units amounts and activity:

 
| ** **                                  | ** ** | **Units** | ** ** | **Weighted   Average   Grant  Price** | ** ** |
|---------------------------------------------|------------|-----------|------------|-------------------------------------------------|------------|
| **Outstanding at January 1,  2010**    |       | 585,669   |       | $                                               | 5.68       |   |
| Granted                                     |       | 166,534   |       | 11.36                                           |       |
| Vested                                      |       | (172,750  | )          | 6.76                                            |       |
| Forfeited                                   |       | (1,780    | )          | 4.95                                            |       |
| **Outstanding at September 30,  2010** |       | 577,673   |       | $                                               | 7.00       |   |

 

**12.   Stockholder’s Equity**

 

In connection with the Company’s initial public offering on August 19,2005, the Company issued, for $100, an option to the representative of theunderwriters to purchase up to a total of 1,000,000 units at a price of $7.50per unit. Each unit consisted of one share of the Company’s common stock,$0.0001 par value, and two warrants. The warrants expired on August 17,2009, after which each unit consisted of only one share of common stock. In March 2010,the purchase option was exercised at a market price of $11.51 per share.  The purchase option was exercised on acashless basis and therefore no cash proceeds were received by theCompany.  Accordingly, 348,393 shares ofcommon stock were issued in March 2010.

 

Forthe three and nine months ended September 30, 2010, exercises of employeestock options totaled 33,605 shares and 113,841 shares, respectively, with cashproceeds to the Company of $0.2 million and $0.8 million, respectively. Nostock options were exercised in 2009.

 

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In December 2009, the Company established the KapStone Paper andPackaging Corporation Employee Stock Purchase Plan (“ESPP”) effectiveJanuary 1, 2010. The ESPP allows for employees to purchase shares ofcompany stock at a five percent discount from market price. A total of 500,000shares are reserved for future awards. A total of 6,641 shares were issuedunder the ESPP for the nine months ended September 30, 2010.

 

**13.   SegmentInformation**

 

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

 

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

 

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

 
| ** **                       | ** ** | **Three Months Ended********September 30,** | ** ** | ** ** | **Nine Months Ended********September 30,** | ** ** |
|----------------------------------|------------|------------------------------------------------------------|------------|------------|-----------------------------------------------------------|------------|
| **Operating Segment:**      | ** ** | **2010**                                                   | ** ** | **2009**   | ** **                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net sales:                       |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Unbleached kraft                 |       | $                                                          | 207,493    |       | $                                                         | 170,335    |   |   | $ | 583,111 |   | $ | 461,384 |   |
| Other                            |       | —                                                     |       | —     |                                                      |       | — |   | 6,927 |   |
| Intersegment sales               |       | —                                                     |       | —     |                                                      |       | — |   | (899 | ) |
|                             |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Total                            |       | $                                                          | 207,493    |       | $                                                         | 170,335    |   |   | $ | 583,111 |   | $ | 467,412 |   |
|                             |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Net sales to external customers: |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Unbleached kraft                 |       | $                                                          | 207,493    |       | $                                                         | 170,335    |   |   | $ | 583,111 |   | $ | 460,485 |   |
| Other                            |       | —                                                     |       | —     |                                                      |       | — |   | 6,927 |   |
|                             |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Total                            |       | $                                                          | 207,493    |       | $                                                         | 170,335    |   |   | $ | 583,111 |   | $ | 467,412 |   |
|                             |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Operating income / (loss):       |       |                                                       |       |       |                                                      |       |   |   |   |   |
|                             |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Unbleached kraft                 |       | $                                                          | 31,409     |       | $                                                         | 51,952     |   |   | $ | 66,848 |   | $ | 105,245 |   |
| Other                            |       | —                                                     |       | —     |                                                      |       | — |   | 748 |   |
| Gain/(loss) on sale of business  |       | —                                                     |       | (278       | )                                                         |       | — |   | 16,417 |   |
| Corporate                        |       | (4,799                                                     | )          | (5,175     | )                                                         |       | (15,749 | ) | (16,306 | ) |
|                             |       |                                                       |       |       |                                                      |       |   |   |   |   |
| Total                            |       | $                                                          | 26,610     |       | $                                                         | 46,499     |   |   | $ | 51,099 |   | $ | 106,104 |   |

 
| ** **                  | ** ** | **(Unaudited)********September 30,** | ** ** | **December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|-----------------------|------------|------------|------------|------------|------------|------------|
| **Operating Segment:** | ** ** | **2010**                                  | ** ** | **2009**              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total assets:               |       |                                      |       |                  |       |       |       |       |       |       |
| Unbleached kraft            |       | $                                         | 634,065    |                  | $          | 638,050    |       |       |       |       |   |   |
| Corporate                   |       | 60,598                                    |       | 31,073                |       |       |       |       |       |       |
|                        |       |                                      |       |                  |       |       |       |       |       |       |
| Total                       |       | $                                         | 694,663    |                  | $          | 669,123    |       |       |       |       |   |   |

 

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

 

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

 

Thefollowing discussion should be read in conjunction with our ConsolidatedFinancial Statements and related Notes thereto included elsewhere in thisreport.

 

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

 
| ** **                                              | ** ** | **Three Months Ended******** September 30,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):** | ** ** | **2010**                                                         | ** ** | **2009**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                                                | 207,493    |          | $          | 170,335 |   | $ | 37,158 |   |
| Cost of sales, excluding depreciation and  amortization |       | 142,212                                                          |       | 86,812        |       | 55,400 |   |
| Freight and distribution expenses                       |       | 20,161                                                           |       | 16,262        |       | 3,899 |   |
| Selling, general and administrative expenses            |       | 7,631                                                            |       | 7,105         |       | 526 |   |
| Depreciation and amortization                           |       | 11,129                                                           |       | 13,664        |       | (2,535 | ) |
| Gain (loss) on sale of business                         |       | —                                                           |       | (278          | )          | 278 |   |
| Other operating income                                  |       | 250                                                              |       | 285           |       | (35 | ) |
| Operating income                                        |       | 26,610                                                           |       | 46,499        |       | (19.889 | ) |
| Foreign exchange gain                                   |       | 301                                                              |       | 175           |       | 126 |   |
| Interest income                                         |       | 9                                                                |       | —        |       | 9 |   |
| Interest expense                                        |       | 1,319                                                            |       | 5,353         |       | (4,034 | ) |
| Income before provision (benefit) for income taxes      |       | 25,601                                                           |       | 41,321        |       | (15,720 | ) |
| Provision (benefit) for income taxes                    |       | (12,765                                                          | )          | 15,649        |       | (28,414 | ) |
| Net income                                              |       | $                                                                | 38,366     |          | $          | 25,672 |   | $ | 12,694 |   |

 

Netsales for the quarter ended September 30, 2010 were $207.5 millioncompared to $170.3 million for the third quarter of 2009, an increase of $37.2million or 21.8%. The increase in net sales was driven by $28.4 million due tohigher average selling prices and $12.2 million due to a more favorable productmix reflecting a lower percentage of export linerboard sales partially offsetby $1.3 million of lower sales volume. Exchange rates negatively impacted netsales by $2.1 million.

 

Costof sales, excluding depreciation and amortization expense, for the quarterended September 30, 2010 was $142.2 million compared to $86.8 million forthe third quarter of 2009, an increase of $55.4 million, or 63.8%. The increasein cost of sales was mainly due to a $53.5 million decrease in alternative fuelmixture tax credits (the tax credit expired on December 31, 2009), a $2.2million increase in compensation and benefit costs as the Company reinstatedcertain benefits in November 2009 and January 2010 and $2.0 milliondue to inflation on input costs. Partially offsetting the increase in cost ofsales was $2.3 million from lower sales volume and productivity.

 

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Freightand distribution expenses for the quarter ended September 30, 2010 totaled$20.2 million compared to $16.3 million for the quarter ended September 30,2009. The increase of $3.9 million was primarily due to $2.6 million due to alower percentage of export linerboard shipments in which freight costs are paidby the customer and $1.9 million due to inflation mainly on ocean marineshipments partially offset by $0.6 million reflecting a 1.5% decrease in salesvolume.

 

Selling,general and administrative expenses for the quarter ended September 30,2010 totaled $7.6 million compared to $7.1 million for the quarter ended September 30,2009. The increase of $0.5 million reflects $1.6 million of higher compensationand benefit expenses as the Company reinstated certain benefits in November 2009and January 2010. Partially offsetting the increase in selling, generaland administrative expense was a $1.3 million reduction in expense for thetermination of transitional services provided by MeadWestvaco Corporation (“MeadWestvaco”)in the fourth quarter of 2009. For the quarter ended September 30, 2010,selling, general and administrative expenses as a percentage of net salesdeclined to 3.7% from 4.2% for the third quarter of 2009.

 

Depreciationand amortization for the quarter ended September 30, 2010 totaled $11.1million compared to $13.7 million for the quarter ended September 30, 2009.The decrease of $2.6 million was primarily due to lower intangible assetamortization. The Company acquired a coal contract with below market prices inconjunction with the acquisition of substantially all of the assets of theCharleston Kraft Division (“CKD”) of MeadWestvaco in July 2008. Thecontract and related amortization expired on December 31, 2009.

 

Gain(loss) on sale of business reflects a working capital adjustment of $0.3million in the three months ended September 30, 2009 in connection withthe sale of the dunnage bag business in March 2009.

 

Foreign exchange gains for the three months ended September 30,2010 were $0.3 million compared to $0.2 million for the three monthsended September 30, 2009. The change reflects fluctuations in the Euro toU.S. dollar exchange rate.

 

Interestexpense for the quarters ended September 30, 2010 and 2009 was $1.3million and $5.4 million, respectively. Interest expense reflects interest onthe Company’s senior credit agreement and amortization of debt issuance costs.Interest expense was $4.1 million lower in the quarter ended September 30,2010 primarily due to lower debt balances resulting from $285 million of debtrepayments in 2009.

 

Provision(benefit) for income taxes for the quarters ended September 30, 2010 and2009 was ($12.8) million and $15.6 million, respectively, reflecting aneffective tax rate of (49.9%) for the quarter ended September 30, 2010compared to 37.9% for the same period in 2009. The lower provision (benefit)for income taxes in 2010 reflects primarily the combined impact of the $20.7million benefit from the cellulosic biofuel producer’s tax credit and a $15.7million reduction in pre-tax income.

 

**Segment Results**

 

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

 
| ** **                                     | ** ** | **Three Months Ended******** September 30,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------------------|------------|
| **Operating Segment ($000’s):** | ** ** | **2010**                                                         | ** ** | **2009** | ** ** |
| Consolidated net sales:                        |       |                                                             |       |   |   |
| Unbleached kraft                               |       | $                                                                | 207,493    |   | $ | 170,335 |   |
| ** **                                     | ** ** | ** **                                                       | ** ** | ** ** | ** ** |
| Total net sales                                | ** ** | **$**                                                            | 207,493    | ** ** | **$** | 170,335 | ** ** |
|                                           |       |                                                             |       |   |   |
| Operating income / (loss):                     |       |                                                             |       |   |   |
| Unbleached kraft                               |       | $                                                                | 31,409     |   | $ | 51,952 |   |
| Gain/(loss) on sale of business                |       | —                                                           |       | (278 | ) |
| Corporate                                      |       | (4,799                                                           | )          | (5,175 | ) |
|                                           |       |                                                             |       |   |   |
| Total operating income                         | ** ** | **$**                                                            | 26,610     | ** ** | **$** | 46,499 | ** ** |

 

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

 

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***Unbleached Kraft***

 
| ** **                      | ** ** | **Three Months Ended******** September 30,** | ** ** |
|---------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                      | ** ** | **2010**                                                         | ** ** | **2009** | ** ** |
| Net sales                       |       | $                                                                | 207,493    |   | $ | 170,335 |   |
| Operating income                |       | $                                                                | 31,409     |   | $ | 51,952 |   |
| Operating income % of net sales |       | 15.1                                                             | %          | 30.5 | % |
|                            |       |                                                             |       |   |   |
| Average revenue per ton         |       | $                                                                | 614        |   | $ | 495 |   |
| Tons of paper sold              |       | 326,967                                                          |       | 331,879 |   |

 

Forthe quarter ended September 30, 2010, unbleached kraft segment net salesincreased by $37.2 million, or 21.8%, to $207.5 million compared to $170.3million for the quarter ended September 30, 2009. The increase in netsales was mainly due to $28.4 million from higher average selling prices and$12.2 million due to a more favorable product mix reflecting a lower percentageof export linerboard sales partially offset by $1.3 million of lower salesvolume and $2.1 million due to foreign exchange rates. Average selling pricesin the third quarter of 2010 of $614 per ton were $119 per ton higher thanaverage selling prices in the third quarter of 2009 and $29 per ton aboveaverage selling prices in the quarter ended June 30, 2010, reflecting fullrealization of kraft paper and linerboard price increases announced in December 2009and in January and April 2010. The Company expects to fully realize a$40 per ton price increase for kraft paper announced in August 2010 in thequarter ending December 31, 2010. In addition, the Company partiallyrealized smaller price increases for other products in the quarter ended September 30,2010 and expects to fully realize these increases in the later part of 2010 andinto 2011.

 

Unbleachedkraft segment operating income decreased by $20.6 million, or 39.6%, to $31.4million for the quarter ended September 30, 2010 compared to $52.0 millionfor the quarter ended September 30, 2009. The decrease in operating incomewas primarily due to a $53.5 million decrease in alternative fuel mixture taxcredits (the tax credit expired on December 31, 2009), a $2.9 millionincrease in compensation and benefit costs as the Company reinstated certainbenefits in November 2009 and January 2010, $2.1 million due toforeign exchange rates and $2.0 million due to inflation on input costs.Partially offsetting the decrease in operating income was $28.4 million fromhigher average selling prices, $9.4 million due to a more favorable product mixand $2.4 million related to decreased amortization expense related to anexpired intangible asset.

 

Forthe quarter ended September 30, 2010, operating income as a percentage ofnet sales declined to 15.1% from 30.5% for the third quarter of 2009, mainlydue to a decrease in alternative fuel mixture tax credits partially offset byhigher average selling prices.

 

***Corporate***

 

Corporateoperating expense for the quarter ended September 30, 2010 totaled $4.8million compared to $5.2 million for the quarter ended September 30, 2009.The decrease of $0.4 million reflects a $1.3 million reduction in expense forthe termination of transitional services provided by MeadWestvaco in the fourthquarter of 2009, partially offset by $0.9 million of higher compensation andbenefit expenses as the Company reinstated certain benefits in 2010 that weretemporarily suspended in 2009 as a result of poor economic conditions.

 

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**Comparison of Results of Operations for the Nine Months EndedSeptember 30, 2010 and the Nine Months Ended September 30, 2009**

** **
| ** **                                              | ** ** | **Nine Months Ended******** September 30,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):** | ** ** | **2010**                                                        | ** ** | **2009**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                                               | 583,111    |          | $          | 467,412 |   | $ | 115,699 |   |
| Cost of sales, excluding depreciation and  amortization |       | 419,197                                                         |       | 271,650       |       | 147,547 |   |
| Freight and distribution expenses                       |       | 56,279                                                          |       | 42,755        |       | 13,524 |   |
| Selling, general and administrative expenses            |       | 23,672                                                          |       | 23,292        |       | 380 |   |
| Depreciation and amortization                           |       | 33,624                                                          |       | 40,761        |       | (7,137 | ) |
| Gain on sale of business                                |       | —                                                          |       | 16,417        |       | (16,417 | ) |
| Other operating income                                  |       | 760                                                             |       | 733           |       | 27 |   |
| Operating income                                        |       | 51,099                                                          |       | 106,104       |       | (55,005 | ) |
| Foreign exchange gain/(loss)                            |       | (597                                                            | )          | 48            |       | (645 | ) |
| Interest income                                         |       | 27                                                              |       | 1             |       | 26 |   |
| Interest expense                                        |       | 4,257                                                           |       | 16,097        |       | (11,840 | ) |
| Income before provision (benefit) for income taxes      |       | 46,272                                                          |       | 90,056        |       | (43,784 | ) |
| Provision (benefit) for income taxes                    |       | (5,578                                                          | )          | 35,160        |       | (40,738 | ) |
| Net income                                              |       | $                                                               | 51,850     |          | $          | 54,896 |   | $ | (3,046 | ) |

 

Netsales for the nine months ended September 30, 2010 were $583.1 millioncompared to $467.4 million for the first nine months of 2009, an increase of$115.7 million or 24.8%. The increase in net sales was driven by $81.0 millionof higher sales volume in the first nine months of 2010 compared to the firstnine months of 2009, mainly due to increased demand reflecting improvingeconomic conditions, $28.3 million of higher average selling prices and $15.8million of a more favorable product mix reflecting a lower percentage of exportlinerboard sales.  Partially offsettingthe increase in net sales was $6.9 million due to the sale of the dunnage bagbusiness in March 2009 and $2.5 million due to foreign exchange rates.

 

Costof sales, excluding depreciation and amortization expense, for the nine monthsended September 30, 2010 was $419.2 million compared to $271.7 million forthe first nine months of 2009, an increase of $147.5 million, or 54.3%. Theincrease in cost of sales was mainly due to an $85.3 million decrease inalternative fuel mixture tax credits (the tax credit expired December 31,2009), $46.1 million from increased sales volume,  $6.8 million related to the tri-annual plannedmaintenance outage at our Charleston mill which occurred in March 2010, a$6.2 million increase in compensation and benefit costs as the Companyreinstated certain benefits in November 2009 and January 2010 and$5.4 million due to inflation on input costs. Partially offsetting the increasein cost of sales was $5.5 million of lower costs due to the sale of the dunnagebag business.

 

Freightand distribution expenses for the nine months ended September 30, 2010totaled $56.3 million compared to $42.8 million for the nine months ended September 30,2009. The increase of $13.5 million was primarily due to $6.9 millionreflecting a 16.2% increase in sales volume, $3.2 million due to inflation and$3.8 million due to a lower percentage of export linerboard shipments in whichfreight costs are paid by the customer, partially offset by $0.4 million due tothe sale of the dunnage bag business.

 

Selling,general and administrative expenses for the nine months ended September 30,2010 totaled $23.7 million compared to $23.3 million for the nine months ended September 30,2009. The increase of $0.4 million reflects $4.0 million of higher compensationand benefit expenses as the Company reinstated certain benefits in November 2009and January 2010 that were previously suspended as a result of pooreconomic conditions in early 2009 and $1.1 million of higher stock compensationexpense. Partially offsetting these increases in selling, general andadministrative expense was $4.3 million of lower expenses due to thetermination of transitional services provided by MeadWestvaco in the fourthquarter of 2009, $0.5 million of lower bad debts and $0.3 million related tothe sale of the dunnage bag business. For the nine months ended September 30,2010, selling, general and administrative expenses as a percentage of net salesdeclined to 4.1% from 5.0% for the nine months ended September 30, 2009.

 

Depreciationand amortization for the nine months ended September 30, 2010 totaled$33.6 million compared to $40.8 million for the nine months ended September 30,2009. The decrease of $7.2 million was primarily due to $7.3 million of lowerintangible asset amortization. The Company acquired a coal contract with belowmarket prices in conjunction with the CKD acquisition. The contract and relatedamortization expired on December 31, 2009.

 

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The$16.4 million gain on sale of a business for the nine months ended September 30,2009 was the result of the sale of the dunnage bag business to Illinois ToolWorks Inc. in March 2009.

 

Foreign exchange losses for the nine months ended September 30,2010 were $0.6 million compared to a foreign exchange gain of$0.1 million for the nine months ended September 30, 2009. The changereflects the impact of a strengthening U.S. dollar in 2010 compared to the Euro.

 

Interestexpense for the nine months ended September 30, 2010 and 2009 was $4.3million and $16.1 million, respectively. Interest expense reflects interest onthe Company’s senior credit agreement and amortization of debt issuance costs.Interest expense was $11.8 million lower in the nine months endedSeptember 30, 2010 primarily due to lower debt balances and interestrates.

 

Provision(benefit) for income taxes for the nine months ended September 30, 2010and 2009 was ($5.6) million and $35.2 million, respectively, reflecting aneffective tax rate of (12.1%) for the nine months ended September 30, 2010compared to 39.0% for the same period in 2009. The lower provision (benefit)for income taxes in 2010 reflects primarily the combined impact of the $20.7million benefit from the cellulosic biofuel producer’s tax credit and a $43.8million reduction in pre-tax income.

 

**Segment Results**

 

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

 
| ** **                                     | ** ** | **Nine Months Ended********September 30,** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------|------------|
| **Operating Segment ($000’s):** | ** ** | **2010**                                                  | ** ** | **2009** | ** ** |
| Consolidated net sales:                        |       |                                                      |       |   |   |
| Unbleached kraft                               |       | $                                                         | 583,111    |   | $ | 461,384 |   |
| Other                                          |       | —                                                    |       | 6,927 |   |
| Intersegment sales                             |       | —                                                    |       | (899 | ) |
|                                           |       |                                                      |       |   |   |
| Total net sales                                | ** ** | **$**                                                     | 583,111    | ** ** | **$** | 467,412 | ** ** |
|                                           |       |                                                      |       |   |   |
| Operating income / (loss):                     |       |                                                      |       |   |   |
| Unbleached kraft                               |       | $                                                         | 66,848     |   | $ | 105,245 |   |
| Other                                          |       | —                                                    |       | 748 |   |
| Gain on sale of business                       |       | —                                                    |       | 16,417 |   |
| Corporate                                      |       | (15,749                                                   | )          | (16,306 | ) |
|                                           |       |                                                      |       |   |   |
| Total operating income                         | ** ** | **$**                                                     | 51,099     | ** ** | **$** | 106,104 | ** ** |

 

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

 

***Unbleached Kraft***

 
| ** **                      | ** ** | **Nine Months Ended********September 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                      | ** ** | **2010**                                                  | ** ** | **2009** | ** ** |
| Net sales                       |       | $                                                         | 583,111    |   | $ | 461,384 |   |
| Operating income                |       | $                                                         | 66,848     |   | $ | 105,245 |   |
| Operating income % of net sales |       | 11.5                                                      | %          | 22.8 | % |
|                            |       |                                                      |       |   |   |
| Average revenue per ton         |       | $                                                         | 578        |   | $ | 533 |   |
| Tons of paper sold              |       | 968,929                                                   |       | 833,805 |   |

 

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Forthe nine months ended September 30, 2010, unbleached kraft segment netsales increased by $121.7 million, or 26.4%, to $583.1 million compared to$461.4 million for the nine months ended September 30, 2009. The increasein net sales was mainly due to $81.0 million of higher sales volume resultingfrom an increase of 135,124 tons of paper sold, $28.3 million of higher averageselling prices and $15.8 million of a more favorable product mix due to a lowerpercentage of export linerboard sales. Exchange rates negatively impacted netsales by $2.5 million.

 

Unbleachedkraft segment operating income decreased by $38.4 million, or 36.5%, to $66.8million for the nine months ended September 30, 2010 compared to $105.2million for the nine months ended September 30, 2009. Operating incomedecreased primarily due to $85.3 million from lower alternate fuel mixture taxcredits, $6.8 million related to the tri-annual planned maintenance outage atour Charleston mill, $5.4 million of inflation on input costs, $7.6 million ofhigher compensation and benefit expenses as the Company reinstated certainbenefits in November 2009 and January 2010 that were previouslysuspended in early 2009 and $2.5 million due to foreign exchange rates. Thedecrease in operating income was partially offset by $28.3 million of higheraverage selling prices, $28.0 million from higher sales volume, $11.1 millionof a more favorable product mix due to a lower percentage of export linerboardsales, $7.3 million related to decreased amortization expense related to anexpired intangible asset and $0.5 million of lower bad debts.

 

Forthe nine months ended September 30, 2010, operating income as a percentageof net sales declined to 11.5% from 22.8% for the first nine months of 2009,mainly due to a lower alternative fuel mixture tax credit and the tri-annualplanned maintenance outage at the Charleston mill partially offset by higheraverage selling prices and higher sales volume.

 

***Other***

 

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

 

***Corporate***

 

Corporateoperating expense for the nine months ended September 30, 2010 totaled$15.7 million compared to $16.3 million for the nine months ended September 30,2009. The decrease of $0.6 million was due to $4.3 million of lower expensesdue to the termination of transitional services provided by MeadWestvaco in thefourth quarter of 2009 partially offset by $2.6 million of higher compensationand benefit expenses as the Company reinstated certain benefits in 2010 thatwere temporarily suspended in 2009 as a result of poor economic conditions and$1.1 million of higher stock compensation expense.

 

**Liquidity and Capital Resources**

 

***Senior Credit Agreement***

 

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

 

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

 

Forthe nine months ended September 30, 2010, the Company made a $10.0 millionvoluntary loan prepayment and a $2.5 million mandatory loan prepayment on theterm loan facility. The Company does not expect to make any additionalvoluntary or mandatory prepayments during the remainder of 2010.

 

***Debt Covenants***

 

Underthe financial covenants of the Senior Credit Agreement, KapStone must comply ona quarterly basis with a maximum permitted leverage ratio of 3.0 to 1. TheSenior Credit Agreement also includes a financial covenant requiring a minimumfixed charge coverage ratio that is 1.1 to 1. As of September 30, 2010, the Company was in compliance with theSenior Credit Agreement with a leverage ratio of 0.89 to 1 and a fixed chargecoverage ratio of 5.97 to 1.

 

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AtSeptember 30, 2010, the Company was in compliance with all otherapplicable covenants in the Senior Credit Agreement.

 

***Other Borrowings***

 

For the nine months endedSeptember 30, 2010, the Company reduced its revolving credit facility by $7.4million. The Company utilizes its revolving credit facility for generalbusiness purposes.

 

OnJanuary 5, 2010, the Company entered into a twelve month financingagreement of $2.6 million at an annual interest rate of 1.62% for the Company’sannual property insurance premium. The agreement requires the Company to makeconsecutive monthly repayments of $0.2 million through the term of thefinancing agreement ending on December 1, 2010. As of September 30,2010, $0.6 million was outstanding under this agreement.

 

***Restricted Cash***

 

OnMarch 31, 2009, the Company consummated the sale of its dunnage bagbusiness to Illinois Tool Works Inc. for $36.0 million less$1.1 million of working capital adjustments. As a condition of sale,$2.5 million of the sale proceeds were held in escrow untilSeptember 30, 2010 to be available to satisfy any losses or indemnityclaims that may arise against the Company in connection with the sale. TheCompany received the $2.5 million held in escrow on September 29, 2010.

 

***Alternative Fuel Mixture Tax Credit***

 

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

 

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

 

***Income taxes***

 

The Company has recorded a $67.7 million tax contingency reserveat September 30, 2010 for an unrecognized tax benefit relating to thetaxability of alternative fuel mixture tax credits (“AFTC”). The Company hastaken the position that the AFTC is similar to a federal excise tax and as aresult is not taxable. To date, the Internal Revenue Service has not issuedguidance concerning this issue.

 

The Companyreceived a $13.2 million U.S. federal income tax refund in June 2010related to the carry back of a 2009 tax loss available to reduce taxes paid inearlier years.  No additional refunds areexpected during 2010.

 

InAugust 2010, the U.S. Internal Revenue Service (“IRS”) approved theCompany’s registration as a producer of cellulosic biofuel for the tax year2009. With this registration, the Company applied for a nonrefundable incometax credit of $1.01 per gallon of qualified cellulosic biofuel for black liquorburned by the Company in early 2009 for which the Company did not claim thealternative fuel mixture tax credit. A $20.7 million benefit (net of U.Sfederal and state taxes) related to the cellulosic biofuel tax credit wasreflected in the Company’s income tax provision as a discrete item for thequarter ended September 30, 2010. The Company reported $33.9 million (thegross tax credit amount) as a deferred tax asset as of September 30, 2010which is available to offset taxable income in future years.

 

***Sources and Uses of Cash***

 
| **Nine months ended September 30 ($000’s)** | ** ** | **2010** | ** ** | **2009** | ** ** |
|---------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Operating activities                                                      |       | $        | 91,136     |     | $          | 123,790 |   |
| Investing activities                                                      |       | (20,691  | )          | 10,765   |       |
| Financing activities                                                      |       | (31,268  | )          | (135,646 | )          |
|                                                                           |            |          |            |          |            |  |  |

 

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Cashand cash equivalents increased by $39.2 million from December 31, 2009,reflecting $91.1 million of net cash provided by operating activities, $20.7million of net cash used in investing activities and $31.3 million of net cashused in financing activities.

 

Netcash provided by operating activities was $91.1 million primarily due to $51.9million of net income for the first nine months of 2010, $20.2 million ofnon-cash charges and $19.1 million of changes in operating assets andliabilities. Net cash provided by operating activities decreased by $32.7million in the nine months ended September 30, 2010 compared to the nine monthsended September 30, 2009 due to a $3.0 million reduction in net income, a $24.6million decrease in non-cash charges primarily due to a $16.4 million gain onthe sale of the dunnage bag business in March 2009 and a $32.5 million decreasein deferred income taxes primarily from the benefit of the cellulosic biofueltax credit, and a $5.0 million decrease in operating assets and liabilities.

 

Netcash used in investing activities was $20.7 million reflecting $23.8 million ofcapital expenditures partially offset by $2.5 million of proceeds from the saleof the dunnage bag business that were released from escrow on September 29,2010 and $0.6 million received from MeadWestvaco relating to the CKDacquisition. For the nine months ended September 30, 2010, capital expenditureswere mainly spent on equipment upgrades and replacements at the paper mills. Inaddition, $2.8 million was spent on IT systems projects.  Net cash provided by investing activitiesdecreased by $31.5 million in the nine months ended September 30, 2010 comparedto the nine months ended September 30, 2009 mainly due to $34.9 million ofproceeds received from the sale of the dunnage bag business in the firstquarter of 2009.

 

Netcash used in financing activities was $31.3 million and includes $25.3 millionof term loan repayments including $12.5 million of prepayments and $7.4 millionof net repayments on the revolving credit facility partially offset by $0.6million of net other borrowings and $0.8 million of proceeds from exercises ofstock options. Net cash used in financing activities decreased by $104.4million in the nine months ended September 30, 2010 compared to the nine monthsended September 30, 2009 due to a lower amount of debt and revolver repaymentsin the first nine months of 2010.

 

***Future Cash Needs***

 

Weexpect that cash generated from operating activities, and if needed, theability to draw from our revolving credit facility will be sufficient to meetthe anticipated 2010 cash needs. The Company expects to spend approximately$10.0 million on capital expenditures for the remainder of 2010. In addition,the Company has $4.7 million of required long-term debt repayments for theremainder of 2010 and expects to fund an additional $0.5 million to its definedbenefit pension plan.

 

**Off-Balance Sheet Arrangements**

 

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

 

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

 

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

 

UnderKapStone Kraft’s Senior Credit Facilities, we have two term loans totaling$119.6 million outstanding at September 30, 2010.  The maturity date is the earlier of:  (a) June 12, 2013 with respect to the term Aloan facility and the revolving credit facility, and June 12, 2015 with respectto the term B loan facility, and (b) the date which is 90 days prior to thedate on which any earn-out, obligations to International Paper Company willbecome (or are reasonably expected to become) due, provided that the maturitydate will not be so accelerated if, among other things, the total leverageratio as of the end of the then most recent fiscal quarter, is less than 2.0 to1.0.

 

Changesin market rates may impact the base rate in our Senior Credit Agreement. Forinstance, if the bank’s LIBOR rate was to increase or decrease by onepercentage point (1.0%), our annual interest expense would change byapproximately $1.1 million based upon our expected future monthly loan balancesper our existing repayment schedule.

 

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

 

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

 

Weare exposed to currency fluctuations as we invoice certain European customersin Euros. The Company uses foreign currency forward contracts to manage aportion of the foreign currency exchange risks associated with foreign sales ofits U.S. operations. Using such foreign currency forward contracts, the Companyreceives or pays the difference between the contracted forward rate and theexchange rate at the settlement date. These contracts are used to hedge thevariability of exchange rates on the Company’s cash flows.

 

**Item 4. —CONTROLS AND PROCEDURES**

 

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

 

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

 

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**PART II. —OTHER INFORMATION**

 

**Item 1. — LEGAL PROCEEDINGS**

 

None.

 

**Item 1A. — RISK FACTORS**

 

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

 

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

 

None.

 

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

 

None.

 

**Item 4. — RESERVED**

 

**Item 5. — OTHER INFORMATION**

 

None.

 

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**Item 6. — EXHIBITS**

 

Thefollowing Exhibits are 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**

 

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

 
|             |   | KAPSTONE  PAPER AND PACKAGING CORPORATION   |
|------------------|--------|---------------------------------------------|
|             |   |                                        |
|             |   |                                        |
| November 3, 2010 | By:    | /s/  Andrea K. Tarbox                       |
|             |   | Andrea  K. Tarbox                           |
|             |   | Vice  President and Chief Financial Officer |

 

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