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** **

 

** **

**UNITED STATES SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**Quarterly Report Pursuant to Section 13or 15(d) of the SecuritiesExchange Act of 1934**

 

**For the quarterly period ended September 30,2008**

 

**Commission File Number: 001-33494**

 

**KapStone Paper and PackagingCorporation**

(Exact name of registrant as specified in its charter)

 

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

 

**KapStone Paper and PackagingCorporation, 1101 Skokie Blvd., Suite 300**

**Northbrook, IL 60062**

(Address of Principal Executive Offices including zip code)

 

**(847) 239-8800**

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

Yes x  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) |   |                        |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes o No x

 

There were 28,370,248shares of the Registrant’s Common Stock, $0.0001 par value, outstanding at October 31,2008, excluding 40,000 shares held as treasury shares.

 

 

 

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**KapStone Paper and PackagingCorporation Index to Form 10-Q**

 

**TABLE OF CONTENTS**

 
| PART I. — FINANCIAL  INFORMATION |                                                                                                                              |
|--------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------|
|                                       |                                                                                                                              |   |
|                                       | Item 1. — Condensed Consolidated  Financial Statements (Unaudited) and Notes to Condensed Consolidated  Financial Statements | 1 |
|                                       |                                                                                                                              |   |
|                                       | Item 2. —  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                       | 15 |
|                                       |                                                                                                                              |   |
|                                       | Item 3. —  Quantitative and Qualitative Disclosures about Market Risk                                                        | 24 |
|                                       |                                                                                                                              |   |
|                                       | Item 4. —  Controls and Procedures                                                                                           | 25 |
|                                       |                                                                                                                              |   |
| PART II. — OTHER  INFORMATION    |                                                                                                                              |
|                                       |                                                                                                                              |   |
|                                       | Item 1. — Legal  Proceedings                                                                                                 | 26 |
|                                       |                                                                                                                              |   |
|                                       | Item 1A. — Risk Factors                                                                                                      | 26 |
|                                       |                                                                                                                              |   |
|                                       | Item 6. — Exhibits                                                                                                           | 29 |
|                                       |                                                                                                                              |   |
| SIGNATURE                                  | 30                                                                                                                                |

 

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**Part 1. Financial Information**

**Item 1. Financial Statements**

 

**KapStone Paper and PackagingCorporation**

**Condensed Consolidated Balance Sheets**

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

 
| ** **                                                                                                                                                                                                                                                                               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                               | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                                                                                                                               | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                                                                               |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                                                                                                                          |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                                |       | $                      | 41,874     |                  | $          | 56,635 |   |
| Trade accounts receivable, net                                                                                                                                                                                                                                                           |       | 83,955                 |       | 30,208                |       |
| Inventories                                                                                                                                                                                                                                                                              |       | 74,203                 |       | 19,846                |       |
| Refundable and prepaid income taxes                                                                                                                                                                                                                                                      |       | 11,416                 |       | —                |       |
| Deferred income taxes                                                                                                                                                                                                                                                                    |       | 2,599                  |       | 1,263                 |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                |       | 12,650                 |       | 735                   |       |
| Total current assets                                                                                                                                                                                                                                                                     |       | 226,697                |       | 108,687               |       |
|                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Plant, property and equipment, net                                                                                                                                                                                                                                                       |       | 481,987                |       | 104,858               |       |
| Other assets                                                                                                                                                                                                                                                                             |       | 2,160                  |       | 3,735                 |       |
| Intangible assets, net                                                                                                                                                                                                                                                                   |       | 48,972                 |       | 5,875                 |       |
| Goodwill                                                                                                                                                                                                                                                                                 |       | 8,902                  |       | 2,295                 |       |
|                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Total assets                                                                                                                                                                                                                                                                             |       | $                      | 768,718    |                  | $          | 225,450 |   |
|                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Current portion of long-term debt and notes                                                                                                                                                                                                                                              |       | $                      | 35,752     |                  | $          | 19,578 |   |
| Accounts payable                                                                                                                                                                                                                                                                         |       | 37,128                 |       | 11,050                |       |
| Accrued expenses                                                                                                                                                                                                                                                                         |       | 32,963                 |       | 4,867                 |       |
| Accrued compensation costs                                                                                                                                                                                                                                                               |       | 12,839                 |       | 6,625                 |       |
| Accrued income taxes                                                                                                                                                                                                                                                                     |       | —                 |       | 1,477                 |       |
| Total current liabilities                                                                                                                                                                                                                                                                |       | 118,682                |       | 43,597                |       |
|                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Other liabilities:                                                                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Long-term debt and notes                                                                                                                                                                                                                                                                 |       | 443,357                |       | 32,922                |       |
| Pension and post-retirement benefits                                                                                                                                                                                                                                                     |       | 7,315                  |       | 3,420                 |       |
| Deferred income taxes                                                                                                                                                                                                                                                                    |       | 14,222                 |       | 1,047                 |       |
| Other liabilities                                                                                                                                                                                                                                                                        |       | 6,853                  |       | 279                   |       |
| Total other liabilities                                                                                                                                                                                                                                                                  |       | 471,747                |       | 37,668                |       |
|                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Commitments and contingencies                                                                                                                                                                                                                                                            |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                               |       |                   |       |                  |       |
| Preferred stock $.0001 par value; 1,000,000 shares authorized;  no shares issued and outstanding                                                                                                                                                                                    |       | —                 |       | —                |       |
| Common stock $.0001 par value, 175,000,000 shares authorized; 28,309,377 shares  issued and outstanding (40,000 treasury shares outstanding) at  September 30, 2008 and 25,280,197 issued and outstanding (40,000  treasury shares outstanding) at December 31, 2007 |       | 3                      |       | 3                     |       |
| Additional paid-in capital                                                                                                                                                                                                                                                               |       | 131,336                |       | 115,002               |       |
| Retained earnings                                                                                                                                                                                                                                                                        |       | 46,887                 |       | 29,101                |       |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                   |       | 63                     |       | 79                    |       |
| Total stockholders’ equity                                                                                                                                                                                                                                                          |       | 178,289                |       | 144,185               |       |
|                                                                                                                                                                                                                                                                                     |       |                   |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                          |       | $                      | 768,718    |                  | $          | 225,450 |   |

 

See notes to condensed consolidated financial statements

 

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**KapStone Paper and PackagingCorporation**

**Condensed Consolidated Statements ofIncome**

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

 

**(unaudited)**

** **
| ** **                                             | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                             | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                             | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                              |       | $                                                        | 207,671    |                                                    | $          | 66,188 |   | $ | 342,962 |   | $ | 191,857 |   |
| Cost of sales, excluding depreciation and amortization |       | 151,064                                                  |       | 39,910                                                  |       | 233,422 |   | 123,704 |   |
| Freight and distribution                               |       | 19,969                                                   |       | 6,116                                                   |       | 33,480 |   | 17,476 |   |
| Selling, general and administrative expenses           |       | 9,757                                                    |       | 4,529                                                   |       | 19,251 |   | 12,552 |   |
| Depreciation and amortization                          |       | 12,953                                                   |       | 3,178                                                   |       | 18,381 |   | 8,272 |   |
| Other operating income                                 |       | 218                                                      |       | 399                                                     |       | 589 |   | 987 |   |
| Operating income                                       |       | 14,146                                                   |       | 12,854                                                  |       | 39,017 |   | 30,840 |   |
| Foreign exchange losses                                |       | 607                                                      |       | —                                                  |       | 607 |   | — |   |
| Interest income                                        |       | 51                                                       |       | 585                                                     |       | 891 |   | 1,467 |   |
| Interest expense                                       |       | 8,772                                                    |       | 1,044                                                   |       | 9,985 |   | 3,317 |   |
| Income before provision for income taxes               |       | 4,818                                                    |       | 12,395                                                  |       | 29,316 |   | 28,990 |   |
| Provision for income taxes                             |       | 2,513                                                    |       | 4,593                                                   |       | 11,530 |   | 10,661 |   |
|                                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income                                             |       | $                                                        | 2,305      |                                                    | $          | 7,802 |   | $ | 17,786 |   | $ | 18,329 |   |
|                                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted-average number of shares outstanding:         |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                  |       | 26,904,070                                               |       | 24,968,097                                              |       | 25,859,149 |   | 24,967,143 |   |
| Diluted                                                |       | 38,012,635                                               |       | 36,674,697                                              |       | 36,429,893 |   | 35,723,847 |   |
| Net income per share:                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                                  |       | $                                                        | 0.09       |                                                    | $          | 0.31 |   | $ | 0.69 |   | $ | 0.73 |   |
| Diluted                                                |       | $                                                        | 0.06       |                                                    | $          | 0.21 |   | $ | 0.49 |   | $ | 0.51 |   |

 

See notes to condensed consolidated financial statements

 

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**KapStone Paper and PackagingCorporation**

**Condensed Consolidated Statements ofCash Flows**

**(In thousands)**

 

**(unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| **Operating activities**                                                           |       |                                                    |       |   |   |
| Net income                                                                         |       | $                                                       | 17,786     |   | $ | 18,329 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                                    |       |   |   |
| Depreciation and amortization                                                      |       | 18,381                                                  |       | 8,272 |   |
| Stock based compensation expense                                                   |       | 1,189                                                   |       | 459 |   |
| Amortization of debt issuance costs                                                |       | 1,170                                                   |       | 193 |   |
| Deferred income taxes                                                              |       | 12,999                                                  |       | 628 |   |
| Changes in operating assets and liabilities:                                       |       |                                                    |       |   |   |
| Trade accounts receivable, net                                                     |       | (17,367                                                 | )          | (5,089 | ) |
| Interest receivable on short-term investments                                      |       | —                                                  |       | (379 | ) |
| Inventories                                                                        |       | 438                                                     |       | 5,280 |   |
| Refundable and prepaid income taxes                                                |       | (11,416                                                 | )          | — |   |
| Prepaid expenses and other current assets                                          |       | (4,937                                                  | )          | (573 | ) |
| Accounts payable                                                                   |       | (3,516                                                  | )     | 2,496 |   |
| Accrued expenses                                                                   |       | 13,818                                                  |       | (881 | ) |
| Accrued compensation costs                                                         |       | 936                                                     |       | 5,609 |   |
| Accrued income taxes                                                               |       | (1,477                                                  | )          | 1,927 |   |
| Net cash provided by operating activities                                          |       | 28,004                                                  |       | 36,271 |   |
|                                                                               |       |                                                    |       |   |   |
| **Investing activities**                                                           |       |                                                    |       |   |   |
| CKD acquisition (net of cash acquired)                                             |       | (470,451                                                | )          | (1,200 | ) |
| KPB acquisition                                                                    |       | —                                                  |       | (150,303 | ) |
| Capital expenditures                                                               |       | (12,714                                                 | )          | (9,070 | ) |
| Purchase of short-term investments                                                 |       | —                                                  |       | (35,000 | ) |
| Net cash (used in) investing activities                                            |       | (483,165                                                | )          | (195,573 | ) |
|                                                                               |       |                                                    |       |   |   |
| **Financing activities**                                                           |       |                                                    |       |   |   |
| Proceeds from long-term debt and notes                                             |       | 455,000                                                 |       | 60,000 |   |
| Borrowings under revolving credit facility                                         |       | 71,800                                                  |       | — |   |
| Debt issuance costs paid                                                           |       | (12,593                                                 | )          | (855 | ) |
| Repayment of long-term debt                                                        |       | (88,953                                                 | )          | (3,750 | ) |
| Receipt of cash held in trust                                                      |       | —                                                  |       | 115,239 |   |
| Redemption of shares                                                               |       | —                                                  |       | (230 | ) |
| Proceeds from the exercises of common stock warrants                               |       | 15,146                                                  |       | 40 |   |
| Investment banking fee paid                                                        |       | —                                                  |       | (1,200 | ) |
| Net cash provided by financing activities                                          |       | 440,400                                                 |       | 169,244 |   |
|                                                                               |       |                                                    |       |   |   |
| Net increase in cash and cash equivalents                                          |       | (14,761                                                 | )          | 9,942 |   |
| Cash and cash equivalents-beginning of period                                      |       | 56,635                                                  |       | — |   |
| Cash and cash equivalents-end of period                                            |       | $                                                       | 41,874     |   | $ | 9,942 |   |

 

See notes to condensed consolidated financial statements

 

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** **

**KAPSTONEPAPER AND PACKAGING CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

**(unaudited)**

 

# **1.**                                      Financial Statements

# ** **

The accompanying unaudited condensed consolidatedfinancial statements of KapStone Paper and Packaging Corporation (the “Company,”“we,” “us,” “our” or “KapStone”) have been prepared in accordance with U.S.generally accepted accounting principles for interim financial information, theinstructions to Form 10-Q and Article 10 of Regulation S-X.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for complete financial statements.In the opinion of management, all adjustments (consisting of a normal recurringnature) considered necessary for a fair presentation have been included.Operating results for the three and nine months ended September 30, 2008are not necessarily indicative of the results that may be expected for the yearending December 31, 2008. For further information, refer to theconsolidated financial statements and related footnotes included in our AnnualReport on Form 10-K/A for the year ended December 31, 2007.

 

KapStone Paper and Packaging Corporation (formerlyStone Arcade Acquisition Corporation) or the “Company” was incorporated inDelaware on April 15, 2005.  On May 25,2006, the Company formed a wholly-owned subsidiary, KapStone Kraft Paper Corporation,or KapStone Kraft.  The Company wasformed to serve as a vehicle for the acquisition through a merger, capitalstock exchange, asset acquisition, or other similar business combination (“BusinessCombination”) of an operating business in the paper, packaging, forest productsand related industries.

 

On January 2, 2007, the Company acquiredsubstantially all of the assets and assumed certain liabilities of the KraftPapers Business (“KPB”) from International Paper Company (“IP”).  Prior to the acquisition of KPB, the Companyhad no operations and was considered a development stage company.

 

On July 1, 2008, the Company consummated anasset purchase agreement with MeadWestvaco Corporation (“MWV”) to purchasesubstantially all of the assets and assume certain liabilities of theCharleston Kraft Division (“CKD”) for $485 million, subject to certainpost-closing adjustments. The accompanying condensed consolidated financialstatements include the results of CKD since the date of acquisition.

 

# **2.             Reclassification**

# ** **

Certain 2007 balances have been reclassified toconform to 2008 presentation, including freight and distribution from cost ofsales, and amortization expense from selling, general and administrativeexpenses in the statements of income for the three and nine month periods endedSeptember 30, 2007. In addition, deferred income taxes have beenreclassified from accrued expenses in the statements of cash flows.

 

# **3.**             Accounting Pronouncements

# ** **

InApril 2008, the Financial Accounting Standards Board (“FASB”) issued StaffPosition (“FSP”) 142-3, *Determination of theUseful Life of Intangible Assets*, which amends the factors thatshould be considered in developing renewal or extension assumptions used indetermining the useful life of a recognized intangible asset. This FSP iseffective for financial statements issued for fiscal years (and interimperiods) beginning after December 15, 2008 (calendar year 2009). TheCompany is currently evaluating the impact of the provisions of this FSP on theconsolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*. SFAS No. 157defines fair value, establishes a framework for measuring fair value andexpands disclosures about fair value measurements but does not change existingguidance as to whether or not an instrument is carried at fair value.  In February 2008, the FASB released aFASB Staff Position, which delayed the effective date of SFAS No. 157 forall non-financial assets and liabilities, except those that are recognized ordisclosed at fair value in the condensed consolidated financial statements on arecurring basis. SFAS No. 157 was first effective for the Company on January 1,2008.

 

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The impact of the adoption of SFAS No. 157 onour financial assets and liabilities, which are principally comprised of cashequivalents, did not have a significant impact on their fair value measurementsor require expanded disclosures.

 

# **4.**                                      CKD Acquisition

# ** **

On July 1, 2008, the Company consummated anasset purchase agreement with MeadWestvaco Corporation (“MWV”) to purchasesubstantially all of the assets and assume certain liabilities of MWV’sCharleston Kraft Division (“CKD”), for $485 million, subject to certainadjustments. CKD consists of an unbleached kraft paper manufacturing facilityin North Charleston, South Carolina, chip mills located in Elgin, Hampton,Andrews and Kinards, South Carolina and a lumber business located inSummerville, South Carolina.

 

The acquisition was financed by cash on hand and bya new  senior secured credit facility of$515 million consisting of a LIBOR based five-year term loan of $390 million, aLIBOR based seven-year term loan of $25 million and a $100 million revolvingcredit facility. In addition, $40 million of seven-year 8.30% senior notes wereissued.  A portion of the proceeds wereused to redeem the Company’s prior credit facility.

 

The CKD business was deemed an attractiveacquisition candidate based upon meeting the Company’s objectives of being aNorth American-based, profitable company in the paper and packaging industryand for its synergies with the Company’s existing operations.

 

In connection with the CKD acquisition, the Companyentered into a Long Term Fiber Supply Agreement (“Supply Agreement”) with MWV.Pursuant to the Supply Agreement, the Company will purchase, on a take or paybasis, certain amounts of pine pulpwood and saw timber at market prices for aperiod of 15 years. The purchases will be accounted for as raw materials.

 

# **The CKD acquisition was accounted for in accordance with the provisionsof SFAS No. 141, *Business Combinations* and the**accompanyingcondensed consolidated financial statements include the results of CKD sincethe date of acquisition.**

# ** **

# **The excess of the purchase price over theaggregate fair value of net assets acquired was allocated to goodwill. Thefollowing table summarizes the purchase price ($000’s):**

 
| Purchase price (net of cash acquired of  $10,572) |   | $      | 474,428 |   |
|---------------------------------------------------|--------|--------|---------|--------|
| Preliminary working capital adjustment            |   | (7,525 | )       |
| Transaction costs                                 |   | 4,748  |    |
|                                              |   |   |    |
| Total purchase price                              |   | $      | 471,651 |   |

# ** **

# **The following table summarizes the preliminaryestimated fair value of the assets acquired and liabilities assumed at the dateof acquisition ($000’s):**

# *** ***

| Trade accounts receivable                   |   | $       | 36,380  |   |
|---------------------------------------------|--------|---------|---------|--------|
| Inventories                                 |   | 54,795  |    |
| Prepaid expenses and other current assets   |   | 6,978   |    |
| Plant, property and equipment               |   | 378,837 |    |
| Deferred income taxes                       |   | 1,160   |    |
| Intangible assets                           |   | 46,520  |    |
| Goodwill                                    |   | 6,607   |    |
| Accounts payable                            |   | (29,594 | )       |
| Accrued expenses                            |   | (14,878 | )       |
| Accrued compensation costs                  |   | (5,278  | )       |
| Other liabilities                           |   | (6,503  | )       |
| Accrued pension and postretirement benefits |   | (3,373  | )       |
| Acquisition consideration                   |   | $       | 471,651 |   |

 

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# **The appraisal process for determining the fair value of the acquired CKDassets, in accordance with SFAS No. 141, *BusinessCombinations*, included a valuation of the acquired assets with aconsideration of the three traditional valuation approaches to fair value:cost, market and income. The preliminary appraisal was based on management’sestimates and assumptions.  As of September 30,2008, the preliminary purchase accounting is still subject to final adjustmentand could materially change in subsequent periods. The Company’s management hasnot finalized its review of all CKD plant and equipment, intangible assets,deferred income taxes and other liabilities.**

# ** **

Goodwill is allocated amongst reporting units inproportion to the fair value of their net assets acquired at July 1, 2008.Goodwill of $6.6 million was allocated to the unbleached kraft segment as aresult of the CKD acquisition. See footnote 14 for additional discussionregarding the Company’s segments.

 

In accordance with SFAS No. 142, *Goodwill and Other Intangible Assets*,goodwill is not amortized, but instead is tested annually for impairment, ormore frequently, if circumstances indicate a possible impairment mayexist.  The impairment test will be conducted in the fourth quarter.

 

The following table summarizes the acquiredintangible assets and their estimated fair value ($000’s):

 
| ** **                                    | ** ** | **Estimated  Fair  Value** | ** ** | **Average  Remaining  Useful Life  In Years** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|---------------------------------------------------------|------------|
| Trademarks and knowledge                      |       | $                          | 27,700     |                                                    | 8          |   |
| Coal supply contract with below-market  terms |       | 13,700                     |       | 1.5                                                     |       |
| Engineering documents                         |       | 2,181                      |       | 12                                                      |       |
| Customer relationships                        |       | 1,989                      |       | 20                                                      |       |
| Transportation lease                          |       | 500                        |       | 5                                                       |       |
| Land lease                                    |       | 290                        |       | 99                                                      |       |
| Customer backlog                              |       | 100                        |       | 1                                                       |       |
| Emission credits                              |       | 60                         |       | 1                                                       |       |
| Total fair value of intangible assets         |       | $                          | 46,520     |                                                    |       |   |

 

The fair value of the intangible assets will beamortized on a straight-line basis over the remaining useful lives.  Estimated amortization expense for the nextfive years is as follows ($000’s):

 
| 2008 (third and fourth quarter only) |   | $      | 6,570  |   |
|--------------------------------------|--------|--------|--------|--------|
| 2009                                 |   | 13,060 |   |
| 2010                                 |   | 3,847  |   |
| 2011                                 |   | 3,847  |   |
| 2012                                 |   | 3,847  |   |
| 2013                                 |   | 3,797  |   |
| Thereafter                           |   | 11,552 |   |
| Total amortization                   |   | $      | 46,520 |   |

 

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The following unaudited pro forma consolidatedresults of operations assume that the acquisition of CKD occurred as of thebeginning of the periods presented. This pro forma data is based on historicalinformation and does not necessarily reflect the actual results that would haveoccurred, nor is it indicative of future results of operations ($000’s).

 
| ** **                   | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                   | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                   | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                         |       |                             |       |                            |       |   |   |   |   |
| Net sales                    |       | $                                | 207,671    |                            | $          | 190,540 |   | $ | 596,268 |   | $ | 568,414 |   |
| Net income                   |       | $                                | 2,305      |                            | $          | 8,144 |   | $ | 6,020 |   | $ | 13,135 |   |
| Net income per share basic   |       | $                                | 0.09       |                            | $          | 0.33 |   | $ | 0.23 |   | $ | 0.53 |   |
| Net income per share diluted |       | $                                | 0.06       |                            | $          | 0.22 |   | $ | 0.17 |   | $ | 0.37 |   |
|                              |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

# ** **

# **Certain corporate services were performed and allocated or charged by MWVto the historical CKD business. For the three and nine months ended September 30,2007, and the nine months ended September 30, 2008, amounts allocated or chargedby MWV to CKD were $5,304, $15,911 and $14,775, respectively, and are includedin net pro forma income.**

# ** **

# **5.**                                      Inventories

# ** **

Inventories consist of the following at September 30,2008, and December 31, 2007, respectively ($000’s):

 
| ** **                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                     | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| Raw materials                  |       | $                      | 20,964     |                  | $          | 5,351 |   |
| Work in process                |       | 1,573                  |       | 655                   |       |
| Finished goods                 |       | 33,449                 |       | 9,851                 |       |
| Replacement parts and supplies |       | 18,217                 |       | 3,989                 |       |
|                           |       |                   |       |                  |       |
| Total inventories              |       | $                      | 74,203     |                  | $          | 19,846 |   |

# ** **

# **6.**                                      Accrued expenses

# ** **

 Accruedexpenses consist of the following at September 30, 2008, and December 31,2007, respectively ($000’s):

 
| ** **                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                      | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| Accrued interest                |       | $                      | 7,124      |                  | $          | 65 |   |
| Accrued taxes other than income |       | 5,428                  |       | 1,835                 |       |
| Accrued maintenance cost        |       | 3,956                  |       | 402                   |       |
| Accrued liability with MWV      |       | 3,822                  |       | —                |       |
| Accrued energy                  |       | 3,396                  |       | —                |       |
| Accrued workers compensation    |       | 1,920                  |       | 5                     |       |
| Accrued freight                 |       | 1,839                  |       | 569                   |       |
| Other accruals                  |       | 5,478                  |       | 1,991                 |       |
| Total accrued expenses          |       | $                      | 32,963     |                  | $          | 4,867 |   |

 

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# **7.**                                      Long-Term Debt andCredit Facility

# ** **

*Senior Credit Agreement*

 

On June 12, 2008, theCompany entered into a Credit Agreement, effective with the consummation of theacquisition of CKD, (the “Senior Credit Agreement”) which provides for anaggregate of up to $515 million in senior secured credit facilities (the “SeniorCredit Facilities”), consisting of a $390 million term A loan facility, a $25million term B loan facility and a $100 million revolving credit facility(including a letter of credit sub-facility). The Senior Credit Agreement replaces the prior senior secured creditfacility due on December 31, 2011. The Senior Credit Facilities areguaranteed by the Company and its domestic subsidiaries and are secured bysubstantially all of the Company’s assets.

 

The Senior Credit Facilitiesare required to be repaid in consecutive quarterly installments with finalpayments of all outstanding principal and interest on the maturity date. Thematurity date is the earlier of:  (a) June 12,2013 with respect to the term A loan facility and the revolving creditfacility, and June 12, 2015 with respect to the term B loan facility, and (b) thedate which is 90 days prior to the date on which any earn-out obligations toInternational Paper Company will become (or are reasonably expected to become)due (January 2, 2011); provided that the maturity date will not be soaccelerated if, among other things, the total leverage ratio as of the end ofthe then most recent fiscal quarter is less than 2.0 to 1.0.

 

Outstanding principal underthe term A loan facility and the revolving credit facility initially bearsinterest at a rate equal to, at the Company’s option, either (1) the baserate plus a margin of 1.50%, or (2) the reserve adjusted one, two, threeor six-month LIBOR rate plus a margin of 3.00%.   Commencing six months after the closing ofthe Senior Credit Facilities, pricing under the term A loan facility and therevolving credit facility and the unused line fee for the revolving creditfacility will be determined by reference to a pricing grid based on our totalleverage ratio.  Under the pricing grid,the applicable margins for the term A loan facility and the revolving creditfacility will range from 0.0% to 1.5% for base rate loans and from 1.50% to3.00% for Eurodollar loans, and the unused line fee for the revolving creditfacility will range from 0.375% to 0.50%. At September 30, 2008, the revolving credit facility was a baserate loan at a rate of 6.5% and term loan A was a LIBOR loan with a 6.1225%rate. The unused line fee for the revolving credit facility was 0.50% at September 30,2008.

 

Outstanding principal underthe term B loan facility bears interest at a rate equal to, at the Company’soption, either (1) the base rate plus a margin of 2.00% or (2) the reservedadjusted one, two, three or six-month Eurodollar rate plus a margin of3.50%.  At September 30, 2008, theterm B loan was a LIBOR loan with a 6.6225% rate.

 

The term loan facilities andthe revolving credit facility may be prepaid at any time without premiumpenalties.  The Senior Credit Facilitiesare subject to mandatory prepayment with specified percentages of the net cashproceeds of certain asset dispositions, casualty events, exercise ofoutstanding warrants, debt and equity issuances, and with excess cash flow, ineach case subject to certain conditions. During the three months ended September 30,2008, an $11.9 million mandatory prepayment was made reflecting proceeds fromthe exercises of common stock warrants.

 

Borrowings under therevolving credit facility may be used for working capital and other generalcorporate purposes.

 

***Note Purchase Agreement***

 

Pursuant to the NotePurchase Agreement dated July 1, 2008 (the “Note Purchase Agreement”) theCompany issued senior secured promissory notes (the “Senior Notes”) with anaggregate principal amount of $40 million. The Senior Notes are guaranteed by the Company and secured bysubstantially all of the Company’s assets.

 

The Senior Notes arerequired to be repaid in annual installments until the maturity date of July 1,2015 and bear interest at the rate of 8.30%.

 

The Senior Notes may beprepaid at any time with the payment of an applicable yield-maintenanceamount.  In the event that a mandatoryprepayment event occurs under the Senior Credit Agreement (certain assetdispositions, casualty events, exercises of outstanding warrants, debt andequity issuances and excess cash flow, in each case subject to certainconditions), then the Company is required to offer to repay, without premium, apro rata portion of 

 

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the Senior Notes held byeach holder who accepts the Company’s prepayment offer (such portion based onthe product of (a) the net cash proceeds from the mandatory  prepayment event required to be prepaidpursuant to the Senior Credit Agreement multiplied by (b) a fraction, thenumerator of which is the aggregate outstanding principal amount of the SeniorNotes held by such holder and the denominator of which is the sum of (x) theaggregate outstanding principal amount under the Senior Credit Agreement and (y) theaggregate outstanding principal amount under all Senior Notes.)

 

Long-term debt and notes at September 30, 2008and December 31, 2007, is summarized as follows ($000’s):

 
| ** **                                                      | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                      | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| Term A loan with interest payable quarterly  at LIBOR plus 3.0% |       | $                            | 371,719    |                        | $          | — |   |
| Term B loan with interest payable quarterly  at LIBOR plus 3.5% |       | 23,828                       |       | —                      |       |
| Senior Notes with interest payable  quarterly at 8.3%           |       | 40,000                       |       | —                      |       |
| Revolving credit facility (6.5% at  September 30, 2008)    |       | 54,800                       |       | —                      |       |
| Term loan (6.3% at December 31, 2007)                      |       | —                       |       | 52,500                      |       |
| Less current portion of long-term debt and  notes               |       | (35,752                      | )          | (19,578                     | )          |
| Less unamortized debt issuance costs                            |       | (11,238                      | )          | —                      |       |
| Total                                                           |       | $                            | 443,357    |                        | $          | 32,922 |   |

 

The Company recordedapproximately $12.6 million of debt issuance costs associated with the newSenior Credit Agreement, which is being amortized over a five-year period usingthe effective interest method. In addition, in the three months ended September 30,2008, $0.2 million of debt issuance costs from the prior credit facility wereamortized.

 

The Senior Credit Agreementand Senior Notes contain, among other provisions, requirements for maintainingcertain financial ratios and limitations on certain payments. As of September 30,2008, the Company was in compliance with such provisions.

 

# **8.**                                      Stockholder’s equity

# ** **

In connection with the Company’s initial publicoffering, on August 19, 2005, the Company sold 20,000,000 units (“Units”)for a gross price of $6.00 per Unit. Each Unit consists of one share of thecompany’s common stock, $0.0001 par value, and two warrants. Each warrantentitles the holder to purchase from the Company one share of common stock atan exercise price of $5.00 and expires on August 15, 2009.

 

The warrants are redeemable by the Company at aprice of $0.01 per warrant upon 30 days notice after the warrantsbecome exercisable, only in the event thatthe last sale price of the common stock is at least $8.50 per share for any 20trading days within a 30 day trading period ending on the third day prior tothe date on which notice of redemption is given.

 

For the nine months ended September 30, 2008,3,029,180 common stock warrants were exercised with proceeds totaling $15.1million.

 

# **9.**                                      Income taxes

# ** **

The Company’s U.S. federal statutory tax rate is 35%for 2008 and 2007. The Company’s effective tax rate for the nine months ended September 30,2008 and 2007 was 39.3% and 36.8%, respectively. The effective tax rate for thethree and nine months ended September 30, 2008 increased due to a lowerbenefit from the federal domestic manufacturing deduction.

 

In the normal course of business, we are subject toexamination by taxing authorities. The Company’s open tax years are 2005through 2007.

 

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** **

**10.****                              ****Net income per share**

 

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

 
| ** **                                                               | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net income as reported                                                   |       | $                                                        | 2,305      |                                                    | $          | 7,802 |   | $ | 17,786 |   | $ | 18,329 |   |
| Weighted-average number of common shares for basic net income per  share |       | 26,904,070                                               |       | 24,968,097                                              |       | 25,859,149 |   | 24,967,143 |   |
| Incremental effect of dilutive common stock equivalents:                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Common stock warrants                                                    |       | 10,734,412                                               |       | 11,690,113                                              |       | 10,331,418 |   | 10,747,228 |   |
| Underwriter’s purchase option                                       |       | 243,280                                                  |       | —                                                  |       | 120,111 |   | — |   |
| Unvested restricted stock awards                                         |       | 130,873                                                  |       | 16,487                                                  |       | 119,215 |   | 9,476 |   |
|                                                                     |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted-average number of shares for diluted net income per share       |       | 38,012,635                                               |       | 36,674,697                                              |       | 36,429,893 |   | 35,723,847 |   |
|                                                                     |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income per share – basic                                        |       | $                                                        | 0.09       |                                                    | $          | 0.31 |   | $ | 0.69 |   | $ | 0.73 |   |
|                                                                     |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income per share – diluted                                      |       | $                                                        | 0.06       |                                                    | $          | 0.21 |   | $ | 0.49 |   | $ | 0.51 |   |

 

Stock option grants wereoutstanding during all periods, but were not included in the computation ofdiluted earnings per share because the effect of including the stock option grantswould be anti-dilutive.

 

Underwriter’s purchaseoption with respect to 1,000,000 Units was outstanding during the three andnine months ended September 30, 2007, but such Units were not included inthe computation of diluted earnings per share because the effect of includingthe underwriter’s option would be anti-dilutive.

# ** **

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

# ** **

**DefinedBenefit Plan**

 

As part of the Company’sacquisition of the Kraft Papers Business (KPB) in January 2007, theCompany established the KapStone Paper and Packaging Corporation DefinedBenefit Plan (“Plan”) to provide benefits for approximately 560 unionrepresented employees.  This plan is partof the collective bargaining agreement between KapStone and the United Steel,Paper and Forestry, Rubber, Manufacturing, Energy, Allied-Industrial, Chemicaland Service Workers Union, AFL-CIO, and CLC. The assumed liability for the retroactive benefits provided for priorservice was $1.4 million at January 2, 2007, and employees began to accruebenefits under the Plan as of January 1, 2007.

 

As part of the CKDacquisition, the Company assumed certain liabilities of $1.4 million fordefined benefit obligations for 615 union employees at July 1, 2008. CKDunion employees began earning benefits under the KapStone Plan as of theacquisition date and has been considered in the determination of net pensioncost for the three and nine months ended September 30, 2008.

 

Net pension costrecognized for the three and nine months ended September 30, 2008 and 2007for the Company’s pension plan, is as follows ($000’s):

 
| ** **                                       | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                             |       |                                                     |       |                                                    |       |   |   |   |   |
| Service cost for benefits earned during the year |       | $                                                        | 694        |                                                    | $          | 288 |   | $ | 1,306 |   | $ | 863 |   |
| Interest cost on projected benefit obligation    |       | 60                                                       |       | 20                                                      |       | 138 |   | 60 |   |
| Expected return on plan assets                   |       | (7                                                       | )          | —                                                  |       | (19 | ) | — |   |
| Amortization of prior service cost               |       | —                                                   |       | 25                                                      |       | — |   | 75 |   |
| Net pension cost                                 |       | $                                                        | 747        |                                                    | $          | 333 |   | $ | 1,425 |   | $ | 998 |   |

 

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KapStone funds its Planaccording to IRS funding limitations. Based on those limitations, KapStonefunded $1.0 million to the pension plan during the three months ended September 30,2008.

 

**OtherPost-retirement Benefits**

 

As part of the CKDacquisition, the Company assumed certain liabilities of $1.8 million forretiree medical/life obligations for employees not eligible to retire at June 30,2008. Net postretirement cost recognized for each of the three and nine monthsended September 30, 2008 for the Company’s retiree medical and lifeinsurance plan was approximately $0.1 million.

 

**DefinedContribution Plans**

 

In January 2007, theCompany established the KapStone’s Retirement Savings Plan, a definedcontribution plan covering all eligible employees. Company contributions to theplan are based on matching of employee contributions, vest immediately forsalaried employees and vest after three years for union employees. For thethree months ended September 30, 2008 and 2007, the Company recognizedexpense of $0.8 million and $0.2 million, respectively, for matchingcontributions. For the nine months ended September 30, 2008 and 2007, theCompany recognized expense of $1.5 million and $0.8 million, respectively.

 

The Company’s RetirementSavings Plan, which covers all eligible salaried employees, provides forcontributions based on an employee’s salary and age.  The Company contributions vest 100% afterthree years. For the three months ended September 30, 2008 and 2007, theCompany recognized expense for the Retirement Savings Plan of $0.5 million and$0.2 million, respectively. For the nine months ended September 30, 2008and 2007, the Company recognized expense of $0.8 million and $0.5 million,respectively.  Retirement Savings Plancontributions are made to employees’ 401(k) accounts in January ofeach year.

 

**12.****                              ****Stock-Based Compensation**

 

On December 29,2006, the Company’s stockholders approved the 2006 Incentive Plan (“2006 Plan”).  A maximum of 3.0 million shares of our commonstock, available for issuance pursuant to stock options, restricted stockawards or stock appreciation rights (collectively called “Awards”), may begranted under the 2006 Plan. If any Award is forfeited or expires without beingexercised, or if restricted stock is repurchased by the Company, the shares ofstock subject to the Award shall be available for additional grants under the2006 Plan. The number of shares available under the 2006 Plan is subject toadjustment in the event of any stock split, stock dividend, recapitalization,spin-off or other similar action. Awards may be granted to employees, officersand directors of, and consultants or advisors to, the Company and anysubsidiary corporations. Options intended to qualify, under the standards setforth in certain federal tax rules, as incentive stock options (“ISOs”) may begranted only to employees while actually employed the Company. Non-employeedirectors, consultants and advisors are not entitled to receive ISOs. OptionAwards granted under the 2006 Plan are exercisable for a period fixed by theadministrator, but not longer than 10 years from the date of grant, at anexercise price which is not less than the fair market value of the shares onthe date of the grant.

 

KapStone accounts forthese awards under SFAS No. 123(R), *Share-BasedPayment*, which requires that the cost resulting from all share-basedpayment transactions be recognized as compensation cost over the vesting periodbased on the fair value of the instrument on the date of grant. The Companyrecognized $0.5 million and $1.2 million of compensation cost for the three andnine months ended September 30, 2008, respectively, and $0.3 million and$0.5 million for the three and nine months ended September 30, 2007,respectively.

 

At September 30,2008, the Company had reserved 3.0 million shares of common stock for stockoption and restricted stock awards.

 

**StockOptions**

 

In 2008, the Company’sCompensation Committee approved the issuance of 747,781 stock options todirectors, executive officers and employees of the Company.  The stock options vest as follows: 50% aftertwo years and the remaining 50% after three years.  The stock options awarded in 2008 have acontractual term of ten years. The stock options are subject to forfeitureshould  recipients terminate theiremployment with the Company for certain reasons prior to vesting in theirawards, or upon the occurrence of certain other events such as termination withcause. The 

 

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exercise price of thesestock options is based on the closing market price of our common stock on thedate of grant and compensation expense is recorded on an accelerated basis overthe awards’ vesting periods.

 

The weighted average fairvalue of the KapStone stock options granted in 2008 was $2.11. The fair valuewas calculated using the Black-Scholes option-pricing model based on the marketprice at the grant date and the weighted average assumptions specific to theunderlying options. The expected volatility assumption is based on volatilityof related industry stocks. The Company uses the “simplified method”, definedin SEC Staff Accounting Bulletin (“SAB”) No. 107, to determine theexpected life assumption for all of its options.  The Company uses the “simplified method”, as permitted by SAB No. 110, as itdoes not have any historical exercise data to provide a reasonable basis uponwhich to estimate expected life due to the limited time its equity shares havebeen publicly traded.The risk-free interest rate was selected based upon yields of U.S.Treasury issues with a term similar to the expected life of the stock options.

 

The assumptions utilizedfor determining the fair value of stock options awarded during the period areas follows:

 
| KapStone Stock Options Black-Scholes assumptions (weighted average): |   |   |   |
|----------------------------------------------------------------------|--------|--------|--------|
| Expected volatility                                                  |   | 24.4   | %      |
| Expected life (years)                                                |   | 6.5    |   |
| Risk-free interest rate                                              |   | 3.4    | %      |
| Expected dividend yield                                              |   | — | %      |
| Expected forfeitures                                                 |   | 2.0    | %      |

 

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

 
| ** **                                 | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Weighted**          | ** ** | **Intrinsic**        | ** ** |
|--------------------------------------------|------------|-------------|------------|--------------|------------|-----------------------|------------|----------------------|------------|
| ** **                                 | ** ** | ** **  | ** ** | **Average**  | ** ** | **Average**           | ** ** | **Value**            | ** ** |
| ** **                                 | ** ** | ** **  | ** ** | **Exercise** | ** ** | **Remaining**         | ** ** | **(dollars in** | ** ** |
| ** **                                 | ** ** | **Options** | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Thousands)**       | ** ** |
| **Outstanding at January 1, 2008**    |       | 631,050     |       | $            | 6.77       |                  | 6.3        |                 | $          | 147 |   |
| Granted                                    |       | 747,781     |       | 6.97         |       | 9.6                   |       | —               |       |
| Exercised                                  |       | —      |       | —       |       | —                |       | —               |       |
| Lapsed (forfeited or canceled)             |       | (33,131     | )          | (6.98        | )          | —                |       | —               |       |
| **Outstanding at September 30, 2008** |       | 1,345,700   |       | $            | 6.88       |                  | 7.9        |                 | $          | (703 | ) |
| **Exercisable at September 30, 2008** |       | —      |       | —       |       | —                |       | —               |       |

 

Total stock-basedcompensation recorded in the Condensed Consolidated Statements of Incomerelated to the stock option grants was $0.3 million and $0.7 million for thethree and nine months ended September 30, 2008, respectively, and $0.2million and $0.3 million for the three and nine months ended September 30,2007, respectively.

 

As of September 30, 2008,there was $1.8 million of total unrecognized compensation cost related tonon-vested stock options. That cost is expected to be recognized over theremaining vesting period of approximately two years   No stock options were vested as of September 30,2008.

 

**RestrictedStock**

 

In 2008, the Company’sCompensation Committee granted 194,688 restricted stock units to executiveofficers and employees as compensation for service. These restricted stockunits are restricted as to transferability until they vest three years from thegrant date. These restricted stock units are subject to forfeiture should theseemployees terminate their employment with the Company for certain reasons priorto vesting in their awards, or the occurrence of certain other events. Thevalue of these restricted stock units is based on the closing market price ofour common stock on the date of grant and compensation expense is recorded on astraight-line basis over the awards’ vesting periods.

 

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The following tablesummarizes restricted stock amounts and activity:

 
| ** **                                 | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|--------------------------------------------|------------|------------|------------|--------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | **Average**  | ** ** |
| ** **                                 | ** ** | **Units/** | ** ** | **Grant**    | ** ** |
| ** **                                 | ** ** | **Shares** | ** ** | **Price**    | ** ** |
| **Outstanding at January 1, 2008**    |       | 174,000    |       | $            | 6.76       |   |
| Granted                                    |       | 194,688    |       | 6.99         |       |
| Vested                                     |       | —     |       | —       |       |
| Forfeited                                  |       | —     |       | —       |       |
| **Outstanding at September 30, 2008** |       | 368,688    |       | $            | 6.88       |   |

 

Total stock-basedcompensation recorded in the Condensed Consolidated Statements of Incomerelated to the restricted stock awards was $0.2 million and $0.5 million forthe three and nine months ended September 30, 2008, respectively, and $0.1million and $0.2 million for the three and nine month periods ended September 30,2007, respectively. As of September 30, 2008, there was $1.6 million oftotal unrecognized compensation cost related to the restricted stock which,will be recognized over the remaining vesting period of approximately twoyears. No restricted stock awards were vested as of September 30, 2008.

 

# **13.**                               Annual Planned Maintenance Outage

 

Cost of sales for thenine month periods ended September 30, 2008 and 2007 includedapproximately $6.0 million and $4.6 million, respectively, for the annualplanned maintenance outage costs at the Company’s North Carolina unbleachedkraft paper facility, which are expensed as incurred.  The annual planned maintenance outageoccurred in the third quarter of 2008 and in the second quarter of 2007.

 

# **14.**                               Segment Information

 

Prior to the acquisitionof CKD, the Company had two reportable segments, unbleached kraft and dunnagebags.  After the CKD acquisition theCompany determined, in accordance with SFAS No. 131, *Disclosuresabout Segments of an Enterprise and Related Information*, that it hasone reportable segment. The unbleached kraft reportable segment consists of theCompany’s unbleached kraft paper mills in Roanoke Rapids, North Carolina andNorth Charleston, South Carolina, which produce unbleached kraft paper,linerboard products, unbleached kraft board and saturating kraft. Theseproducts are sold to customers who convert our products into end-marketfinished products. The all other category consists of the Company’s dunnage bagoperating segment, based in Fordyce, Arkansas, which converts unbleached kraftpaper and film into inflatable dunnage products, which are used to securefreight to minimize movement and potential damage of goods and products duringtransport, and the lumber business operating segment, based in Summerville,South Carolina, which produces dimensional softwood board lumber which is soldto regional lumber yards.

 

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

 

The Company operates intwo geographic segments, the United States and International. For the ninemonths ended September 30, 2008 approximately 29% of consolidated netsales were to International customers.

 

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Segment disclosures havebeen revised to conform to the new presentation for all reporting periods.

 
| ** **                                                                          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Operating Segment (in thousands of U.S. dollars):** | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net sales:                                                                          |       |                                                     |       |                                                    |       |   |   |   |   |
| Unbleached kraft                                                                    |       | $                                                        | 194,726    |                                                    | $          | 58,967 |   | $ | 315,631 |   | $ | 169,968 |   |
| All other                                                                           |       | 13,781                                                   |       | 8,254                                                   |       | 30,578 |   | 24,706 |   |
| Elimination of intersegment sales                                                   |       | (836                                                     | )          | (1,033                                                  | )          | (3,247 | ) | (2,817 | ) |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Total                                                                               |       | $                                                        | 207,671    |                                                    | $          | 66,188 |   | $ | 342,962 |   | $ | 191,857 |   |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Net sales to external customers:                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Unbleached kraft                                                                    |       | 193,890                                                  |       | 57,934                                                  |       | 312,384 |   | 167,151 |   |
| All other                                                                           |       | 13,781                                                   |       | 8,254                                                   |       | 30,578 |   | 24,706 |   |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Total                                                                               |       | $                                                        | 207,671    |                                                    | $          | 66,188 |   | $ | 342,962 |   | $ | 191,857 |   |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Operating income / (loss):                                                          |       |                                                     |       |                                                    |       |   |   |   |   |
| Unbleached kraft                                                                    |       | $                                                        | 19,884     |                                                    | $          | 15,297 |   | $ | 50,364 |   | $ | 36,703 |   |
| All other                                                                           |       | 1,332                                                    |       | 1,420                                                   |       | 3,932 |   | 4,732 |   |
| Corporate                                                                           |       | (7,070                                                   | )          | (3,863                                                  | )          | (15,279 | ) | (10,595 | ) |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Total                                                                               |       | $                                                        | 14,146     |                                                    | $          | 12,854 |   | $ | 39,017 |   | $ | 30,840 |   |

 
| **Operating Segment (in thousands of U.S. dollars):** | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Total assets :                                                                      |       |                             |       |                            |       |
| Unbleached kraft                                                                    |       | $                                | 663,066    |                            | $          | 144,798 |   |
| All other                                                                           |       | 43,151                           |       | 17,079                          |       |
| Corporate                                                                           |       | 62,501                           |       | 63,573                          |       |
| Total                                                                               |       | $                                | 768,718    |                            | $          | 225,450 |   |

 

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**Item 2.****      ****MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

This Quarterly Report on Form 10-Q includesforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. We have based these forward-lookingstatements on our current expectations and projections about future events.These forward-looking statements are subject to known and unknown risks,uncertainties and assumptions about us that may cause our actual results,levels of activity, performance or achievements to be materially different fromany future results, levels of activity, performance or achievements expressedor implied by such forward-looking statements. In some cases, forward-lookingstatements can be identified by terminology such as “may,” “should,” “could,”“would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” orthe negative of such terms or other similar expressions. Factors that mightcause or contribute to such a discrepancy include, but are not limited to,those described in Item 1A in this Form 10-Q and in our other Securitiesand Exchange 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 such statements as a result of new information, future events orotherwise.

 

The following discussion should be read in conjunctionwith our Condensed Consolidated Financial Statements and related Notes theretoincluded elsewhere in this report.

 

**Overview**

 

We were formed on April 15, 2005 to serve as avehicle to effect a merger, capital stock exchange, asset acquisition or othersimilar business combination (“Business Combination”) with an operating businessin the paper, packaging, forest products and related industries.

 

On January 2, 2007, the Company purchasedsubstantially all of the assets and assumed certain liabilities of the Kraft Papers Business (“ KPB’’), adivision of International Paper Company (“IP”), consisting of an unbleachedkraft paper manufacturing facility in Roanoke Rapids, North Carolina and RideRite® Converting, an inflatable dunnage bag manufacturer located in Fordyce,Arkansas, for a cash purchase price of $155 million in cash, less certainpost-closing adjustments of $7.8 million, plus two contingent earn-out paymentsof up to $60 million (in aggregate), based on KPB’s annual earnings beforeinterest, income taxes, depreciation and amortization, or EBITDA, during thefive years immediately following the acquisition.  Any contingent earn-out payments will beaccounted for as additional purchase price consideration and recorded asgoodwill.

 

On July 1, 2008, the Company consummated an assetpurchase agreement with MeadWestvaco Corporation (“MWV”) to purchasesubstantially all of the assets and assume certain liabilities of MWV’sCharleston Kraft Division (“CKD”) for $485 million, subject to certain closingadjustments.  The acquisition consists ofan unbleached kraft paper manufacturing facility in North Charleston, SouthCarolina, chip mills located in Elgin, Hampton, Andrews and Kinards, SouthCarolina and a lumber business located in Summerville, South Carolina.

 

The results reported below do not reflect any actualor pro forma adjustments related to the acquisition prior to the consummationof the acquisition on July 1, 2008. The results reported below include theresults of CKD since the date of acquisition, July 1, 2008.

 

 See Liquidityand Capital Resources – CKD Acquisition for discussion of the financing of theCKD acquisition.

 

**Comparisonof Results of Operations for the Three Months Ended September 30, 2008 andthe Three Months Ended September 30, 2007**

 

The Company’s management uses a variety of financialmeasurements to analyze its performance. These measurements include (1) OperatingIncome, (2) Tons Sold, (3) Selling, General & Administrative(“SG&A”) expenses and (4) Average revenue per ton (for unbleachedkraft).

 

*Operating Income.*   Operating income is used by the Company’s management primarily as ameasure of its segments’ operating performance. The Company’s managementdefines operating income as sales minus costs associated with these sales.Sales include sales of unbleached kraft paper products, linerboard and dunnagebags net of term allowances and discounts. For purposes of calculatingoperating income, costs include the cost of raw 

 

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materials, labor, maintenance, depreciation andamortization, freight and distribution expenses and selling, general andadministrative expenses.

 

*Selling, General and AdministrativeExpenses.*   SG&A expenses include selling, customerservice and corporate employee salaries and benefits, professional fees, andinformation technology expenses, including fees paid  for transitional services support.

 

*Average Revenue per Ton.* Average revenue per ton represents gross revenue divided by the tons ofunbleached kraft products sold.

 
| ** **                                              | ** ** | **Three Months Ended September 30,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):** | ** ** | **2008**                                                 | ** ** | **2007**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                                        | 207,671    |          | $          | 66,188 |   | $ | 141,483 |   |
| Cost of sales, excluding depreciation and amortization  |       | 151,064                                                  |       | 39,910        |       | 111,154 |   |
| Freight and distribution                                |       | 19,969                                                   |       | 6,116         |       | 13,853 |   |
| Selling, general and administrative expenses            |       | 9,757                                                    |       | 4,529         |       | 5,228 |   |
| Depreciation and amortization                           |       | 12,953                                                   |       | 3,178         |       | 9,775 |   |
| Other operating income                                  |       | 218                                                      |       | 399           |       | (181 | ) |
| Operating income                                        |       | 14,146                                                   |       | 12,854        |       | 1,292 |   |
| Foreign exchange losses                                 |       | 607                                                      |       | —        |       | 607 |   |
| Interest income                                         |       | 51                                                       |       | 585           |       | (534 | ) |
| Interest expense                                        |       | 8,772                                                    |       | 1,044         |       | 7,728 |   |
| Income before provision for income taxes                |       | 4,818                                                    |       | 12,395        |       | (7,577 | ) |
| Provision for income taxes                              |       | 2,513                                                    |       | 4,593         |       | (2,080 | ) |
| Net income                                              |       | $                                                        | 2,305      |          | $          | 7,802 |   | $ | (5,497 | ) |

 

Net sales for the quarter ended September 30,2008 were $207.7 million compared to $66.2 million for the third quarter of2007, an increase of 214%. The increase in net sales was driven primarily bythe acquisition of the Charleston Kraft Division (CKD) of MeadWestvacoCorporation (MWV) on July 1, 2008. The acquisition accounted for $141.1million of the increase. The balance of the increase in net sales was driven byhigher prices of $5.3 million, mainly in the unbleached kraft segment, offsetby sales volume decline of $4.9 million in the quarter mainly in the unbleachedkraft segment reflecting lower production volumes due to a change in the timingof the annual planned maintenance outage from June in 2007 to July in2008. Refer to the segment results below for detailed sales information foreach segment.

 

Cost of sales for the quarter ended September 30,2008 was $151.1 million compared to $39.9 million for the third quarter of2007, a 279% increase. The increase in cost of sales was driven primarily bythe acquisition of CKD on July 1, 2008. The acquisition accounted for$102.7 million of the increase which included a $0.7 million non-cashpurchase accounting charge to adjust acquired inventory to fair value. Thebalance of the increase in cost of sales was driven by a change in the timingof the annual planned maintenance outage which took place in June in 2007at a cost of approximately $4.6 million, but not until July in 2008 at acost of $6.0 million. In addition, inflation on energy and raw material costs of$4.5 million increased cost of sales which was partially offset by lower salesvolume and productivity improvements of $2.0 million. Production levels in theunbleached kraft segment were 10% lower in the 2008 period due to the change inthe annual planned maintenance outage.

 

Freight and distribution expenses for the quarterended September 30, 2008, totaled $20.0 million compared to $6.1 millionfor the quarter ended September 30, 2007. The increase of $13.9 millionwas driven primarily by the CKD acquisition of $13.0 million. In addition,higher transportation rates due to fuel oil surcharges and a higher percentageof shipments by truck compared to rail increased costs by $1.5 million. Lowersales volume reduced costs for the current quarter by $0.6 million compared tothe 2007 period.

 

Selling, general and administrative expenses for thequarter ended September 30, 2008 totaled $9.8 million compared to $4.5million for the quarter ended September 30, 2007. The increase of $5.3million is due to $2.2 million of CKD directselling and administrative expenses, acquisition related start up expenses of$1.5 million, transitional support from MWV of $1.8 million and other costincreases of $0.5 million, partially offset by lower 

 

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transitional support services from IP for the KPBacquisition of $0.7 million as the Company terminated the transitional servicesagreement upon going live with its new ERP system.

 

Depreciation and amortization for the quarter ended September 30,2008 totaled $13.0 million compared to $3.2 million for the quarter ended September 30,2007. The increase of $9.8 million mainly reflects the impact of the CKDacquisition comprised of $6.8 million of depreciation and $3.3 million ofamortization of intangible assets, which includes $2.3 million for theamortization of the intangible asset related to the coal contract.

 

Other operating income for the quarters ended September 30,2008 and 2007 totaled $0.2 million and $0.4 million, respectively. Otheroperating income includes commissions the Company receives from marketingbleached paper produced and sold by IP to KapStone customers.

 

Foreign exchange losses of $0.6 million for thequarter ended September 30, 2008 reflect the impact of a 9% stronger USdollar compared to the euro. The Company invoices certain European customers ineuros.

 

Interest income for the quartersended September 30, 2008 and 2007 was $0.1 million and $0.6 million,respectively. Interest income represents earnings on the Company’s cash andcash equivalents. The decrease in interest income reflects the Company use ofcash and cash equivalents to fund a portion of the CKD acquisition.

 

Interest expense for the quartersended September 30, 2008 and 2007 was $8.8 million and $1.0 million,respectively. Interest expense reflects interest on the Company’s long-term debtand amortization of deferred financing costs. Interest expense was $7.8 millionhigher in the quarter ended September 30, 2008 as the Company obtained anew $515 million senior credit facility and $40 million of senior notes tofinance the CKD acquisition. Interest expense for the three months ended September 30,2008, includes $7.8 million of interest and fees, $0.8 million for amortizationof financing costs, and $0.2 million of amortization of debt issuance costsfrom the prior credit facility.

 

Provision for income taxes for thequarter ended September 30, 2008 decreased by $2.1million due to lowerpre-tax income and a higher effective tax rate. The effective tax rate for thequarter ended September 30, 2008 increased due to a lower benefit from thefederal domestic manufacturing deduction.

 

**Segment Results**

 

The following table presents a reconciliation ofconsolidated net sales and operating income to amounts reported by segment:

 
| ** **                                     | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Operating Segment ($000’s):** | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
| Consolidated net sales:                        |       |                                                     |       |   |   |
| Unbleached kraft                               |       | $                                                        | 194,726    |   | $ | 58,967 |   |
| All other                                      |       | 13,781                                                   |       | 8,254 |   |
| Elimination of intersegment sales              |       | (836                                                     | )          | (1,033 | ) |
|                                           |       |                                                     |       |   |   |
| Total net sales                                |       | $                                                        | 207,671    |   | $ | 66,188 |   |
|                                           |       |                                                     |       |   |   |
| Operating income / (loss):                     |       |                                                     |       |   |   |
| Unbleached kraft                               |       | $                                                        | 19,884     |   | $ | 15,297 |   |
| All other                                      |       | 1,332                                                    |       | 1,420 |   |
| Corporate                                      |       | (7,070                                                   | )          | (3,863 | ) |
|                                           |       |                                                     |       |   |   |
| Total operating income                         |       | $                                                        | 14,146     |   | $ | 12,854 |   |

 

The following represents analysis and commentary forresults of operations for the Company’s unbleached kraft reportable segment andthe dunnage bags and lumber business operating segments in all other:

 

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***Unbleached Kraft***

 
| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                        | 194,726    |   | $ | 58,967 |   |
| Operating income ($000’s): |       | $                                                        | 19,884     |   | $ | 15,297 |   |
| Operating income % of net sales |       | 10.2                                                     | %          | 25.9 | % |
|                            |       |                                                     |       |   |   |
| Average revenue per ton         |       | $                                                        | 605        |   | $ | 551 |   |
| Tons sold                       |       | 321,792                                                  |       | 107,092 |   |

 

For the three months ended September 30, 2008,the unbleached kraft segment net sales increased by $135.7 million, or 230%, to$194.7 million compared to $59.0 million for the three months ended September 30,2007. The CKD acquisition accounted for $136.2 million and 223,836 tons sold.The balance of the sales change reflects lower volume for the existing businessof 9,136 tons, or $5.0 million, resulting from lower production due to a changein the timing of the annual planned maintenance outage in North Carolina to July 2008.The 2007 annual planned maintenance outage occurred in June. The averagerevenue per ton for the existing business increased by $46/ton to $597/ton,resulting in an increase in net sales of $4.5 million. Intersegment sales tothe all other segment of $0.8 million decreased by $0.2 million.

 

Unbleached kraft segment operating income increased by$4.6 million, or 30%, to $19.9 million for the three months ended September 30,2008 compared to $15.3 million for the three months ended September 30,2007. The CKD acquisition accounted for $13.4 million of the operating incomeincrease. Included in CKD’s results is a $1.0 million non-cash purchaseaccounting charge adjusting finished goods inventory to fair value, which wasrecognized within cost of sales upon sale of the inventory. Also included inCKD’s results is a $2.3 million quarterly charge for the amortization of anintangible asset recorded for the acquired coal contract with favorable pricesvalued at $13.7 million at the date of acquisition. The balance of theoperating income change reflects a change in the annual planned maintenanceoutage, which took place in June in 2007, to July in 2008, whichnegatively impacted the current quarter by approximately $6.0 million. Higheraverage revenue per ton contributed $4.5 million of operating income but wasoffset by inflation on energy, raw materials and freight of approximately $5.0million and lower sales volume of $2.3 million for the quarter ended September 30,2008.  Operating income as a percentageof net sales declined to 10.2%.

 

***All other***

* *
| ** **                      | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                        | 13,781     |   | $ | 8,254 |   |
| Operating income ($000’s): |       | $                                                        | 1,332      |   | $ | 1,420 |   |
| Operating income % of net sales |       | 9.7                                                      | %          | 17.2 | % |

 

For the three months ended September 30, 2008,net sales for “all other” increased by $5.5 million, or 66%, to $13.8 millioncompared to $8.3 million for the three months ended September 30, 2007.The lumber business from the CKD acquisition accounted for $4.9 million of thesales increase. The balance of the increase in net sales came mainly fromhigher dunnage bag average revenue per bag of $0.7 million.

 

All other operating income decreased by $0.1 million,or 7%, to $1.3 million for the three months ended September 30, 2008compared to $1.4 million for the three months ended September 30, 2007.The decrease in operating income was due to a loss for the lumber business of$0.3 million partially offset by higher operating income in the dunnage bagbusiness. Operating income as a percentage of net sales declined to 9.7%.

 

***Corporate***

 

Corporate expenses for the three months ended September 30,2008 totaled $7.1 million compared to $3.9 million for the three months ended September 30,2007. The increase of $3.2 million is due to CKDacquisition start up expenses of $1.5 million, transitional services providedby MWV of $1.8 million, amortization expense of the Company’s new ERP system of$0.3 million  and higher stockcompensation costs of $0.3 million, partially offset 

 

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by lower transitional support services from IP of $0.7million as the Company terminated its transitional services agreement with IPupon converting to its new ERP system.

 

**Comparison of Results of Operationsfor the Nine Months Ended September 30, 2008 and the Nine Months Ended September 30,2007**

 
| ** **                                              | ** ** | **Nine  Months Ended September 30,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):** | ** ** | **2008**                                                      | ** ** | **2007**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                                             | 342,962    |          | $          | 191,857 |   | $ | 151,105 |   |
| Cost of sales, excluding depreciation and amortization  |       | 233,422                                                       |       | 123,704       |       | 109,718 |   |
| Freight and distribution                                |       | 33,480                                                        |       | 17,476        |       | 16,004 |   |
| Selling, general and administrative expenses            |       | 19,251                                                        |       | 12,552        |       | 6,699 |   |
| Depreciation and amortization                           |       | 18,381                                                        |       | 8,272         |       | 10,109 |   |
| Other operating income                                  |       | 589                                                           |       | 987           |       | (398 | ) |
| Operating income                                        |       | 39,017                                                        |       | 30,840        |       | 8,177 |   |
| Foreign exchange losses                                 |       | 607                                                           |       | —        |       | 607 |   |
| Interest income                                         |       | 891                                                           |       | 1,467         |       | (576 | ) |
| Interest expense                                        |       | 9,985                                                         |       | 3,317         |       | 6,668 |   |
| Income before provision for income taxes                |       | 29,316                                                        |       | 28,990        |       | 326 |   |
| Provision for income taxes                              |       | 11,530                                                        |       | 10,661        |       | 869 |   |
| Net income                                              |       | $                                                             | 17,786     |          | $          | 18,329 |   | $ | (543 | ) |

 

Net sales for the nine months ended September 30,2008 were $343.0 million compared to $191.9 million for the first nine monthsof 2007, an increase of 79%. The increase in net sales was driven primarily bythe acquisition of the CKD on July 1, 2008. The acquisition accounted for$141.1 million of the increase. The balance of the increase in net sales wasdriven by higher prices of $13.3 million, mainly in the unbleached kraftsegment, offset by lower volume of $3.3 million. Refer to the segment resultsbelow for detailed sales information for each segment.

 

Cost of sales for the nine months ended September 30,2008, was $233.4 million compared to $123.7 million for the first nine monthsof 2007, an increase of 89%. The increase in cost of sales was primarily drivenby the acquisition of CKD on July 1, 2008. The acquisition accounted for$102.7 million of the increase. The balance of the increase in cost of saleswas mainly due to inflation on raw material costs of $10.2 million and a $1.4million increase in the cost of the annual planned maintenance outage partiallyoffset by lower sales volume. In addition, 2008 and 2007 results included $0.7million and $1.5 million non-cash purchase accounting charges, respectively, toadjust acquired inventory to fair value as part of the CKD and KPB acquisitions.

 

Freight and distribution expenses for the nine monthsended September 30, 2008 totaled $33.5 million compared to $17.5 millionfor the nine months ended September 30, 2007. The increase of $16.0 millionmainly reflects the acquisition of CKD. The acquisition accounted for $13.0million of the increase. The balance of the increase in freight anddistribution reflects higher transportation rates due to fuel oil surcharges of$2.9 million and a higher percentage of shipments by truck compared to rail of$0.5 million, partially offset by lower sales volume of $0.4 million.

 

Selling, general and administrative expenses for thenine months ended September 30, 2008 totaled $19.3 million compared to$12.6 million for the same period in 2007. The increase of $6.7 millionreflects CKD’s direct selling and administrative expenses of $2.2 million,acquisition related start up expenses of $1.6 million, transitional servicesprovided by MWV of $1.8 million, higher stockcompensation costs of $0.7 million and other cost increases of $1.5 million,partially offset by lower transitional support services from IP of $1.1 millionas the Company terminated its transitional service s agreement with IP uponconverting to its new ERP system.

 

Depreciation and amortization for the nine monthsended September 30, 2008, totaled $18.4 million compared to $8.3 millionfor the nine month period ended September 30, 2007. The increase of $10.1million is due to the CKD acquisition which resulted in $6.8 million ofdepreciation and $3.3 million of amortization of intangible assets, whichincludes $2.3 million of amortization for the intangible asset related to thecoal contract.

 

Other operating income for the nine months ended September 30,2008 and 2007 totaled $0.6 million and $1.0 million, respectively. Otheroperating income includes commissions the Company receives from marketingbleached paper produced and sold by IP to KapStone customers.

 

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Foreign exchange losses of $0.6 million for the ninemonths ended September 30, 2008 reflect the impact of a 9% stronger USdollar compared to the euro. The Company invoices certain European customers ineuros.

 

Interest income for the nine monthsended September 30, 2008 and 2007 was $0.9 million and $1.5 million,respectively. Interest income represents earnings on the Company’s cash andcash equivalents. The decrease in interest income reflects the Company’s use ofcash and cash equivalents used to fund a portion of the CKD acquisition.

 

Interest expense for the nine monthsended September 30, 2008 and 2007 was $10.0 million and $3.3 million,respectively. Interest expense reflects interest on the Company’s long-termdebt and amortization of debt issuance costs. Interest expense was $6.7 millionhigher in the nine months ended September 30, 2008, primarily due to theCompany obtaining a new $515 million senior credit facility and $40 million ofsenior notes to finance the CKD acquisition. In addition, interest expense forthe nine months ended September 30, 2008 includes $0.3 million ofamortization of the debt issuance costs from the prior credit facility.

 

Provision for income taxes for thenine months ended September 30, 2008 increased by $0.9 million due to ahigher effective tax rate driven by a lower benefit from the federal domesticmanufacturing deduction. The effective tax rate of 39.3% for the nine monthsended September 30, 2008 compared to 36.8% for the same period in 2007.

 

**Segment Results**

 

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

 
| ** **                                     | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Operating Segment ($000’s):** | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Consolidated net sales:                        |       |                                                    |       |   |   |
| Unbleached kraft                               |       | $                                                       | 315,631    |   | $ | 169,968 |   |
| All other                                      |       | 30,578                                                  |       | 24,706 |   |
| Elimination of intersegment sales              |       | (3,247                                                  | )          | (2,817 | ) |
|                                           |       |                                                    |       |   |   |
| Total net sales                                |       | $                                                       | 342,962    |   | $ | 191,857 |   |
|                                           |       |                                                    |       |   |   |
| Operating income / (loss):                     |       |                                                    |       |   |   |
| Unbleached kraft                               |       | $                                                       | 50,364     |   | $ | 36,703 |   |
| All other                                      |       | 3,932                                                   |       | 4,732 |   |
| Corporate                                      |       | (15,279                                                 | )          | (10,595 | ) |
|                                           |       |                                                    |       |   |   |
| Total operating income                         |       | $                                                       | 39,017     |   | $ | 30,840 |   |

 

The following represents analysis and commentary forresults of operations for the Company’s unbleached kraft reportable segment andthe dunnage bags and lumber business operating segments in all other:

 

***Unbleached Kraft***

 
| ** **                      | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                       | 315,631    |   | $ | 169,968 |   |
| Operating income ($000’s): |       | $                                                       | 50,364     |   | $ | 36,703 |   |
| Operating income % of net sales |       | 16.0                                                    | %          | 21.6 | % |
|                            |       |                                                    |       |   |   |
| Average revenue per ton         |       | $                                                       | 594        |   | $ | 542 |   |
| Tons sold                       |       | 531,573                                                 |       | 313,487 |   |

 

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For the nine months endedSeptember, 2008, unbleached kraft segment net sales increased by $145.6million, or 86%, to $315.6 million compared to $170.0 million for the ninemonths ended September 30, 2007. The CKD acquisition accounted for $136.2million of the sales increase and 223,836 additional tons sold. The balance ofthe net sales change reflects higher average revenue per ton of $41,contributing approximately $12.6 million to the sales increase, due to the fullrealization of 2007 price increases and a portion of price increasesimplemented in February, July and August of 2008. Volume solddecreased by 5,750 tons, or $3.2 million. Intersegment sales to all other segments of $3.2 million increased by$0.4 million compared to the prior year.

 

Unbleached kraft segmentoperating income increased by $13.7 million, or 37%, to $50.4 million for thenine months ended September 30, 2008 compared to $36.7 million for thenine months ended September 30, 2007. The CKD acquisition accounted for$13.4 million of the increase. Included in CKD’s results is a $1.0 millionnon-cash purchase accounting charge adjusting finished goods inventory to fairvalue, which was recognized within cost of sales upon sale of inventory. Alsoincluded in CKD’s results is a $2.3 million quarterly charge for theamortization of an intangible asset recorded for the acquired coal contractwith favorable prices valued at $13.7 million at the date of acquisition. Thebalance of the change in operating income reflects higher average revenue perton, which contributed $12.6 million, offset by inflation on energy, rawmaterials, freight and other costs of $11.8 million and a $1.4 million increasein the cost of the annual planned maintenance outage and lower salesvolume.  In addition, 2007operating income included a $1.2 millionnon-cash purchase accounting charge adjusting acquired finished goods inventoryto fair value and $1.0 million for a two-day unplanned outage caused by anelectrical fire. Operating income as a percentage of net sales declined to16.0%.

 

***All other***

* *
| ** **                      | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                       | 30,578     |   | $ | 24,706 |   |
| Operating income ($000’s): |       | $                                                       | 3,932      |   | $ | 4,732 |   |
| Operating income % of net sales |       | 12.9                                                    | %          | 19.2 | % |

 

For the nine months endedSeptember 30, 2008, net sales for “all other” increased by $5.9 million,or 24%, to $30.6 million compared to $24.7 million for the nine months ended September 30,2007, mainly due to the lumber business from the CKD acquisition, whichaccounted for $4.9 million of the net sales increase. The balance of the netsales increase was due to higher dunnage bag prices and increased volume.

 

All other operatingincome decreased by $0.8 million, or 17%, to $3.9 million for the nine monthsended September 30, 2008 compared to $4.7 million for the nine monthsended September 30, 2007.  The CKDacquisition accounted for $0.3 million of the operating income reduction. Thebalance of the reduction was driven by inflation on raw material and freightcosts which exceeded price increases in the dunnage bag segment. Operatingincome for the nine months ended September 30, 2007 included a $0.3million non-cash purchase accounting charge adjusting acquired finished goodsinventory to fair value as part of the KPB acquisition. Operating income as apercentage of net sales declined to 12.9%.

 

***Corporate***

 

Corporate expenses forthe nine months ended September 30, 2008 totaled $15.3 million compared to$10.6 million for the nine months ended September 30, 2007. The increaseof $4.7 million included $1.6 million related to CKD acquisition start upexpenses, $1.8 million of transitional services provided by MWV, higher stock compensation costs of $0.7 million,amortization expense for the Company’s new ERP system of $0.6 million and  other costs increases of $1.1 million,partially offset by lower transitional support services from IP of $1.1million.

 

**Liquidityand Capital Resources**

 

Seefootnote 7 in the Notes to the Consolidated Financial Statements.

 

***KPB Acquisition***

 

On January 2, 2007,we consummated the purchase of substantially all of the assets and theassumption of certain liabilities of KPB. The assets consist of an unbleachedkraft paper manufacturing facility in Roanoke Rapids, North Carolina and RideRite® Converting, an inflatable dunnage bag manufacturer located in Fordyce,Arkansas. The 

 

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liabilities assumedconsist of trade accounts payable, accrued expenses and certain long termliabilities. The purchase price for the acquisition was $155.0 million in cashless certain post-closing adjustments of $7.8 million, plus contingent earn-outpayments of up to $60.0 million (in aggregate) based on KPB’s annual earningsbefore interest, income taxes, depreciation and amortization (“EBITDA”) duringthe five-year period immediately following the acquisition. The firstcontingent payment will be equal to 5.3 times KPB’s average annual EBITDA forthe five-year period immediately following the acquisition, less $165.0 millionand subject to a maximum of $35.0 million. The second contingent payment is an “allor nothing” payment and is payable if, and only if, KPB’s average annual EBITDAfor the same five-year period equals or exceeds $49.2 million. Generally, bothpayments, if earned, will be due and paid at the end of the five year period.

 

If these contingentearn-out payments are made, they will be accounted for as additional purchaseprice consideration.

 

Funding for theacquisition came from a combination of restricted cash funds held in trust at December 31,2006 and a prior credit facility with various financial institutions andLaSalle National Bank Association.

 

***CKD Acquisition***

 

On July 1, 2008, we consummated the purchase of substantially allof the assets, and the assumption of certain liabilities of  CKD from MWV for $485 million, subject tocertain adjustments.  There was nocontingent consideration arrangement in the CKD acquisition. The acquisitionconsists of an unbleached kraft paper manufacturing facility in NorthCharleston, South Carolina, chip mills located in Elgin, Hampton, Andrews and Kinards,South Carolina and a lumber business located in Summerville, South Carolina.

 

We used borrowings under our new Senior Credit Agreement (as definedbelow), together with the proceeds from the issuance of Senior Notes (asdefined below) and cash, to finance the consideration for our acquisition ofCKD, to repay our prior credit facility with various financial institutions andLaSalle Bank National Association, and to pay transaction costs.

 

***Credit Facilities***

 

*Senior Credit Agreement*

 

We entered into a Credit Agreement, dated as of June 12, 2008, andeffective with the consummation of the acquisition of CKD, (the “Senior CreditAgreement”), among us, KapStone Kraft Paper Corporation, as borrower (“KapStoneKraft”), our other subsidiaries named therein, as guarantors, the lenders namedtherein, and Bank of America, N.A., as Administrative Agent, Swing Line Lenderand L/C Issuer.  The Senior CreditAgreement provides for an aggregate of up to $515,000,000 in senior securedcredit facilities (the “Senior Credit Facilities”), consisting of a$390,000,000 term A loan facility, a $25,000,000 term B loan facility and a$100,000,000 revolving credit facility (including a letter of creditsubfacility).  The Senior CreditFacilities are guaranteed by KapStone Kraft and our other domestic subsidiariesand are secured by substantially all of our assets, including all of thecapital stock of the borrower and guarantor subsidiaries and up to 66% of thecapital stock of our foreign subsidiaries.

 

The term A loan facility is required to be repaid by us in consecutivequarterly installments of $7,102,923 from September 30, 2008 to June 30,2009, $9,470,564 from September 30, 2009 to June 30, 2010,$11,838,205 from September 30, 2010 to March 31, 2013, with a finalpayment of all outstanding principal and interest on the maturity date.  The term B loan is required to be repaid byKapStone in consecutive quarterly installments of $455,316  from September 30, 2008 to June 30,2009, $607,087 from September 30, 2009 to June 30, 2010, $758,859from September 30, 2010 to March 31, 2015 and $5,615,559 on thematurity date.  Borrowings under therevolving credit facility may be used for working capital and other generalcorporate purposes and are required to be repaid in full on the maturitydate.  The maturity date is the earlierof:  (a) June 12, 2013 withrespect to the term A loan facility and the revolving credit facility, and June 12,2015 with respect to the term B loan facility, and (b) the date which is90 days prior to the date on which any earn-out obligations to InternationalPaper will become (or are reasonably expected to become) due; provided that thematurity date will not be so accelerated if, among other things, the totalleverage ratio at the end of the then most recent fiscal quarter is less than2.0 to 1.0.

 

Outstanding principal under the term B loan facility bears interest ata rate equal to, at our option, either (1) the base rate (which is thehigher of the then current Federal Funds rate plus 0.5% or the prime rate mostrecently announced 

 

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by Bank of America, N.A., the administrative agent under the SeniorCredit Facilities) plus a margin of 2.00% or (2) the reserved adjustedone, two, three or six-month Eurodollar rate plus a margin of 3.50%.

 

Outstanding principal under the term A loan facility and the revolvingcredit facility initially bears interest at a rate equal to, at our option,either (1) the base rate plus a margin of 1.50%, or (2) the reserveadjusted one, two, three or six-month Eurodollar rate plus a margin of3.00%.  The undrawn portion of therevolving credit facility is subject to an unused line fee calculated initiallyat an annual rate of 0.50%.  Commencingsix months after the closing of the Senior Credit Facilities, pricing under theterm A loan facility and the revolving credit facility and the unused line fee forthe revolving credit facility will be determined by reference to a pricing gridbased on our total leverage ratio.  Underthe pricing grid, the applicable margins for the term A loan facility and therevolving credit facility will range from 0.0% to 1.5% for base rate loans andfrom 1.50% to 3.00% for Eurodollar loans, and the unused line fee for therevolving credit facility will range from 0.375% to 0.50%.  Outstanding letters of credit are subject toan annual fee equal to the applicable margin for Eurodollar loans under therevolving credit facility as in effect from time to time, plus a fronting feeon the undrawn amount thereof.

 

The term loan facilities and the revolving credit facility may beprepaid at any time without premium.  TheSenior Credit Facilities are subject to mandatory prepayment with specifiedpercentages of the net cash proceeds of certain asset dispositions, casualtyevents, exercise of outstanding warrants, debt and equity issuances, and withexcess cash flow, in each case subject to certain conditions.

 

The Senior Credit Facilities contain covenants that restrict, amongother things, our ability to create liens, incur indebtedness and guarantees,make certain investments or acquisitions, merge or consolidate, dispose ofassets, pay dividends, repurchase or redeem capital stock and subordinatedindebtedness, change the nature of  ourbusiness, enter into certain transactions with affiliates, and make changes inaccounting policies or practices except as required by generally acceptedaccounting principles.  The Senior CreditFacilities also contain a total leverage ratio covenant and a fixed chargecoverage ratio.  The Senior CreditFacilities contain events of default including, but not limited to, nonpaymentof principal or interest, violation of covenants, breaches of representationsand warranties, cross-default to other indebtedness, bankruptcy and otherinsolvency events, material judgments, certain ERISA events, actual or assertedinvalidity of loan documentation and certain changes of control.

 

*Note Purchase Agreement*

 

Pursuant to the Note Purchase Agreement dated July 1, 2008 (the “NotePurchase Agreement”) by and among us, KapStone Kraft and the purchasers listedin the Purchaser Schedule attached to the Note Purchase Agreement (the “Purchasers”),the Purchasers purchased from KapStone Kraft senior secured promissory notes(the “Senior Notes”) with an aggregate principal amount of $40,000,000.  The Senior Notes are guaranteed by theCompany and the Company’s other domestic subsidiaries and are secured bysubstantially all of our assets, including all of the capital stock of KapStoneKraft and the other guarantor subsidiaries and up to 66% of the capital stockof the Company’s foreign subsidiaries.

 

The Senior Notes mature on July 1, 2015 and bear interest at therate of 8.30% per annum, payable quarterly on the 1st day of October, January, April andJuly in each year.  The Senior Notesare required to be repaid by KapStone Kraft in annual installments of$3,000,000 on July 1, 2009; $4,000,000 on July 1, 2010; $5,000,000 onJuly 1, in each of the years 2011 to 2014, inclusive and $13,000,000 on July 1,2015.  The Senior Notes may be prepaid atany time with the payment of an applicable yield-maintenance amount.  In the event that a mandatory prepaymentevent occurs under the Senior Credit Agreement (certain asset dispositions,casualty events, exercises of outstanding warrants, debt and equity issuancesand excess cash flow, in each case subject to certain conditions), thenKapStone Kraft is required to offer to repay, without premium, a pro rataportion of the Senior Notes held by each holder who accepts the KapStone Kraft’sprepayment offer (such portion based on the product of (a) the net cashproceeds from the mandatory prepayment event required to be prepaid pursuant tothe Senior Credit Agreement multiplied by (b) a fraction, the numerator ofwhich is the aggregate outstanding principal amount of the Senior Notes held bysuch holder and the denominator of which is the sum of (x) the aggregateoutstanding principal amount under the Senior Credit Agreement and (y) theaggregate outstanding principal amount under all Senior Notes.)

 

The Senior Notes contain covenants substantially the same as thecovenants contained in the Senior Credit Agreement.

 

Subject to the Intercreditor Agreement described below, if an event ofdefault (other than an event of default resulting from certain events ofbankruptcy, insolvency or reorganization) occurs and is continuing, the holdersof 

 

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more than 50% in principal amount of Senior Notes then outstanding maydeclare all of the Senior Notes immediately due and payable together withinterest accrued thereon and any yield maintenance amount; provided that ifsuch event of default arises from the failure to pay principal, any yieldmaintenance amount or interest on the Senior Notes, any holder of a Senior Notemay declare all of the Senior Notes held by such holder to be immediately dueand payable.  If an event of defaultrelating to the certain events of bankruptcy, insolvency or reorganizationoccurs and is continuing, the principal, interest and any yield maintenanceamount on all of the Senior Notes shall automatically become immediately dueand payable without notice or demand of any kind.

 

*Intercreditor and Collateral Agency Agreement*

 

The Company, KapStone Kraft and each of its guarantor subsidiariesentered into an Intercreditor and Collateral Agency Agreement dated July 1,2008 (the “Intercreditor Agreement”) with Bank of America, N.A., asadministrative agent under the Senior Credit Agreement, and each of the holdersof Senior Notes.  The IntercreditorAgreement provides, among other things, that the borrowings under the SeniorCredit Agreement and the Senior Notes shall be secured equally and ratably bythe assets of the Company, KapStone Kraft and the Company’s other domesticsubsidiaries.  Bank of America, N.A. isappointed as collateral agent to act on behalf of the holders of the SeniorNotes and the lenders under the Senior Credit Agreement.

 

***Cash flow***

 

Cash on hand as of September 30,2008 decreased by $14.8 million from December 31, 2007, to $41.9 million,reflecting cash generated from operations of $28.0 million, net cash outflowfrom investing activities of $483.2 million and net cash inflow from financingactivities of $440.4 million.

 

Net cash inflow fromoperating activities was $28.0 million due to net income of $17.8 million and non-cashcharges of $33.7 million. Changes in operating assets and liabilities used $23.5million, mainly reflecting an increase in trade accounts receivables of $17.4million, refundable and prepaid income taxes of $11.1 million and prepaidexpenses and other current assets of $4.9 million, partially offset by higher currentliabilities of $9.8 million.

 

Net cash outflow frominvesting activities was $483.2 million reflecting the CKD acquisition of$470.5 million and capital expenditures of $12.7 million. For the nine monthsended September 30, 2008, capital expenditures mainly reflect $10.3million for the unbleached kraft segment and include equipment upgrades andreplacements at the paper mills in Roanoke Rapids, North Carolina and NorthCharleston, South Carolina and $2.1 million for the Company’s new ERP system.

 

Net cash inflow generatedfrom financing activities totaled $440.4 million during the nine months ended September 30,2008, and reflects borrowings from a new senior credit facility to finance theCKD acquisition of $526.8 million and $15.1 million received from exercises ofcommon stock warrants, partially offset by $89.0 million of debt repayments,which includes $11.9 million of mandatory prepayments resulting from proceedsfrom exercises of common stock warrants, and $12.6 million paid for debtissuance costs.

 

***Future Cash Needs***

 

We expect that cashgenerated from revenues and our revolving credit facility will be sufficient tomeet anticipated cash needs primarily consisting of debt service, workingcapital and capital expenditures.

 

**Off-BalanceSheet Arrangements**

 

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

 

**ContractualObligations**

 

Thefollowing table summarizes our material contractual obligations as ofSeptember 30, 2008 ($000’s):

 
| ** **                                 | ** ** | **Payments Due by Period** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**                | ** ** | **Total**                  | ** ** | **1 Year** | ** ** | **2 Years** | ** ** | **3 Years** | ** ** | **4 Years** | ** ** | **5 Years** | ** ** | **Thereafter** | ** ** |
| Long-term debt  obligations(1)             |       | $                          | 490,347    |   | $ | 35,752 |   | $ | 46,830 |   | $ | 55,388 |   | $ | 55,388 |   | $ | 268,820 |   | $ | 28,169 |   |
| Interest on  long-term debt obligations(2) |       | 105,344                    |       | 27,729 |   | 24,476 |   | 21,093 |   | 17,577 |   | 11,102 |   | 3,367 |   |
| Fiber supply  agreement(3)                 |       | 442,320                    |       | 39,578 |   | 38,873 |   | 37,636 |   | 36,398 |   | 35,573 |   | 254,262 |   |
| Total                                      |       | $                          | 1,038,011  |   | $ | 103,059 |   | $ | 110,179 |   | $ | 114,117 |   | $ | 109,363 |   | $ | 315,495 |   | $ | 285,798 |   |

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| (1)    |   | These  obligations are reflected on our condensed Consolidated Balance Sheets at  September 30, 2008 in current portion of long-term debt and long-term  debt, as appropriate.                                                                                                                                                                               |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                              |
| (2)    |   | Assumes  debt is carried to full term and excludes any mandatory prepayments for 2008.  Debt bears interest at variable rates. The amounts above assume future  interest will be incurred at the bank’s LIBOR rate on September 30,  2008. These obligations are not reflected on our Condensed Consolidated  Balance Sheet at September 30, 2008. |
|   |   |                                                                                                                                                                                                                                                                                                                                                              |
| (3)    |   | These  obligations are not reflected on our Condensed Consolidated Balance Sheet at  September 30, 2008.                                                                                                                                                                                                                                                     |

 

 

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

 

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

 

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Under KapStone Kraft’s new Senior Credit Facilities, we have two termloans totaling $395.5 million and a revolving loan of $54.8 millionat September 30, 2008.  The maturitydate is the earlier of:  (a) June 12,2013 with respect to the term A loan facility and the revolving creditfacility, and June 12, 2015 with respect to the term B loan facility, and (b) thedate which is 90 days prior to the date on which any earn-out obligations toInternational Paper will become (or are reasonably expected to become) due;provided that the maturity date will not be so accelerated if, among otherthings, the total leverage ratio is of the end of the then most recent fiscalquarter, less than 2.0 to 1.0.

 

Changes in market ratesmay impact the base rate in our senior credit agreement. For instance, if thebank’s LIBOR rate was to increase or decrease by one percentage point (1.0%),our annual interest expense would change by approximately $4.5 million basedupon our expected future monthly loan balances per our existing repaymentschedule.

 

The principal market riskto which we are exposed is commodity and energy price risk. We are exposed toprice fluctuations of certain commodities used in production as well asfluctuations in the price of its finished goods. Key raw materials and energyused in the production process include roundwood and woodchips, coal,electricity and caustic soda. We purchase these raw materials and energy at themarket prices, and do not use forward contracts or other financial instrumentsto hedge its exposure to price risk related to these commodities. Prices forpaper and related products are subject to market conditions.

 

**Item4. — CONTROLS AND PROCEDURES**

 

As of the end of theperiod covered by this report, our Chief Executive Officer and our ChiefFinancial Officer carried out an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures, as required by Rule 13a-15(b) underthe Securities Exchange Act of 1934. Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were designed, and were effective, to give reasonableassurance that information required to be disclosed about us and oursubsidiaries are recorded, processed, summarized and reported within the timeperiods specified by the rules and forms of the SEC and is accumulated andcommunicated to management as appropriate to allow timely decisions regardingrequired disclosure in our filings under the Securities Exchange Act of 1934.

 

The following change toour internal control over financial reporting during the three months ended September 30,2008 has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting:

 

The Company entered intoa transitional services agreement with MWV upon consummating the acquisition ofCKD. The agreement includes that MWV will provide certain accounting,distribution and logistics activities and information technology services forthe Company until CKD can be migrated to the Company’s enterprise resourceplanning system.

 

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** **

**PART II.— OTHER INFORMATION**

 

**Item 1. — LEGAL PROCEEDINGS**

 

None.

 

**Item 1A. — RISK FACTORS**

 

Withthe exception of the following update to the risk factors relating to theacquisition of the CKD of MWV, there have been no material changes from theRisk Factors described in our Form 10-K/A for the year ended December 31,2007 (“Form 10-K”).  Each of theRisk Factors below should be read in conjunction with the Risk Factors andinformation disclosed in our Form 10-K/A.

 

***The anticipated benefits of the CKDacquisition may not be realized.***

 

Weconsummated the transaction contemplated by the asset purchase agreement withMWV with the expectation that the acquisition of CKD will result in variousbenefits including, among other things, benefits relating to enhanced revenues,a broader array of product offerings, the expansion of our productioncapabilities, operational improvements and a diversification of our customerbase. The transaction will present challenges to management, including theintegration of operations, properties and personnel of CKD and our existingoperations. Achieving the anticipated benefits of the transaction is subject toa number of uncertainties, including, but not limited to, whether we canintegrate our business and the CKD business in an efficient and effectivemanner. Failure to achieve these anticipated benefits could result in increasedcosts, decreases in the amount of expected revenues and diversion of management’stime and energy and could materially impact our business, financial conditionand operating results.

 

***We may fail to realize theanticipated synergies and cost savings expected from the  CKD acquisition.***

 

Oursuccess after the CKD acquisition will depend, in part, on our ability torealize the anticipated growth opportunities and cost savings from integratingour business with CKD.  To realize theseanticipated benefits, we must successfully integrate our business with CKD in amanner that permits these synergies to be realized.  If we are not able to successfully achievethese objectives, such anticipated benefits may not be realized fully, or atall, or may take longer to realize than expected.

 

***We may have difficulty integratingour business with the CKD business and may incur substantial costs inconnection with the integration.***

 

Achievingthe anticipated benefits of the transaction will depend on the successfulintegration of our products, operations, personnel, and facilities with thoseof CKD in a timely and efficient manner.

 

Althoughwe do not anticipate material difficulties in connection with such integration,the possibility exists that such difficulties could be experienced inconnection with the transaction, especially given the relatively large size ofthe transaction. The time and expense associated with integrating ourbusinesses and CKD may exceed our expectations and limit or delay the intendedbenefits of the transaction. Similarly, the process of integrating sales andmarketing forces and administrative functions and coordinating productofferings can take longer, cost more, and provide fewer benefits than initiallyprojected. To the extent any of these events occurs, the benefits of thetransaction may be reduced.

 

Integratingour business with CKD will be a complex, time-consuming and expensive process.Before the transaction, KapStone and CKD operated independently, each with itsown business, products, customers, employees, culture and systems. We may facesubstantial difficulties, costs and delays in integrating the two businesses.These difficulties, costs and delays may include:

 
| · |   | Costs  and delays in implementing common systems and procedures;                                          |
|--------|--------|-----------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                      |
| · |   | Potential  charges to earnings resulting from the application of purchase accounting to  the transaction; |
|   |   |                                                                                                      |
| · |   | Difficulty  comparing financial reports due to differing financial and/or internal  reporting systems;    |

 

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| · |   | Diversion  of management resources from the business;                                                                                      |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                       |
| · |   | Challenges  in retaining and integrating management and other key employees of KapStone  and CKD;                                          |
|   |   |                                                                                                                                       |
| · |   | Difficulties  in coordinating infrastructure operations in an effective and efficient  manner; and                                         |
|   |   |                                                                                                                                       |
| · |   | The  inability to achieve the synergies anticipated to be realized from the  transaction on the timeline presently anticipated, or at all. |

 

Wemay seek to combine certain operations and functions using common informationand communication systems, operating procedures, financial controls and humanresource practices, including training, professional development and benefitprograms. We may be unsuccessful in implementing the integration of thesesystems and processes in a timely and efficient manner. Any one or all of thesefactors may cause increased operating costs, worse than anticipated financialperformance and/or the loss of customers and employees. Many of these factorsare also outside of our control.

 

***We may have difficulty integratingour system of internal control over financial reporting with that of CKD.***

 

Thefailure to integrate our system of internal control over financial reportingwith that of CKD following the transaction could affect adversely our abilityto exercise effective internal control over financial reporting. A failure toexercise effective internal control over financial reporting could result in amaterial misstatement in our annual or interim consolidated financial statements.

 

***As a result of the CKD acquisition,including the financing necessary to consummate the transaction, we havesubstantial indebtedness.***

 

Asa result of the transaction, we incurred substantial indebtedness, includingthe financing necessary to pay the cash consideration and transaction-relatedcosts. Our substantial indebtedness could have the following consequences:

 
| · |   | Our ability to obtain additional financing  for working capital, capital expenditures, acquisitions, general corporate  purposes or other purposes may be impaired in the future; |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                              |
| · |   | A  substantial portion of our cash flow must be dedicated to the payment of  principal and interest on our indebtedness;                                                          |
|   |   |                                                                                                                                                                              |
| · |   | We  are substantially leveraged which might place us at a competitive  disadvantage;                                                                                              |
|   |   |                                                                                                                                                                              |
| · |   | We  are subject to restrictive covenants that may negatively affect our  operational or financial flexibility or our ability to pursue additional  acquisitions;                  |
|   |   |                                                                                                                                                                              |
| · |   | We  may be hindered in our ability to adjust rapidly to changing market  conditions; and                                                                                          |
|   |   |                                                                                                                                                                              |
| · |   | Our  high degree of leverage could make us more vulnerable in the event of a  downturn in general economic conditions or our business.                                            |

 

***As a result ofthe CKD acquisition, our operations have become increasingly global innature.  Our business, financialcondition and results of operations could be adversely affected by thepolitical and economic conditions of the countries in which we conductbusiness, by fluctuations in exchange rates and other factors related to ourinternational operations.***

*** ***

Approximately 50% of CKD’s annual revenues in2007 were derived from export sales and sales from locations outside of theU.S. As our international operations and activities expand, we face increasingexposure to the risks of operating in many foreign countries. These factorsinclude:

 
| · |   | Changes in foreign  currency exchange rates which could adversely affect our competitive  position, selling prices, and therefore the demand for our products in a  particular market. |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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| · |   | Trade protection measures  in favor of local producers of competing products, including government  subsidies, tax benefits, trade actions (such as anti-dumping proceedings) and  other measures giving local producers a competitive advantage over the  company. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                |
| · |   | Changes generally in  political, regulatory or economic conditions in the countries in which we  conduct business.                                                                                                                                                  |

 

These risks could affect the cost of sellingour products, our pricing, sales volume, and ultimately our financialperformance. The likelihood of such occurrences and their potential effect onthe company vary from country to country and are unpredictable.

 

***Our business depends on effectiveinformation management systems.***

*** ***

We rely on our enterprise resource planning(ERP) systems to support such critical business operations as processing salesorders and invoicing, inventory control, purchasing and supply chainmanagement, payroll and human resources, and financial reporting. Weperiodically implement upgrades to such systems or migrate one or more of ouraffiliates, facilities or operations from one system to another. If we areunable to adequately maintain such systems to support our developing businessrequirements or effectively manage any upgrade or migration, we could encounterdifficulties that could have a material adverse impact on our business,internal controls over financial reporting, financial results, or our abilityto timely and accurately report such results.

 

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**PART II.— OTHER INFORMATION**

 

**Item 6. — EXHIBITS**

 

Thefollowing Exhibits are filed as part of this report.

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                       |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 2.3              |       | Asset  Purchase Agreement dated April 4, 2008 among MeadWestvaco South Carolina  LLC, MeadWestvaco Corporation, KapStone Paper and Packaging Corporation and  Oak Acquisition, LLC. (1)                                                                                                                                                                          |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 3.1              |       | Amended  and Restated By-laws. (1)                                                                                                                                                                                                                                                                                                                                    |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.13            |       | Amendment  to the KapStone Paper and Packaging Corporation 2006 Incentive Plan. (2)                                                                                                                                                                                                                                                                                   |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.14            |       | Performance  Incentive Plan of KapStone Paper and Packaging Corporation. (2)                                                                                                                                                                                                                                                                                          |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.15            |       | Form of  Restricted Stock Unit Agreement. (2)                                                                                                                                                                                                                                                                                                                    |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.16            |       | Long-Term  Fiber Supply Agreement, dated July 1, 2008, by and among MeadWestvaco  Forestry LLC and KapStone Charleston Kraft LLC (with certain confidential  information deleted there from). (4)                                                                                                                                                                |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.17            |       | Note  Purchase Agreement, dated July 1, 2008, by and among KapStone Paper and  Packaging Corporation, KapStone Kraft Paper Corporation and The Prudential  Insurance Company of America. (4)                                                                                                                                                                     |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.18            |       | Credit  Agreement, dated September 12, 2008, by and among KapStone Kraft Paper  Corporation, as Borrower, KapStone Paper and Packaging Corporation, as  Parent, the Subsidiaries of the Borrower identified therein, as Guarantors,  Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C  Issuer, and the Other Lenders Party thereto. (3) |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.19            |       | Intercreditor  and Collateral Agency Agreement, dated July 1, 2008, by and among Bank  of America N.A., as Collateral Agent, and Bank of America, N.A., as  Administrative Agent Under the Credit Facility Agreement on Behalf of the  Secured Lender Parties and Certain Institutional Lenders. (4)                                                             |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 21.1             |       | Subsidiaries  (5)                                                                                                                                                                                                                                                                                                                                                     |
|             |       |                                                                                                                                                                                                                                                                                                                                                                  |
| 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.                                                                                                                                                                                                        |

 

----

| (1)    |   | Incorporated  by reference to the Registrant’s Current Report filed on Form 8-K on  April 4, 2008.      |
|--------|--------|------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                   |
| (2)    |   | Incorporated  by reference to the Registrant’s Current Report filed on Form 8-K on  April 10, 2008.     |
|   |   |                                                                                                                   |
| (3)    |   | Incorporated  by reference to the Registrant’s Current Report filed on Form 8-K on  September 12, 2008. |
|   |   |                                                                                                                   |
| (4)    |   | Incorporated  by reference to the Registrant’s Current Report filed on Form 8-K on  July 2, 2008.       |
|   |   |                                                                                                                   |
| (5)    |   | Incorporated  by reference to the Registrant’s Quarterly Report filed on Form 10-Q on  August 4, 2008.       |

 

29

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Table of Contents

 

**SIGNATURE**

 

In accordance with the requirements of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                    | KAPSTONE  PAPER AND PACKAGING CORPORATION |
|-------------------------|-------------------------------------------|
|                    |                                      |   |
|                    |                                      |   |
| November 10,  2008 | By:                                       | /s/  Andrea K. Tarbox |
|                    |                                      | Andrea  K. Tarbox |
|                    |                                      | Vice  President and Chief Financial Officer |
|                         |                                           |  |  |

 

30

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