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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 thequarterly period ended June 30, 2008**

 

**CommissionFile Number: 000-51444**

 

**KapStone Paper and PackagingCorporation**

(Exact name of registrant as specified in itscharter)

 

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

 

**KapStonePaper and Packaging Corporation, 1101 Skokie Blvd., Suite 300**

**Northbrook,IL 60062**

(Address of Principal Executive Officesincluding zip code)

 

**(847)239-8800**

(Registrant’s Telephone Number, IncludingArea Code)

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yesx  No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).Yes o  Nox

 

Therewere 25,777,782 shares of the Registrant’s Common Stock, $0.0001 par value,outstanding at July 31, 2008, excluding 40,000 shares held as treasuryshares.

 

 

 

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**KapStonePaper and Packaging Corporation 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                        |   | 11 |
|                                       |                                                                                                                              |   |   |
|                                       | Item 3. — Quantitative and Qualitative Disclosures  about Market Risk                                                        |   | 22 |
|                                       |                                                                                                                              |   |   |
|                                       | Item 4. — Controls and Procedures                                                                                            |   | 22 |
|                                       |                                                                                                                              |   |   |
| PART II.  — OTHER INFORMATION    |                                                                                                                              |   |
|                                       |                                                                                                                              |   |   |
|                                       | Item  1. — Legal Proceedings                                                                                                 |   | 23 |
|                                       |                                                                                                                              |   |   |
|                                       | Item  1A. — Risk Factors                                                                                                     |   | 23 |
|                                       |                                                                                                                              |   |   |
|                                       | Item 2. — Unregistered Sales of Equity Securities and  Use of Proceeds                                                       |   | 25 |
|                                       |                                                                                                                              |   |   |
|                                       | Item 3. — Defaults Upon Senior Securities                                                                                    |   | 25 |
|                                       |                                                                                                                              |   |   |
|                                       | Item 4. — Submission of Matters to a Vote of Security  Holders                                                               |   | 26 |
|                                       |                                                                                                                              |   |   |
|                                       | Item  5. — Other Information                                                                                                 |   | 26 |
|                                       |                                                                                                                              |   |   |
|                                       | Item 6.  — Exhibits                                                                                                          |   | 27 |
|                                       |                                                                                                                              |   |   |
| SIGNATURE                                  |                                                                                                                              | 29     |

 

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**Part 1.Financial Information**

 

**Item 1. Financial Statements**

 

**KapStonePaper and Packaging Corporation**

**CondensedConsolidated Balance Sheets**

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

** **
| ** **                                                                                                                                                                                                                                                                           | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                           | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                                                                                                                           | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                                                                           |       |              |       |                  |       |
| Current assets:                                                                                                                                                                                                                                                                      |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                            |       | $                 | 56,508     |                  | $          | 56,635 |   |
| Trade accounts receivable, net                                                                                                                                                                                                                                                       |       | 34,167            |       | 30,208                |       |
| Inventories                                                                                                                                                                                                                                                                          |       | 17,088            |       | 16,358                |       |
| Inventories consigned to third parties                                                                                                                                                                                                                                               |       | 3,114             |       | 3,488                 |       |
| Deferred income taxes                                                                                                                                                                                                                                                                |       | 2,039             |       | 1,263                 |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                            |       | 1,932             |       | 735                   |       |
| Total current assets                                                                                                                                                                                                                                                                 |       | 114,848           |       | 108,687               |       |
|                                                                                                                                                                                                                                                                                 |       |              |       |                  |       |
| Plant, property and equipment, net                                                                                                                                                                                                                                                   |       | 104,423           |       | 104,858               |       |
| Other assets                                                                                                                                                                                                                                                                         |       | 7,011             |       | 3,735                 |       |
| Intangible assets, net                                                                                                                                                                                                                                                               |       | 5,783             |       | 5,875                 |       |
| Goodwill                                                                                                                                                                                                                                                                             |       | 2,295             |       | 2,295                 |       |
|                                                                                                                                                                                                                                                                                 |       |              |       |                  |       |
| Total assets                                                                                                                                                                                                                                                                         |       | $                 | 234,360    |                  | $          | 225,450 |   |
|                                                                                                                                                                                                                                                                                 |       |              |       |                  |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                                                                        |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                                                                 |       |              |       |                  |       |
| Current portion of long-term debt                                                                                                                                                                                                                                                    |       | $                 | 7,583      |                  | $          | 19,578 |   |
| Accounts payable                                                                                                                                                                                                                                                                     |       | 13,126            |       | 11,050                |       |
| Accrued expenses                                                                                                                                                                                                                                                                     |       | 7,239             |       | 4,867                 |       |
| Accrued compensation costs                                                                                                                                                                                                                                                           |       | 6,444             |       | 6,625                 |       |
| Accrued income taxes                                                                                                                                                                                                                                                                 |       | 829               |       | 1,477                 |       |
| Total current liabilities                                                                                                                                                                                                                                                            |       | 35,221            |       | 43,597                |       |
|                                                                                                                                                                                                                                                                                 |       |              |       |                  |       |
| Other liabilities:                                                                                                                                                                                                                                                                   |       |              |       |                  |       |
| Long-term debt                                                                                                                                                                                                                                                                       |       | 29,778            |       | 32,922                |       |
| Pension and post-retirement benefits                                                                                                                                                                                                                                                 |       | 4,117             |       | 3,420                 |       |
| Deferred income taxes                                                                                                                                                                                                                                                                |       | 3,509             |       | 1,047                 |       |
| Other liabilities                                                                                                                                                                                                                                                                    |       | 286               |       | 279                   |       |
| Total other liabilities                                                                                                                                                                                                                                                              |       | 37,690            |       | 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; 25,498,762 shares issued and  outstanding (40,000 treasury shares outstanding) at June 30, 2008 and  25,280,197 issued and outstanding (40,000 treasury shares outstanding) at  December 31, 2007 |       | 3                 |       | 3                     |       |
| Additional paid-in capital                                                                                                                                                                                                                                                           |       | 116,785           |       | 115,002               |       |
| Retained earnings                                                                                                                                                                                                                                                                    |       | 44,582            |       | 29,101                |       |
| Accumulated other comprehensive income                                                                                                                                                                                                                                               |       | 79                |       | 79                    |       |
| Total stockholders’ equity                                                                                                                                                                                                                                                      |       | 161,449           |       | 144,185               |       |
|                                                                                                                                                                                                                                                                                 |       |              |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                      |       | $                 | 234,360    |                  | $          | 225,450 |   |

 

See notes to condensed consolidated financialstatements

 

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**KapStonePaper and Packaging Corporation**

**CondensedConsolidated Statements of Income**

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

 

**(unaudited)**

** **
| ** **                                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                              | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Net sales                                               |       | $                                                   | 68,162     |                                              | $          | 60,242 |   | $ | 135,291 |   | $ | 125,669 |   |
| Cost of sales, excluding depreciation and  amortization |       | 40,800                                              |       | 41,358                                            |       | 82,358 |   | 83,794 |   |
| Freight and distribution                                |       | 6,924                                               |       | 5,674                                             |       | 13,511 |   | 11,360 |   |
| Selling, general and administrative  expenses           |       | 4,564                                               |       | 4,287                                             |       | 9,494 |   | 8,007 |   |
| Depreciation and amortization                           |       | 2,835                                               |       | 2,929                                             |       | 5,428 |   | 5,110 |   |
| Other operating income                                  |       | 187                                                 |       | 127                                               |       | 371 |   | 588 |   |
| Operating income                                        |       | 13,226                                              |       | 6,121                                             |       | 24,871 |   | 17,986 |   |
| Interest income                                         |       | 293                                                 |       | 485                                               |       | 840 |   | 882 |   |
| Interest expense                                        |       | 460                                                 |       | 1,117                                             |       | 1,213 |   | 2,273 |   |
| Income before provision for income taxes                |       | 13,059                                              |       | 5,489                                             |       | 24,498 |   | 16,595 |   |
| Provision for income taxes                              |       | 4,808                                               |       | 2,040                                             |       | 9,017 |   | 6,068 |   |
|                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Net income                                              |       | $                                                   | 8,251      |                                              | $          | 3,449 |   | $ | 15,481 |   | $ | 10,527 |   |
|                                                    |       |                                                |       |                                              |       |   |   |   |   |
| Weighted-average number of shares outstanding:          |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                   |       | 25,391,330                                          |       | 24,960,000                                        |       | 25,336,688 |   | 24,966,667 |   |
| Diluted                                                 |       | 36,719,720                                          |       | 36,627,912                                        |       | 35,638,521 |   | 35,248,423 |   |
| Net income per share:                                   |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                   |       | $                                                   | 0.32       |                                              | $          | 0.14 |   | $ | 0.61 |   | $ | 0.42 |   |
| Diluted                                                 |       | $                                                   | 0.22       |                                              | $          | 0.09 |   | $ | 0.43 |   | $ | 0.30 |   |

 

See notes to condensed consolidated financialstatements

 

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**KapStonePaper and Packaging Corporation**

**CondensedConsolidated Statements of Cash Flows**

**(Inthousands)**

 

**(unaudited)**

 
| ** **                                                                         | ** ** | **Six  Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| **Operating activities**                                                           |       |                                                    |       |   |   |
| Net income                                                                         |       | $                                                       | 15,481     |   | $ | 10,527 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                                    |       |   |   |
| Depreciation and amortization                                                      |       | 5,428                                                   |       | 5,110 |   |
| Stock based compensation expense                                                   |       | 691                                                     |       | 223 |   |
| Amortization of debt issuance costs                                                |       | 100                                                     |       | 129 |   |
| Deferred income taxes                                                              |       | 1,686                                                   |       | 963 |   |
| Other                                                                              |       | (175                                                    | )          | — |   |
| Changes in operating assets and  liabilities:                                      |       |                                                    |       |   |   |
| Trade accounts receivable, net                                                     |       | (3,959                                                  | )          | (1,128 | ) |
| Inventories                                                                        |       | (356                                                    | )          | 4,284 |   |
| Prepaid expenses and other current assets                                          |       | (1,197                                                  | )          | (1,128 | ) |
| Accounts payable                                                                   |       | 2,076                                                   |       | 3,737 |   |
| Accrued expenses                                                                   |       | 1,987                                                   |       | (993 | ) |
| Accrued compensation costs                                                         |       | (181                                                    | )          | 5,632 |   |
| Accrued income taxes                                                               |       | (648                                                    | )          | 784 |   |
| Net cash provided by operating activities                                          |       | 20,933                                                  |       | 28,140 |   |
|                                                                               |       |                                                    |       |   |   |
| **Investing activities**                                                           |       |                                                    |       |   |   |
| Acquisition costs paid                                                             |       | (2,393                                                  | )          | (340 | ) |
| KPB acquisition                                                                    |       | —                                                  |       | (150,303 | ) |
| Capital expenditures                                                               |       | (4,620                                                  | )          | (5,665 | ) |
| Net cash (used in) investing activities                                            |       | (7,013                                                  | )          | (156,308 | ) |
|                                                                               |       |                                                    |       |   |   |
| **Financing activities**                                                           |       |                                                    |       |   |   |
| Proceeds from long-term debt                                                       |       | —                                                  |       | 60,000 |   |
| Debt issuance costs paid                                                           |       | —                                                  |       | (855 | ) |
| Repayment of long-term debt                                                        |       | (15,139                                                 | )          | (1,875 | ) |
| Receipt of cash held in trust                                                      |       | —                                                  |       | 115,239 |   |
| Redemption of shares                                                               |       | —                                                  |       | (230 | ) |
| Proceeds from the exercises of common stock  warrants                              |       | 1,092                                                   |       | 19 |   |
| Investment banking fee paid                                                        |       | —                                                  |       | (1,200 | ) |
| Net cash provided by (used in) financing  activities                               |       | (14,047                                                 | )          | 171,098 |   |
|                                                                               |       |                                                    |       |   |   |
| Net increase in cash and cash equivalents                                          |       | (127                                                    | )          | 42,930 |   |
| Cash and cash equivalents-beginning of  period                                     |       | 56,635                                                  |       | — |   |
| Cash and cash equivalents-end of period                                            |       | $                                                       | 56,508     |   | $ | 42,930 |   |

 

See notes to condensed consolidated financialstatements

 

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** **

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

 

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

 

**(unaudited)**

 

# **1.**                                      Financial Statements

# ** **

The accompanyingunaudited condensed consolidated financial statements of KapStone Paper andPackaging Corporation (the “Company,” “we,” “us,” “our” or “KapStone”) havebeen prepared in accordance with U.S. generally accepted accounting principlesfor interim financial information, the instructions to Form 10-Q and Article 10of Regulation S-X. Accordingly, they do not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof a normal recurring nature) considered necessary for a fair presentation havebeen included. Operating results for the three and six months ended June 30,2008 are not necessarily indicative of the results that may be expected for theyear ending 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 andPackaging Corporation (formerly Stone Arcade Acquisition Corporation) or the “Company”was incorporated in Delaware on April 15, 2005.  On May 25,2006, the Company formed a wholly-owned subsidiary, KapStone Kraft PaperCorporation, or KapStone Kraft.  The Company was formed to serve as avehicle for the acquisition through a merger, capital stock exchange, assetacquisition, or other similar business combination (“Business Combination”) ofan operating business in the paper, packaging, forest products and relatedindustries.

 

On January 2, 2007,the Company acquired substantially all of the assets and assumed certainliabilities of the Kraft Papers Business (KPB) from International Paper Company(IP). The accompanying condensed consolidated financial statements include theresults of KPB since this date. Prior to the acquisition of KPB, the Companyhad no operations and was considered a development stage company.

 

# **2.**                                      Reclassification

# ** **

Certain 2007 balanceshave been reclassified to conform to 2008 presentation, including freight anddistribution from cost of sales, and amortization expense from selling, generaland administrative expenses in the statements of income for the three and sixmonth periods ended June 30, 2007. In addition, deferred income taxes havebeen reclassified from accrued expenses in the statements of cash flows.

 

# **3.**                                      Accounting Pronouncements

# ** **

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, *FairValue Measurements*. SFAS No. 157 defines fair value,establishes a framework for measuring fair value and expands disclosures aboutfair value measurements but does not change existing guidance as to whether ornot an instrument is carried at fair value.  In February 2008, theFASB released a FASB Staff Position, which delayed the effective date of SFAS No. 157for all non-financial assets and liabilities, except those that are recognizedor disclosed at fair value in the condensed consolidated financial statementson a recurring basis. SFAS No. 157 was first effective for the Company on January 1,2008.

 

The impact of theadoption of SFAS No. 157 on our financial assets and liabilities, which isprincipally comprised of cash equivalents, did not have a significant impact ontheir fair value measurements or require expanded disclosures.

 

# **4.**                                      Stockholder’s equity

# ** **

In connection with theCompany’s initial public offering, on August 19, 2005, the Company sold20,000,000 units (“Units”) for a gross price of $6.00 per Unit. Each Unitconsists of one share of the company’s common stock, $0.0001 par value, and twowarrants. Each warrant entitles the holder to purchase from the Company oneshare of common stock at an exercise price of $5.00 and expires on August 15,2009.

 

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The warrants areredeemable by the Company at a price of $0.01 per warrant upon 30 daysnotice after the warrants become exercisable, only in the event that the lastsale price of the common stock is at least $8.50 per share for any 20 tradingdays within a 30 day trading period ending on the third day prior to thedate on which notice of redemption is given.

 

For the six months ended June 30,2008, 218,565 common stock warrants were exercised with proceeds totaling $1.1million.

 

# **5.**                                      Inventories

# ** **

Inventories consist ofthe following at June 30, 2008, and December 31, 2007, respectively ($000’s):

 
| ** **                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Raw materials                  |       | $                 | 5,890      |                  | $          | 5,351 |   |
| Work in process                |       | 459               |       | 655                   |       |
| Finished goods                 |       | 6,897             |       | 6,363                 |       |
| Replacement parts and supplies |       | 3,842             |       | 3,989                 |       |
|                           |       |              |       |                  |       |
| Inventories                    |       | $                 | 17,088     |                  | $          | 16,358 |   |

 

# **6.**                                      Income taxes

# ** **

The Company’s U.S.federal statutory tax rate is 35% for 2008 and 2007. The Company’s effectivetax rate for the six months ended June 30, 2008 and 2007 was 36.8% and36.6%, respectively.  Differences between the effective tax rate and thefederal statutory tax rate are due to the impact of state tax, net of federalbenefit and the domestic manufacturing deduction.

 

In the normal course ofbusiness, we are subject to examination by taxing authorities. The Company’sopen tax years are 2005 through 2007.

 

**7.**             **Net income per share**

 

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

 
| ** **                                                               | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|------------|---------------------------------------------------|------------|
| ** **                                                               | ** ** | **2008**                                            | ** ** | **2007**   | ** **                                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net income as reported                                                   |       | $                                                   | 8,251      |       | $                                                 | 3,449      |   |   | $ | 15,481 |   | $ | 10,527 |   |
| Weighted-average number of common shares for basic net income per  share |       | 25,391,330                                          |       | 24,960,000 |                                              |       | 25,336,688 |   | 24,966,667 |   |
| Incremental effect of dilutive common stock equivalents:                 |       |                                                |       |       |                                              |       |   |   |   |   |
| Common stock warrants                                                    |       | 11,040,067                                          |       | 11,655,972 |                                              |       | 10,129,922 |   | 10,275,786 |   |
| Underwriter’s purchase option                                       |       | 117,052                                             |       | —     |                                              |       | 58,526 |   | — |   |
| Unvested restricted stock awards                                         |       | 171,271                                             |       | 11,940     |                                              |       | 113,385 |   | 5,970 |   |
|                                                                     |       |                                                |       |       |                                              |       |   |   |   |   |
| Weighted-average number of shares for diluted                            |       | 36,719,720                                          |       | 36,627,912 |                                              |       | 35,638,521 |   | 35,248,423 |   |
|                                                                     |       |                                                |       |       |                                              |       |   |   |   |   |
| Net income per share – basic                                        |       | $                                                   | 0.32       |       | $                                                 | 0.14       |   |   | $ | 0.61 |   | $ | 0.42 |   |
|                                                                     |       |                                                |       |       |                                              |       |   |   |   |   |
| Net income per share – diluted                                      |       | $                                                   | 0.22       |       | $                                                 | 0.09       |   |   | $ | 0.43 |   | $ | 0.30 |   |

 

Stock option grantstotaling 1.3 million were outstanding during the three and six month periodsended June 30, 2008, but were not included in the computation of dilutedearnings per share because the effect of including the stock option grantswould be anti-dilutive.

 

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Underwriter’s purchaseoption of 1,000,000 units were outstanding during the three and six monthperiods ended June 30, 2007, but were not included in the computation ofdiluted earnings per share because the effect of including the underwriter’soption would be anti-dilutive.

 

# **8.**                                      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 part of the collective bargainingagreement between Kapstone and the United Steel, Paper and Forestry, Rubber,Manufacturing, Energy, Allied-Industrial, Chemical and Service Workers Union,AFL-CIO, CLC.  The assumed liability for the retroactive benefits providedfor prior service was $1.4 million at January 2, 2007, and employeesaccrue benefits under the Plan as of January 1, 2007.

 

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

 
| ** **                                       | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------|------------|------------|---------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                            | ** ** | **2007**   | ** **                                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                             |       |                                                |       |       |                                              |       |   |   |   |   |
| Service cost for benefits earned during the year |       | $                                                   | 306        |       | $                                                 | 288        |   |   | $ | 612 |   | $ | 575 |   |
| Interest cost on projected benefit obligation    |       | 39                                                  |       | 20         |                                              |       | 78 |   | 40 |   |
| Expected return on plan assets                   |       | (6                                                  | )          | —     |                                              |       | (12 | ) | — |   |
| Amortization of prior service cost               |       | —                                              |       | 25         |                                              |       | — |   | 50 |   |
| Net pension cost                                 |       | $                                                   | 339        |       | $                                                 | 333        |   |   | $ | 678 |   | $ | 665 |   |

 

KapStone will fund itspension plan according to IRS funding limitations. Based on those limitations,KapStone expects to contribute $1.0 million to the pension plan during thethird quarter of 2008.

 

**OtherPost-retirement Benefits**

 

As part of the KPBacquisition, the Company assumed certain liabilities for retiree medical/lifeobligations for employees not eligible to retire at December 31, 2006 of$0.9 million. Net postretirement cost recognized for the three and six monthsended June 30, 2008 and 2007 for the Company’s retiree medical and lifeinsurance plan was less than $0.1 million, respectively.

 

**DefinedContribution Plans**

 

In January 2007, theCompany established a defined contribution plan covering all eligibleemployees. Company contributions to the 401(k) plan are based on matchingof employee contributions, vest immediately for salaried employees and vestafter three years for union employees. For each of the three months ended June 30,2008 and 2007, the Company recognized expense of $0.3 million for matchingcontributions. For the six months ended June 30, 2008 and 2007, theCompany recognized expense of $0.7 million and $0.6 million, respectively.

 

The Company’s RetirementSavings Plan, which covers all eligible salaried employees, provides forcontributions based on an employee’s salary and age.  The Companycontributions vest 100% after three years. For each of the three months ended June 30,2008 and 2007, the Company recognized expense for the Retirement Savings Planof $0.1 million. For the six months ended June 30, 2008 and 2007, theCompany recognized expense of $0.3 million and $0.1 million respectively.  Retirement Savings Plan contributions aremade to employees’ 401(k) accounts in January of each year.

 

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**9.             Stock-Based Compensation**

 

On December 29,2006, the Company’s stockholders approved the 2006 Incentive Plan (“Plan”).  Amaximum of 3.0 million shares of our common stock, available for issuancepursuant to stock options, restricted stock awards or stock appreciation rights(collectively called “Awards”), may be granted under the Plan. If any Award isforfeited or expires without being exercised, or if restricted stock isrepurchased by the Company, the shares of stock subject to the Award shall beavailable for additional grants under the Plan. The number of shares availableunder the Plan is subject to adjustment in the event of any stock split, stockdividend, recapitalization, spin-off or other similar action. Awards may begranted to employees, officers and directors of, and consultants or advisorsto, the Company and any subsidiary corporations. Options intended to qualify,under the standards set forth in certain federal tax rules, as incentive stockoptions (“ISOs”) may be granted only to employees while actually employed theCompany. Non-employee directors, consultants and advisors are not entitled toreceive ISOs. Option Awards granted under the Plan are exercisable for a periodfixed by the administrator, but not longer than 10 years from the date ofgrant, at an exercise price which is not less than the fair market value of theshares on the 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 $0.7 million of compensation cost for the three andsix months ended June 30, 2008, respectively, and $0.2 million for each ofthe three and six month periods ended June 30, 2007.

 

At June 30, 2008,the Company reserved 3.0 million shares of common stock for stock option andrestricted stock awards.

 

**StockOptions**

 

In April 2008, theCompany’s Compensation Committee approved the issuance of 689,679 stock optionsto directors, executive officers and employees of the Company.  The stock options vest as follows: 50% aftertwo years and the remaining 50% after three years.  The stock optionsawarded in 2008 have a contractual term of ten years. The stock options aresubject to forfeiture should the recipient terminate their employment with theCompany for certain reasons prior to vesting in their awards, or the occurrenceof certain other events such as termination with cause. The exercise price ofthese stock options is based on closing market price of our common stock on thedate of grant (April 10, 2008 for the 2008 awards) and compensationexpense is recorded on an accelerated basis over the awards’ vesting periods.

 

The fair value of theKapStone stock options granted in April 2008 was $2.19. The fair value wascalculated 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 bySAB No. 110, as it does not have any historical exercise data to provide areasonable basis upon which to estimate expected life due to the limited timeits equity shares have been publicly traded.The risk-free interest rate was selected based uponyields of U.S. Treasury issues with a term similar to the expected life of thestock options.

 

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

 
| ** **                                                           | ** ** | **Three Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                           | ** ** | **2008**                                        | ** ** |
| KapStone Stock Options Black-Scholes assumptions (weighted average): |       |                                            |       |
| Expected volatility                                                  |       | 24.4                                            | %          |
| Expected life (years)                                                |       | 6.5                                             |       |
| Risk-free interest rate                                              |       | 3.1                                             | %          |
| Expected dividend yield                                              |       | —                                          | %          |
| Expected forfeitures                                                 |       | 2.0                                             | %          |

 

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# ** **

A summary of informationrelated 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                                 |       | 689,679     |       | 6.90         |       | 9.8                   |       | —               |       |
| Exercised                               |       | —      |       | —       |       | —                |       | —               |       |
| Lapsed (forfeited or canceled)          |       | (33,131     | )          | (6.98        | )          | —                |       | —               |       |
| **Outstanding at June 30, 2008**   |       | 1,287,598   |       | $            | 6.84       |                  | 8.1        |                 | $          | (209 | ) |
| **Exercisable at June 30, 2008**   |       | —      |       | —       |       | —                |       | —               |       |

 

Total stock-basedcompensation recorded in the Condensed Consolidated Statements of Incomerelated to the stock option grants was $0.3 million and $0.4 million for thethree and six months ended June 30, 2008 respectively, and $0.1 millionfor the three and six month periods ended June 30, 2007.

 

As of June 30, 2008,there was $1.9 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 June 30,2008.

 

**RestrictedStock**

 

In April 2008, theCompany’s Compensation Committee granted 175,422 restricted stock units toexecutive officers and employees as compensation for service. These restrictedstock units are restricted as to transferability until they vest three yearsfrom the grant date. These restricted stock units are subject to forfeitureshould these employees terminate their employment with the Company for certainreasons prior to vesting in their awards, or the occurrence of certain otherevents. The value of these restricted stock units is based on the closingmarket price of our common stock on the date of grant and compensation expenseis recorded on a straight-line basis over the awards’ vesting periods.

 

The following tablesummarizes our restricted stock amounts and activity:

 
| ** **                              | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|-----------------------------------------|------------|------------|------------|--------------|------------|
| ** **                              | ** ** | ** ** | ** ** | **Average**  | ** ** |
| ** **                              | ** ** | **Units/** | ** ** | **Grant**    | ** ** |
| ** **                              | ** ** | **Shares** | ** ** | **Price**    | ** ** |
| **Outstanding at January 1, 2008** |       | 174,000    |       | $            | 6.76       |   |
| Granted                                 |       | 175,422    |       | 6.90         |       |
| Vested                                  |       | —     |       | —       |       |
| Forfeited                               |       | —     |       | —       |       |
| **Outstanding at June 30, 2008**   |       | 349,422    |       | $            | 6.83       |   |

 

Total stock-basedcompensation recorded in the Condensed Consolidated Statements of Incomerelated to the restricted stock awards was $0.2 million and $0.3 million forthe three and six months ended June 30, 2008, respectively, and $0.1 millionfor the three and six month periods ended June 30, 2007. As of June 30,2008, there was $1.7 million of total unrecognized compensation cost related tothe restricted stock which will be recognized over the remaining vesting periodof approximately two years. No restricted stock awards were vested as of June 30,2008.

 

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# ** **

# **10.**                               Annual Planned Maintenance Outage

# ** **

Cost of sales for thethree and six month periods ended June 30, 2007 included approximately$4.6 million for the annual planned maintenance outage. The planned maintenanceoutage for 2008 is scheduled to be completed in the quarter ended September 30,2008.

 

**11.          Segment Information**

 

The Company operates inone geographic segment, the United States. The Company operates in twooperating segments: unbleached kraft and dunnage bags. The unbleached kraftsegment produces a variety of unbleached kraft paper and linerboard products.These products are sold to customers who convert the paper into end-marketfinished products. The dunnage bags segment converts unbleached Kraft paper andfilm into inflatable dunnage products, which are used to secure freight tominimize movement and potential damage of goods and products during transport.The products are sold to distributors and on a direct basis for use bymanufacturers, less-than-trailer-load carriers and retail regional distributioncenters. Corporate expenses that benefit the entire organization are notcharged to the operating segments. Corporate capital expenditures representmainly expenditures for a new Enterprise Resource Planning system.

 
| ** **                                                                          | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|------------|---------------------------------------------------|------------|
| **Operating Segment (in thousands of U.S. dollars):** | ** ** | **2008**                                            | ** ** | **2007**   | ** **                                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net sales:                                                                          |       |                                                |       |       |                                              |       |   |   |   |   |
| Unbleached kraft                                                                    |       | $                                                   | 60,545     |       | $                                                 | 52,519     |   |   | $ | 120,905 |   | $ | 111,001 |   |
| Dunnage bags                                                                        |       | 8,905                                               |       | 8,684      |                                              |       | 16,797 |   | 16,452 |   |
| Elimination of intersegment sales to Dunnage bags                                   |       | (1,288                                              | )          | (961       | )                                                 |       | (2,411 | ) | (1,784 | ) |
|                                                                                |       |                                                |       |       |                                              |       |   |   |   |   |
| Total                                                                               |       | $                                                   | 68,162     |       | $                                                 | 60,242     |   |   | $ | 135,291 |   | $ | 125,669 |   |
|                                                                                |       |                                                |       |       |                                              |       |   |   |   |   |
| Net sales to external customers:                                                    |       |                                                |       |       |                                              |       |   |   |   |   |
| Unbleached kraft                                                                    |       | 59,257                                              |       | 51,558     |                                              |       | 118,494 |   | 109,217 |   |
| Dunnage bags                                                                        |       | 8,905                                               |       | 8,684      |                                              |       | 16,797 |   | 16,452 |   |
|                                                                                |       |                                                |       |       |                                              |       |   |   |   |   |
| Total                                                                               |       | $                                                   | 68,162     |       | $                                                 | 60,242     |   |   | $ | 135,291 |   | $ | 125,669 |   |
|                                                                                |       |                                                |       |       |                                              |       |   |   |   |   |
| Operating income / (loss):                                                          |       |                                                |       |       |                                              |       |   |   |   |   |
| Unbleached kraft                                                                    |       | $                                                   | 15,930     |       | $                                                 | 7,892      |   |   | $ | 30,480 |   | $ | 21,406 |   |
| Dunnage bags                                                                        |       | 1,269                                               |       | 1,817      |                                              |       | 2,600 |   | 3,312 |   |
| Corporate                                                                           |       | (3,973                                              | )          | (3,588     | )                                                 |       | (8,209 | ) | (6,732 | ) |
|                                                                                |       |                                                |       |       |                                              |       |   |   |   |   |
| Total                                                                               |       | $                                                   | 13,226     |       | $                                                 | 6,121      |   |   | $ | 24,871 |   | $ | 17,986 |   |
|                                                                                |       |                                                |       |       |                                              |       |   |   |   |   |
| Depreciation and amortization:                                                      |       |                                                |       |       |                                              |       |   |   |   |   |
| Unbleached kraft                                                                    |       | $                                                   | 2,459      |       | $                                                 | 2,860      |   |   | $ | 4,932 |   | $ | 4,993 |   |
| Dunnage bags                                                                        |       | 94                                                  |       | 61         |                                              |       | 185 |   | 101 |   |
| Corporate                                                                           |       | 282                                                 |       | 8          |                                              |       | 311 |   | 16 |   |
|                                                                                |       |                                                |       |       |                                              |       |   |   |   |   |
| Total                                                                               |       | $                                                   | 2,835      |       | $                                                 | 2,929      |   |   | $ | 5,428 |   | $ | 5,110 |   |
| Capital Spending:                                                                   |       |                                                |       |       |                                              |       |   |   |   |   |
| Unbleached kraft                                                                    |       | $                                                   | 1,785      |       | $                                                 | 889        |   |   | $ | 2,560 |   | $ | 2,938 |   |
| Dunnage bags                                                                        |       | 28                                                  |       | 28         |                                              |       | 149 |   | 57 |   |
| Corporate                                                                           |       | 506                                                 |       | 2,670      |                                              |       | 1,911 |   | 2,670 |   |
|                                                                                |       |                                                |       |       |                                              |       |   |   |   |   |
| Total                                                                               |       | $                                                   | 2,319      |       | $                                                 | 3,587      |   |   | $ | 4,620 |   | $ | 5,665 |   |

 

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# **12.**                               Subsequent Event

# ** **

On July 1, 2008, theCompany consummated an asset purchase agreement with MeadWestvaco Corporationto purchase substantially all the assets and assume certain liabilities of theCharleston Kraft Division for $475 million, subject to certain post-closingadjustments. The acquisition consists of an unbleached kraft papermanufacturing facility and electric cogeneration facility in North Charleston,South Carolina and a lumber business located in Summerville, South Carolina.

 

The acquisition wasfinanced by cash on hand and by a new five-year senior secured credit facilityof $515 million consisting of LIBOR based term loans of $415 million and a $100million revolving credit facility. In addition, $40 million of 8.30% seniornotes due July 1, 2015 were issued. A portion of the proceeds were used to pay off the prior creditfacility. The new credit facility was entered into on June 12, 2008, and becameeffective with the consummation of the acquisition on July 1, 2008.

 

The Charleston Kraft Divisionbusiness was deemed an attractive acquisition candidate based on meeting theCompany’s objectives of being a North American based profitable company in thepaper and packaging industry and for its synergies with the Company’s existingoperations.

 

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| **Item 2.** | ** ** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION  AND RESULTS OF OPERATIONS** |
|-------------|------------|-------------------------------------------------------------------------------------------------|

 

This Quarterly Report on Form 10-Qincludes forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. We have based these forward-lookingstatements on our current expectations and projections about future events.These forward-looking statements are subject to known and unknown risks,uncertainties and assumptions about us that may cause our actual results,levels of activity, performance or achievements to be materially different fromany future results, levels of activity, performance or achievements expressedor implied by such forward-looking statements. In some cases, you can identifyforward-looking statements by terminology such as “may,” “should,” “could,” “would,”“expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or thenegative of such terms or other similar expressions. Factors that might causeor contribute to such a discrepancy include, but are not limited to, thosedescribed in Item 1A in this Form 10-Q and in our other Securities andExchange Commission filings.  The information contained in this form 10-Qrepresents our best judgment at the date of this report based on informationcurrently available.  In providing forward-looking statements, KapStonedoes not intend, and does not undertake any duty or obligations, to updatetheir statements as a result of new information, future events or otherwise.

 

The following discussionshould be read in conjunction with our Condensed Consolidated FinancialStatements and related Notes thereto included elsewhere in this report.

 

**Overview**

 

We were formed on April 15,2005 to serve as a vehicle to effect a merger, capital stock exchange, assetacquisition or other similar business combination (“Business Combination”) withan operating business in the paper, packaging, forest products and relatedindustries.

 

On January 2, 2007,the Company purchased substantially all of the assets and  assumed certainliabilities of the Kraft Papers Business, or KPB, a division of InternationalPaper Company (IP), consisting of an unbleached kraft paper manufacturingfacility in Roanoke Rapids, North Carolina and Ride Rite® Converting, aninflatable dunnage bag manufacturer located in Fordyce, Arkansas, for a cashpurchase price of $155 million in cash less certain post-closing adjustments of$7.8 million, plus two contingent earn-out payments of up to $60 million (inaggregate), based on KPB’s annual earnings before interest, income taxes,depreciation and amortization, or EBITDA, during the five years immediatelyfollowing the acquisition.  Any contingent earn-out payments will beaccounted for as additional purchase price consideration and recorded asgoodwill.

 

The accompanyingmanagement discussion and analysis include the results of KPB since January 2,2007. Prior to the acquisition of KPB, the Company had no operations norgenerated operating revenues and was considered a development stage company.

 

On July 1, 2008, theCompany consummated an asset purchase agreement with MeadWestvaco Corporation(MW) to purchase substantially all of the assets and assume certain liabilitiesof MW’s Charleston Kraft Division (CKD) for $475 million, subject to certainpost-closing adjustments.  The acquisition consists of an unbleached kraftpaper manufacturing facility and electric cogeneration facility in NorthCharleston, South Carolina and a lumber business located in Summerville, SouthCarolina.  The results reported below do not reflect any actual or proforma adjustments related to the acquisition.

 

 See Liquidity and Capital Resources – CKDacquisition for discussion of the financing of the CKD acquisition.

 

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**Comparisonof Results of Operations for the Three Months Ended June 30, 2008 and theThree Months Ended June 30, 2007**

 

The Company’s managementuses a variety of financial measurements to analyze its performance. Thesemeasurements include (1) Operating Income, (2) Productivity, (3) Selling,General & Administrative (“SG&A”) expenses and (4) Averagerevenue per ton (for unbleached kraft) and average revenue per dunnage bag (forRide Rite® Converting).

 

*OperatingIncome.*    Operatingincome is used by the Company’s management primarily as a measure of itssegments’ operating performance. The Company’s management defines operatingincome as sales minus costs associated with these sales. Sales include sales ofunbleached kraft paper products, linerboard and dunnage bags net of termallowances and discounts. For purposes of calculating operating income, costsinclude the cost of raw materials, labor, maintenance, depreciation andamortization, freight and distribution expenses and selling, general andadministrative expenses.

 

*Selling,General and Administrative Expenses.*   SG&A expenses include selling,customer service and corporate employee salaries and benefits, professionalfees, and information technology expenses, including fees paid to IP fortransitional services support.

 

*AverageRevenue per Ton/Dunnage Bag.*  Average revenue per ton/bag represents thegross revenue divided by the tons of unbleached kraft paper or the number ofdunnage bags sold, as applicable.

 
| ** **                                              | ** ** | **Three Months Ended June 30,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):** | ** ** | **2008**                                            | ** ** | **2007**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                                   | 68,162     |          | $          | 60,242 |   | $ | 7,920 |   |
| Cost of sales, excluding depreciation and amortization  |       | 40,800                                              |       | 41,358        |       | (558 | ) |
| Freight and distribution                                |       | 6,924                                               |       | 5,674         |       | 1,250 |   |
| Selling, general and administrative expenses            |       | 4,564                                               |       | 4,287         |       | 277 |   |
| Depreciation and amortization                           |       | 2,835                                               |       | 2,929         |       | (94 | ) |
| Other operating income                                  |       | 187                                                 |       | 127           |       | 60 |   |
| Operating income                                        |       | 13,226                                              |       | 6,121         |       | 7,105 |   |
| Interest income                                         |       | 293                                                 |       | 485           |       | (192 | ) |
| Interest expense                                        |       | 460                                                 |       | 1,117         |       | (657 | ) |
| Income before provision for income taxes                |       | 13,059                                              |       | 5,489         |       | 7,570 |   |
| Provision for income taxes                              |       | 4,808                                               |       | 2,040         |       | 2,768 |   |
| Net income                                              |       | $                                                   | 8,251      |          | $          | 3,449 |   | $ | 4,802 |   |

 

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Net sales for the quarterended June 30, 2008, were $68.2 million compared to $60.2 million for thesecond quarter of 2008, an increase of 13.3%. The increase in net sales wasdriven by an $7.8 million increase in the unbleached kraft segment due tohigher prices and volume, partially as a result of a change in the timing ofthe annual planned maintenance outage from June in 2007, to July 2008,and a $0.2 million increase in the dunnage bag segment due to higher volume.Refer to the segment results below for detailed sales information for eachsegment.

 

Cost of sales for thequarter ended June 30, 2008, was $40.8 million compared to $41.4 millionfor the second quarter of 2007, a 1.4% decrease due to 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,partially offset by higher sales volume and inflation on energy and rawmaterial costs. Production levels in the unbleached kraft segment were 15.2%higher in the 2008 period due to the change in the annual planned maintenanceoutage. Cost of sales in 2007 also included approximately $0.6 million due to atwo-day unplanned outage caused by an electrical fire.

 

Freight and distributionexpenses for the quarter ended June 30, 2008, totaled $6.9 millioncompared to $5.7 million for the quarter ended June 30, 2007. The increaseof $1.2 million reflects higher transportation rates due to fuel oilsurcharges, a higher percentage of shipments by truck compared to rail andhigher sales volume.

 

Selling, general andadministrative expenses for the quarter ended June 30, 2008 totaled $4.6million compared to $4.3 million for the quarter ended June 30, 2007. Theincrease of $0.3 million is due to higher stockcompensation costs of $0.3 million, CKD acquisition start up expenses of $0.3million and occupancy and other costs of $0.3 million; partially offsetby lower transitional support services from IP of $0.6 million as the Companyterminated the transitional services agreement upon going live with it’s newERP system.

 

Depreciation andamortization for the quarter ended June 30, 2008, totaled $2.8 millioncompared to $2.9 million for the quarter ended June 30, 2007. The decreaseof $0.1 million reflects lower depreciation in the unbleached kraft segment,partially offset by higher amortization in Corporate mainly due to theamortization of Company’s new Enterprise Resource Planning (ERP) computersoftware which was placed into service on April 1, 2008.

 

Other operating incomefor the quarters ended June 30, 2008 and 2007, totaled $0.2 million and$0.1 million, respectively. Other operating income includes commissions theCompany receives from marketing bleached paper produced and sold by IP toKapStone customers.

 

Interestincome for the quarters ended June 30, 2008 and 2007 was $0.3 million and$0.5 million, respectively. Interest income represents earnings on the Company’scash and cash equivalents. The decrease in interest income reflects lowerinterest rates during the 2008 quarter.

 

Interestexpense for the quarters ended June 30, 2008 and 2007, was $0.5 millionand $1.1 million, respectively. Interest expense reflects interest on theCompany’s long-term debt and amortization of deferred debt issuance costs.Interest expense was $0.6 million less in the quarter ended June 30, 2008,due to a lower amount of outstanding debt and lower interest rates.

 

Provisionfor income taxes for the quarter ended June 30, 2008, increased by $2.8million due to higher pre-tax income. The effective tax rate for the quarterended June 30, 2008 was 36.8% compared to 37.2% for the similar period in2007. The decrease in the effective tax rate reflects a greater benefit fromthe domestic manufacturing deduction.

 

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**SegmentResults**

 

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

 
| ** **                                           | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **Operating Segment ($ 000’s):** | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Consolidated net sales:                              |       |                                                |       |   |   |
| Unbleached kraft                                     |       | $                                                   | 60,545     |   | $ | 52,519 |   |
| Dunnage bags                                         |       | 8,905                                               |       | 8,684 |   |
| Elimination of intersegment sales                    |       | (1,288                                              | )          | (961 | ) |
|                                                 |       |                                                |       |   |   |
| Total net sales                                      |       | $                                                   | 68,162     |   | $ | 60,242 |   |
|                                                 |       |                                                |       |   |   |
| Operating income / (loss):                           |       |                                                |       |   |   |
| Unbleached kraft                                     |       | $                                                   | 15,930     |   | $ | 7,892 |   |
| Dunnage bags                                         |       | 1,269                                               |       | 1,817 |   |
| Corporate                                            |       | (3,973                                              | )          | (3,588 | ) |
|                                                 |       |                                                |       |   |   |
| Total operating income                               |       | $                                                   | 13,226     |   | $ | 6,121 |   |

 

The following representsanalysis and commentary for results of operations for the Company’s twooperating segments: Unbleached kraft and Dunnage bags.

 

***Unbleached Kraft***

 
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                   | 60,545     |   | $ | 52,519 |   |
| Operating income ($000’s): |       | $                                                   | 15,930     |   | $ | 7,892 |   |
| Operating income % of net sales |       | 26.3                                                | %          | 15.0 | % |
|                            |       |                                                |       |   |   |
| Average revenue per ton         |       | $                                                   | 581        |   | $ | 539 |   |
| Tons of paper sold              |       | 104,131                                             |       | 97,449 |   |

 

For the threemonths ended June 30, 2008, unbleached kraft segment net sales increasedby $8.0 million, or 15.2%, to $60.5 million compared to$52.5 million for the three months ended June 30, 2007. The averagerevenue per ton increased $42 per ton, contributing approximately $4.4 millionto the sales increase, due to the full realization of 2007 price increases andthe partial realization of first quarter 2008 price increases. Volume of papersold increased by 6,682 tons driven by higher production as the Companychanged its annual planned maintenance outage to July 2008, partiallyoffset by a lighter mix of paper. The 2007 annual planned maintenance outageoccurred in June.  Intersegment sales to the dunnage bag segment of$1.3 million increased by $0.3 million.

 

Unbleached kraft segmentoperating income increased by $8.0 million, or 101.3%, to$15.9 million for the three months ended June 30, 2008 compared to$7.9 million for the three months ended June 30, 2007. The Companychanged its annual planned maintenance outage, which took place in June in2007, to July in 2008, which benefitted the current quarter byapproximately $4.6 million. Higher average revenue per ton contributed$4.4 million of the increased operating income. Higher sales volume andproductivity gains were partially offset by inflation on energy, chemicals andfreight of approximately $3.9 million for the quarter ended June 30,2008. In addition, operating income for the 2007 period was negativelyimpacted by approximately $1.0 million due to a two-day unplanned outage causedby an electrical fire. Operating income as a percent of net sales improved to26.3%.

 

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***Dunnage Bags***

* *
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                   | 8,905      |   | $ | 8,684 |   |
| Operating income ($000’s): |       | $                                                   | 1,269      |   | $ | 1,817 |   |
| Operating income % of net sales |       | 14.3                                                | %          | 20.9 | % |
|                            |       |                                                |       |   |   |
| Average revenue per bag         |       | $                                                   | 3.82       |   | $ | 3.93 |   |
| Bags sold (000’s)          |       | 2,333                                               |       | 2,211 |   |

 

For the threemonths ended June 30, 2008, net sales for the dunnage bag segmentincreased by $0.2 million, or 2.3%, to $8.9 million compared to$8.7 million for the three months ended June 30, 2007 mainly due to a5.5% increase in unit sales. Average revenue per bag of $3.82 decreased by$0.11 or 2.8%, for the three months ended June 30, 2008 compared to thesimilar period in the prior year due to increased price competition in 2-plybags.

 

Dunnage bagsegment operating income decreased by $0.5 million, or 27.8%, to$1.3 million for the three months June 30, 2008 compared to$1.8 million for the three months ended June 30, 2007. The reductionin operating income was due to lower selling prices of $0.2 million, inflationon raw material costs of $0.2 million and other cost increases of $0.1 million.Operating income as a percent of net sales declined to 14.3%.

 

***Corporate***

 

Corporate expensesfor the three months ended June 30, 2008 totaled $4.0 millioncompared to $3.6 million for the three months June 30, 2007. Theincrease of $0.4 million is due to higher stock compensation costs of $0.3million, CKD acquisition start up expenses of$0.3 million, personnel additions of $0.2 million, and higher occupancy andother costs of $0.2 million, partially offset by lower transitionalsupport services from IP of $0.6 million as the Company terminated itstransitional services agreement with IP upon converting to its new ERP system.

 

**Comparisonof Results of Operations for the Six Months Ended June 30, 2008 and theSix Months Ended June 30, 2007**

 
| ** **                                              | ** ** | **Six  Months Ended June 30,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):** | ** ** | **2008**                                                | ** ** | **2007**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                                       | 135,291    |          | $          | 125,669 |   | $ | 9,622 |   |
| Cost of sales, excluding depreciation and amortization  |       | 82,358                                                  |       | 83,794        |       | (1,436 | ) |
| Freight and distribution                                |       | 13,511                                                  |       | 11,360        |       | 2,151 |   |
| Selling, general and administrative expenses            |       | 9,494                                                   |       | 8,007         |       | 1,487 |   |
| Depreciation and amortization                           |       | 5,428                                                   |       | 5,110         |       | 318 |   |
| Other operating income                                  |       | 371                                                     |       | 588           |       | (217 | ) |
| Operating income                                        |       | 24,871                                                  |       | 17,986        |       | 6,885 |   |
| Interest income                                         |       | 840                                                     |       | 882           |       | (42 | ) |
| Interest expense                                        |       | 1,213                                                   |       | 2,273         |       | (1,060 | ) |
| Income before provision for income taxes                |       | 24,498                                                  |       | 16,595        |       | 7,903 |   |
| Provision for income taxes                              |       | 9,017                                                   |       | 6,068         |       | 2,949 |   |
| Net income                                              |       | $                                                       | 15,481     |          | $          | 10,527 |   | $ | 4,954 |   |

 

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Net sales for the sixmonths ended June 30, 2008, were $135.3 million compared to $125.7 millionfor the first six months of 2007, an increase of 7.6%. The increase in netsales was driven by a $9.3 million increase in the unbleached kraft segment dueto higher prices and volume partially as a result of a change in the annualplanned maintenance outage from June in 2007, to July 2008, and a$0.3 million increase in the dunnage bag segment due to higher volume. Refer tothe segment results below for detailed sales information for each segment.

 

Cost of sales for the sixmonths ended June 30, 2008, was $82.4 million compared to $83.8 millionfor the first six months of 2007, a 1.7% decrease. The decrease in cost ofsales was mainly due to a change in the timing of the annual plannedmaintenance outage, which occurred in June in 2007 to July in 2008.The cost of the 2007 outage was approximately $4.6 million. In addition, 2007results included a $1.5 million non-cash purchase accounting charge to adjustacquired inventory to fair value as part of the KPB acquisition. Partiallyoffsetting these decreases were inflation on energy and raw material costs ofapproximately $4.7 million and the impact of higher sales volume. Cost of salesin the 2007 period includes approximately $0.6 million due to the impact of atwo-day unplanned outage caused by an electrical fire.

 

Freight and distributionexpenses for the six months ended June 30, 2008, totaled $13.5 millioncompared to $11.4 million for the six months ended June 30, 2007. Theincrease of $2.1 million reflects higher transportation rates due to fuel oilsurcharges, a higher percentage of shipments by truck compared to rail andhigher sales volume.

 

Selling, general andadministrative expenses for the six months ended June 30, 2008 totaled$9.5 million compared to $8.0 million for the similar period in 2007. Theincrease of $1.5 million is due tohigher stock compensation costs of $0.5 million,personnel additions of $0.5 million, CKD acquisition start up expenses of $0.3million, higher sales expenses of $0.3 million and occupancy and othercosts of $0.4 million; partially offset by lower transitional support servicesfrom IP of $0.5 million as the Company terminated its agreement with IP uponconverting to its new ERP system.

 

Depreciation andamortization for the six months ended June 30, 2008, totaled $5.4 millioncompared to $5.1 million for the six month period ended June 30, 2007. Theincrease of $0.3 million is mainly due to amortization of the Company’s new ERPsoftware which was placed into service on April 1, 2008.

 

Other operating incomefor the six month periods ended June 30, 2008 and 2007 totaled $0.4million and $0.6 million, respectively. Other operating income includescommissions the Company receives from marketing bleached paper produced andsold by IP to KapStone customers.

 

Interestincome for the six months ended June 30, 2008 and 2007 was $0.8 millionand $0.9 million, respectively. Interest income represents earnings on theCompany’s cash and cash equivalents. The decrease in interest income reflectslower interest rates in 2008.

 

Interestexpense for the six month periods ended June 30, 2008 and 2007, was $1.2million and $2.3 million, respectively. Interest expense reflects interest onthe Company’s long-term debt and amortization of deferred debt issuance costs.Interest expense was $1.1 million less in the six month period June 30,2008, due to a lower amount of outstanding debt and lower interest rates.

 

Provisionfor income taxes for the six months ended June 30, 2008, increased by $2.9million due to higher pre-tax income and reflects an effective tax rate of36.8% compared to 36.6% for the similar period in 2007. The increase in theeffective tax rate reflects a reduced benefit from the domestic manufacturingdeduction.

 

**SegmentResults**

 

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

 

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| ** **                                           | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------|------------|
| **Operating Segment ($ 000’s):** | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| Consolidated net sales:                              |       |                                              |       |   |   |
| Unbleached kraft                                     |       | $                                                 | 120,905    |   | $ | 111,001 |   |
| Dunnage bags                                         |       | 16,797                                            |       | 16,452 |   |
| Elimination of intersegment sales                    |       | (2,411                                            | )          | (1,784 | ) |
|                                                 |       |                                              |       |   |   |
| Total net sales                                      |       | $                                                 | 135,291    |   | $ | 125,669 |   |
|                                                 |       |                                              |       |   |   |
| Operating income / (loss):                           |       |                                              |       |   |   |
| Unbleached kraft                                     |       | $                                                 | 30,480     |   | $ | 21,406 |   |
| Dunnage bags                                         |       | 2,600                                             |       | 3,312 |   |
| Corporate                                            |       | (8,209                                            | )          | (6,732 | ) |
|                                                 |       |                                              |       |   |   |
| Total operating income                               |       | $                                                 | 24,871     |   | $ | 17,986 |   |

 

The following representsanalysis and commentary for results of operations for the Company’s twooperating segments: Unbleached kraft and Dunnage bags.

 

***Unbleached Kraft***

 
| ** **                      | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                 | 120,905    |   | $ | 111,001 |   |
| Operating income ($000’s): |       | $                                                 | 30,480     |   | $ | 21,406 |   |
| Operating income % of net sales |       | 25.2                                              | %          | 19.3 | % |
|                            |       |                                              |       |   |   |
| Average revenue per ton         |       | $                                                 | 576        |   | $ | 538 |   |
| Tons of paper sold              |       | 209,781                                           |       | 206,398 |   |

 

For the six monthsended June, 2008, unbleached kraft segment net sales increased by$9.9 million, or 8.9%, to $120.9 million compared to$111.0 million for the six months ended June 30, 2007. Averagerevenue per ton increased $38 per ton, contributing approximately $8.0 millionto the sales increase, due to the full realization of 2007 price increases anda portion of price increases implemented in the first half of 2008. Volume ofpaper sold increased by 3,383 tons driven by higher production in 2008resulting from a change in timing of the annual planned maintenance outagewhich took place in June in 2007 to July in 2008, partially offset bya lighter mix of paper sold.  Intersegment sales to the dunnage bagsegment of $2.4 million increased by $0.6 million.

 

Unbleached kraftsegment operating income increased by $9.1 million, or 42.5%, to$30.5 million for the six months ended June 30, 2008 compared to$21.4 million for the six months ended June 30, 2007. Higher averagerevenue per ton contributed $8.0 million of the increased operatingincome. In addition to the impact of the pricing gains, the change in thetiming of the annual planned maintenance outage improved operating income byapproximately $4.6 million.  Inflation onenergy, chemicals, freight and other costs negatively impacted operating incomeby approximately $5.9 million for the six months ended June 30,2008.  In addition, 2007operating income included a $1.2 million non-cashpurchase accounting charge adjusting acquired finished goods inventory to fairvalue and $1.0 million for a two-day unplanned outage caused by an electricalfire. Operating income as a percent of net sales improved to 25.2%.

 

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***Dunnage Bags***

* *
| ** **                      | ** ** | **Six  Months Ended June 30,** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                       | 16,797     |   | $ | 16,452 |   |
| Operating income ($000’s): |       | $                                                       | 2,600      |   | $ | 3,312 |   |
| Operating income % of net sales |       | 15.5                                                    | %          | 20.1 | % |
|                            |       |                                                    |       |   |   |
| Average revenue per bag         |       | $                                                       | 3.79       |   | $ | 3.87 |   |
| Bags sold (000’s)          |       | 4,434                                                   |       | 4,255 |   |

 

For the six monthsended June 30, 2008, net sales for the dunnage bag segment increased by$0.3 million, or 1.8%, to $16.8 million compared to$16.5 million for the six months ended June 30, 2007 mainly due to a4.2% increase in unit sales. Average revenue per bag of $3.79 decreased by$0.08 or 2.1%, for the six months ended June 30, 2008 compared to thesimilar period in the prior year due to increased price competition in 2-plybags and mix.

 

Dunnage bagsegment operating income decreased by $0.7 million, or 21.2%, to $2.6 millionfor the six months June 30, 2008 compared to $3.3 million for the sixmonths ended June 30, 2007. Unfavorable volume/mix of $0.4 million andinflation on raw material costs of $0.4 million and other cost increases of$0.2 million contributed approximately $1.0 million of the reduction tooperating income. Operating income for the six months ended June 30, 2007,included a $0.3 million non-cash purchase accounting charge adjusting acquiredfinished goods inventory to fair value as part of the KPB acquisition.Operating income as a percent of net sales declined to 15.5%.

 

***Corporate***

 

Corporate expensesfor the six months ended June 30, 2008, totaled $8.2 million comparedto $6.7 million for the year six months June 30, 2007. The increaseof $1.5 million is due to higher stockcompensation costs of $0.5 million, personnel additions of $0.5 million, CKDacquisition start up expenses of $0.3 million, amortization expense for theCompany’s new ERP system of $0.2 million and occupancy and other costsof $0.4 million; partially offset by lower transitional support services fromIP of $0.5 million.

 

**Liquidityand Capital Resources**

 

***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 liabilities assumed consist of trade accounts payable, accruedexpenses and certain long term liabilities. The purchase price for theacquisition was $155.0 million in cash less certain post- closing adjustmentsof $7.8 million, plus contingent earn-out payments of up to $60.0 million(in aggregate) based on KPB’s annual earnings before interest, income taxes,depreciation and amortization (“EBITDA”) during the five year periodimmediately following the acquisition. The first contingent payment will beequal to 5.3 times KPB’s average annual EBITDA for the five year periodimmediately following the acquisition, less $165.0 million and subject to amaximum of $35.0 million. The second contingent payment is an “all ornothing” 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.

 

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***CKD Acquisition***

 

On July 1, 2008, we consummated the purchase of substantially allof the assets, and the assumption of certain liabilities, of the CharlestonKraft Division (CKD) from MeadWestvaco Corporation (MW) for $475 million,subject to certain post-closing adjustments. The acquisition consists of an unbleached kraft paper manufacturingfacility and an electric cogeneration facility in North Charleston, SouthCarolina 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 on hand, to finance the consideration for ouracquisition of CKD, to repay our prior credit facility with various financialinstitutions and LaSalle Bank National Association, and to pay transaction feesand expenses.

 

***Credit Facilities***

 

*Senior Credit Agreement*

 

On June 12, 2008, we entered into a Credit Agreement, dated as of June 12,2008, and effective with the consummation of the acquisition of CKD, (the “SeniorCredit Agreement”), 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 term B loan facility of $25,000,000 and a$100,000,000 revolving credit facility (including a letter of credit subfacility).  The Senior Credit Facilities are guaranteedby KapStone Kraft and our other domestic subsidiaries and are secured bysubstantially all of our assets, including all of the capital stock of theborrower and guarantor subsidiaries and up to 66% of the capital stock of ourforeign subsidiaries.

 

The term A loan facility is required to be repaid by us in consecutivequarterly installments of $7,312,500 from September 30, 2008 to June 30,2009, $9,750,000 from September 30, 2009 to June 30, 2010, $12,187,500from September 30, 2010 to March 31, 2013, with a final payment ofall outstanding principal and interest on the maturity date.  The term B loan is required to be repaid byKapStone in consecutive quarterly installments of $468,750 from September 30,2008 to June 30, 2009, $625,000 from September 30, 2009 to June 30,2010, $781,250 from September 30, 2010 to March 31, 2015 and$5,781,250 on the maturity date. Borrowings under the revolving credit facility may be used for workingcapital and other general corporate purposes and are required to be repaid infull on the maturity date.  The maturitydate is the earlier of:  (a) June 12,2013 with respect to the term A loan facility and the revolving credit facilityand 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 is less than 2.0 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 the higherof the then current Federal Funds rate plus 0.5% of the prime rate mostrecently announced by Bank of America, N.A., the administrative agent under theSenior Credit Facilities) plus a margin of 2.00% or (2) the reservedadjusted one, 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 feefor the revolving credit facility will be determined by reference to a pricinggrid based on our total leverage ratio. Under the pricing grid, the applicable margins for the term A loanfacility and the revolving credit facility will range from 0.0% to 1.5% forbase rate loans and from 1.50% to 3.00% for Eurodollar loans, and the unusedline fee for the revolving credit facility will range form 0.375% to0.50%.  Outstanding letters of credit aresubject to an annual fee equal to the applicable margin for Eurodollar loansunder the revolving credit facility as in effect from time to time, plus afronting fee on the undrawn amount thereof.

 

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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 their business, enter into certaintransactions with affiliates, and make changes in accounting policies orpractices except as required by generally accepted accounting principles.  The Senior Credit Facilities also contain atotal leverage ratio covenant and a fixed charge coverage ratio.  The Senior Credit Facilities contain eventsof default including, but not limited to, nonpayment of principal or interest,violation of covenants, breaches of representations and warranties,cross-default to other indebtedness, bankruptcy and other insolvency events,material judgments, certain ERISA events, actual or asserted invalidity of loandocumentation 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 number 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 are 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 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 default relatingto the certain events of bankruptcy, insolvency or reorganization occurs and iscontinuing, the principal, interest and any yield maintenance amount on all ofthe Senior Notes shall automatically become immediately due and payable withoutnotice or demand of any kind.

 

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* *

*Intercreditor and CollateralAgency Agreement*

 

The Company, KapStone Kraft and each of itsguarantor subsidiaries entered into an Intercreditor and Collateral AgencyAgreement dated July 1, 2008 (the “Intercreditor Agreement”) with Bank ofAmerica, N.A., as administrative agent under the Senior Credit Agreement, andeach of the holders of Senior Notes.  TheIntercreditor Agreement provides, among other things, that the borrowings underthe Senior Credit Agreement and the Senior Notes shall be secured equally andratably by the assets of the Company, KapStone Kraft and the Company’s otherdomestic subsidiaries.  Bank of America,N.A. is appointed as collateral agent to act on behalf of the holders of theSenior Notes and the lenders under the Senior Credit Agreement.

 

***Cash flow***

 

Cashon hand as of June 30, 2008, decreased by $0.1 million from December 31,2007, reflecting cash generated from operations of $20.9 million, partiallyoffset by net cash outflow from investing activities of $7.0 million and netcash outflow from financing activities of $14.0 million.

 

Netcash inflow from operating activities was $20.9 million due to net income of$15.5 million and non-cash charges of $7.7 million. Changes in operating assetsand liabilities used $2.3 million reflecting an annual payment of $1.2 millionfor insurance premiums, incentive payments of $1.7 million and higher tradeaccounts receivables of $4.0 million, partially offset by higher accountspayable of $2.1 million and accrued expenses of $2.0 million.

 

Netcash outflow from investing activities was $7.0 million reflecting capitalexpenditures of $4.6 million. For the six months June 30, 2008, capitalexpenditures mainly reflect $2.6 million for the unbleached kraft segment andinclude equipment upgrades and replacements at the paper mill in RoanokeRapids, North Carolina and $1.8 million for the Company’s new ERP system. Acquisition costs paid of $2.4 million represents costs incurred for theacquisition of the Charleston Kraft Division of MeadWestvaco Corporation.

 

Netcash outflow generated from financing activities totaled $14.0 million duringthe six months ended June 30, 2008, and reflects repayments of long-termdebt of $15.1 million, partially offset by $1.1 million received from exercisesof common stock warrants.

 

***Future Cash Needs***

 

Weexpect that cash generated from revenues will be sufficient to meet anticipatedcash needs primarily consisting of debt service, working capital and capitalexpenditures.

 

**Off-Balance Sheet Arrangements**

 

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

 

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**Item 3.—    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK**

 

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

 

Under KapStone Kraft’s new Senior SecuredCredit Facility, we have two term loans totaling $415 million and a revolvingloan of $100 million. Advances under the revolving line of credit are primarilybased upon percentages of eligible accounts receivable and inventories. The maturity date is the earlier of:  (a) June 12,2013 with respect to the term A loan facility and the revolving credit facilityand 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 is less than 2.0 to 1.0.

 

 Changesin market rates may impact the base rate in our senior credit agreement. Forinstance, if the bank’s base rate was to increase or decrease by one percentagepoint (1.0%), our annual interest expense would change by approximately $4.3million based upon our expected future monthly loan balances per our existingrepayment schedule.

 

Theprincipal market risk to which we are exposed is commodity and energy pricerisk. We are exposed to price fluctuations of certain commodities used inproduction as well as fluctuations in the price of its finished goods. Key rawmaterials and energy used in the production process include roundwood andwoodchips, coal, electricity and caustic soda. We purchase these raw materialsand energy at the market prices, and do not use forward contracts or otherfinancial instruments to hedge its exposure to price risk related to thesecommodities. Prices for paper and related products are subject to marketconditions. We have no long-term contracts to purchase raw materials or energyat fixed prices.

 

**Item 4. —CONTROLS AND PROCEDURES**

 

Asof the end of the period covered by this report, our Chief Executive Officerand our Chief Financial Officer carried out an evaluation of the effectivenessof the design and operation of our disclosure controls and procedures, asrequired by Rule 13a-15(b) under the Securities Exchange Act of 1934.Based upon that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were designed,and were effective, to give reasonable assurance that information required tobe disclosed about us and our subsidiary is recorded, processed, summarized andreported within the time periods specified by the rules and forms of theSEC and is accumulated and communicated to management as appropriate to allowtimely decisions regarding required disclosure in our filings under theSecurities Exchange Act of 1934.

 

Thefollowing change to our internal control over financial reporting wasimplemented during the three months ended June 30, 2008, has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting:

 

TheCompany began using its own enterprise resource planning system (ERP) on April 1,2008. As part of the conversion from the ERP system hosted by InternationalPaper Company (IP), the Company terminated its Transitional Services Agreementwith IP.

 

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**PART II.— OTHER INFORMATION**

 

**Item 1. —   LEGALPROCEEDINGS**

 

None.

 

**Item 1A. — RISK FACTORS**

 

Withthe exception of the following update to the risk factors relating to theacquisition of the Charleston Kraft Division (CKD) of MeadWestvaco Corporation,there have been no material changes from the Risk Factors described in our Form 10-K/Afor 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.

 

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

 

Weconsummated the asset purchase agreement with MeadWestvaco with the expectationthat the acquisition of CKD will result in various benefits including, amongother things, benefits relating to enhanced revenues, a broader array ofproduct offerings, the expansion of our production capabilities, operationalimprovements and a diversification of our customer base. The transaction willpresent challenges to management, including the integration of operations,properties and personnel of CKD and our existing operations. Achieving theanticipated benefits of the transaction is subject to a number ofuncertainties, including, but not limited to, whether we can integrate our businessand the CKD business in an efficient and effective manner. Failure to achievethese anticipated benefits could result in increased costs, decreases in theamount of expected revenues and diversion of management’s time and energy andcould materially impact our business, financial condition and operatingresults.

 

***We may fail to realize theanticipated synergies and cost savings expected from the pending CKDacquisition.***

 

Oursuccess after the CKD acquisition will depend, in part, on our ability to realizethe anticipated growth opportunities and cost savings from integrating ourbusiness with CKD.  To realize these anticipated benefits, we mustsuccessfully integrate our business with CKD in a manner that permits thesesynergies 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:

 

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·                  Costs and delays in implementing common systemsand procedures;

 

·                  Potential charges to earnings resulting fromthe application of purchase accounting to the transaction;

 

·                  Difficulty comparing financial reports due todiffering financial and/or internal reporting systems;

 

·                  Diversion of management resources from thebusiness;

 

·                  Challenges in retaining and integratingmanagement and other key employees of KapStone and CKD;

 

·                  Difficulties in coordinating infrastructureoperations in an effective and efficient manner; and

 

·                  The inability to achieve the synergiesanticipated to be realized from the transaction on the timeline presentlyanticipated, or at all.

 

Afterthe transaction is consummated, we may seek to combine certain operations andfunctions using common information and communication systems, operatingprocedures, financial controls and human resource practices, includingtraining, professional development and benefit programs. We may be unsuccessfulin implementing the integration of these systems and processes in a timely andefficient manner. Any one or all of these factors may cause increased operatingcosts, worse than anticipated financial performance and/or the loss ofcustomers and employees. Many of these factors are 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 financialstatements.

 

***As a result of the CKD acquisition, includingthe financing necessary to consummate the transaction, we have substantialindebtedness.***

 

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:

 

·                  Ourability to obtain additional financing for working capital, capitalexpenditures, acquisitions, general corporate purposes or other purposes may beimpaired in the future;

 

·                  A substantial portion of our cash flow mustbe dedicated to the payment of principal and interest on our indebtedness;

 

·                  We will be substantially more leveraged thancertain of our competitors, which might place us at a competitive disadvantage;

 

·                  We will be subject to restrictive covenantsthat may negatively affect our operational or financial flexibility or ourability to pursue additional acquisitions;

 

·                  We may be hindered in our ability to adjustrapidly to changing market conditions; and

 

·                  Our high degree of leverage could make usmore vulnerable in the event of a downturn in general economic conditions orour business.

 

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***As a result ofthe CKD acquisition, our operations will 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 rateswhich could adversely affect our competitive position, selling prices, andtherefore the demand for our products in a particular market.

 

·                                          Trade protection measures in favor of localproducers of competing products, including government subsidies, tax benefits,trade actions (such as anti-dumping proceedings) and other measures givinglocal producers a competitive advantage over the company.

 

·                                          Changes generally in political, regulatory oreconomic 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, internalcontrols over financial reporting, financial results, or our ability to timelyand accurately report such results.

 

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

 

None.

 

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

 

None.

 

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

 

TheRegistrant’s Annual Meeting of Stockholders was held on May 29, 2008. Atthe meeting, stockholders voted on (1) the election of two directors forterms of office expiring at the Annual Meeting of Stockholders in 2011, (2) theapproval of the Performance Incentive Plan, and (3) the ratification ofthe appointment of Ernst & Young LLP as independent registered publicaccounting firm of the Registrant for 2008.

 
| ** ** | ** **                                  | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Withheld/Abstentions** | ** ** |
|------------|---------------------------------------------|------------|--------------------|------------|------------------------|------------|--------------------------|------------|
|       |                                        |       |               |       |                   |       |                     |       |
| 1.         | Directors  for re-election                  |       |               |       |                   |       |                     |       |
|       | Matthew Kaplan                              |       | 23,235,918         |       | —                 |       | 183,440                  |       |
|       | John M. Chapman                             |       | 23,222,818         |       | —                 |       | 196,540                  |       |
|       |                                        |       |               |       |                   |       |                     |       |
| 2.         | Approval of  Performance Incentive Plan     |       | 19,543,185         |       | 45,510                 |       | 3,830,663                |       |
|       |                                        |       |               |       |                   |       |                     |       |
| 3.         | Ratification  of Ernst & Young LLP |       | 23,386,161         |       | 1,500                  |       | 31,697                   |       |

** **

**Item 5.—    OTHER INFORMATION**

 

None.

 

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**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 thereon). (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 June 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                                                                                                                                                                                                                                                                                                                                                     |
|             |       |                                                                                                                                                                                                                                                                                                                                                             |
| 31.1             |       | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                           |
|             |       |                                                                                                                                                                                                                                                                                                                                                             |
| 31.2             |       | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                           |
|             |       |                                                                                                                                                                                                                                                                                                                                                             |
| 32.1             |       | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |
|             |       |                                                                                                                                                                                                                                                                                                                                                             |
| 32.2             |       | Certification  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |

 

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| (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  June 12, 2008.  |
|   |   |                                                                                                               |
| (4)    |   | Incorporated  by reference to the Registrant’s Current Report filed on Form 8-K on July 2,  2008.   |

 

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**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 |
|----------------------|--------------------------------------------|
|                 |                                       |   |
|                 |                                       |   |
| August 4,  2008 | By:                                        | /s/  Andrea K. Tarbox |
|                 |                                       | Andrea  K. Tarbox |
|                 |                                       | Vice  President and Chief Financial Officer |

 

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