Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended September 30,2009**

 

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

 

**For thetransition periodfrom                     to             **

 

**Commission File Number: 001-33494**

 

**KapStone Paper and PackagingCorporation**

(Exact name of registrant as specified in its charter)

 

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

 

**KapStone Paper and PackagingCorporation**

**1101 Skokie Blvd., Suite 300**

**Northbrook, IL 60062**

(Address of Principal Executive Officesincluding zip code)

 

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

 

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

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months(or for such shorter period that the registrant was required to submit and postsuch files).    Yes o Noo

 

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

 

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

 

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

 

There were 45,413,624 shares of the Registrant’sCommon Stock, $0.0001 par value, outstanding as of October 30, 2009,excluding 40,000 shares held as treasury shares.

 

 

 

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Table of Contents

 

**KapStone Paper and Packaging CorporationIndex to Form 10-Q**

 

**TABLE OF CONTENTS**

 
| PART I. — FINANCIAL  INFORMATION |                                                                                                          |
|--------------------------------------------|---------------------------------------------------------------------------------------------------------------|
|                                       |                                                                                                          |   |
|                                       | Item 1. —  Consolidated Financial Statements (Unaudited) and Notes to Consolidated  Financial Statements | 1 |
|                                       |                                                                                                          |   |
|                                       | Item 2. — Management’s Discussion and Analysis of  Financial Condition and Results of Operations    | 12 |
|                                       |                                                                                                          |   |
|                                       | Item 3. — Quantitative and Qualitative Disclosures  about Market Risk                                    | 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                                   | 23 |
|                                       |                                                                                                          |   |
|                                       | Item 3. — Defaults Upon Senior Securities                                                                | 23 |
|                                       |                                                                                                          |   |
|                                       | Item 4. — Submission of Matters to a Vote of Security  Holders                                           | 23 |
|                                       |                                                                                                          |   |
|                                       | Item  5. — Other Information                                                                             | 23 |
|                                       |                                                                                                          |   |
|                                       | Item 6.  — Exhibits                                                                                      | 24 |
|                                       |                                                                                                          |   |
| SIGNATURE                                  | 25                                                                                                            |

 

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**Part 1. Financial Information**

 

**Item 1. — Financial Statements**

 

**KapStonePaper and Packaging Corporation**

**ConsolidatedBalance Sheets**

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

 
| ** **                                                                                                                                                                                                                                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                 | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                                                                                                                                 | ** ** | **(unaudited)**        | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                                                 | ** ** | ** **             |       |                  |       |
| Current assets:                                                                                                                                                                                                                                            | ** ** | ** **             |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                 |       | $                      | 3,074      |                  | $          | 4,165 |   |
| Trade accounts  receivable, less allowances of $2,884 in 2009 and $2,421 in 2008                                                                                                                                                                           |       | 59,615                 |       | 71,489                |       |
| Other receivables                                                                                                                                                                                                                                          |       | 15,189                 |       | 6,207                 |       |
| Inventories                                                                                                                                                                                                                                                |       | 61,600                 |       | 89,692                |       |
| Refundable and prepaid  income taxes                                                                                                                                                                                                                       |       | 2,947                  |       | 14,145                |       |
| Prepaid expenses and  other current assets                                                                                                                                                                                                                 |       | 3,193                  |       | 1,748                 |       |
| Restricted cash                                                                                                                                                                                                                                            |       | 2,500                  |       | —                |       |
| Deferred income taxes                                                                                                                                                                                                                                      |       | 5,620                  |       | 3,363                 |       |
| Total current assets                                                                                                                                                                                                                                       |       | 153,738                |       | 190,809               |       |
|                                                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Plant, property and  equipment, net                                                                                                                                                                                                                        |       | 470,304                |       | 483,780               |       |
| Other assets                                                                                                                                                                                                                                               |       | 1,553                  |       | 882                   |       |
| Intangible assets, net                                                                                                                                                                                                                                     |       | 29,517                 |       | 45,195                |       |
| Goodwill                                                                                                                                                                                                                                                   |       | 5,449                  |       | 6,524                 |       |
|                                                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Total assets                                                                                                                                                                                                                                               |       | $                      | 660,561    |                  | $          | 727,190 |   |
|                                                                                                                                                                                                                                                       |       |                   |       |                  |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                             | ** ** | ** **             |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                                       | ** ** | ** **             |       |                  |       |
| Current portion of  long-term debt and notes                                                                                                                                                                                                               |       | $                      | 25,960     |                  | $          | 40,556 |   |
| Accounts payable                                                                                                                                                                                                                                           |       | 36,404                 |       | 42,214                |       |
| Accrued expenses                                                                                                                                                                                                                                           |       | 16,607                 |       | 30,462                |       |
| Accrued compensation  costs                                                                                                                                                                                                                                |       | 8,689                  |       | 13,646                |       |
| Total current  liabilities                                                                                                                                                                                                                                 |       | 87,660                 |       | 126,878               |       |
|                                                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Other liabilities:                                                                                                                                                                                                                                         |       |                   |       |                  |       |
| Long-term debt and  notes, net                                                                                                                                                                                                                             |       | 187,059                |       | 389,374               |       |
| Pension and  post-retirement benefits                                                                                                                                                                                                                      |       | 6,994                  |       | 8,355                 |       |
| Deferred income taxes                                                                                                                                                                                                                                      |       | 32,757                 |       | 15,951                |       |
| Other liabilities                                                                                                                                                                                                                                          |       | 23,556                 |       | 5,865                 |       |
| Total other liabilities                                                                                                                                                                                                                                    |       | 250,366                |       | 419,545               |       |
|                                                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Commitments and  contingencies                                                                                                                                                                                                                             |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Preferred stock $0.0001  par value; 1,000,000 shares authorized; no shares issued and outstanding                                                                                                                                                          |       | —                 |       | —                |       |
| Common stock $0.0001  par value, 175,000,000 shares authorized; 45,413,624 shares outstanding  (40,000 treasury shares outstanding) at September 30, 2009 and  28,370,248 outstanding at December 31, 2008 (40,000 treasury shares  outstanding) |       | 5                      |       | 3                     |       |
| Additional paid-in  capital                                                                                                                                                                                                                                |       | 219,107                |       | 132,206               |       |
| Retained earnings                                                                                                                                                                                                                                          |       | 103,662                |       | 48,766                |       |
| Accumulated other  comprehensive loss                                                                                                                                                                                                                      |       | (239                   | )          | (208                  | )          |
| Total stockholders’  equity                                                                                                                                                                                                                           |       | 322,535                |       | 180,767               |       |
|                                                                                                                                                                                                                                                       |       |                   |       |                  |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                           |       | $                      | 660,561    |                  | $          | 727,190 |   |

 

See notes to consolidated financial statements

 

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**KapStone Paper and Packaging Corporation**

**Consolidated Statements of Income**

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

 

**(Unaudited)**

 
| ** **                                              | ** ** | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                              | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Net sales                                               |       | $                                          | 170,335    |                                      | $          | 207,671 |   | $ | 467,412 |   | $ | 342,962 |   |
| Cost of sales,  excluding depreciation and amortization |       | 86,812                                     |       | 151,064                                   |       | 271,650 |   | 233,422 |   |
| Freight and  distribution expenses                      |       | 16,262                                     |       | 19,969                                    |       | 42,755 |   | 33,480 |   |
| Selling, general and  administrative expenses           |       | 7,105                                      |       | 9,757                                     |       | 23,292 |   | 19,251 |   |
| Depreciation and  amortization                          |       | 13,664                                     |       | 12,953                                    |       | 40,761 |   | 18,381 |   |
| Gain/(loss) on sale of  business                        |       | (278                                       | )          | —                                    |       | 16,417 |   | — |   |
| Other operating income                                  |       | 285                                        |       | 218                                       |       | 733 |   | 589 |   |
| Operating income                                        |       | 46,499                                     |       | 14,146                                    |       | 106,104 |   | 39,017 |   |
| Foreign exchange  gain/(loss)                           |       | 175                                        |       | (607                                      | )          | 48 |   | (607 | ) |
| Interest income                                         |       | —                                     |       | 51                                        |       | 1 |   | 891 |   |
| Interest expense                                        |       | 5,353                                      |       | 8,772                                     |       | 16,097 |   | 9,985 |   |
| Income before provision  for income taxes               |       | 41,321                                     |       | 4,818                                     |       | 90,056 |   | 29,316 |   |
| Provision for income  taxes                             |       | 15,649                                     |       | 2,513                                     |       | 35,160 |   | 11,530 |   |
|                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Net income                                              |       | $                                          | 25,672     |                                      | $          | 2,305 |   | $ | 54,896 |   | $ | 17,786 |   |
|                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average number  of shares outstanding:         |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                   |       | 36,548,515                                 |       | 26,904,070                                |       | 31,096,354 |   | 25,859,149 |   |
| Diluted                                                 |       | 36,940,773                                 |       | 38,012,635                                |       | 31,355,785 |   | 36,429,893 |   |
| Net income per share:                                   |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                   |       | $                                          | 0.70       |                                      | $          | 0.09 |   | $ | 1.77 |   | $ | 0.69 |   |
| Diluted                                                 |       | $                                          | 0.69       |                                      | $          | 0.06 |   | $ | 1.75 |   | $ | 0.49 |   |

 

See notes to consolidated financial statements

 

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**KapStonePaper and Packaging Corporation**

**ConsolidatedStatements of Cash Flows**

** **

**(In thousands)**

** **

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Nine  Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                         | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| **Operating  activities**                                                          |       |                                      |       |   |   |
| Net income                                                                         |       | $                                         | 54,896     |   | $ | 17,786 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                      |       |   |   |
| Depreciation and  amortization                                                     |       | 40,761                                    |       | 18,381 |   |
| Stock based  compensation expense                                                  |       | 1,686                                     |       | 1,189 |   |
| Amortization of debt  issuance costs                                               |       | 4,210                                     |       | 1,170 |   |
| Loss on disposal of  fixed assets                                                  |       | 756                                       |       | — |   |
| Deferred income taxes                                                              |       | 13,750                                    |       | 12,999 |   |
| Gain on sale of  business                                                          |       | (16,417                                   | )          | — |   |
| Changes in operating  assets and liabilities:                                      |       |                                      |       |   |   |
| Trade accounts  receivable, net                                                    |       | 9,081                                     |       | (17,367 | ) |
| Other receivables                                                                  |       | (12,100                                   | )          | (3,254 | ) |
| Inventories                                                                        |       | 23,242                                    |       | 438 |   |
| Refundable and prepaid  income taxes                                               |       | 13,124                                    |       | (11,416 | ) |
| Prepaid expenses and  other current assets                                         |       | (1,445                                    | )          | (1,683 | ) |
| Other assets                                                                       |       | (1,041                                    | )          | 51 |   |
| Accounts payable                                                                   |       | (5,102                                    | )          | (3,516 | ) |
| Accrued expenses                                                                   |       | 3,386                                     |       | 13,767 |   |
| Accrued compensation  costs                                                        |       | (4,997                                    | )          | 936 |   |
| Accrued income taxes                                                               |       | —                                    |       | (1,477 | ) |
| Net cash provided by  operating activities                                         |       | 123,790                                   |       | 28,004 |   |
|                                                                               |       |                                      |       |   |   |
| **Investing  activities**                                                          | ** ** | ** **                                |       |   |   |
| CKD acquisition                                                                    |       | 1,000                                     |       | (470,451 | ) |
| KPB earn-out                                                                       |       | (3,977                                    | )          | — |   |
| Proceeds from sale of  business                                                    |       | 34,898                                    |       | — |   |
| Restricted cash                                                                    |       | (2,500                                    | )          | — |   |
| Capital expenditures                                                               |       | (18,656                                   | )          | (12,714 | ) |
| Net cash provided by  (used in) investing activities                               |       | 10,765                                    |       | (483,165 | ) |
|                                                                               |       |                                      |       |   |   |
| **Financing  activities**                                                          | ** ** | ** **                                |       |   |   |
| Proceeds from revolving  credit facility                                           |       | 64,300                                    |       | 71,800 |   |
| Repayments on revolving  credit facility                                           |       | (76,700                                   | )          | (17,000 | ) |
| Proceeds from long-term  debt and notes                                            |       | —                                    |       | 455,000 |   |
| Repayments of long-term  debt and notes                                            |       | (208,093                                  | )          | (71,953 | ) |
| Proceeds from the  exercises of warrants into common stock                         |       | 85,217                                    |       | 15,146 |   |
| Debt issuance costs                                                                |       | (370                                      | )          | (12,593 | ) |
| Net cash (used in)  provided by financing activities                               |       | (135,646                                  | )          | 440,400 |   |
|                                                                               |       |                                      |       |   |   |
| Net decrease in cash  and cash equivalents                                         |       | (1,091                                    | )          | (14,761 | ) |
| Cash and cash  equivalents-beginning of period                                     |       | 4,165                                     |       | 56,635 |   |
| Cash and cash  equivalents-end of period                                           |       | $                                         | 3,074      |   | $ | 41,874 |   |

 

See notes to consolidated financial statements

 

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

 

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

 

**(Unaudited)**

 

# **1.**                                      Financial Statements

# ** **

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

 

# **2.**                                      Reclassification

# ** **

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

 

# **3.**                                      Accounting Pronouncements

# ** **

The Accounting StandardsCodification (“ASC”) has become the source of authoritative U.S. generallyaccepted accounting principles (U.S. GAAP). The ASC only changes thereferencing of financial accounting standards and does not change or alterexisting U.S. GAAP.

 

The Company adopted a newaccounting standard included in ASC 855, “Subsequent Events” which establishes general standards ofaccounting for and disclosure of events that occur after the balance sheet datebut before financial statements are issued. This statement became effective forinterim and annual periods ending after June 15, 2009.

 

The Company has evaluatedsubsequent events after the balance sheet date of September 30, 2009through November 4, 2009, which is the date of the accompanying financialstatements were issued. Refer to Note 16 for the required disclosure.

 

The Company adopted a newaccounting standard included in ASC 820, “Fair Value Measurements and Disclosures”which provide additional guidance for estimating fair value when the volume andlevel of activity for the asset or liability have significantly decreased. Thisstandard also includes guidance on identifying circumstances that indicate atransaction is not orderly. This standard emphasizes that even if there hasbeen a significant decrease in the volume and level of activity for the assetor liability and regardless of the valuation technique(s) used, theobjective of a fair value measurement remains the same. Fair value is the pricethat would be received upon sale of an asset or paid to transfer a liability inan orderly transaction (that is, not a forced liquidation or distressed sale)between market participants at the measurement date under current marketconditions. This standard became effective for interim and annual reportingperiods ending after June 15, 2009, and is applied prospectively. Theadoption of this standard did not have an effect on the consolidated financialstatements.

 

The Company adopted a newaccounting standard included in ASC 825, “Financial Instruments” requiring  disclosures about fair value of financialinstruments for interim reporting periods of publicly traded companies as wellas in annual financial statements. This standard became effective for interimand annual reporting periods ending after June 15, 2009. The adoption ofthis standard did not have an effect on the consolidated financial statements.

 

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# ** **

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

# ** **

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

 
| Sale  price                         |   | $       | 36,000 |   |
|-------------------------------------|--------|---------|--------|--------|
| Working  capital adjustments        |   | (1,091  | )      |
|                                |   | 34,909  |   |
| Transaction  costs                  |   | (100    | )      |
| Net  assets of dunnage bag business |   | (18,392 | )      |
| Gain  on sale                       |   | $       | 16,417 |   |

 

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

 
| ** **                             | ** ** | **(unaudited)**    | ** ** | ** **            | ** ** |
|----------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                             | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| Trade  accounts receivable, net        |       | $                  | 2,793      |                  | $          | 2,742 |   |
| Inventories                            |       | 4,850              |       | 5,281                 |       |
| Plant,  property and equipment         |       | 2,261              |       | 2,318                 |       |
| Intangible  assets                     |       | 5,701              |       | 5,727                 |       |
| Goodwill                               |       | 3,934              |       | 1,064                 |       |
| Accounts  payable and accrued expenses |       | (1,147             | )          | (2,522                | )          |
| Total  net assets                      |       | $                  | 18,392     |                  | $          | 14,610 |   |

 

As a result of the sale,the Company incurred an earn-out liability of $4.0 million in accordance withthe Kraft Paper Business (“KPB”) asset purchase agreement dated June 23,2006 with International Paper Company (“IP”). The terms of the KPB assetpurchase agreement include a contingent earn-out payment due in 2012 (the fifthanniversary of the acquisition); however, in the event of a sale of the dunnagebag business prior to that date, a percentage of the earn-out becomes due andpayable within 30 days following the sale provided certain criteria are met.The earn-out was paid on April 30, 2009.

 

The terms of the dunnagebag sale agreement include a contingency for certain slow-moving inventoryitems, which were excluded from the working capital adjustment calculated atclosing. In the quarter ended September 30, 2009, the Company incurredapproximately $0.3 million for working capital adjustments related to this contingency.

 

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

 

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

# ** **

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

 

In March 2009, theInternal Revenue Service approved the Company’s registration as an alternativefuel mixer. The Company generated refund claims totaling $121.9 million for thefirst nine months of 2009 covering fuel used at its Charleston mill from January 29th through September 30th and at itsRoanoke Rapids mill from February 14th  through September 30th.  At September 30,2009, $14.4 million of the credit was included as a reduction to finished goodsinventory. For the three and nine month periods ended September 30, 2009,$53.5 million and $107.5 million, respectively, of the alternate fuel mixturetax credits were recorded as a reduction to cost of sales.

 

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The alternate fuelmixture tax credit is scheduled to expire on December 31, 2009.

 

# **6.             Inventories**

# ** **

Inventories consist ofthe following at September 30, 2009, and December 31, 2008,respectively (in thousands):

 
| ** **                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| Raw materials                   |       | $                      | 13,702     |                  | $          | 19,877 |   |
| Work in process                 |       | 1,155                  |       | 2,070                 |       |
| Finished goods                  |       | 27,576                 |       | 49,804                |       |
| Replacement parts and  supplies |       | 19,167                 |       | 17,941                |       |
| Total inventories               |       | $                      | 61,600     |                  | $          | 89,692 |   |

 

**7.             Accrued Expenses**

 

Accrued expenses consistof the following at September 30, 2009, and December 31, 2008,respectively (in thousands):

 
| ** **                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| Accrued interest                 |       | $                      | 115        |                  | $          | 7,024 |   |
| Accrued taxes other  than income |       | 4,166                  |       | 6,896                 |       |
| Accrued energy costs             |       | 4,301                  |       | 5,453                 |       |
| Other accuals                    |       | 8,025                  |       | 11,089                |       |
| Total accued expenses            |       | $                      | 16,607     |                  | $          | 30,462 |   |

 

**8.             Long-Term Debt**

 

Long-term debt and notesat September 30, 2009 and December 31, 2008, are summarized asfollows (in thousands):

 
| ** **                                                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| ** **                                                      | ** ** | ** **             | ** ** | ** **            | ** ** |
| Term A loan with interest payable monthly at LIBOR  plus 2.625% |       | $                      | 206,650    |                  | $          | 364,616 |   |
| Term B loan with interest payable monthly at LIBOR  plus 3.5%   |       | 13,247                 |       | 23,373                |       |
| Senior Notes with interest payable quarterly at  8.3%           |       | —                 |       | 40,000                |       |
| Revolving credit facility (4.75% at  December 31, 2008)    |       | —                 |       | 12,400                |       |
| Sub-total                                                       |       | 219,897                |       | 440,389               |       |
| Less current portion of long-term debt and notes                |       | (25,960                | )          | (40,556               | )          |
| Less unamortized debt issuance costs                            |       | (6,878                 | )          | (10,459               | )          |
|                                                            |       |                   |       |                  |       |   |   |
| Total long-term debt and notes, net                             |       | $                      | 187,059    |                  | $          | 389,374 |   |

 

In accordance with theCompany’s Senior Credit Agreement, $85.2 million of mandatory prepayments weremade as a result of exercises of common stock warrants in the quarter ended September 30,2009. In addition, the Company made voluntary prepayments of $30.2 million. Inconnection with the mandatory and voluntary prepayments, the Company amortizedan additional $1.2 million of debt issuance costs in the quarter ended September 30,2009.

 

In the quarter ended September 30,2009, the Company extinguished the remaining $33.6 million of its senior notesin addition to a scheduled principal payment of $3.0 million. In connectionwith the extinguishment the Company amortized an additional $0.6 million ofdebt issuance costs.

 

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# ** **

# **At September 30,2009, $13.0 million of letters of credit were outstanding under the SeniorCredit Agreement.**

# ** **

# **9.**                                      Income Taxes

# ** **

The Company’s U.S.federal statutory income tax rate is 35.0% for 2009 and 2008. The Company’seffective tax rate for the nine months ended September 30, 2009 and 2008was 39.0% and 39.3%, respectively.

 

During the three monthsended September 30, 2009, the Company established a $41.3 million liability forunrecognized tax benefits related to the tax position taken regarding thealternative fuel mixture tax credits all of which would impact the effectivetax rate if recognized. It is reasonably possible that the total amount ofunrecognized tax benefit relating to the tax position taken regarding thealternative fuel mixture tax credits will increase by approximately $27.7million within the next twelve months.

 

In the normal course ofbusiness, we are subject to examination by taxing authorities. The Company’sopen tax years are 2006 through 2008. The Company’s 2007 and 2008 federalincome tax returns are currently under examination by the Internal RevenueService (IRS).

 

**10.          Net Income Per Share**

 

Basic and diluted netincome per share is calculated as follows (in thousands except for share andper share data):

 
| ** **                                                               | ** ** | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                               | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net income as reported                                                   |       | $                                          | 25,672     |                                      | $          | 2,305 |   | $ | 54,896 |   | $ | 17,786 |   |
| Weighted-average number  of common shares for basic net income per share |       | 36,548,515                                 |       | 26,904,070                                |       | 31,096,354 |   | 25,859,149 |   |
| Incremental effect of  dilutive common stock equivalents:                |       |                                       |       |                                      |       |   |   |   |   |
| Common stock warrants                                                    |       | —                                     |       | 10,734,412                                |       | — |   | 10,331,418 |   |
| Underwriter’s purchase  option                                      |       | —                                     |       | 243,280                                   |       | — |   | 120,111 |   |
| Unvested stock options                                                   |       | 92,083                                     |       | —                                    |       | 30,694 |   | — |   |
| Unvested restricted  stock awards                                        |       | 300,175                                    |       | 130,873                                   |       | 228,737 |   | 119,215 |   |
|                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average number  of shares for diluted net income                |       | 36,940,773                                 |       | 38,012,635                                |       | 31,355,785 |   | 36,429,893 |   |
|                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Net income per share –  basic                                       |       | $                                          | 0.70       |                                      | $          | 0.09 |   | $ | 1.77 |   | $ | 0.69 |   |
|                                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Net income per share –  diluted                                     |       | $                                          | 0.69       |                                      | $          | 0.06 |   | $ | 1.75 |   | $ | 0.49 |   |

# ** **

Common stock warrantswere not included in the calculation of diluted earnings per share for thethree and nine months ended September 30, 2009 since the weighted averageshare price per share of common stock was $4.96 and $3.42, respectively,compared to the warrant’s conversion price of $5.00 and the effect would beanti-dilutive.

 

Stock option grantstotaling 2.1 million and 2.2 million were outstanding during the three and ninemonths ended September 30, 2009, respectively, but were not included inthe computation of diluted earnings per share because the effect of includingthe stock option grants would be anti-dilutive. Stock option grants totaling1.3 million were outstanding during the three and nine months ended September 30,2008, but were not included in the computation of diluted earnings per sharebecause the effect of including the stock option grants would be anti-dilutive.

 

Underwriter’s purchaseoption with respect to 1,000,000 Units was outstanding during the three andnine months ended September 30, 2009, but such Units were not included inthe computation of diluted earnings per share because the effect of includingthe underwriter’s option would be anti-dilutive.

 

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

# ** **

**DefinedBenefit Plan**

 

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

 

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

 

Net pension costrecognized for the three and nine months ended September 30, 2009 and 2008for the Company’s pension plan, is as follows (in thousands):

 
| ** **                                        | ** ** | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                        | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                              |       |                                       |       |                                      |       |   |   |   |   |
| Service cost for  benefits earned during the year |       | $                                          | 703        |                                      | $          | 694 |   | $ | 2,145 |   | $ | 1,306 |   |
| Interest cost on projected  benefit obligation    |       | 93                                         |       | 60                                        |       | 280 |   | 138 |   |
| Expected return on plan  assets                   |       | (38                                        | )          | (7                                        | )          | (115 | ) | (19 | ) |
| Net pension cost                                  |       | $                                          | 758        |                                      | $          | 747 |   | $ | 2,310 |   | $ | 1,425 |   |

 

KapStone funds its Planaccording to IRS funding requirements. Based on those requirements, the Companyfunded $3.8 million to the Plan for the nine months ended September 30,2009. An additional $1.7 million is planned to be funded prior to December 31,2009.

 

**OtherPost-Retirement Benefits**

 

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

 

**DefinedContribution Plans**

 

The KapStone DefinedContribution Plan (“Contribution Plan”) covers all eligible employees. Companycontributions to the Contribution Plan are based on matching of employeecontributions, vest immediately for salaried and non-bargained hourly employeesand vest after three years for union employees. For the three months ended September 30,2009 and 2008, the Company recognized expense of $0.4 million and $0.8 million,respectively, for matching contributions. For the nine months ended September 30,2009 and 2008, the Company recognized expense of $1.6 million and $1.5 million,respectively, for matching contributions.

 

The Company’s RetirementSavings Plan, which covers all eligible salaried and non-bargained hourlyemployees, provides for an annual contribution based on an employee’s salaryand age.  The Company contributions vest 100% after three years. For thethree months ended September 30, 2009 and 2008, the Company recognizedexpense of $0 and $0.5 million, respectively. For the nine months ended September 30,2009 and 2008, the Company recognized expense of $0 and $0.8 million,respectively.

 

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

 

**12.          Stock-Based Compensation**

 

On December 29,2006, stockholders approved the 2006 Incentive Plan (“2006 Plan”).  Amaximum of 3.0 million shares of our common stock, available for issuancepursuant to stock options, restricted stock awards or stock appreciation rights(collectively called “Awards”), may be granted under the 2006 Plan. If anyAward is forfeited or expires without being exercised, or if restricted stockis repurchased by the Company, the shares of stock subject to the Award shallbe available for additional grants under the 2006 Plan. Awards may be grantedto employees, officers and directors of, and consultants or advisors to, theCompany and any subsidiary corporations. Options intended to qualify, under the standards set forth in certain federaltax rules, as incentive stock options (“ISOs”) may be granted only toemployees.

 

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The Company accounts forstock awards under ASC 718,**Compensation- Stock Compensation, which requires that the cost resulting from allshare-based payment transactions be recognized as compensation cost over thevesting period based on the fair value of the instrument on the date of grant.The Company recognized $0.6 million and $1.7 million of compensation cost forthe three and nine months ended September 30, 2009, respectively, and $0.5million and $1.2 million for the three and nine months ended September 30,2008, respectively.

 

**StockOptions**

 

In May 2009, theCompany’s Compensation Committee granted 829,702 stock options to directors,executive officers and employees of the Company.  The stock options vest as follows: 50% aftertwo years and the remaining 50% after three years.  The stock optionsawarded in 2009 have a contractual term of ten years. The stock options aresubject to forfeiture should the recipient terminate his or her employment withthe Company for certain reasons prior to vesting in their awards, or theoccurrence of certain other events such as termination with cause. The exerciseprice of these stock options is based on the closing market price of our commonstock on the date of grant (May 13, 2009 for the 2009 awards) andcompensation expense is recorded on an accelerated basis over the awards’vesting periods.

 

The fair value of theKapStone stock options granted in May 2009 was $1.79. The fair value wascalculated using the Black-Scholes-Merton option-pricing model based on themarket price at the grant date and the weighted average assumptions specific tothe underlying options. The expected volatility assumption is based onvolatility of related industry stocks. The Company uses the “simplified method”,defined in SEC Staff Accounting Bulletin (“SAB”) No. 110, to determine theexpected life assumption for all of its options.  The Company uses the “simplifiedmethod”, as permitted by SAB No. 110, as it does not have historicalexercise data to provide a reasonable basis upon which to estimate expectedlife due to the limited time its equity shares have been publicly traded.The risk-free interest rate was selectedbased upon yields of U.S. Treasury issues with a term similar to the expectedlife of the stock options.

 

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

 
| ** **                                                                   | ** ** | **Nine Months  Ended********September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2009**                                              | ** ** |
| KapStone Stock  Options Black-Scholes-Merton assumptions (weighted average): |       |                                                  |       |
| Expected  volatility                                                         |       | 47.0                                                  | %          |
| Expected  life (years)                                                       |       | 6.25                                                  |       |
| Risk-free  interest rate                                                     |       | 2.3                                                   | %          |
| Expected  dividend yield                                                     |       | —                                                | %          |

 

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

# ** **

| ** **                                  | ** ** | **Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Intrinsic  Value (dollars  in Thousands)** | ** ** |
|---------------------------------------------|------------|-------------|------------|---------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| **Outstanding  at January 1, 2009**    |       | 1,346,347   |       | $                                     | 6.87       |                                           | 7.7        |                                         | $          | (6,045 | ) |
| Granted                                     |       | 829,702     |       | 3.70                                  |       | 9.7                                            |       | 3,684                                        |       |
| Exercised                                   |       | —      |       | —                                |       | —                                         |       | —                                       |       |
| Lapsed (forfeited or  canceled)             |       | (9,522      | )          | 6.85                                  |       | —                                         |       | —                                       |       |
| **Outstanding  at September 30, 2009** |       | 2,166,527   |       | $                                     | 5.66       |                                           | 7.9        |                                         | $          | 5,381 |   |
| **Exercisable  at September 30, 2009** |       | 308,525     |       | $                                     | 6.76       |                                           | 4.6        |                                         | $          | 852 |   |

# ** **

Total stock-basedcompensation related to the stock option grants was $0.4 million and $1.0million for the three and nine months ended September 30, 2009,respectively, and $0.3 million and $0.7 million for the three and nine monthsended September 30, 2008, respectively.

 

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As of September 30,2009 and 2008, there was $1.9 million and $1.8 million, respectively, of totalunrecognized compensation cost related to non-vested stock options. The cost isexpected to be recognized over a weighted average period of two years.

 

**RestrictedStock**

 

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

 

The following tablesummarizes our restricted stock amounts and activity:

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

 

Total stock-basedcompensation related to the restricted stock awards was $0.3 million and $0.7million for the three and nine months ended September 30, 2009,respectively, and $0.2 million and $0.5 million for the three and nine monthsended September 30, 2008, respectively.

 

As of September 30,2009 and 2008, there was $1.5 million and $1.6 million, respectively, of totalunrecognized compensation cost related to the restricted stock which will berecognized over the remaining vesting period of approximately two years. Norestricted stock awards were vested as of September 30, 2009.

 

# **13.             Stockholder’sEquity**

# ** **

In connection with theCompany’s initial public offering, on August 19, 2005, the Company sold 20,000,000units (“Units”) for a gross price of $6.00 per Unit. Each Unit consists of oneshare of the Company’s common stock, $0.0001 par value, and two warrants. Eachwarrant entitled the holder to purchase from the Company one share of commonstock at an exercise price of $5.00 with an expiration date of August 17,2009. For the three and nine months ended September 30, 2009, 17,043,376common stock warrants were exercised with proceeds totaling $85.2 million. On August 17,2009, the 19,371,454 remaining warrants expired.

 

For the three and ninemonths ended September 30, 2008, 2,810,615 and 3,029,180, respectively,common stock warrants were exercised with proceeds totaling $14.1 million and$15.1 million, respectively.

 

**14.          Annual Planned Maintenance Outage**

 

Cost of sales for thethree and nine month periods ended September 30, 2008 includedapproximately $6.0 million for the annual planned maintenance outage for theCompany’s North Carolina unbleached kraft paper facility. The annual plannedmaintenance outage in 2009 occurred in October 2009.

 

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**15.          Segment Information**

 

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

 

The Company’s reportableand operating segments are based on financial information regularly evaluatedby the chief operating decision maker in determining resource allocation andassessing performance, in accordance with ASC 280, Segment Reporting. Inthe third quarter 2009 the Company revised its reporting structure and as aresult the lumber mill operation is now included in the unbleached kraftsegment.

 

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

 

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

 

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

 
| ** **                            | ** ** | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| **Operating  Segment (in thousands)** | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net sales:                            |       |                                       |       |                                      |       |   |   |   |   |
| Unbleached kraft                      |       | $                                          | 170,335    |                                      | $          | 199,601 |   | $ | 461,384 |   | $ | 320,506 |   |
| All other                             |       | —                                     |       | 8,906                                     |       | 6,927 |   | 25,703 |   |
| Intersegment sales                    |       | —                                     |       | (836                                      | )          | (899 | ) | (3,247 | ) |
|                                  |       |                                       |       |                                      |       |   |   |   |   |
| Total                                 |       | $                                          | 170,335    |                                      | $          | 207,671 |   | $ | 467,412 |   | $ | 342,962 |   |
|                                  |       |                                       |       |                                      |       |   |   |   |   |
| Net sales to external  customers:     |       |                                       |       |                                      |       |   |   |   |   |
| Unbleached kraft                      |       | $                                          | 170,335    |                                      | $          | 198,765 |   | $ | 460,485 |   | $ | 317,259 |   |
| All other                             |       | —                                     |       | 8,906                                     |       | 6,927 |   | 25,703 |   |
|                                  |       |                                       |       |                                      |       |   |   |   |   |
| Total                                 |       | $                                          | 170,335    |                                      | $          | 207,671 |   | $ | 467,412 |   | $ | 342,962 |   |
|                                  |       |                                       |       |                                      |       |   |   |   |   |
| Operating  income/(loss):             |       |                                       |       |                                      |       |   |   |   |   |
| Unbleached kraft                      |       | $                                          | 51,952     |                                      | $          | 19,608 |   | $ | 105,245 |   | $ | 50,087 |   |
| All other                             |       | —                                     |       | 1,608                                     |       | 748 |   | 4,209 |   |
| Gain/(loss) on sale of  business      |       | (278                                       | )          | —                                    |       | 16,417 |   | — |   |
| Corporate                             |       | (5,175                                     | )          | (7,070                                    | )          | (16,306 | ) | (15,279 | ) |
|                                  |       |                                       |       |                                      |       |   |   |   |   |
| Total                                 |       | $                                          | 46,499     |                                      | $          | 14,146 |   | $ | 106,104 |   | $ | 39,017 |   |

 
| ** **                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |    |   |   |   |
|---------------------------------------|------------|------------------------|------------|-----------------------|------------|---------|--------|--------|--------|
| **Operating  Segment (in thousands)** | ** ** | **2009**               | ** ** | **2008**              | ** ** |    |   |   |   |
| Total assets:                         |       |                   |       |                  |       |    |   |   |   |
| Unbleached kraft                      |       | $                      | 640,147    |                  | $          | 679,606 |   |   |   |   |   |
| All other                             |       | —                 |       | 17,132                |       |    |   |   |   |
| Corporate                             |       | 20,414                 |       | 30,452                |       |    |   |   |   |
|                                  |       |                   |       |                  |       |    |   |   |   |
| Total                                 |       | $                      | 660,561    |                  | $          | 727,190 |   |   |   |   |   |

 

**16.          Subsequent Event**

 

Subsequentto the balance sheet date of September 30, 2009, the Company made a $25.0million voluntary prepayment on its long-term debt.

 

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

 

This Quarterly Report on Form 10-Qincludes forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended. We have based theseforward-looking statements on our current expectations and projections aboutfuture events. These forward-looking statements are subject to known andunknown risks, uncertainties and assumptions about us that may cause our actualresults, levels of activity, performance or achievements to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by such forward-looking statements. In somecases, you can identify forward-looking statements by terminology such as “may,”“should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,”“continue,” or the negative of such terms or other similar expressions. Factorsthat might cause or contribute to such a discrepancy include, but are notlimited to, those described in Part II Item 1A in this Form 10-Q, in Part IItem 1A of our Form 10-K for the fiscal year ended December 31, 2008and in our other Securities and Exchange Commission filings.  Theinformation contained in this Form 10-Q represents our best judgment atthe date of this report based on information currently available.  Inproviding forward-looking statements, KapStone does not intend, and does notundertake any duty or obligations, to update its statements as a result of newinformation, future events or otherwise.

 

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

 

**Overview**

 

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

 

On January 2, 2007,the Company purchased substantially all of the assets and  assumed certainliabilities of the Kraft Papers Business (“ KPB”), a division of InternationalPaper Company, consisting of an unbleached kraft paper manufacturing facilityin Roanoke Rapids, North Carolina and Ride Rite® Converting, an inflatabledunnage bag manufacturer located in Fordyce, Arkansas, for a purchase price of$155 million in cash, less certain post-closing adjustments of $7.8 million,plus two contingent earn-out payments of up to $55 million (in aggregate andadjusted for the 2009 sale of Ride Rite® Converting), based on KPB’s annualearnings before interest, income taxes, depreciation and amortization, orEBITDA, during the five years immediately following the acquisition.

 

On July 1, 2008, theCompany  purchased substantially all ofthe assets and assumed certain liabilities of the Charleston KraftDivision (“CKD”), a division of MeadWestvaco Corporation (“MWV”), consisting ofan unbleached kraft paper manufacturing facility in North Charleston, SouthCarolina, including a cogeneration facility, chip mills located in Elgin,Hampton, Andrews and Kinards, South Carolina and a lumber mill located inSummerville, South Carolina, for a purchase price of $485 million less certainadjustments of $14.0 million.

 

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

 

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

 

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**Comparisonof Results of Operations for the Three Months Ended September 30, 2009 andthe Three Months Ended September 30, 2008**

** **
| ** **                                              | ** ** | **Three  Months Ended September 30,** | ** ** | **Increase/** | ** ** | **%  Increase/** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------|------------|---------------|------------|------------------|------------|
| **(In  thousands)**                                     | ** ** | **2009**                                   | ** ** | **2008**      | ** ** | **(Decrease)**   | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                          | 170,335    |          | $          | 207,671          |       | $ | (37,336 | ) | -18.0 | % |
| Cost of sales,  excluding depreciation and amortization |       | 86,812                                     |       | 151,064       |       | (64,252          | )          | -42.5 | % |
| Freight and  distribution expenses                      |       | 16,262                                     |       | 19,969        |       | (3,707           | )          | -18.6 | % |
| Selling, general and  administrative expenses           |       | 7,105                                      |       | 9,757         |       | (2,652           | )          | -27.2 | % |
| Depreciation and  amortization                          |       | 13,664                                     |       | 12,953        |       | 711              |       | 5.5 | % |
| Loss on sale of  business                               |       | (278                                       | )          | —        |       | (278             | )          | N/A |   |
| Other operating income                                  |       | 285                                        |       | 218           |       | 67               |       | 30.7 | % |
| Operating income                                        |       | 46,499                                     |       | 14,146        |       | 32,353           |       | 228.7 | % |
| Foreign exchange  gain/(loss)                           |       | 175                                        |       | (607          | )          | 782              |       | 128.8 | % |
| Interest income                                         |       | —                                     |       | 51            |       | (51              | )          | -100.0 | % |
| Interest expense                                        |       | 5,353                                      |       | 8,772         |       | (3,419           | )          | -39.0 | % |
| Income before provision  for income taxes               |       | 41,321                                     |       | 4,818         |       | 36,503           |       | 757.6 | % |
| Provision for income  taxes                             |       | 15,649                                     |       | 2,513         |       | 13,136           |       | 522.7 | % |
| Net income                                              |       | $                                          | 25,672     |          | $          | 2,305            |       | $ | 23,367 |   | 1013.8 | % |

 

Net sales for the quarterended September 30, 2009, were $170.3 million compared to $207.7 millionfor the third quarter of 2008, a decrease of $37.4 million or 18.0%. Thedecrease in net sales was primarily due to $28.0 million of lower averagerevenue per ton and $11.8 million of a less favorable product mix due to ahigher percentage of linerboard sales, which has a lower average selling pricethan other products, offset by $11.3 million of higher sales volume. Inaddition, the sale of the dunnage bag business in the first quarter of 2009contributed $8.9 million of the decrease.

 

Cost of sales for thequarter ended September 30, 2009, was $86.8 million compared to $151.1million for the third quarter of 2008, a decrease of $64.3 million, or 42.5%.The decrease in cost of sales was mainly due to $53.5 million of alternativefuel mixture tax credits, $6.0 million as a result of a change in the timing ofthe annual planned maintenance outage from the third quarter in 2008 to thefourth quarter in 2009, $6.3 million due to the sale of the dunnage bagbusiness, $4.7 million of deflation on energy and raw materials and $2.1million of temporary salary and benefit curtailments, partially offset by $9.2million of higher volume and product mix.

 

Freight and distributionexpenses for the quarter ended September 30, 2009, totaled $16.3 millioncompared to $20.0 million for the third quarter of 2008. The decrease of $3.7million was mainly due to $2.6 million reflecting a higher percentage of 2009shipments being comprised of exports where the customer pays for the freightand $2.4 million of lower fuel oil surcharges and lower costs due to favorablefreight contract negotiations, offset by higher volume.

 

Selling, general and administrativeexpenses for the quarter ended September 30, 2009, totaled $7.1 millioncompared to $9.8 million for the third quarter of 2008. The decrease of $2.7million reflects $0.8 million of lower compensation and benefit expenses as theCompany temporarily suspended certain benefits as a result of economicconditions, $0.5 million of lower transitional services provided by MWV and$1.5 million of lower CKD acquisition start-up expenses. As a percent of netsales, selling, general and administrative expenses dropped from 4.7% in 2008to 4.2% in 2009.

 

Depreciation andamortization for the quarter ended September 30, 2009, totaled $13.7million compared to $13.0 million for the third quarter of 2008. The increaseof $0.7 million is primarily due to higher capital expenditures.

 

The loss on sale ofbusiness of $0.3 million is the result of working capital adjustments inconnection with the sale of the dunnage bag business. The dunnage bag businesswas sold in March 2009.

 

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Foreignexchange gains for the quarter ended September 30, 2009 increased by $0.8million compared to the same period in 2008. The increase reflects theweakening of the U.S. dollar in the third quarter of 2009 of approximately 4%,compared to the strengthening of the U.S. dollar in the third quarter of 2008of approximately 8%.

 

Interestincome for the quarter ended September 30, 2009 decreased by $0.1 millioncompared with the same period in 2008. Due to lower interest rates in 2009, theCompany used its excess cash to pay down principal balances on its long-termdebt rather than investing.

 

Interestexpense for the quarters ended September 30, 2009 and 2008 was $5.4million and $8.8 million, respectively. Interest expense reflects interest onthe Company’s long-term debt and amortization of debt issuance costs. Interestexpense was $3.4 million lower in the quarter ended September 30, 2009primarily due to lower debt levels and lower interest rates. Amortization ofdebt issuance costs for the quarters ended September 30, 2009 and 2008 was$2.5 million and $0.8 million, respectively. The increase of $1.7 million isprimarily due to $1.9 million of accelerated amortization expense in connectionwith mandatory and voluntary debt prepayments during the three months ended September 30,2009.

 

Provisionfor income taxes for the quarters ended September 30, 2009 and 2008 was$15.6 million and $2.5 million, respectively. The increase of $13.1 million isa result of $36.5 million of higher pre-tax income. The effective tax rate forthe quarter ended September 30, 2009 was 37.9% compared to 52.2% for thesimilar period in 2008.The effective tax rate for the quarter ended September 30, 2009 decreasedfrom the same period in 2008 due to a higher expected benefit from the federaldomestic manufacturing deduction.

 

**SegmentResults**

 

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

 
| ** **                            | ** ** | **Three  Months Ended September 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| **Operating  Segment (in thousands)** | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| Consolidated net sales:               |       |                                       |       |   |   |
| Unbleached kraft                      |       | $                                          | 170,335    |   | $ | 199,601 |   |
| All other                             |       | —                                     |       | 8,906 |   |
| Intersegment sales                    |       | —                                     |       | (836 | ) |
|                                  |       |                                       |       |   |   |
| Total net sales                       |       | $                                          | 170,335    |   | $ | 207,671 |   |
|                                  |       |                                       |       |   |   |
| Operating  income/(loss):             |       |                                       |       |   |   |
| Unbleached kraft                      |       | $                                          | 51,952     |   | $ | 19,608 |   |
| All other                             |       | —                                     |       | 1,608 |   |
| Loss on sale of  business             |       | (278                                       | )          | — |   |
| Corporate                             |       | (5,175                                     | )          | (7,070 | ) |
|                                  |       |                                       |       |   |   |
| Total operating income                |       | $                                          | 46,499     |   | $ | 14,146 |   |

 

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

 

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***Unbleached Kraft***

 
| ** **                       | ** ** | **Three  Months Ended September 30,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| Net sales                        |       | $                                          | 170,335    |   | $ | 199,601 |   |
| Operating income                 |       | 51,952                                     |       | 19,608 |   |
| Operating income % of  net sales |       | 30.5                                       | %          | 9.8 | % |
|                             |       |                                       |       |   |   |
| Average revenue per ton          |       | $                                          | 495        |   | $ | 605 |   |
| Tons of paper sold               |       | 331,879                                    |       | 321,792 |   |

 

For the three monthsended September 30, 2009, unbleached kraft segment net sales decreased by$29.3 million, or 14.7%, to $170.3 million compared to$199.6 million for the three months ended September 30, 2008. The decreasein net sales was primarily due to $28.0 million of lower average revenue perton, as per ton prices decreased from $605 per ton in 2008 to $495 per ton inthe third quarter of 2009, or a reduction of $110 per ton, reflecting theimpact of market driven price reductions, and $11.8 million of a less favorableproduct mix, as shipments of linerboard accounted for a higher percentage oftons of paper sold, offset by $10.5 million of higher sales volume.

 

Unbleached kraft segmentoperating income increased by $32.4 million, or 165.3%, to$52.0 million for the three months ended September 30, 2009 comparedto $19.6 million for the three months ended September 30, 2008.Operating income increased by $53.5 million due to alternate fuel mixture taxcredits, $6.0 million as a result of a change in the annual planned maintenanceoutage from the third quarter in 2008 to the fourth quarter in 2009, $7.1million of deflation on energy and raw materials, $5.5 million due to an increasein volume and $2.4 million of temporary salary and benefit curtailments,partially offset by $28.0 million of lower average revenue per ton, $11.5million of a less favorable product mix and $2.5 million due to an unplannedoutage, which includes $1.1 million of lost alternative fuel mixture taxcredits. Included in operating income, for both quarters in 2009 and 2008, is$2.4 million of amortization for an intangible asset, acquired as part of theCKD acquisition, consisting of a coal contract with favorable prices.  The coal contract will terminate on December 31,2009.

 

For the quarter ended September 30,2009, operating income as a percentage of net sales increased to 30.5% from9.8% for the third quarter of 2008 due to alternative fuel mixture tax creditsand the change in timing of the annual planned maintenance outage, partiallyoffset by lower margins on sales.

 

***All Other***

 
| ** **                       | ** ** | **Three  Months Ended September 30,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| Net sales                        |       | $                                          | —     |   | $ | 8,906 |   |
| Operating income                 |       | —                                     |       | 1,608 |   |
| Operating income % of  net sales |       | —                                     |       | 18.1 | % |
|                                  |            |                                            |            |  |  |  |  |

 

The dunnage bag businesswas sold March 31, 2009.

 

***Corporate***

 

Corporate expenses forthe three months ended September 30, 2009 totaled $5.2 millioncompared to $7.1 million for the three months ended September 30,2008. The decrease of $1.9 million is primarily due to $1.5 million oflower start-up expenses related to the CKD acquisition, $0.5 million of lowercompensation and benefit expenses as the Company temporarily suspended certainbenefits as a result of economic conditions and $0.5 million of lowertransitional services provided by MWV, partially offset by other expenseincreases of $0.6 million.

 

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**Comparisonof Results of Operations for the Nine Months Ended September 30, 2009 andthe Nine Months Ended September 30, 2008**

** **
| ** **                                              | ** ** | **Nine  Months Ended September 30,** | ** ** | **Increase/** | ** ** | **%  Increase/** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|------------|---------------|------------|------------------|------------|
| **(In  thousands)**                                     | ** ** | **2009**                                  | ** ** | **2008**      | ** ** | **(Decrease)**   | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                         | 467,412    |          | $          | 342,962          |       | $ | 124,450 |   | 36.3 | % |
| Cost of sales,  excluding depreciation and amortization |       | 271,650                                   |       | 233,422       |       | 38,228           |       | 16.4 | % |
| Freight and  distribution expenses                      |       | 42,755                                    |       | 33,480        |       | 9,275            |       | 27.7 | % |
| Selling, general and  administrative expenses           |       | 23,292                                    |       | 19,251        |       | 4,041            |       | 21.0 | % |
| Depreciation and  amortization                          |       | 40,761                                    |       | 18,381        |       | 22,380           |       | 121.8 | % |
| Gain on sale of  business                               |       | 16,417                                    |       | —        |       | 16,417           |       | N/A |   |
| Other operating income                                  |       | 733                                       |       | 589           |       | 144              |       | 24.4 | % |
| Operating income                                        |       | 106,104                                   |       | 39,017        |       | 67,087           |       | 171.9 | % |
| Foreign exchange  gain/(loss)                           |       | 48                                        |       | (607          | )          | 655              |       | 107.9 | % |
| Interest income                                         |       | 1                                         |       | 891           |       | (890             | )          | -99.9 | % |
| Interest expense                                        |       | 16,097                                    |       | 9,985         |       | 6,112            |       | 61.2 | % |
| Income before provision  for income taxes               |       | 90,056                                    |       | 29,316        |       | 60,740           |       | 207.2 | % |
| Provision for income  taxes                             |       | 35,160                                    |       | 11,530        |       | 23,630           |       | 204.9 | % |
| Net income                                              |       | $                                         | 54,896     |          | $          | 17,786           |       | $ | 37,110 |   | 208.6 | % |

 

Net sales for the ninemonths ended September 30, 2009, were $467.4 million compared to $343.0million for the first nine months of 2008, an increase of $124.4 million or36.3%. The increase in net sales was due to nine months of sales in 2009 forCKD (acquisition consummated on July 1, 2008) compared to three months forthe same period in 2008, which increased sales by $188.2 million. Excluding theadditional six months of CKD’s results, net sales were lower in the first ninemonths of 2009, compared to the same period in 2008 by $63.8 million of which$18.8 million is a result of the sale of the dunnage bag business on March 31,2009. In addition, net sales decreased by $34.7 million due to lower averagerevenue per ton and $14.2 million due to a less favorable product mix, as theCompany had a higher percentage of linerboard sales, which has a lower averageselling price than other products, offset by an increase of $3.9 million ofvolume.

 

Cost of sales for thenine months ended September 30, 2009, was $271.7 million compared to$233.4 million for the first nine months of 2008, an increase of $38.3 million,or 16.4%. Excluding $130.7 million for the additional six months of CKD’sresults, cost of sales decreased by $92.4 million due to $73.3 million ofalternative fuel mixture tax credits and $13.2 million due to the sale of thedunnage bag business in the first quarter of 2009. Cost of sales also decreasedby $6.0 million as a result of a change in the timing of the annual maintenanceoutage from the third quarter in 2008 to the fourth quarter in 2009. Inaddition, deflation on energy and raw materials decreased costs by $3.7 millionand temporary salary and benefit curtailments decreased costs by $2.7 million,partially offset by $5.0 million of additional costs due to product mix andvolume.

 

The total amount ofalternative fuel mixture tax credits recorded as a reduction in cost of salesfor the first nine months of 2009 was $107.5 million of which $34.2 million isincluded in the additional six months of CKD’s results.

 

Freight and distributionexpenses for the nine months ended September 30, 2009, totaled $42.8million compared to $33.5 million for the nine months ended September 30,2008, an increase of $9.3 million. Excluding $15.9 million for the additional six months of CKD’s resultsand $1.0 million for the sale of the dunnage bag business, freight anddistribution expenses were $5.6 million lower in 2009, mainly due to $3.0million reflecting a higher percentage of 2009 shipments being comprised ofexports where the customer pays for the freight and $3.7 million of lower fueloil surcharges and lower costs due to favorable freight contract negotiations,offset by higher volume.

 

Selling, general andadministrative expenses for the nine months ended September 30, 2009,totaled $23.3 million compared to $19.3 million for the similar period in 2008.The increase of $4.0 million reflects $4.2 

 

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million for an additionalsix months of CKD’s results, $2.4 million oftransitional services provided by MWV, $1.7 million of professional fees andservices and $0.7 million of bad debt expenses for three customerbankruptcies, partially offset by $2.3million of lower compensation and benefit expenses as the Company temporarilysuspended certain benefits as a result of economic conditions and $1.6 millionof lower start-up expenses related to the CKD acquisition. As a percent of netsales, selling, general and administrative expenses dropped from 5.6% in 2008to 5.0% in 2009.

 

Depreciation andamortization for the nine months ended September 30, 2009, totaled $40.8million compared to $18.4 million for the nine month period ended September 30,2008. The increase of $22.4 million was mainly due to the additional six monthsof CKD’s results, which added an additional $14.3 million of depreciation and$6.7 million of amortization of intangibles, including $4.9 million ofamortization for the intangible asset related to an acquired coal contract withbelow market prices at July 1, 2008. The acquired coal contract expires December 31,2009. Excluding the additional six months of CKD results, depreciation andamortization increased by $1.4 million primarily due to an upgrade to theCompany’s Enterprise Resource Planning (“ERP”) system and other capitalexpenditures.

 

The $16.4 million gain onsale of business is the result of the sale of the dunnage bag business toIllinois Tool Works Inc. on March 31, 2009.

 

Foreignexchange gains for the nine months ended September 30, 2009 increased by$0.7 million compared to the same period in 2008. The increase reflects theweakening of the U.S. dollar of approximately 4% in the first nine months of2009, compared to a strengthening of the U.S. dollar of approximately 8% forthe period of July 1, 2008 through September 30, 2008.  As a result of the CKD acquisition on July 1,2008 the Company acquired certain European customers which are invoiced ineuros.

 

Interestincome for the nine months ended September 30, 2009 decreased by $0.9million compared with the same period in 2008. Due to lower interest rates in2009 the Company used its excess cash to pay down principal balances on itslong-term debt rather than investing.

 

Interestexpense for the nine months ended September 30, 2009 and 2008 was $16.1million and $10.0 million, respectively. Interest expense reflects interest onthe Company’s long-term debt and amortization of debt issuance costs. Interestexpense was $6.1 million higher in the nine months ended September 30,2009 primarily due to higher debt levels relating to the CKD acquisition,partially offset by lower interest rates, and $1.9 million of acceleratedamortization expense related to mandatory and voluntary debt prepayments.Amortization of debt issuance costs for the period ended September 30,2009 was $4.2 million compared to $0.9 million for the same period in 2008.

 

Provisionfor income taxes for the nine months ended September 30, 2009 and 2008 was$35.2 million and $11.5 million, respectively, reflecting an effective tax rateof 39.0% compared to 39.3% for the similar period in 2008. The $23.7 millionincrease is a result of $60.7 million of higher pre-tax income.

 

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**SegmentResults**

 

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

 
| ** **                                          | ** ** | **Nine  Months Ended September 30,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| **Operating Segment (in thousands)** | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| Consolidated net sales:                             |       |                                      |       |   |   |
| Unbleached kraft                                    |       | $                                         | 461,384    |   | $ | 320,506 |   |
| All other                                           |       | 6,927                                     |       | 25,703 |   |
| Intersegment sales                                  |       | (899                                      | )          | (3,247 | ) |
|                                                |       |                                      |       |   |   |
| Total net sales                                     |       | $                                         | 467,412    |   | $ | 342,962 |   |
|                                                |       |                                      |       |   |   |
| Operating  income/(loss):                           |       |                                      |       |   |   |
| Unbleached kraft                                    |       | $                                         | 105,245    |   | $ | 50,087 |   |
| All other                                           |       | 748                                       |       | 4,209 |   |
| Gain on sale of  business                           |       | 16,417                                    |       | — |   |
| Corporate                                           |       | (16,306                                   | )          | (15,279 | ) |
|                                                |       |                                      |       |   |   |
| Total operating income                              |       | $                                         | 106,104    |   | $ | 39,017 |   |

 

 

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

 

***Unbleached Kraft***

 
| ** **                       | ** ** | **Nine  Months Ended September 30,** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| Net sales                        |       | $                                         | 461,384    |   | $ | 320,506 |   |
| Operating income                 |       | 105,245                                   |       | 50,087 |   |
| Operating income % of  net sales |       | 22.8                                      | %          | 15.6 | % |
|                             |       |                                      |       |   |   |
| Average revenue per ton          |       | $                                         | 533        |   | $ | 594 |   |
| Tons of paper sold               |       | 833,805                                   |       | 531,573 |   |

 

For the nine months endedSeptember 30, 2009, unbleached kraft segment net sales increased by$140.9 million, or 44.0%, to $461.4 million compared to$320.5 million for the nine months ended September 30, 2008. Theincrease in net sales was due to nine months of sales in 2009 for CKD comparedto three months for the same period in 2008, as the acquisition occurred on July 1,2008, which increased sales by $188.2 million. Excluding the additional sixmonths of CKD’s results, net sales were lower by $47.3 million in the firstnine months of 2009 compared to the first nine months of 2008, mainly due to$34.7 million of lower average revenue per ton and $14.2 million of a lessfavorable product mix, as the Company had a higher percentage of linerboardsales, offset by an increase in volume of $1.5 million.  Average revenueper ton in the first nine months of 2009 was $533 per ton, or $61 per ton lowerthan average revenue per ton in the first nine months of 2008.

 

Unbleached kraft segmentoperating income increased by $55.1 million, or 110.0%, to$105.2 million for the nine months ended September 30, 2009 comparedto $50.1 million for the nine months ended September 30, 2008.  Operating income increased by $16.3 milliondue to the additional six months of CKD’s results, $73.3 million due toalternate fuel mixture tax credits, $6.0 million as a result of a change in thetiming of the annual planned maintenance outage from the third quarter in 2008to the fourth quarter in 2009, $7.4 million of

 

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deflation on energy andraw materials and $3.0 million of salary and benefit curtailments, partiallyoffset by $34.7 million of lower average revenue per ton, $13.6 million of aless favorable product mix and $2.5 million due to an unplanned outage, whichincludes $1.1 million of lost alternative fuel mixture tax credits. Included inoperating income for the nine months ended September 30, 2009, is $7.3million of amortization for an intangible asset, acquired as part of the CKDacquisition, consisting of a coal contract with favorable prices. The coalcontract will terminate on December 31, 2009.

 

The total amount of thealternative fuel mixture tax credits recorded in operating income for the firstnine months of 2009 was $107.5 million of which $34.2 million is included inthe additional six months of CKD’s results.

 

For the nine months endedSeptember 30, 2009, operating income as a percentage of net sales increasedto 22.8% from 15.6% for the first nine months of 2008 mainly due to alternativefuel mixture tax credits, lower costs for energy and raw materials and changein the timing of the annual planned maintenance outage partially offset bylower margins on sales.

 

***All Other***

* *
| ** **                       | ** ** | **Nine  Months Ended September 30,** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| Net sales                        |       | $                                         | 6,927      |   | $ | 25,703 |   |
| Operating income                 |       | 748                                       |       | 4,209 |   |
| Operating income % of  net sales |       | 10.8                                      | %          | 16.4 | % |
|                                  |            |                                           |            |  |  |  |  |

 

For the nine months endedSeptember 30, 2009, net sales and operating income decreased due to thesale of the dunnage bag business on March 31, 2009.

 

***Corporate***

 

Corporate expenses forthe nine months ended September 30, 2009, totaled $16.3 million comparedto $15.3 million for the nine months ended September 30, 2008. Theincrease of $1.0 million is primarily due to $2.4 million reflecting ninemonths of transitional services provided by MWVin 2009 compared to three months in 2008, $1.7 million of professional andother services, partially offset by $2.0 million of lower compensationand benefit expenses as the Company temporarily suspended certain benefits as aresult of economic conditions and $1.6 million of lower start-up expensesrelated to the CKD acquisition.

 

**Liquidityand Capital Resources**

 

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

 

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

 

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

 

# **At September 30,2009, $13.0 million of letters of credit were outstanding under the SeniorCredit Agreement.**

# ** **

At September 30,2009, the Company had no outstanding borrowings under the revolving creditfacility.

 

***Debt Covenants***

 

Under the financialcovenants of the Senior Credit Agreement, KapStone must comply on a quarterlybasis with a maximum permitted leverage ratio that is currently 3.5 to 1. TheSenior Credit agreement also includes a

 

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financial covenantrequiring a minimum fixed charge coverage ratio that is 1.1 to 1.  At September 30,2009 the Company was in compliance with the Senior Credit Agreement with aleverage ratio of 1.42 to 1.00 and a fixed charge coverage ratio of 2.89 to1.00.  The maximum permitted leverageratios for the quarters ending September 30, 2009 and December 31,2009 are 3.5 to1. and 3.0 to 1, respectively. The minimum fixed charge coverageratio for the quarters ending September 30, 2009 and December 31,2009 is 1.1 to 1.

 

At September 30,2009, the Company was in compliance with all other applicable covenants in theSenior Credit Agreement.

 

***Alternative Fuel Mixture Tax Credit***

 

On March 31, 2009,the Company received approval from the Internal Revenue Service for itsregistration as an alternative fuel mixer, which provides for a refund of $0.50per gallon of alternate fuel used in the Company’s pulp making process. As aresult, for the nine months ended September 30, 2009, the Company receivedrefunds of $109.7 million.  The Company expects credits for the fourthquarter of 2009 to exceed $50.0 million.

 

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

 

***Sale of Dunnage Bag Business***

 

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

 

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

 

***Income Taxes***

 

For the nine months endedSeptember 30, 2009, the Company received $13.1 million of federal incometax refunds. No additional refunds are expected for 2009.

 

For 2010, the Company isevaluating two additional tax benefits that it may qualify for directly, orindirectly. The first is a tax credit under Section 40(b)(6) of $1.01per gallon tax credit for cellulosic biofuel producers. The second is a subsidyof up to $45 per dry ton under the Biomass Crop Assistance Program (BCAP) forsuppliers of biomass who sell to approved facilities, which will convertbiomass to energy.  Both KapStone’s millsare approved facilities, and the Company is researching how it can indirectlybenefit from this subsidy in the form of lower raw material costs.

 

***EarlyExtinguishment of Senior Notes***

 

In July 2009, theCompany extinguished its remaining balance of senior notes totaling $33.6million.

 

***Exercisesof warrants into common stock***

 

In August 2009, theCompany received $85.2 million from exercises of warrants into common stock.The entire proceeds were used to make mandatory prepayments on the Company’slong-term loans in accordance with the Senior Credit Agreement. On August 17,2009, the remaining balance of approximately 19 million warrants expired.

 

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***Sources and Uses of Cash***

 
| **Nine months ended  September 30 (in thousands)** | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating  activities                                   |       | $          | 123,790    |       | $          | 28,004 |   |
| Investing  activities                                   |       | 10,765     |       | (483,165   | )          |
| Financing  activities                                   |       | (135,646   | )          | (440,400   | )          |
|                                                         |            |            |            |            |            |  |  |

 

Cash flow from allactivities during the nine months ended September 30, 2009 decreased cashby $1.1 million from December 31, 2008, reflecting cash provided byoperations of $123.8 million, cash provided by investing activities of $10.8million offset by cash used in financing activities of $135.6 million.

 

Cash provided byoperating activities was $123.8 million due to $54.9 million of net income forthe first nine months of 2009 and $61.2 million of non-cash charges offset bythe gain on sale of the dunnage bag business of $16.4 million. Changes inoperating assets and liabilities provided $24.1 million.

 

Cash provided byinvesting activities was $10.8 million reflecting proceeds from the sale of thedunnage bag business of $34.9 million and a $1.0 million working capitaladjustment related to the CKD acquisition offset by $18.7 million of capitalexpenditures, $4.0 million for the KPB earn-out related to the sale of thedunnage bag business and $2.5 million of proceeds from the sale of the dunnagebag business held in escrow. For the nine months ended September 30, 2009,capital expenditures include $16.5 million for the unbleached kraft segment forequipment upgrades, IT projects and replacements at the paper mills. Inaddition, $2.2 million was spent on an upgrade to the Corporate ERP system.

 

Cash used in financingactivities totaled $135.6 million during the nine months ended September 30,2009, and reflects $284.8 million of repayments on long-term debt, notes andrevolver offset by borrowings under the revolving credit facility of $64.3million and $85.2 million of proceeds from the exercises of common stockwarrants.

 

***Future Cash Needs***

 

We expect that cashgenerated from operating activities, and if needed, the ability to draw fromour revolving credit facility will be sufficient to meet anticipated cashneeds.

 

Subsequentto the balance sheet date of September 30, 2009, the Company made a $25.0million voluntary prepayment on its long-term debt.

 

The Company expects tospend an additional $11.6 million on capital expenditures in 2009. In addition,the Company has $6.3 million of required long-term debt repayments for theremainder of 2009 and expects to fund $1.7 million to its Defined Benefit Planby December 31, 2009.

 

**Off-BalanceSheet Arrangements**

 

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

 

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

 

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

 

Under KapStone’s newSenior Credit Facilities, we have two term loans totaling $219.9 millionoutstanding at September 30, 2009.  The maturity date is the earlierof:  (a) June 12, 2013 with respect to the term A loan facilityand the revolving credit facility, and June 12, 2015 with respect to theterm B loan facility, and (b) the date which is 90 days prior to the dateon which any earn-out, obligations to IP will become (or are reasonablyexpected to become) due, excluding the earn-out as a result of the sale of thedunnage bag business; provided that the maturity date will not be soaccelerated if, among other things, the total leverage ratio as of the end ofthe then most recent fiscal quarter, is less than 3.5 to 1.0.

 

Changes in market ratesmay impact the base rate in our Senior Credit Agreement. For instance, if thebank’s LIBOR rate was to increase or decrease by one percentage point (1.0%),our annual interest expense would change by approximately $2.1 million basedupon our existing repayment schedule.

 

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

 

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

 

**Item 4. — CONTROLS AND PROCEDURES**

 

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

 

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

 

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**PART II. — OTHER INFORMATION**

 

**Item 1. — LEGAL PROCEEDINGS**

 

We are party to variouslegal proceedings arising from our operations. We establish reserves for claimsand proceedings when it is probable that liabilities exist and where reasonableestimates of such liabilities can be made. While it is not possible to predictthe outcome of any of these matters, based on our assessment of the facts andcircumstances now known, we do not believe that any of these matters,individually or in the aggregate, will have a material adverse effect on ourfinancial position. However, actual outcomes may be different from thoseexpected and could have a material effect on our results of operations or cashflows in a particular period.

 

**Item 1A. — RISK FACTORS**

 

With the exception of thefollowing updates to the risk factors relating to the alternative fuel mixturetax credit and the Company’s union contract in South Carolina, there have beenno material changes from the Risk Factors described in our Form 10-K forthe year ended December 31, 2008 (“Form 10-K”).  The Risk Factorbelow should be read in conjunction with the Risk Factors and informationdisclosed in our Form 10-K.

 

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

 

The U.S. governmentprovides an excise tax credit to taxpayers for the use of alternative fuelmixtures.  The alternative fuel mixture tax credit, as it relates toliquid fuel derived from biomass, is scheduled to expire on December 31,2009.  In recent months, certain members of Congress and others haveindicated their opposition to pulp and paper companies receiving the taxcredit.  They have called for the amendment of the tax credit in amanner that would eliminate or reduce its benefits for pulp and papercompanies.  In response, other members of Congress and interested partieshave voiced their support for maintaining the tax credit and its availabilityto all taxpayers, including pulp and paper companies.  We do not knowwhether the U.S. government will amend the tax credit to eliminate or reduceits benefits for pulp and paper companies, but there is the possibility thatsuch action may be taken.  Any such amendment of the tax credit couldhave a material adverse effect on our financial condition and results ofoperations.

 

A three year unioncontract, which represents approximately 600 employees in South Carolina,expired on June 30, 2009. The Company is in negotiations with the unionand there have been no slow-downs or work stoppages since the contractexpired. Although the ultimate outcome of negotiations cannot be predicted withcertainty, the Company fully expects to come to an agreement with the union anddoes not expect any future slow-downs or work stoppages.

 

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

 

None.

 

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

 

None.

 

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

 

None.

 

**Item 5. — OTHER INFORMATION**

 

None.

 

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**PART II. — OTHER INFORMATION**

 

**Item 6. — EXHIBITS**

 

The following Exhibitsare filed as part of this report.

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                        |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                   |
| 3.3              |       | Amended and Restated  By-Laws. (1)                                                                                                                                                                     |
|             |       |                                                                                                                                                                                                   |
| 31.1             |       | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) under the Securities  Exchange Act of 1934, as Adopted Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                                                                                   |
| 31.2             |       | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a) under the Securities  Exchange Act of 1934, as Adopted Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                                                                                   |
| 32.1             |       | Certification of Chief  Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                         |
|             |       |                                                                                                                                                                                                   |
| 32.2             |       | Certification of Chief  Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                         |

 

 

| (1) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K filed on October 5,  2009 |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------|

 

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**SIGNATURE**

 

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

 
|                  | KAPSTONE PAPER AND  PACKAGING CORPORATION   |
|-----------------------|---------------------------------------------|
|                  |                                        |
|                  |                                        |
| November 4, 2009 | By:                                         | /s/ Andrea K. Tarbox |
|                  | Andrea K. Tarbox                            |
|                  | Vice President and  Chief Financial Officer |

 

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